Should environmental projects be subsidised? An empirical analysis
ABSTRACT Imperfect markets, asymmetric information and transboundary pollution are all characteristics that in most cases lead to inefficient “market” outcomes, and which thus are arguments for (public) intervention in the market. On the other hand, these characteristics also imply strategic behaviour by the economic agents, and then the effects of public intervention may be different from the traditional results of e.g. subsidies. The point of departure for this paper is the trading of an environmental project in a market with the above mentioned characteristics and where the pollution is transboundary. The trade is promoted by (foreign) authorities in that they offer a grant is trade takes place. We show that the effects of the grant strongly depend on the interests of the authorities, and that the subsidisation does not necessarily make the trading outcome more efficient.
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Should environmental projects be subsidised? An empirical
Working Paper Series in Economics and Management
No. 06/03, December 2003
Department of Economics and Management
Norwegian College of Fishery Science
University of Tromsø
Should environmental projects be
subsidised? An empirical analysis.*
NORUT Social Science Research/University of Tromso
P.B. 6433, N-9294 Tromsoe/N-9291 Tromsoe
phone: +47 776 29400/fax: +47 776 29461
Imperfect markets, asymmetric information and transboundary pollution are all characteristics that
in most cases lead to inefficient “market” outcomes, and which thus are arguments for (public)
intervention in the market. On the other hand, these characteristics also imply strategic behaviour
by the economic agents, and then the effects of public intervention may be different from the
traditional results of e.g. subsidies.
The point of departure for this paper is the trading of an environmental project in a market with the
above mentioned characteristics and where the pollution is transboundary. The trade is promoted
by (foreign) authorities in that they offer a grant is trade takes place. We show that the effects of
the grant strongly depend on the interests of the authorities, and that the subsidisation does not
necessarily make the trading outcome more efficient.
Keywords: imperfect market, asymmetric information, transboundary pollution,
* I would like to thank Prof. Derek J. Clark for very useful comments and suggestions during the
work with the paper. I would also like to thank Prof. Manfred J. Holler, Dr. Claire W.Armstrong
and Heide Coenen for useful comments to earlier drafts of the paper. All errors in the paper are the
** Corresponding address: Institute of Socio Economics, University of Hamburg, von Melle Park
5, D-20146 Hamburg.
Should environmental projects be subsidised? An empirical analysis
There are several economically based reasons for subsidising environmental projects. One of
the consequences of the implementation of such projects is cleaner nature. This is a collective
good, and when people beyond the trading agents are positively affected by the
implementation of a project it can be said to have positive external effects. From basic
economic theory we know that both in the case of collective goods and when there exists
external effects, the market left alone provides a suboptimal quantity of the good.
Another argument is that when there is asymmetric information in a market, e.g. that the seller
of a project does not know the valuation of the buyer, one can show that under given
assumptions1 there is no efficient trading mechanism. In such a situation a subsidy may
promote the efficiency of the trading outcome.
Further, when the pollution caused by economic activity is transboundary, then it can be
shown2 that when each country only takes into consideration the damage made in their own
country when regulating the activity, the resulting polluting emissions will be too high
compared to what is socially optimal. When the countries affected by the pollution co-operate
the socially optimal emission level may be implemented, but in many cases this require a
1 The assumptions are that there is a probability for no gains from trade and that budget balance is required.
Myerson and Satterthwaite (1983) were the first to derive this result and it has been known as one of the
inefficiency theorems (Fudenberg and Tirole 1993, p.275).
2 Among these we can mention Mähler (1989), Kaitala et al (1991)
side-payment (which can be defined as a subsidy) to the country, which have to decrease its
emission the most3.
However, introducing a grant in a trading situation will have multiple and varying effects,
depending on the characteristics of the market and the ex ante information structure. Hence,
the aim of this paper is as follows:
I: To discuss the effects on market efficiency of a subsidy to an environmental project when
the market is monopolistic, there is asymmetric information and the trading agents behave
II: To derive the optimal (public) subsidy to offer in the above situation, and discuss how this
varies with the interests of the provider of the subsidy (e.g. authorities, Government).
As we see it, the market characteristics mentioned under I) are rather usual concerning the
trading of environmental projects. This will be further documented in section 2. Also, a
Government may have its own interests to follow in the environmental politics, and these
need not coincide with welfare maximisation. Hence, we give examples of different possible
interest of a Government offering subsidies to an environmental project.
The paper is organised as follows: In section two we present the empirical case on which the
analysis in this paper is based. In section 3 an analytical model is presented and solved by use
of a Bayesian game. In section 4 we concretise the role of the provider of the grant
3 For such a co-operative solution with side-payments see Kaitala et al (1991) who describes the situation
between Finland and parts of the former Soviet Union.
(Government), assuming three different types of this agent. In section 5 the results from the
model is discussed with respect to the empirical case, and in section 6 we conclude.
The border area between Finland, Norway and Russia is characterised by significant
environmental degradation due to pollution from an extensive industrial activity. One of the
main sources of this pollution is the nickel smelter Petsjenganikel in the town of Nikel. Since
1988 there have been negotiations between Finnish, Norwegian and Russian representatives
about modernising the plant and thus reducing emissions of sulphur dioxide by 90%. Both
Finnish and Norwegian companies possess the relevant technology, and they have developed
plans (projects) for how to transfer it to Petsjenganikel. The respective governments have
attached a grant to such a project if implemented. However, neither succeeded in reaching an
agreement with the Russian counterpart. Below is a short presentation of the negotiations.
A: The first phase (1990-1991)
The registration of long-transported pollution in Europe through the monitoring programmes
EMAP (European Monitoring Assessment Programme) in 1976-1978 showed severe
pollution streams from Russia to Finland and Norway. Later Russian-Norwegian expert
groups, under the Joint Norwegian-Russian Commission on Environmental Questions
explored the local environmental impacts of these pollution streams (AMAP 1997). One of
the main sources of the transboundary pollution streams between Russia, Finland and Norway
is the nickel-plant Petsjenganikel. In 1990 a general agreement was reached between Russian,
Finnish, Swedish and Norwegian authorities about reducing the emissions of SO2 from
Petsjenganikel. The Finnish company Outokumpu developed a technological solution,