Notes

Year LX, 2018, Single Issue

EUROPEAN INSTRUMENTS FOR
ENVIRONMENTAL POLICIES AND
RESOURCES FOR SUPRANATIONAL DEMOCRACY*

1. Introduction

Study of measures aimed at fighting pollution must necessarily start with the definitions of the terms public goods, market failure, negative externality and public intervention. Goods can be classified as private (if they are rival and excludable in consumption), club (not rival but excludable), common resources (rival but not excludable), or public (neither rival nor excludable). Clean air, given that it is shared by everyone and its consumption cannot be regulated, falls into the category of public goods. In a public goods economy, individuals have no interest in revealing their preferences, in particular their marginal evaluations. Underestimating or concealing these evaluations is thus the dominant strategy of consumers, who act as free-riders and effectively prevent economic actors from producing public goods, which will therefore neither be demanded nor supplied. This is a textbook case of market failure, given that these goods cannot be produced efficiently in a free decentralised economy. With regard to air pollution, it is also necessary to consider the question of negative externalities. An externality occurs when one actor’s production or consumption choice directly influences another one’s pay-off, without being compensated for. In environmental economics this is a key concept, because pollution is classified as a negative externality mainly caused by producers and affecting both producers and consumers. This constitutes another example of market failure, which therefore demands some kind of public intervention.[1] In the following sections we will discuss the main strategies public authorities may adopt in order to tackle the problem of pollution.
 

2. Public Action to Protect the Environment

Bosi[2] identifies six main strategies that states, through incentives, disincentives and regulation mechanisms, can use in order to protect the environment. The first two, namely public production and mergers of companies, aim to internalise externalities. Public production serves to bring the polluting economic activity under the control of a political authority, meaning that the relative emissions are controlled by political rules. Pollution thus ceases to be an externality, since its level, being determined by voters, becomes a political choice that is made taking into account an economic pay-off. The limit of this strategy is that it is a radical solution that considerably limits the freedom of economic players in a decentralised economy. Company mergers, on the other hand, internalise externalities by unifying the production cost functions of the firms involved. The weakness of this strategy, therefore, is that it impacts only on negative pure production (i.e. producer-to-producer) externalities. However, this is offset by its very low cost of implementation, compared with that of the public production strategy. I will analyse the other strategies in more detail.
 

2.1. Regulation.

Through regulation, political authorities can oblige companies to keep emissions below given limits, and individual consumers to avoid certain behaviours. In the short term, companies may react to a legal restriction by decreasing production. They may also invest in research and development, so as to equip themselves with less-polluting installations in the future. However, recourse to industrial regulation has two considerable drawbacks. First, it necessitates the recruitment of inspectors, who constitute a significant cost for the public authority; moreover, individual cases may differ considerably from each other, with the result that a single regulation may not affect all polluters equally. Second, at international level, since regulation is seen by companies as an onerous obligation, they may choose to relocate their factories to countries with less stringent rules.

Regulation of emissions from consumer goods is less problematic, particularly in the field of standardised mass consumption. After all, standardised goods are easier to monitor, and citizens cannot relocate their activity in the way companies can. The European regulation on passenger car emissions is one of the best-known cases. A report commissioned by the European Commission to monitor the effects of regulation on prices[3] shows that in a free market economy prices are determined more by competition than by the costs to companies deriving from the regulations themselves, including fines for transgressions. In the light of this brief consideration, we can say that a regulatory policy on consumption is suitable both for national states and for regional organisations, because consumers are bound to their territory. States would only be induced to leave this kind of legislation to a supranational body for two reasons: it would allow them to share the costs of policy implementation, and would also boost cross-border business. On the other hand, regulating companies’ emissions at national level is a less efficient solution because states embrace a more restricted territory and, theoretically, in a global scenario, the activities of a limited number of organisations would be easier to coordinate. Nevertheless, regulation policies alone are not enough to fund democratic supranational bodies that lack fiscal capacity, given that the only income would derive from fines for transgressions, which are by definition intermittent and unpredictable.
 

2.2. Allocation of Property Rights: the Coase Theorem.

The Coase theorem was enunciated in 1960, and thus coincided with the birth of environmental economics.[4] Even though it was widely criticised, it gave rise to a debate that considerably enriched this topic. Robert Coase criticised the very concept of externalities as a cause of market failures, since the reactions of damaged individuals are themselves externalities against the player that inflicted the damage. This situation can be overcome only if property rights are fully allocated, so that only the market has the right to interfere with the goods of others. Therefore, the destination of property rights is not important, given that individuals are able to trade them efficiently; what matters is the state’s ability to allocate them and guarantee a free-trading environment.[5] The first prominent critic of this approach was Allen Kneese,[6] who highlighted two main problems. First, there arises a problem of equity, in the sense that it is fairer to compensate a victim of pollution rather than expect him to pay for his health. Second, in the real world, establishing a market without transaction costs is difficult, and in the case of a large number of individuals affected by externalities, it is too expensive to aggregate their preferences and thus create a market.[7] A case study shows that “the Coase theorem is not robust in the presence of imperfect information, non-maximising behaviour and transaction costs. (...) The use of standard schemes or government intervention may, under some conditions, be a more effective and cost-efficient approach.”[8] This report confirms Kneese’s points, showing that application of the theorem is more complicated in practice than in theory.
 

2.3. Pigouvian Taxes.

The theorisation of so-called Pigouvian taxes stems from the work of Arthur C. Pigou.[9] A public intervention is justified by the difference between the value of the marginal private net product and the value of the marginal social net product. This difference impacts on private and public marginal costs, leading to a situation in which producers have no interest in reducing the losses incurred by society, which are negative externalities. Therefore, public intervention is required in the form of a targeted fiscal policy. The value of the tax should be equal to the external marginal cost, calculated from an ex-post efficiency perspective, leading the producer to reach a maximised level of production net of the taxation. As in the case of the Coase theorem, the transition from theory to policy is very complicated. In fact, it is difficult for a public authority to gather information about every producer’s marginal costs and optimal levels of production in order to calculate the right amount of the tax. Furthermore, assuming that this amount is determined, it would remain valid only in the short term, i.e. for as long as industrial activities remain the same. Any increase or decrease in the number of firms would make it necessary to recalculate the tax.[10] Italian legislation adopted as a result of the Kyoto Conference provides a current example of the Pigouvian tax.
 

2.4. Transferable Pollution Rights: the Basis of Cap-and-Trade Policies.

The proposal of transferable pollution rights seeks to decrease negative externalities by combining the role of public institutions with the market economy. In this scenario the state provides pollution rights in the form of vouchers which limit companies’ emissions to a given level. The total amount of permitted pollution is thus politically decided, and the assignment of the rights should be based on efficiency and equity criteria. After this phase, producers will start bargaining the value of these vouchers and redistributing them, according to their own individual cost-benefit evaluations. The placing of a limit on the total number of allowances in circulation ensures that they have a value, and this whole process should result in their optimal distribution.[11] According to the International Monetary Fund,[12] choosing between a carbon tax and the above-described Emissions Trading System (ETS) is less important than getting the design basics of the chosen option right. The important thing is to cover emissions comprehensively, establish stable prices in line with environmental objectives, and exploit fiscal opportunities. The ETS actually presents some weaknesses: the permits concern only certain polluting activities and therefore do not achieve full coverage; they require accompanying price stability provisions, and furthermore, the allowances have to be put to auction in order to obtain revenue to finance broader fiscal policies. This theoretical design has been adopted in different areas of the world, in particular by the European Union.
 

3. Taxing Pollution and Supranational Institutions

3.1. The Game Theory Approach.

Game theory is a discipline that lends itself very well to studies on the management of environmental problems as it can accurately describe certain situations that typically arise during the process of negotiating international agreements on climate. Intergovernmental conferences in this field commonly adopt the “pledge-and-review” scheme, which basically means that states are required to fulfil certain tasks and present reports on their efforts. The “pledge and-review” scheme creates a competitive environment whose outcome is similar to the “tragedy of the commons” situation.[13] Accordingly, the dominant strategy of the actors, assuming that they are self-interested and fully informed on the relative benefits and costs, is to avoid cooperation because they cannot influence another player’s behaviour. The Nash equilibrium[14] is a non-cooperative solution, and it arises because acting virtuously alone is relatively less advantageous than refusing to act. The following table schematises simply the situation described, showing the players’ outcome in the short term; the solution corresponding to a Nash equilibrium is shown in bold.
 

The traditional response to this dilemma, which condemns the international arena to impotence, is to create a supranational power that can force states to cooperate: this new political actor should be capable of enforcing laws that will decrease the pay-off for non-cooperative behaviours. But, since this political development is not in sight, many scholars from the “Carbon Price Project” have proposed a new approach for promoting international cooperation.[15] The idea is to evaluate each state’s contribution and redistribute, in equal parts, the sum raised at international level. Assuming that the players each start off with two units, and that the redistributed resources double in value, with the excess being assigned to a third player, each actor’s final pay-off would be equal to the non-redistributed resources plus the value of the states’ minimum contribution multiplied by two. For example, if one of the states does not contribute, nothing is redistributed to it, and therefore its pay-off is equal to the starting resources. Therefore, it is in the states’ interest to all redistribute the same amount of resources. This new approach, known as the “common commitment game”, can be summarised in the following table.
 

This situation provides multiple Nash equilibria, since, unlike what we saw in the first case, there is no single dominant strategy. Therefore, actors will coordinate their action in order to achieve the maximum outcome, i.e. the desirable solution given the environmental needs.

The main critical issue with the game theory approach is the fact that it considers states as individual and homogeneous players. It is thus difficult to imagine that political choices, like putting a price on carbon emissions, can be determined only by the national interest and the decisions of other states. For massive cooperation to be achieved, each state involved in the process has to choose to massively cooperate. If only one state refuses, the whole game ceases to be a useful tool. Another concern is that the role of the game regulator is not well identified, and were this regulator to be an international organisation, such as the World Bank or the UN, it would also lack democratic accountability. Furthermore, if no enforcement is envisaged, the international arena would remain the same, with the issue of carbon pricing continuing to be left to intergovernmental negotiations. Even though this outcome might amount to a practical success in relation to a specific issue, it would not contribute to the creation of a supranational democratic institution. In conclusion, game theory is useful for understanding why international agreements fail, but, since it is based on self-interested actors, it cannot serve as a roadmap for achieving a supranational democracy.
 

3.2. International Conferences on Climate.

Game theory is a useful means of analysing why numerous international climate change conferences based on the “pledge-and-review” method have failed. The Kyoto Conference,[16] for example, must be considered a failure because, after declaring an overall common commitment to decreasing emissions by a given percentage, the states decided to act individually. Moreover, on July 25, 1997, the US Senate passed the Byrd-Hagel Resolution, which blocked any attempt to adopt the measures envisaged in Kyoto. American senators were concerned about the relative advantage developing countries would obtain if developed ones were forced to cut their emissions. In particular, the text of the resolution states: “The United States should not be a signatory to any protocol (...) which would mandate new commitments to limit or reduce greenhouse gas emissions (...) unless the protocol or other agreement also mandates new specific scheduled commitments to limit or reduce greenhouse gas emissions for Developing Country Parties within the same compliance period, or would result in serious harm to the economy of the United States”.

The Paris Agreement[17] is based on a different concept, in fact the treaty will become binding only if a minimum number of countries sign it. Its text states that the “agreement shall enter into force on the thirtieth day after the date on which at least 55 Parties to the Convention accounting in total for at least an estimated 55 percent of the total global greenhouse gas emissions have deposited their instruments of ratification, acceptance, approval or accession”. These numbers suggest that only a common action on the part of the world’s biggest polluters, which are always reluctant to ratify agreements of this kind, would really have the power to breathe life into the treaty. Moreover, the Paris Agreement requires all Parties to put forward their best efforts through nationally determined contributions and to strengthen these efforts in the years ahead, and to report regularly on their emissions and on their implementation efforts. This mechanism is actually very reminiscent of the “pledge-and-review” scheme that has failed to bring success to the Kyoto Conference.
 

4. National and European Environmental Policies

Having briefly outlined the two most famous international conferences on climate change, and their weaknesses, let us now look at the situation on the European stage, both at national and EU level.
 

4.1. National Level: Carbon Taxes.

Since the EU lacks the features of a fiscal union, only its member states have the power to implement fiscal policies. In Italy, the first law regulating taxation on emissions is law no. 448/1998 Public finance measures for stabilisation and development, where article 8, paragraph 1 states: “In order to pursue the objective of reducing carbon emissions, in accordance with the conclusions of the Kyoto Conference of December 1-11, 1997, excise duty rates on mineral oils must be recalculated (...)” The second paragraph states that the change in these rates must not increase the overall tax burden on citizens. Therefore, paragraph 10 provides that the increased revenue generated should be offset by a reduction of fiscal pressure on certain other budget lines. Therefore, Italy transposed into law the principles of the Kyoto Conference, but the result was limited to a reallocation of fiscal burden, without introducing any funding of political instruments to further cut carbon emissions.[18] Currently the country taxes oil products when these are used to produce energy. This case constitutes an exception to the EU’s “Energy Tax Directive”, which envisages a fiscal drag on electricity output.[19] Among the various national policies, an interesting case study is the British Climate Change Levy. As McEldowney and Salter [2015] show,[20] the CCL falls short of being a carbon tax and is, in effect, an energy tax, but, as indicated, the tax rate does not vary directly in relation to the carbon content of fuels. In its own terms, it has nevertheless made a contribution to achieving the UK climate change targets. Estimates vary, but savings of 12.8 million tonnes of carbon dioxide are calculated to have been made between 2001 from 2010, which corresponds to a 20 per cent reduction in carbon emissions.[21] The example provided indicates that a national policy could achieve important results, even if coordination with other counties is not ensured.
 

4.2. EU Level: Emissions Trading System.

The European Union’s Emissions Trading System (EU ETS) was established in 2005 and it concerns the countries of the European Economic Area, i.e. the EU member states plus Iceland, Liechtenstein and Norway. It covers around 45 per cent of greenhouse gas emissions in this area. The whole operation was divided into three phases. Phase 1 (2005-2007) covered only CO₂ emissions from power generators and energy-intensive industries, and free allowances were distributed. In phase 2 (2008-2012), a lower cap on allowances was set: the proportion of free allocations fell slightly to around 90 per cent, several countries held auctions, and the penalty for noncompliance was increased. In phase 1, trading volumes rose from 321 million allowances in 2005 to 1.1 billion in 2006 and 2.1 billion in 2007. Currently, the programme is in phase 3, whose main feature is the application of a single, EU-wide cap on emissions in place of the previous system of national caps. Auctioning is the default method for allocating allowances (replacing free allocation), and more sectors and gases have been included. Phase 4 will start in 2021 and end in 2030, the official term envisaged by the Paris Agreement. To achieve the EU’s target of an at least 40 per cent reduction, the sectors covered by the ETS must reduce their emissions by 43 per cent compared with 2005.

The EU ETS has two main limits: it covers only part of the total emissions, and the revenue from auctions is available only to the member states, not to the EU. Moreover, most of the credits gained have been used to finance domestic activities. The main revenue use categories are renewable energy (2.89 billion euros, or 40.6 per cent of total revenue use), energy efficiency-related spending (1.95 billion euros, or 27.4 per cent), and sustainable transport (774 million euros, or 10.9 per cent).[22]
 

5. Conclusions

As we have seen, the current projects can be divided into two categories: carbon pricing and cap-and-trade policies. The first solution does not require the creation of supranational democratic actors, since it is based on cooperation between individual states. An “internationally-harmonised domestically-collected carbon price” is sustainable.[23] The second one, on the other hand, needs supranational actors able to coordinate states and create a common scheme: democratic accountability is thus not mandatory. The purpose of this paper was to analyse the specific issue of carbon emissions, and the fiscal instruments set up by governments to limit them. But every report indicates that a successful environmental action can only derive from a combined recipe of proposals, which includes both state-led and market-led initiatives and embraces interventions of different kinds. In order to efficiently implement a combination of these policies, citizens and governments will likely require supranational institutions, as French president, Emmanuel Macron, recently declared. In a speech on green finance delivered in Brussels on March 28, 2018, he stated that European citizens need a true European system of own resources in order to sustain a green and durable economy. Consequently, an autonomous budget would ensure the capability to make important investments in infrastructures and projects in the field of ecological transition. This budget must not be incompatible with environmental purposes or other policies, and indeed must offer new instruments that may contribute to the pursuit of the ecological vision. Macron then proposed the implementation of a border tariff as an instrument to finance a European budget line for environmental policies.[24] This sort of green dumping seems interesting but also rather unrealistic, especially given that Germany, which has important commercial interests with carbon-dependent countries, would likely oppose it. Nevertheless, the whole proposal fits in with Macron’s idea of a sovereign Europe, whose realisation requires a democratically controlled eurozone budget funded with European own resources. This is currently the only position held by a European head of government that calls for the creation of new supranational institutions, and therefore its success is important to all those who wish to see the creation of democratic institutions above the level of the national states.

* This lecture was delivered at the Supranational Democracy Dialogue meeting, held in April 2018 at the University of Salento.

[1] Paolo Bosi, Corso di Scienza delle Finanze, Bologna, Il Mulino, 7^th ed., 2015.

[2] Ibidem.

[3] Adarsh Varma, Dan Newman, Duncan Kay, Gena Gibson, Jamie Beevor, Ian Skinner, and Peter Wells, Effect of regulations and standards on vehicle prices. Technical report, Didcot, AEA Technology plc., 2011; https://www.google.com/search?q=E%EF%AC%80ect+of+regulations+and+standards+on+vehicle+prices.+Technical+report&ie=utf-8&oe=utf-8&client=firefox-b.

[4] Steven G. Medema, Of Coase and Carbon: The Coase theorem in Environmental Economics, 1960-1979, Denver, University of Colorado 2011.

[5] Paolo Bosi, Corso di Scienza delle Finanze, op. cit..

[6] Allen V. Kneese, The Economics of Regional Water Quality Management, Baltimore, The Johns Hopkins Press and Resources for the Future, 1964.

[7] Ibidem.

[8] Jens Abildtrupa, Frank Jensenb, and Alex Dubgaardb, Does the Coase theorem hold in real markets? An application to the negotiations between waterworks and farmers in Denmark, Journal of Environmental Management, 93 (2012), p. 169.

[9] Arthur C. Pigou, The Economics of Welfare, London, Macmillan and Co., 1920.

[10] Dennis W. Carlton and Glenn C. Loury, The Limitations of Pigouvian Taxes as a Long-Run Remedy for Externalities, The Quarterly Journal of Economics, 95, n. 3, (1980), p. 559. Richard N. Cooper, Peter Cramton, Ottmar Edenhofer, Christian Gollier, Eloi Laurent, David JC MacKay, William Nordhaus, Axel Ockenfels, Joseph Stiglitz, Steven Stoft, Jean Tirole, and Martin L. Weitzman, Global Carbon Pricing. The Path to Climate Cooperation, Cambridge, Mass, The MIT Press, 2017.

[11] Paolo Bosi, Corso di Scienza delle Finanze, op. cit..

[12] Mai Farid, Michael Keen, Michael Papaioannou, Ian Parry, Catherine Pattillo, Anna Ter-Martirosyan, et al. After Paris: Fiscal, Macroeconomic, and Financial Implications of Climate Change, Staff Discussion Notes No. 16/01, International Monetary Fund, 2016.

[13] This phrase was first used by G. Hardin in 1968 (G. Hardin, The Tragedy of the Commons, Science, 162 (1968), p. 1243; http://science.sciencemag.org/content/162/3859/1243.full) to describe situations where freely accessible goods, whose ownership is not clearly defined and whose exploitation is not regulated, are inevitably bound to run out because of the exploitation by individuals pursuing only their own interests (free-riders). The tragedy can only be avoided if the ownership of such goods is clearly defined and their exploitation is regulated by the owners.

[14] J.F. Nash, Jr demonstrated that in a game in which each player chooses his strategy in order to obtain the highest profit, none of the players is interested in changing his strategy unless another player changes his own (strategic rationality). If each actor adopts a dominant strategy, i.e. adopts the choice giving him the highest pay-off taking into account opponents’ expected moves, a Nash equilibrium is reached. In the case of the tragedy of commons, a Nash equilibrium, given the interaction of actors’ dominant strategies, leads to a non-cooperative and therefore sub-optimal solution.

[15] Richard N. Cooper et al., Global Carbon Pricing. The Path to Climate Cooperation, op. cit.

[16] https://treaties.un.org/Pages/ViewDetails.aspx?src=IND&mtdsg_no=XXVII-7-a&chapter=27&clang=_en.

[17] https://unfccc.int/sites/default/files/english_paris_agreement.pdf.

[18] Italian Law no. 448 of 23 December 1998, Misure di finanza pubblica per la stabilizzazione e lo sviluppo, Gazzetta Ufficiale, n. 302, 29 December 1998, supplemento ordinario n. 210/L.

[19] OECD. Taxing Energy Use 2018. Paris, OECD Publishing, 2018.

[20] John McEldowney and David Salter, Environmental taxation in the UK: The Climate Change Levy and policy making, Denning Law Journal, 27 (2015), p. 37.

[21] Ibidem.

[22] Xavier Le Den, Edmund Beavor, Samy Porteron, and Adriana Ilisescu, Analysis of the use of Auction Revenues by the Member States, European Commission, 2017.

[23] Martin L. Weitzman, Can Negotiating a Uniform Carbon Price Help to Internalize the Global Warming Externality? Harvard Project on Climate Agreements, Journal of the Association of Environmental and Resource Economists, 1 (2014), p. 29.

[24] Emmanuel Macron, Discours du Président de la République à la conférence sur la finance verte, Brussels, March 2018.