Path dependence and the risk of institutional lock-in

In the emissions trading literature some contend that is it not problematic to start with credit trading, assuming that such a scheme can later be trans­formed into a permit trading system (for example, Tietenberg and Victor, 1994).

Essential components in the analysis are the distinction between the set-up costs of establishing a legal institution and the running costs of continuing it. Set-up costs can be subdivided into sunk costs (of the existing arrangement) and switching costs (of a new arrangement). The former are not relevant for the decision whether or not to continue and extend the existing arrangement because they were made in the past (‘bygones are forever bygones’, accord­ing to economic theory), but switching costs are relevant when establishing a new one because they still have to be made. Four factors can then be identi­fied that contribute to a possible institutional lock-in of credit trading.

First, credit trading profits from the learning effects associated with build­ing on existing environmental policy.

Second, credit trading builds on the sunk costs of existing environmental policy. These start-up costs that have already been incurred play no role in the decision to continue current environmental policy without emission ceilings, whether or not modified to take account of credit trading. Although permit trading reduces running costs, it involves relatively high start-up costs be­cause it implies crossing over to a new legal arrangement. Resistance by vested interests contributes to these switching costs.

Third, policy makers will be more persuaded to opt for credit trading if there is a predominant perception that the problem-solving capacity of the existing environmental laws is growing or stable. If the effort of policy makers is directed to ‘satisficing’ rather than ‘optimizing’, they are less receptive to theoretically superior alternatives such as permit trading.

Fourth and finally, credit trading can profit from network or coordination benefits by building on extant policy. If regulation is seen as the govern­ment’s ‘product’, administrative costs are its ‘production costs’. Contrary to what Pierson (2000) suggests, there is an incomplete (but not absent) analogy with increasing returns to scale. In short: the advantage for the government of building upon existing legal arrangements does not originate from producing larger quantities of (similar) rules, but what matters is that the differential administrative costs (the extra costs of adding another collection of units) decline as the institutional scale increases. This can be done by expanding an existing environmental instrument (horizontally) to cover extra target groups, such as more segments of industry, or the government itself can expand the instrument (vertically) by adding an element such as credit trading. These processes are driven by increasing returns to scope, rather than increasing returns to scale.

The preconditions for an institutional break-out are the opposite of those set out above for an institutional lock-in. This puts us in a position to analyse the path-dependent evolution of environmental law. The chances for permit trading then improve, for instance, as the information on this instrument ameliorates, as the costs of switching to a permit trading system decline, and as the problem-solving capacity of existing environmental regulation deterio­rates.