Review of Environment, Energy and Economics - Re3 Firm Preferences for Environmental Regulation
 

 

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Nov
27
2014
 
Firm Preferences for Environmental Regulation
by Félix Muñoz-García and Sherzod B. Akhundjanov
Environment - Articles
 

This paper summarizes the findings of two papers that examine the effect of environmental regulation on the production decisions and profits of polluting and green firms. Using a game-theoretic framework, we find conditions under which the green firm favors regulation (a standard finding), but also derive conditions for the opposite –and more surprising– scenario, whereby the green firm opposes environmental regulation, while the brown firm favors it. We also show that similar preference reversals can occur towards uniform and fine-tuned regulation. Our study highlights the role that firm heterogeneity plays in determining firm preferences towards environmental regulation.

Keywords: Cost asymmetry, Cost disadvantage, Emission fees, Green firms
JEL Classification: L13, D62, H23, Q50


Suggested citation: Muñoz-García, Félix and Akhundjanov, Sherzod B., Firm Preferences for Environmental Regulation (November 27, 2014). Review of Environment, Energy and Economics (Re3), http://dx.doi.org/10.7711/feemre3.2014.11.003
 

1. Introduction
Last decade has witnessed a growing concern for anthropogenic (human) impact on the environment and its inevitable negative consequences for future generations. As consumers become more sensitive to the environmental footprint of products and services they purchase, the industry had to adjust to such a change in taste and preferences (e.g., by the entry of green firms and either the exit or overhaul of existing polluting firms), in addition to changes in the design and stringency of environmental regulations. Although the introduction of stricter and more comprehensive environmental policies is welcomed by consumers, who are driven by health and aesthetic benefits of clean ecosystem, the industry, driven primarily by profit motives and competitive advantage, can exhibit mixed, and sometimes unexpected, preferences to the implementation of such policies.

It is a tautology that environmental regulation is supported by those firms inflicting minimal damage on the environment (i.e., “green” firms). For instance, General Electric and the ABB Group, which have a strong commitment to cleaner environment and sustainable use of natural resources, have been relentless in pressing for tighter pollution standards. Although such lobbying efforts are predominantly construed as firms’ concern for nature and a vital element of corporate social responsibility, economists view this practice as a strategic tool that green companies use in order to increase the production costs of their polluting rivals (i.e., “brown” firms), thereby improving their own competitiveness and, ultimately, expanding their market share. [Note 1]

In two recent studies, Muñoz-García and Akhundjanov (2014a,b) demonstrate how firm heterogeneity (with respect to production costs and environmental impact) can interact with a regulatory setting (no regulation, uniform regulation, and non-uniform regulation) to produce unexpected findings regarding firms’ preferences towards the regulatory context. In particular, we derive conditions under which green and brown firms’ conventional preferences towards the introduction of environmental regulation are reversed: polluting firms find regulation beneficial, and hence actively lobby in favor of its introduction, whilst relatively clean firms oppose such regulation. Furthermore, we present conditions for the reversal of green and brown firms’ preferences between uniform and non-uniform (i.e., “fine-tuned”) regulation. Our theoretical predictions, hence, shed light on the recent lobbying efforts for stringent environmental policy of relatively polluting firms, such as the mining company Rio Tinto and the oil company BP. [Note 2]  The proposed theoretical framework allows the regulatory agencies, such as the Environmental Protection Agency (USA) and the European Environment Agency (EU), to better anticipate contexts in which environmental regulation will be opposed or supported by larger groups of firms in the industry.

2. Model and Results
We consider a Cournot duopoly model where firms, producing a homogenous good, are allowed to differ with respect to their production costs and the extent of environmental damage resulting from each unit of output produced. The firm with lower damage parameter is called “green”, while that with larger parameter is “brown”. The heterogeneity along two dimensions allows us to analyze green and brown companies that are not necessarily cost-efficient and cost-inefficient, respectively, an assumption frequently imposed in the previous literature. The regulator’s objective is to induce firms to engage in socially optimal production by imposing a fee per unit of output which, for generality, we allow to differ across firms (thus separately analyzing the case of non-uniform and uniform fees). In order to examine whether government policy is detrimental or beneficial to each firm’s profits, we compare the market equilibrium with and without environmental policy. Within the same theoretical framework, we also compare firms’ profits corresponding to uniform and non-uniform regulation to determine firms’ preferences for the two policy instruments. 

2.1. When is regulation good for profits?
We first demonstrate that, when the green firm’s production is extremely clean (with pollution-free production being a special case), this firm is exempt of non-uniform emission fees, while its brown competitor remains subject to such a fee. Since in this context the environmental regulation unambiguously benefits the green firm, by increasing the production costs of its brown rival (negative effect), then the introduction of regulation is supported by the green firm but opposed by the brown firm.

Firms do not necessarily exhibit such obvious, and stereotypical, preferences towards environmental policy under less extreme settings. In particular, when the green firm’s production process, while still remaining cleaner than that of the brown firm’s, entails a non-negligible level of environmental damage, it becomes necessary to regulate the production of the green firm as well in order to maintain the socially optimal level of pollution. As a consequence, the regulator has to impose non-uniform emission fees on both the brown and green firms, which, in turn, makes both firms experience the negative effect of emission fees. Interestingly, such regulation can also produce a positive effect on the brown firm’s profits when this company is at a cost-disadvantage relative to its green competitor. Specifically, the regulator anticipates that the market share of an efficient green firm will be bigger than that of an inefficient brown firm, and that translates into a sizeable aggregate environmental damage of the green firm. That is, even though each unit of output produced by the green firm entails smaller environmental damage relative to the brown firm, with large aggregate production the green firm’s small per-unit damage accumulates to a considerable amount. In this setting, the regulator has to impose a stricter emission fee on the green than on the brown firm to curb excess pollution. Hence the introduction of environmental policy hurts the green firm more than the brown, thereby reducing the relative cost-disadvantage that the brown firm suffered prior to the imposition of such regulation (positive effect).

Our findings suggest that the positive effect of environmental regulation can dominate its negative effect when the brown firm suffers a substantial cost-disadvantage. [Note 3] In such cases, the brown firm becomes the “unexpected ally” of the regulator, and supports the introduction of regulation to ameliorate its significant cost-disadvantage. [Note 4]  In contrast, the green firm opposes such regulation, as not only does it raise the firm’s production costs but it also shrinks the cost-advantage that the firm experienced in the absence of regulation. Our theoretical predictions help to understand the recent lobbying efforts of freight train companies (relatively green firms) against tougher new pollution standards, and those of trucking companies (relatively polluting firms) in favor of such standards (Roth, 2008; Baker and Davenport, 2014). Since freight trains produce far less pollution than freight trucks (See Table 1), one would naturally expect the opposite reaction from each type of firm. However, such a common belief would overlook firms’ relative efficiency. Freight trains are three or more times more fuel efficient than freight trucks (Scott and Sinnamon, 2006), and, as our findings suggest, the efficiency of the green firm relative to its brown rival produces a setting whereby the green (brown) firm opposes (supports) the introduction of environmental regulation since emission fees would shrink the firm’s cost-advantage (cost-disadvantage, respectively).

Table 1. Air emission factor ranges for freight truck and rail, in grams/tone-km

Source: OECD (1997)
Note: CO – carbon monoxide; CO2 – carbon dioxide; HC – hydrocarbons (e.g., methane, pentane, etc.); NOx – nitrogen oxides; SO2 – sulfur dioxide; VOC – volatile organic carbon compounds.

If, in contrast, the green firm is at a cost-disadvantage relative to the brown firm, the brown firm will now have larger market share and thus face stricter emission fee. Consequently, the green (brown) firm supports (opposes) regulation in order to alleviate (retain, respectively) the relative cost differential. The US power companies recently behaved as our model predicts, with nuclear power plants (green firms) supporting the EPA’s new federal carbon limits on electricity generation but fierce opposition of carbon-intensive power companies (brown firms) to such regulation. [Note 5] In particular, in the absence of carbon controls, pulverized coal generation has a significant cost-advantage relative to nuclear power, with the estimated costs of $63.10 and $83.22 per Mwh, respectively (US CRS, 2008). However, with the imposition of carbon controls, the cost-advantage of coal-fired generation totally disappears, with the estimated costs of $100-120 and $83.22 per Mwh for coal and nuclear generation, respectively (US CRS, 2008).

2.2. Uniform or Non-Uniform Regulation
We also analyze industry preferences between uniform and non-uniform regulation. First, if the green firm’s production is significantly clean (again, pollution-free state being a special case), the green firm is exempted from paying a non-uniform emission fee, whereas it would remain subject to a uniform fee. [Note 6] Consequently, the green firm supports non-uniform regulation, which unambiguously harms its brown rival, while the brown firm, despite being hurt by both regulatory instruments, supports uniform regulation, which at least leaves its cost differential unaltered. [Note 7] On the other hand, when the environmental damage of the green firm is non-negligible, both firms become subject to non-uniform regulation. In this context, our results suggest that an inefficient (brown or green) firm is better off with a non-uniform policy, which helps the firm ameliorate its significant cost-disadvantage, while a relatively efficient firm benefits from a uniform policy, which increases all firms’ marginal costs but keeps its cost advantage unaffected.

3. Discussion and Policy Implications
Comparing the social welfare arising under different regulatory settings, we find that a uniform regulation is welfare-improving relative to no regulation since it ensures that the aggregate production is efficient. However, such regulation is suboptimal as it does not distinguish between firms with different costs and environmental impacts. Non-uniform regulation, on the other hand, is socially optimal as it accounts for firm heterogeneity and thus imposes a different fee on each type of firm. Given the welfare ranking of different regulatory contexts, the social planner can use our theoretical framework to anticipate the industry reaction to the introduction of different forms of environmental policy.

Our study highlights the role of relative efficiency in the design of optimal environmental policy. In particular, when the green firm is extremely clean, regardless of firms’ relative efficiency, the brown firm opposes a fine-tuned regulation. In contrast, when the green firm is not extremely clean, relative efficiency becomes relevant: (a) when firms are cost-asymmetric, government officials should expect a strong political support towards fine-tuned regulation from relatively inefficient firms, but opposition from the most efficient firms in the industry; (b) when firms are cost-symmetric, both the brown and green firms oppose regulation, since none of them experiences a large positive effect of regulation. Figure 1 summarizes our results by depicting the costs of the brown and green firm (cB and cG, respectively) and identifying the regions in which the brown, green, or no firm favors regulation. [Note 8]

Figure 1. Firm preferences for environmental regulation



From a policy perspective, our results emphasize the unintended effects of non-environmental policies on firm preferences towards environmental regulation. For instance, policies that reduce firms’ (brown or green) production costs (e.g., tax credit) would inadvertently build a political opposition to non-uniform regulation. In contrast, policies that increase firms’ (brown or green) costs (e.g., administrative fees) could unintentionally help to build support towards ‘fine-tuned’ environmental policies. Finally, policies targeted to relatively green firms, so as to make their production processes even cleaner, would ensure that the regulator’s and green firms’ incentives are aligned.

Notes

[Note  1]  See, for instances, Maloney and McCormick (1982) for firms supporting regulation in order to improve their competitiveness in different U.S. industries; Salop and Scheffman (1983, 1987), Krattenmaker and Salop (1986), Hart and Tirole (1990) and Loertscher and Reisinger (2014) for firms’ interests in raising their rival’s costs by strategically choosing a costly action. For the role of regulation as a form of market predation, whereby stringent policies would drive certain firms out of the industry, see Ordover and Willig (1981).
 
[Note  2] In particular, Rio Tinto and BP joined 46 companies participating in the Pew Center on Global Climate Change, which lobbies in favor of “mandatory climate policy.”

[Note  3] This implies the market share of the green firm will be even larger, and thus even larger environmental impact will be associated with the green firm’s production. As a consequence, the regulator imposes a harsher fee on this firm.
 
[Note  4] An inefficient (brown or green) firm can experience the “resuscitative effect” of a non-uniform regulation, if the positive effect of non-uniform regulation, i.e., cost-amelioration, is so large that it helps the firm, not participating in the industry in the absence of regulation, start producing.

[Note  5] See Johnson (2013).

[Note  6] Non-uniform (or “fine-tuned”) regulation is a flexible policy instrument in that it assigns different emission fees to firms with different production characteristics, so as to induce a socially desirable level of production and pollution. Hence, under non-uniform regulation, the regulator can assign zero fees on firms with a minimal environmental impact (in order to encourage a higher production from them) and positive fees on the polluting firms (in order to make them internalize the costs of their negative externalities). On the other hand, uniform regulation is an inflexible policy instrument, as it does not consider firm heterogeneity and requires all industry participants to pay the same fee as long as the industry as a whole emits pollution.

[Note  7] Unlike non-uniform emission fees, uniform fees do not reduce an inefficient firm’s cost-disadvantage. Instead, the uniform regulation increases the production costs of both efficient and inefficient firms. If the firm’s (brown or green) cost-disadvantage is relatively high to start with, then such regulation can produce a “shutting-down effect” (i.e., forcing the firm to stop producing).

[Note  8] Cutoffs C R/B, CB , CG, and CR/G are obtained by comparing firms’ profits in different regulatory settings. For more details, see Muñoz-García and Akhundjanov (2014a).
 

References

1. Baker, P. and C. Davenport (2014) “Obama Orders New Efficiency for Big Trucks,” The New York Times, 18 Feb. 2014.

2. Hart, O. and J. Tirole (1990) “Vertical Integration and Market Foreclosure,” Brookings Papers on Economic Activity: Microeconomics, 4, pp. 205-86.

3. Johnson, K. (2013) “Businesses Weigh Response If New Climate Rules Come,” The Wall Street Journal, 12 Feb. 2013, pp. A4 Print.

4. Krattenmaker, T. G. and S. C. Salop (1986) “Anticompetitive Exclusion: Raising Rivals Costs to Achieve Power over Price,” The Yale Law Journal, 96(2), pp. 209-293.

5. Loertscher, S. and M. Reisinger (2014) “Market Structure and the Competitive Effects of Vertical Integration,” Rand Journal of Economics, 45(3), pp. 471-494.

6. Maloney, M. and R. McCormick (1982) “A Positive Theory of Environmental Quality Regulation,” Journal of Law and Economics, 25(1), pp. 99-124.

7. Muñoz-García, F. and S. B. Akhundjanov (2014a) “Environmental Regulation: Supported by Polluting Firms but Opposed by Green Firms?” Washington State University, School of Economic Sciences, Working paper 2013-5.

8. Muñoz-García, F. and S. B. Akhundjanov (2014b) “Firm Preferences for Environmental Policy: Industry Uniform or Firm Specific?” Washington State University, School of Economic Sciences, Working paper 2014.

9. Ordover, J. A. and D. R. Willig (1981) “An Economic Definition of Predation: Pricing and Product Innovation,” The Yale Law Journal, 91(1), pp. 8-53.

10. Organization for Economic Co-operation and Development (OECD) (1997) “The Environmental Effects of Freight,” Paris.

11. Roth, A. (2008) “Railroads Roll With a Greener Approach: Industry Makes Case that Switch to Trains is More Eco-Friendly,” The Wall Street Journal, 29 May 2008.

12. Salop, S. C. and D. T. Scheffman (1983) “Raising Rivals’ Costs,” American Economic Review, 73, pp. 267-71.

13. Salop, S. C. and D. T. Scheffman (1987) “Cost-Raising Strategies,” Journal of Industrial Economics, 26, pp. 19-34.

14. Scott, J. and H. Sinnamon (2006). “Smokestacks on Rails: Getting Clean Air Solutions for Locomotives on Track,” Environmental Defense Fund. New York.

15. US Congressional Research Service (US CRS) (2008) “Power Plants: Characteristics and Costs” (RL34746; Nov. 13), by Stan Kaplan. Federation of American Scientists Digital Collection; Accessed in Sep. 15, 2014.



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Félix Muñoz-García and Sherzod B. Akhundjanov, School of Economic Sciences,Washington State University, USA
 
   
 
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