Question

6.) Externalities, the Environment, and Natural Resources

Explain why some politicians believe paying firms for pollution reduction is an effective incentive to obtaining cleaner air and water. Then, explain whether or not the incentive is effective in the short-run and in the long-run.

Answer 1

Economic incentives have only recently begun to play a larger role. As regulators seek to meet increasingly costly environmental quality goals, they have begun to look at incentives as a more flexible, lower cost alternative. It is expected that the regulatory system can be made more effective by promoting environmentally efficient choices with less government interference. Incentive-based policies aim to encourage polluters to find innovative, low-cost ways to reduce their environmental emissions by offering them rewards or by doling out punishments in the form of taxes or fees, marketable permits, or liability.

Taxes or fees charge the polluter a certain amount per unit of pollution, the value of which is determined by the regulator. Marketable permits allow companies to pollute at a level that is marginally cost-effective. It allows them to buy additional permits as needed if they fail to meet their targets internally, and to sell excess permits if they exceed their internal pollution reduction targets. Liability involves establishing a precautionary level that allows for the greatest benefit to society, and holding firms to that standard if a problem arises. While more flexible than true established standards, it puts the burden on the firm to take certain levels of precaution with respect to environmental issues or to be held accountable for any negative results.

Incentives have several advantages, including allowing the source to play a role in determining the most cost-effective way to reduce their emissions and, thereby, in meeting their marginal costs. All three types of incentives attempt to maintain the equimarginal principle, which is when the marginal control costs will be equal across all sources. This creates an efficient or least cost overall solution. Also, when compared to command and control mechanisms, the regulator requires less information under an incentive program since there is greater motivation for ‘polluters’ to devise their own innovative solutions. Therefore, the regulator does not need to know how cost-effective various control options will be, or what the cost is at any particular installation, because the source will be held accountable for all of their actions and will pay both pollution control costs and damage costs.

A tax may be ineffective if there are no practical alternatives. However, if the government subsidies alternatives, then firms and consumers will be more willing to switch. For example, solar power is an alternative to burning coal. A government subsidy can make solar power competitive and encourage its development. The subsidy is justified because the development of solar power has a significant positive externality.

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.

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.

Economic-incentive instruments have captured the attention of environmental policy makers in recent years because of the potential advantages they offer over traditional command-and-control approaches. In theory, properly designed and implemented economic-incentive instruments allow any desired level of pollution cleanup to be realized at the lowest possible overall cost to society, because they provide incentives for the greatest reductions in pollution by those firms that can achieve these reductions most cheaply. Rather than equalizing pollution levels among firms, economic-incentive instruments equalize the incremental amount that firms spend to reduce their pollution (their marginal abatement costs).

Economic-incentive instruments have delivered attractive results where implemented and promise additional future benefits. To date, their effectiveness has been undermined by unrealistic expectations, lack of political skill, flaws in design, and constraints imposed by the internal structure of firms. These are all remediable. Policy makers should direct their efforts to making future applications work better than those that came before.