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  • pg 1
									Evaluating potential for
incentive based policy

   Jeff Connor, CSIRO Adelaide
      Click to edit Master subtitle style
What are policy instruments?                           www.csiro.au

  Typical environmental economics textbook typology:
   Not (primarily) incentive based
      Output or performance standards
      Input, practice or process standards
      Information, education, morale suasion
   Incentive based
      Price based
         • Environmental charges
         • Incentive payments (& tendering)
      Quantity based
         • Tradeable permits
         • Environmental offsets
      Market barrier elimination
The promise of incentive based policy (IBP)                www.csiro.au

  Early economic theory (e.g. Baumol and Oates, 1975) found
    potential for cost savings from MBI like tax and cap and
    trade under “first best” market conditions

  Two main reasons:
   Increased flexibility with outcome based policy relative to
    “technology” standards
   Opportunity to reallocate mitigation effort from high to low
    cost mitigation sources relative to uniform standards

  Experience with MBI policy for point source somewhat
    confirmed theory (e.g. US SO2 trading)
The challenge of designing incentive based policy for
diffuse source emissions (where simple economics
 In 37 US point source – diffuse source credit trading programs only 6
  recorded trades (Kuch, 2003)
 In some cases where trade has occurred mitigation plus transactions exceed
  point source mitigation costs without trade (Fang and Easter, 2003)

Key challenges
 Focussing on performance with flexibility in compliance when actual
  outcome monitoring is technically infeasible or very costly
 High transactions cost on for agencies of administration, auditing, monitoring
  performance with many small disperse sources
 Complex information processing requirement for program participants on the
  supply side of a market for “environmental services” to can appreciation for
  potential profitability of MBI policy participation, and to participate
What is real world environmental policy?                                 www.csiro.au

  Policy = instrument mix
     Standards                  and/or
     Information                  “
     Environmental charges        “
     Tendering                    “
     Cap and Trade                “
     Offsets                      “
  + bundle of design features:
   Basis (emissions, inputs, outputs)
   Timing (banking, borrowing, on implementation, on outcome)
   Targeting, Differentiating (all sources, most significant sources,
    varying charges, permit requirement etc. by source)
   Transactions requirements (investigation, information gathering
    requirements of agencies & participants)
A framework for evaluating potential for
new policy (to improve efficiency)                                  www.csiro.au

  Goal - Moving from standard environmental economics (ceteris paribus)
   Simplify real world to perfect market conditions, recommend Pareto
    efficient single instrument
  To not ceteris paribus - consider all challenges to implementing policy and
    realising efficiency gain)
   Evaluate how biophysical, technical, institutional, and
    economic context determines
      Feasibility - What contexts make some policy infeasible
      Efficiency - What contexts make some policies likely to be inefficient
   Evaluate how policy can be crafted as a mix of instrument
    types with design features to overcome feasibility and
    efficiency impediments
Policy Option Screening Logic                                                                                         www.csiro.au

Institutional feasibility:
                                                 in Short Term                                in Long Term

                                                                                              Identify institutional changes that
                                                 Identify MBI approaches that are
Identify presence of institutional                                                                  could make additional MBI
                                                      feasible given current             
      prerequisites to various MBI types                                                            options feasible in the longer
                                                       institutional settings

Technical feasibility:
                                                 in Short term                                in Long Term

                                                                                              Identify technical monitoring and
Presence of biophysical, technical
                                                 Identify MBI approaches that are                   modelling capacity that could be
     context factors potentially
                                                      feasible given current technical            developed to make additional
     influencing technical feasibility of
                                                       monitoring                                   MBI approaches feasible in the
     MBI approaches
                                                                                                    longer run

Efficiency screening:

                                                 Step 1                                       Step 2

                                                 Identify potential efficiency
                                                                                              Identify design features that could be
Presence of biophysical, social, technical             impediments to MBI’s based on
                                                                                                    included in MBI’s with potential
     context factors potentially                      context research and               
                                                                                                    to overcome identified
     influencing MBI efficiency                        experience/theory relating
                                                                                                    efficiency impediments
                                                       context to inefficiency
Institutional feasibility                                                                           www.csiro.au

                                                                                              Tradeable permits
                                                                                              & offsets possible
                                          Do standards define a cap on
                                          individually permissible
                                    Yes   quantity of discharge or input
Do standards or regulations
exist limiting actions with                                                        No         Offsets possible
adverse environmental impact?
                                                                  Neither tradeable permits
                                                                  nor offsets possible
Are those who create adverse        Yes
environmental impact charged
or is there willingness to charge                                 Environmental charges
them?                                                             possible

                                                                  Incentive payments &
Are taxpayers charged for           Yes
                                                                  tendering possible
provision of environmental
goods or is there willingness to
charge them?
                                    No                            Price-based instrument
                                                                  not possible
Monitoring feasibility   www.csiro.au
Evaluating efficiency potential                               www.csiro.au

  All IBP involves some form of market with demand
     and supply:
   Auctions –
      agencies demand for environmental action
      Participants supply environmental action
   Cap and Trade
      Participants as demanders and suppliers of emissions
  Efficiency impediments – factors that shift demand or
     supply curves, limiting potential for transactions,
     trade gains
To identify impediments to MBI efficiency
comprehensively we began lit.                           www.csiro.au

  Theoretical (comparative static analysis) investigations in
   near perfect market conditions (e.g. Baumol and Oates, 1975;
   Dale, 1968; Montgomery, 1972);
  Theoretical investigations in “second best” setting (with
   asymmetric information, where proxies rather actual
   emissions are measurable, outcomes are uncertain ect.) (e.g.
   Griffin and Bromely, 1982; Segerson, 1988; Shortle and Dunn,
  Adoption literature (Rogers, Pannell et al 2004);
  Social context literature (Ostrom)
  Modelling studies focussed on diffuse source water quality
   issues (e.g. House and Hefland, 1995), and
  Qualitatively of quantitatively evaluations of MBI experience
   diffuse source issues (e.g. Feng and Easter, 2003; Norris,
   Brown and Batie, 2002; Randall, 2003; Schray, 2003) or point
   source issues (Stavins, 2001, Harrington et al, 2004).
lit identifying impediment we can be sorted by
considering failure of efficiency conditions                                      www.csiro.au

Condition required for markets to function      Impediments to efficient diffuse source
“perfectly efficiently” (Marshall, 1890)        pollution MBI that are a failure of this
The complete set of markets condition - for     1. Lack of property rights for
all potential transactions and contingencies,   externalities.
fully specified and enforced property rights    2. High costs of establishing /
including for externalities or public goods.    maintaining property rights
The price-taker condition – sufficient          3. “Thin markets” – few potential buyers
numbers of buyers and sellers so that no-one    and/or sellers - limited potential for
influences terms of transactions.               trade - rent capture possibilities
The complete information condition - all        4. Significant information cost and risks
potential market participants have complete     of costly learning errors on supply side.
and costless capacity to understand             5. Imperfect and/or costly information
consequences of all decisions they can make.    requirements on demand side
The rationality condition - market              6. capital /cashflow constraints
participants act competitively to maximise      7. risk aversion
utility and profits                             8. non-market/extra market preferences
Findings relating context to efficiency
impediment significance                                                              www.csiro.au

Context factors                                       Impediments

Limited geographic area, small numbers                3. “Thin markets” – few potential buyers
Temporally correlated demand supply                   and/or sellers - limited potential for
determinants (e.g. weather, river flows)              trade - rent capture possibilities

Complex abatement processes, complex info             4. Significant information cost and risks
requirements to find optimal strategies,              of costly learning errors on supply side.
Complex environmental processes, expensive            5. Costly information requirements on
monitoring                                            demand side
Little variation in biophysical factors determining   6. Small variation across sources in
environmental outcomes of production                  externality abatement cost
Capital intensive abatement, small sources,      7. capital /cashflow constraints
Complex abatement processes, instruments with
complex info requirements, limited mngt capacity 8. risk aversion
Small cohesive communities, local common pool
externalities, new technologies for abatement    9. non-market/extra market preferences
Designs to overcome impediments                                        www.csiro.au

Impediment / context                        MBI design solutions
Property rights                             Develop legislation, Develop
Monitoring                                  environmental
Thin markets Geographically limit trade    Expand market area
area,                                      Banking/borrowing, seasonally adjust
Temporally correlated excess supply/demand credits
Info cost supply Small sources > few        Instruments with info requirements
strategic environmental mngt resources,     on demand side (e.g. auction),
complex abatement options, complex info     collective agreements & other
requirements “optimal” strategy discovery   designs with public info revelation
Info cost demand Complex environmental      Modelled impact related to
processes, expensive monitoring             observable proxy as policy basis
Capital constraints                         Finance arrangements
Risk aversion                               Info provision policy,
Non-market preferences                      Collective agreement, Cooperation
                                            payments or penalties
Case study – NZ freshwater lake nitrate
pollution                                                    www.csiro.au

   Nitrogen in grazing stock excreta leaching to
    groundwater is cause of algal bloom and clarity
    loss in Taupo and Rotorua lakes
   Best estimate - 20% reduction in nitrate load required to
    ensure against further decline in visibility in Lake Taupo
   Conceptually, such reductions achievable with uniformly
    applied specific practice requirements
   efficiency policies should: a) involve performance based
    goals, b) allow flexibility in practices to reach goals, and c)
    relate incentives to environmental performance.
   Possibilities:
Conceptually possible MBI approaches                               www.csiro.au

   A charge or payment on performance (k.g. of nitrate load) or
    proxy (head of livestock) & differentiate on observed site
    characteristics (soil, distance to lake)
   Tendering incentive payments prioritised based on estimated
    cost effectiveness
   Offset - preclude more livestock grazing intensification
    without compensating reductions to guarantee a “net” nitrate
    load reduction.
   Tradeable permit approach - cap nitrate load – allow meeting
    cap by reducing loading, using their permitted amount or
    buying permits.
What is institutionally feasible?                           www.csiro.au

   Limited (short run) potential for Quantity based
    instruments –RMA requires no consents for the use of
    land, particularly in an agricultural context
   While limits can be defined in local plans, entitlements
    to continue land uses at current intensity and type
    (Section 10 and 20A of the RMA) create uncertainty
   In the longer run - New standards can be introduced
    under Section 43 of the RMA, and 2005 RMA
    amendments allow credit trade, offsets
   Charges are institutionally possible but it may be difficult
    to charge at rates sufficient to reduce nitrates enough
What is technically feasible?                            www.csiro.au

   Direct monitoring of emission and impact is not
   Need for auditable performance proxy (e.g.
    stocking rate) & way to relate this to performance
    (e.g. differentiated impact per head based on
    proximity, soil type, timing of grazing ect.)
   Overseer model a potential basis
Potential efficiency impediments and design
solutions identified:                  www.csiro.au

1. Administration costs: many small diffuse sources, means the
  administrative cost of addressing all sources likely high.
  Solutions Targeting the most significant sources
 2. Transaction costs of participation: particularly for
  tradeable credit approaches Solution – complementary
  information policy to help landholder understand feasibility and
  cost of impact reduction and trading options
 3. Environmental monitoring and modelling: a nitrogen
  balance auditing system is as basis for a farm level tradable
  nitrogen credit or charge system is technically feasible but
  could introduce cost of agency and participant side (Dwyer,
Impediments and solutions                               www.csiro.au

   4. Variation in cost of abatement: ? further biophysical
    evaluation would be required to assess potential
    differences in cost effectiveness across sources.
   5. Market size: the relatively small geographic area of
    the watershed suggests that there may be potential for
    thin markets for tradeable permits or auction style
    payment policy. But not charges
   6. Risk of higher than expected environmental
    damage: ?
   7. Segments: possible (likely?) that a proportion of the
    population may not be particularly responsive to
    incentives for reasons such as credit/time preferences,
    social attitudes and risk preferences. Solutions -
    complementary information, or finance policies
General conclusions from context determines
impediments, impediments determine design

   Multiple significant impediments likely for most diffuse
    source environmental issues
   The right solution is typically multiple instruments, policy as
    a “bundle” of design attributes tailored to address relevant
   Different solutions for different “market segment” often best
   Tradeoffs likely in design choices between demand side
    cost saving benefits of targeting, differentiation, and supply
    side information costs of complex information requirements
   Cooperative rather than competitive solutions make
    efficiency sense in some contexts

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