Grantee Research Project Results
Final Report: An Investigation of Compliance Behavior and Enforcement of Emissions Trading Programs Using Experimental Analyses
EPA Grant Number: R829608Title: An Investigation of Compliance Behavior and Enforcement of Emissions Trading Programs Using Experimental Analyses
Investigators: Murphy, James , Stranlund, John
Institution: University of Massachusetts - Amherst
EPA Project Officer: Hahn, Intaek
Project Period: January 1, 2002 through December 31, 2003 (Extended to April 28, 2005)
Project Amount: $227,860
RFA: Market Mechanisms and Incentives for Environmental Management (2001) RFA Text | Recipients Lists
Research Category: Environmental Justice
Objective:
The objective of this research project was to examine compliance behavior in emissions trading programs and the design of cost-effective enforcement strategies for these policies. To accomplish this objective, a series of laboratory experiments were designed and conducted to test existing theories about compliance and enforcement.
Emissions trading programs (also referred to as transferable or tradable emissions permits, and cap-and-trade policies) are an innovative approach to controlling pollution that continues to gather support from policy-makers and members of the regulated community. Conceptually, emissions trading programs are quite simple, yet have very powerful implications. By exploiting the power of a market to allocate pollution control responsibilities, well-designed trading programs promise to achieve environmental quality goals more cheaply than traditional command-and-control regulations because they provide more flexibility to sources of pollution and greater incentives to find and implement cost-effective ways to control their emissions.
Despite the perceived advantages of market-based environmental policies over traditional command-and-control approaches, it is clear that the efficiency gains expected of emissions trading programs will not materialize if these programs are not enforced well. Although there is a substantial body of theory about enforcing emissions trading programs, as well as information about how existing trading programs are enforced, there are no empirical analyses of the determinants of compliance decisions in emission trading programs, or how this behavior may be different under other policies (e.g., command-and-control policies). The experiments of this research address this omission. Hence, this research project provides a theoretically and empirically balanced understanding of how market mechanisms and incentives in managing environmental problems should be designed, implemented, and managed to meet environmental quality goals cost effectively.
Summary/Accomplishments (Outputs/Outcomes):
Direct and Indirect Price Effects
The theoretical literature in emissions trading programs generally suggests that there are some important differences in compliance behavior between market-based mechanisms and command-and-control regulations that warrant fundamentally different strategies for enforcement. One of the more important differences is that firms in an emissions trading program are linked together through the functioning of the permit market, whereas they operate largely independently under both command-and-control policies and emissions taxes. Thus, compliance and enforcement of emissions trading programs are inextricably linked to permit markets. Indeed, any factor that affects compliance decisions will in turn impact the permit market, which has its own indirect effect on compliance via the permit price.
The first publication from this research, “Direct and Market Effects of Enforcing Emissions Trading Programs: An Experimental Analysis” (Murphy and Stranlund, 2005a), examines the direct and indirect market effects of enforcement on pollution and compliance decisions. Consistent with theoretical predictions, the experiments reveal a direct effect of enforcement on individual violations, as well as a countervailing market effect through the permit price. Increased enforcement—through increased monitoring or higher penalties—motivates firms to reduce their violations by purchasing more permits. This puts upward pressure on the equilibrium permit price, but higher permit prices motivate firms toward greater violations. The direct effect is always larger so that increased enforcement results in lower violations. The basic conclusion in this regard is clear—the productivity of enforcement pressure in reducing noncompliance in emissions trading programs is partially offset by a countervailing price effect. Regulators that ignore this price effect would overestimate the effectiveness of any attempt to reduce violations.
The experimental results also provide strong support for a somewhat surprising result about enforcement and emissions choices; there is no direct effect of enforcement on the emissions choices of firms, there is only a negative price effect. That is, a firm’s choice of emissions is independent of the enforcement strategy it faces. This choice, however, is not independent of the price of permits. An important implication of this conclusion is that increased enforcement can only have an impact on environmental quality if it is large enough and applied widely enough to lead to an increase in the equilibrium permit price. Increased enforcement pressure applied to a single firm, or a small subset of firms, will have no environmental impact.
Matters are quite different for emissions standards and taxes. Under fixed emissions standards, adjusting emissions levels is the only way a firm can change its level of noncompliance. Thus, increased enforcement of emissions standards will reduce emissions and improve environmental quality. In the case of a fixed emissions tax, however, increased enforcement will have no affect on emissions. In this case, as in the case of competitive emissions trading, firms’ emissions choices are independent of changes in enforcement strategies. In contrast to emissions trading, however, the “price” of emissions is fixed, so that the indirect effect on emissions from enforcement cannot occur.
Although this work was motivated primarily by our desire to trace the direct and market effects of enforcement, we did discover another effect that contradicts a standard theory of compliance behavior. Compliance and emissions choices by risk-neutral competitive firms in emissions trading programs should be independent of the initial allocation of permits. Our results contradict these conclusions. What appears to be the most significant point in this case is that the initial allocation of permits determines who will be net sellers of permits and who will be net buyers of permits. We find that net sellers tend to retain more permits and have lower violations and higher emissions than the competitive equilibrium prediction, whereas net buyers hold fewer permits and tend toward higher violations and lower emissions. Because fewer permits change hands, permit prices tend to be higher than competitive equilibrium predictions.
The Determinants of Compliance
The second paper from this research, “A Laboratory Investigation of Compliance Behavior under Tradable Emissions Rights: Implications for Targeted Enforcement” (Murphy and Stranlund, 2005b), examines the determinants of compliance by firms in emissions trading programs, and compares these results to those obtained when firms face fixed emissions standards. Regulators might use information about firm-level determinants of compliance behavior in different ways depending on their enforcement objectives. If some firms tend toward higher violations, then a regulator that is primarily motivated to detect higher violations will direct a greater share of enforcement efforts toward these firms. If, however, a budget-constrained regulator seeks to distribute enforcement efforts to minimize aggregate violations, the regulator is not necessarily concerned about whether some firms have higher violations. The main concern is to direct enforcement effort to where it is most productive; hence, those firms that are more responsive to increased enforcement will be monitored more often, regardless of violation level.
Conceptually, individual compliance choices of risk-neutral competitive firms in emissions trading programs should be independent of differences in any firm-level characteristic. Consequently, regulators have no reason to condition enforcement efforts on firm-level characteristics. Their reasoning is straightforward. Because compliance in emissions trading programs means that a firm holds enough permits to cover its emissions, a risk-neutral competitive firm’s marginal benefit of noncompliance consists of what it has to spend for permits to make certain it is compliant—the prevailing permit price. Thus, a firm’s compliance decision is made by comparing this permit price with the marginal expected penalty for emissions in excess of permits. Because this marginal cost-benefit comparison does not depend on anything unique to a particular firm, the compliance decision is independent of any firm characteristic.
This result contrasts sharply with the effects of firm-level characteristics on compliance with command-and-control standards. A risk-neutral firm’s decision about whether to comply with a fixed emissions standard should be determined by the relationship between its marginal reduction in abatement costs from exceeding the standard and the marginal expected penalty for the resulting violation. Therefore, firms with higher marginal abatement costs or stricter standards will have a greater incentive to be noncompliant.
Our experimental results are largely consistent with the general hypothesis that individual compliance decisions in emissions trading programs are independent of differences in a firm’s characteristics, but not completely. We discovered that individual violations are independent of parametric differences in their abatement costs. Individual violations, however, are not independent of the initial allocation of permits. Again, what appears to matter most about the initial allocation of permits is how it determines who will sell permits and who will buy permits. We found that subjects that are predicted to buy permits tend to have higher violation levels than subjects that are predicted to sell permits. We also tested whether the marginal productivity of increased enforcement in reducing individual violations varies according to differences in abatement costs and initial allocation of permits. We found that the marginal productivity of enforcement was statistically independent of firm-specific characteristics.
We also ran a series of experiments in which subjects faced fixed emissions standards to compare compliance behavior under emissions trading and emissions standards. These experiments were identical to our market experiments, except that subjects could not trade their initial allocation of permits. The results of these experiments provide an empirical study of how compliance behaviors differ under the two types of policies. Subjects with higher abatement costs had significantly higher violations and were much more responsive to increased enforcement.
These results have important implications for designing enforcement strategies for competitive emissions trading programs. Although the results suggest that a regulator whose objective is to detect and penalize firms that tend toward higher violations may wish to monitor permit buyers more closely, irrespective of abatement costs, there appears to be no justification for targeting firms to maximize the productivity of enforcement resources. Under fixed emissions standards, however, there is substantial justification for targeted enforcement strategies that are conditioned on information about firms’ abatement costs.
Self-Reporting
Perhaps the most difficult component of enforcing an emissions trading program is keeping track of each firm’s emissions so that they can be compared to permit holdings to determine compliance. Like many environmental policies in the United States, emissions monitoring in existing emissions trading programs relies heavily on self-reported information by the facilities. Because of the prevalence of self-reporting requirements in the enforcement of environmental policies, there is presently a rather large theoretical literature that investigates the consequences of self-reporting and self-policing schemes in the enforcement of legal standards. We have designed and conducted experiments that examine self-reporting behavior under both fixed standards and emissions trading. The results under fixed standards are contained in the paper, “An Investigation of Voluntary Discovery and Disclosure of Environmental Violations Using Laboratory Experiments” (Murphy and Stranlund, 2005c). The data from the self-reporting experiments under emissions trading have not yet been analyzed.
State and federal self-discovery and disclosure rules seek to encourage greater compliance with environmental regulations by reducing penalties for violations of these regulations that are voluntarily discovered and reported to authorities. For example, the U.S. Environmental Protection Agency Audit Policy reduces penalties “for regulated entities that voluntarily discover, promptly disclose, and expeditiously correct noncompliance.” The main conceptual benefit of structuring incentives for firms to disclose their violations is that monitoring efforts can be reduced, relative to a conventional enforcement strategy that does not attempt to elicit firm self-disclosure. Because the government does not need to monitor firms that disclose their violations, it can focus its limited monitoring resources on the subset of firms that do not disclose.
The effect of a voluntary disclosure policy on total enforcement costs, however, could be ambiguous if the costs of sanctioning violations are significant. Because voluntarily disclosed violations are sanctioned with certainty, a disclosure policy is expected to result in a greater number of sanctions, suggesting that sanctioning costs may be higher than under a conventional enforcement strategy. Sanctioning costs, however, need not increase if the costs of sanctioning disclosed violations are lower than the costs of sanctioning undisclosed violations. Voluntarily disclosed violations may involve a reduced evidentiary burden for the government and eliminate a reporting firm’s incentive to challenge the imposition of a penalty. Although more penalties are levied under a voluntary disclosure policy, fewer of these will be for the potentially more costly undisclosed violations. Obviously, whether a voluntary disclosure policy can reduce enforcement costs would then depend on the relative magnitudes of monitoring costs and the costs of sanctioning disclosed and undisclosed violations.
In fact, it may not be possible to simultaneously motivate a significant number of disclosed violations and maintain the same level of deterrence as a conventional enforcement strategy if firms must go through a costly discovery process to determine whether they are in violation. Increasingly complex regulations may make it difficult for firms, particularly large firms, to determine whether they are in compliance without a costly self-audit. When firms must incur costs to audit their performance to discover potential violations, a policy that motivates them to voluntarily discover and disclose any violation may result in less compliance because penalties must be reduced far enough to “compensate” them for their investment in self-discovery.
Experiments were conducted to test these hypotheses, and the results are largely consistent with expectations. Specifically, the experiments lend ample support for the hypothesis that, relative to conventional enforcement strategies, a voluntary disclosure policy can be designed to conserve monitoring costs without sacrificing deterrence. As expected, however, this policy results in more sanctioned violations, but fewer of these were the potentially more costly sanctions for undisclosed violations. In addition, we found strong support for the hypothesis that if firms must incur a cost to discover whether they are violating a standard, inducing a significant number of violation disclosures results in worsened environmental performance. In general, reducing penalties for voluntarily disclosed violations tends to reduce environmental performance, conserve monitoring costs, and change sanctioning costs in a way that depends on the relative costs of sanctioning disclosed and undisclosed violations.
Optimal Noncompliance
Although theoretical literature exits on compliance and enforcement of emissions trading programs, there is a significant omission in this literature; there is no published work that examines what the optimal level of noncompliance should be for emissions trading programs. This omission is addressed in, “Optimal Noncompliance in Emissions Trading Programs” (Stranlund, 2005). This paper is being revised for submission to a journal later this year. This paper examines the design of an emissions trading program to minimize the sum of aggregate control costs, aggregate monitoring costs, and the expected costs of sanctioning noncompliant firms in meeting an aggregate emissions target. It is assumed that the policy instruments available to a regulator are the distribution of monitoring efforts among firms and the aggregate supply of emissions permits. Given a fixed penalty schedule, the determination of monitoring and permit supply determines the amount of noncompliance that should be tolerated to meet the regulatory objective.
It is shown that the regulatory choice of noncompliance depends in large measure on the structure of penalties for individual violations. That is, the modeling exercise also answers the question of whether violations in emissions trading programs (emissions in excess of permit holdings) should be a constant unit penalty for violations, or if the marginal penalty should be increasing in the size of individual violations. It is shown that, with a given linearly increasing marginal penalty schedule, a simple condition involving the relative marginal costs of monitoring and collecting penalties determines whether the optimal level of noncompliance is zero or positive. The fundamental tradeoff in this setting is between light monitoring and allowing a certain amount of noncompliance to conserve on monitoring costs, and more intense monitoring to induce perfect compliance to eliminate the expected costs of collecting penalties.
With a given constant marginal penalty, however, it is not possible to increase violations to reduce monitoring, because the amount of monitoring necessary to induce the aggregate emissions standard is fixed. Therefore, minimizing the expected costs of achieving the standard requires eliminating the costs of sanctioning noncompliant firms. That is, full compliance by all firms is optimal when a constant marginal penalty is employed.
That full compliance is optimal when a constant marginal penalty is employed implies that some amount of noncompliance can only be optimal if violations are punished with an increasing marginal penalty. Thus, the regulatory choice of noncompliance rests on a comparison of the costs of a policy with an increasing marginal penalty that allows for some noncompliance and a policy that induces full compliance with a constant marginal penalty. The resolution of this comparison is straightforward: any policy that achieves an aggregate emissions target with a linearly increasing marginal penalty and that allows some noncompliance is more expensive than an alternative policy involving perfect compliance and a constant marginal penalty. This last result does not depend on setting an arbitrarily high marginal penalty. In fact, the constant marginal penalty need not be higher than the equilibrium marginal penalty under the policy with the increasing marginal penalty.
The policy significance of the results of this paper is clear. To achieve the cost of an aggregate emissions target, an emissions trading program should include a constant marginal penalty that exceeds the market price of permits; the supply of permits should be set equal to the emissions target, and monitoring should be sufficient to induce perfect compliance. Experiments were designed and conducted to test this conclusion, but the data have not yet been analyzed.
Future Research
This project has generated a rich data set that we will analyze in the coming year to further investigate enforcement and compliance behavior under both emissions trading schemes and fixed emissions standards. Our current plan is to produce at least four additional papers that will be submitted to peer-reviewed journals. One paper, with John Spraggon, will evaluate our fixed standards results using a quantal response model. Although our results strongly support comparative static predictions (i.e., changes in behavior in response to changes in parameters, such as enforcement level), the level of the observed decisions does not always correspond with theoretical predictions. It is possible that some of these differences between predicted and observed behavior can be attributed to decision errors that are a function of the payoff structure. Basically, quantal response models assume that deviations from predicted outcomes may be more likely when the payoff loss from a decision error is relatively small. Another paper will address a fundamental policy question: to achieve a fixed aggregate emissions target cost-effectively, should emissions trading programs be designed to achieve perfect compliance, or does allowing a certain amount of noncompliance reduce the costs of reaching the emissions target? We conducted a series of experiments designed to test hypotheses about the relationship between the structure of the penalties and optimal noncompliance. The third paper will test hypotheses about the impacts of avoidance activities (the ability to hide violations from the regulator) on a firm’s decision to be noncompliant and to voluntarily disclose any violations in a permit market. The last paper will evaluate the welfare consequences of noncompliance both when permits are tradable and when standards are fixed.
Journal Articles on this Report : 1 Displayed | Download in RIS Format
Other project views: | All 22 publications | 2 publications in selected types | All 1 journal articles |
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Murphy JJ, Stranlund JK. Direct and market effects of enforcing emissions trading programs: an experimental analysis. Journal of Economic Behavior & Organization 2006;61(2):217-233. |
R829608 (Final) |
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Supplemental Keywords:
enforcement, compliance, emissions trading, permit markets, standards, command-and-control, self-reporting, voluntary disclosure, audit policy, behavior, environmental auditing, experimental economics, laboratory experiments, remediation,, RFA, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, Economics and Business, Market mechanisms, Social Science, market incentives, policy instruments, effects of policy instruments, financial mechanisms, market-based mechanisms, compliance behavior, impact of federal policy instruments, policy incentives, policy making, decision making, incentives, socioeconomics, enforcement and compliance, cap and trade systems, environmental impact fees, pollution fees, tradeable permits, allowance allocation, allowance market performance, marketable permitsRelevant Websites:
http://www.umass.edu/resec/faculty/murphy/research.html Exit
Progress and Final Reports:
Original AbstractThe perspectives, information and conclusions conveyed in research project abstracts, progress reports, final reports, journal abstracts and journal publications convey the viewpoints of the principal investigator and may not represent the views and policies of ORD and EPA. Conclusions drawn by the principal investigators have not been reviewed by the Agency.