THE FAILURE OF MARKETABLE PERMIT SYSTEMS AND UNCERTAINTY OF ENVIRONMENTAL POLICY: A SWITCHING REGIME MODEL APPLIED TO THE DUTCH PHOSPHATE QUOTA PROGRAM

A well-known feature of pollution control with tradable quota rights is that the benefits to ownership will capitalize into prices of the quota. Quota present a unique opportunity to examine the effect of risks introduced by governmental programs because all the return to quota is dependent upon these programs. The uncertainty of future regulatory action results from the probability that the stream of incomes could be reduced (portfolio risk) by policy variation or stopped (default risk) by a substantial switch or shock in policy regime. Eliminating the quota program is the extreme case of default risk, as it would terminate the quota benefits. The paper concentrates on the paradox that environmental regulation can provoke economic and environmental inefficiencies because of policy uncertainty. The theory on investment under uncertainty argues that when future returns are uncertain, an opportunity to wait and see has some (quasi) option value. Under uncertainty, investments and disinvestments will take place at respectively higher and lower levels of returns creating an inaction interval. This interval means that returns to quota can vary over a wide range before trade takes place and offers a new, theoretical explanation for the failure of marketable permit systems. The objectives of this paper are threefold. First, the option value theory is employed to forge a natural connection between political uncertainty and quota price volatility. Second, based on the option value theory, a switching regime model is developed for investing and disinvesting in quota. Third, the empirical evidence for the Dutch Phosphate Quota Program indicates that policy risks led to asset fixity. Consequently, the market of tradable phosphate quota was not effective with major negative implications for both economic and environmental efficiency.