PROJECT WORK

NEGATIVE EXTERNALITIES

SUBMITTED TO: SUBMITTED BY:

Mr. Qayoom Anshumaan Arya(L/1504)

Assiatant Professor Scholar

School of Law School of Law

Raffles University Raffles University

ACKNOWLEDGMENT

I take this opportunity to express our humble gratitude and personal regards to Mr.Rahul Soni for
inspiring us and guiding us during the course of this assignment work and also for his
cooperation and guidance from time to time during the course of this assignment work on the
topic.
I have prepared this assignment not only for marks but also to increase our knowledge.
NEGATIVE EXTERNALITIES AND GOVERNMENT INTERVENTION

What forms of government intervention might help to correct the market failure from negative
externalities?

To many economists interested in environmental problems the key is to internalise external

costs and benefits to ensure that those who create the externalities include them when making
decisions.

Pollution Taxes

 One common approach to adjust for externalities is to tax those who create negative
externalities.
 This is known as "making the polluter pay".
 Introducing a tax increases the private cost of consumption or production and ought to
reduce demand and output for the good that is creating the externality.
 Some economists argue that the revenue from pollution taxes should be 'ring-fenced' and
allocated to projects that protect or enhance our environment.
 For example, the money raised from a congestion charge on vehicles entering busy
urban roads, might be allocated towards improving mass transport services; or the
revenue from higher taxes on cigarettes might be used to fund better health care
programmes.

How to deal with the mountain of waste?

Despite a decade of soaring recycling rates, the UK still landfills more rubbish than any other
country in Europe. Each landfill site releases huge amounts of methane – a greenhouse gas 20
times as damaging as CO2 – into the atmosphere. Reports suggest the UK is now running out of
places to bury its waste – one study found every landfill site will be full by 2018.

Under severe pressure from the European Union to cut the amount of rubbish it buries, the
British government introduced a landfill tax for local authorities that mean the amount they must
pay per tonne rises with every passing year. From a base rate of £7-per-tonne in 2000, the charge
has now hit £56 – and will rise to £80 by 2014.

To get to a 'zero waste' economy local authorities will have to persuade people and businesses to
create less waste in the first place, as well as re-use and recycle more. Where it's not possible to
turn waste into new products, it makes more sense to use it to generate power for homes and
businesses, rather than send it to landfill. So enters the spectre of the incinerator, long associated
in this country with dirty, industrial plants spewing out toxic smoke.

But new technology allows for other ways of dealing with waste. Anaerobic digesters are another
option, taking green and organic waste and using biological processes to turn it into electricity.

Burning rubbish is such old technology," said an anti-incinerator campaigner. "If you burn
things, there have to be emissions.

Source: News reports

Examples of Environmental Taxes include:

1. The Landfill Tax - this tax aims to encourage producers to produce less waste and to
recover more value from waste, for example through recycling or composting and to use
environmentally friendly methods of waste disposal
2. The Congestion Charge: -this is a high profile environmental charge introduced in
February 2003. It is designed to cut traffic congestion in inner-London by charging
motorists £8 per day to enter the central charging zone
3. Plastic Bag Tax: A tax on plastic bags has not been introduced into England and Wales
4. Vehicle excise duty (VED): VED starts from a theoretical 'nil' rate and accelerating up
depending on the carbon emissions of the vehicle
Share of CO2 emissions in the UK - by industry / sector

Evaluation: Problems with Environmental Taxes

Pollution taxes can lead to government failure

1. Assigning the right level of taxation: There are problems in setting tax so that private
cost will exactly equate with the social cost.
2. Consumer welfare effects: Producers may pass on the tax to the consumers if the
demand for the good is inelastic and, as result, the tax may only have a small effect in
 reducing demand. Taxes on some de-merit goods (for example cigarettes) may have
a regressive effect on lower-income consumers and leader to a widening
of inequalities in the distribution of income.

Employment and investment consequences: If pollution taxes are raised in one country,
producers may shift to countries with lower taxes. This will not reduce global pollution, and
create problems such as unemployment and a loss of international

Externalities and Regulation

The government can intervene in a market using regulations and laws. For example, the Health
and Safety at Work Act covers all public and private sector businesses. Local Councils can take
action against noisy, unruly neighbours and can pass by-laws preventing the public consumption
of alcohol. The British government introduced a ban on smoking in public places from July
2007. The European Union has introduced directives on how consumer durables such as cars,
batteries, fridges freezers and other products should be disposed of. The onus is now on
producers to provide facilities for consumers to bring back their unwanted products.

Examples of regulations to address negative externalities

 Health and Safety at Work Act covering all businesses.

 Renewables Obligation Certificates to encourage the supply of renewable energy (+
penalties for not meeting targets)
 Councils using by-laws preventing public consumption of alcohol.
 Consumer protection legislation e.g. against dangerous goods
 Laws such as the ban on smoking in public places from July 2007
 The European Union has introduced directives on how durables such as cars, batteries,
fridges freezers should be disposed of
 The EU also imposes increasingly tough rules on carbon emissions from vehicles which
all EU manufacturers must meet
 Speed limits on roads and weight limits for lorries
 Quotas on how much fishing can take place in EU waters
 Bans on sale of certain substances / minimum age of legal sale
  Lowering alcohol limit for drivers – reduced by Scotland in 2014

Alternative to taxing the bad - subsidising positive externalities

 An alternative to taxing activities that create negative externalities is to subsidise

activities that lead to positive externalities
 This reduces the costs of production for suppliers and encourages a higher output
 For example the Government may subsidise state health care; public transport or
investment in new technology for schools and colleges to help spread knowledge and
understanding
 There is also a case for subsidies to encourage higher levels of training as a means to
raise labour productivity and improve our international competitiveness
The polluter pays principle

In the case of negative environmental impacts, there is now general endorsement of the Polluter
Pays Principle (PPP) which has been adopted by all OECD countries. However, the question of
what is 'pollution' whose avoidance costs should be borne by producers and how to define
'environnmental benefits' for which producers should be compensated is a social construct which
depends entirely on the distribution of property rights in the environment in any society.

For example, take the issue of discharging slurry into a stream. If the law takes the view that a
farmer has the right to use the stream in this way, then the public must bear the cost of
compensating the farmer for requiring him to adopt an alternative, and presumably more costly,
way of disposing of his slurry. If, on the other hand, the view is taken that the public's right to
enjoy the stream in its original state is the prior one, then the farmer would be prohibited from
discharging slurry, or might be permitted to do so (up to a level compatible with the capacity of
the stream) for an appropriate fee.

Other examples (note how the problem changes depending on the initial distribution of property
rights. Reflect on your own view as to the reasonableness of the assignment of property rights in
each instance):

 the preservation of the tropical rain forests as a CO2 sink - should Brazil be required to
protect its forests, or should the West be required to compensate Brazil for doing so?
 public access to farmland for recreational purposes - should farmers be compensated for
giving rights of way on their land, or is this a public entitlement?
 wetland preservation - should farmers be prevented from draining important wetlands on
their property, or should they be compensated for foregoing their right to improve their
land in this way?
 traditional farm buildings - should farmers be required to preserve farm buildings of
heritage interest, or should the public compensate farmers for so doing?
 Farmers are asked to improve the housing of their animals by giving them more space in
response to public concerns about animal welfare - should they be compensated by the
public or not?
In each instance, there will be a reference benchmark which will separate what farmers are
allowed to do in terms of managing their land without penalty, or expected to provide by way of
positive environmental benefits without compensation, and situations where penalities or
compensation apply. The position of this reference benchmark is likely to change over time, and
to vary across societies, depending on their environmental preferences and the distribution of
political power. In what follows we assume that there is an agreed reference benchmark and that
what constitutes pollution or a negative externality is well defined.

Allocate property rights to the environment

The reason why environmental bads are overproduced and environmental benefits are
underproduced is because of the absence of private property rights in the environment, thus
giving rise to market failure and the existence of negative or positive externalities. While market
failure is usually taken as justifying some form of government intervention, one tradition in the
literature suggests that the environmental problem could be resolved if the government simply
ensured that property rights in the environment existed. This insight was made by Ronald Coase
and is often referred to as the Coase Theorem. It can be illustrated as follows.

Consider a water treatment plant and a pig farmer. The pig farmer has the possibility of
disposing of the slurry from his pigs into the river. If he does this, however, the costs to the water
treatment plant of cleaning the water increase. The diagram shows the marginal benefit AB to the
pig farmer and the marginal damage OE suffered by the treatment plant, both as a function of Q,
the number of pigs produced.

Without considering the external effect for the treatment plant, the pig farmer will produce OB
pigs. This number maximises his profit which is equal to OAB. The area OBE gives the amount
of damage suffered by the treatment plant. The difference between these two quantities
represents the net gain to social welfare from the pig farmer's activity. As drawn, this is close to
zero.

Social welfare could be maximised if the pig farmer reduced his output of pigs to OD. At this
level of output, the marginal benefit of an additional pig just equals the marginal cost of
additional pollution. Increase in social welfare is shown by OAC.

Coase's insight was that, given well-defined property rights, negotiation between the parties is a
simple means to bring about social efficiency without government intervention. To see this,
consider two opposite rules. One is the zero liability rule, where there is no law against pollution.
The other is the full liability rule, which requires that externalities be limited to zero.

Under the zero liability rule, the pig farmer can continue to dispose of his slurry into the river
without taking into account its effect on the water treatment plant.
However, it is in the interests of the plant to offer the farmer compensation to reduce the number
of pigs and thus the level of pollution. At any point to the right of D, the costs to the plant are
greater than the marginal benefit to the farmer. Hence, the plant should be able to 'bribe' the
farmer to reduce output to the socially efficient level D.

Under the full liability rule, the treatment plant enjoys a right to clean water. In order to operate,
the pig farmer will have to pay the treatment plant to accept a particular level of pollution.
Again, because the marginal benefits to the farmer at any point to the left of D are greater than
the marginal costs to the plant, it should be possible for the farmer to 'bribe' the plant to allow
him to increase output to the socially optimal level.
Under either rule, the resulting output is Pareto-optimal and thus independent of the initial
distribution of property rights. Of course, the distribution of income between the plant and the
farmer is crucially influenced by the nature of the property right assignment rule adopted.

Critics point to the impracticality of this solution to environmental problems in the real world:

 transactions costs involved in negotiating solutions would be high where more than two
parties were involved, and in practice it may be difficult to identify who all the affected
parties are
 the optimal solution assumes that there is full information about the environmental
implications of different activities which is unlikely
 often property rights are not divisible (e.g. landscape amenity values) implying that
individual market transactions do not work and the free rider problem makes collective
action to pay compensation difficult.

However, property rights assignment may have a role to play in one class of environmental
problems, namely, those caused by the 'tragedy of the commons'. This refers to the (mis)use of
common property resources such as fish stocks in the ocean, forest resources or (of most
relevance to Irish agriculture) overgrazing on common land. The basic idea is that, although
everyone recognises that environmental degradation is taking place, no one individual has an
incentive to reduce production unless everyone does so, and there is no mechanism to ensure
this. One solution to this problem would be to privatise the resource, on the asssumption that an
individual owner would now have the incentive to conserve the resource for future exploitation.
Commonages are quite common in mountain areas in Ireland but have been damaged in recent
years by overgrazing caused by increased sheep numbers. Assistance can be provided to divide
up commonages and to fence off individual areas, although whether this is a preferable solution
to one where rules could be more effectively enforced by the group is an open question.
Market-based instruments to tackle pollution

Market-based instruments (MBIs) create incentives that encourage people, acting in their own
self-interest, simultaneously to treat the environment in a way that is in the best interests of
society. MBIs have two potential advantages over other types of instruments:

 MBIs allow different farms to make different adjustments in response to their unique
business structures and opportunities. I
 MBIs provide incentives to discover cheaper ways to achieve outcomes thus reducing the
future costs of achieving targets.

MBIs work through different mechanisms:

 Price-based instruments alter the prices of goods and services to reflect their relative
impact. They provide certainty to industry as to the compliance costs of achieving an
outcome but the environmental outcome generated to the broader community is
uncertain.
 Rights-based instruments can be designed to control the quantity of the environmental
good or service (or a suitable proxy) to the socially desired level. These instruments
provide certainty as to the environmental outcome but not as to the cost to industry of
achieving that outcome.
 Instruments designed to reduce market friction are less common. They aim to stimulate a
market to produce a desired environmental outcome through improving the workings of
existing markets by reducing transaction costs or improving information flows.
Responses to market friction tend to be less certain and longer term (Whitten et al.,
2003).

There are two market-based solutions to controlling pollution:

 fiscal measures (price-based)

 trading in emissions quotas (rights-based)
Fiscal measures

A common approach to aligning the private and social costs of negative externalities is through
a tax on the polluter based on an evaluation of the damage caused. In the diagram below, X is
the level of output if the costs of pollution are ignored and K is the socially optimal production
level. Two points should be noted about this diagram. First, the optimal level of pollution is not
necessarily zero, as many environmentalists often argue. Second, the environment often has
some assimilative capacity, so that up to a certain level of production there are no pollution costs
incurred.

The government could impose a simple flat-rate tax QZ on output which would remove the
incentive to increase production beyond the socially-optimal level K. Note that a flat-rate tax can
be criticised as unjust because (a) it taxes output over levels OZ which do not generate external
costs, and (b) it has a uniform effect on all output YK, despite the fact that marginal increases in
output above Z add increasing marginal amounts of external costs. A tax system which would
overcome these objections is shown by the curve RK. Such a tax would be levied on
pollution emissions above the level where they incur environmental costs.

Note the following points:

  Agricultural pollution is not of the 'point' or 'end-of-pipe' variety which allows emissions
to be precisely measured. It is often widely dispersed, originating on many different
farms and in varying intensities. This makes the use of an emissions-based tax infeasible.
 Instead, taxation can target a variable which is clearly linked to pollution, for example,
cattle numbers in the case of greenhouse gas emissions, or fertiliser use in the case of
nitrate emissions. Taxing an input rather than pollution itself can lower the costs of tax
collection, monitoring and enforcement although it is not necessarily fair. Farmers who
take the trouble to avoid generating pollution are taxed as much as those do not take care,
e.g. when spreading slurry on fields. Also, the heterogeneity of many inputs, e.g.
pesticides, makes it difficult to design a taxation scheme which does not overpenalise
certain inputs and undertax others.
 The effectiveness of taxation in controlling pollution can be limited because of low price
elasticies of input demand. For example, a Danish study calculated that to reduce
nitrogen use by 30 per cent (which was the Danish Government target in order to
improve water quality) would require a fertiliser tax of 150 per cent of the then current
nitrogen fertiliser tax.
 Scott (1997) argues that, even before considering taxation, the removal of fiscal
privileges to polluting inputs should be undertaken. She points out that the zero-rating of
both fertiliser and feed for VAT purposes encourages their use and discusses how the
operation of the VAT refund system for farmers in Ireland could be modified to prevent
this bias.

Alternatively, subsidies can be paid to farmers to encourage them to avoid pollution (although
this runs counter to the polluter pays principle). Examples include:

 grants paid to farmers under the Control of Farmyard Pollution Scheme (one of the
structural policies financed under the FEOGA Guidance Section) to help finance better
facilities for the handling of slurry, silage and other pollutants;
 under the MacSharry reform of the beef regime in 1992, extensification payments are
made to farmers who reduce their livestock stocking rates below a threshold level
(although there is controversy whether this policy was aimed at controlling production or
protecting the environment).
  In the Lough Sheelin water quality improvement scheme in Cavan (where the water
quality of this angling lake had seriously deteriorated because of the concentration of pig
numbers in its catchment area), the government subsidised the transport of slurry out of
the catchment area to help minimise the pollution load (the scheme had to stopped when
it was found that farmers were adding water to their slurry to increase the number of trips
for which they were paid!).

Emissions permit trading

This is a market-based scheme in the sense that it uses economic mechanisms to minimise the
total cost of meeting a particular pollution target. Suppose, for example, that the government
wishes to limit nitrogen application to a pre-determined level decided in the light of
environmental criteria. Each farmer is given a quota, or permit, to use a specified quantity of
nitrogen but these quotas can be traded. Farmers who decide to use less fertiliser than their quota,
by managing their fertiliser use better or by altering their product mix, would be able to sell their
excess permits. Those farmers where the marginal value of fertiliser use was particularly high
would be willing to buy permits. Through permit trading, the desired reduction in nitrogen use
can be achieved in a way which equalises the marginal abatement cost across farmers and thus
minimises the total social cost of achieving the environmental target (this is explained further
below).

Note the following:

 the Netherlands had a manure quota system along these lines to deal with the
environmental implications of its heavy concentration of pigs.
 there will always be controvery about the initial distribution of permits (the initial
allocation of property rights) - should this be on the basis of historic use, or equal permits
to all farmers, or what method should be used?
 there may be significant transactions costs involved in setting up and monitoring and
quota trading scheme.
Regulatory approaches

Regulations (or non-market approaches) to control environmental pollution can be divided into
two types:

 performance standards. These are regulations based on measuring the observable

outcome of the polluter's behaviour, such as limits on the chemical residues in water
effluent from a factory or power station. Such emission-based standards are used for
point sources of pollution but are rarely practical in agricultural situations because the
pollution contributions of individual farms are virtually unobservable.
 design standards. These are regulations which govern the way farmers produce food and
manage their land. For example, to reduce nutrient runoff, regulations could be imposed
on waste management practices and on the level, timing and form of nutrient applications
to cropland. Pesticide losses can be controlled by specifying rules on the amount and
timing of pesticide applications.

Examples of regulatory approaches, including the EU Nitrates Directive, Water Pollution Acts
and Integrated Pollution Control licences, are discussed.

Regulatory approaches can lead to higher total costs of pollution abatement. Consider the
situation of two polluters with different marginal abatement cost curves shown in the diagram
below. A marginal abatement cost curve shows the cost to the farmer (usually in terms of lost
output) from complying with a pollution standard. Assume that each farm initially produces 20
units of pollution and that the government introduces a regulation limiting pollution emissions to
half this total. If each farm is required to reduce its pollution by this amount, the costs of
reducing the marginal unit of pollution are much higher on one farm than the other. The costs of
a regulatory approach can be minimised by allowing trade in emissions permits. In this example,
the low cost abater would sell its rights to pollute to the high cost abater until the marginal
abatements costs were equalised across farms. This would occur with the farm with low
abatement costs reducing its pollution emissions to 5 units while the high-cost abatement farm
would only reduce its emissions to 15 units. However, this is the least cost solution since most of
the required reduction in pollution takes place on the farm where it is cheapest to make this
reduction.

Conclusions

 whether market-based or regulatory approaches are used to reduce pollution, because of

the non-point nature of agricultural pollution these policies work by targeting inputs or
outputs associated with pollution rather than the pollution itself. As a result, marginal
abatement costs are not equal across activities unless some form of trading in pollution
permits is introduced. However, the closer the policy can target the pollution, the less the
cost to the agricultural sector. For example, specific policies to reduce nitrogen input
(such as a fertiliser tax) will cost farmers less than a general tax on farm produce
designed to achieve the same level of reduction in nitrogen use.
 fiscal policy instruments generally have lower monitoring and enforcement costs than
either emissions permit trading or regulatory approaches