Evaluating potential for incentive based policy

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Evaluating potential for incentive based policy

• Jeff Connor, CSIRO Adelaide
• Jeff.Connor_at_CSIRO.AU

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What are policy instruments?

• 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

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The promise of incentive based policy (IBP)

• 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)

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The challenge of designing incentive based policy
for diffuse source emissions (where simple
economics failed)

• Example
• 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

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What is real world environmental policy?

• 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)

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A framework for evaluating potential for new
policy (to improve efficiency)

• 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)
• Framework
• 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

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Policy Option Screening Logic
Table 3 MBI screening framework overview
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Institutional feasibility
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Monitoring feasibility
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Evaluating efficiency potential

• 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 permits
• Efficiency impediments factors that shift
  demand or supply curves, limiting potential for
  transactions, trade gains

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To identify impediments to MBI efficiency
comprehensively we began lit.

• 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,
  2001).
• 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).

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lit identifying impediment we can be sorted by
considering failure of efficiency conditions
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Findings relating context to efficiency
impediment significance
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Designs to overcome impediments
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Case study NZ freshwater lake nitrate pollution

• 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

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Conceptually possible MBI approaches

• 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.

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What is institutionally feasible?

• 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

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What is technically feasible?

• Direct monitoring of emission and impact is not
  possible
• 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

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Potential efficiency impediments and design
solutions identified

• 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, 2002).

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Impediments and solutions

• 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

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General conclusions from context determines
impediments, impediments determine design thinking

• 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
  impediments
• 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