On optimal extraction under asymmetric information over reclamation costs

A polluted site is left behind when the resource extraction operation ends. The extracting firm is often required to post a bond to guarantee that the site is properly reclaimed, but a problem is that these monies are often insufficient to cover the reclamation cost. A possible reason for this is that the extracting firm has private information about the future reclamation costs and can use this information advantage to its benefit. The question then is how to improve the policy.

In principle and in practice the regulator has at least the following options to try to find out the true cost. First, the regulator can simply ask the firm to report the reclamation cost as is often done in practice. Of course, the problem is that the firm has incentives to misrepresent the cost to obtain a small cost and bond, and either the taxpayers must pay the cleanup, or the cleanup is not properly done. Second, the regulator can use the publicly available information and try to estimate the reclamation costs. This was the idea behind the CERCLA-proposal of the U.S. EPA (which was later reversed under the new administration). However, the problem with this approach is that the available information is not site-specific, which implies that the estimated cost may not be the correct one and the firm pays too much or too little. Third option for the regulator is to design a mechanism that induces the firm to report its cost truthfully, and this option is analyzed in the paper.

The main question is how to design a contract between the regulator and the firm, when there are two market failures: stock pollutant produced during the operation and the information asymmetry. The analyzed contract specifies a bond paid before the operation commences, a pollution stock tax paid during operation and a mechanism to reveal the reclamation cost. The results characterize the contract and its properties, and it is shown that the pollution tax under asymmetric information can be lower or higher than under complete information. Applying the contract can for example save public funds and improve the state of the environment.


Reference: Lappi, P. On optimal extraction under asymmetric information over reclamation costs. Journal of Economic Dynamics and Control. In press. https://doi.org/10.1016/j.jedc.2020.103987

This project has received funding from the European Union's Horizon 2020 research and innovation programme under the Marie Sklodowska-Curie Grant Agreement N. 748066. The paper was mainly written while working on the project at CMCC and Ca' Foscari University of Venice, and the support and funding is greatly appreciated.