Environmental pollution control under alternative incentive structures

Ramu Govindasamy

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: The present study examines environmental pollution control under alternative incentive structures with an emphasis on the effectiveness and practicality of alternative policy tools. The focus is on three instruments for controlling pollution: (1) Environmental Bonds; (2) Budget Balancing Incentive Mechanisms; and (3) Environmental Rank Order Tournaments;Environmental bonds typically require more information for implementation than either budget balancing incentive mechanisms or rank order tournaments. However, there is a trade-off between the cost savings from acquiring information and the potential costs from committing an error in assigning pollution control responsibility;Paper I examines the limits to environmental bonds. It identifies three major limitations to environmental bonds: (1) government moral hazard; (2) liquidity constraints; and (3) legal restrictions. Liquidity constraints are a major factor in reducing the attractiveness of applying environmental bonds to the agricultural sector;An additional limitation associated with environmental bonds is that it requires monitoring of individual firms. Xepapadeas (1991) introduced a budget balancing incentive scheme for risk neutral firms, combining subsidies and a random penalty. Paper II shows that, contrary to Xepapadeas, risk aversion is a necessary condition to attain compliance. Using Holmstrom (1982) and Rasmusen (1987), the paper proves that the compliance can be achieved only if the firms are sufficiently risk averse. It also shows that the compliance with the social objectives can be improved by shifting the probability of detection and the fine from a high risk averse firm to a low risk averse firm. The paper also shows that the increase in number of firms has a negative effect on compliance;The problem with the random penalty mechanism is that the firm which is in compliance with optimal pollution abatement objectives, set by the regulator, may still get penalized when the ambient concentration exceeds the optimal level. Rank order tournament is an alternative budget balancing incentive mechanism that induces optimal pollution control effort through tournament among the firms and provides solutions to both complete monitoring and random penalization problems. It is shown that in case of risk neutral firms, rank order tournament can be designed to yield the same efficiency conditions as that of Pigouvian tax when the relation between effort and abatement is nonlinear.

Date: 1993-01-01
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