Market-based instruments

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Market-based instruments (MBIs) are policy instruments that use price or other economic variables to provide incentives for polluters to reduce harmful emissions. They seek to address the market failure of negative environmental externalities either by incorporating the external cost of production or consumption activities through taxes or charges on processes or products, or by creating property rights and facilitating the establishment of a proxy market for the use of environmental services.

Market-based instruments are also referred to as economic or price-based policy instruments. MBIs include charges, subsidies, marketable (or tradeable) permits and others including deposit/refund systems, eco-labelling, licenses, and property rights (economics). For instance, the European Union Emission Trading Scheme is an example of a market-based instrument to achieve better environmental outcomes (in this case reducing greenhouse gas emissions).

Market-based instruments differ from other policy instruments such as voluntary agreements (actors voluntarily agree to take action) and regulatory instruments (whereby public authorities mandate the environmental performance to be achieved or the technologies to be used), although implementing an MBI also commonly requires some form of regulation.

Market based instruments can be implemented in a systematic manner, across an economy or region, across economic sectors, or by environmental medium (e.g. water). Individual MBIs are instances of environmental pricing reform.

Transferable permits

A market-based transferable permit sets a maximum level of pollution (a 'cap'), but is likely to achieve that level at a lower cost than other means, and, importantly, may reduce below that level due to technological innovation.

When using a transferable-permit system, it is very important to accurately measure the initial problem and also how it changes over time. This is because it can be expensive to make adjustments (either in terms of compensation or through undermining the property rights of the permits). Permits' effectiveness can also be affected by things like market liquidity, the quality of the property right, and existing market power.^[1] Another important aspect of transferable permits is whether they are auctioned or allocated via grandfathering.

An argument against permits is that formalising emission rights is effectively giving people a license to pollute, which is believed to be socially unacceptable. However, although valuing adverse environmental impacts may be controversial, the acceptable cost of preventing these impacts is implicit in all regulatory decisions.^[2]

Taxes

A market-based tax approach determines a maximum cost for control measures. This gives polluters an incentive to reduce pollution at a lower cost than the tax rate. There is no cap; the quantity of pollution reduced depends on the chosen tax rate.

A tax approach is more flexible than permits, as the tax rate can be adjusted until it creates the most effective incentive. Taxes also have lower compliance costs than permits. However, taxes are less effective at achieving reductions in target quantities than permits. Using a tax potentially enables a double dividend, by using the revenue generated by the tax to reduce other distortionary taxes through revenue recycling.^[3] There can also be conflict between objectives with a tax: less pollution means less revenue.

Market-based instruments vs command and control approaches

An alternate approach to environmental regulation is a command and control approach. This is much more prescriptive than market-based instruments. Command and control regulatory instruments would be emission standards, process/equipment specifications, limits on input/output/discharges, requirements to disclose information, and audits. Command and control approaches have been criticised for restricting technology, as there is no incentive for firms to innovate.^[4]

Market-based instruments do not prescribe that firms use specific technologies, or that all firms reduce their emissions by the same amount, which allows firms greater flexibility in their approaches to pollution management. However, command and control approaches may be beneficial as a starting point, when regulators are faced with a significant problem yet have too little information to support a market-based instrument. Command and control approaches can also be preferred when regulators are faced with a thin market, where the limited potential trading pools mean the gains of a market-based instrument would not exceed the costs (a key requirement for a successful market-based approach).^[5]

Market-based instruments may also be inappropriate in dealing with emissions with local impacts, as trading would be restricted to within that region. They may also be inappropriate for emissions with global impacts, as international cooperation may be difficult to attain.

References

1. ^ Guerin, K. (2003). Property Rights and Environmental Policy: A New Zealand Perspective.Wellington, New Zealand: NZ Treasury
2. ^ Guerin, K. (2003). Property Rights and Environmental Policy: A New Zealand Perspective.Wellington, New Zealand: NZ Treasury
3. ^ Guerin, K. (2003). Property Rights and Environmental Policy: A New Zealand Perspective.Wellington, New Zealand: NZ Treasury
4. ^ Guerin, K. (2003). Property Rights and Environmental Policy: A New Zealand Perspective.Wellington, New Zealand: NZ Treasury
5. ^ Guerin, K. (2003). Property Rights and Environmental Policy: A New Zealand Perspective.Wellington, New Zealand: NZ Treasury

External links

• European Environment Agency
• www.economicinstruments.com