Market based Instruments

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Market based Instruments

• International Patterns of Adoption
• Remaining Challenges
• Emerging Approaches

• Alan Randall

AARES Market Based Instruments Symposium
Canberra September 3, 2003
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The Cliché command-and-control regulation is in
eclipse and flexible incentives are on the rise
worldwide

• The Reality
• Command-and-control is hyperbole
• Flexible incentives are a very mixed bag

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Adoption of Flexible Incentives

• Market Based Instruments
• Pollution charge
• Effluent fees
• Deposit-refund programs
• User fees
• Tax differentiation
• Pollution trading
• Cap-and-trade
• Pollution reduction credits

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Adoption of Trading -- examples

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Adoption of Flexible Incentives

• Market Based Instruments
• Market reforms
• Market creation
• Liability rules
• Product labeling
• Reporting requirements
• Removal of subsidies on environmentally-damaging
• activities

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Stavins on MBIs

• MBIs work best when performance is the regulatory
  goal, and flexibility to choose abatement
  strategy is maximized
• Double dividend considerations relevant to choice
  of instruments (charges vs. auctioned permits vs.
  grandfathered permits)
• Trading programs work best when cap-and-trade
• Monitoring and enforcement are keys to success

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Adoption of Flexible Incentives

• Other flexible incentives
• 1. Negotiated agreements
• Both policy and response are negotiated
• Common in Europe
• Work best when -- Bruyninckx
• policy objectives can be accomplished
• even with some laggards in the set
• goals are well-defined
• agreements have a norm-setting aspect
• obligations of all parties are clearly defined
• a serious enforcement mechanism is in place

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Adoption of Flexible Incentives

• Other flexible incentives
• Voluntary approaches
• Agreements
• Eco-labeling
• Industry codes and standards
• Negotiated and voluntary approaches work best
• as supplements to a strong regulatory framework.
• They make a nice frosting on the regulatory cake,
• But the cake itself must be there -- Randall

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Water quality trading

• Adoption
• 46 programs worldwide
• 40 in US
• 37 approved by USEPA
• 6 trades recorded

• Why so few trades?
• Who needs trades, if programs reduce P-source
• compliance costs?
• Program design impedes trading
• Weak regulatory stance re NP sources policy
  of
• subsidizing BMPs

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Lower Boise River -- Schary
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Research objectives - multi-project research
program

• Standard P-NP trading schemes role of trading
  ratio
• Mechanism Design a group performance contract
• Focus groups to gauge farmer acceptance of the
  contract
• Laboratory experiments with the contract
• Mobile lab experiments
• Implementation in a demonstration watershed

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Standard P-NP trading schemes

• Trading in pollution reduction credits
• P seeks permission to increase effluents ? buys
  PRCs
• NP wants to sell PRCs, but is able only to
  offer promises
• to implement BMPs
• Regulator translates promises to implement BMPs
  into PRCs
• uses models to predict pollution reduction from
  implementing BMPs
• applies trading ratio to impose a degree of
  conservativism
• on the calculation of PRCs earned

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Analysis of the P-NP trading ratio

• Trading ratio typically is relatively high ?
  impedes trade
• Why so high?
• Uncertain performance of BMPs under field
  conditions
• Inflexibility of prescribed BMPs
• Uncertain performance of farmers in
  implementing BMPs
• Moral hazard
• Adverse selection
• Motivation for developing performance contract

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Mechanism Design a group performance contract

• Advantages
• NP could sell PRCs, eliminating the trading
  ratio
• Individual NPs are free to choose least-cost
  abatement technologies
• Challenges
• Moral Hazard in Teams Only the joint product
  of a group of agents
• is observable.
• Contract must make individual payments
  conditional on team output
• Adverse Selection Agents have different
  abatement resources,
• technologies, costs, but agents type is
  private information
• Develop a contracting process such that
  low-cost abaters will
• self-select onto the team

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Mechanism Design a group performance contract

• Contract 1 (Pushkarskya, 2003)
• 2 stage generalized agency problem
• Regulator offers to buy pollution reduction
  credits from a contracting team of NPs solves
  adverse selection problem via a bidding process
  that selects the least-cost team
• Individual abatement targets are assigned and
  enforced within the team
• Limitation
• Assumes team members know each others costs

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Mechanism Design a group performance contract

• Contract 2 (Taylor, 2003)
• Relax assumption regarding team members
  knowledge of others costs
• 2 stage generalized agency problem
• Regulator solves adverse selection through an
  abatement procurement auction. NPs bid
  individual abatement quantity and payment
  demanded team is formed from the lowest cost
  bidders
• Moral hazard solved by an all-or-nothing team
  contract

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Focus Group Format

• Introductory discussion
• Describe a hypothetical scenario
• Imagine selling pollution abatement
• What practices can be used to reduce N and how
  well do they work for downstream water quality?
• What do these practices cost?
• Imagine joining with neighbors in a group
  performance contract
• What do you observe about your neighbors farming
  practices?
• Can you influence your neighbors decisions?
• How important is weather risk versus moral
  hazard?
• Contract experiments and discussion

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How Important is Weather vs. Other Risks of Load
Impacts?

• Farmers discussed three risks of failure to meet
  collective target
• Farmer performance
• Effectiveness of BMPs
• Weather
• Weather was important, but not the most important
  in all cases

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Contracting game bidding process and group
performance

• Farmers given cost information for abatement on
  their farm
• Farmers bid price ( per ton) and quantity ?
  pay-out asked
• Team is formed of low-cost abaters
• Contract is All or Nothing individual pay-out
  is amount asked if team succeeds zero if team
  fails
• Farmers state their actual effort in reducing N
• Weather is stochastic
• Good (20), Average (0), or Bad (-20), with
  equal probability
• Farmers are informed of outcome team
  succeeds/fails
• Discussion of reasons for failure/success,
  opportunity costs of
• sub-optimal bidding / team failure

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Findings

• Farmers concerned about 0 payout in case of
  collective failure
• Many still bid into the game
• Higher sure payments would increase moral hazard
• Rather than one time payment, farmers prefer a
  set of payments over time with annual targets
• Weather strategies become apparent to the farmers
• Bid prices rise with additional iterations

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Concluding comments

• Increasing adoption of flexible incentives
• A sensible policy incorporating a role for FIs
• The foundation serious regulation to protect
  human and ecosystem health
• MBIs are favored regulatory instruments wherever
  feasible
• Other FIs are used to supplement regulatory tools
• Good environmental citizenship is encouraged for
  industries, firms, public agencies, and
  individuals

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Concluding comments

• What are the impediments to water quality
  trading?
• King and Kuch
• Weak regulatory stance re NP sources
• Policy of subsidizing BMPs

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Concluding comments

• What are the impediments to water quality
  trading?
• King and Kuch
• Weak regulatory stance re NP sources
• Policy of subsidizing BMPs

• Randall and colleagues
• Design based P-NP trading programs are
  fatally flawed

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Concluding comments

• At Ohio State, we are excited about the prospects
  for a group performance contract for NP sources
• The idea is not new, so why are we taking it
  seriously now
• We have solved some problems with previous
  contracts
• Our implementation process is well-considered
  baby steps
• Widespread frustration with design based trading
  programs
• Weak performance of design based P-NP trading
  programs has implications for potential trading
  schemes involving agriculture
• Salinity trading
• Carbon trading