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An Experimental Study of Transactions Costs, Liability Rules and Point-Nonpoint Source Trading in Environmental Markets

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This research will conduct laboratory economics experiments to provide practical information for policymakers designing tradable emissions permit markets. The experiments address design choices such as regulatory reporting requirements and transactions costs, the initial allocation of permits, if and how nonpoint sources can participate, and liability rules in case firms fail to meet anticipated abatement goals.

The experiments will address three general research questions concerning the design of environmental markets: (1) How do transactions costs interact with the initial permit allocation mechanism to influence the overall cost-effectiveness of a tradable permits system? (2) Can permit markets for point source emitters be combined with incentive mechanisms to control nonpoint sources in order to minimize overall control costs? In particular, the experiments will determine if it is possible to combine a tradable permit system for point sources with an incentive scheme such as land use change auctions for nonpoint sources. (3) What kinds of liability rules can reduce enforcement costs when a permit seller fails to meet emission reduction commitments? The experiments will add to the growing body of environmental economic research that studies these and other details of market design.

Approach:
Economics experiments involve human subjects making decisions motivated by economic profits in environments simplified to be consistent with theoretical economic models. The study design includes dozens of laboratory sessions with eight to twelve subjects in each session. The sessions are allocated to treatment cells designed to address the above research questions.

Expected Results:
This project will result in a number of publications, as articles in peer-reviewed academic journals and other outlets. The principal investigator will also report results in numerous presentations on emissions trading to a wide variety of audiences. The end result of the research funded by this grant and dissemination of these research findings will be a better understanding on the part of regulators, policymakers, researchers, and others of the potential usefulness of market mechanisms for environmental management. This will lead to a more cost-effective allocation of federal and state environmental protection resources and a better understanding of how abatement costs can be managed to address health risks and other environmental concerns.

Supplemental Keywords:
permit allocations, air emissions, TMDL, water quality, watersheds. , Economic, Social, & Behavioral Science Research Program, RFA, Scientific Discipline, Economics and Business, Market mechanisms, Social Science, allowance allocation, allowance market performance, compliance behavior, decision making, effects of policy instruments, emissions trading, enforcement and compliance, environmental economics, financial mechanisms, impact of federal policy instruments, incentives, liability rules, market incentives, market-based mechanisms, marketable permits, policy incentives, policy instruments, policy making, pollution fees, socioeconomics

Metadata

EPA/NSF ID:
R829609
Principal Investigators:
Cason, Timothy N.
Technical Liaison:
Research Organization:
Purdue University
Funding Agency/Program:
EPA/ORD/Incentives
Grant Year:
2001
Project Period:
January 1, 2002 to December 31, 2003
Cost to Funding Agency:
$144,136
Project Status Reports:
For the year 2002
Objective:
The objectives of this research project are to: (1) report a testbed laboratory experiment in which landholders/sellers in sealed-offer auctions compete for part of a fixed, allocated budget; and (2) investigate the auctions’ potential for nonpoint pollution control.

Progress Summary:
Nonpoint source pollution, such as nutrient runoff to waterways from agricultural production, is an environmental problem that typically involves asymmetric information. Land use changes to reduce pollution incur opportunity costs that are privately known to landholders, but these changes provide environmental benefits that may be more accurately estimated by regulators.

The first manuscript generated by this project reports a testbed laboratory experiment in which landholders/sellers in sealed-offer auctions compete to obtain part of a fixed budget allocated by the regulator to subsidize abatement. In one treatment, the regulator reveals to landholders the environmental benefits estimated for their projects, and in another treatment, the regulator conceals the potential projects' "environmental quality." Preliminary results show that sellers' offers misrepresent their costs more for high-quality projects when quality is revealed, so total abatement is lower and seller profits are higher when landholders know their projects' environmental benefits. This suggests that concealing this information may improve regulatory efficiency.

The second manuscript investigates the potential of auctions for nonpoint pollution control. Auctions may permit the regulator to identify those management changes that have greater environmental benefit and lower opportunity cost. One treatment employs uniform price auction rules in which the price is set at the lowest price per unit of environmental benefits submitted by a seller who had all offers rejected, so sellers have an incentive to offer their projects at cost. Another treatment employs discriminative price rules that are not incentive compatible, because successful sellers receive their offer price. Our results indicate that subjects recognize the cost-revelation incentives of the uniform price auction as a majority of offers are within 3 percent of cost. By contrast, a majority of offers in the discriminative price auction are at least 10 percent greater than cost. But the regulator spends more per unit of environmental benefit in the uniform price auction, and the discriminative price auction has superior overall market performance.

The project has proceeded on schedule. Data collection is nearly complete for the laboratory auctions for land use change to address nonpoint source pollution, and two manuscripts have been completed and are described below. The final experimental sessions for the auctions are scheduled for early August 2003.

Future Activities:
Future activities involve software development and the experimental design that are nearly complete for the second phase of the project, which will use laboratory methods to study: (1) compliance with environmental regulations under targeted enforcement based on Harrington (1988,
Journal of Public Economics); and (2) compliance in, and performance of, emissions trading markets with transactions costs and emissions uncertainty. Data collection is scheduled for fall 2003 and winter 2004, with manuscript preparation and presentation during 2004 (anticipated presentations at the Economic Science Association Conference and the Association of Environmental and Resource Economists Conference).

Publications and Presentations:
Cason TN. A laboratory study of auctions for reducing non-point source pollution.Journal of Environmental Economics and Management.
Supplemental Keywords:
testbed, landholders/sellers, environmental quality, nonpoint source pollution. , Economic, Social, & Behavioral Science Research Program, RFA, Scientific Discipline, Economics and Business, Market mechanisms, Social Science, allowance allocation, allowance market performance, compliance behavior, decision making, effects of policy instruments, emissions trading, enforcement and compliance, environmental economics, financial mechanisms, impact of federal policy instruments, incentives, liability rules, market incentives, market-based mechanisms, marketable permits, policy incentives, policy instruments, policy making, pollution fees, socioeconomics

Project Reports:
Final
Objective:
This research project focused on two objectives, both investigating design features of environmental markets that affect transactions costs. The first objective considered auctions designed to reduce nonpoint source pollution, and the second objective examined liability, enforcement, and compliance in tradable allowance markets with imperfect emissions control.

Environmental policymakers increasingly have turned to auctions, tradable emission allowances, and other incentive-based regulations to meet environmental policy objectives. When properly designed and appropriately applied, these approaches provide flexibility that can substantially reduce abatement costs and promote the development of new technologies and management strategies to reduce pollution. As regulators consider new market designs, new industries, and additional emission sources for such incentive regulations, they can draw on previous experience and theoretical models to guide market design choices. For many new approaches, however, the available field experience is limited or nonexistent, and theoretical models often are overly simplified relative to complications that can arise in the field. The laboratory economics experiments conducted on this project provide an empirical testing ground using economic environments that are more realistic than can be captured by theory alone. They therefore generate an additional source of information for practical guidance of regulatory policy.

Nonpoint source pollution, such as nutrient runoff to waterways from agricultural production, is an environmental problem that typically involves asymmetric information. Land use changes to reduce pollution incur opportunity costs that are known privately to landholders, but these changes provide environmental benefits that may be estimated more accurately by regulators. These information asymmetries generate transactions costs when the regulator attempts to promote favorable land use changes. The first key objective of this research project was to investigate information conditions and pricing rules that reduce transactions costs in land use change auctions. The experiments identify performance advantages from reducing the information provided to landowners and from employing discriminative, “received-your-own-offer” auction rules.

The second major objective of this research project was to investigate compliance incentives, liability, and enforcement rules in tradable emission allowance markets. Emissions in practice can only be controlled imperfectly, and enforcement resources are quite limited in many regulatory contexts. Compliance incentives also are influenced by the rules defining the allowances, such as whether or not unused allowances are bankable for future use. The experiments compare optimal compliance decisions to actual compliance choices made by human laboratory subjects, and they also investigate the interaction between compliance and allowance banking. We find that allowing banking reduces allowance price variability and therefore implicitly reduces transactions costs. Allowing banking, however, also increases noncompliance and emission levels. The overall research project results provide regulatory guidance for a variety of details that must be addressed in the practical implementation of new market mechanisms for environmental management.

Summary/Accomplishments:
The export of pollutants in watersheds originates from both point and nonpoint sources, and for nonpoint sources, the abatement responsibility is difficult to identify. This is because export typically occurs through overland runoff and movement of water through the soil profile. Nonpoint sources in agriculture generate a large fraction of certain types of pollution, and unfortunately existing nonpoint source regulation and conservation programs have not been fully successful in engaging private landowners. Consequently, auctions and other market incentive mechanisms are being used increasingly for encouraging land use changes for natural resource management. Examples include the Conservation Reserve Program in the United States and the Conservation Stewardship Scheme and Nitrate Sensitive Areas Scheme in the United Kingdom. In Australia, auctions are proposed in areas such as salinity control, nutrient control, and conservation of existing vegetation where land use change is required to achieve environmental improvement.

The first part of this research project employed laboratory experiments to compare the performance of various design features for different land use change auctions. In these auctions, the landowner/sellers compete in sealed-offer auctions to obtain part of a fixed budget allocated by the regulator to subsidize pollution abatement. The first publication from this research project examines the relationship between the auction’s information structure and the landowners’ incentives to reveal their costs, with the goal of identifying information conditions that allow the regulator to award land management contracts to maximize the pollution abated for a fixed auction budget. In one treatment the regulator reveals to landowners the environmental benefits estimated for their projects, and in another treatment the regulator conceals the potential projects’ “environmental quality.” The results show that landowners’ offers misrepresent their costs more for high-quality projects when quality is revealed, so total abatement is lower and landowner profits are higher when landowners know their projects’ environmental benefits. This suggests that concealing this information may improve regulatory efficiency.

A second research project paper compares the performance of two different auction pricing rules for these land use change auctions because pricing rules can affect directly the transactions costs of environmental markets. One experimental treatment employs uniform price auction rules in which the price is set at the lowest price per unit of environmental benefits submitted by a landowner who had all of her offers rejected, so landowners have an incentive to offer their projects at cost. Another treatment employs discriminative price rules that are not incentive compatible because successful landowners receive their offer price. Our results indicate that subjects recognize the cost-revelation incentives of the uniform price auction because a majority of offers are within 3 percent of cost. By contrast, a majority of offers in the discriminative price auction are at least 10 percent greater than cost. The regulator spends more per unit of environmental benefit, however, in the uniform price auction, and the discriminative price auction has superior overall market performance. In particular, when holding all other features of the economic environment constant (which is only possible with experimental methods), switching from a uniform price to a discriminative price auction significantly increases the improvement in environmental quality and reduces the rents realized by landowners.

A third publication produced during this research project summarizes the results from these two auction studies and highlights their lessons for practical auction implementation in the field. The experiments allow a comparison of alternative auction designs in “wind tunnels” that are more complex and realistic than typical theoretical environments. This “market engineering” provides a critical link between economic theory and field implementation. The first experiment indicates that revealing the environmental benefits associated with land management options reduces auction performance, although it does increase profit transfers to landowners. Landowners behave strategically when they know the environmental benefits of their projects, raising their offer price for higher benefit projects. The second experiment examines the pricing rule of the auctions and finds that discriminative price auctions perform significantly better than uniform price auctions on all market performance measures. Although both experiments employ cost and environmental benefit parameters for specific environmental problems (nitrogen reduction and salt reduction) to improve the potential application of these design lessons, we view these “proof of concept” laboratory experiments as only a first step. Future auction experiments should, for example, use nonstudent subjects, employ more realistic environmental terminology, and model the interaction of environmental benefits across different land use changes.

The second part of this research project addresses the research objective concerning transactions costs, liability, and enforcement in tradable allowance markets. The economic and environmental gains expected from emissions trading programs depend on how these programs are implemented in the field. The fourth manuscript lays the foundation for the compliance and enforcement research using an experiment to study Harrington’s (1988 Journal of Public Economics) dynamic model of regulatory enforcement. In this theoretical model, some agents have an incentive to comply even when the cost of compliance each period is greater than the expected penalty. Imperfect enforcement arises in the field for a variety of reasons, such as enforcement budgets that limit auditing and inspection frequency or statutory limits on fines. Nevertheless, many regulatory policymakers have observed that firms and individuals often comply with regulations even when both the frequency of audits and the penalty for violations are low. This is seen in areas as diverse as income tax collection, customs, antitrust laws, and environmental regulation. The Harrington model can (theoretically) help solve this empirical puzzle, but direct empirical evidence to assess its accuracy is difficult to collect using field data. The laboratory method can help to provide a more direct empirical assessment.

To evaluate this model, the experiment implemented an enforcement policy that moves subjects between two inspection groups that differ in the probability of inspection and severity of fine. Subjects decide to comply or not in the presence of low, medium, or high compliance costs. Enforcement leverage arises in the Harrington model from movement between the inspection groups based on previous observed compliance and noncompliance. Observed noncompliant subjects are moved to the high-enforcement group, and observed compliant subjects may be rewarded with assignment to the low-enforcement group. The results indicate that consistent with the model, violation rates increase when compliance cost becomes higher and as the probability of switching groups becomes lower. Behavior does not change as sharply as the model predicts, however, because violation rates do not jump from 0 to 1 as parameters vary across critical thresholds. A simple model of bounded rationality explains these deviations from optimal behavior .

The final project paper embeds this imperfect enforcement model in a tradable emission permit market with emissions uncertainty. Subjects face exogenous, random positive or negative shocks to their emission levels after they make production and emission control plans. In some sessions we allow subjects to bank their unused permits for future use. Although some emissions trading programs in the field allow unlimited banking (e.g., the federal Sulfur Dioxide Trading Program), others do not allow any banking (e.g., the Regional Clean Air Incentives Market Program in southern California), and others impose restrictions on the aggregate total of permits that can be banked (e.g., the Ozone Transport Commission in the Eastern United States). The experiment considers only the extremes of unlimited banking and completely prohibited banking.

In all sessions of this final experiment, subjects can trade in a reconciliation period to buy or sell extra permits following the shock realization. Subjects then report their emissions to the regulatory authority, and they are placed in different inspection groups depending on their compliance history, consistent with the Harrington enforcement model. If they are inspected and found to be noncompliant, they are moved to a “high-enforcement” group and are subject to more frequent inspection and higher fines.

The experiment identifies important interactions between emission shocks, banking, compliance, and enforcement. We find that the relationship between emission shocks and price changes is significantly stronger without banking, so banking helps smooth out the price variability that arises from the imperfect control of emissions. Price stability in emissions markets is important for a variety of reasons, including encouraging the appropriate level of expenditure and research and development investment on abatement technology and reducing transactions costs more generally. This greater price stability comes at a cost, however, because noncompliance and emissions are significantly greater when banking is allowed . The benefits to underreporting emissions are greater when unused permits can be banked for future use or sale. Regulators therefore would need to consider this tradeoff between the price stability that banking provides and the increase in emissions as a result of noncompliance.

References:

Harrington W. Enforcement leverage when penalties are restricted. Journal of Public Economics 1988;37(1):29-53.

Publications and Presentations:
TypeCitation
Journal ArticleCason TN, Gangadharan L. A laboratory comparison of uniform and discriminative price auctions for reducing non-point source pollution. Land Economics (in press, 2005).
Journal ArticleCason TN. A laboratory study of auctions for reducing non-point source pollution. Journal of Environmental Economics and Management.
Journal ArticleCason TN, Gangadharan L. An experimental study of compliance and leverage in auditing and regulatory enforcement. Journal of Public Economics (submitted, 2004).
Journal ArticleCason TN, Gangadharan L. Auction design for voluntary conservation programs. American Journal of Agricultural Economics (in press, 2004).
Journal ArticleCason TN, Gangadharan L. Emissions variability in tradable permit markets with imperfect enforcement and banking. Journal of Economic Behavior and Organization (submitted, 2004).

Supplemental Keywords:
laboratory experiments, land use change, nonpoint source pollution, emissions uncertainty, enforcement, compliance, banking, emission allowances, market-based mechanisms, environmental quality, environmental economics, , Economic, Social, & Behavioral Science Research Program, RFA, Scientific Discipline, Economics and Business, Market mechanisms, Social Science, allowance allocation, allowance market performance, compliance behavior, decision making, effects of policy instruments, emissions trading, enforcement and compliance, environmental economics, financial mechanisms, impact of federal policy instruments, incentives, liability rules, market incentives, market-based mechanisms, marketable permits, policy incentives, policy instruments, policy making, pollution fees, socioeconomics


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