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Economic instruments in environmental policy

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Abstract

Due to market failures often is necessity for government to regulate environmental pollution by employing command-and-control regulations and/or economic instruments. Despite its cost inefficiency and inflexibility command-and-control policies are still dominant regulation approach to pollution control. Most important factors that are lying behind this inconsistency are lack of understanding of how economic instruments work to protect the environment, and the major influence of rent-seeking and interest group politics on the design of actual environmental policy. Opportunities for much greater environmental and economic benefits are, therefore, lost.
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Economic instruments in environmental policy
Bojan Vračarević
1
1
University of Belgrade – Faculty of Geography, Belgrade, Serbia
Corresponding author: Bojan Vračarević, University of Belgrade – Faculty of Geography, Belgrade, Serbia, e-mail: bojanvracarevic@gmail.com
Abstract Due to market failures often is necessity for government to regulate environmental pollution by employing command-and-control
regulations and/or economic instruments. Despite its cost inefficiency and inflexibility command-and-control policies are still dominant
regulation approach to pollution control. Most important factors that are lying behind this inconsistency are lack of understanding of how
economic instruments work to protect the environment, and the major influence of rent-seeking and interest group politics on the design of
actual environmental policy. Opportunities for much greater environmental and economic benefits are, therefore, lost.
Key words: economic instruments, command-and-control regulations, environmental policy, political economy
1. INTRODUCTION
Existence of market failures, such as external
effects, common goods, public goods and imperfect
information, lead to over-exploitation of the natural
resources and environmental degradation. In most
cases, government intervention is necessary in order
to correct negative effects of these failures. Once
objectives are agreed and targets adopted, policy-
makers can use command-and-control regulation or
economic instruments (
incentive-based instruments).
Command and control instruments operate by
imposing mandatory obligations or restrictions on the
behaviour of firms and individuals. Incentive-based
instruments work by creating incentives for
individuals or firms to voluntarily change their
behaviour [11]. Rather than governments stipulating
the technologies that must be used to curb pollution
or the maximum allowable emissions, (command and
control approach), economic instruments can provide
the financial incentive to act in a more
environmentally responsible manner through the use
of such mechanisms as taxes, subsidies, marketable
permits, changes to property rights, negotiated
agreements, emissions or access charges, and other
financial approaches to modifying behaviour [15].
In all cases, to design good rules, the
government regulators need to know the details about
specific industries and about the alternative
technologies that those industries could adopt. This
information is often difficult for government regulators
to obtain.
Despite the goals of environmentalists, it would
be impossible to prohibit all activity that leads to
environmental degradation. Thus, instead of trying to
eradicate pollution entirely, society has to weigh the
costs and benefits to decide the kinds and quantities of
pollution it will allow [9].
Both approaches also attempt to shift the costs
and responsibilities associated with pollution back
onto the polluter (‘polluter pays principle’). However,
differences between the policy types are extremely
important in terms of how successful they are in
achieving their environmental targets and at what cost
[15].
The literature on using incentive-based
instruments to internalize externalities dates back to
1960s and has increased markedly since the 1970s.
Economic instruments are also used for natural
resource management. Common applications are in
the management of water quantity, fisheries, forestry
and wetlands. Economic instruments are also used to
preserve soil and land quality, and to preserve species
and wildlife [11].
2. ECONOMIC INSTRUMENTS VERSUS COMMAND-
AND-CONTROL
The common rule of regulation is that
intervention is justified if there are serious market
UDK: 502.14:338.246.2
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failures, and if those failures are expected to have a
greater efficiency cost than the cost of the
intervention—government failure [5]. In other words,
there is a plausible justification for some kind of
regulatory or legal action if individuals do not
otherwise take into account the full social costs of
their actions.
Several policy criteria should be considered
when evaluating the success of policy approach. These
include environmental effectiveness; economic
efficiency; reduction in administrative, monitoring and
enforcement costs; environmental awareness and
attitudinal changes and inducement of innovation. [2].
Economists are particularly interested in the
relative effectiveness and efficiency of various polices:
that is, whether a specific policy meets its intended
goals, and whether that policy is likely to do more good
than harm when important impacts, such as those
related to the environment, health, safety, or energy
security, are taken into account [1].
The key to the promise of economic instruments
is their ability to harness the power of the market and
self interest and to turn these former adversaries of
sustainable development into powerful allies [10, 14].
Also, Helm [6] argues that ”economic instruments do
not discriminate between the supply and demand side
of markets…by contrast with planning, this approach
does not ‘pick winners’.”
Economic instruments work by internalizing
environmental costs and externalities through
increasing the prices that individuals and industries
must pay to use resources or to emit pollutants. As
resources or emissions become more expensive,
consumers have strong monetary incentives to reduce
resource use, either through conservation, substituting
materials with a more favourable environmental
profile or rationalizing consumption. Not only does
this encourage reduced emissions, but the use of
economic instruments can also be more conducive to
sustainable development by reducing pressure on
natural resources [15].
First of all,
economic instruments
t
yp
ic
a
l
ly
allow
firms more
flexibility than command-and- control
regulations and capitalize on the heterogeneity
of
abatement
costs across
polluters to reduce
aggregate
pollution
efficiently. They create
an incentive for the
private
sector
to
incorporate
pollution abatement into
production or consumption decisions and to innovate
in such a way as to continually search for the least
costly method of abatement, and, in that way,
encourage research to develop new, less expensive,
and potentially superior technologies [2, 15]. This
flexibility achieves environmental goals at lower cost,
which, in turn, makes the goals easier to achieve and
easier to establish [14].
The benchmark used to evaluate a market-
based approach is typically a command-and- control
regime that often involves technological requirements
that the regulator might impose to achieve a similar
environmental objective. Not surprisingly, economists
find most market-based approaches have the
potential to produce cost savings [1].
Economic instruments are, in general,
administratively and bureaucratically light, in that the
burden falls on setting and revising the economic
instrument, whereas command-and-control requires
administrators for each aspect of the policy, with
inspection, compliance and enforcement procedures,
based upon information requirements.
A number of empirical studies have sought to
compare the costs of obtaining a given reduction in
pollution using an incentive-based versus command
and-control approach. The particular results depend
on the type of pollution being considered and the site
of the pollution. A vast majority of the relevant
empirical studies have found the control costs to be
substantially higher with the regulatory command-
and-control system than the least cost means of
allocating the control responsibility. One summary of
11 studies reviewed [14] shows that command-and
control ranges from 1.07 to 22 times (average of 6.13)
more expensive than the cost-effective approach.
Also, empirical studies in the United States show
that the efficiency gains associated with using
economic instruments rather than command-and-
control regulation have been substantial. The authors
estimate that in 1992, existing incentive-based
programs saved $11 billion over command-and-
control approaches, and that they will save over $16
billion by the year 2000 [3, 15]. Other studies
analysed potential cost savings from
marketable
permit systems [1].They suggest that the range of
potential cost savings is large. Most of
the
studies
predict cost savings above 40 per cent by moving to
marketable permits from
an
existing
command-and-
control
approach, and some predict cost savings
above 90 per
cent.
Also, economic instruments have been argued
to provide a double dividend [6]. Many of them have
the benefit that they generate revenues for the public
sector.
Revenues that can potentially help to enforce,
improve, and expand environmental and resource
protection programmes [15], or can be used to reduce
distortionary taxes such as income taxes, which
reduce the incentive for work, or sale taxes which
distort consumption decisions [10]. For example,
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81
revenues
from
environmentally related
taxes
in
2000
constituted about
7% of total OECD
tax
revenue,
a figure that is
growing
steadily and
which
had
accelerated
at the end of the
1990s
[11].
There are many advantages of economic
incentives as instruments of environmental
management in
developing countries
over
command-and-control regulations. First, they can
achieve the desired effect at the least possible cost—
this is vital to developing countries with limited
resources and a dire need to maintain their
competitiveness in world markets. Second, economic
instruments can serve to provide a decentralized, non-
governmental enforcement mechanism to ensure
environmental responsibilities are upheld, a great help
in countries with severely limited enforcement
budgets [15]. Third, economic incentives present
fewer opportunities for rent-seeking behavior than do
regulations and therefore they are likely to both be
more effective and more equitable. Finally, unlike
regulations that require bloated bureaucracies and
large budgets, economic incentives generate revenues
which should be welcomed by countries facing tight
budgets and budgetary deficits [10].
To summarize, main benefits of economic
instruments include:
Reduction in overall cost of achieving
emission reductions by providing flexibility,
Encouraged use of innovative abatement
technologies, and
Allocation of natural resources to parties
who value them most [15].
Because of this, economic instruments are
ideally situated for reconciling environmental concerns
with development needs and integrating
environmental and economic policy [10].
Finally, there is a wider learning effect: the
economic instrument itself carries information. The
process of introducing the instrument educates the
affected parties. It attracts the affected parties’
attention, and is often accompanied by media
information on ways of substituting to mitigate the
impact [6].
Nevertheless, incentive-based approaches are
far from replacing command-and-control regulation
for dealing with environmental issues. As the costs of
traditional environmental programs continue to
increase-it is estimated they already amount to more
than 2 percent of GDP-the efficiency of incentive-
based approaches may make them more attractive to
policymakers [12].
3.
POLITICS AFFECTS POLICY
With regards to above-mentioned analysis, it is
important not only to establish which instrument
works best in particular contexts, but also why the
optimal instruments are so rarely chosen [5].
Interestingly, country analysts have noted that often
there is no formal process of evaluation at all prior to
recommending a particular policy approach [15].
Several scholars have argued that the actual
design of economic instruments typically departs
dramatically for political reasons from the "efficient"
design of such instruments Frequently, taxes have
been used to raise revenues rather than to reflect
optimal damages [3].
The starting point in trying to understand this
reluctance is the positive theory of government,
regulation and bureaucracy. Rather than simply
assume that public bodies pursue the public interest,
these bodies are better understood as rent-seeking
agents [6].
A government failure can arise if the
government selects a policy which leads to an
inefficient outcome. In certain cases, this outcome
may actually reduce overall economic efficiency
compared with the status quo. Government failures
may arise for a number of reasons. For example,
politicians or regulators may simply not have an
incentive to pursue
e
ff
icient policies. In addition,
regulators may lack adequate information. Both
market failures and government failures can
contribute to the inefficient if they are not rectified
[1].
One study [16] provides a comprehensive
analysis of the empirical evidence on the economic
impact of government policies to correct market
failures in the United States. Main findings are that
the government interventions frequently occur when
no significant market failure exists. In addition, many
policies aimed at addressing market failures could have
corrected them at significantly lower cost.
Still, despite all advantages and potential
benefits of economic instruments command-and-
control environmental regulations are prevalent in the
world [2,7,11,15]. These approaches are often viewed
as more "secure" in terms of addressing a particular
environmental concern because they are proscriptive,
although the causes of this dominance are, as we will
see, more diverse. Rosen and Gayer [12] argue that
“...perhaps legislators like to immediate sense of doing
something that enacting regulations gives them, even
though more passive measures like creating a market
would probably do the job efficiently. A cynic would
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82
argue that the regulatory solution is the result of
politicians’ desire to have it both ways: Pass noble
sounding legislation to please environmentalists, but
make it unworkable to keep business happy.“ As a
matter of fact, this is not far from truth.
A combination of factors seems to explain
the current dominance of command-and-control
approaches throughout the world despite the benefits
of economic instruments. These include: a lack of
understanding of how economic instruments work to
protect the environment and how to choose the
appropriate instrument; political interests that seek to
minimize control costs via regulation; and a preference
for keeping the status quo. Opportunities for much
greater environmental and economic gains are,
therefore, lost [15]. Hepburn [7] states that political
factors are more important than economic
considerations in explaining why particular instruments
are employed for particular problems.
Actually, many environmental policies are not
economically efficient, though some improve on
efficiency relative to the status quo. This is not
terribly surprising, given that politics plays a large role
in policy choice and economic efficiency is not widely
accepted as an overarching objective for particular
policies [1]. Indeed, one of the primary lessons of the
political economy of regulation is that economic
efficiency is not likely to be a key objective in the
design of policy [3]. Economics can illustrate the costs
and benefits of intervention, but not the desirability [5].
In fact, countries are often reluctant to set taxes and
charges high enough to act as economic incentives
because of political reasons, resistance by industry or
concerns about competitiveness [10].
For example, from an efficiency perspective, the
world as a whole is doing too little to reduce net CO2
emissions. Most of the world’s countries are doing
little or nothing to limit CO2 emissions, yet almost all
economic studies find significant marginal damages
from emitting CO2 into the atmosphere. One study
finds a social cost of carbon of $27/tC, and other
meta study of social cost of carbon estimates finds a
social cost of carbon of
$20/tC
[1].
Finally, observation made by Helm [6] reveals
interesting aspect of the matter in question: ”…there is
typically an asymmetry between the response to
greater efficiency through the use of economic
instruments and the exposure should policy fail. The
losses tend to have greater influence than the gains.
This asymmetry is reflected in the way politicians
respond to ‘events’. When a negative case arises in the
media, there is a demand to ‘do something’, with
command-and-control regulation the typical response
to ensure ’it never happens again.’“
4. CONCLUSION
Economic instruments are, without doubt,
uniquely suited for the integration of environmental
and economic policy, and can be designed to advance
sustainable development.
Yet, despite their many advantages, such as
potential to achieve environmental targets at a lower
cost than traditional regulation, and to generate
technological innovation in the areas of pollution
control and prevention, role of economic instruments
has been limited, and politicians and their officials
show a reluctance to move away from traditional
command-and-control approach in environmental
policy.
It is sure that as the focus on efficiency
sharpens, the use of economic instruments will
become more appealing. Also, as citizens’ legitimate
demands for better public outcomes increase, so the
social argument for using economic theory to improve
instrument choice will become more powerful.
Although the role of economics is becoming
more prominent, it does not follow that environmental
policy will become more efficient. This apparent
inconsistency, and even paradox that economic
instruments remain the exception rather than the rule,
can be explained by the political economy of
environmental policy. In short, rent-seeking and
interest group politics have been shown to have a very
important impact on the design of actual policy.
Acknowledgements
:
This work was supported by the Ministry of Science
and Technological Development of the Republic of
Serbia under Grant No 176017.
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In this essay, we describe some important themes in energy and environmental policy. There are two main reasons for our interest in these policies. First, such policies will likely be important in the coming decades as issues related to climate change and energy security come to the fore. Second, there are important lessons to be learned from a careful review of the actual performance of energy and environmental policies. We undertake a selective survey of the literature to highlight what is known about the efficiency of particular kinds of policies, laws and regulations in these areas.
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