Some of the key lessons from the scholarly literature on political economy can be applied to instrument choice in climate policy at the national level. Since much of that scholarship focuses on policymaking in a limited set of developed nations, in particular in the USA, great care must be taken before applying any of these lessons to domestic politics generally.

6.1.5.1 Key Lessons from the Political Economy Literature

A useful starting-point is to view the policy process (at least in countries with strong legislatures) as analogous to a “political market” (Keohane et al., 1999). The demand side of such a “market” consists of the interest groups with a stake in the policy; in the environmental arena, such groups include regulated industries, producers of complementary products, environmental organizations, and (to a lesser extent) labour and consumer organizations. The supply side consists of the legislators and the administration involved in the design and implementation of the environmental policies and measures.

One key insight of this literature is that some forms of regulation can actually benefit the regulated industry, for example, by limiting entry into the industry or imposing higher costs on new entrants (Rasmusen and Zupan, 1991; Stigler, 1971). In the environmental arena, conventional regulation may provide firms with rents that result from reductions in output and raised prices as a consequence of regulation (Buchanan and Tullock, 1975; Maloney and McCormick, 1982). Stricter standards for new pollution sources benefit existing firms by raising barriers to entry (Nelson et al., 1993). Polluters’ self-interest may also help explain the prevalence of tradable permits that have been allocated free (“grandfathered”) when market-based instruments have been used. Permits allocated free to existing firms represent a transfer of rents from government to industry while auctioned permits and emissions taxes generally impose a heavier burden on polluters. Finally, VAs may be the preferred policy approach from industry’s perspective, because these leave more of the initiative with the private sector (at least so it is perceived), which may enhance industry’s chances of capturing rents.

Of course, it is important to recognize that industry may not act monolithically, since policies may have differential distributional impacts within a sector. A policy that imposes costs on industry as a whole might still be supported by firms that would fare better than their competitors. For example, firms that can achieve emissions reductions more cheaply may be more supportive of market-based schemes, such as tradable permits, than their higher-cost competitors (Kerr and Maré, 1997). In the realm of global environmental policy, the ban on ozone-depleting chlorofluorocarbons (CFCs) under the Montreal Protocol was, for instance, supported by those who expected to dominate the market for HFCs, then the leading substitute chemicals (Oye and Maxwell, 1995).

Regulated firms are not the only group with a stake in regulation; opposing interest groups will defend their own interests. Environmental groups, for example, tend to favour stringent targets, although many have opposed market-based instruments out of a philosophical concern that such policies give firms “licenses to pollute” or because of objections to attempts to quantify or monetize the environmental damages from pollution (Kelman, 1981; Hahn, 1989; Sandel, 1997). Some groups draw an ethical distinction between taxes and tradable permit systems, in which taxes are morally deficient because they put a price on emissions but set no upper limit on allowable pollution, while permits ensure a set level of emissions (Goodin, 1994). Other environmental groups support market-based policies in the hope that the resultant cost savings will make a higher level of environmental quality politically attainable, and possibly in part because of their own self-interest in distinguishing themselves from other environmental organizations (Svendsen, 1999). The US Clean Air Act defines permits as “limited authorizations to emit”, to avoid limiting the ability to set lower emissions limits, which may also be a response to concerns of the environmental lobby that air should not become private property (Tietenberg, 1998). This indicates that the design of market-based instruments may be flexible enough to accommodate ethical concerns without undermining effectiveness.

While the political economy literature emphasizes the importance of preferences of interest groups, it has tended to neglect the “supply side” of the political equation: the legislators and government officials who ultimately design and implement regulatory policy. Government actors may have their own interests and preferences with respect to policy instruments:

• ideology or past experience may favour one instrument over another (Kneese and Schulze, 1975; Hahn and Stavins, 1991);
  
• legislators may prefer policies with (large but) hidden costs to those with (small but) visible ones (McCubbins and Sullivan, 1984; Hahn, 1987); and
  
• legislators responsible to local districts may emphasize distributional concerns over efficiency (Shepsle and Weingast, 1984).

Finally, the environmental administration may prefer direct regulation over market-based instruments, not only insofar as they are more familiar with it, but also because it gives them more control, and usually requires a relatively large administrative capacity.

These political factors, however, vary widely among countries. Whether or not a legislature exists, and if so whether in a parliamentary or presidential system, affects the support for particular policy instruments. Whether legislators are elected by district or by party list may affect the political support for different policy instruments as well. Factors such as the extent of interest-group organization and how groups interact with government are also critical–interest groups lobby legislators in some countries, sit on quasi-governmental decision-making bodies in others, are relegated to raising public awareness elsewhere, and in some countries are non-existent. Less tangible cultural and historical factors can also be critical in influencing the choice of instrument. For example, a country’s experience with free markets generally may influence whether or not it chooses to use market-based policy instruments for environmental protection (Keohane, 1998). Finally, there are clear political economy limitations of individually applied price, non-price, and regulatory policies that often lead to the linked or combined policy strategy that is observed in practice.

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