ENVIRONMENTAL REGULATION: Why we need policies inspired by the ”polluter pays principle”

Polluters should be taxed for the impact of their pollution on society; and the victims of pollution should be fully compensated for the damages it causes. These are the central conclusions of research by Stefan Ambec and Lars Ehlers, which is published in the June 2016 Economic Journal. Their study argues that given the importance of considerations of fairness in global debates about the appropriate policy instruments for protecting the environment, the ''polluter pays principle'' is the only one that delivers.

They begin by noting that public policies for environmental protection have distributional effects on welfare in society. Pollution taxation or subsidisation of pollution abatement induces different changes in stakeholders'' profits. Similarly, the way that pollution allowances are assigned in an emissions trading scheme matters for the firms involved. For an environmental policy to be accepted by a society, its distributional effects should be perceived as fair.

Fairness is central in the debate about policy instruments for protecting the environment. For example, during climate negotiations, several principles of fairness have been invoked, leading to conflicting policy recommendations.

Developed countries are mostly in favour of the sovereignty principle: under the premise that all nations have equal rights to the atmosphere, this takes current levels of greenhouse gas emissions as the status quo. The principle implies that limitations on future emissions should be proportional to the current ones.

In contrast, developing countries support the responsibility principle. For example, during the Kyoto negotiation, Brazil argued that responsibility for compensating environmental damage should be related to the degree of responsibility for its causes. This principle implies that emission reductions should be proportional to historical contribution.

In the setting of a society where nations can be both polluting and victims of pollution, the authors analyse the fairness properties of one principle that guides the design of environmental policies: the polluter pays principle.

They begin by clarifying what the polluter pays principle recommends for the design of policy instruments. The principle states that the costs of pollution should be borne by the entity that profits from the process that causes pollution. It implies that not only should polluters be taxed for the impact of their pollution on society but also the victims of pollution should be fully compensated for the damages caused by pollution. The tax rate depends on the polluters'' deterioration of society''s total welfare.

More precisely, the polluters should pay the difference between the total welfare with and without its emissions. The resulting welfare of any nation is equal to the difference of society''s welfare minus the welfare of the hypothetical society in which this nation does not produce pollution and only suffers from it.

Next, the authors identify three natural principles of distributional fairness for a society:

• First, both polluters and victims of pollution should not experience a welfare loss compared with a status quo in which pollution is absent. As some pollution is efficient in society, everyone should benefit from it, at least weakly.

• Second, any polluter (nation or firm) should get the full welfare variation for the society of any change of its pollution impact. If a polluting firm manages to reduce its harm on society, it should get the full benefit from this reduction. Similarly, if its emissions become dirtier, it should get the full welfare loss from this change. This induces efficient investment incentives in cleaner production technologies.

• Third, no polluter should obtain a higher welfare than the one it would get if it were alone to pollute (and compensating others for the incurred damages). This principle ensures that a polluter does not benefit from the presence of other polluters through some environmental regulation – that is, by enjoying windfall profits selling emission allowances.

It turns out that the welfare distributions resulting from public policies inspired by the polluter pays principle are the only ones to satisfy these three principles.

''Regulation via the Polluter-Pays Principle'' by Stefan Ambec and Lars Ehlers is published in the June 2016 issue of the Economic Journal. Stefan Ambec is at the Toulouse School of Economics. Lars Ehlers is at the University of Montreal.