Voluntary environmental agreements: bargaining over more than emissions

European Journal of Political Economy Vol. 18 (2002) 545 – 559 www.elsevier.com/locate/econbase

Voluntary environmental agreements: bargaining over more than emissions Sverre Grepperud * Centre for Health Administration, University of Oslo, Rikshospitalet, N-0027, Oslo, Norway Bodø Graduate School of Business, N-8049, Bodø, Norway Received 23 June 2000; received in revised form 19 February 2001; accepted 7 September 2001

Abstract This paper analyses voluntary agreements (VA) between public agencies and polluting industries. It is shown that voluntary agreements provide gains both for governments and for industries relative to the use of emission licenses and can thus be seen as both rational and self-enforcing. The condition for this conclusion is that the regulator has preferences over labour participation rates due to the presence of layoff costs. The gains for both parties in signing an agreement are highest when the industry is one with high productivity, low wages, and low environmental costs, while the effects on gains differ across the two negotiating parties for high output elasticities with respect to emissions and labour. D 2002 Elsevier Science B.V. All rights reserved. JEL classification: C78; D62; Q20 Keywords: Environmental policy; Voluntary agreements; Nash bargaining game

1. Introduction A voluntary agreement (VA) is the process and outcome of negotiations between an industry (or single firm) and a public agency (national, federal or regional), initiated to improve environmental performance. VAs vary with respect to scope and scale. In most cases, however, they are target based with respect to environmental performance in terms of quantity and include a time schedule for achieving the target. Such agreements can be viewed as alternatives to standard regulatory instruments such as emission standards (ES), environmental taxation, and emission quota trading. An important distinction between a VA and traditional instruments is that, for the latter, there is a legal basis to impose restrictions upon the polluting industry, while for a VA, the decision to abate pollution is *

Tel.: +47-23-07-53-11; fax: +47-23-07-53-10. E-mail address: [email protected] (S. Grepperud).

0176-2680/02/$ - see front matter D 2002 Elsevier Science B.V. All rights reserved. PII: S 0 1 7 6 - 2 6 8 0 ( 0 2 ) 0 0 1 0 5 - 2

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Table 1 The number of implemented VAs by 1996 for EU member states Country

Number of agreements

Austria Belgium Denmark Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom EU total

20 6 16 2 8 93 72 1 11 5 107 10 6 11 9 305

Sector Agriculture

Energy

X

X X X X X

X X X

X X

X

Industry X X X X X X X X X X X X X X X

Source: European Environment Agency (1997, p. 23).

not required by law (voluntary). However, VAs can hardly be understood in separation from other regulatory instruments. An obvious threat available for governments in cases of the breakdown of VAs is to introduce traditional instruments such as emission standards or environmental taxation. From this perspective, polluting firms ‘‘voluntarily’’ join an agreement to avoid legislative regulation. The most extensive documentation on VAs is EEA (1997), which covers all EU members. This report confirms the impression of an increased interest in VAs in the last decade. While the number of signed VAs in the EU was less than 5 in the period 1980– 1985, the average became 12 in the period 1986 –1994 and the numbers were 47 and 34 for 1995 and 1996, respectively.1 As follows from Table 1, all EU countries are reported by 1996 to have implemented VAs at the national level, representing a total of more than 300 agreements. However, the frequency across member states varies widely.2 The most important sectors for the implementation of VAs are industry and energy, addressing environmental problems such as climate change, ozone depletion, air pollution, and waste management.3 In addition, VAs are also implemented in non-EU countries such as USA, Japan, Canada, Norway, and New Zealand.4

1 EEA (1997, p. 11) defines VAs as ‘‘those commitments undertaken by firms and sector associations, which are the result of negotiations with public authorities and/or explicitly recognised by the authorities’’. 2 The numbers do not include VAs at the subnational level. 3 For some countries, VAs are also implemented in the agricultural sector (water resources and soil depletion). 4 For more information on VAs, see IEA (1996), OECD (1997), and CERNA (1997). For specific information at country level (both EU and non-EU members), see CAVA (1998) and the references therein. For a discussion on the potential dangers of VAs, see, e.g., Grepperud (1998).

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A puzzle in the environmental literature is why governments prefer VAs to emission licenses, because both instruments are target based with respect to emission quantity and have similar properties regarding allocative efficiency.5 VAs might imply a more lenient (milder) form of regulation than emission standards and therefore become preferable from industry’s point of view.6 However, for the government, less restrictive regulation can be conducted just as simply by using emission standards. One explanation may be that the negotiation process itself provides information that would not be available given a traditional type of regulation. Ga˚rn Hansen (1996) stresses that preference learning and utility derived from a participatory process may be central aspects of VAs. Other explanations appearing in the literature focus on differences in transaction costs (enforcement, negotiation, and administrative costs) across regulatory instruments and other costefficiency considerations (see, e.g. Carraro and Leveque, 1999). This paper presents a different explanation for voluntary agreements. In doing so, we contrast VAs with the most common regulatory instrument: emission licenses. The analysis is a positive one, where governments are believed to have a willingness to pay for avoiding labour layoffs. It is shown that such preferences provide a rationale for organising environmental regulation in terms of VAs rather than by emission licenses. In Section 2, the role of manning preferences in environmental regulation is discussed. Section 3 derives emission and employment levels that provide gains for both parties. Section 4 identifies factors that influence the relative gains arrived at through VAs relative to standard regulation.

2. The role of layoff costs in environmental regulation Social welfare functions in the environmental literature often have industry profits and environmental damages as arguments (see, e.g. Oates, 1992). Here, defining preferences over labour layoffs as well extends this approach. There are at least four different justifications for such a modelling approach. First, industries located in rural areas (e.g. agriculture) tend to receive more subsidies than industries in urban areas, suggesting that society’s evaluation of activities or political influence may differ across industries and regions.7 One possible explanation for contingent preferences of this type is employment considerations. Second, a motivation for the welfare state is the shielding of individuals from market risks. Governments, in contrast to firms, have a long-term financial responsibility for laid-off workers via the social security system (early retirement pensions, unemployment payments, and social assistance). Safety nets imply that labour layoffs are costly for the government. Third, long-term unemployment may erode human capital.

5 VAs may induce cost effectiveness if quotas can be traded. However, the same potential exists for licenses given the determination of aggregate standards for a group (‘‘bubbles’’) instead of firm-to-firm regulation. 6 The application of VAs relative to market-based instruments (taxes) may follow from adverse distributive effects. However, market-based instruments can be designed so that any differences in compliance costs are reduced or even eliminated (through various compensation schemes or ‘‘grandfathering’’). 7 The presence of rural-area development programs also suggests the existence of such preferences. Other possible explanations are food security and rural amenities.

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There is much evidence on how unemployment may pacify former employees. Individuals lose energy, both to look for work and to improve their skills, and over time, their potential labour productivity declines and may even push them on disability pensions (Lindbeck, 1985). In both cases, social costs are imposed. Fourth, layoffs, especially in unionised economies, seem to attract attention as well as resistance. Under some circumstances, labour layoffs contradict notions of fairness in society. If so, there may be electoral costs of unemployment. The above arguments represent distributional, political, and social as well as budgetary reasons for a regulator to be concerned with labour layoffs.8 Below we will analyse regulator behaviour under the presence of layoff costs. First, however, we consider a situation where environmental regulation is absent, in the following denoted as unregulated firm (UF). Let the industry (or firm) be described by the aggregate production technology, F(E,L), where L denotes employment and E denotes a second input and emissions at the same time. In a global warming context, E may be thought of both as fossil fuel consumption and as CO2 emissions.9 The production function is increasing in both arguments and strictly concave in (E,L), and labour and emissions are assumed to be complementary factors in production, AðAFðE;LÞ=ALÞ > 0. The AE profit function of the industry, given an output price equal to one, now becomes PðE; LÞ ¼ FðE; LÞ  wL  qE

ð1Þ

where w and q denote (private) input unit costs for L and E, respectively. The optimal factor quantities, EUF and LUF, are now determined by the following standard neo-classical conditions: BFðEUF ; LUF Þ=BE  q ¼ BFðEUF ; LUF Þ=BL  w ¼ 0

ð2Þ

where Eq. (2) also implicitly defines the neoclassical demand functions, L( q,w) and E( q,w). Assume now that E is under the control of the regulator. In this case, the firm faces a restricted profit function of the following type: PR ðE; LÞ ¼ FðE; LÞ  wL  qE:

ð3Þ

Maximising Eq. (3) with respect to L yields a (restricted) labour demand function of the following type: LR = L(w;E) u l(E). It is now straightforward to show, given production factor complementarity, that firm employment will decrease for a stricter license, dl(E)/ dE>0. Consequently, a regulator with preferences for employment in the regulated industry experiences benefits (or less costs) the lower are labour layoffs in response to regulation. Such benefits are here represented by the function, v(d), where labour layoffs is defined as the difference in labour participation rates, ex ante regulation, LUF, and ex-post

8 In fact, a standard argument applied by industry, trade unions, and labour unions opposing environmental regulation is the concern for industry employment. 9 The one-to-one relationship between the quantity of E as an input and the externality is, of course, a simplification.

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regulation, L: d = LUF  L. Furthermore, it is assumed that that a reduction in the number of layoffs represents a gain for the regulator in terms of saved costs, Bv(d)/Bd < 0.10 In the following, the benefit function is expressed as v(LUF  L) u V(L), where BV/BL>0.11,12 Assuming a perfectly elastic market demand for firm output, the conditional objective function of the regulator is W ðE; LÞ ¼ PðE; LÞ  DðEÞ þ V ðLÞ

ð4Þ

where W is strictly concave in (E,L), and D(E) denotes environmental damages. Below we will derive the socially optimal license under two different assumptions given the preferences described in Eq. (4). First, a Stackelberg game (emission standard game) is assumed, where the regulator controls emissions (license) only, while the subsequent employment decision is left with the industry. In this case, the response function of the industry coincides with l(E) and the social optimality condition can be derived by inserting l(E) into Eq. (4) and maximising w.r.t. E, which yields BFðEES ; lðEES ÞÞ=BE  q  BDðEES Þ=BE ¼ ðBlðEES Þ=BEÞ½BFðEES ; LES Þ=BL  w  ðBlðEES Þ=BEÞðBV ðLES Þ=BLÞ ¼ ðBlðEES Þ=BEÞðBV ðLES Þ=BLÞ

ð5Þ

where EES and LES are the optimal license and optimal industry employment, respectively. From Eq. (5), it follows that the optimal license level is determined by equating the marginal change in industry net profits, subtracted the marginal costs of pollution, with the marginal change in layoffs costs. Now Eq. (5) will be compared with the same condition given that the regulator is able to determine both emissions and labour participation rates [complete regulation (CR)]. The first-order conditions now become BFðECR ; LCR Þ=BE  q  BDðECR Þ=BE ¼ BFðECR ; LCR Þ=BL  w þ BV ðLCR Þ=BL ¼ 0:

ð6Þ

By comparing Eqs. (2), (5) and (6), it follows that all three conditions coincide, if neither environmental externalities nor employment preferences enter the objective function of the regulator: In that case, any intervention is undesirable. When there are no employment preferences, only Eqs. (5) and (6) coincide. As a consequence, the regulator can now safely leave the employment decision with the industry. However, if both environmental costs and employment preferences are part of the objective function, then Eq. (5) differs

10

An equivalent approach would be to introduce layoffs as an argument in a cost function. Layoff costs can also involve cost of public funds due to higher unemployment benefits. 12 Note that we ignore any opportunity gains that may arise from labour layoffs such as utility from leisure and the value of labour in other productive activities, which again stresses the positive features of the model. 11

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from Eq. (6). Below we rank input use, profits, and welfare for the three cases (UF, CR, and ES) when employment preferences are present: EUF > EES ; EUF > ECR ;

LUF > LES ; LUF > LCR ;

PUF > PES > PCR ;

WUF < WES < WCR : It follows that the first-best outcome for the regulator, WCR, is not attainable by the use of emission licenses. Hence, the regulator can do better if she is able to determine industry labour participation rates. The reason lies with the fact that industry labour demand, for a given E, does not coincide with society’s demand for labour. The industry is best off if unregulated but prefers ES to CR. The above findings make clear that if the regulator values employment (layoffs) differently than the market (industry), environmental – employment trade-offs exist.13 These findings raise the question of whether input – mix combinations exist that make both parties better off.

3. Voluntary agreements vs. emission standards The purpose of this section is to investigate whether there are attainable gains for both parties relative to the emission standard game. This is achieved by specifying the objective functions presented in Section 2 and by introducing some simplifying assumptions that improve analytical tractability. First, a Cobb– Douglas technology for industry production is assumed,14 while emission unit costs are set equal to zero ( q = 0). Firm profits now become PðE; LÞ ¼ AE r La  wL

where a > 0; r > 0 and a þ r < 1

ð7Þ

where A is a constant in the production function, and r and a are the elasticities of output with respect to emissions and labour, respectively. Second, the damage function is assumed linear, D(E) = DE, where D is marginal environmental damage. Third, regulators’ willingness to pay for avoiding layoffs is now represented by the following function, V(L) = vL, where v is the marginal welfare gain from less layoffs and is set equal to w.15 The regulator’s welfare function now becomes W ðE; LÞ ¼ AE r La  DE:

ð8Þ

13 For absent employment preferences, the following ranking matters: PUF>PES = PCR; WUF < WES = WCR. Welfare now coincides for CR and ES, saying that the regulator cannot improve on welfare by controlling labour participation rates. 14 This specification implies factor complementarity. 15 This assumption simplifies the analysis without changing the main results. In some economies, the income differential between individuals in work and out of work is small. A comparative analysis for Netherlands and Germany finds that the ratio between benefits payments (unemployment insurance and social assistance) and previous earnings varies within the range of 73 – 115% across groups in the two countries (CPB, 1997).

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Isoprofit curves and isowelfare curves in a (E,L) plane serve as indifference curves for the industry and the regulator, respectively. The slopes of isoprofit curves and isowelfare curves through (E,L) are as follows: dE ðAE r aLa1  wÞ ¼ dLjP¼P ArE r1 La

ð9Þ

dE AE r aLa1 : ¼ dLjW ¼W ArE r1 La  D

ð10Þ

For any L, it can be seen from Eq. (9) that isoprofit curves have a negative slope until E makes the marginal productivity of labour to equate with the wage rate, then positive. For a higher L, the switch occurs at a higher E. For any L, higher E creates larger profits for the firm, so higher isoprofit curves are better for industry. The numerator of Eq. (10) is always negative. Thus, for any L, Eq. (10) is first negative and then becomes positive as E increases. For any E, a higher L creates higher welfare for the regulator, so isowelfare curves to the right are better for the regulator. The indifference maps of the industry and the regulator are shown in Fig. 1 where P1>P0 and W2 < W1. The industry demand curve for labour (DDV in Fig. 1) slopes upward due to production complementarity and is the locus of maximum points of the industry indifference curves in the (E,L) plane. We can now undertake a closer investigation of the emission standard game. For any emission license chosen by the regulator, the industry seeks the highest isoprofit curve. To put it another way, for a given E, the industry employs labour until the marginal productivity of labour equals the market wage rate (along DDV in Fig. 1). The regulator,

Fig. 1. Stackelberg leader – follower game (emission standards).

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being aware of the industry response, can now, by deciding on E, achieve any point along the industry demand curve. However, the regulator will be best off by choosing the emission level determined by the tangency of an indifference curve with the industry’s demand curve for labour (W2 in Fig. 1). Hence, the outcome of the Stackelberg leader – follower game (emission standards) will be A in Fig. 1, which yields profits equal to P0 for the industry. A contract curve (CCV in Fig. 1) is characterised by equality of the slopes of the regulator’s indifference curve (iso-welfare) and the industry’s indifference curve (isoprofit). This condition yields ðAE r aLa1  wÞðArE r1 La  DÞ ¼ AE r aLa1 ArE r1 La > 0:

ð11Þ

It is observed from Eq. (11) that the first term of the left side coincides with the first-order condition for optimal industry employment (see numerator in Eq. (9)), while the second term coincides with the condition determining the optimal emission license. It follows from Eq. (11) that the product of the two terms is positive along the contract curve. Furthermore, it is evident that both terms cannot be positive because the firm will always do better for higher quantities of E and thus higher quantities of L. Hence, both terms are negative. From this we know that the contract curve in our problem (CCV) must be located to the right of the industry’s labour demand curve (DDV) in Fig. 1. All points to the northeast of A in Fig. 1, constrained by the area between P0 and W2, have this property and can be denoted as the area of Pareto improvements (API). Consequently, we have proved the existence of (E,L) combinations that represent gains for both parties relative to the emission standard game (A in Fig. 1) and that these combinations all represent emission and labour participation rates being higher than the corresponding levels in the emission standard game. VAs are institutions for which bargaining may occur both over emissions and over employment rates, and the existence of API provides us with their rationale. A VA, in this perspective, becomes a flexible device where the regulator makes concessions with respect to pollution abatement in exchange for industry concessions with respect to labour layoffs. Hence, the bargaining outcome implies ‘‘overmanning’’ from the industry’s point of view. Consequently, the industry needs to be compensated for such costs to be willing to participate in an agreement voluntarily. In our model, this is achieved by agreeing upon an emission level higher than the ‘‘optimal’’ level in the corresponding emission standard game. The analysis presented in Section 2 has already made clear that the presence of API depends crucially on the existence of manning preferences (v>0). Only when the regulator has a wish to influence industry manning decisions in the emission standard game will (E,L) combinations exist that make both industry and regulator better off. Furthermore, VAs become self-enforcing agreements in this perspective. To see this, consider an agreement that represents a Pareto improvement relative to the emission standard game (e.g. B in Fig. 1). Additional layoffs, in accordance with the labour demand function (DDV), for a level of E = EB, will increase profits. However, a rational regulator response (welfare increasing) will be to leave the agreement and rather play the emission standard game (A in Fig. 1). Opportunistic regulatory behaviour, in terms of a stricter emission

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license than the one agreed upon, EB, will improve welfare, if industry employment still remains at LB. However, the optimal (profit-increasing) response of the industry will now be to increase layoffs. Opportunistic behaviour from each of the players affects the payoff of the other player, which again induces a rational response that improves the player’s own situation at the expense of the opponent. However, the final outcome puts both parties in a worse situation, compared to the agreement that leaves both parties without incentives to leave the agreement. The above conclusions arise because the industry generates two externalities, one from emissions and one from layoffs. Using a standard single policy instrument (license) in this situation leads to lower welfare compared to bargaining over both emissions and employment. However, our analysis has not considered alternative policy instruments to influence employment. One possibility is for government to control employment directly (‘‘manning’’ standards). For western societies, however, there has been an absence of governmental will (or legal basis) to control firm employment decisions. The institutional setting can be said to prevent governments from choosing the scheme it prefers. A subsidy on employment is an alternative for improving efficiency. However, there are limitations associated with this instrument as well. International trade agreements do not allow wage subsidies and ‘‘first best’’ is unattainable due to the cost of raising public funds.16 VAs are also often initiated by executive branches of the government, while the application of wage subsidies needs to be sanctioned by legislative branches, thus making VAs preferable for executive branches to the extent they disagree with legislative branches on policy priorities.

4. Factors determining gains in voluntary agreements The purpose of this final section is to identify how factors such as technology can influence the size of the gains from a VA. This is done to predict when VAs are likely to occur. Transaction costs may for example disadvantage VAs relative to standard regulation. Thus, the potential gains arrived at must be sufficiently large to induce their application. To conduct such an analysis, I here compare the value function for both cases (ES and VA).17 4.1. The emission standard game In this game, the determination of L follows the determination of E. Hence, we proceed by backward induction. The determination of L follows from maximising PR ðE; LÞ ¼ AE r La  wL w.r.t. L, which yields AaE r La1 ¼ w:

ð12Þ

16 VAs and wage subsidies also differ in other respects. A selective use of wage subsidies discriminate among industries in this way, creating political pressure. The outcome as concerns layoffs is uncertain to the government when using subsidies. 17 An alternative is to derive the equilibrium outcomes of the Nash bargaining game by using the outcomes of the ES game as threat points. Here, this approach is not chosen because an explicit solution cannot be derived. However, the optimality conditions that matter for this approach are presented in Appendix A.

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Eq. (12) says that, for a given emission license, labour participation rates (layoffs) are determined by equalising the marginal productivity of labour with the market wage rate in the industry. We now turn to the first phase of the game. The outcome with respect to emissions is derived from the following maximisation problem using Eqs. (8) and (12): W ðE; LÞ:

max E

ð13Þ

The solution to this problem can be found implicitly by solving Eq. (12) with respect to E, inserting this expression into Eq. (13), and maximising with respect to L, which gives La ¼

a h w i a1

aA

ra

ð14Þ

E 1a :

The equilibrium outcomes of the sequential game with respect to emissions and labour (layoffs) are derived by combining Eqs. (12) and (14) and can be expressed as follows:  EES ¼

D Aðr=ð1  aÞÞ

1a  rþa1 h

r   rþa1 a 1r h w i rþa1 w i rþa1 D ; LES ¼ : aA Aðr=ð1  aÞÞ aA

ð15Þ

The outcomes in Eq. (15) depend on the following: the output factor elasticity for labour and emissions, the wage rate, the production technology coefficient, and the unit environmental cost of emissions. Eq. (12) can now be applied to confirm that the emission standard game is not located on the contract curve, and by inserting Eq. (15) into the payoff functions presented in Eqs. (7) and (8), explicit expressions for the payoff functions evaluated in equilibrium are derived: 

WES

r  rþa1 h

a w i rþa1 A½1  a; aA r   rþa1 a h w i rþa1 h D r i ¼ A 1 : Ar=ð1  aÞ aA 1a

PES ¼

D Ar=ð1  aÞ

ð16Þ

It follows from earlier assumptions that both expressions are strictly positive. 4.2. A voluntary agreement It seems reasonable that rational agents will reach an outcome by the means of a VA that is located along the contract curve. There is no reason why parties pursuing selfinterest should not reap all possible gains. Efficient bargaining or the maximisation of some (weighted) sum of profits and welfare provide us with equilibria of this type. Here we pursue the latter approach, which yields the maximisation problem: max E;L

bPðE; LÞ þ ð1  bÞW ðE; LÞ

ð17Þ

where b specifies the weights of the two parties’ payoff functions and can be interpreted as bargaining power. In the following, our attention is restricted to symmetric Nash solutions

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only, which implies that b equals {1\left/2}, which may be interpreted as if the parties have equal time preference rates.18 We have chosen not to consider an equilibrium that involves cash transfers, because governmental agencies have limited possibilities for undertaking such contracts for legitimacy reasons. However, a convenient property with symmetric bargaining games is that equilibria coincide with those of games that allow for side payments.19 Solving Eq. (17) yields the following equilibrium values:   1a   r a 1r h w i rþa1 D rþa1 h w i rþa1 D rþa1 EVA ¼ and LVA ¼ : ð18Þ 2Ar aA 2aA 2rA The payoff functions for each of the agents given a VA now become   r a h w i rþa1 D rþa1 PVA ¼ A½1  2a and 2aA 2rA   r a h w i rþa1 D rþa1 WVA ¼ A½1  2r: 2aA 2rA

ð19Þ

It follows from Eq. (19) that each of the payoff functions is positive if a < 0.5 and r < 0.5. 4.3. A comparison of payoffs To arrive at expressions for the difference in profits and welfare across the two games, we derive the following expressions: DP ¼ PVA  PES r   rþa1 a h w i rþa1 h i r D aþr ¼ A ð1  2aÞ2 1ar  ð1  aÞð1  aÞ rþa1 aA rA

ð20Þ

and DW ¼ WVA  WES r   rþa1 a h w i rþa1 h i r aþr D ¼ A ð1  2rÞ2 1ra  ½1  r=ð1  aÞð1  aÞ rþa1 : aA rA

ð21Þ

We already know from the maximisation problem (see Eq. (17)) that the derived (E,L) combination is located at the contract curve. However, Pareto efficiency per se does not imply that Eqs. (20) and (21) represent gains relative to the outcome of the ES game. For this to be the case, both expressions must be strictly positive at the same time as the (E,L) combination is located northeast of A (see Fig. 1) and being restricted by the isowelfare curve W2 and the isoprofit curve P0 (for example, B). 18 Binmore et al. (1986) show that the Nash solution can be derived as the limiting case of Rubinstein’s (1982) bargaining model. 19 The maximisation problem for a contract including side payments is max W ðE; LÞ þ PðE; LÞ.

E;L

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The signs of Eqs. (20) and (21) are determined by r and a. However, their effects are many and complex, and numerical simulations are undertaken to analyse their impact. Table 2 presents outcomes with respect to DW, DP, and DQ = DW + DP for different value combinations of r and a. We already know that the contract described in Table 2 implies ‘‘overmanning’’ and ‘‘overpollution’’ relative to the ES game. For the industry, this implies that the demand for labour (layoffs) is determined by the equality between the marginal productivity of labour and a constant lower than the market wage. For the regulator, the marginal productivity of emissions in equilibrium is lower than the unit cost of environmental costs (D). The contract can be said to imply a scaling down of the marginal input costs (w and D), which again represents costs for the industry with respect to employment and for the regulator with respect to emissions. The bold table elements in Table 2 refer to value combinations of r and a that yield strictly positive DW and DP. Consequently, the same table elements represent technologies that make the VA a Pareto improvement relative to the ES game. We observe that DP increases for higher values of r, which again determines the elasticity of the marginal productivity of emissions: k u ElEArEr  1La = r  1. The same increase in r has the opposite effect on net gains for the regulator (DW). Furthermore, it follows that a higher a that determines the elasticity of the marginal productivity of labour, x u ElLAEraLa  1 = a  1, increases net gains for the regulator while the same increase lowers industry gains. Consequently, no simple systematic pattern for how DQ changes with r and a can be observed, implying that the elasticity of labour demand with respect to emissions, g = ElEL = r/(1  a), plays no significant role in determining gains. Furthermore, all value combinations representing mutual gains are located along or (close to) the diagonal of Table 2, implying that a VA can only be reached if the industry technology is ‘‘balanced’’ in the sense that output elasticities with respect to the ‘‘tradable’’ inputs are (relatively)

Table 2 Gains in welfare and profits from a VA as opposed to effluent standardsa

a = 0.1

a = 0.2

a = 0.3

a = 0.4

a = 0.45

a

r = 0.1

r = 0.2

r = 0.3

r = 0.4

r = 0.45

#P = 0.022 #W = 0.028 #Q = 0.050 DP =  0.008 DW = 0.078 DQ = 0.070 DP =  0.040 DW = 0.134 DQ = 0.094 DP =  0.086 DW = 0.205 DQ = 0.125 DP =  0.106 DW = 0.251 DQ = 0.144

#P = 0.067 #W = 0.002 #Q = 0.070 #P = 0.031 #W = 0.049 #Q = 0.080 DP =  0.001 DW = 0.100 DQ = 0.098 DP =  0.037 DW = 0.149 DQ = 0.112 DP =  0.058 DW = 0.182 DQ = 0.123

DP = 0.119 DW =  0.025 DQ = 0.094 #P = 0.072 #W = 0.021 #Q = 0.094 #P = 0.035 #W = 0.063 #Q = 0.098 #P = 0.000 #W = 0.104 #Q = 0.105 DP =  0.018 DW = 0.127 DQ = 0.108

DP = 0.188 DW =  0.061 DQ = 0.126 DP = 0.124 DW =  0.010 DQ = 0.114 #P = 0.078 #W = 0.028 #Q = 0.106 #P = 0.039 #W = 0.058 #Q = 0.097 #P = 0.023 #W = 0.069 #Q = 0.092

DP = 0.233 DW =  0.086 DQ = 0.146 DP = 0.158 DW =  0.031 DQ = 0.126 #P = 0.104 #W = 0.006 #Q = 0.111 #P = 0.058 #W = 0.039 #Q = 0.089 #P = 0.032 #W = 0.036 #Q = 0.069

The numerical results are conducted under the assumption of A = w = d = 1.

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equal in size. If the technology is sufficient ‘‘unbalanced’’, an agreement is unattainable in the sense that the terms of trade become unfavourable for one of the parties. By conducting comparative statics with respect to the other parameters of the model, we arrive at additional insights. It is immediately apparent from Eqs. (20) and (21) that a higher value of the parameter D (present in the environmental damage function) decreases both industry’s and regulator’s gains from joining a VA. A higher D increases the damages associated with any given pollution level, thus reducing welfare. The relative attractiveness of trading higher E with higher L is reduced for the regulator, making it more costly for the firm to trade higher emissions with fewer layoffs. A higher wage rate, w, has a direct negative effect on firm profits. In addition, the same change worsens the terms of trade between emissions and employment. For these reasons, the gains that can be reached by a VA are reduced both for the industry and for the regulator. A higher value of A can be interpreted as a Hicks-neutral technological change, in that industry output becomes higher for any input levels. From Eqs. (20) and (21), it follows that such a change provides gains for both parties.

5. Conclusion The voluntary approach is gaining increasing currency as a new approach to environmental regulation. However, the rationale for such agreements is not obvious, because they seemingly are similar to standard environmental instruments such as emission licenses. In this paper, I have presented a positive theory of VAs that provides us with one possible explanation for their widespread application. The basic premise of this paper is a regulator who finds it costly to induce labour layoffs in association with environmental regulation. The presence of such costs introduces an additional externality, and by bargaining (in a Coasian sense) over both externalities, rather than applying emissions licenses, mutual gains are created. Standard environmental policy instruments in this perspective become institutions that allocate bargaining power among stakeholders in a specific way given by law and convention. Polluting firms control employment decisions, while the regulator, when choosing to intervene, has complete power over environmental objectives. A VA, on the other hand, becomes a more flexible institution, in which the regulator and the polluting industry bargain over both decision variables. VAs can be said to be arenas in which the parties meet to voluntarily ‘‘exchange’’ bargaining power, in the sense that the regulator makes concessions with respect to pollution abatement in exchange for industry concessions with respect to layoff decisions. The Netherlands, Germany, and the Nordic countries are the pioneering economies with respect to VA applications, and the same nations have the most extensive social security systems of Europe with a high union labour density. These observations are consistent with the hypotheses presented in this paper. Another common denominator, especially for the Netherlands and the Nordic countries, is the history of a contractual form of decision making within national governments (corporatism). The institutionalisation of bargaining, over a wide range of policy issues, between labour unions, producer organisations, and government that has occurred in these countries over several decades has contributed to facilitating the use of VAs.

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Our analysis does not suggest that VAs, as portrayed in this paper, are desirable from a societal point of view. Reluctance to accept labour layoffs may, especially in the long run, produce inefficiencies. However, efficiency considerations and standard welfare functions are not always relevant for explaining institutions or choice of policy. Concern over competitiveness and employment constitute probable explanations for why licenses have been preferred to environmental taxation in the history of environmental regulation—in spite of economists being persistent in their advice on taxation. VAs also have a potential for being an instrument for addressing policy targets other than those associated with the environment (e.g. energy conservation) and governmental trades may have more serious consequences than those identified in this analysis involving voter group support or side payments (bribes). The literature on international environmental agreements (IEAs) addresses global reciprocal externalities and the difficulty of reaching stable agreements due to free-rider incentives. Some of this literature focuses on transfers and abatement control combined with R&D cooperation among signatories as instruments to offset or reduce free-rider incentives (Carraro and Siniscalco, 1995). Such multidimensional trades represent approaches that share similarities with the analysis in this paper.

Acknowledgements The work related to this paper is financed by ProSus, Norwegian Research Council. I am grateful to S. Holden, S. Kverndokk, P.A. Pedersen, K. Solbraekke, and two anonymous referees for very helpful suggestions. The usual disclaimer applies.

Appendix A. Voluntary agreements portrayed as a Nash bargaining game The following maximisation problem matters for VAs portrayed as Nash bargaining games: max ½PðE; LÞ  PES b ½W ðE; LÞ  WES 1b : E;L

ðA:1Þ

The first-order conditions for problem Eq. (A.1) become b½PðE; LÞ  PES b1 ½W ðE; LÞ  WES 1b BPðE; LÞ=BE ¼ ½PðE; LÞ  PES b ðb  1Þ½W ðE; LÞ  WES b BW ðE; LÞ=BE

ðA:2Þ

b½PðE; LÞ  PES b1 ½W ðE; LÞ  WES 1b BPðE; LÞ=BL ¼ ½PðE; LÞ  PES b ðb  1Þ½W ðE; LÞ  WES b BW ðE; LÞ=BL

ðA:3Þ

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[Eqs. (A.2) and (A.3) can now be expressed as follows by using Eqs. (6), (7) and (15): AE r aLa1 ArE r1 La  D ¼ r a1 ArE r1 La AE aL w 2 r h i rþa1 a  w  rþa1  3 r a D r AE L  DE  A 1  Ar=ð1aÞ aA 1a 7 b 6 ¼ 4 5 ðA:4Þ r h i rþa1 a   b1 D w rþa1 AE r La  wL  Ar=ð1aÞ A½1  a aA As can be seen from above, the equilibrium outcomes of VAs in this setting become dependent upon the outcomes of the emission standard game (threat points).

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