Economic Incentives

Economic Topics

Policy-makers have two broad types of instruments available for changing consumption and production habits in society. They can use traditional regulatory approaches (sometimes referred to as command-and-control approaches) that set specific standards across polluters, or they can use economic incentive or market-based policies that rely on market forces to correct for producer and consumer behavior. Incentives are extensively discussed in several EPA reports:

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Two basic types of traditional regulatory approaches exist. The first, a technology or design standard, mandates specific control technologies or production processes that polluters must use to meet an emissions standard.  The second, a performance-based standard, also requires that polluters meet an emissions standard, but allows the polluters to choose any available method to meet that standard.  Performance-based standards that are technology-based, for example, do not specify a particular technology, but rather consider what available and affordable technologies can achieve when establishing a limit on emissions. At times, EPA may completely ban or phase out the use or production of a particular product or pollutant, as it has done with chlorofluorocarbons (CFCs) and certain pesticides.  Regulations can be uniform or can vary according to size of the polluting entity, production processes, or similar factors. Regulations are often tailored in this manner so that similar regulated entities are treated equally.

While traditional regulatory and voluntary approaches are valuable policy tools for some types of environmental problems, incentive based policies are becoming increasingly popular as tools for addressing a wide range of environmental issues, from acid rain to climate change. Market-based approaches or incentives provide continuous inducements, monetary and near-monetary, to encourage polluting entities to reduce releases of harmful pollutants. As a result, market-based approaches 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. A criticism of command-and-control policies is that firms are only encouraged to reduce to a regulated level. With market incentives, firms will reduce their emissions as long as it is financially valuable for them to do so, and this generally happens at a point where marginal abatement costs are equated across all regulated firms. Cost savings to firms also often translate into cost savings to customers who purchase products from regulated firms, resulting in lower overall social costs. The main disadvantage associated with economic incentives is that they can be inappropriate for dealing with environmental issues that pose equity concerns. Emissions trading programs, for example, could have the unintended consequence of concentrating pollution in economically-disadvantaged areas (pollution hot-spots). Example market-based approaches include:

In addition to the instruments listed above, hybrid approaches – those that combine aspects of command-and-control and market-based incentive policies – are often discussed in the literature and increasingly used in practice. These approaches are appealing to policymakers because they often combine the certainty associated with a given emissions standard with the flexibility of allowing firms to pursue the least costly abatement method.  However, hybrid approaches are not always the most economically efficient approach because either the level of abatement or the cost of the policy is greater than what would be achieved through the use of a market-based incentive approach.  Examples of hybrid approaches include:

EPA has also pursued a number of non-regulatory approaches that rely on voluntary initiatives to achieve improvements in emissions controls and management of environmental hazards.  These programs are usually not intended as substitutes for formal regulation but instead act as important complements to existing regulation.  Many of EPA’s voluntary programs encourage polluting entities to go beyond what is mandated by existing regulation.  Others have been developed to improve environmental quality in areas that policymakers expect may be regulated in the future but are currently not regulated, such as greenhouse gas emissions and non-point source water pollution.

Types of economic incentive and hybrid-based approaches

Marketable Permit Systems or Trading Programs

There are two types of trading programs currently used in the United States: Emission Reduction Credits (ERCs) and Capped allowance systems (i.e. cap-and-trade).

  1. Emission Reduction Credits (ERCs): ERCs are uncapped trading systems, meaning there is no set limit on the maximum allowable level of pollution within a regulated area. Instead, pollution limits are rate-based, meaning polluters cannot exceed a rate of emissions (e.g. grams per mile for motor vehicles). Polluters earn credits by reducing emissions below their specified rate. The largest criticism of ERCs is that there is not a cap on total emissions, so if, for example, more companies enter the market, emissions can actually increase with economic growth.
  2. Capped Allowance Systems: A capped allowance system or cap-and-trade system sets a maximum allowable cap on total emissions. The cap is equal to the total number of allowances or permits allocated to a group of polluters.  These allowances are distributed among the individual polluters and the number of allowances held by each firm sets the limit on the amount of pollution they have the right to emit. Allowances can be doled out through grandfathering, where polluters receive free allowances based on their historic emissions levels (i.e., larger firms will receive more credits than smaller firms), or through an allowance auction, where firms compete to purchase allowances. Once allocated, firms must either reduce their emissions directly, or they can purchase allowances from other firms who have reduced below their required level.

Trading programs are cost-effective approaches to environmental protection because firms are granted the flexibility to either reduce their own emissions or purchase pollution “allowances” from other firms who have reduced below their required level. An example is the U.S. Acid Rain Program, a cap-and-trade system that cost-effectively reduced sulfur dioxide emissions from electric utilities. Other examples include voluntary carbon trading schemes, such as the Chicago Climate Exchange; and nutrients trading programs (between water polluting firms and agricultural producers) that aim to reduce excessive loading of fertilizer and pesticides into water bodies.

Emissions Taxes, Fees, and Charges

Fees, charges, and taxes are widely used incentives which generally place a per unit monetary charge (or fee or tax) on pollution emissions or waste to reduce the overall quantity. The main drawback is that fees, charges and taxes cannot guarantee a specific amount of pollution reduction, only that those who pollute will be penalized. Examples include pollution taxes, water user fees, wastewater discharge fees, and solid waste disposal fees.

Subsidies for Pollution Control

Subsidies are forms of financial government support for activities believed to be environmentally friendly. Rather than charging a polluter for emissions, a subsidy rewards a polluter for reducing emissions. Examples of subsidies include grants, low-interest loans, favorable tax treatment, and procurement mandates. Subsidies have been used for a wide variety of purposes, including: brownfield development after a hazardous substance contamination; agricultural grants for erosion control; low-interest loans for small farmers; grants for land conservation; and loans and grants for recycling industrial, commercial and residential products. While subsidies offer incentives to reduce emissions similar to a tax, they also encourage market entry to qualify for the subsidy.

Tax-Subsidy Combinations (e.g. Deposit-Refund Systems)

Deposit-refund systems are a prominent example of a Tax-Subsidy incentive approach. Take, for example, a beverage container recycling program. First, a product charge or tax is initiated that increases the upfront cost of purchasing the container. Second, a subsidy is rewarded to the consumer for recycling or properly disposing of the container. Deposit-refund systems are also available for lead-acid batteries, automobile parts, pesticide containers, propane gas containers, large paper drums, and beer keys.

Hybrid Approaches

Combining Standards and Pricing Approaches

Pollution standards set specific emissions limits, and thereby reduce the chance of excessively high damages to health or the environment but may impose large costs on polluters. Emissions taxes restrict costs by allowing polluting sources to pay a tax on the amount they emit, but because there are no emission limits, taxes leave open the possibility that pollution may be excessively high. A combination of standards and pricing mechanisms, referred to as a "safety-valve", may be used to limit both costs and pollution in these cases. This combination imposes the same emissions standard on all polluters and all polluters are then subject to a unit tax for emissions in excess of the standard. This policy combination has some attractive features. First, if the standard is set properly, proper protection of health and the environment will be assured since the standard provides protection against excessively damaging pollution levels. Second, high abatement cost polluters can defray costs by paying the emissions fee instead of cleaning up.

Liability Rules

Liability assignment is most often targeted at producers of waste or emissions that are easily identifiable and hazardous to public health. The purpose of liability is to not only hold polluters accountable for the proper management and disposal of their waste or emissions, but also for cleanup and remediation costs. There are two major U.S. laws that are liability-based: the Comprehensive Environment Response, Compensation, and Liability Act (CERCLA) and the Oil Pollution Act of 1990. These two laws not only give polluters an incentive to make more careful and socially conscious decisions, but also hold them financially responsible to the victims of pollution.

Information Disclosure

Information disclosure programs are designed to influence firm behavior through the dissemination of information on items such as production processes, labor standards, and pollution levels, to the federal, state and local government agencies, or to the public. By making business owners, employees, shareholders and customers a part of the regulatory process, all parties have an incentive to practice behavior that is socially responsible.

Both voluntary and mandatory reporting programs exist in the United States. An example of a mandatory information disclosure program is the 1969 National Environmental Policy Act (NEPA). NEPA requires federal agencies to prepare Environmental Impact Statements (EIS) for any activities that could significantly effect the environment. An EIS is a report specifying potential environmental damages and alternative approaches to the agency action to minimize adverse impacts.

Labeling schemes are widely used voluntary reporting programs. Generally, a non-profit organization or government agency sets standards for a product to meet environmentally sustainable goals. Companies who meet these goals are allowed to place the label’s seal on their product, which will potentially make the product more appealing to consumers.

Voluntary actions

Voluntary programs are useful for policy-makers who wish to test potential policy options or who want to encourage better production or consumption practices. Goals of voluntary actions include providing participating firms with a competitive edge (firms that participate in a voluntary program might have larger social appeal than those that do not), increase-value added to businesses, and reduce pollution. Most voluntary programs are designed and implemented by the U.S. Environmental Protection Agency.

There are several benefits available to companies who wish to join a voluntary program. First, participation can improve their public image. Second, the program might offer technical or other types of assistance in exchange for participation. Third, because voluntary programs are sometimes initiated as a pilot test to a regulation, participation can help the company to more quickly transition to a formal law, and possible limit potential litigation and monitoring and enforcement costs.

A general problem with voluntary action programs is that it is quantitatively difficult to assess the success of the program. Program evaluators have developed several statistical methods, however, to research success rates.

Key Considerations

The selection of the most appropriate market-based incentive or hybrid regulatory approach depends on a wide variety of factors, including:

  1. The type of market failure being addressed;
  2. The specific nature of the environmental problem;
  3. The degree of uncertainty surrounding costs and benefits;
  4. Concerns regarding market competitiveness;
  5. Monitoring and enforcement issues;
  6. Potential for economy-wide distortions; and
  7. The ultimate goals of policy makers. 

The Type of Market Failure

Market-based or hybrid instruments aim to address two main types of market failure. The first is the failure of firms or consumers to integrate into their decision-making the impact of their production or consumption decisions on entities external to themselves.  Market-based or hybrid instruments that incorporate the costs of environmental externalities from pollution (i.e., or unintended consequences such as damages to human and environmental health) into their analysis address this market failure. The second type of market failure is the inability of firms or consumers to make optimal decisions due to lack of information on investment options, available abatement technologies, or associated risks. Information disclosure or labeling are often suggested when this occurs because policy makers believe that private and public sector decision-makers will act to address an environmental problem once information has been disseminated.

The Nature of the Environmental Problem

The use of a particular market-oriented approach is often directly associated with the nature of the environmental problem.  Do emissions derive from a point source or a non-point source?  Do emissions stem from a stock or flow pollutant? Are emissions uniformly mixed or do they vary by location? Does pollution originate from stationary or mobile sources? Point sources, which emit at identifiable and specific locations, are much easier to identify and control than diffuse and often numerous non-point sources, and therefore are often amenable to the use of a wide variety of market instruments. Although non-point sources are not regulated under EPA, the pollution emitted from a non-point source is. This makes the monitoring and control of non-point source emissions a challenge. In instances where both point and non-point sources contribute to a pollution problem, a good case can be made for a tax-subsidy combination or a tradable permits system. Under such a system, emissions from point sources might be taxed while non-point source controls are subsidized.

Flow pollutants tend to dissipate quickly, while stock pollutants persist in the environment and tend to accumulate over time.  While it is possible to rely on a wide variety of market and hybrid instruments for the control of flow pollutants, stock pollutants may require strict limits to prevent bioaccumulation or detrimental health effects at small doses, making direct regulation potentially more appealing.  If the limit is not close to zero, then a standard-and-pricing approach or a marketable permit approach that defines particular trading ratios to ensure that emission standards are not violated at any given source are potentially practical options.  These same instruments are appealing when pollutants are not uniformly mixed across space.   In this case, it is important to account for differences in baseline pollution levels, and in emissions across more and less polluted areas.

Stationary sources of pollution are easier to identify and control through a variety of market instruments than are mobile sources.  Highly mobile sources are usually numerous, each emitting a small amount of pollution. Emissions therefore vary by location and damages may vary by time of day or season.  For example, health impacts associated with vehicle traffic are primarily a problem at rush hour when roads are congested and cars spend time idling or in stop-and-go traffic.  Differential pricing of resources used by these mobile sources (such as higher tolls on roads or greater subsidies to public transportation during rush hour) is a potentially useful tool.

The Degree of Uncertainty

The choice between price-based instruments (e.g. taxes or charges) and quantity-based instruments (e.g. marketable permits) also has been shown theoretically to rest on the degree of uncertainty surrounding the estimated benefits and costs of pollution control as well as on how marginal benefits and costs change with the stringency of the pollution control target.  If uncertainty associated with the costs of abatement exists and policymakers wish to guard against potential high costs borne by polluters as a result of regulation, then they can limit these costs by using a price instrument.  If, on the other hand, more uncertainty associated with the benefits of controlling pollution exist and policymakers wish to guard against high environmental damages, they can limit these damages by using a quantity instrument. The policymaker also should be aware of any discontinuities or threshold values above which sudden large changes in damages or costs could occur due to a small increase in the level of abatement required.

Market Competitiveness

Market power is a type of market failure in and of itself, resulting in output that is too low and prices that are too high compared to what would occur in a competitive market. Instruments that cause firms to further restrict output may create additional inefficiencies in sectors in which firms have some amount of market power.  A combination of market-based instruments may work more effectively than a single instrument in this instance.  In addition, to the extent that cost burdens are differentiated, the use of certain market-based instruments may cause a change in market structure to favor existing firms, creating barriers of entry and allowing these firms a certain degree of control over price.  Permit systems that set aside a certain number of permits for new firms, for instance, may guard against such barriers.

Monitoring and Enforcement Issues

Market-oriented instruments differ in the degree of difficulty required to monitor and enforce them.  For example, subsidies, deposit-refund systems, and information disclosure shift the burden of proof to demonstrate compliance from government to regulated entities.  Because firms generally are in a better position than government to monitor and report their own emissions, they may do so at a potentially lower cost. This feature makes these approaches attractive when monitoring is difficult or emissions must be estimated (e.g. when there are non-point sources or large numbers of small polluters). In these cases, attempts to prohibit or tax the actions of polluters are likely to fail due to the risk of widespread noncompliance (e.g. illegal dumping to avoid the tax) and costly enforcement.

Potential Economy-Wide Distortions

Analysts should also consider the potential distortionary effects of market-based instruments.  Instruments that include a revenue-raising component, such as auctioned permits or taxes, may allow for opportunities to direct collected resources to the reduction of market inefficiencies.

The Goals of the Policymaker

Finally, the goals of policymakers may influence the instrument selected to regulate pollution.  Each instrument considered may have different distributional and equity implications for both costs and benefits that should be accounted for when deciding among instruments.  For example, policymakers may wish to ensure clean-up of future pollution by firms.  In this case, insurance and financial assurance mechanisms may be useful instruments to supplement existing standards and rules when there is a significant risk that sources of future pollution might be incapable of financing the required pollution control or damage mitigation method.  In addition, the level at which policymakers allow the market to determine exact outcomes may influence the instrument chosen.  Marketable permits, for example, set the total level of pollution control, but the market determines which polluters reduce emissions. On the other hand, taxes let the market determine the extent of control by individual polluters and the total level of control. 

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Last updated on August 5, 2024