Economic Instruments for Pollution Control and Prevention – A

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Economic Instruments for Pollution Control and Prevention – A
Brief Overview
Duncan Austin
World Resources Institute
September, 1999
More than two decades after environmental regulations were first
introduced in the U.S., a new form of regulation promises to transform the
pattern of pollution control.  So-called “economic instruments”, which aim to
control pollution by harnessing the power of market incentives, offer a more
cost-effective, flexible and dynamic form of regulation than conventional
measures.
The key benefit of economic (or fiscal) instruments is that they would
allow a given pollution target to be met for lower overall cost than traditional
regulations - a considerable advantage given the perceived high financial
burden of regulatory compliance.  There are other benefits too.  Economic
instruments grant firms and individuals greater autonomy in deciding how to
meet targets; they create ongoing incentives for firms to design new and
improved abatement technologies ensuring that pollution control becomes
ever cheaper; they reduce the information burden on regulators; and they
provide potential revenue sources for state or federal governments.  In
addition, economic instruments may provide greater flexibility in dealing with
smaller and diffuse emissions sources which collectively contribute large
amounts of pollution, but which until now have been largely ignored in favor
of controlling the pollution from more obvious sources.
The use of economic instruments is becoming more widespread.
Surveys show that about 100 economic instruments were in place in 14 OECD
countries by 1987, rising to 150 by 1993 (OECD, 1997).  In the U.S. they
have been used most prominently to control SO2 emissions under the Clean
Air Act.  As yet many applications of economic instruments are relatively
small-scale in nature, and have often been introduced for the sole purpose of
raising revenue.  However, there is a growing familiarity and comfort with
using such instruments which suggests more extensive and more large-scale
use of such instruments is in the offing.Economic Instruments for Pollution Control and Prevention – A Brief Overview
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I. “Command and Control” Instruments: the traditional
approach to environmental protection
In shaping the early environmental policies of the 1970s, policymakers instituted standard-based systems in keeping with prevailing legal
traditions of dealing with activities deemed excessive by society (Spence and
Weitzman, 1994).  This “command and control” pattern of regulation set
uniform targets for how much firms should emit, often by dictating the
processes that should be used in their facilities.
Two broad types of command and control regulations are discernible:
technology-based and performance-based (Stavins and Whitehead, 1992).
The former specify the methods and equipment that firms must use to meet
the target.
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 Performance standards, on the other hand set an overall target for
each firm, or plant, and give firms some discretion in how to meet the
standard.  Crucially, though, performance standards still hold firms to a
uniform level across the industry, ignoring the possibility that some
companies may be able to make reductions more readily than others.
In addition, early command and control regulations were often based
on “end of pipe” solutions with little thought given to how pollution could be
reduced through more systemic changes to the core production process or
even in product design.  Of course, changes at that level require the active
input of manufacturers familiar with the industry.  However, command and
control regulations give the manufacturer little incentive to pursue such
changes.  There is no reward for beating a target, only the risk that the
regulator will promptly raise the standard to reflect the new technology.
While command and control (or direct) regulations were successful in
securing the first tranche of emissions reductions from previously unregulated
industries, more than two decades after their introduction they are now viewed
as increasingly burdensome.  Industry bemoans the financial costs such
regulations impose and the intrusiveness of a process which often dictates
their technology choice. Regulators bear the burden of keeping abreast of
technological developments in many different industries.  Moreover, the
process of ratcheting standards up over time often brings the two groups into
antagonistic debate and involves lengthy and detailed discussion about the
costs and suitability of alternative technologies upon which to base the next
standard.
                                                     
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 Even where the standard is not couched in terms of exact technologies, they are often
clearly premised on specific technologies which all firms end up using.Economic Instruments for Pollution Control and Prevention – A Brief Overview
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One final weakness of existing regulations is that they have focused on
large point sources, both because these were obvious first targets, but also to
minimise the information, monitoring and measurement burdens on
regulators.  Hence, large industrial plants have been forced to reduce effluents
to waters and lakes, while the diffuse pollution from agricultural activities in
the very same watersheds is largely unrestrained.  In many cases, relatively
cheap reduction efforts by farmers may yield the same environmental benefit
as is presently achieved only at high cost through control of large point
sources.
II.  Economic Instruments: a better approach?
Economists have long advocated the use of economic instruments as
an alternative, or supplement, to direct regulation.  Most importantly,
economists argue that economic instruments can create a system for pollution
reduction that achieves the same level of environmental protection for a lower
overall cost (or achieves more for the same cost). Given the importance of the
overall costs of environmental protection in political debate, this is a crucial
advantage. Economic instruments also allow for a more hands-off regulation
and decentralized decision-making, giving greater freedom to firms and plants
about how to comply.
Correcting a “Market Failure”
To understand the underlying logic of economic instruments, one must
understand why pollution arises in the first place.  Economists perceive
pollution as a ‘market failure’ which arises because ‘polluters’ – from the
heavy plants of popular imagination to people who turn on their lights at home
– are not faced with the full consequences or implications of their production,
consumption or disposal choices.  In the classic textbook example, a
manufacturer releases effluents into the nearby river, with adverse effects on
fish populations. Downstream, commercial fishermen find their livelihoods
under threat, recreational anglers start to find their weekend pastime less
enjoyable, while others may simply be distressed by the loss of wildlife and
the damage to ecosystems (e.g. Pearce and Turner, 1990).  Because the use of
the river as an effluent depository is perceived as free, the manufacturer has
no incentive to curb effluents, in contrast to the permanent incentive he has to
reduce labor, material, machinery and energy inputs, all of which have costs
attached to them.  In economic terms, the downstream impacts are
‘externalities’ that lie outside of the manufacturer’s decision-making
framework.Economic Instruments for Pollution Control and Prevention – A Brief Overview
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The underlying premise for economic instruments is to correct this
market failure by placing a cost on the release of pollutants.
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  This will
internalize the ‘externalities’ into the decision making process.  Placing a
charge, or a fee, on every unit of effluent released into the river, transforms
the manufacturer’s decisions regarding how much he will produce, and how
he will produce it.  Now, the manufacturer must minimize total production
costs that consist not only of labor, material, machinery and energy inputs, but
also of the effluent output.  In some cases, the manufacturer may simply
decide to invest in an “end-of-pipe” solution that pays for itself in terms of
avoided effluent charges.  In other cases, he may decide to alter the core
production process, perhaps installing new technologies, or working with new
materials which result in less waste. By adjusting the charge level, or the cost
attached to effluent outputs, the regulator can induce a different degree of
response from manufacturers, and hence control the overall level of pollution.
By changing the charge level over time, the regulator has a relatively simple
way of ratcheting up standards.
Several different types of economic instrument exist, all of which
embody the same logic. (See Box).  The most common alternative to a charge,
and the preferred mechanism in the U.S., is the use of ‘tradable permits’.
Instead of an effluent charge, a manufacturer would be required to hold a
permit to release a given quantity of pollution.  Because these permits are
tradable, the manufacturer can pay to get hold of more permits if he needs
them, or  he can sell his existing permits if he can work out a way to reduce
his current pollution levels.  By controlling the aggregate number of permits
the regulator effectively controls the total release of pollution. Subsidies, both
implicit and explicit, can also be used though are much less common.
In addition, economic instruments can be applied to certain products
which cause pollution in their production, use or disposal.  Such products
include fuel, fertilisers, pesticides, batteries, and even, in Belgium, disposable
cameras and razors (OECD, 1997).  In some cases, the charge is part of a
deposit-refund scheme which allows the user to redeem the initial payment if
the product is returned to an appropriate waste channel.
                                                     
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 Hence, a technical definition for an economic instruments is a ‘tool that affect estimates of
the costs and benefits of alternative actions open to economic agents’ (OECD, 1997).Economic Instruments for Pollution Control and Prevention – A Brief Overview
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A short taxonomy of Economic instruments
1.  Charges, fees or taxes
These are prices paid for discharges of pollutants to the environment,
based on the quantity and/or quality of the pollutant(s).  To be most effective
the charge is levied directly on the quantity of pollution (‘emissions tax or
charge’), though if this is difficult to measure or monitor, it may be necessary
to levy a charge on a proxy for the emissions, typically on the resource that
causes the pollution (‘product tax or charge’). Product charges occur at
different usage points.  They have been levied on products either as they are
manufactured (e.g. fertilizers), consumed (e.g. pesticides) or disposed of (e.g.
batteries) (Barde, 1997).
How effective product charges are depends on how well ‘linked’ the
input, or product, is to the eventual stream of pollution.  In the case of taxing
carbon fuels as a proxy for carbon dioxide emissions, the ‘linkage’ is very
strong as virtually all the carbon contained in fuels is released during
combustion.  Taxing the fuel is thus little different to taxing the emissions.
On the other hand, taxing pesticides as a proxy for release of certain chemicals
into water systems is less well linked as the degree of chemical infiltration
will depend on a mixture of variables relating to soil and slope conditions, the
timing of applications etc.
2. Tradable Permits
These are similar to charges and taxes except that they operate by fixing
an aggregate quantity of emissions rather than charging a price for each unit
of emissions.  Instead of being charged for releases, one needs to hold a
‘permit’ to emit or discharge.  By controlling the total number of permits, one
is effectively controlling the aggregate pollution quantity.
3. Charge-Permit Hybrids
It is possible to blend the quantity-based permit approach with a pricebased charge or tax approach to try to harness their different strengths while
avoiding their weaknesses.  A good example is RFF’s proposal to use a hybrid
mechanism to control CO2 emissions in the U.S. (RFF, 1998). This would
consist primarily of a permit program that would require domestic energy
producers (and importers) to obtain permits equivalent to the volume of
carbon dioxide eventually released by the fuels they sell.  However, by setting
the overall permit quantity, one has no idea what price permits will sell for –
this will only be revealed as businesses and consumers begin to reduce their
CO2 emissions. In order to guard against excessively high permit prices that
might arise – the very prospect of which may prevent the program being
implemented in the first place – the second aspect of the proposal would be
for the government to release an unlimited number of permits at $25 per ton ofEconomic Instruments for Pollution Control and Prevention – A Brief Overview
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carbon should the market price of permits reach that level.  This effectively
sets up a charge system of $25 per ton, capping the possible market price.
A system like this attempts to control on the basis of quantity, which is the
most desirable goal, while creating an ‘escape valve’ should costs rise too
high.  Even if the escape valve is utilised, the program amounts to the
institution of a charge on carbon.
4. Deposit-refund schemes
Under these schemes, a surcharge is levied on a product at the point of
payment.  When pollution is avoided by returning the product, or its polluting
components, to a specified collection stream the surcharge is refunded.  These
economic instruments have been used most often for drinks containers,
batteries and packaging (OECD, 1997).
5. Subsidies
Where taxes or charges can be used as a penalty on discharges, subsidies
can be used to reward the reduction of discharges in a similar manner. The
financial incentive is effectively the same, though the flow of funds is in a
different direction.  A subsidy program will involve a transfer of funds from
the government to the industry, while a charge program would be a revenue
source for the government.
Subsidies may be relatively explicit in the form of grants and soft loans, or
be somewhat indirect, such as in adjusted depreciation schedules.  (Barde,
1997).
Three Key Advantages
Economists have championed economic instruments mainly on the
grounds of three key advantages that they hold over traditional forms of
regulation:
1.  Static efficiency (or “cheaper now”).   One of the crucial properties
of economic instruments is that firms not only take different actions, but may
also end up with different levels of emissions.  Firms that find it relatively
cheap to undertake reductions do more than firms that find it more expensive,
ensuring that the overall cost of reduction is less expensive than if all firms
were required to meet a uniform standard.
In practice, manufacturing plants are far from uniform.  Even if they
are making the same product, they will tend to operate different technologies,
use slightly different processes, and will vary with respect to size, scale, age
and hence, overall efficiency.  All of these factors will ensure that the costs of
meeting the standard are very different for different companies.  For one firm
the costs to make an extra unit of reduction may be quite high.  In contrast,
another firm may be able to make an extra unit of reduction (and more) for aEconomic Instruments for Pollution Control and Prevention – A Brief Overview
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relatively low cost.  Rather than require the same standard from both of them,
the overall cost of making reductions will be lowest if the latter firm takes
advantage of the cheaper reductions it faces. The impact on the environment
will be no different, but the aggregate cost of the regulation will be reduced.
This outcome can be readily achieved with an economic instrument.
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On the face of it, this might not seem fair – companies make
reductions on the basis of their ability to do so, not on the basis of how much
better or worse they are relative to competitors.  This is in contrast to a rulebased approach where certain forms of behavior are expected from everyone.
Importantly, though, both are suitably rewarded or penalized for their efforts.
The first firm  may continue to emit more pollution but pays a price for doing
so. The second firm undertakes further control and reaps a lower tax bill, and
competitive advantage, for doing so.
An economic instrument can achieve a given level of environmental
protection for lowest overall cost by creating a framework that allows for
differential response by companies depending on their ability to make
reductions.  In contrast, target- or performance-based command and control
regulation is less efficient because it ignores the fact that some plants can
make reductions more cheaply than others.  To control the overall level of
pollution, the regulator simply adjusts the level of the charge (or the quantity
of permits).
2.  Dynamic Efficiency (or “cheaper in the future”).  Under a
command and control approach, industries invest to meet the standard and
then stop.  In contrast, placing a price on effluents creates a permanent
incentive for environmental improvement.  Because every emission, or
effluent, effectively has a price attached to it, any profit-maximizing entity has
an ongoing incentive to make further reductions over time.  Engineers and
designers have a permanent incentive to generate new processes or equipment,
to develop new product designs, to create new abatement methods and to
reconfigure existing production lines to reduce the outflow of the targeted
pollutants.  An economic instrument creates a permanent incentive for
environmental improvement and should accelerate the development of new
and cheaper pollution reducing technologies
                                                     
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 Technically, this outcome could also be achieved through direct regulations were the
regulator able to  work out the differential reductions required from each firm that would lead
to the target being met at lowest possible aggregate cost.  However, that would require that
the regulator have full information about the costs of making reductions at each and every
plant.  In contrast, the economic instrument arrives automatically at the same differential
reduction levels simply by setting a given charge level (or permit quantity).Economic Instruments for Pollution Control and Prevention – A Brief Overview
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3.  Revenue Raising.   Finally, the use of many economic instruments
allows the state or federal regulatory agency to raise money.  A charge, for
example, raises funds that can either be used to finance environmental cleanups, or to replace existing taxes.  The same is true if permits are initially
allocated through an auction.
Alternatively, the regulator may forego the opportunity to raise
revenue and instead grant a valuable property right directly to the groups
being regulated – a potential fillip that eases the regulatory process.
Distributional Consequences of Economic Instruments
This third advantage touches on the distribution issue of new
instruments.  The introduction of an economic instrument transforms the
government’s presumed right to set standards into an instrument that induces
monetary flows from one party to another.  Different forms of economic
instruments imply very different property rights for different parties.  This can
be seen clearly by comparing an emissions charge with an equivalent subsidy
program.
Consider the case where a manufacturer confronts a charge of $10 per
unit of emissions.  Any reduction made saves the manufacturer $10 per unit
which would otherwise have been paid to the regulator.  Under an equivalent
subsidy, the regulator pays the polluter $10 to reduce each unit of emissions.
Either way, the manufacturer’s incentive to reduce the emission is the same as
it leaves him $10 better off (and the regulator $10 worse off).  However, the
baseline and the established property rights are very different as are the
overall financial implications of the program from the company and
regulatory perspectives.  The use of a charge implies that the manufacturer has
no ‘right’ to pollute, and instead that the right has to be ‘bought’.  In contrast,
the subsidy institutes a ‘right’ to pollute at current levels and leaves the
government or regulator to ‘buy’ any reductions below that level.
Exactly the same issue is raised in deciding the initial allocation of
tradable permits.  These may be auctioned to companies (equivalent to the tax
case) or “grand-fathered” to companies on the basis of their existing emissions
(equivalent to the subsidy case).
It is important to bear in mind that for every property rights winner,
there is a loser who might otherwise have been the beneficiary.  Hence, while
grandfathering permits may be useful in dampening industry opposition to
new regulations, grandfathering foregoes any revenue that the government
might have raised by auctioning the permits.  This revenue would allow either
additional spending programs, or more likely, a reduction of existing taxesEconomic Instruments for Pollution Control and Prevention – A Brief Overview
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creating benefits for different groups of the public depending on the exact use
of the funds.
A Carbon Tax or a Tax Shift
One potential application of economic instruments deserves particular
mention.  Many groups have proposed a ‘carbon tax’ to reduce the carbon
dioxide emissions that come from fossil fuels and which threaten to change
the climate.  A carbon tax would essentially be a product charge placed on
fossil fuels in proportion to their carbon content.  Coal which has a higher
carbon content than oil and natural gas would thus be taxed relatively more.
The rising prices of these fossil fuels would induce people to use oil and gas
in favor of coal; to use more renewables instead of fossil fuels; and to be more
efficient in their use of energy generally.  Applying such a tax would ensure
that the economy as a whole achieved a given level of carbon dioxide
reduction for the lowest overall cost.
Because of the scale of fossil fuel use in the economy, any carbon tax
could raise significant amounts of revenue, which could be used to a make a
significant reduction in an existing federal tax. (Taxes on labor and/or capital
are most often cited as possible candidates for a reduction).  In the same way
that placing a tax on carbon reduces its presence, reducing a tax on, say, labor,
would tend to increase employment.  Hence, a ‘tax shift’ would increase taxes
on ‘bads’ (i.e. carbon) while we wish to discourage, while reducing the tax on
‘goods ’ (e.g. employment or investment), which we desire more of.
Small carbon taxes are already in place in some European countries.
However, efforts to promote the idea at EU level and in some U.S. states,
most notably Minnesota, have so far been unsuccessful.
III. Conclusions
The use of economic instruments would allow additional
environmental improvements to be met at least cost, or would allow present
standards to be met more cost-effectively.  As a regulatory mechanism they
are more in keeping with the prevailing market structure that automatically
promotes efficient solutions and that encourages and rewards innovation.
Though economic instruments have been in the textbooks for as long as
conventional regulations have been in the statute books, their use to date has
been confined to relatively few applications.   As their advantages become
more widely understood, and as the desire grows to balance benefits and costs
of environmental protection, it is likely that their use will increase in coming
decades.  In practice, with a well established regulatory system based on
traditional measures already in place, the key issue will be to work out howEconomic Instruments for Pollution Control and Prevention – A Brief Overview
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economic instruments can complement, and integrate with, conventional
measures.Economic Instruments for Pollution Control and Prevention – A Brief Overview
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References
Barde, Jean-Phillipe, (1997), “Environmental Taxation: Experience in OECD
countries” in EcoTaxation, edited by T. O’Riordan, Earthscan,
London.
OECD (1997), Evaluating Economic Instruments for Environmental Policy,
OECD, Paris, France.
Pearce, David and K. Turner, (1990) Economics of Natural Resources and the
Environment, Harvester Wheatsheaf, Hertfordshire, U.K.
Resources for the Future (1998) “A Proposal for Credible Early Action in U.S.
Climate Policy”, by Raymond Kopp, Richard Morgenstern, William
Pizer, and Michael Toman.
Spence, A. Michael and M. L. Weitzman, (1994) “Regulatory Strategies for
Pollution Control” in Economics of the Environment: Selected
Readings, edited by Robert Dorfman and Nancy Dorfman, W.W.
Norton, New York
Stavins, Robert and Brad Whitehead (1992), “The Greening of America’ s
Taxes”, Progressive Policy Institute, Policy Report, February.