Environmental problems are typical example of externalities. The market cannot thus deal with them. Even the definition of legal rights over natural resources (which should lead to optimal outcomes according to the Coase theorem) does not enable the market to deal with them by itself, since such a strategy is subject to a set of practical limits and a set of public policies (initial distribution of legal rights, competition policy, reform of the judicial system...). Therefore, there is a case for some environmental policy and for the definition of environmental standards.

The question is now how should we enforce the standards defined by the policy-makers. Given either an EQS or a UES, is it better to implement the standard by taxing (that is, pricing pollution) or by setting quantity restrictions ?

I The case for quantity restriction (regulatory approach)

A - The traditional approach : regulatory instruments upon firms / industries

The traditional approach to problem of over-use of natural resources and of excessive pollution has been to curb these excesses by regulation. These regulations take a variety of forms.

1 - Prohibitions

·Prohibiting the abstraction, use or disposal of particular substances, products, processes, etc.

· E.g. : forbidden use of prescribed chemicals, radio-active substances...

2 - Setting of maximum limits

· maximum limits for the abstraction of particular natural resources

· E.g. : water abstraction, mineral extraction, fish catches.

3 - Prescribing the technology

· Prescribing technology, which may be used for particular process of production.

· E.g. : cement manufacturing process, fuel...

B - Achievements

The achievements of this traditional approach have been considerable. One has only to compare the environmental quality in EU countries which have effective environment regulations, and those in some Central and Eastern European countries which have not.

C - The flaws

In spite of these achievements, the regulatory approach suffers from different flaws.

1 - Not the most cost effective method

This is a major flaw. Given a pollution abatement target level (for a given industry), imposing on each firm the same level of abatement is not the way to minimise the overall abatement cost. As we shall see, taxes are more efficient in that respect.

2 - Provides limited incentive to cost-reducing innovations in pollution-control technology

Indeed, whatever the pollution abatement you are not allowed to discharge more.

3 - Quantitative standards may not be enforced (non compliance)

What happens if a firm exceeds the limit ? Either nothing or a fine is imposed - which amounts to a tax.. On the other hand A tax is always paid.

4 - Requires information rarely possessed by the central authorities

Indeed, a regulation imposing a given level of pollution abatement presupposes that the government is able to calculate the optimal level of abatement. This presupposes in turn ,that the government knows the Marginal Cost Curve and Marginal Benefit Curve of pollution abatement for the society :

To know A*, the government must know MB and MC curves. This is not realistic.

· Actually, taxes face the same problem Þ we cannot know the size of the optimal tax.

5 - Directed at the symptoms rather than to the cause of environmental problems

Quantitative regulations do not deal with the socio-economic causes of environmental problems. They do not try to internalise the externalities.

II The Case for taxation (I) : internalisation of externalities ?

Controlling pollution by taxation rather than by quantitative regulations seems to fit economists' predilection for relying on price rather than on quantitative control. Let us show the economic rationale and its limits.

A - In theory, a tax can internalise environmental externalities

1 - The intuitive function of a tax : to internalise external costs

· Let us remind that : Social cost = Private costs + External Costs

· Given the fact that pollution is an externality, an 'obvious' solution might seem to be to internalise this externality : polluters should pay a tax equal to the external costs imposed on others.

· Indeed, if we increase the PC with a Tax that equals the EC to society, we end up with : PC = SC (The condition for efficiency is met).

2 - To attain efficiency, EC (damage to environment) must be precisely estimated

· The basic requirement is therefore that Tax = External cost

· The External cost should be understood as the damage to the environment the action causes.

· Thus, to attain efficiency, the damage to the environment must be precisely estimated.

· The public authorities have to assess the likely damage, at each level of treatment, and express it in monetary terms - in order to construct its charge schedule.

· In other words, the public authorities must know the Marginal Benefit curve of pollution abatement.

B - Unfortunately, the correct size of the tax is unknowable

1 - This estimation of the damage is very difficult

· To do this is a very difficult task. In many cases scientific knowledge on the environmental effects of pollutants is incomplete or very uncertain

· There is a two step problem :

working out the physical relationship between the pollutant and the harm caused.
Putting a monetary valuation on the harm

· Additionally, many types of environmental resources have no market price.

4 - Conclusion : taxation cannot practically internalise the external cost

In the absence of reliable monetary measure of the External Cost (damage to the environment), the tax cannot perfectly reflects the External Cost and therefore, the Private Cost cannot equal to the Social Cost.

III - The case for taxation (2) : curtail resource use to a level target ?

A - Taxation can attain targeted level of waste abatement in a cost efficient way

1 - A more modest objective

Taxation, consequently, cannot properly internalise the externality. This is very disappointing, as compared with the intuition on can have that taxation could internalise externalities.

Yet, taxes may still be used to serve a more modest objective : to curtail the use of a given resource to a predetermined target level.

2 - Achieving a target of waste reduction

Lets us consider a given type of waste and assume that only two firms (A and B) in the economy produce it. A charge OX per unit of waste is imposed on both A and B. This tax is used here as a means of achieving a target of waste reduction of OYa+b.

P 250

Each firm finds it profitable to reduce the wastes it discharges so long as the saving in charges (OX per unit) are greater than its MPTC (Marginal Pollution Treatment Cost).

Since Firm B is more cost efficient in waster reduction than Firm A, it finds it profitable to abate its wastes to a greater extent (making therefore a greater contribution to the overall waste-reduction target).

3 - Taxes will minimise the cost of abatement

·The target is achieved at the lowest total treatment cost.

· In order to attain efficiency, more pollution treatment should be undertaken by the most efficient firms (lower MPTC).

· The abatement should be spread between firms in such a way that the marginal cost of abatement is equal for each firm.

· Moreover, taxation provides a strong incentive to all dischargers to reduce their MPTC.

4 - Quantitative restriction is not cost-efficient

· A regulatory system may achieve its overall waster reduction target by requiring all dischargers to achieve the same waste reduction (e.g.1/2 .OYa+b).

· This would not minimise the total treatment coast.

B - Problem : this require to know the MPTC

1 - Public authorities must know individual MPTC

· To achieve the target level of pollution abatement through a tax, the government needs to know the individual MPTC of each firm. If this information is lacking the government cannot identify the correct tax which would result in the attainment of the target.

· If the tax is too high, the target will be exceeded ; if the tax is too low, the target will not be reached.

2 - This reduces the usefulness of taxes

Implementing a UES through taxes may be awkward if firms within a country have different technologies).

IV The example of the energy tax proposal 1991

Despite the cost minimisation argument, until recently, pollution taxes have hardly been used in most EU countries and are still rare (Sweden is probably the EU country with most use).

A - The proposal

·In 1991n the Commission proposed an energy tax in two parts :

- one part related to the carbon content of fuels

- the other part on all non-renewable energy

· The proposal also allow for possible exemptions for some industries which are particularly energy intensive (e.g. steel) in order to preserve their competitiveness.

· Such exemption could be removed if other competitor countries agreed to tax such industries in a similar way.

B - Opposition

· The proposal arouses considerable opposition, especially from fuel producers and many industrial groups.

· The result was that the Commission effectively agreed to make implementation contingent on the acceptance of carbon taxes in the major competitors (Japan, USA)

C - Result

· At the earth summit of Rio de Janeiro (1992) US opposed all binding international agreement (on the ground that scientific evidences were weak).

· Eventually, UK refusal to agree forced the abandonment of any EU-wide carbon tax.

· Currently, EU directives merely 'encourage' member states to use environmental taxes.

· As we can see, the main concerns was :

- international competitiveness

- distortion of trade

CONCLUSION

Neither the taxation approach nor the quantitative restriction approach can pretend to reach optimality, since the true damage to the environment by pollution is so difficult to estimate.

However, when it is accepted that the aim is not an optimal level of pollution, there is a strong argument for achieving the fairly arbitrary standard by the use of taxes rather than by simply telling all firms to abate by some particular percentage.

The regulatory approach (that is the setting up of quantitative restriction on firms) does not address the problems at their socio-economic roots (externality), does not minimise the cost to society of pollution abatement, is difficult to enforce and gives poor incentive to cost reducing innovations

There is thus a fairly clear case for a more systematic use of taxation, which tends to internalise the externalities (event though a fully correct internalisation is not possible)

Moreover, even though any environmental standard is somewhat arbitrary, taxation is the way to achieve it at the lowest cost possible.

As a result, EU programs tend to give more and more importance to economic instruments (taxation) as opposed to quantitative restrictions.

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