Self-policing in a targeted enforcement regime.

1. Introduction

There is an on-going debate in both the theoretical and empirical literature about the effectiveness of self-policing policies such as the Environmental Protection Agency's (EPA) Audit Policy. The EPA consistently publicizes the Audit Policy as a successful, innovative approach to compliance. For example, the introduction to EPA's 2002 Enforcement and Compliance Assurance Report, "Environmental Results through Smart Enforcement," includes the 26% increase in companies that self-disclose violations as one of the year's highlights (U.S. EPA 2003, p. 4). However, Pfaff and Sanchirico's (2004) finding that the typical self-disclosed violation is relatively insignificant leads them to question whether the Audit Policy is as effective as the EPA claims. Similarly, Stafford (2005) examines compliance with hazardous waste regulations before and after the establishment of the federal Audit Policy and does not find any significant evidence that the federal Audit Policy has affected overall compliance. (1)

The theoretical literature on self-policing is also mixed. While many theoretical models of self-policing show that it can increase environmental protection (e.g., Kaplow and Shavell 1994; Innes 1999a), other models demonstrate how self-policing can have significant negative effects (e.g., Heyes 1996; Friesen 2006). This paper adds to the debate over the ability of self-policing to increase environmental protection by considering one aspect of self-policing that has been ignored in previous models--that self-policing may influence future enforcement activity.

EPA's Audit Policy provides incentives for regulated facilities to conduct environmental audits and voluntarily self-police by offering significant penalty reductions for any disclosed violations that meet certain eligibility criteria. Additionally, the EPA's website for environmental auditing notes that when regulated facilities self-police, it can render "formal EPA investigations and enforcement actions unnecessary." (2) Although the EPA website implies that self-policing can affect future enforcement activity and Stafford (2007) finds that self-disclosures do decrease the probability of future inspections, to date all theoretical models of self-policing are essentially static models.

This paper adds to the existing theoretical literature on self-policing by incorporating self-policing into Harrington's (1988) dynamic targeted enforcement model. The paper then investigates the effect of self-policing on facility behavior and examines the circumstances under which self-policing can increase environmental protection and the circumstances under which it can be detrimental. The remainder of the paper is organized as follows: Section 2 provides a brief description of EPA's self-policing policy; section 3 reviews the theoretical literature on self-policing; section 4 presents a theoretical model of self-policing in a targeted enforcement regime; section 5 discusses the implications of self-policing for environmental performance under this model; and section 6 concludes.

2. EPA's Self-Policing Policy

In December of 1995 EPA issued "Incentives for Self-Policing: Discovery, Disclosure, Correction and Prevention of Violations," which encouraged facilities to voluntarily undertake environmental audits and provided incentives for facilities to voluntarily disclose and correct any violations of environmental regulations discovered by the audit. (3) Because this policy evolved from an EPA effort to encourage environmental auditing, the self-policing policy is more commonly referred to as the Audit Policy. Under the Audit Policy, any facility that voluntarily identifies, discloses, and corrects violations of environmental regulations is eligible for a reduction in the penalties associated with those violations. To be eligible for a complete waiver of punitive penalties, the self-disclosure must meet nine conditions:

i. Systematic discovery: Discovery must either take place during an environmental audit or during a self-evaluation that is part of a due diligence program.

ii. Voluntary discovery: The process through which the violation is discovered cannot be required by federal, state, or local authorities and cannot be required by statutes, regulations, permits, or consent agreements.

iii. Prompt disclosure: Violations must be disclosed within 21 days of discovery.

iv. Independent discovery and disclosure: The disclosure cannot be made after an inspection or investigation has been announced or notice of a suit has been given.

v. Correction and remediation: Any harm from the violation must be remediated and the violation must be corrected within 60 days of the date of discovery unless technological issues are a factor.

vi. No recurrence: The facility must identify why the violation occurred and take steps to ensure that it won't recur.

vii. No repeat violations: The same or a closely related violation cannot have occurred within the past three years at the facility or within the past five years at other facilities owned by the same parent organization.

viii. Not excluded: No serious harm or imminent endangerment to human health and the environment can have occurred as a result of the violation and the violation cannot have been a violation of an order, consent agreement, or plea agreement.

ix. Cooperation: The facility must cooperate with EPA, including providing all requested documents.

The Audit Policy does not apply to the portion of the penalty that is based on the economic benefit gained from noncompliance. For example, if a facility neglects to sample a particular waste stream for several months and discovers this violation through an environmental audit, assuming the violation meets all of the conditions above, the facility would receive a complete reduction in the punitive portion of the penalty but would continue to owe a penalty equal to the savings it received from not having conducted those samples. This requirement is necessary to ensure that regulated entities have no incentive to deliberately violate and then self-police. In the preceding example, there would be no benefit to deliberately not sampling and then self-policing if the regulated entity has to pay the cost of sampling after disclosure.

In 2005, approximately 1500 facilities self-disclosed a violation under the Audit Policy. To put this number in context, during this same time frame, 21,000 facilities were inspected or evaluated by EPA, and approximately 1.1 million facilities were subject to EPA regulation. (4) Facilities disclose violations of all of EPA's environmental statutes including the Clean Air Act, the Clean Water Act, and the Emergency Planning & Community Right-To-Know Act. An analysis of disclosures made in the early years of the Audit Policy (1994-1999) conducted by Pfaff and Sanchirico (2004) found that the majority of disclosed violations were reporting and recordkeeping violations. Since that early analysis, the number of disclosures has risen significantly and the distribution of disclosures across statutes has shifted somewhat. Unfortunately, EPA's database of disclosures does not contain enough information to conduct a similar analysis of more recent disclosures to determine whether the pattern of disclosures found by Pfaff and Sanchirico still holds. However, I can use more recent data to determine the typical penalty reduction. During the 2001-2005 period, data on penalty reduction is available for 70% of the disclosures received by EPA. Of these disclosures, 97% (or over two-thirds of all of the disclosures) resulted in a complete waiver of all penalties. (5)

3. Theoretical Literature on Self-Policing

The term "self-policing" is used in this paper and by EPA to denote a situation in which a facility voluntarily notifies authorities that it has violated a regulation. (6) In keeping with EPA's use of the term, in this paper the act of self-policing does not require the remediation of environmental damages caused by the violation. (7) However, for facilities to fully benefit from EPA's Audit Policy, they must remediate any damages that result from the self-disclosed violation.

A number of theoretical papers have examined the concept of voluntary self-policing in a static setting. Kaplow and Shavell (1994) model a probabilistic enforcement regime in which facilities deliberately choose between compliance and noncompliance. The authors show that introducing self-policing will not affect deterrence as long as self-policers face a reduced fine equal to the certainty equivalent of the sanction they would face if they did not disclose but instead took their chances that the violation would be discovered. Additionally, self-policing will result in a welfare improvement because enforcement effort is reduced because self-policers need not be inspected. Moreover, if individuals are risk averse rather than risk neutral, Kaplow and Shavell show that self-policing can lead to welfare improvements through the reduction of risk.