What is the environmental impact of market-based approaches to environmental policy and are they effective in controlling greenhouse gas emissions?
Introduction
Greenhouse gas emissions, and other forms of environmental pollution, are economic externalities as they impose costs on individuals and communities who did not create the pollution (Jaffe et al, 2005). These economic externalities are side effects that are experienced by individuals not connected with the polluting process (Owen, 2006). As such, the individual or entity from which the pollution originates does not need to reflect the pollution costs within their prices. The problem therefore lies in the associated costs to society that environmental pollution causes. These damages and costs, which include climate change, in the form of biodiversity loss, rising sea levels and extreme weather events, are not paid for by the companies or industries that emit the pollution and so they do not need to factor these costs into the market price of the goods or services that they provide (Muller et al, 2011). The result of this is that society produces and consumes high volumes of pollution-creating products, whilst industries continue to produce these goods and services without having to account for the costs associated with environmental pollution (Frankel and Rose, 2005).

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This form of market failure is addressed by market-based environmental policies that construct systems which incorporate the costs associated with environmental pollution into the industry’s decision making and financial process (Metcalf, 2009). The theoretical basis for these market-based policies is that when an industry or other pollution making entity see, and must pay for, the societal cost of pollution, then they will design innovative ways in which to reduce their environmental impact. In addition, the full environmental cost of the products will be reflected in the price, therefore enabling consumers to make informed purchasing decisions (Owen, 2006). The remainder of this document will consider the effectiveness of market-based policies compared with traditional command and control regulations.
Command and Control versus Market-Based Policies
Traditional command and control policies required polluters to reduce emissions by installing specific technology in order to meet specific performance emission standards (Hepburn, 2006). However, opponents to the command and control mindset state that this form of regulation is inflexible and does not take into consideration that some industries are able to meet these targets at a much lower cost than others (Liu et al, 2014). Additionally, the command and control regulatory approach does not incentivise industries to innovate and reduce their environmental impacts by more than what is required by the standard (Haselip et al, 2015).
Conversely, market-based approaches have been reported to provide greater flexibility for industry (Pirard, 2012). However, it is necessary to address the type of pollutant being emitted, as there are some that need to be maintained at a very low level for health-related reasons (Centre for Climate and Energy Solutions, 2012). As such, it may be necessary to control these types of pollutants with command and control regulations in order to ensure that health-related thresholds are not breached. Greenhouse gases are not harmful on a localised basis. Their effects are only seen when they are globally mixed within the atmosphere and cause damage on a global scale (Meinshausen et al, 2011). As such, many proponents claim that market-based regulatory approaches are particularly appropriate to reduce greenhouse gas emissions (Pirard, 2012; Hrabanski et al, 2013; Boisvert et al, 2013). Indeed, there is evidence to suggest that these policies provide greater compliance flexibility and can reach and improve environmental objectives at much lower overall costs (Boisvert et al, 2013).
One key aspect of these market-based policies is that they provide a financial incentive for industry to develop and deploy lower environmental pollution emitting technologies, whilst leaving the private market to decide which technologies can be expanded and utilised (Pirard, 2012). Within this structure, each regulated industry is able to independently choose the most cost-effective method to achieve the required pollution abatement. As previously mentioned, some industries are able to reduce their pollution more easily and cheaply than others, due to the technology or equipment that they are using. This enables them to reduce their pollution more, therefore compensating for those industries who are unable to meet traditional command and control targets due to the costs involved. As such, the overall environmental target can still be achieved but at a much lower societal and industry cost (Pirard, 2012). A good example of the success of market-based policies has been seen within the US. At the federal level, sulphur dioxide emissions have been reduced at a fraction of the original estimated cost (CCES, 2012). In addition, at state level, market-based approaches have been successfully incorporated into cap-and-trade and renewable energy programs to reduce nitrogen oxides and other greenhouse gases (CCES, 2012). The following sections will consider two distinct examples of market-based policies that can control greenhouse gas emissions.
Taxes
Taxes, that set a price on each unit of pollution, are the most basic form of market-based policies. This pollution tax ensures that the industry producing the pollution pays an additional cost dependent on the amount of pollution that is emitted (Vossler et al, 2013). This cost incentivises the industry to reduce the amount of pollution produced and encourage them to change their processes or incorporate better technology within their production line (Suter et al, 2005). As such, the more emissions that are reduced, the less pollution tax the industry needs to pay. However, it is necessary to calculate the societal cost of the pollution in order to set the price of the tax (Chiroleu-Assouline et al, 2014). This can be a complex process with the societal costs of pollution being difficult to quantify. For example, if the pollution emitted from a certain industry caused a population decline in a commercial shellfishery, then the damages could be based on the lost value of the shellfish at current market price. However, if the emitted pollution causes the extinction of a species or the destruction of a habitat, it is less clear on how society should assign a financial cost which equates to that loss. In addition, it is necessary to address how the environmental pollution emitted from today’s industries can cause damage to future generations and how to quantify these consequences when there are a range of possible outcomes (CCES, 2012).
Cap-and-Trade
The cap-and-trade approach sees the regulatory authority determining a total quantity of pollution that is acceptable (Betsill and Hoffmann, 2011). This is the cap. Industries are able to trade emission allowances based on their needs. However, there is a limited number of these allowances, so trading comes at a cost (Betsill and Hoffmann, 2011). Each regulated industry holds enough allowances to ensure that the cap is not breached whilst also creating demand for the allowances (Stephan and Paterson, 2012). For some businesses, it may be less costly for them to reduce their emissions than to buy allowances, therefore encouraging them to analyse their polluting activities and reduce their environmental impact. Some businesses are able to reduce their emissions to such an extent that they have excess allowances, which can be either banked for future use or sold to businesses that are struggling to reduce emissions. However, due to the scarcity of the allowances and their tradable nature, a price is placed on greenhouse gas emissions (Stephan and Paterson, 2012). This price results in an incentive for businesses to develop innovative technology to reduce emissions, with an added incentive to reduce their emissions to such a level that they can avoid buying allowances or can trade allowances they have been given (Betsill and Hoffmann, 2011). With the latter, businesses are able to raise revenue by selling these excess allowances (Piraud, 2012). This reduced environmental cost can then be passed on to their consumers, with cheaper goods and services, therefore giving them an advantage within the consumer market.
Problems with Quantity-based and Price-Based Market Policies
Evidence suggests that there is a tradeoff between quantity-based (cap-and-trade) and price-based (pollution tax) approaches (CCES, 2012). This tradeoff is either greater environmental certainty or greater compliance cost certainty. By setting an explicit price on each unit of environmental pollution, the regulated businesses have a high degree of price of certainty (Pizer, 2006). However, what is less certain is the amount of environmental pollution reduction that can be achieved, as each business will respond differently to the tax costs. For example, by placing a tax on each litre of fuel, one company may reduce its fuel consumption by 20%, whilst another company may only reduce its consumption by 2%. As such, it is difficult to estimate what price to place on the tax in order to achieve a specific emission reduction goal.
Conversely, with quantity-based market approaches, such as the cap-and-trade program, there is more certainty surrounding the environmental outcomes due to the scarcity of pollution allowances that make up the cap (Pizer, 2006). However, with this environmental certainty comes a cost uncertainty for the businesses emitting the pollution, as the cost of this pollution will be determined by the market price for the allowances (Pizer, 2006). Yet some market-based policies can be designed to allow more certainty for both price and quantity. For example, The Centre for Climate and Energy Solutions (2011) included price floors and allowance reserves, which act as prices ceilings, within the Regional Greenhouse Gas Initiative in California, in order to give more compliance cost certainty.
Revenue Uses from Taxes or Allowance Sales
Both price-based and quantity-based regulatory approaches have the potential to raise revenue for the government (Nordhaus, 2007). With environmental taxes, potential revenue raised will equate to the total quantity of greenhouse gas emissions released to the environment within a set timescale multiplied by the price of the tax. With cap-and-trade programs, the amount of revenue generated depends on the price allowances make on the open market and the number of allowances that are offered up for sale (Nordhaus, 2007). Regardless of how these revenues are raised, the benefits to society of this revenue stream are clear. Revenue use examples include the reduction of existing distortionary taxes on capital and labour investments in order to reduce the economy wide cost of the program, and the offset of taxes on the labour markets, individuals and businesses, as seen in both Sweden and British Columbia (Aldy et al, 2008).
Nevertheless, some experts suggest that this carbon revenue should be used for other purposes. These experts argue that there is a need to address the question of equity in addition to economic efficiency (MacKenzie, 2009). This equity would avoid burdening some households and businesses, particularly if they adopted clean energy approaches, technological adaptation, or positioned themselves within the research and development arena. An example of this can be seen within the member states of the Regional Greenhouse Gas Initiative. In this initiative, 100% of allowances are auctioned and 25% of the revenues generated are targeted towards consumer benefit, energy efficiency programs and renewable energy schemes. In total, over the last 7 years, these allowance auctions have generated more than $2 billion (Regional Greenhouse Gas Initiative, 2015).
Conclusion
It can be seen from the above narrative that both price-based and quantity-based market approaches to reducing greenhouse gas emissions can be highly successful and popular methods of achieving environmental targets. Environmental taxes ensure that the cost of environmental pollution is covered by the polluter in a “polluter pays” approach. Each unit of pollution is given a specific price which the polluter has to pay. These costs incentivise the industry to adopt more environmentally friendly approaches in order to reduce their financial outgoings. Cap-and-trade programs have a given number of allowances distributed between businesses within an industry sector. Companies that can produce their goods in a more environmentally friendly manner, which sees them having an excess of allowance, are able to trade these allowances on the open market to companies who are less able to meet environmental targets. However, due to the costs of these allowances, there is an added incentive for businesses to adopt, or develop, new technologies that reduce their environmental impact. However, both approaches have their limitations as it is difficult to quantify the financial costs of pollution in order to set a price on environmental taxes, and there are many uncertainties for the environment and for businesses with the cap-and-trade approach. Nevertheless, despite these uncertainties and challenges associated with price setting, it is considered that the flexibility for businesses and potential improvements for the environment by adopting these approaches over the traditional command and control regulation outweigh any negatives. Whilst it is accepted that market-based approaches will not work for all environmental pollutants, for greenhouse gases, which cause effects on a global scale, the evidence suggests that these approaches will encourage innovation and incentivise businesses to adopt best available technology.
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