Australasian Journal of Economics Education
Volume 10, Number 1, 2013, pp.32-38
ANALYSING EMISSION COMPLIANCE IN THE
TEXTBOOK MODEL*
Gerald Visgilio
Connecticut College
ABSTRACT
The model used in most undergraduate environmental economics textbooks to
analyze pollution control policies shows an emission source reducing its waste in
a least cost manner, operating in full compliance with the law. In this paper, the
conventional textbook model is extended by analyzing how a polluting facility,
operating under a cap-and-trade (CAT) program, responds to the imposition of an
excess emission penalty. Specifically, the discussion is framed in terms of the
following questions: Will a source discharge in excess of its permits and pay a
fine for its excess emissions? Will it abate its excess emissions? Will it buy
additional permits to cover these emissions? Hopefully, this paper will encourage a
productive interchange between teachers and students about the level of emission
compliance by a polluting facility.
Keywords: cap-and-trade, command-and-control, expected net cost, excess emission
penalty
JEL classifications: A20, Q50, Q52, Q58
1. INTRODUCTION
Title IV of the Clean Air Act Amendments of 1990 in the United States,
less formally called the Acid Rain Program (ARP), was a major policy
initiative for regulating sulfur dioxide (SO2) emissions. Title IV, which
uses a cap-and-trade (CAT) approach for SO2, has been referred to as
the “grand policy experiment” (Stavins 1998, p. 69) and a “living
*
Correspondence: Gerald Visgilio, Department of Economics, Connecticut College, Box
5571, 270 Mohegan Ave, New London, CT 06320, USA, Email: [email protected].
Thanks to two anonymous referees for comments and suggestions.
ISSN 1448-448X © 2013 Australasian Journal of Economics Education
Emission Compliance in the Textbook Model 33
legend” (Burtraw & Palmer 2004, p. 41) with considerable scholarly
research showing it to be a cost-effective approach for achieving the
annual SO2 statutory cap of 8.95 million tons.1 Under Title IV, an
individual ARP unit is free to select its least cost abatement strategy,
which may involve placing scrubbers on smoke stacks, switching from
high sulfur to low sulfur coal, blending fuels, and reducing output.
Although Title IV allows the trading and banking of SO2 discharge
permits (referred to as allowances in the law),2 each ARP emitting unit
is legally required to hold one allowance for each ton of SO 2 that it
discharges into the atmosphere, and since the start of the program in
1995, there has been nearly perfect compliance among regulated units.3
Can the model presented in introductory environmental economics
textbooks be used to shed light on the issue of high compliance among
emission sources? In most basic textbooks the discussion of cap-andtrade usually focuses on major efficiency aspects of the policy – cost
effectiveness, the equi-marginal principle, and technological
innovation.4 This analysis shows the typical emission source operating
in a least cost manner by selecting its best pollution control strategy
from an array of activities that may involve output reduction, input
changes, waste treatment, and residual recycling. The individual
source, which also may buy or sell discharge permits at the marketestablished price, holds enough permits to cover its emissions. The
1
Burtraw & Palmer (2004) provide a detailed discussion of Title IV, Harrington &
Morgenstern (2007) give a comparison between economic incentives policies and
command and control (CAC) policies, and Chan et al. (2012) discuss SO2 allowance
trading and its implications for the construction of a climate change policy.
2
Stavins (1998) indicates that by a “statutory provision” of the Clean Air Act
Amendments of 1990, permits (allowances) are not property rights.
3
The reader is directed to EPA Acid Rain Progress Reports for the years from 1995 to
2009. Under the law, each APR emission source, at the end of every calendar year, has a
sixty-day grace period in which to adjust its allowance holdings – to make sure that it
holds a sufficient number of allowances to cover its discharge of SO2 for the preceding
year. When an ARP source neglects to reconcile the number of allowances its holds with
the amount of its emissions, the source must pay a fine of $2,000 (inflation-adjusted to
$3,337 in 2008) per ton of excess SO2 emissions. The fine must be paid to the EPA by
July 1 of the current year for excess emissions that were discharged in the previous year.
In addition, a violating source also must surrender discharge permits to the EPA, from its
current year allowance allocation, equal to its excess emissions.
4
Field & Field (2012), Kahn (2005), Kolstad (2010), and Tietenberg & Lewis (2009)
provide a good economic evaluation of market-based policy instruments.
34 G. Visgilio
issue of non-compliance generally is omitted or given little attention in
the textbook explanation of cap-and-trade.5
The purpose of this paper is to provide an economic analysis of
compliance by discussing how an individual emission source, operating
under a CAT policy, responds to imposition of a penalty for its excess
emissions. My analysis uses the marginal abatement cost (MAC)
diagram that is presented in most introductory environmental
economics textbooks.
Although my analysis draws from the
conventional textbook model, it goes beyond that model by discussing
how a polluting facility will respond to the economic incentive effect
of an excess emissions penalty. Specifically, this paper looks at cost
effective approach decision making by an emission source when faced
with a penalty for emissions in excess of the number of permits that it
holds.6 More specifically, my analysis frames the discussion in terms
of the following important questions: Will an emission source
discharge in excess of its permits and risk paying a fine for its excess
emissions? Will it abate its excess emissions? Will it acquire additional
permits to cover these emissions? By recognizing that CAT policies
may provide emission sources with an efficient incentive for full
compliance, this paper addresses an important and perhaps overlooked
pedagogical issue for undergraduate students in introductory
environmental courses.
2. THE ECONOMICS OF COMPLIANCE
With a CAT policy, a violating firm, facing a penalty for each unit of
its excess emissions, responds by selecting its least cost strategy from
the following options: (1) it continues to emit in excess of the number
of permits it holds; (2) the source eliminates excess emissions by
purchasing permits; or (3) it reduces its waste discharge so that its
emissions just equal its permits. A source, when deciding on its
preferred emission control strategy, considers both the total and
marginal costs of compliance and noncompliance. In reaching a
5
Berck & Hefand (2011) and Downing (1984) provide a detailed discussion of
compliance under command and control. My analysis is different from theirs by
discussing compliance under cap-and-trade and by comparing incentives for compliance
under both CAT and CAC.
6
With respect to enforcement and monitoring, an added “advantage of market-based
instruments is that they may enhance compliance” (Keohane & Olmstead 2007, p.178).
Under CAT, emission sources have a strong incentive to inform the environmental control
agency whenever they purchase additional discharge permits (See Field & Field 2012,
p.260).
Emission Compliance in the Textbook Model 35
decision about whether it should comply with the law, the source will
compare the total cost of compliance with that of noncompliance.
When making its decision at the margin, an individual source compares
the incremental cost of compliance with that of noncompliance.
Since a source may not be caught and punished each time it violates
the law, the offending source may find it cost effective to emit in excess
of the number of permits that it holds. In my analysis, the source’s
decision about compliance or noncompliance is expressed as follows:
E[NC] = E[TP] – LCC
(1)
where E[NC] is the expected net cost, E[TP] is the expected total
penalty for noncompliance, and LCC is the least cost means of
compliance. The source’s decision to comply with the law depends on
whether E[NC] is positive or negative – when E[TP] > LCC, the source
complies and when E[TP] < LCC, it violates. The source’s decision to
comply with the law depends on the severity and the certainty of the
punishment as well as the cost of compliance. In other words, high
expected penalties and/or low compliance costs are likely to induce full
or high compliance.
My graphical illustration of a polluting source, operating under a
marketable permit policy, is shown in Figure 1. In my diagram,
emissions (e) and permits (q) are represented on the upper and lower
horizontal axes respectively. The vertical axis shows the market price
of p per permit and the expected fine of βf per unit of excess emissions,
with β being the probability of getting caught and f the per unit fine.
The MAC curve, in the body of the illustration, is increasing as
abatement increases. As with any CAT program, each emission source
may buy or sell discharge permits and it is required by law to hold
enough permits to cover its aggregate emissions. In the analysis that
follows, Figure 1 is used to discuss two scenarios where a polluting
facility, operating within the framework of a CAT policy, contemplates
whether it should discharge in excess of the number of permits it holds.
In scenario (1), an emission source is holding q1 and thinking about
reducing its emissions from e2 to e1. Here, the source will have excess
emissions of (e2 – e1), and it faces an expected penalty of βf(e2 – e1), or
Area (D+E+F). The source, however, may eliminate its excess
emissions either by purchasing additional permits or by reducing its
emissions. If it purchases (q2 – q1) permits, the source pays a total
36 G. Visgilio
permit cost of p(q2 – q1), or Area (E+F). If, however, it reduces
emissions from e2 to e1, it incurs a total abatement cost of only Area (F).
The emission source, in this situation, will compare its least cost
compliance strategy to the expected fine for noncompliance, and
equation (1) may be rewritten as:
E[NC] = Area (D + E + F) – Area (F)
(2)
Since Area (D+E+F) > Area (F), E[NC] is positive and the source will
reduce its emissions to comply with the law. In short, Figure 1 shows
that a CAT policy will induce an emission source to achieve optimal
abatement at least cost whenever βf exceeds p.
Figure 1: Excess Emissions for an Individual Emission Source
The source also may bring about excess emissions by selling permits
without undertaking an equivalent amount of emission abatement. In
scenario (2), the source is assumed to be operating at q1 and e1. If the
source contemplates selling (q1 – q0) permits, while continuing to
discharge at e1, it will have excess emissions of (e1 – e0). For these
emissions, the expected total penalty or fine is βf(e1 – e0), or Area
(A+B+C). Once again, the source reviews its least cost compliance
strategy – either abating waste at a cost shown by Area (B+C) or not
Emission Compliance in the Textbook Model 37
selling permits with a value of p(q1 – q0), or Area (C). Equation (1) now
may be expressed as:
E[NC] = Area (A+B+C ) – Area (C)
(3)
Since E[NC] > 0, the source complies and does not sell any of its
permits. As in the previous example, Figure (1) again shows that
whenever βf is greater than p, CAT brings about cost effective
compliance.
3. CONCLUDING REMARKS
Will an emission source fully comply with the cap-and-trade policy?
How does the source decide the means by which it complies with
pollution control policy? Under what circumstances will a polluting
facility find it profitable to discharge an amount in excess of the number
of permits that it holds? Hopefully, this paper serves as a platform for
a productive dialogue – perhaps an exchange between teachers and
students in environmental economics courses – about high levels of
compliance among emission sources such as those in the U.S. ARP or
those regulated under other CAT programs.
In this paper, the conventional textbook model was used to
graphically show and explain the economic incentive effects of penalty
per unit of excess emissions for a polluting facility that operates within
the framework of a cap-and-trade program. Specifically, my analysis
provides some insight with respect to the least cost response of an
emission source to the imposition of such a penalty. In this context, the
source compares the cost of compliance with that of noncompliance and
selects its preferred plan of action – it may elect to pay the fine or it
may opt to eliminate its excess emissions, either by purchasing
additional permits or by reducing its discharge of waste. My analysis
also shows that an emission source recognizes both the severity and the
certainty of the punishment when reaching a decision about whether it
is profitable to violate the law. More specifically, the analysis presented
in this paper suggests that, because of the uncertainty associated with
detecting violations, a polluting source will not comply with the law
when the expected penalty is less than its least cost compliance strategy.
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38 G. Visgilio
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