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Chapter 2 Market-based instruments: a taxonomy

Market-based instruments (MBIs) span a range of measures and approaches. Fundamentally, they are policy measures that influence outcomes through their effect on costs and profits. In the hands of policymakers, they can affect the operation of established markets or create new ones. They are commonly also referred to as ‘economic’ instruments because they attribute value to assets and directly affect decisions based on considerations of price and income.

There is a growing literature on MBIs focusing on theoretical aspects and their practical application. The main categories of MBI, and their variants, are described below.

2.1 Broad categories and characteristics

MBIs are designed to influence the behaviour of resource users to ensure that resources are used more efficiently – that is, to ensure that the welfare associated with resource use is increased. A plethora of MBIs have been developed (see Box 2.1) – many of which share some core characteristics and can be grouped together.

Two basic categories are universally recognised:

  • price-based instruments:
    • establish an explicit and mandated price for resources or outputs that are deemed to have a social or environmental cost associated with them; and
  • quantity (or rights)-based instruments:
    • impose quantitative limits on resource use, and supplement these restrictions with rights of access or usage that can be transferred and sold.

A third class of MBI can also be added. This class is often used to capture a range of policy actions and approaches that operate on existing markets to help them work more efficiently, and deliver outcomes that maximise the benefits generated by resource consumption.

This group aims to correct market imperfections or ‘frictions’ that lead to poor resource use, and can be termed:

  • market enhancement instruments.

This group of three is a handy categorisation of the wide range of market-based instruments and approaches that can be observed in use, and in development, across a range of public policy areas. Some analysts suggest extra categories (eg, Stavins (2001, p 4) proposes a separate category for ‘subsidy reductions’) while others eg, Portney (2003, pp 15–18)) prefer a taxonomy based on the initial two.

Box 2.1: Common examples of market-based instruments and approaches

There are numerous examples of market-based instruments employed by policymakers as tools for resource and environmental management. Many of these have common characteristics and can be grouped accordingly. Instruments and approaches in common practice include:

  • levies;

  • royalties;

  • emission and effluent charges;

  • user / entry charges;

  • product charges;

  • administrative charges;

  • tax differentiation (environment taxes);

  • subsidies;

  • grants;

  • soft loans;

  • tax allowances;

  • deposit refund systems;

  • market creation;

  • transferable permit schemes;

  • market intervention;

  • liability insurance;

  • enforcement incentives;

  • non-compliance fees; and

  • performance bonds.

Source: National Oceans Office (Australia) www.oceans.gov.au/uses_economic/page_005.jsp (accessed 19/01/06)

All economists recognise the ‘value’ focus of MBIs as a core characteristic, and their operation on and within a market framework.

For the purposes of this report, and the key objectives of marine resource management some key options and approaches can be recognised. These are:

  • charges and taxes;

  • subsidies and tax concessions;

  • property rights and market support; and

  • tradable permits and quotas.

These will be focused on in more detail in the following discussion.

Taxes and charges

A pollution charge or tax can be defined as a ‘price’ to be paid on the use of the environment. On a practical level while charges and taxes operate in a similar manner, there is a distinction between the two. Charges are payments for which a good or service is rendered in return, while taxes are payments on the basis of, for example, the level of pollution for which no direct return in terms of goods or services is given (Industry Commission 1997, p 14).

Pigouvian taxes

Taxes that are designed to ‘internalise’ social or environmental costs in private consumption and production decisions are known as ‘Pigouvian’ taxes – after Arthur Pigou, a British economist who worked at the turn of the last century and was influential in developing theory in the area of environmental taxes.

A Pigouvian tax is levied on a polluting activity in an effort to ‘privatise’ the cost to third parties of that activity. If it is possible to introduce an appropriately designed tax on those causing the externality, then a socially optimal distribution of resource use could be attained at the least cost to society (ABARE 2001, p 27).

The objective of the tax (and the rate that is decided upon) is to drive pollution output down to a level that equates the social and environmental cost of the pollution with the economic cost of further reductions. In effect, imposing pollution costs on the polluter gives an incentive to cut back pollution output to the level where social and environmental effects can be compensated (through tax payments), and the economic benefits of further production exceed the environmental costs associated with it.

User charges are a related method of ‘internalising’ costs associated with negative externalities or driving behavioural change. Rather than taxing activity levels or particular behaviours, they often involve a fixed charge for the use of environmental services, and can be reflected as an access or license fee.

Product charges or taxes could be introduced on products that could have a harmful effect on the environment – either in the manufacturing or consumption phase. They can be based on a product, such as the use of petroleum, or on a product characteristic, such as the carbon content in petroleum.

Subsidies and tax concessions

A subsidy is a payment by government (directly or through another body) to those who undertake certain activities the government wishes to promote. A tax concession, on the other hand, reduces the amount of tax owed to the government by those undertaking such activities. Ideally, the size of a subsidy or tax concession should not exceed the overall benefits derived from the action or activity for which the subsidy or concession is given (Industry Commission 1997, p 14). Such measures tend to reduce costs and have an expansionary effect on the activities targeted – working in a broadly similar way (but opposite direction) to the Pigouvian tax described above.

Such measures, in theory, can provide incentives to address environmental problems. In practice, however, many subsidies promote economically inefficient and environmentally unsound practices because they have a tendency to promote over-consumption and additional production (Stavins 2001, pp 4-5). Pollution reduction aims tend to be served more efficiently by tax, rather than subsidy, approaches.

A variant on this is the deposit–refund system. Buyers of products that are potentially damaging to the environment pay a surcharge that is refunded to them when they return the product or container to an approved centre for recycling or disposal.

Property rights and market support

The underlying cause of environmental services being under-supplied (or pollution being ‘over-supplied’) is the failure of markets to generate appropriate values for these services (or negative externalities) by providing a framework in which resource owners, users, consumers and other stakeholders can share ‘value’ information and make satisfactory agreements for exchange at low costs.

Well-defined property rights are fundamental prerequisites for a market to function. Experience suggests that property rights are ‘well defined’ if they are adequately configured in three dimensions. According to Van Bueren (2001, p 5), the rights must be:

  • defined clearly so as to reside with a specific person or entity;

  • defended easily against non-owners who might wish to use or ‘steal’ the entitlement; and

  • fully transferable by the owner to others on whatever terms are mutually satisfactory to buyer and seller.

Properly defined property rights provide the owner with an incentive to improve or preserve the resource beyond the time they expect to make use of it. Under these circumstances potential buyers of the resource would be willing to pay up to an amount equivalent to the benefits they receive for the right to use the resource. If property rights are well defined, then any further government intervention could be relegated to simply facilitating the exercise of these rights.

Information

Lack of information is a common source of failure in a range of markets. Public provision of information is a powerful means by which governments can facilitate the operation of markets and improve decision making by their participants (ABARE 2001, p 27). It can also entail governments undertaking (or funding) scientific and economic research aimed at understanding the dynamics and interrelationships in ecological and economic systems. Such information can be very important to determining values and risks for natural resource management purposes, and reflecting these in public policy processes.

Substantial gains can be made in environmental protection simply by reducing existing market imperfections. An example is the introduction of liability rules that encourage firms to consider the potential environmental damages of their decisions.

Tradable permits

Tradable permits are a particular example of creating a market for resource by allocating property rights over a resource that was previously ‘common property’ and hence vulnerable to over-use and exploitation. These instruments work by establishing some overall limit on environmental degradation, such as a limit on total pollution / emissions of substances or a quota on natural resources that can be extracted / removed. This limit or quota is allocated amongst market participants, who are then free to trade permits (which represent a defined quantity of their individual quota allocation). This system promotes economic efficiency by allowing scarce assets to flow to those who can extract the greatest value from them, and promoting constraint among those who reduce their usage most cheaply. This relatively straightforward arrangement is often referred to as a ‘cap and trade’ system.

As noted by OECD / IEA (2004):

Most tradable permit experiences link government regulations with markets. Permits delivered by governments to economic agents, most often firms, are recognised as a means of complying with a certain regulation. The permits are then simply recognised as tradable. In the case of polluting emissions, for example, firms are given allowances or permits to emit fixed (absolute) amounts of emissions over a given period of time. Firms that can cheaply reduce their emissions more than stipulated by the government regulation can offer to sell surplus emission rights to others that have only costlier options for reducing emissions. As a result, the total cost incurred by companies in achieving the environmental goal set by the government is lower than in case of pure ‘command-and-control’ environmental regulation …. and this benefits the society as a whole.

Philibert & Reinaud (2004), p 9

Basic trading approaches have spawned a wide range of variants that can differ in terms of the way tradable units are generated (and the obligations on those who participate in the system) and the allowable units of exchange. Variations on the ‘permit trading’ theme can include:

  • baseline-credit arrangements – depending on their design and the stringency of ‘baselines’, these can represent lower compliance obligations on participants – and be popular with industry for that reason. ‘Credits’ are created at the discretion of participants, and quota allocation arrangements can be either implicit or undefined within the scheme.

  • offset schemes – allow a business to conduct an activity that may have negative environmental impacts in exchange for positive offsetting actions. This is basically a trading arrangement where ‘like for like’ is exchanged rather than negotiating a monetary ‘price’. For example, a business may be allowed to alter a wetland substantially if it agrees to undertake activities to protect, restore and / or enhance another wetland. A potential benefit of this approach is that businesses must directly account for environmental costs within investment and production decisions. However, to be effective, offset rates must accurately reflect the relationship between environmental damage and mitigating action. In some instances, it may not be feasible to resolve the scientific uncertainty associated with calculation of such a measure, or be satisfied that there is reasonable homogeneity in the assets and offsets being exchanged. Nevertheless, there are also examples of offset arrangements embracing – in principle – the potential for ‘monetised’ exchanges (eg, WA EPA 2006) – environmental damage might be offset through the purchase of tradable environmental credits or a contribution to a ‘… statutory trust fund with the … purpose of … environmental improvement activity’ (Environmental Improvement Authority (Western Australia) 2006, p 9).

  • bubble programs – an emission bubble allows an individual firm to increase its emissions in some production centres, provided these increases are offset with emission reductions in other centres. Firms are judged to be in compliance if the sum of individual emissions does not exceed the limit set for the bubble. This is an example of an airshed or ecosystem ‘equivalence’ (and non-equivalence) arrangement.

2.2 Common applications in natural resource management

Taxes and charges

A wide range of ‘green’ tax or changing initiatives can be observed internationally – although few appear to have been designed and implemented with the explicit Pigouvian objective of restoring consumption or output levels to a social optimum. Nevertheless, to the extent that these arrangements have been implemented with a view to curtailing activity levels and easing environmental pressures, they can be thought of as Pigouvian in nature.

The EU Environment Agency reports a gradual increase in the importance of what it terms ‘environment’ taxes since 1980, though pollution taxes make up a relatively small share of this total. Dominant contributions in the ‘environmental’ category come from energy and transport taxes – and while both these are associated with social and environmental problems such as air pollution, greenhouse gas emissions and urban congestion, the extent to which they have been targeted as a pollution source, or as a convenient tax base (which tends to be relatively insensitive to price) is unclear.

The difficulty in assessing the ‘purity’ of Pigouvian taxes and the predominance of indirect tax approaches has been noted by Morgenstern (1995) in his overview of IMF survey work:

… the IMF has recently completed a survey of tax laws in 42 nations – industrial and developing countries, and economies in transition. They found that Pigouvian taxes were used in one or more instances in ten of the 19 OECD countries surveyed (mostly on hazardous wastes and aircraft noise). None was used in the U.S. and none was used outside the OECD except in the economies in transition where all four countries surveyed were found to use them. However, as the authors note, “it is easy to exaggerate the role of Pigouvian taxes because the rates rarely reflect environmental damages and, particularly in economies in transition, there is reason to believe that actual practices diverge sharply from legislated provisions” (McMorran & Nellor, 1994, p 8).

In contrast, indirect environmental taxes, including levies on fuels, energy, fertilizers, and beverage containers are widely used. The IMF found them in 20 of the 23 non OECD nations and in all 19 of the OECD countries surveyed. Unfortunately, definitional issues abound once you depart from pure Pigouvian taxes, and it is difficult to know exactly when a tax is properly labeled an environmental tax.

Morgenstern (1995), p.9

New Zealand’s own experience with the proposed carbon tax highlights the significant design and stakeholder issues that need to be dealt with in applying an environmental taxation approach.

In addition to pollution and effluent taxes, a Pigouvian approach can also be discerned in resource management arrangements such as the sale of recreational fishing licenses (which acts as an entry deterrent and can also provide a revenue source for re-stocking and monitoring) and plastic bag levies (aimed at reducing the incidence of litter).

Subsidies and tax concessions

Tax concessions and subsidies can be used to promote the use of a product considered more environmentally friendly than alternatives. Examples include concessional sales tax treatment of products such as recycled paper, or special fuel excise arrangements for bio-diesel, ethanol or gas. A wide range of subsidy programs operate in the EU, North America and other developed nations (including New Zealand) to encourage environmentally friendly activities such as renewable energy, energy conservation and more sustainable farming practices.

Tradable permits

Tradable permit systems are an increasingly popular method of environmental resource management.

One of the best-known examples of a tradable permit system is the United States’ system for regulating SO2 emissions, the primary precursor of acid rain. A robust market of bilateral SO2 permit trading has emerged among liable electricity producers, resulting in cost savings in the order of $1 billion annually, compared with the anticipated costs under some command-and-control regulatory alternatives. This program has apparently had exceptionally positive welfare effects, with benefits being as much as six times greater than costs (Stavins 2001, p 28). Fisheries managers – including those in New Zealand – are also highly familiar with the use of tradable quota systems.

As noted by OECD / IEA (2004), trading systems are becoming increasingly widespread – in terms of their policy application and their geographic usage:

A quarter century after its first formulation, the concept of tradable permits has received numerous applications to preserve the environment and natural resources by rationing access to the commons. A survey a few years ago found nine applications in air-pollution control, seventy-five in fisheries, eight in the water and five in land-use control (OECD, 1999a). More recent developments include tradable renewable energy certificates (‘green certificates’), tradable energy efficiency improvement certificates (‘white certificates’), waste management, experiences or at least thoughts in transport and, last but not least, many developments in the field of greenhouse gases (OECD, 2002). Moreover, originally experienced in a relatively small number of countries (mostly the USA), tradable permit experiences are rapidly expanding throughout the world. For example, the EU is finalising its EU-wide CO2 emissions trading scheme, while China has been experimenting with air pollutant emissions trading in six cities since 1994 – though with limited success (Greenspan Bell, 2003) – and its government is investigating a possible nationwide SO2 emissions trading scheme (Yang & Schreifels, 2003).

Philibert & Reinaud (2004), p 10

Property rights and market support

Efforts to remove ‘friction’ from markets by reducing red tape and on-costs are widespread. Since well-functioning markets depend, in part, on the existence of well-informed producers and consumers, information programs can – in theory – help foster market-oriented solutions to environmental problems. The European Union established an ‘Eco-label’ in 1993, which was initially intended to replace existing national labels in Europe. By 1999, the Eco-label had been applied to 200 products, including detergents, light bulbs, linens and t-shirts, appliances, paper, mattresses, and paints. National labelling systems also continue to be used across the EU.

The German ‘Eco-Angel’ label program, the world’s first, began in 1977. More than 4,200 products in dozens of sectors have received the label, including almost 600 foreign products. The Nordic Swan has been applied in Norway, Sweden, Finland, and Iceland since 1989, and now covers 1,000 products. The French ‘NF Environment’ label has been granted for paint products and garbage bags, and Spain’s environmental label has been applied to ten classes of consumer products. The Czech Republic uses eco-labels on the basis of product life cycle analysis tests (paid for by applicants), and has issued 262 labels in 21 chiefly industrial product categories (Stavins 2001, pp 36-37). Eco-labels have also been employed in New Zealand. The Environmental Choice label has been licensed for use on over 200 products, spanning floor coverings to dishwashing liquid.

Experience has highlighted strengths and weaknesses in all these approaches, and their greater suitability to certain applications than others. These issues are addressed in the following chapter.

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