Rule of Law and Policy-Induced Environmental Technology Adoption

Rule of law and policy-induced environmental technology adoption

Davide Infante

Associate Professor of Political Economy

Department of Economics and Statistics, University of Calabria, 87036 Campus di Arcavacata di Rende (Cosenza) – Italy; tel: 0039 0984 492460;

fax: 0039 0984 492421; e-mail: .

Janna Smirnova

Postdoctoral Research Fellow in Political Economy

Department of Economics and Statistics, University of Calabria, 87036 Campus di Arcavacata di Rende (Cosenza) – Italy; tel: 0039 0984 492444;

fax: 0039 0984 492421; e-mail: .

Address for manuscript correspondence: Prof. Davide Infante, Department of Economics and Statistics, University of Calabria, 87036 Campus di Arcavacata di Rende (Cosenza) – Italy; tel: 0039 0984 492460; fax: 0039 0984 492421;

e-mail: .

Rule of law and policy-induced environmental technology adoption

Abstract

The implementation of environmental technologies almost always complies with regulation that is interdependent with the strength of the rule of law. We develop a model demonstrating that when the rule of law is reinforced, pollution abatement standard is more efficiently established and leads to the more successful adoption of environmentally friendly technologies. We show that a more stringent rule of law contributes to the achievement of second best allocation with less resource drainage caused by rent-seeking and with lower costs of regulatory intervention. The model sheds new light on implementation of environmental policies in a reinforcing institutional context of developing economies.

JEL classification: H11; H23; P20.

Key Words: Rule of law; Pollution; Environmental technologies; Rent-seeking

Running Title: Rule of law and environmental technology

1. Introduction

Policy and institutional quality are highly interdependent: a strong institutional environment is the result of successfully implemented policies, while effective policies are grounded in high-quality institutions. Understanding the nature of this relationship is crucial for economic development, particularly for societies involved in significant social and economic changes, such as transition and developing economies characterized by economic instability and a weak institutional environment. In such contexts, institutions and policies undergo continuous changes, which in turn influence the policy-institution equilibrium.

To analyse the relationship between institutions and policies we have developed a model that focuses on the rule of law since it is one of the most important institutions determining the implementation and outcome of economic policy. A tangible example where the quality of the rule of law plays a crucial role is that involving the adoption of environmentally friendly technologies. In fact, environmental issues represent an ideal context for studying the interdependence between institutions and policiesfor two reasons. The first is the fact that environmental sustainability is a real and current international concern. Secondly, environmental controls (Lovely and Popp 2008)almost always comply with regulation, thus providing a context to model the interaction between institution strength and success of regulatory policy(environmental policies are reviewed by Jaffe et al. 2002 and Requate 2005).

While it is recognized that a complex interdependent relation exists between the quality of institutions and the functionality of environmental policies, to our knowledge there has been little theoretical work investigating this nexus. Our model takes a step in this direction and examines how the stringency of the rule of law, influences whether regulator policies are successfully implemented. In particular, we demonstrate that reinforcing the rule of law not only increases the adoption of environmentally friendly technologies, but also improves the implementation of pollution abatement standards. More stringent rule of law leads to better allocation of resources and thus increases social welfare.

2. Theoretical background

Among other crucial institutions, that of the rule of law has been captured through both empirical and theoretical studies (for the discussion see Haggard and Tiede 2011). In most of the cases, the rule of law is measured throughthe protection of property rights (Acemoglu and Johnson 1993, Shleifer and Vishny 1994; Acemoglu and Verdier 1998, Grossman 2001,Gradstein 2004, Donnelly 2006). Some authors consider the rule of law to be reflected in other contexts. For example, Cervellatiet al. (2008b) interpreted the rule of law as the presence of social contracts that delimit the conflicts society. Donnelly (2006) gave another plausible definition of the rule of law describing it as the legitimacy by which the state provides security for its citizens. This vision is close to Paavola’s (2007) who underlines that legitimacy must rest on procedural justice.Another approach considers the importance of legal origins as the fundamentals of the rule of law (Acemoglu et al. 2001, Beck et al. 2003, Djankov et al 2003). Finally, others (Licht et al. 2007,Cervellati 2008a,Norman 2009) have captured the rule of law using the well-known composite index provided by Kaufmann et al. (2007) or other indexes (Butkiewicz et al. 2006).

The above contributions underline the importance of the enforcement of the rule of law for determining successful economic policies. Following this reasoning, the rule of law should play a crucial role also in implementation of environmental regulations.According to Vatn (2005 and 2010), the institutional frame is fundamental for environmental policy, given that it influences agents behaviour which becomes especially important in the presence of externalities typically present in environmental issues.

A constantly increasing body of literature has provided evidence on the importance of institutions in environmental issues. Among empirical studies,much attention has been dedicated to the impact of corruption on environmental issues (Damania et al. 2003, Cole 2007,Leitão 2010). Corruption is demonstrated to have a negative effect on environmental quality, undermining the working of environmental policies, especially in developing economies. Institutions such as political liberties, civil rights and democracy (Torras and Boyce 1998, Bhattarai and Hammig 2001, Frankel and Rose 2002) are proved to contribute positively on pollution abatement. Secure property rights are also important for improvement of environmental quality (Culas 2007). In turn, legal protection is demonstrated to have negative relationship with pollution levels (Di Vita 2009).

At the theoretical level, Brock and Taylor (2003), Dinda (2004) and Yandle et al.(2004) discuss the influence of institutions on environmental quality and demonstrate the importance of institutional strength in pollution abatement. Weisbuch (2000)analyses the influence of institutions in decision making process regarding environmental issues. Paavola (2007) discusses the incidence of property rights on the use of environmental resources. Damania et al. (2003), Fredriksson and Svensson (2003)and Wilson and Damania (2005) demonstrate the negative effects of corruption on the stringency of environmental policy.

Although rule of law is one of the important institutions for environmental policies, as discussed by Galeotti (2007), it has not been much considered. Few works (Panayotou1997, Bhattarai and Hammig 2001) incorporate the rule of law by utilising composed indexes and demonstrate that institutional improvementsignificantly reduce the degree of pollution.

Our work differs from the previous studies on environment-institutions relationship by analysing theoretically the rule of law in environmental issues through investigating on regulatorpolicythatpromotes the adoption of environmentally friendly technologies.The model also adds the analysis of the importance of institutionsto a growing theoretical literature on the interactionbetween environmental policy and technological change (among recent works are Kerr and Newell 2003, Goel and Hsieh 2006, Lovely and Popp 2008 and the review elaborated by Jaffe at al. 2002).

Our theoretical framework is related to the model presented by Acemoglu and Verdier (2000)who explored the issue of new technology adoption in the presence of corruption. This framework has been further developed by Infante and Smirnova (2009)byincorporating into the model an institutional parameter toinvestigate on the importance of institutional enforcement. The present work extends the above two models to investigate the relationship between the adoption of environmentally friendly technologies and the stringency of the rule of law. To our knowledge, to date, no model has yet explored this relationship.

3. Model

The modelis based on stylized features of an economy in which agents can be both entrepreneurs or inspectors. The entrepreneurs produce output with currently available but anenvironmentally unfriendly technology. A regulator sets either fines and subsidies to incentivise entrepreneurs into choosing the cleantechnology. Inspectors monitor firms randomly to determine which should be subsidised or fined. Although inspectors can be corrupt and seek bribes from a firm, there is the possibility that the firm appeals to the court. The probability of appealing to court is taken as a measure of the strength of the rule of law. The aim of the regulator is therefore to implement a policy so to achieve a second-best allocation where all entrepreneurs utilise the environmentally friendly technology, thereby neutralising pollution.

The outcomes of the model are firstly obtained for a weak institutional context. Thereafter, we assume that therule of law is reinforced (section 3.5)and, finally, revise the outcomes of the model to capture these changes.

3.1. Regulator

In a closed economy with a command control context, the entrepreneurs (n) produce output (y) by utilizing a production process which relies on a polluting technology. The benevolent regulator[1] makes the decision to regulate the pollution level (), providing incentives that encourage entrepreneurs to adopt an environmentally friendly technology of cost c, where. To do this, the regulator employs, choosing from among the entrepreneurs, some inspectors[2], who must enforce the regulation, offering these inspectors wage w. The total number of entrepreneurs and inspectors is normalised to 1.

To incentivise the choice of the new technology, inspectors transfer subsidies (s) to reward entrepreneurs who adopt the environmentally friendly technology (of number m), and collect fines (f) to sanction entrepreneurs who continue to utilize a polluting technology (of number n-m).

We assume that the regulator aims to obtain the complete abatement of emissions, which requires that all of the entrepreneurs adopt the new technology[3](in this case it would be n=m). Indeed, for the regulator, total neutralisation of external harm is convenient only when the benefits from the complete abatement of emissions offset the costs needed for abatement. Therefore, the regulator incentivises the adoption of the environmentally friendly technology only in the case where intervention increases social welfare. In other words, the decision to regulate is taken only when the welfare level attainable through intervention is greater than that without intervention. That is, where:

(1)

(2)

3.2. Entrepreneurs and inspectors

Since the adoption of the environmentally friendly technology is costly, entrepreneurs adopt it only in the presence of regulatory stimuli. These stimuli are expressed as environmental subsidies and fines. Both subsidies and fines are activated only when monitoring is undertaken by the inspector, so that, subsidies and fines are paid and obtained with a probability , andhence .Following Acemoglu and Verdier (2000) this also means that an inspector can monitor only one entrepreneur. To avoid the regulator supporting the entire social cost of pollution abatement, it is assumed that subsidies are rationed, i.e. that not all of the adopters receive subsidies,given that the total amount of environmental taxes should be equal to environmental subsidies. Moreover, subsidies are takenin the form of tax offsets, that are discounted from general revenue tax that both types of entrepreneurs pay. The presence of general revenue tax guarantees the sustainability of regulator’sbudget[4].

In such a rationed context subsidies and fines thus represent an ideal terrain for inspectors’ rent-seeking activities (Bardhan 1997,Saha 2001). An inspector who is self-interested would have quite a degree of freedom to practice corruption and, in addition to the salary received as an inspector, may obtain a bribe (b), from both entrepreneurs who do adopt the new technology and those who do not. The adopters may be extorted and be asked to pay a bribe to obtain their rightful subsidy, while non-adopters may also be asked to pay a bribe so that the inspector falsely reports use of the new technology. Obviously, in the latter case .The probability of practicing rent-seeking is given by r.

3.3. Rule of law

The rule of law is inserted in the model following Donnelly (2006, p.37) who states that, “When citizens can bring disputes concerning rights to court rather than fight in the streets, the rule of law is enhanced”. We, therefore, define the rule of law as the probability that an entrepreneur, who is the subject of extortion or corrupt proposals, appeals to a court. This approach is close to that adopted by Rijckeghem and Weder (2000), who, on the contrary, used an index of rule of law as a proxy of the probability that corruption will be detected. Hence, we suppose that in the case where an inspector seeks bribes, there is a certain probability (d) that the inspector is reported. Assuming that the regulator may penalize the inspector and not the entrepreneur for rent-seeking activities, in the event that corruption is reported by entrepreneurs, the corrupt inspector will be fired, losing salary and other gains.

Our model considers the rule of law reinforced when the probability of being reported increases in the range from zero to one. Therefore, the strength of the rule of law and the degree to which society accepts rent-seeking activities becomes decisive in whether individuals opt for corrupt practices. Where the rule of law is weak and rent-seeking activities offer high returns, there is greater incentive to switch to rent-seeking activities. By contrast, where the rule of law is strong and corruption is less practicable, the payoff that an inspector receives is greater if s/he adheres to honest practices.

3.4. Implementing the pollution abatement policy

3.4.1. Sequence of events

By introducing inspectors, the aim of the regulator is to achieve a second-best equilibrium where all the entrepreneurs choose to utilize the environmentally friendly technology to neutralise pollution and increase social welfare. To achieve this equilibrium, the regulator utilises the following instruments: the inspectors’ wages, and entrepreneurs’ subsidies and fines.

The sequence of events is traced through backward induction (see Figure 1). At the first stage, the regulator calculates the second-best allocation of agents to obtain n=m, by considering technological, budgetary, non-bankruptcy and corruption constraints, also taking into account the following factors: a) the cost of adopting a new technology; b) the output of entrepreneurs; c) the probability that inspectors practice corruption and extortion; d) the level of bribes; e) the strength of rule of law. At the following stage, on the basis of the second-best allocation of agents, the abatement standard of external harm, (), is determined by comparing welfare functions (1) and (2). This abatement standard or, in other words, the threshold level of pollution, determines whether the regulator undertakes action. In fact, the regulator decides to incentivise the adoption of the environmentally friendly technology if the actual level of pollution is greater than the obtained abatement standard. Once the decision to intervene is taken, the regulator establishes the levels of subsidies, fines and inspectors’ wages so that the composition of these variables would indeed lead to the allocation of agents n=m to neutralize external harm (=0). This mechanism of regulator intervention is represented in Figure 1.

Fig. 1. The pollution abatement strategy: flows and outcomes.

3.4.2. Second-best allocation and the abatement standard

In this section we describe the steps involved for establishing the aforementioned regulator’s policy. In order to define the second-best allocation of entrepreneurs and inspectors, the regulator must first consider the technological constraint:

, (3)

where on the left side there are the gains of entrepreneurs who adopt the new technology, while on the right side there are the gains obtained by entrepreneurs who continue to use the polluting technology.

The first three terms of inequality (3) define the output, minus the loss (in the form of pollution produced by entrepreneurs who continue to use the old technology), and minus the cost of adopting the environmentally friendly technology. The latter two terms on the left side refer to the gains obtained through subsidy which is received, given the probability of being monitored, and losses due to a bribe, given the probability of being monitored by a corrupt inspector. On the right side, the first term defines the entrepreneur’s output and the second refers to losses due to the payment of fines, if monitored by an honest inspector. The last term defines losses due to a bribe, given the probability of being monitored by a dishonest inspector. Obviously, the regulator establishes that the gains of entrepreneurs who adopt the new technology are greater than of those who do not adopt it.

At the same time, the regulator should consider that fines paid by entrepreneurs who continue to utilize the environmentally unfriendly technology should not exceed the output produced by these entrepreneurs, so the non-bankruptcy constraint has the following form:

(4)

In order to minimize rent-seeking activities, the regulator sets the gains of the honest inspector to be greater than that of the corrupt inspector. The gains of the honest inspector are given by the wagealone, w. The gains of the dishonest inspector is the sum of her wage plus the benefits from receiving a bribe, minus the wage lost given the probability that illegal actions are reported, so that:

(5)

Finally, the regulator must also consider the sustainability of the budget, so that the revenues of the regulator are greater than the expenditures: