Toward a Total-Cost Approach to Environmental Instrument Choice

Much of the theoretical literature on environmental instrument reflects a normative presumption that only "economic" instruments, such as effluent taxes or tradable quotas, can produce an efficient outcome. Other potential alternatives, such as non-tradable quotas or more general Pigovian taxes are ruled out as inherently inefficient. Moreover, most of the literature relies on an important but unwarranted presumption: that cost and benefit functions, although they may be subject to uncertainty, are identical regardless of the regime that is chosen; that is price and quota systems are assumed to face the same cost and benefit curves with the same expected values. More crucially, the models assume that no regime will be subject to greater or lesser uncertainty than another. Under these assumptions, environmental instrument choice is determined simply by the relative elasticities of the curves. The real world is far more complicated than existing models of environmental instrument choice suggest. For one thing, monitoring and enforcement costs may be quite different for one regime than another. These cost differentials may affect not only comparisons between effluent tax and tradable permit schemes, but comparisons between "economic" instruments generally and more traditional regulatory instruments, such as technology-based standards or general Pigovian taxes. In some cases, for technological or institutional reasons, economic instruments will not efficiently or effectively attain exogenously set pollution-reduction goals. This paper offers a broader framework for comparing environmental instruments. Whereas most theoretical models focus exclusively on the comparative compliance/abatement costs of alternative regulatory instruments, this paper incorporates administrative costs and residual pollution costs into what we term a "total-cost" approach. The implications of this approach for environmental policy are then discussed in the context of efforts to reduce greenhouse-gas emissions under the 1997 Kyoto Protocol. The paper concludes that the incorporation of administrative (monitoring and enforcement) costs and residual pollution costs into theoretical models can greatly enhance the utility of those models for environmental policy making