Definition

An environmental policy, on an economic analysis of law point of view, is an instrument to correct malfunctions and subsequent inefficiencies that originate from the presence of market failures: the environment appears as a “public good” that may not be appropriated by anyone and has no market price; the damage to the environment is a case of “externality,” in that it is, fully or partly, a social cost that is not internalized into the accounts of the parties causing it (Cropper and Oates 1992).

Introduction

Different policies can be implemented to reach a given set of environmental protection objectives. But nearly all environmental policies consist of two components: the identification of an overall goal (such as a certain level of air quality or an upper limit on emission rates) and the choice of instruments to achieve that goal. In practice, these two components are often linked within the political process, because both the selection of a goal and the mechanism for achieving that goal have important political implications.

“But looking at this problem from a law and economics perspective, we can move from the theoretical definition of the efficiency of different instruments to their practical, and so direct, potential to achieve concrete objectives. In particular, three objectives emerge as relevant in judging the practical efficiency of environmental policies: the first is paying accident compensation to the victims; the second is prevention, in the sense of providing incentives for firms to improve safety standards; and the third is connected with technological change in the sense of encouraging firms to adopt lower-risk technologies” (Porrini 2005, pp. 350, 351).

Hereafter, the choice between environmental policies is considered in terms of ex ante versus ex post interventions on the behavior of (potential) injurers that (can) cause an environmental accident with a consequent environmental damage. Moreover, market-based policies can be implemented as an indirect form of incentive for correct behavior. The two market-based policies, taxes and tradable permits system, are compared on the basis of the difference between price and quantity instruments. And finally, the real situation of the presence of an environmental policy mix is considered as a research challenging topic.

Ex Ante Command-and-Control Policy

Generally, an ex ante policy focuses on the potential injurer’s activity from which the damage originates, with effects that precede the occurrence of the same. In the environmental sector, in particular, the standard-setting instrument is most common and consists in the enforcement, by an agency, of a given prevention level in any way that may be quantitatively defined. Practically, this ex ante policy is founded on a centralized structure in charge of setting standards and then ensuring their compliance, according to the so-called classical “command-and-control” process.

As to the US experience with ex ante policy, the activity of the EPA (Environmental Protection Agency) provides a clear example of policy of this kind implemented by an independent environmental authority. This agency performs its tasks through the enforcement of polluting emission thresholds and the performance of inspections and, possibly, of actions brought to the federal courts.

The choice to develop this ex ante policy provides the advantage of centralized agencies to assure a cost-effective calculation on the basis of the expected damage and of the marginal cost of the different technical preventive instruments. So, following the traditional economic analysis of law approach, well-defined standards generate the correct incentive for the firm to act with caution and take the best production and prevention decisions (Calabresi 1970).

Moreover, in its application, the centralized search facilities, the continual oversight of problems, and a range of regulatory tools make this kind of policy capable of systematically assessing environmental risks and implementing a comprehensive set of instruments. But, on the other hand, as disadvantages, the agencies may not be very flexible in adapting to changing conditions, and a centralized command structure, relying on expert advice, may be subject to political pressure as well as to collusion and capture by the regulated firms.

Summarizing, the choice to implement an ex ante command-and-control kind of policy responds to the need of “uniformity versus flexibility.” “To be efficient, such regulations, require information on alternative techniques and a balancing between the profit to the industry and the environmental impacts of various production techniques and processes. Specific production standards may, therefore, rapidly become obsolete” (Faure and Skogh 2003, p. 198).

Ex Post Liability Policy

The most common ex post policy consists in a liability system that provides for a legal authority to identify a party responsible for the damage caused by an environmental accident.

Again, the experience in USA can be considered as an example given that the problem of environmental liability in that country has emerged more than 30 years ago. In fact, in 1980 the Congress issued the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) with the main purpose to bring quick relief and remedy action after an accident, to cope with the “decontamination” of polluted sites, and to recover the cleanup and compensation costs from the liable parties.

The ex post policy is based on the system of liability assignment to the polluting company according to the so-called polluter pays principle. Such principle has been defined as “economic” in that it provides for the economic option of charging the cost of the environmental damage to a specific party that is liable for the accident, rather than generally to the society.

A system of liability satisfies the need to compensate affected parties for physical and economic damage originated from a real event loss and to stimulate preventive measures against future accident.

On an economic analysis of law point of view, in a world of perfect (complete) information, this ex post policy is an efficient method to solve the problem of internalizing the economic effects of environmental accident. In fact, the firms face the proper incentive to take the optimal level of precaution, and the individuals, harmed by pollution, receive the proper compensation, possibly through an insurance provider.

But in practice, the assignment of individual responsibility shows relevant problems that we can summarize in:

  1. (i)

    a specific polluter could in many cases be difficult to identify because some consequences (i.e., a disease or a reduction in health) may be attributed to a number of different factors besides the pollution and, even if a link between a pollutant and the consequences may be established, it could turn out to be difficult to determine the firm responsible for the damage;

  2. (ii)

    compulsory insurance contracts that the firms are induced or forced to buy could be incomplete or insufficient because of the difficulty to determine the probability of accident and the distribution of the loss caused by environmental damage, hence making the pricing of the contracts complex;

  3. (iii)

    the polluter can in some cases be insolvent and unable to pay for cleanup or compensation costs because of the (small) size of the firms operating in dangerous activities in comparison with the (high) costs and penalties of environmental damage.

A liability system can be applied using either a negligence or a strict liability regime. The law and economic literature compares the two regimes considering how they provide a potential polluter with incentives to take adequate preventive measures (Cooter and Ulen 1988). And, generally, strict liability is preferred in the presence of informational issues (Epstein 1973). This could be the case of environmental accidents, where it is particularly difficult to determine the standard to assign liability on the basis of negligence: in reality, pollution has many sources and (potentially) many victims, and it is a hard task to prescribe efficient pollution standards based on a calculus of the abatement cost and the external harm of every source of pollution.

Ex Ante Versus Ex Post Policies

The traditional economic analysis of law approach compares ex ante and ex post policies on the basis of their role in achieving the efficiency goal to stimulate the socially optimal level of preventive care and in so doing controlling the environmental risk.

The authorities responsible for meeting these objectives are the regulatory agencies, which fix standards and check their compliance, and the courts, which assign liability. “Statutory regulation, unlike tort law, uses agency officials to decide individual cases instead of judges and juries; resolves some generic issues in rulemakings not linked to individual cases, uses nonjudicialized procedures to evaluate technocratic information, affects behavior ex ante without waiting for harm to occur, and minimizes the inconsistent and unequal coverage arising from individual adjudication. In short, the differences involve who decides, at what time, with what information, under what procedures, and with what scope” (Rose-Ackerman 1991).

A seminal contribution by Shavell (1984) presents four determinants on the basis of which comparing the two different policy systems.

The first determinant is the difference in information between private parties and the regulatory authority. It clearly could happen that the nature of the activities carried out by the firms is such that the private parties have better knowledge about the cost of preventive care and of the risks involved. In such a case, a liability system is more efficient because it makes the private parties the residual claimants of the control of risks. But it may also happen that the regulator has better knowledge because of the possibility of centralizing information and decisions, in particular when knowledge of risks requires special replicable and reusable expertise. In such a case, direct regulation is likely to be more efficient.

A second determinant is the limited capacity of private parties to pay the full costs of an accident, either because of limited liability or of insufficient assets; this is the case called “judgment proof” (Shavell 1986). An ex post liability policy allows to reach a social optimal solution, only if the private parties can finally cover the damage in the dimension decided by the court. In all the cases in which the damage is superior to the resources of the private parties, a liability system does not provide private parties with proper incentives for preventive care. So the greater the probability or the severity of an accident are and the smaller the assets of the firm are (relative to the potential damages), then the greater the efficiency of ex ante regulation.

The third determinant is the probability with which the responsible parties would face a legal suit for harm caused. This problem is particularly present in environmental risks: in many cases the victims are widely dispersed with none of them motivated to initiate a legal action, harm may appear only after a long delay, and specifically responsible polluters may be difficult to identify. In the comparison with ex ante policy, ex post liability is more uncertain and so less efficient.

The fourth determinant is connected with the general level of administrative expenses incurred by the private parties and the public. The cost of a liability system includes the cost of legal procedure and the public spending for maintaining legal institutions. The cost of an ex ante policy includes the private costs of compliance and the public spending for maintaining the regulatory agencies. In this case the advantage of the liability system is that legal costs are sustained only if a suit occurs, and, if the system works well, stimulating the efficient level of prevention, the number of suits will decrease, and therefore the costs are becoming lower in time. On the other hand, under an ex ante policy, the administrative costs are sustained whether or not the accident occurs because the process of regulation is costly by itself, and the regulator needs in any case to collect continually information about the parties, their activities, and the risks.

Summarizing, ex ante policy is better when harm is large, is spread among many victims or, takes a long time to show up, when accidents are not very rare events, and when standards or requirements are easy to find and control.

In another contribution, Kolstad et al. (1990) support the hypothesis of the complementarity between ex ante and ex post policies because, even if the economic literature has mainly studied separately the two systems, characterizing each of them by different inefficiencies, the phenomenon of joint use of ex ante and ex post systems is widespread.

Among the determinants presented by Shavell (1984) and above analyzed on the basis of which comparing the two different regulatory systems, the authors concentrate on the fact that potential injurer is in many circumstances uncertain about whether a court will hold him liable in the event of accident and subsequent suit. But an ex ante regulatory system can correct this inefficiency, at least in part.

The development in the contributions within the economic analysis of law literature shows an increasing attention to the relationship between ex ante and ex post policies characterized by imperfections in their implementation, as complements or substitutes, both in providing the incentives to the optimal level of preventive care. So the debate about policy choice mainly focuses on the achievement of a given target in terms of efficiency in a framework where imperfections are considered as reasons to prefer one policy to the other.

Market-Based Policies: Taxes and Tradable Permits

Within the category of market-based instruments, there are policies that encourage behavior through market signals rather than through explicit directives to firms. So, in practice, rather than imposing uniform emission standards, market-based instruments introduce a cost for the firm in the form of a tax or of the price for a permit, leaving then the firms to deal with the problem to control and limit the pollution level on the base of their marginal costs.

So stressing an efficiency kind of argument, in the case of the implementation of market-based instruments, each firm determines until which level it is more convenient to reduce pollution given the possibility to pay a tax or to buy a polluting permit.

The two most important features of market-based instruments with regard to traditional command-and-control approach are cost-effectiveness and dynamic incentives for technology innovation and diffusion. On one hand, command-and-control policies, to set standards, require that policy makers obtain detailed information about the compliance costs, each firm faces the problem that such information may be not available to government; by contrast, market-based instruments provide for a cost-effective allocation of the environment control burden without the need for this information.

As market-based policies, the most common are tradable permits system and environmental taxes.

A system of tradable permits is based on the allocation of a number of permits to the firms, each of them allowing the emission of a given amount of a pollutant; if the facility is able to reduce its emissions (preferably through the use of less polluting technologies), it can sell its remaining emission permits to other firms that are unable to meet their quotas.

It is clear that the advantage of this policy is the possibility to fix the level of pollution control and in the case of technological change, without additional government intervention, to freeze this level.

On the other hand, a policy based on taxation attributes a price on polluting activities that will be incorporated by the firm in the price of the products. In this case the incentive for the adoption of abatement techniques relies on the market mechanism because if a firm does not apply the optimal techniques, it will pay more taxes and sell its products at a higher price than other firms with negative effects in terms of competition.

Market-based instruments, as regulatory devices that shape behavior through market signals rather than explicit instructions on pollution control levels or methods, are often described as “harnessing market forces” because they can encourage firms and individuals to undertake actions that serve both their own financial interest and public policy goals (Stavins 1998).

Environmental taxes and tradable permits system are both market-based policy instruments, but their implementation is different: taxes fix the marginal cost for carbon emissions and allow quantities emitted to adjust, whereas tradable permits fix the total amount of carbon emissions and allow price level to change according to market forces. Because of these differences, the former are defined as “price” instruments for the correlated effect to increase the price of certain goods and services, thereby decreasing the quantity demanded, while tradable permits are defined as “quantity” instruments for the feature to directly fix the quantity trough the number of permits.

The literature on environmental policy choice describes alternative instrument taxes as price control instruments and tradable permits as quantity control ones, and many contributions compare their relative performance in terms of efficiency under uncertainty.

The starting seminal article of Weitzman (1974) analyzed the optimal instrument choice under a static partial equilibrium framework, consisting of a reduced form specification of costs and benefits from abatement. In the setup, an agency issues either a single price order (fixed price) or a single quantity order (fixed quantity), and these fixed policies result in different expected social welfare outcomes under uncertainty. Specifically, Weitzman shows that, with imperfect information about the abatement costs, the relative slopes of the marginal benefit (damage) function and the marginal cost function determine whether one instrument is preferred to another. If the expected marginal benefit function from reducing emissions is flatter than the marginal cost of abatement, then a price control is preferred. If, however, the marginal benefit function is steeper, then a quantity control is preferred.

In the law and economic literature, Kaplow and Shavell (2002) deal with the standard context of a single firm producing externality; moreover, they consider the case of nonlinear corrective tax, and multiple firms jointly create an externality, demonstrating the superiority of taxes to permits.

Despite the results of the majority of contributions that a taxation system is preferable to tradable permits system in terms of economic efficiency, this policy obviously faces political opposition. On the supply side of the market, companies oppose taxes, as a cost that implies a revenue transfer to the government and also as a factor that can imply negative effect on competition in an international context; on the demand side, consumers are typically not happy and pay at the end a higher price on the products, and environmental groups oppose taxes because, unlike tradable permits system, these fail to guarantee a particular reduction in the emission level.

Conclusive Remarks About the Mix of Policy Instruments

We have analyzed the different policies as alternative instruments that can be implemented to reach given environmental objectives considering, on a law and economic perspective, their different degree of efficiency.

But environmental policy instruments usually operate as part of a “mix” of instruments, and in practice several different policies are applied to address a given environmental problem as broadly as possible with the target to cover all sources of pollution in every relevant sector of the economy.

The efficiency of these mixes can be enhanced by adhering to many of the same principles that guide the use of individual instruments and by explicitly considering the way in which different instruments interact.

For example, one possible mix could be tradable permits together with tax system.

On an efficiency point of view, while a policy based on “quantity,” such as a tradable permits system, can provide a degree of certainty as to the environmental outcome, the compliance costs that will eventually be faced by polluters are likely to be quite uncertain under these systems. But this uncertainty can be reduced by introducing a tax system as a “safety valve” in the permit price. In effect, this allows polluters to emit whatever amount they like, in return for paying a fixed price, the “tax,” for any emissions for which they do not hold an allowance, should the permit price exceed a predefined level.

This mix between environmental policies presents some economic advantages that are key motivating forces to try to develop research on this topic.

First of all, policy mix allows for exchanges across different systems and thereby facilitates cost-effectiveness, that is, achievement of the lowest-cost emission reductions across the set of linked systems, minimizing the overall cost of meeting the collective cap.

Mixed systems may also provide regulatory stability as an advantage for affected firms, in the sense that it may be more difficult to introduce changes in an emission-reduction scheme when those changes require some sort of coordination with other policies (Johnstone 2003).

There are also administrative benefits from the mix that come from sharing knowledge about the design and operation of different policies to find the best practice, but also from the reduction of administrative costs through the sharing of such costs and the avoidance of duplicative services.

Despite the just mentioned economic advantages, we cannot find in the law and economic literature until now so many researches that develop theoretical models based on the mixed use of different environmental policy instruments that are still considered mainly as alternative.