Environmental policies as economic instruments

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Theoretical framework

The Environmental Kuznets Curve

In 1955 Simon Kuznets published an article presenting what is now referred to as the Kuznets Curve. The underlying intention of this paper was to start a discussion on how personal income inequality and economic growth were linked, as presented in figure 2. The theoretical evidence of this article was lacking, however this was also part of the intention: the article’s aim was to show that economics needed to look further into other fields, such as demography. This should be done in order to grasp the linkages between economics and population growth patterns. By looking into fields outside of economics, the economic field itself would develop and no longer be based on too many assumptions (Kuznets, 1955).
“Meeting the needs of the present generation without compromising with the needs of future generations” – this definition of sustainable development, presented in Our Common Future was a starting point for raising public awareness on environment and development (WHO, 1987)
In 1991 the Kuznets curve was developed further, and the EKC was created. Grossman and Krueger (1991) included the relationship between income and environmental degrada-tion in their study on the environmental impacts in Mexico of North American Free Trade Association (NAFTA). In this paper they concluded that after a certain level of income, countries will see diminishing pollution. The authors’ main conclusion on the environmen-tal effects of trade liberalisation was the ones due to policy changes and intersectoral struc-ture changes of economic activity (Grossman & Krueger, 1991). Furthermore they con-clude that economic growth will effect environmental quality through three channels: scale effects, technological effects, and composition effects. The effects from trade on the envi-ronment has been investigated multiple times and it gives both positive and negative effects on the environment. This is in line with trade theory, the Ricardo model based on compar-ative advantages due to technological differences (Brakman et al., 2009).
The World Bank put extra focus on the two-way relationship between the environment and development in the World Development Report 1992, which investigates the relationship between GDP and environmental degradation over time, although not through the termi-nology of EKC (WB, 1992). This report claims policies are an additional source next to economic growth for countries to solve the environmental problems. The government level is the main force in environmental issues since private market provides insufficient in-centive to engage. The policies taken by a government can be aimed towards both goals, and environmental policies can be used to complement and reinforce development.
The report comment on following to have respective impacts on the environment:
-Economic policies: affects scale, composition, and efficiency of production.
-Environmental policies: reinforce efficiency and provide incentives to adopting less-damaging technologies.
Above concludes into one of the main findings of the EKC theory: a rising income will create a greater demand for improving environmental quality (WB, 1992). Additional to the greater demand for environmental improvements that arises alongside with increasing in-come, is also the explanation that environmental improvements from structural changes. Structural changes that follows from economic growth implies changes in pollution levels as the economy moves from clean agrarian production, to polluting industry, and finally to a clean service sector (Ciegis et al., 2007). This structural differences will directly affect the pollution levels and can therefore bring a somewhat skewed result of the EKC between developing and developed countries. As theories of trade predicts, developing countries are more likely to engage in production based on natural resources and labour while developed countries are more likely to engage in the less-pollution-intense service sector (Hettige et al., 1992).
Even though the EKC hypothesis often is supported by empirical research, it is not the economic growth itself that leads to environmental improvement but the contents of growth; the inputs and the outputs, which in turn is a result of institutions creating incen-tives (Arrow et al., 1995).
Previous studies
There are numerous studies on the relationship between income and pollution explained by the EKC theory. Using many different explanatory variables, different scholars have found the result of turning point to be widely spread, and the numerical value of this turning point will not be the focus in this paper.
One of the main contributors to the work on the Environmental Kuznets Curve is Stern who reviews the theory several times. In one of these, Stern (2004) provides 4 factors to the EKC:
1.Scale of production
2.Output mix
3.Input mix
4.State of technology:

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Production efficiency

Emission specific changes in production

There are numerous underlying dynamics that will determine these factors: education, envi-ronmental regulation and awareness are a few of these. These dynamics are also what is linked to a fairly high level of income. Thus, confirming the EKC hypothesis.
In a special review of the EKC, Barbier (1997) concludes that the early work on EKC fo-cuses much on the structural changes and the composition of goods & services. However, the changes in environment-income linkages are not only exogenous but depend also in endogenous policy changes (Barbier, 1997). Barbier lists the main relationships underlying the EKC where he moves the theory closer to the role of environmental policies compared to Stern (2004):
-Structural economic change plays a crucial role;
-Income and demand for environmental quality;
-Local versus global pollution;
-Country specific effects:
-The role of national and local policy;
-The role of multilateral policy.
One of the first to implement policies as a variable into the EKC empirical research was Panayotou (1997) when looking into SO2-emissions. The EKC is a potential “black hole”, which Panayotou describes as “it hides more than it reveals since income level is used as a catch-all surrogate variable for all the changes that take place with economic development” (Panayotou, 1997). An attempt is to get around this potential problem by including policy as a variable together with the rate of economic development.
Adoption of proper policies and property rights can change the steepness of the EKC, and thereby lower the turning point. In his paper investigating the EKC for SO2- emission, Pa-nayotou identifies three determinants for environmental quality: 1. The scale of economic activity; 2. The composition of economic activity; 3. The effect of income on demand and supply of pollution abatement effort. The latter is his contribution to the theory of EKC. The policy variable used by Panayotou is chosen from a composition of five indicators for institutions in general, where Panayotou used respect/enforcements of contract. The finding is that policies might results in positive effects that will offset the negative effects on the en-vironment from economic growth and population density. This is true both for low income and higher income countries, but will have a larger impact on higher income levels since higher income levels are required for abatement to take place (Panayotou,1997).
Including policies as a variable have shown to effect the turning point. Further studies with policies as a explanatory variable has been made by creating a dynamic model. A simulation of this, made by Anderson & Cavendish (2001), shows how the time of implementing a policy will result the turning point for CO2-emissions in the energy sector. The study tries to go further than relating CO2-emission to income and therefore explains the effect by policies (resulting in technological process) exogenous of income. The reason for this is the fact that the turning point for CO2-emission ranges from 13’000$ – 35’000$ depending on explanatory variables in the EKC (Anderson & Cavendish, 2001).
Technological progress is true for developed countries but hardly for developing countries and this studies tries to show how time is a determinant for policies to give result. The simulation shows that for developing countries, with an initial GDP/capita of 2’500$ and a growth rate of 4%, the peak levels of emission of the EKC will decrease by two thirds, and the turning point will be half a century earlier from en early implementation of policies compared to a 100-year delayed “no policy” (Anderson and Cavendish, 2001 fig5). The main benefit from implementing environmental policies is the incentive for technolog-ical progress and this simulation also found that even though there is a lag between imple-mentation and effect of a policy, it is not as long as what is usually the result of an EKC. Policies are often used as a way to internalise the externalities.

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1 Introduction
2 Policy Background
3 Theoretical framework
3.1 The Environmental Kuznets Curve
3.2 Previous studies
3.3 Criticism
3.4 Environmental policies as economic instruments
4 Empirical Framework
4.1 Defining variables
4.2 Methodology
5 Results and discussion
6 Conclusion
Suggestions for further research
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Environmental Policies and the EKC

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