Not just incentives

Good regulatory mechanisms are also necessary to reduce industrial emissions

By Tarun Bajaj
Last Updated: Sunday 07 June 2015

Not just incentives

-- Command regulations have been the most preferred means to prevent industries from polluting the environment. These operate through a set of coercive legal forms, involving a complex and detailed set of rules and regulations. In recent times, such regulations have attracted criticism of being an unfair mechanism. This has focussed attention of academics and practitioners on devising more flexible and less interventionist schemes such as Trade Emission Permits (teps).

In the environmental context, a tep regime generally operates by allocating permits to industrial firms, free or at a price. These allow firms to cause pollution up to a certain limit. A firm that is able to exceed its targets of pollution control can trade its surplus permits in the market. Generally, the entitlement of permits decreases every year, which means that the total pollution is also targeted to be reduced.

In the traditional mode of command regulation, firms exceeding their pollution targets would have no advantage. Non-compliance will lead to harsh consequences. Further, under the command and control regime, emission standards are often set at levels that poor firms can afford. teps, in contrast, create incentives to reduce pollution to much lower limits.

But many say teps places resourceful entities at an advantage by giving them opportunities of buying their way out of pollution reduction requirements. This may not be necessarily true. In economic terms, any entity will act to maximise its profits. Thus, a resourceful firm may actually not buy its way out if it can find a less expensive method of compliance. It can even indulge in over-compliance and sell its permits in the market.

Another criticism of teps is that it provides resourceful entities with opportunities to capture all permits available in the market. This can, however, be prevented by an effective monitoring mechanism. This means one would have to supplement economic alternatives with elements of command regulation. The market alone will not be able to take care of the pollution problem and the regulator will have to intervene directly.

Finally, some criticise teps for their unfair geographical distribution of harm. Such a regime might be able to meet global pollution targets but it might end up creating a situation where some regions are more polluted than others. This can be prevented by mandating a minimum reduction of pollution by each firm. Again, this requires command regulation to supplement economic alternatives.

Another pre-condition for the successful implementation of the tep scheme is that the object being controlled must be divisible in a non-intrusive manner. For example, companies cannot trade in an obligation to provide clean air, but can trade a permit to emit specific amounts of gases. This has to be monitored or else resourceful firms can escape compliance.

Another important condition is that price of permits should reflect its economic value and that trading costs in them should be minimal. Else, such costs enter into the total compliance costs of the firm, taking away the inherent advantage of the scheme.

All this suggests that teps may not be the best alternative in all circumstances. Further, they take away the regulator's flexibility. Earlier, the regulator could have taken a lenient view of non-compliance by a small firm or compassionately considered the exigencies of a large firm. But now any such flexibility would be deemed unfair.

Economic incentives like teps demonstrate their effectiveness in a number of ways but to say that they can fully replace the traditional methods of command regulation is not appropriate. Emission permits should not be interpreted narrowly as a mechanism that requires total abolition of public control. In fact, combining traditional regulation with alternatives, such as teps, can provide optimal solutions to environmental pollution problems.

Tarun Bajaj is with the Indian Administrative Service

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