Cost-effective approaches to environmental problems promise significant cost savings relative to traditional approaches. But because changes in environmental policy aimed at cost-effectiveness can adversely affect some members of society, the provision of compensation may be needed to ensure political support and to satisfy concerns about equity. In the context of such policy changes, this provision hinges on the comparative harm inflicted by different approaches, among other factors. One principle for promoting equity and ensuring economic efficiency in the provision of compensation is to link the form of compensation to the form of harm a policy change inflicts.
United States policymakers are taking cost-effective approaches to environmental and other social policy problems more seriously than ever before. Unlike command-and-control (CAC) approaches to environmental regulation, which prescribe detailed measures for achieving a stated level of environmental quality, cost-effective approaches typically allow flexibility in how a given level of quality is to be achieved. In many cases, cost-effective approaches that incorporate economic incentives—taxes, marketable permits, property rights, and, occasionally, subsidies—can make it possible to meet policy goals at a lower cost than more traditional CAC approaches. For example, the trading of permits for sulfur dioxide emissions, provided for in the Clean Air Act Amendments of 1990, could potentially save the electric utility industry up to $1.5 billion per year in meeting emissions reduction goals aimed at curbing acid rain. Economists have estimated in a number of studies that cost-effective approaches such as incentive-based (IB) regulation could achieve various environmental goals at a cost savings of 50 to 90 percent as compared with CAC approaches. With the United States currently spending $115 billion per year to comply with environmental regulations, even small savings can be important because such savings free resources for other uses, including the resolution of other social problems.
Yet—although this point is not widely appreciated—the move to cost-effective policies also generates losers. For instance, not everyone will be made better off by the advent of an emissions trading program under the 1990 Clean Air Act Amendments. The flexibility inherent in the program will enable many utilities to abandon the use of high-sulfur coal. One group that will be adversely affected is residents in regions of the country that produce high-sulfur coal, where as many as 16,000 coal miners may lose their jobs. That it is possible in theory for society to compensate the losers and still realize a cost savings is of little consolation to those who come out on the short end of the stick as a result of a change in policy.
Recently, as a contribution to Project 88—Round II, a bipartisan study on incentive-based environmental policies sponsored by senators Timothy Wirth of Colorado and the late John Heinz of Pennsylvania, researchers at Resources for the Future (RFF) surveyed a number of cost-effective approaches to environmental problems. In each case (and even when a switch from more costly CAC policies was being contemplated), a clear set of losers could be readily identified. This finding has led RFF researchers to think about ways to use some of the cost savings of LB policies to cushion or eliminate losses that others would suffer from society’s pursuit of environmental goals.
When Is Compensation Justified?
What are the social motivations for providing compensation to individuals harmed by a policy change? One pragmatic reason—and the one probably most important in actual policymaking—is to build political support for a policy change. When potential losers have the power to block the change, it may be necessary to at least partially offset losses to gain acceptance of the change. This is especially the case when the losers are easily identifiable and well organized, and the gainers are widely distributed and poorly organized.
A less pragmatic motivation stems from concerns about equity. Society may feel compelled to provide compensation when some of its members, especially those who are less fortunate, suffer significant losses from a policy change. Suppose, for example, a particular policy would provide very small benefits to a very large number of people, but would impose all its costs on a small group of very poor people (building a freeway through a poor neighborhood, for instance). Even though total benefits might exceed total costs by a wide margin, society might be uneasy about implementing a policy with perverse equity implications. Indeed, dealing equitably with those who suffer windfall losses may be necessary not only to achieve equity in the process of change, but to preserve social cohesion and a belief in the fairness of social rules and institutions.
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Society may also favor the provision of compensation on the grounds of economic efficiency. Specifically, individuals may be unwilling to endorse policies for which total benefits exceed total costs if they are unsure that they will personally receive benefits in excess of costs. If they were reassured that compensation would be offered to at least lessen the burden on those individuals who might be big losers, they might support such policies as a matter of course. Thus a commitment to providing compensation can serve a “social insurance” rationale.
Finally, it is worth noting that some people believe losers from policy changes should always be compensated. They hold that the provision of compensation in all cases would encourage policymakers to take greater care in calculating the actual tradeoffs of policy changes before implementing those changes.
How Much Compensation Is Justified?
Generally, the context of a policy change must be considered to determine how much compensation is justified. This determination hinges on several factors. One is the baseline against which the policy change is being measured—that is, the current policy (or lack of one) or another policy that could be implemented in place of the one being contemplated. The baseline determines not only the amount of harm being inflicted but also the identity of the losers from a policy change. For example, suppose a restriction on economically wasteful grazing of livestock on federal land is being proposed. If this restriction is being measured against the baseline of previously allowed grazing on federal land, the losers would be those who had been earning a living by grazing livestock on that land. But if grazing had never taken place on federal land, the losers from the proposed restriction would be the ranchers who might have profitably operated there. Society presumably would feel that the amount of compensation justified is greater in the first case than in the second case.
Thus the baseline is important in calculating the amount of compensation justified as a result of changes in environmental policy aimed at cost-effectiveness, because some policy changes could be measured against different baselines. For instance, in considering changes in policies regarding hazardous waste management, should LB approaches be compared with a baseline of no regulation or with a baseline of the existing inflexible rules under the Resource Conservation and Recovery Act (RCRA) and the Comprehensive Environmental Response, Compensation, and Liability Act (known as Superfund)?
To illustrate this point further, consider the evolution of that portion of the 1990 Clean Air Act Amendments dealing with acid rain. Against the current baseline of no policy at all, the losers from new LB regulations are sure to include those electric utilities’ shareholders and ratepayers who would have to bear the costs of controlling sulfur dioxide emissions. However, if the baseline is CAC regulation—especially regulation that requires the use of specific emissions control technology such as sulfur removal systems (scrubbers)—then incentive-based approaches like emissions trading create a different set of losers. In this case, electricity consumers and corporate shareholders would benefit relative to the baseline because they would pay less for pollution control than they would through CAC regulation, while miners of high-sulfur coal would suffer losses due to the shrinking market for their product.
In actual policymaking, frequently the most important reason for providing compensation is to ensure political support for a policy change.
In addition to the baseline, another factor that affects the size of compensation is the degree of surprise contained in a policy change. The magnitude of compensation that is viewed as justified is likely to reflect the degree to which the policy change could be anticipated. For example, society might feel that greater compensation would be justified if there was a sudden change in policy. However, the legitimacy of a claim might be diminished if ample warning of a change had been given. For example, with regard to the 1990 Clean Air Act Amendments, many people seem to feel that the claim to compensation by miners of high-sulfur coal has been diminished by the fact that tougher acid rain controls have been debated for nearly fifteen years. Indeed, legislation on acid rain that was offered just a few years ago would have contained a sizable compensation package for coal miners, but was stymied by legislators from the affected regions.
When a switch to an IB policy is being contemplated, another factor that affects the amount of compensation is the fact that IB policies already embody elements of compensation. Unlike CAC policies, IB policies provide implicit compensation to the extent that they lessen the burden on individuals who would be negatively affected. For instance, given that society has decided to do something about acid rain, cost burdens are minimized through the use of IB policies (even though some groups would benefit if forced scrubbing or some other mandated technological approach were required). Thus less compensation may be justified when IB policies replace more costly CAC policies.
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Incentive-based policies can also embody an element of explicit compensation. In the case of emissions permits and emissions taxes, the initial allocation of permits and the dispensation of tax revenues constitute transfers of wealth that explicitly compensate some of the agents who must comply with emissions reductions at the expense of other such agents. A well-functioning emissions permit market or system of emissions taxes will achieve an efficient outcome independently of how permits are initially allocated among emitters or tax revenues are dispensed. However, implementation of a permit market or emissions tax system would be incomplete if policymakers failed to prescribe the initial allocation of permits or the dispensation of tax revenues. Thus, unlike CAC policies, IB policies require policymakers to address compensation issues by assigning costs within an industry.
Hence, IB policies may invite less compensation than CAC policies for two reasons. First, the magnitude of the negative effects of a policy change are reduced due to the implicit compensation resulting from the economic efficiency of IB policies. Second, the distribution of the remaining cost burden can be directly remedied, in part, through the explicit apportioning of costs.
What Form Should Compensation Take?
When motivated purely by altruism, a monetary transfer is often thought to be the most efficient form of compensation because it maximizes the well-being of the recipient while minimizing the cost to the donor. Unfortunately, the presumed superiority of monetary compensation breaks down in a wide assortment of circumstances.
One disadvantage of monetary compensation is the difficulty individuals have in placing a fair dollar figure on harm. This is because compensable harm virtually always takes multiple forms. For example, harm due to the operation of an industrial facility may take the form of decreased property values, increased traffic congestion, and negative health effects that occur over time and are of an uncertain nature. Subjective monetary valuation of such harm can lead to inconsistent decisions on compensation. Some individuals simply do not want to calculate a monetary value for harm, perhaps because they find it offensive to do so. Even if economists could consistently assign a monetary value to harm, individuals might not be able to reconcile that valuation to their own satisfaction.
One alternative to monetary transfers that avoids the problem of monetary valuation is linked compensation, wherein the form of compensation directly addresses the form of harm. To take the example of harm from operation of an industrial facility again, linked compensation could call for the dedication of money or land for local amenities such as open space to bolster property values, road improvements to remedy congestion problems, and community programs to improve public health. The benefits of these amenities would persist over time, thereby partly averting the perplexing tradeoffs between the present and the future. Most important, the tradeoffs between the benefits of the amenities and the harm posed by the facility are made transparent in a way that is impossible with monetary valuation.
Linked compensation is likely to meet with greater acceptance than monetary compensation because subjective comparisons between similar objects are easier to make than comparisons between dissimilar objects, such as those required in monetary valuations of compensable harm. In psychology, this phenomenon is known as the compatibility hypothesis. This hypothesis suggests that calculation of and consistent judgment about fair tradeoffs are facilitated when individuals are asked to consider compensation that responds to the nature of harm.
Linked compensation also appears superior to monetary compensation for political reasons. For example, when compensation in the form of a monetary transfer is being considered, community concerns can be characterized as “extortion” and offers of compensation as “bribes.” These characterizations are less tenable when linked compensation is being offered. In fact, the offer of such compensation validates community concerns, indicating to the public that its concerns are being taken seriously and that policymakers are willing to compromise. Moreover, linked compensation avoids political issues that arise in monetary transfers, such as how money is to be divided. In general, linked compensation promotes a perception of fairness, which is particularly important in the absence of precedents for monetary valuations. This perception can instill a sense of procedural equity that is important to reaching an agreement on the compensation to be provided.
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The superiority of linked compensation is also supportable on grounds of efficiency. First, whenever government has imprecise information about the distribution of compensable harm among the population (a prevalent circumstance), the offer of monetary transfers invites individuals to misrepresent their qualifications to claim compensation intended for others, a phenomenon known as adverse selection. In this circumstance, linked compensation is more efficient than monetary compensation—as long as the compensable goods or services cannot easily be transferred or exchanged among individuals—because individuals have less incentive to unjustly misrepresent their claim to resources.
Second, the anticipation of monetary compensation tends to discourage potentially injured parties from pursuing appropriate behavior to avoid or minimize harm, creating a situation referred to as moral hazard. Indeed, the potential for such a situation has been a prevalent argument against ever providing compensation. However, linked compensation reduces moral hazard and leads to more efficient avoidance behavior.
Third, linked compensation is frequently less expensive than a monetary transfer. When harm affects a public good—by depressing property values, for example—a compensating investment in a public good—say, dedication of land for open space—creates benefits for the donor as well as the public. These benefits to the donor partially offset the dollar cost of the investment. On the other hand, when the compensable harm is privately experienced—as in the case of a potential threat to the health of some individuals—a compensating investment in a health service or a health monitoring system may allow the donor to extend its own existing employee health programs, thus spreading out the fixed costs of its health programs.
Finally, linked compensation can be superior to monetary compensation when compensation is motivated by paternalism rather than by altruism. When the party providing compensation is interested in improving the overall welfare of the recipient, this interest is usually regarded as altruism. When the party providing compensation is interested in improving a particular aspect of the recipient’s welfare, this interest is regarded as paternalism. Linkage between the nature of the harm and the nature of the compensation can help to satisfy paternalistic interests while facilitating the provision of compensation.
Linked compensation facilitates consistent judgments about fair tradeoffs, promotes a perception of fairness, and encourages economic efficiency.
Compensation motivated by paternalism may play an important role in negotiations concerning international environmental problems such as global warming or the depletion of the ozone layer. The enormous potential cost of abating these problems requires that negotiators place a premium on finding cost-effective approaches. Since the less developed countries—which are experiencing the most rapid increase in population, energy use, and pollution—typically have less efficient technologies than the industrialized countries, a cost-effective approach would require large investments to improve technological efficiency in the economies of less developed countries. Most observers agree that the industrialized countries have to be willing to make large transfers of resources to less developed countries for this purpose. But in the United States, at least, the political climate is not conducive to dedicating additional resources to international aid. However, transfers of resources that are specifically targeted for technological investments to reduce pollution in developing countries may serve the paternalistic self-interest of developed countries seeking cost-effective solutions to international environmental problems.
Some have suggested that IB approaches, such as an international system for trading emissions permits or for taxing pollutant emissions, could provide cost-effective mechanisms for reducing global pollution. The transfer of revenues that would occur would be targeted for improving technological efficiency in less developed countries.
Linked compensation inherently complements incentive-based approaches to environmental problems in domestic situations as well. For example, a CAC approach to air pollution typically requires a new industrial facility to conform with specific performance standards. This approach may not be cost-effective, and often does not compensate those who are harmed by the additional air pollution from the new facility. One less costly approach, which effectively compensates those who would be harmed by additional sources of pollution, is the automobile “death certificate” program initiated in southern California by the Unocal Oil Company. Under this program, Unocal bought and scrapped highly polluting pre-1977 automobiles to offset its own new sources of pollution. This approach is both cost-effective and widely perceived by the community as fair.
In summary, the role of compensation is an area of research in which one can reach few general conclusions. Every person has an individual sense of justice and an equally valid opinion about the merits of compensation in specific circumstances. However, linked compensation is one principle that has broad applicability. It makes the connection between harm and compensation explicit, thereby promoting a sense of allocative equity. It also serves to validate individual concerns, helping to promote a sense of procedural equity. Moreover, it encourages economic efficiency in the delivery of compensation. For all these reasons, linked compensation can be a useful principle for implementing new approaches to cost-effective environmental regulation.
This article is based on research conducted by Burtraw and RFF Vice President Paul R. Portney.
