Market Failure and Policy Instruments: Climate Change

This paper aims at discussing CO₂ emissions as the result of market failure and some alternatives to deal with it. In details, I firstly demonstrate why climate change is caused by market failure through greenhouse gasses emissions (GHG) and CO₂ emissions. Secondly I outline and briefly mention several policy instruments available to deal with such problems. Thirdly and lastly, I discussed each instrument’s advantages and disadvantages.

The market usually does not function very well when it comes to public good as the public good has no price in it. Price can be assigned when there is property rights attached to the goods. That is exactly what is happening with public good, it lacks of property rights or is having ill-defined property rights. Imposing property rights means that we give the right to utilize the goods to some one/entities/clubs. Meanwhile, the characteristics of public good are non-excludability and non-rivalry. Non excludability means that it is impossible to exclude some one from utilizing the good. Non-rivalry means that the consumption of the good by an individual does not reduce the available amount for others to consume.

Carbon dioxide (CO₂) and other GHG are emitted to the earth atmosphere. Meanwhile, the atmosphere itself is a public good. It is non-excludable as everyone in the earth can emit anything to it or breathe the air from the atmosphere. It is non-rivalry since my emission does not reduce others’ rights to emit. It does not have price and thus no available market mechanism. In the end, when everyone emits GHG and CO₂ to the atmosphere, then there will be excessive stock pollutions in the atmosphere. Moreover, it is subsequently causing climate change.

However, as the awareness of the danger of climate change arise, countries started to seek out solutions to this problem. The climate change is a complex problem since it is a transboundary problem –i.e. climate change happens in everywhere and is caused in every place- and the existence of spill over –i.e the abatement of one country is enjoyed by other countries, so does the pollution of one country is affecting other countries too-.

There are several policy instruments available that can be used to mitigate the climate change problem. The policy instruments are grouped into three categories that are institutional approaches such as voluntary bargaining, command and control such as emission regulation, and economic incentive instruments such as taxes, subsidies, and tradable emission permits. The underline idea in economic incentive instrument is to give price to the emission so that profit-maximizing firm will also taking into account the opportunity cost of emission into their production plan.[1]

A profit-maximizing firm produces goods at optimal output level of maximal profit. Profit is maximal when marginal costs of firm equals to marginal benefits of firm (MC = MB). However when firm pollutes and the pollution is not priced, it creates social costs/damages to the society. The damages are called externality and are often not calculated in product price. By giving price to the damages –either through subsidies, taxes, or emission trades- the pollution then influences the cost function of the firm. Thus the firm internalizes the externalities.

Environmental taxes or known as Pigouvian Taxes is a practice of assigning taxes to pollution emitted by firms. Taxes are assigned to pollution as it will be less efficient if assigned to inputs or final products.[2] Pollutions are to some extent allowed as in an economic point of view, it is never about achieving zero pollution, and instead it is about balancing the benefits and costs. There are three steps to find the balance between benefits and costs –i.e. the optimal pollution level- that is identifying firm/industry profit function, the social damages function –that is the externality effects-, and the optimal pollution level.

The optimal pollution level is the point where the shadow price of social benefit is equal to the shadow price of cost. The shadow price of social benefit is the reduction in social damages due to a reduction in product produced, while the shadow price of cost is the loss of firm profits due to a reduction of a unit produced. In order to find the shadow price, we should calculate the marginal function –i.e. the first derivative- of firm’s profit function and social damages function. The next step is to equalize the marginal social benefit and marginal abatement costs. Environmental taxes then are applied to this level.

Subsidies work similarly to environmental taxes as at the optimal pollution level both mechanism –the environmental taxes and subsidies- are levied or paid at the same rate.[3] However, as Perman (2003) noted “the two instruments are different in their effects on income distribution”. Taxes caused firms to lose income while subsidies caused firms to gain income. In the short-run and at the optimal pollution level both mechanisms are similar; nevertheless, as subsidies are given in form of lump-sum payment, subsidies may give different long-term effects.[4]

Another mechanism of economic incentive mechanism is marketable emission permit. The idea is that government set an overall industry emission level and let the firms distribute the emission level independent of government intervention. In general, the mechanism works as follow: first, the government set a targeted industry emission level; second, an initial emission permit is distributed to each firm; third, firms sell/buy permit to another firms. This mechanism is also known as the cap-and-trade mechanism. Firms are able to sell or buy permit as they are different in their profit function. A firm may find it more profitable to emit more while other firms may find it more profitable to emit less and sell the excess allowances. Thus, an increase in one firm is compensated by decrease in other firm/s. Tradability is an important characteristic of marketable emission permit that grouped it into economic incentive instruments, otherwise it will be categorized as a command and control instruments.

There are several indicators to compare between above mentioned mechanism that is cost-efficiency and monitoring-administering-and-enforcing-compliance costs, long run effects, double dividend, and equity/distribution. It is obvious that command and control instruments are least cost-efficient compare to economic incentive instruments as compliance costs are usually high. European union emission trading for example estimates that the cost of emission trading is between 2.9 billion euros and 3.7 billion euros compare to 6.8 billion euros compliance costs annually.[5] Among economic incentive instruments, emission trading is the most cost-efficient compare to other instruments.[6] However, command and control may create greater long-run effects in term of technology advancement compare to other instruments as it provides incentive and guidance for technology research. I think that emission trading will give the biggest “double dividend” as it creates a lot of job opportunity. As of distribution issue, taxes may cause bigger effect for consumer –i.e. consumers bear the cost- regardless of polluter pays principle especially when market is of monopoly or oligopoly market.

Furthermore, in the presence of corruption, I think the emission trading will give best results compare to other instruments. The reason is that emission trading will minimize the involvement of civil servant in its operation and thus minimize the possibility of corruption.

Based on above comparisons, I think the best instrument is the emission trading.

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REFERENCES

European Commision. (2005) EU Action Against Climate Change: EU Emission Trading - an Open Scheme Promoting Global Innovation, Belgium.
Perman, R., Common, M., Mcqilvray, J., Ma, Yue. (2003) Natural Resources and Environmental Economics, 3^rd edition.

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[1] Perman, R., Common, M., Mcqilvray, J., Ma, Yue. (2003) Natural Resources and Environmental Economics, 3^rd edition.
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5] European Commision. (2005) EU Action Against Climate Change: EU Emission Trading - an Open Scheme Promoting Global Innovation, Belgium.
[6] Perman, et. Al. Ibid.

The Drawbacks of Environmental Taxes

One way to internalize externalities is by introducing environmentally related taxes. It is also effective and efficient instruments for environmental policy.[1] However, I think that this idea is not suitable –or have to be prepared more carefully– in the developing countries and less developed countries –in this paper, I use Indonesia as an example- where corruption is innate. I firstly discussed briefly the problems of tax collection and of tax-generated revenue usage in the context of third world countries. Secondly, I argue that tax may further increase environmental damage through increase in natural resources extraction. Thirdly, the problem of marginalized people dependency on cheap-yet-environmental-harmful products and services is brought into the paper. Fourthly, I discussed the effect of environmental taxes to the national competitiveness. Lastly, considering those four reasons, I argue that social responsible approach is better than environmental taxes in the third world countries.

Taxes contribute 66.59% of Indonesian’s National Budget income in 2006.[2] Whilst, the not-taxes incomes are earned from natural resources-related income and state-owned enterprises profit. However, despite of tax administration reform started in 2000, the taxes mentioned above are only collected from 1.71% of Indonesian population.[3] It shows how big the scale of tax evasion in Indonesia is. In my opinion, there are two important issues regarding this matter, which is social trust towards tax collectors and the perceived benefit of paying taxes.

First issue, the public trust regarding tax collectors –and to other civil servants- are low. Taxation department is seen as the dent of corruption. Corruption is initiated in two ways that is of tax collectors and of taxpayers. The first way, it is believed by public that tax collectors always calculate higher tax than of taxpayers’ calculation. The main reason of doing so is so that taxpayers choose to bribe tax collectors, instead of going through the time-consuming court settlement of tax dispute. The second way, taxpayers deliberately offer tax collectors some amount of money in exchange for lower tax calculation and thus saving some money. Another “advantage” for taxpayers of doing so is time-saving. Second issue, in Indonesia, paying taxes has long been perceived as not giving direct benefits such as social securities to the taxpayers. To some extent, this perception discouraging taxpayers from paying taxes.

From the point of view of welfare analysis, there is a dead weight loss created from three effects of environmental taxes which are budget gained from additional tax revenue, consumer’s loss as price increased and quantity consumed is decreased, producer’s loss as quantity decreased and the taxes burden (i.e reduced firm’s profit). Yet, there is environmental benefit gained from less environmental damage as quantity is decreased. The net welfare is positive as long as environmental benefit is bigger than dead weight loss, vice versa.

However, taking the corruption into account, I think that a positive net welfare is harder to achieve. My reasoning is that the environmental taxes revenue will not fully receive by state, as it is distorted by corruption, and thus lowering the budget gain. Meanwhile, the producer’s loss and consumer’s loss remain same and thus the dead weight loss is bigger. Therefore, introducing environmental taxes in heavy corruption countries may further harm the net welfare. Furthermore, environmental taxes, in these circumstances, will give incentive to corrupt more and hence increase the rate of corruption.

One of the environmental taxes goals is to conserve environment through reducing consumption and reducing natural resources extraction. The consumption reduction is achieved due to price increase. As consumption is reduced, logically speaking, the production is also reduced and thus the need of raw material is decreased. However, Chichilnisky (1994: 855) argues that “taxes can lead to more extraction of resources, defeating their original purpose”.[4] The logic behind it, first, is as the demand for raw material decreased, the resource’s price is decreased, and thus the extractors’ income is declined too. Second, the extractors –many of them are subsistence workers- will extract more in order to arrive in the same income level. Why is this not happening in developed countries? The reason is that natural resources are capital-intensive goods while they are labour-intensive goods in third world countries.[5] Thus, the environmental taxes can be a backfire to environmental conservation. This is another drawback of tax.

Additional tax means additional cost to consumers. In the marginalized community where income is low, a cost increase is harmful. If the community is dependent on those products and services –signalled by relatively inelastic demand and high consumption rate-, then the harmful effect will be magnified. The government often tries to keep the cheap price as the products and services are of basic needs such as fuel (gasoline, kerosene, and gas), water, electricity, and food. To some extent, price increase can cause social distress and political instability and then it increases social costs. Again, there is possibility that environmental taxes are harmful to the net welfare. Of course, the effect of price increase can be compensated by returning taxes to the community through subsidies. However, we have to bear in mind that different goods have different utility functions. Thus the compensation may not always be able to replace the cost.

Imposing environmental taxes can lowered the national competitiveness especially in the region where there is not standardized environmental policies among countries. Environmental taxes are hurting both the country and the company. It hurts the country as tax decrease the country’s investment attractiveness compare to other countries that are not imposing that tax. It can even –to some extent- induce company relocation. Instead of giving “double dividend”, environmental taxes can lower employment in that country. Environmental taxes hurt the company as it increase product price and make it less competitive in international or regional markets. In my opinion, when this kind of taxes is going to be imposed, then it should be imposed and standardized in the closely related geographical region and trade partners such as in EU and NAFTA agreement.

In summary, I argue that imposing environmental taxes in third world countries such as Indonesia may have drawback that can exceed the benefit of environmental taxes. I give four reasons that is corruption, intensifying natural resources extraction rate, increasing social distress and political instability, and weakening national competitiveness. Considering these drawbacks, I prefer more to the social responsibility approach. First, it minimizes interventions from state and thus reducing the corruption opportunity. Instead of having “double dividend” from increasing employment, the “double dividend” of social responsibility is the decreasing corruption rate. Second, the approach tries to ensure ethical business practices. One of the ethical principles is to pay adequate salary to the workers and to buy accountably extracted raw materials with equitable price. Third, the approach usually caused less cost to the company compare to the cost from complying regulation. It implies that product cost may not increase higher than if it is taxed and thus it does not hurt company’s product competitiveness. In addition, it may open new markets for the social responsible products. Moreover, the approach does not influence national competitiveness as it is usually a voluntary involvement. However, social responsibility approach needs public control and facilitating bargaining from the country.

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[1] OECD. (2006), The Political Economy of Environmentally Related Taxes.

[2] Anggaran Penerimaan dan Belanja Negara & Neraca Keuangan Republik Indonesia 2005-2006 (translation: Indonesian’s National Budget & Fiscal Balance 2005-2006).

[3] Harian Bisnis Indonesia, 10 juta NPWP dikaji Ulang (translation: The number of 10 million taxpayers will be checked again), 16 May 2006.

[4] Chichilnisky, Graciela. (1994), North-South Trade and the Global Environment, The American Economic Review, Vol. 84, No. 4., pp. 851-874.

[5] Chichilnisky, Ibid, p. 854

Water: Public or Private Goods?

Water has long been treated as public goods and has been managed solely by state or state-owned enterprise. At the other hand, nowadays, there is a growing demand to treat water as private goods. Although, according to van der Veeren – and many other eminent figures such as Vandana Shiva – water should remind as public goods[1], in this paper one tries to elaborate the idea of water as private goods. Firstly, one discusses briefly the lack of state-management of public goods. Secondly, one explores the promise – at least at the theory level – of privatization. Thirdly, by bringing the promise to the empirical world, one analyzes the drawbacks of privatization. Lastly, one indicates improvement alternatives of water management policy.

State management through government body or through state-owned enterprise is well-known – at least in the developing and less-developed countries – for its low service quality, inefficiency, corruption, vested political interests, and mismanagement. It is – to some extent – caused by monopoly of service and goods, and public control. As a monopoly, state-owned enterprise does not have to improve its production efficiency in order to survive as in the competitive market. Customer has no choice but to accept the condition of goods and the level of service offered. Customer service is then not a factor to retain customer and thus generating low service quality. Water service – in term of degree of access and product price – is often used in political agenda such as election campaign. Setting product price based on political agenda without considering production cost will further deepened the net loss of water state-owned enterprise. In the end, all of these negative aspects create high transaction cost and therefore burdening the economy and the society.

The idea behind water as private goods is that by privatizing water, it creates a non-monopoly market. Non-monopoly market, theoretically speaking, implies that everyone can get into the market and offer his/her products to buyers. Buyer reacts rationally by selecting the optimal offer, which is the offer that gives him/her the maximal utility. In order to make his/her products competitive, producers will keep on innovating and improving its service and efficiency. By doing so, market’s efficiency is improving and so thus the buyer utility (as they now able to consume higher product quality, higher amount, or even cheaper product price). To some point, the market will reach its Pareto efficiency which is not achievable in the case of state management. It looks like a win-win situation.

However, this is not happening in reality. Instead of providing wider water access and cheaper price, privatization resulting in a higher price and stagnant water access. So why is it happening? Among other reasons, one highlights two subjects which are profit seeking and market entry. Profit seeking means that a firm’s prime goal is to produce profit. Firm’s business continuation is dependent to profit. In previous condition, state-owned enterprise may sell water below its production cost. Thus, when privatization is taken place, product price is corrected (i.e. increased) to its production cost and profit margin. Furthermore, firm may not provide water access to some people as there is not sufficient potential customer in some remote/small area. It seems difficult to enter the market as water processing industry needs high investment and working capital. This, by itself, is limiting the number of firm in the market. The market is now having oligopoly instead of having full-competition market. Although oligopoly is better than monopoly, but it is still not as good as the full-competition market.

Now, how are we going to deal with those problems? One divides it based on actors such as state, society, and company/market. State can play a role as a facilitator through issuing rules and regulations regarding water market. It can require companies to provide a minimum service level in term of water quality, access, water distribution, etc. It also can induce a price ceiling (i.e. maximum product price allowed) for water. In brief, it is state responsibility to ensure a conducive market for improving water services. Subsidies can also serve as one of government tools in providing water access and improving water distribution to the marginalized people. In the other hand, government can give subsidies in different sectors for example education and health (while maintaining high water price). The arrangement then is to ensure that the net benefit of subsidies – in education or health or etc – is greater than the net loss from increasing water price. Thus, it improves the net welfare.

Society plays important role in controlling firm’s practices through public participation. Public participation can varies from submitting service complaint until boycott. The crucial factor here is that society is information-literate (i.e. having enough information). Public can also participate in form of capital/equity (i.e. buying stocks) so that public gains some control over company’s business practice. Another form of public participation is through legalizing the cultural/traditional water management. This traditional arrangement – such as Subak in Bali-Indonesia – has proven to be effective and efficient.[2]

Company should balance its prime goal with other goals. Company practices should be in-line with those of sustainable development. Corporate social responsibility – as one kind of sustainable development approach – deals with balancing company’s economic goal (profit), environment goal, and social goal. This notion seems to be a win-win solution for companies as it still takes profit into account without excluding environment and social problems. There is wariness that once water becomes private goods, it will exclude more negative externalities from its production function (i.e. firm does not internalizing externalities). However, externalities are also been dealt with in corporate social responsibility scheme through increasing/improving environment indicators and social indicators.

In summary, one tries to demonstrate the possibility of transforming water from public goods into private goods. Although empirically water privatization does not meet its promise, yet by making a better preparation (i.e. making a conducive market) the promise may be fulfilled. The preparation can be done by state, society, and company. As long as the company is internalizing externalities – that is correcting the property rights – and state is able to cut the effect of price increase by giving subsidies – that is improving net welfare –, then water privatization would not be of any problem.

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[1] van der Veeren, Rob, lecture in class of Environmental Economics in Practice, 08 November 2006, Wageningen University and Research Centre.

[2] Suarja, I.G. and Thijssen, Rik, Traditional Water Management in Bali, LEISA Magazine, September 2003. Accessed at 13 November 2006, available on-line at:
http://www.leisa.info/index.php?url=show-blob-html.tpl&p%5Bo_id%5D=12689&p%5B