Short Notes

Incentive-based (IB) policies - Incentive-based policies are regulatory approaches that use
financial instruments to incentivize companies and individuals to reduce their negative
impacts on the environment. There are several types of incentive based policies.
Financial benefits:
Tax incentives: credits or deductions for investments that support the environment.
Grants and subsidies: Financial assistance for eco-friendly projects
Performance-based payments: Provide immediate incentives for achieving environmental
goals.
Penalties for Environmental Damage:
Environmental taxes: Taxes imposed on activities causing pollution. These fines serve as a
direct cost for non-compliance and encourage companies to invest in pollution prevention
measures.
Fines and fees: Businesses that violate environmental standards may face monetary penalties.
Loss of permits: Permits and licenses for industries that don't satisfy environmental
performance guidelines may be canceled. This shows the significance of following
regulations because it not only has immediate costs but also has the potential to shut down
business.
Cap and trade: The control authority can efficiently determine the cost-minimising allocation
without a trial-and-error process. Under this policy, all sources are collectively capped on
emissions, and allowances to emit are either allocated or sold. Each allowance permits a
specific amount of emissions, (usually 1 ton). The control authority issues precisely enough
allowances to meet the desired emissions level, which can be distributed through auction or
free allocation. Regardless of acquisition method, allowances are transferable. Firms
exceeding their allowances may buy from those emitting less. Excess emissions result in
severe monetary sanctions. This system facilitates a cost-effective and market-driven
approach to emission control.

Market-driven tools:
Tradable pollution permits: Tradable permits enable companies to purchase and sell licenses,
creating a market that incentivizes cleaner operations.
Deposit-Refund Systems: These are essentially a consumer incentive system, but businesses
can gain as well by making eco-friendly products and saving money on waste disposal.

For instance, if the government wants to reduce emission levels in the electricity generation,
subsidies on inputs or outputs or both may be provided to the firms to encourage generating
power through cleaner sources like solar or wind power plants. Simultaneously, the
government can impose more taxes or fees on the companies that use fossil fuels to generate
power such as thermal power plants.

Command and control (CAC) approach- According to the command and control approach,
the government sets particular regulations and standards to regulate how production and
consuming activities are carried out. Aimed at controlling the environmental degradation, the
government: (i) enacts rules and regulations, (ii) institutes enforcement authorities at different
levels to implement them and (iii) places a system of fine and penalties for dealing with cases
of violation of the rules and regulations.
The Command and Control (CAC) method involves the government i) enacting
environmental laws to control particular activities, ii) promote socially acceptable behavior,
and iii) ensure compliance by using tools like fines, the police, and courts. CAC requires the
adoption of specific pollution-control systems and sets emission limitations. For instance, the
government actively intervenes to assure standard compliance by compelling firms to
implement specific pollution treatment technologies. On the other hand, emission standards,
legally set allowable pollution levels. When the marginal abatement costs of pollution
treatment are uniform for all regulated companies, CAC is appropriate

Difference between IB and CAC approaches:

Command and control approaches focus on rules and regulations to impose restrictions on
particular behaviors without regard to direct financial gain, whereas incentive-based
approaches employ financial incentives to promote environmentally beneficial behavior.
While command and control techniques can be more inflexible and prescriptive,
incentive-based systems are frequently more adaptable and economical, using market forces
to achieve environmental goals.

Introduction

One of the most difficult choices faced by policymakers regarding environmental laws is
whether it would be beneficial for the environment to begin taxing polluters for their
discharges or will it be more effective to fine them for not meeting certain emissions
standards? Will a regulatory agency find it less costly to enforce a ban or oversee a system of
tradable permits? Which strategy will reduce a pollutant the quickest? Unfortunately, there is
not a single answer which ticks all the boxes. Many factors enter into the decision to favor
either policies that lean more toward incentive based (IB) and toward direct regulation,
commonly referred to as command-and-control (CAC) policy. Underlying determinants
include a country’s governmental and regulatory infrastructure, along with the nature of the
environmental problem itself.

However, in this paper: The net benefits of incentive based regulation: A case study of
environmental standard setting, it shows that economists commonly believed that IB
instruments have an efficiency advantage over CAC instruments, although the case is not
airtight. IB instruments are more cost effective at achieving a given emissions reduction. But
to get from cost effectiveness to efficiency requires additional assumptions, including that the
system is one of perfect competition and that the emissions are not location-specific. A
theoretical counter to this hypothesis is that a CAC instrument can be as efficient if the
emissions standard for each plant is chosen so that the marginal costs of abatement equal the
marginal social costs of pollutant damage. But we must keep in mind while praising the IB
approach that it has overlooked the idea that in most cases environmental, workplace, product
safety standards typically take the form of maximum permissible concentrations of harmful
substances so they typically register the readings below the critical level, CAC policies
generally result in “overcontrol” beyond the standards. So, if the overcontrol is of no value
then CAC policies will indeed be more expensive than the IB approach. On the contrary if
reduced concentrations bring improvement in the environment then CAC approach will be
appreciated. Thus, any additional benefits associated with CAC approach overpowers the cost
effective factor associated in case of IB approach.
The real advantages of IB instruments are only realized over time, because they provide a
continual incentive to reduce emissions, thus promoting new technology, and permit
maximum flexibility in achieving emissions reductions (Winston Harrington and Richard D.
Morgenstern, 2004). The effects of CAC on technology are potentially complex. On the other
hand, the requirement to install a specific technology conceivably discourages research, since
discovering new ways to reduce emissions can lead to more stringent regulations. More
stringent performance standards for new plants have the stated objective of promoting
technology, but they can also have the harmful effect of postponing retirements of older,
dirtier plants and discouraging entry by outside firms.

CAC policies have higher administrative costs (Winston Harrington and Richard D.
Morgenstern, 2004). Administrative costs are determined by the amount of interaction
between the regulator and regulated source. Supporters of this hypothesis note that the
complexity of setting and enforcing specific requirements is higher than implementing
fee-based EI policies. In addition, fees for increased emissions tend to rise gradually, whereas
with CAC, a line separates compliance from violation. The potentially high incremental cost
at the point of violation gives regulated sources an incentive to defend themselves legally
rather than accept sanctions, thus adding to the regulators’ burden.

This paper’s objective is to appreciate the possibility discussed above which has been
recognised by economists (Scott Atkinson & T. H. Tietenberg, 1982) with the help of
empirical evidence.

Framework

Suppose, we have a specific region, say, an airshed, a system of waterways, or an ambient

environment in a large factory in which there are m sources of pollution, each of which is
fixed in location.

We define environmental quality in terms of pollutant concentrations at each of the n receptor

points in the region. Thus, we measure environmental quality by a vector, Q = (q1, q2,....., qn)
whose elements indicate the concentration of the pollutant at each of the receptors.

The dispersion of emissions from the m sources in the region is described by an m x n matrix
of unit diffusion (or transfer) coefficients:

Where dij indicates the increase in pollutant concentration at receptor j from an additional unit
of emission of the pollutant by source i.

If we represent the pattern of waste emissions in the region by the vector, E = (e1, e2,.......,em)
where ei denotes the level of emissions by source i then we can determine the level of
pollution at various receptor points by mapping the vector of emissions through the diffusion
matrix such that, 𝐸𝐷 = 𝑄
Now, we introduce abatement costs into the model. Let Ci(ei) be the abatement cost function
that captures the cost to source i of holding its emission to ei.

Let us assume that some predetermined standard for environmental quality has been set. The
standard takes the form of a maximum permissible level of pollutant concentration at any
receptor point in the region. Suppose, an environmental agency follows a
‘command-and-control’ (CAC) approach that requires all similar sources to adopt the same
control procedures and tighten up the procedures to comply with the standard. Such a control
program would result in a specific vector of emissions from sources, say, Ec. Therefore, by
mapping the vector Ec through the diffusion matrix, we can obtain the vector of pollutant
concentrations, Qc. The agency's particular regulatory program will then determine the vector
of environmental quality, along with the corresponding levels of damage and control costs.

Suppose instead that the environmental agency pursues an IB strategy such that it seeks the
vector of emissions (E1) that can attain the standard at minimum aggregate abatement cost:
∗
𝑀𝑖𝑛 Σ𝐶(𝑒𝑖) 𝑠. 𝑡 𝐸𝐷 ≤ 𝑄

Where Q∗ is the upper bound on allowable pollutant concentrations. This can be done by
using effluent fees or transferable discharge permits. Such a program would achieve the
standard at a lower cost than the CAC program. Thus, for any given Q∗ we are to find levels
of emissions, concentrations, and damages that are higher under the IB solution than the CAC
outcome.

Estimation

Previously we have discussed the two types of policies namely ‘Incentive Based’ and
‘Command And Control’. The author used a model created by McGartland that takes into
account the costs, associated particulate reduction efficiencies, and technological control
possibilities for roughly 400 real sources in Baltimore in order to estimate the marginal costs
of TSP control under the two regimes. For each feasible standard taken into consideration, the
least-cost combination of control options across all particulate sources that guarantees
attainment at all receptors is reflected in the marginal abatement cost function under the IB
approach. The author used the basic principles of Baltimore's regulatory approach to estimate
marginal costs for the CAC regime. The sources of pollution were categorized and similar
sources were grouped together. Next the marginal costs for additional control were estimated
for each source category.
Now we describe the benefit estimation used by the author. In order to calculate the marginal
benefits of using alternative standards, the author first used the geographic coordinates of
each receptor to assign the Baltimore metropolitan area's population in 1980 to one of the 23
receptors in the area. As a result, "exposed population" by receptor varied in number, with
3,800 individuals assigned to one receptor and over 180,000 to another. Given these
exposures, marginal benefits from successively tighter TSP standards for four different
categories: reduced premature mortality, reduced morbidity, reduced soiling damages to
households, and improved visibility were considered. For each category, the changes in TSP
levels that would accompany successively tighter standards were first translated into physical
improvements and then monetized these physical improvements using recent studies on the
valuation of premature mortality, morbidity, soiling, and visibility.
In summary, the cost model is utilised to determine the technological means by which a
hypothetical modification to the TSP standard for Baltimore will be implemented under the
CAC and IB approaches. The author translates physical changes in air quality into welfare
improvements and simultaneously values them to arrive at estimates of marginal benefits by
using the mortality, morbidity, soiling, and visibility "dose-response" functions. That is the
process behind the empirical results presented.

Findings

The text discusses a study focusing on environmental standards, particularly Total Suspended
Particulates (TSP) concentrations, and evaluates the outcomes under two regulatory
approaches: Incentive-Based (IB) and Command & Control (CAC). The study presents
results in Table 1 and Figures 1 and 2, illustrating marginal control costs (MC) and marginal
benefits (MB) for different TSP standards under the two regimes.

The marginal benefit and abatement cost curves are mostly well behaved for the IB or least
cost case. Marginal benefits remain roughly constant over most of the relevant range,
tapering off after achieving a standard of 85µg/m³. The occasional fluctuations in the MB
curve reflect the differing degree to which individual receptors are controlled as standards
become more stringent. Marginal abatement cost remain low and well below marginal
benefits for less stringent standards but rise rapidly after reaching a standard of 90ųg/m³.

In contrast, under the CAC case the functions are not so well behaved. The marginal cost
curve exhibits a large hump around the 90µg/m³ standard due to the regulatory rule. Moving
from 95µg/m³ to 90µg/m³ requires additional and costly control measures for a large number
of sources, which under the CAC rule must be applied to the whole class of polluting sources
resulting in a sharp increase in control costs.

The figures demonstrate that as standards become more stringent (moving left to right), the
maximum permissible TSP concentration decreases. For instance, under the IB case, moving
from a standard of 105µg/m³ to the more stringent standard of 100µg/m³ incurs a marginal
control cost of $1.82 million and a marginal benefit of $8.53 million.

Equating marginal cost to marginal benefit we get the "optimum" standard under each
system. In this study, the "optimum" standard under IB is approximately 90 µg/m³, while
under CAC, it is 100 µg/m3. The findings indicate that the IB approach tends to result in more
stringent standards than the CAC approach, supporting the statement that less costly control
techniques i.e. the IB method enables higher environmental quality.

However, the study emphasizes that standards do not directly correlate with air quality levels,
and highlights the distinction between them. Though in the Baltimore case it is seen that the
IB “optimum” leads us to choose the more stringent standard for air quality, it doesn't
necessarily translate to better air quality. Standards set ceilings on permissible levels of
pollutant concentrations, but most receptors have concentrations far below the required
standard. Thus the same standard produces different vectors of air quality under the two
systems.
Table 2 provides estimated TSP concentrations for various standards in the 23 Baltimore
receptors under both regulatory systems, emphasizing the differences in air quality outcomes.
It reveals variations among receptors, with some showing better air quality at less stringent
standards and others exhibiting higher concentrations. It was found that for receptor 1 the
TSP level for a standard of 100 µg/m3 is 61.4 µg/m3 under CAC but under the IB “optimum”
of 90 µg/m3 it is 61.6 µg/m3. Hence the less stringent standard gives better air quality than the
optimal more stringent one in this particular receptor. But this does not hold for all receptors.
The binding receptors will have higher TSP concentrations at the less stringent standards
(receptor 5). At receptor 1, 2, 3 and 6 the TSP concentrations are far below the standards.

Fig 3 shows a population-weighted average of the TSP levels at all 23 receptor points. A
comparison of these weighted averages for the optimum under the two systems reveals that
the IB outcome yields a weighted average TSP level of 62.9 µg/m3 as compared to 63.7
µg/m3 under CAC. Thus average air quality is slightly and negligibly better under the IB
optimum than the CAC optimum which is in sharp contrast to the large difference under the
two systems in the “optimal” standard.

Thus the study suggests that while the IB approach may lead to more stringent standards, it
doesn't guarantee better air quality. The regulatory system's impact on pollutant
concentrations should be considered for a comprehensive evaluation of environmental
outcomes.
The very first result gives us that if we compare the weighted average TSP level under the
two “optimal standards”, they show negligible difference in air quality. This result is a bit
surprising because the IB regime results in a more stringent optimal standard than its CAC
counterpart.

However, what is more interesting is to calculate the total net benefits of pollution control
under the two systems. This will give us an idea about which system to adopt in controlling
pollution in order to extract the highest benefit. In the very first table what we can at most
calculate is the marginal net benefits for successively tighter air quality standards beginning
with 120 µg/m3. This makes the calculation of total benefits a bit problematic.

Thus, we need to make certain adjustments while calculating the total net benefits. We feel
that benefit functions cannot be extended to value changes in air quality over extreme levels
like 500 µ g/m3. Consequently, we chose as a baseline the vector of air quality that results
from a standard of 120 µg/m3.

The details of the calculation have been provided in the table below: -
IB calculation – For the IB system, we sum the differences between the MB and MC curves
(ref: - Fig 1. Least-Cost Case) from the baseline vector i.e. 120 µ g/m3 to the optimal level,
earlier calculated, of 90 µ g/m3. We find that the net benefits from our baseline are roughly
$45 million.

CAC calculation – If we look at Population-Weighted Averages of Receptor TSP Levels, for

any given standards (including our baseline), the resulting vector of air quality under the
CAC outcome indicates cleaner air than under the IB result. Therefore, we cannot sum the
differences between the MB and MC curves from 120 µ g/m3 to the “optimal” standard of
100 µ g/m3 and compare the estimate to IB net benefit calculation.

Thus, we need to make a cost and benefit adjustment to make the CAC “starting point”
comparable to that under the IB system.

Cost adjustment – We find that to go from an uncontrolled level of about 500 µ g/m3 to our
selected baseline of 120 µg/m3 it costs an estimated $7.81 million more than under the IB
system. So, for purposes of comparison we must add to the cumulative cost of the CAC
system this additional sum of $7.81 million.

Benefit adjustment – We reiterate that we do not extend our benefit functions to the
uncontrolled state of 500 µg/m3. However, we must account for the cleaner air that the CAC
outcome provides at the baseline standard. This gives us an estimate of $28.67 million for the
value of differentially superior air quality generated by CAC relative to its IB counterpart at
the baseline standard.

After these two adjustments the CAC starting point is equivalent to the IB regime. The net
benefits of the CAC scheme are roughly $39 million.
Using this method of adjustments, we must note one important thing. The cumulative net
benefits that have been estimated using our method gives a gross underestimation of the
actual cumulative net benefits. This is because we omit any valuation of the benefits provided
by the improvement in air quality from the uncontrolled state i.e. 500 µg/m3 to the baseline
i.e. 120 µg/m3. We omit them because (as mentioned earlier) we are not comfortable using
our benefit functions to value changes over such extreme levels of pollution. Thus, this brings
in the question of comparability of net benefits under the standards mentioned. The answer to
this lies in the fact that cumulative benefits are understated by the same sum for the IB and
CAC cases. The figures can thus be used legitimately to compare the net benefits under the
two systems.

When we finally compare the results from table 3 under both the standards, we find the
difference between the cumulative net benefits under the two systems to be quite small. The
IB outcome exceeds those under the CAC case by $6 million when evaluated at their
respective “optima”. However, if we did not take into account the differentials in benefits
under the two standards then we would get very different results.

However, the absolute levels of benefits and costs associated with various standards must not
be taken very seriously. Some sensitivity analysis using upper and lower bounds for our
benefits estimates suggests that the “optimal” standard under both systems is quite sensitive
to our choice of benefit measures.

Conclusion

The theme of this paper is that IB policies are designed to achieve prescribed regulatory
standards and CAC policies are designed with at least one eye on cost savings when
reductions below the level of the relevant environmental, workplace, or product standards
result in beneficial effects. In these cases, the "overcontrol" that makes CAC policies more
expensive also makes them more effective.

One problem is that neither approach results in the economically optimal outcome in the full
sense. We have been careful to describe the standard for which marginal benefits equal
marginal costs under either system as the "optimal" outcome, But it is clear that there is an
economically superior outcome, namely the Pareto-efficient solution.

One may legitimately ask why we do not reject both of the suboptimal regimes we examine
in favour of the first-best outcome. Our response to this question is twofold. First, the
first-order conditions for the economic optimum would have us determine an emissions
vector such that for each source the marginal benefits from an additional unit of abatement
equal marginal cost. Secondly, we find it very difficult to see how an environmental agency
could implement such procedures. As the spirit of this paper suggests, we have sought to
consider those alternatives that appear feasible in an actual policy setting.

In the choice between the two approaches, we have argued that the case in the literature has
been biased in favor of IB measures. However, it is important to put this contention in the
proper perspective. One reason that the CAC outcome fares so well in our analysis is that
Baltimore air quality authorities employed a somewhat sophisticated and relatively
cost-effective procedure for TSP control. Under a less enlightened regulatory regime, control
costs could be much higher for equivalent air quality levels.
CAC policies will get bad marks in comparison to the IB alternatives. Badly designed CAC
measures, in short, will yield bad outcomes. Economic analysis plays a larger role in CAC
standard setting and program design. Efforts by economists to make CAC measures more
effective may, for particular programs, produce outcomes that compare quite well with IB
alternatives. Particularly when we take into account real world regulatory institutions that
require uniformity of fees (or in other ways reduce the flexibility needed to achieve the full
advantages of the IB approach), incentive-based programs may not dominate well-designed
CAC measures.