Economics of Environmental Compliance and Enforcement

Abstract

Enforcement activity by regulators plays an important and sometimes underappreciated role in the effectiveness of environmental regulation by encouraging regulated entities to comply. Nearly all ex ante cost-benefit analyses assume 100% compliance with regulation. One notable exception is the U.S. Environmental Protection Agency’s 2008 lead renovation rule in which a 75% compliance rate was assumed when estimating the ex ante benefits and costs, based on the literature regarding compliance rates in the construction sector. Why do entities comply with environmental regulation? Economists typically use deterrence models to explain the incentives for compliance. They began with simple models that used the frequency of inspections and the size of penalties to calculate the expected cost of noncompliance, but the models have since become more sophisticated along several dimensions. Dynamic penalty strategies by regulators can significantly increase the cost of being labeled a serious violator. Stochastic fluctuations in pollution levels with regular self-reporting requirements can lead firms to over-comply on average to avoid the risk of reporting violations. Inspections and enforcement actions at one facility can have general deterrence impacts at other facilities nearby as well as a specific deterrence impact at the inspected facility. Violations and penalties may impose additional costs on firms in terms of loss of reputation and pushback from customers and people living nearby. These differences in reputational costs may help explain observed heterogeneity in compliance behavior by firms. Compliance and enforcement behaviors are also affected by the institutional, legal, and scientific context in which they occur. Even with regulations set at the national level, enforcement activity is often carried out at the sub-national level, with the possibility of considerable heterogeneity across jurisdictions in terms of enforcement stringency. This is most obvious in federal countries such as the United States, where enforcement responsibilities for many regulations are delegated to state agencies, and with supra-national regulatory systems such as the European Union, where national agencies are responsible for enforcing regulations. It can also arise in a large country, where even a strong central government may have difficulty ensuring similar enforcement behavior in different regions. Empirical research also developed over time, initially testing whether enforcement activity affected compliance, then testing for heterogeneous impacts across different firms or different enforcement tools, then moving to more robust research designs. Variations in enforcement intensity have also been used to proxy for overall regulatory stringency in empirical studies of the economic impact of environmental regulation.