Regulation versus liability

Regulation and tort law are alternative methods (though often used in combina­tion) for preventing accidents. The former requires a potential injurer to take measures to prevent the accident from occurring.

However, before dealing with the problem of the comparison between the two instruments we shall first define their main features.

A regulation system is typically characterized by a centralized structure in the sense that it is a system based on an authority or an agency that uses a number of tools to control environmental damages. By ‘regulation’ we mean ‘a directive to individual decision-makers requiring them to set one or more output or input quantities at some specified levels or prohibiting them from exceeding (or falling short of) some specified levels’ (Baumol and Oates, 1975, p. 126). Usually the regulation system takes the form of the setting of stan­dards: in this case under a mandatory technology or abatement standard, the regulator can order the firms to reduce their emissions by a certain percentage, to emit no more than a specified amount of a pollutant, and/or to install a particular abatement technology. Alternatively, there are incentive market-based instruments, such as marketable permits and taxes (Backhaus, 1999).

First, we can affirm that in a world with perfect or at least complete information, following a law and economics approach, the policy instrument consisting in a regulatory system is efficient in solving the problem of inter­nalizing the potential effects of environmental accidents. In fact, using this instrument, ex ante the firm has an incentive to take adequate precautions. But ‘problems of measurement and the breakdown of second-order condi­tions (among other things) constitute formidable obstacles to the determination of truly first-best environmental policy’ (Cropper and Oates, 1992, p.

In fact, in an incomplete information context many problems can arise. These will be analysed in the next section in connection with the different forms of regulation.

A liability system for environmental damages can be considered to be a policy instrument in the sense that such a system provides protection for the victims against the consequences of an environmental accident and gives incentives to the actors in a potential accident to take the necessary preven­tive measures (Calabresi, 1970; Shavell, 1987). Consider the typical liability system applied to risks created by hazardous activities: in this case the victim files an action against defendants for all injuries caused by their conduct, claiming a causal link between the defendants’ conduct and the plaintiff’s injury.

A liability system can be applied using either a negligence or a strict liability regime. The law and economics literature generally concludes that both regimes provide a potential polluter with incentives to take adequate preventive measures. But problems arise if we consider the practical applica­tion of the regimes and the presence of informational issues. Regarding the specific case of environmental accidents, it is particularly difficult to deter­mine the standard to assign liability on the basis of negligence: for example, pollution has many sources and many victims and it is a hard task to pre­scribe efficient pollution standards based on a calculus of the abatement cost and the external harm of every source of pollution.

In fact, in the case of assignment of liability for an environmental accident, a strict liability regime is applied more often. In the United States, the CERCLA (Comprehensive Environmental Response, Compensation and Liability Act 1980, 1985, 1996) type of liability is typically a strict, joint and several liability, on the owners and operators of the firm that is responsible for an environmental accident. The liability system in the European Union, as set out by the Commission, in the White Paper on Environmental Liability,² is essentially a strict (no-fault) and non-retroactive liability system for damage caused by inherently dangerous activities.³

The two policy instruments, regulation and liability, may present different informational issues, as in Rose-Ackerman (1991, p.

Statutory regulation, unlike tort law, uses agency officials to decide individual cases instead of judges and juries; resolves some generic issues in rulemakings not linked to individual cases, uses nonjudicialized procedures to evaluate techno­cratic information, affects behavior ex ante without waiting for harm to occur, and minimizes the inconsistent and unequal coverage arising from individual adjudi­cation. In short, the differences involve who decides, at what time, with what information, under what procedures, and with what scope.

In a comparison of regulation and liability, Shavell (1984a) considers as a first determinant the difference in know-how between private parties and the regulatory authority related to the benefits of activities, the cost of reducing risks, and the probability and the severity of accidents. It is evident that the nature of the activities carried out by firms is such that private parties could have a better knowledge of the benefits, the risks involved and the cost of reducing risks. In such a case a liability system is better because it makes private parties the residual claimants of risk control. However, in some cases the regulator is better informed because of the possibility of centralizing information and decisions, in particular when a knowledge of risks requires special replicable and reusable expertise. In such a case, direct regulation is likely to be the better system.

A second determinant is the limited capacity of private parties to pay the full costs of an accident, either because of limited liability or because of insufficient assets. Shavell claims that a traditional liability regime does not provide private parties with proper incentives for taking precautions. A regu­latory system can impose decisions on firms either directly or indirectly. So, the greater the probability or the severity of an accident, and the smaller the assets of the firm relative to the potential damages, then the greater the appeal of regulation.

The third determinant is the likelihood that the responsible parties would face a legal suit for harm caused. This is a particular problem in environmen­tal risks: in many cases the victims are widely dispersed; they may not be motivated to initiate a legal action; harm may be evident only after a long delay; and specifically responsible polluters may be difficult to identify. Compared with a regulatory system, the liability system is more uncertain and provides less incentive for risk control.

The fourth determinant is the amount of administrative expense incurred by the private parties and the public. The cost of a liability system includes the cost of compliance, the legal expenses and the public expenses for main­taining legal institutions. The cost of the regulatory system includes the public expenses for maintaining the regulatory agencies and the private costs of compliance. In this case the advantage of the liability system is that legal costs are incurred only if a suit is brought and, if the system works well, in the sense that there are incentives for choosing the efficient level of care, the suits are few and therefore the costs are low. On the other hand, under regulation, the administrative costs are incurred whether or not the harm occurs because the process of regulation is costly by itself and the regulator needs to collect information about the parties, their activities and the risks.

Considering the four determinants, Shavell concludes that administrative costs and differences in knowledge favour liability, while inability to pay and avoiding lawsuits favour regulation. In general, a liability system is more efficient when private parties possess better information and when there is a low probability that an accident will occur. Regulation is usually better when harm is great, is spread among many victims or takes a long time to become apparent, when accidents are not very rare events, and when standards or requirements are easy to establish and control.

Shavell (1984b) deals with the characterization of the relationship between the regulation systems, as complements or substitutes in providing incentives to reduce the level of risk, showing that no single regulation system leads the parties to exercise the socially desirable level of care. This is due to different factors: on the one hand, the agency suffers from a lack of information and, on the other, a liability system presents the possibility that the parties would not pay fully for harm and might not even be sued. Shavell first considers the case where only the ex post regulation system or the ex ante one can be used and then the case where both systems can be used jointly so that the parties must satisfy ex ante standards and are also subject to ex post liability. The conclusion is that it is generally socially advantageous to use both ex ante and ex post regulation systems.

In another contribution, Kolstad et al. (1990) stress that the two policies may be complementary. They claim that even if the phenomenon of complementary use of ex ante and ex post systems is widespread, the economic literature has generally studied the two separately, characterizing each of them by different inefficiencies. In addition to Shavell’s (1984a) four determinants, Kolstad et al. consider the imperfection in the definition of legal standards which may lead firms to choose a level of precaution different from the socially optimal one. They conclude that the liability system, applied jointly with ex ante regulation, can correct the above inefficiencies, at least in part.

Other contributions try to include informational issues in the analysis of the comparison between ex ante and ex post regulation systems. Schmitz (2000) presents a critical evaluation of the above papers suggesting the use of the two systems as complementary instruments to overcome the limited effic­iency of liability due to enforcement errors and to injurers avoiding lawsuits. Schmitz proposes the comparison between ex ante and ex post systems as imperfect instruments through a formal model of how the imperfections affect the outcome: the extension of liability to private financiers is imperfect in so far as the private financier maximizes his/her own profit rather than social welfare; the regulatory agency may be captured by the parties who may cause environmental accidents; an asymmetric information framework is considered where the level of precautionary activities is the private informa­tion of the firm.

This analysis of the contributions on the comparison between ex ante and ex post regulation systems has shown some results in terms of the choice of environmental policies, including informational issues. In the next section we shall analyse in turn different instruments included in the general definition of regulation and liability.