• About this site|
• Site index|
• Contact us|
• Jobs

Market-based Approaches to Marine Environmental Regulation

Chapter 1 Introduction

Chapter 2 Market-based instruments: a taxonomy

Chapter 3 Factors affecting MBI relevance and performance

Chapter 4 Applying MBIs in a marine context

Bibliography

Appendix Multiple use in a coastal plan area – a case study

Chapter 3 Factors affecting MBI relevance and performance

The following sections discuss pre-conditions for the application of market-based instruments (MBIs) and factors affecting their suitability to certain policy objectives.

3.1 Framework conditions for MBIs

There are several basic factors that will assist in successfully applying policy instruments to address environmental problems. The following conditions have been identified by Australia’s Industry Commission (now the Productivity Commission) as being necessary for an environmental policy or measure to be successful:

• evidence that a significant environmental problem exists, or is likely to arise, which otherwise would not be adequately addressed;

• strong public and / or industry support for action to address the problem;

• availability of appropriate expertise to help design, implement and monitor the use of the instrument;

• capacity to establish an effective and efficient administrative and legal framework to implement the instrument;

• measures in place for reviewing, adapting and refining approaches to changing circumstances; and

• clear goals against which effectiveness can be evaluated (Industry Commission 1997, p 22).

A critical factor in MBI success is a supportive broader policy and institutional environment. Other government policies or institutional arrangements can reduce the effectiveness of MBIs if they provide an incentive for individuals or firms to undertake activities that result in outcomes that are counter to objectives of MBIs. For example, in the recent past, in a number of countries, subsidies have been used to promote resource exploitation and industry development, with no reference to environmental outcomes. Such policies can be inconsistent with existing environmental policies.

Governments must also have the legal rights required to create MBIs, and the conditions required for their effective use. For example, governments must possess the right to impose certain taxes and charges, to declare and assign property rights, to impose penalties for non-compliance, to determine allowable emission levels or to collect information in order to monitor the performance. In considering the appropriateness of certain MBIs, it is possible that choices may be limited by the legal capacity that a government has to implement different options. This can be reflected in issues associated with international jurisdictions and agreements (such as the Law of the Sea) and the obligations national governments can impose in these areas.

The structure and variation in the firms that impact (positively or negatively) on the desired environmental outcome is also important. Certain industries may be structured in such a way that means MBIs are not an appropriate policy tool or in a way that makes certain MBIs preferable to others. For example, Whitten et al (2004, pp 11-12) highlight the following lessons:

• the greater the degree of firm heterogeneity, uncertainty or variability generally the greater the gains relative to traditional command and control regulations;

• the less site-specific the impacts of pollution (that is, the less likely it is that hot-spots will develop) the more likely an MBI will be cost-effective;

• if outcomes are critical (for example due to threshold or irreversibility issues) then rights-based methods are preferred;

• rights-based instruments work best when the firms using them have experience with similar tools (such as trading in water markets) and there are low-cost mechanisms for exchange.

The availability of information is also critical. Relevant questions for policymakers in assessing and applying MBIs include:

• How (and over what time frame) will firms respond to the incentives that the MBI approach offers?

• How well can polluters and resource users be identified, and relevant activity levels monitored?

• How do proposed mitigation actions relate to environmental outcomes?

• How will the institutional environment evolve?

The Pigouvian tax is a good example of an instrument that, while offering considerable elegance from a theoretical perspective, faces a few challenges in a practical context.

Identifying the tax rate that will deliver the desired trade-off between economic and environmental benefits (and allow production to proceed at the ‘socially optimal level of pollution’) is a key challenge. This is often difficult because governments seldom have good information on production cost conditions in an industry, or how it will respond to a given level of tax or per unit charge. In such cases, governments must embark on a process of ‘price discovery’ – varying the rate in order to drive (or maintain) production levels at or near that identified as the social optimum.

3.2 Choosing the appropriate MBI

The choice of MBI depends on the characteristics of the problem and the needs of the instrument itself. For all MBIs (and indeed other policy approaches) it is important to construct a clearly defined and measurable goal.

The inherent transparency and empirical nature of MBIs (which focus on catch units, litres or kilograms of discharge, dollars and / or units of production) imposes a discipline on MBIs that is seldom matched by other policy approaches.

In fact, a significant determinant of the performance of MBIs is associated with the capacity of these measures to be applied to activities (and constituencies) that are readily monitored, and are tightly aligned with the environmental or resource outcomes sought.

Legal and political considerations can also affect MBI choice. This and other aspects have been highlighted by Robinson & Ryan (2002) in a recent review of economic instruments for environmental management. An overview of these considerations – important to both instrument selection and design – is reproduced in Table 3.1. It relates to a wide range of issues – spanning tenure and access considerations for leasehold properties, and to the need to consider the impact of administrative costs in selection and design.

Table 3.1: Considerations in the choice and design of an economic instrument

Source: Robinson & Ryan (2002), pp 6–8.

In considering instrument selection and design issues it is critical to establish and build on a solid foundation of information. This process of scientific investigation and knowledge accumulation should generally precede policy action, and is critical to orienting and monitoring an approach based on economic incentives and the use of transparent metrics.

Price versus quantity-based

There is a range of perception and social acceptability issues that come into play for political decisions makers in choosing between a price-based approach (eg, taxes and charges) or quantity (eg, licenses and quota) to a resource management problem. Issues in this regard can include the optics of ‘handing over’ or selling exclusive rights to common pool resources, or governments imposing a new set of tax or charging arrangements. However, there is a set of economic efficiency (and environmental efficacy) considerations that can also be important in choosing between these policy approaches.

A dimension already mentioned relates to urgency or certainty of outcome. As noted, if policymakers have identified a particular resource outcome that needs to be achieved, and attach a high level of importance to that outcome, then a quantity approach – involving access restrictions and quotas – is likely to provide the most reliable and immediate result.

However, trading activity (and the economic flexibility it offers) can take some time to establish. Costs associated with complying with the revised level of resource availability can be higher in the meantime. On the other hand, a price-based approach automatically allows for the possibility of additional resource consumption (and avoidance of unwelcome shortages and price spikes) – provided the price is met.

The efficiency rule for choosing between environmental management instruments under conditions of uncertainty is known as the Weitzman Theorem. Weitzman (1974) demonstrated that where the value of marginal benefits and costs associated with abatement are uncertain, but where economic costs are likely to increase faster (ie, have a steeper slope) than environmental benefits, a smaller welfare loss is likely to result from a pricing mechanism than a strict quantity constraint (Weitzmann 1974).

This simply recognises that, if there is a risk that policymakers might under or over-shoot the socially optimal pollution level, it is best to lock in a quantity target (and risk an increase in abatement costs) if adverse environmental impacts are rising strongly – but if the risk of a blow out in compliance costs is of greater concern then a price approach is the better choice. In practice, this implies that quotas are likely to be appropriate for managing a hazardous pollutant discharges or threatened species or habitat, while a tax approach would be an appropriate instrument for dealing with a relatively benign pollutant or slowly accumulating environmental threat.

On-costs must also be considered. These are relevant to choices between MBIs and also to consideration of MBI options relative to adoption of a regulatory approach.

For a quantity approach underpinned by trading, there is a need to develop contracts of exchange and absorb costs such as negotiation or search fees, brokerage and insurances in order for trading to take place. Allocation of permits or licences can also involve significant time and effort on the part of government – with due consideration of the potential efficiency and equity implications involved. This has been a complex and protracted exercise for policymakers looking to establish a domestic permit trading system for greenhouse gas emissions.

For a tax (or subsidy) approach, trading costs are avoided – but business compliance costs still apply, as do costs associated with revenue collection by government. Efficiency implications can also be associated with incentives for evasion under a price approach relative to a trading system in which the tax ‘liability’ is commoditised and converted into a tradable ‘asset’ that is exchanged between commercial entities.

MBIs have generally been more effective where emissions are from a point source such as a pipe, or smoke stack discharging from an industrial facility than when emissions are from diffuse sources (eg, agricultural run-off). This is due to differences in the feasibility and cost of monitoring stable ‘point’ sources versus populations and activities that are atomistic, opportunistic or volatile.

The feasibility of applying a trading system to a diffuse source (such as the flow of nitrates into Lake Taupo) will be heavily influenced by how reliably policymakers can monitor and attribute pollutant flows. Measurement and attribution are important dimensions for a trading system.

The choice of price-based instruments is influenced by a key set of institutional rules – rules about who is responsible for paying the cost of mitigation. These rules are often less formally institutionalised than property rights and often set on a once-off basis in specific legislation. In an investigation of market-based approaches, CSIRO (2004) noted that precedent is often an important basis for institutional rules – environmental charges are much more likely to be politically acceptable where there is some tradition of making the polluter pay. Likewise, incentive payments and tendering approaches are more likely to be politically acceptable where there has been a tradition of charging the general public for provision of public environmental goods (CSIRO 2004, p 33).

Tradable permits

Trading systems are likely to be feasible and appropriate for situations in which:

• there is a willingness to grant private property or exclusive access rights to a common pool resource;

• the traded commodity is relatively homogeneous and significant qualitative differences do not apply; and

• resource or environmental conservation is a principal objective.

However, a range of factors can also mitigate their performance and these need to be taken into account in determining their suitability for purpose. The OECD (2003) has highlighted these attributes and the potential for combining trading with other approaches. A brief discussion of these cases is provided in Box 3.1. They highlight the desirability of a market with many players and good acceptance of the tradable unit for liquidity purposes and the possible role of supplementary ‘market support’ measures and mechanisms for covering off the risk of a cost ‘blow-out’.

Use of environmental offsets is also relevant here, as an approach that embodies a trading function with an onus on policymakers ensuring that a ‘like for like’ or ‘equivalent value’ (or higher) exchange is being made. Issues can arise in determining circumstances and thresholds that trigger ‘offset’ requirements, the type of trades that are allowable, and situations where environmental or biodiversity assets are so unique that they cannot be adequately replaced or compensated for. These are judgements that must be made by governments.

Source: OECD Working Party on National Environmental Policy (2003), p 33.

Subsidies and tax concessions

Whilst providing an incentive to change behaviour, and in many cases giving polluters the flexibility to do this in the manner they choose, subsidies and tax concessions do not cause the polluter to internalise the costs to the environment of their polluting activities. In fact, by providing an additional – albeit earmarked – source of income to polluters, they can encourage expansion of the polluting industry and diminish the abatement outcome relative to a policy that caused pollution impacts to be internalised as a business cost (Baumol & Oates 1988, esp. Ch 14, and Parry, 1997).

Subsidies and tax concessions may also have the undesirable effect of rewarding those who have been poor environmental performers prior to their introduction, or encouraging an increase in polluting activities in anticipation of a beneficial subsidy (linked to past emissions) in the future. Such payments may also be inefficient where they are made to those who would undertake action even in the absence of a financial incentive. These design and incentive issues are discussed at length in the economics literature in the context of ‘moral hazard’ and ‘adverse selection’.

Despite the arguments against subsidies and tax concessions, there may be situations where a firm is unable to capture sufficient benefits from undertaking a certain activity and the desired behaviour is unlikely to occur without the provision of an external financial incentive. In these cases, and where effective polluter pays measures cannot be devised, the use of subsidies and tax concessions may be desirable (Industry Commission 1997, p 17).

In principle, subsidies may be appropriate in cases where:

• a socially or environmentally beneficial activity can be reliably targeted (producing a benefit is generally not equivalent to ceasing to generate a cost);

• mandatory coverage of a target population is not feasible; and

• budget constraints are not critical.

Taxes and charges

Taxes and charges are suited to situations where the individuals responsible for the problem or the polluting activity can be readily identified. However, the costs of monitoring and enforcement may still be high because of the need to ensure that all individuals responsible for the problem are subjected to the tax. Where a tax or charge is used, the individual or firm responsible for the environmental damage bears all of the costs of changing resource use or management practices.

Taxes and charges can be appropriate in situations where:

• the risk of ‘excessive economic costs’ dominate concerns about potential costs associated with insufficient environmental action;

• the action or commodity to be taxed is the direct cause of the negative externality being targeted, or is closely connected to it;

• there is clarity over the rate of tax necessary to reduce pollution output to socially acceptable levels;

• significant equity issues do not arise (ie, a tax approach that impacts heavily on a low-income or disadvantaged community may not be consistent with over-arching welfare objectives); and

• there is a desire for improved cost recovery, or expanded revenue.

3.3 Effectiveness of MBIs

Experiences with MBIs offer some guidance to the conditions under which such approaches are likely to work well, and when they may face greater difficulties.

Where the costs and opportunities for pollution reduction differ widely among sources, or are uncertain or are likely to be changeable over time, a market-based system is likely to offer greater gains, relative to conventional, command-and-control approaches. This is because they do not mandate a blanket approach, but facilitate arrangements that attribute a price or value to community resources and allow individuals to adjust their consumption and activity patterns in accordance with that price and their own priorities and circumstances. The greater these uncertainties and divergences, the greater the potential benefits offered by MBIs.

However, implementing MBIs is not a costless exercise, and these costs and the costs that will be borne by administrators and participants in the system must also be taken into account. In comparing the effectiveness of MBIs with other regulatory options, it is necessary to consider the full set of compliance costs (taking account of production and consumption changes as well as transaction costs such as paperwork, brokerage, etc) implied by each, and the incentive structures established for resource management in the future.

In circumstances where policymakers have a good knowledge of costs and opportunities, and these are relatively homogeneous, it is feasible to make regulatory decisions on behalf of a broad population at a relatively low cost – and obviate the need for the significant cash transfers associated with taxes and charges, or the negotiating and contract costs associated with trading. This possibility is known as ‘efficient regulation’. However, in a dynamic setting in which tastes, technologies and prices change, it is inherently difficult to ensure that regulated outcomes will achieve community objectives at least cost. For this, the interaction and engagement of economic participants is important, and these dynamic benefits are a key advantage of MBIs.

Table 3.2 provides a broad summary of the relative strengths and weaknesses of a range of common market-based approaches. Their common link is that they influence behaviour through the use of a price mechanism – either by operating on an existing set of prices, or promoting explicit prices for community assets where none existed previously.

It is clear from the analysis that while some broad observations about the needs and performance of MBIs can be made, design and application of these instruments ultimately require consideration on a case-by-case basis.

Table 3.2: Summary of market-based instruments

Adapted from: Industry Commission (1997) and UNEP (2002)

MBIs require some fundamental conditions to operate. Chief among these are:

1. a pre-existing market or capacity to create or award property rights;
2. a trackable target population that is influenced by cost and profit considerations, and which can substantially influence attainment of the resource management objective; and
3. a readily identifiable and homogenous metric that can be used as the focus of the instrument, changes in the value of which will drive behavioural change and outcomes that are consistent with the resource management objective.

It is via a focus on prices and measurable units in the hands of responsive market participants that MBIs drive change. Importantly, the effectiveness of MBIs will generally be a function of how well each of the above conditions is met. Determining this is a largely qualitative exercise and it is difficult to build a set of diagnostics that can be applied to reliably assess this in advance.

MBIs must be applied and tailored to particular resource needs. In many cases, commercialisation and privatisation actions on the part of governments can be understood in terms of the need to create a framework of private responsibility for resources, and the incentives for ongoing stewardship that that often entails.

[ Previous|Next