24 ELR 10173 -- The Limits of Market-Based Approaches to Environmental Protection

The Limits of Market-Based Approaches to Environmental Protection

William F. Pedersen Jr.

Mr. Pedersen is a partner in the law firm of Shaw, Pittman, Potts & Trowbridge in Washington, D.C. He received his B.A. from Harvard University and his LL.B. from Harvard Law School.

[24 ELR 10173]

Market-based approaches to protecting the environment based on buying and selling "pollution rights" have long been special favorites of the academic community. According to a growing body of literature, a much wider use of this approach could solve the problems of ineffectiveness, inefficiency, and rigidity that characterize our current system of environmental protection.¹

In this literature, "environmental protection" largely means setting and enforcing a limit on discharges of clearly defined "pollutants" into the air and water. This literature often assumes that a set number of major sources is responsible for these discharges, and that equal amounts of discharges from any of these sources have roughly the same environmental effect.

Under our current system, according to the "market-based" argument, each source must install the tightest emission controls it can reasonably afford -- "best available technology." To set these technology standards, the regulatory agency must immerse itself in the technical details of each regulated industry, gathering data that will soon be obsolete and that has no direct relation to protecting the environment. In addition, under this approach the marginal cost of the same amount of pollution control will vary widely from source to source, creating economic inefficiency.²

These problems could be solved, according to market advocates, by substituting a system of tradable pollution rights for our current "technology-based" control system. A regulatory agency would assign these rights to the dischargers in an area. A source with low control costs would probably reduce its emissions rather than using up its rights. It could then sell the surplus rights to a high-cost discharger, enabling that discharger to expend fewer resources on pollution control. The resulting shift of total emission reductions from high control cost to low control cost dischargers would create economic efficiency. In addition, the control agency would no longer have to bury itself periodically in the technical and economic details of source operations.³

Such comments set out an important -- indeed, essential -- perspective. But they often underestimate the many different forms in which environmental problems arise. Those forms are too varied to yield to any single approach. Sometimes only one or two sources cause a pollution problem. Sometimes it is caused by many small sources like cars or dry cleaners. Sometimes it is caused by patterns of land use that allow pollutants to flow readily into a body of water. Sometimes the pollution discharges from different sources in an area vary significantly in toxicity. And often environmental protection involves deciding whether the risks from current or future use of certain chemicals is acceptable, and how to react if it is not, or setting the acceptable level of cleanup for a hazardous waste site, or determining where and how much to protect natural beauty or endangered species.

This Dialogue argues that applying market-based approaches to these problems is always difficult -- often too difficult to be worth the effort -- and sometimes conceptually impossible. For these reasons, market-based approaches yield significant benefits only in special circumstances that are only sometimes present.

More fundamentally, "pollution trading" is only a method of implementing policy. Whether an activity can be controlled by this method tells us literally nothing about whether it was worth controlling in the first place. The current enthusiasm for market-based approaches has considerable potential for obscuring that more basic issue, by hiding from us the variety of the environmental problems we must address, and the choices we must make, to create a coherent environmental policy.

Although emissions trading approaches have much to offer us, for these reasons they cannot substitute for an informed debate on the goals of environmental policy and on what we must control to reach those goals.⁴ And once [24 ELR 10174] we have chosen those goals, there is no automatic reason to believe that tradable emissions rights will be the regulatory mechanism best suited to reach them.

The Limits of "Pollution Trading" Mechanisms

What Pollution Trading Requires

Any "pollution trading" approach requires the creation of a new form of property, namely, the rights that are traded. It also requires a system of market rules for trading them. For example, to establish a system of "discharge rights" for a river basin, the regulatory agency would have to decide which dischargers would be forbidden to discharge without holding such rights, what pollutants or combinations of pollutants the rights would cover, how many rights each discharger would receive, when and how the government could amend the rights, what the rules for trading rights would be, and how such trades would be recorded. Such markets take a considerable legal and political investment to establish, and a smaller but continuing investment to police. In addition, the market will not work unless sources can measure the exact quantity of their discharges. Only such precise measurement can tell them the extent to which their rights exceed their emissions -- thus allowing them to sell rights to others -- or the extent to which their emissions exceed their rights -- thus requiring the purchase of more rights to cover the excess. In many cases, the same emissions will have significantly different impacts in different places. When that is true, the market must either adjust its trading rules to compensate (thus making trading more complicated), or accept a certain oversimplification of the environmental problem it purports to address. For pollution-trading systems to be worth establishing, the gains from trading must outweigh all these costs.

The History of Pollution Trading

These conditions are far more demanding than is often realized. Due to them, pollution trading is best suited to broad environmental problems where the same emissions have about the same effect everywhere, where the "pollutant" being traded is relatively easy to measure, and where the market is restricted to a limited number of large sources that can bear the transaction costs. In those cases, our current system has already proved very open to pollution trading.

Over the past decade, pollution trading under relativelysimple trading rules has become an integral part of the U.S. Environmental Protection Agency's (EPA's) regulations to control lead in gasoline,⁵ materials that deplete the ozone layer,⁶ "acid rain" emissions from power plants,⁷ and the volatility of gasoline.⁸ Automobile fuel economy standards likewise incorporate a "credit trading" approach.⁹ In other cases, such as EPA's "bubble" policy under the Clean Air Act,¹⁰ the nature of the problem (or of the regulatory system) has led to more complicated trading rules and higher transaction costs. Here, a source that wants to trade must show that it complies with all existing regulations, that no adverse local air quality impacts will be created, and that toxic emissions will not increase.¹¹ In consequence, trading has been much more limited.

In general, pollution-trading approaches do not work well when there are only one or two sources in an area, since then the trading possibilities are limited.¹² Nor do they work well when the emissions from different types of sources are themselves different, since that can lead to different environmental effects. If emissions are hard to measure for any reason, or the amount of emissions per source is small, the difficulties of quantification may override the gains from trade. For example, it would probably be hard to design a market-based approach to controlling the use of wood stoves. Finally, environmental protection problems that involve acceptable risk or land use decisions are unsuited to market-based approaches by their essential nature. A review of our actual experience will show how frequently these barriers to market-based approaches are encountered.

[] Air Pollution. Despite many past successes, dramatic growth in emissions trading to control air pollutants appears unlikely. Even under our current system of technology-based individual controls, monitoring costs can amount to a considerable fraction of total compliance expenses. Yet under this system, monitoring need only determine whether a given emission level is or is not being met. For emissions trading to work, a source must define its exact emission level, not just whether it is under or over a regulatory standard. The first of these tasks is often technically more difficult than the second. Accordingly, a full pollution-trading approach could require markedly more elaborate quantification, data tracking, and accounting systems than we now employ. Moreover, over half of the emissions of many air pollutants now come from small sources and motor vehicles.¹³ There is no way to impose the monitoring costs of an emissions trading system directly on such sources. Although trading systems that use surrogate $=10175 limits can be established, they, too, are expensive to design and implement. Finally, under the 1990 Clean Air Act Amendments, almost 200 air pollutants are now regulated as "hazardous."¹⁴ Trading will become literally impossible if the trading system must separately address emissions and emissions changes for each of these 200 substances.

With a regulatory problem defined in this manner, how often will the effort to establish a detailed new trading mechanism be worth it? As trading rules become more complicated, and the average size of sources to be controlled becomes smaller, the benefits of emissions trading will probably decline.

[] Water Pollution. Even more than with air, changes in water quality are sensitive to the location of a pollutant discharge. Also, the sources of water pollution tend to be small or unconventional -- such as construction sites, plowed or fertilized fields, paved roads or parking lots. For that reason, protection of water quality can often require some form of land use control. That in turn must have a large regulatory component.

To take a realistic example, totally protecting water quality in a given stream might require that 80 percent of the bank should remain bordered by trees to a depth of at least 100 feet. Undoubtedly, economists could devise a mechanism for trading development rights in the remaining 20 percent. However, that misses an important point. It is deciding whether and how to restrict development of the 80 percent, not trading development rights in the 20 percent, which raises the central political and public policy issue.

[] Toxic Chemicals. Finally, much of our environmental regulatory effort is devoted to evaluating chemicals, pesticides, drugs, or food additives to determine whether they are safe enough to be allowed to stay on or enter the market, and, if they are not completely safe, whether any restrictions should be imposed on their use. It is hard to see how market-based approaches could make more than a marginal contribution to such judgments. Similarly, no market-based approach can tell us the exact degree of purity to which a hazardous waste site should be cleaned up, or create an alternative to the soil excavation, soil treatment, and soil testing needed to accomplish that cleanup.

Emissions Trading Is a Means and Not an End

Behind these difficulties lies a more fundamental problem. Whether an activity can readily be controlled by pollution-trading approaches has literally no relation to whether such controls will yield environmental protection worth the cost. Several years ago, EPA issued regulations phasing out the future production of asbestos, and establishing an elegant market-based system of tradable "production rights" to implement that gradual prohibition.¹⁵ However, the courts rejected the regulation, not because of any defect in the trading scheme, but because in their view EPA had failed to justify the underlying ban itself.¹⁶

Our current regulatory system focuses far more effort on pollution caused by large industrial facilities than on pollution caused by small sources or by patterns of land use. In consequence, pollution from large industrial sources makes up an ever-smaller part of total pollution. And despite the vast sums spent on controlling pollution over the past 20 years, our understanding of how and when pollution produces its adverse effects is still severely limited. To an important extent, our approach has been "control first; ask questions later."

Market-based approaches are not a necessary cure for these basic flaws. Indeed, they may have some potential to make them worse.

Most importantly, pollution markets work best when designed for a limited number of large sources. That minimizes monitoring and data processing costs, and imposes the costs that are left on those with the resources to bear them. Accordingly, pollution-trading systems have a tendency to continue the focus on large industrial sources that warps our current regulatory system. In particular, it may steer our attention away from problems of land use and risk assessment that are already underemphasized.

Markets work best under simple trading rules. That gives those who design markets an incentive to oversimplify environmental problems to make their market mechanisms more workable. Market-based control approaches are probably more efficient than the alternatives. But we cannot assume that the gains from increased efficiency will always outweigh the losses from oversimplification.

Trading systems also require the regulatory agency to set a cap on the total amount of pollution that covered sources may emit. (The cap will simply be the sum of the individual emission rights.) But there is no reason to expect in advance that this cap will be any more closely linked to environmental results than the emissions allowed by our current system. On the contrary, the easiest way to compute it will be simply to transpose current control requirements into market-based terms, regardless of their actual relation to environmental protection. If using "best available technology" would yield total emissions of 100 in an area, any likely market will simply take that 100 as a baseline, without asking any more questions about its environmental goals than were asked to establish it in the first place. The result may be a more efficient regulatory system, but one that still leaves the basic issues unaddressed.¹⁷

Conclusion

In the future as in the past, our environmental regulatory system will almost certainly continue to rely on emissions trading approaches to address individual problems where $=10176 the conditions for effective use of this approach are met. However, market mechanisms will not set our goals for us and may even disguise their absence. They are also not universally adapted to even achieving the goals that we have set. They will certainly be a useful tool, but only one among many -- including product clearance, land use planning, labeling, "command and control," and removing direct subsidies and tax preferences for environmentally damaging activities -- that should all have their place in a rational system of environmental control.

1. See, e.g., ALLEN V. KNEESE & CHARLES L. SCHULTZE, POLLUTION, PRICES, AND PUBLIC POLICY 1-2, 81-85 (1975); Introduction to ECONOMICS OF THE ENVIRONMENT (R. Dorfman & N. Dorfman eds., 1972).

2. See, e.g., Bruce A. Ackerman& Richard B. Stewart, Reforming Environmental Law, 37 STAN. L. REV. 1333, 1335, 1337-38 (1985).

3. See, e.g., Ackerman & Stewart, supra note 2, at 1341-51.

4. Trading pollution rights is not the only form of market-based (or somewhat market-based) environmental regulation discussed in the literature. See, e.g., Robert W. Hahn & Robert N. Stavins, Incentives for Environmental Protection: Integrating Theory and Practice, 82 AM. ECON. REV. 464 (1992). However, it is by far the most developed, both in publicity and in practice. The most potent single alternative -- imposing a tax on pollution -- has thus far failed to be adopted widely. In addition, because the impact of a tax on pollution is hard to predict in advance, and because the government must also decide how to use the revenues collected, a tax raises policy and program design issues even more complicated than those that attend emissions trading.

Other alternative approaches seem suited only for specialized employment. It may be a careless use of language to label forced public disclosure of environmental information a "market-based" approach. Such forced disclosure of toxic pollutant releases has indeed encouraged large companies to reduce their discharges of these substances. However, disclosure has yet to prove itself systematically as a regulatory tool in any wider arena. And to date our regulatory system has proved most unwilling to relax any existing control requirements either to encourage such voluntary efforts, or even to recognize their successes. Finally, "deposit and return" approaches to encouraging recycling are probably restricted by their nature to specific classes of products like large appliances.

5. See 40 C.F.R. § 80.20 (1992).

6. See Id. §§ 82.5, 82.12.

7. See 42 U.S.C. §§ 7651a, 7651b, ELR STAT. CAA §§ 402, 403.

8. See Regulation of Fuels and Fuel Additives: Standards for Reformulated and Conventional Gasoline, 59 Fed. Reg. 7716, 7843 (Feb. 16, 1994) (to be codified at 40 C.F.R. § 80.67).

9. See 15 U.S.C. §§ 2002, 2003 (Supp. IV 1992).

10. See 51 Fed. Reg. 43814 (Dec. 4, 1986).

11. Id. at 43833.

12. Even here, important gains may be possible by allowing trading among the various emissions points within a source. A regulatory system can allow such intersource trading without addressing all of the complicated questions needed to establish a full areawide trading system covering all sources.

13. See, e.g., U.S. EPA, NATIONAL AIR POLLUTANT EMISSION TRENDS 1900-1992 2-20 to 2-22 (1993).

14. 42 U.S.C. § 7412, ELR STAT. CAA § 112.

15. 54Fed. Reg. 29460 (July 12, 1989).

16. Corrosion Proof Fittings v. U.S. Environmental Protection Agency, 947 F.2d 1201, 22 ELR 20037 (5th Cir. 1991).

17. Some commenters have argued that countries, such as those in eastern Europe, that do not have an established environmental protection regulatory system could benefit more than countries with established systems from market-based approaches. Daniel J. Dudek et al., Environmental Policy for Eastern Europe: Technology-Based Versus Market-Based Approaches, 17 COLUM. J. ENVTL. L. 1 (1992). This could be true. However, adopting a market-based approach would do nothing to help these countries answer the harder questions concerning how much environmental protection to adopt, how fast to apply it, and in particular, where to focus control efforts. In addition, market-based systems, for all their advantages, are harder to set up and apply than a "best available technology" approach, even in the somewhat limited regulatory areas for which they are suited. Accordingly, it appears that market-based approaches must be evaluated and adopted on a case-by-case basis in other countries just as much as in our own.