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Key departmental publications, e.g. annual reports, budget papers and program guidelines are available in our online archive.

Much of the material listed on these archived web pages has been superseded, or served a particular purpose at a particular time. It may contain references to activities or policies that have no current application. Many archived documents may link to web pages that have moved or no longer exist, or may refer to other documents that are no longer available.

Environmental Incentives:
Australian Experience with Economic Instruments for Environmental Management

Environmental Economics Research Paper No.5
Consultancy report prepared by: Dr David James, Ecoservices Pty Ltd
Commissioned by Environment Australia
Commonwealth of Australia, 1997
ISBN 0 642 26850 9

2. Evaluation of economic instruments

2.1 Definition of economic instruments

Instruments for environmental and natural resource management can be defined as administrative mechanisms adopted by government agencies to influence the behaviour of those who value the natural environment, make use of it, or cause adverse impacts as a side-effect of their activities.

A broad distinction can be drawn between direct regulations (commonly described as command-and-control mechanisms) and economic instruments. Command-and-control mechanisms are based primarily on legislative and regulatory provisions and are implemented through directives from regulatory authorities. Regulations alone may be used for environmental protection purposes. Indeed, until recently, they were almost the only instrument used.

Economic instruments operate through market processes or other financial incentives. Although they take effect through various price and/or quantity controls, they usually allow for adaptive choice and decentralised decision-making by those whose behaviour is to be modified.

In reality, the distinction between direct regulations and economic instruments is often blurred as any system of economic instruments usually requires appropriate legislative or regulatory backing. Wherever economic instruments have been used, in Australia and overseas, supporting regulations have been applied.

2.2 Environmental management objectives

For the purpose of this report, environmental management objectives are considered in the broad context of natural resource management and sustainable development. The World Commission on Environment and Development (WCED 1987) emphasised the need to achieve environmental protection as a means of supporting economic development and keeping options open for future generations.

All human and economic activity has some kind of impact on the environment. Production and consumption both rely on the use of primary resources such as energy, materials, biological resources and labour. Impacts include the exploitation of natural resources, modification of ecosystems and the discharge of solid, gaseous and liquid wastes to the environment. Other impacts include thermal pollution, congestion and noise.

Management objectives can be related to each kind of impact. The appropriate design and application of economic instruments to each of these areas require careful consideration of the special characteristics of each problem, the institutional setting and the likely responses of stakeholders.

2.3 The case for economic instruments

Many economists consider that natural resources and the environment are in limited supply. Their overuse and consequent resource degradation are seen to be symptomatic of 'market failure'. Users of natural resources and the environment are not held responsible for the full costs of resource use. This occurs primarily because of the 'public goods' characteristics of the environment, which make it difficult to control access or exclusivity of use. The problems associated with inadequate regimes of use rights or property rights have been long recognised in the professional literature (Bromley 1989; Boer & James 1990).

In the past, governments have relied heavily on direct regulations to achieve environmental management objectives. While such regulations have generally been effective in meeting environmental objectives, they tend to be inflexible and can impose high costs on the community. They can also be expensive to administer. There is substantial evidence that command-and-control systems can be extremely costly if poorly designed and administered (Hufschmidt et al. 1983; Tietenberg 1985; Bureau of Industry Economics 1992).

In the wider context, using economic instruments for environmental protection is seen as a practical means of implementing the principles of sustainable development. The most persuasive case for the use of economic instruments is the claim that they help to achieve environmental objectives at least cost to the community.

Economic instruments rely more on decentralised decision-making and market mechanisms than do direct regulations. By creating markets for natural resources and the environment, the instruments can signal true resource scarcities to users, creating economic incentives for wiser management. In simple terms, governments can influence usage patterns by controlling the quantities/qualities of environmental or natural resource attributes that are traded, or by controlling their prices, either directly where there is a mandate to set prices or indirectly through charges, taxes, subsidies and other economic incentives. These management systems are considered to result in a more efficient use of natural resources and the environment, commonly referred to as the 'efficiency gains' from using economic instruments.

2.4 Theoretical foundations

The theory supporting the use of economic instruments is described only briefly here. Detailed treatments of the theory are provided by Howe (1979), James (1985), Bohm and Russell (1985), Tietenberg (1985), Pearce and Turner (1990) and Opschoor and Turner (1994), among others.

Efficiency gains are derived from a trade-off between the value of economic damage potentially inflicted on the community by human activity and the costs of preventing, mitigating or rectifying such damage. Achieving an efficient solution requires that the sum of these two costs be minimised. This, in turn, requires that marginal environmental damage costs be equated with the marginal costs of environmental protection. Economic instruments are, in theory, capable of achieving this condition, especially when used for their 'incentive effect'.

Pollution charges and tradeable pollution rights are relevant examples of two different kinds of economic instruments designed to control environmental damage. Essentially, what is being traded on the market is the assimilative capacity of the environment to receive wastes from human activities.

The imposition of a charge (emission or effluent fee) on pollutants discharged to the environment operates through the 'price' effect within the market. It will provide an incentive for dischargers to reduce the quantities discharged and implement pollution abatement technology and/or management practices. The total reduction in discharges will be met at least total cost because all dischargers will tend to equate the charge with their marginal abatement costs.

If, instead, tradeable pollution rights (permits) are used, the maximum total allowable discharge load will be determined by the control authority. This represents a 'quantity' control within the market. Dischargers are allowed to compete in a market for rights to discharge wastes to the environment. When the market reaches an equilibrium, the price of permits will be equated to the marginal abatement costs of all dischargers, thus once again the environmental objective will be reached at least total cost to the community.

In the case of natural resources management, the problem of overexploitation of resources can have various causes. An inappropriate allocation of property (or use) rights is frequently the basic problem. Users of the resource are able to exploit the resource 'free' or at a reduced price, leading to resource depletion or degradation. Overuse of open-access fisheries or water resources are common examples. By introducing an economic rationing system, resulting in higher prices (either implicit or explicit) for the resource, a more conservative use of the resource may be achieved. Rationing systems may take various forms, such as tradeable quotas or use rights.

2.5 Some practical limitations

Despite the relative simplicity of the underlying theory of economic instruments, various practical limitations must be taken into account in their design and implementation.

The task of identifying and valuing environmental damage costs is usually complex and surrounded by uncertainty. Techniques have been developed to value environmental impacts and they are being used increasingly in policy applications. Relevant references and guidebooks include those produced by the Department of the Environment, Sport and Territories/Department of Finance/Resource Assessment Commission (1995), Dixon et al. (1994), Hufschmidt et al. (1983), James (1994), New South Wales Environment Protection Authority (1993), Organisation for Economic Cooperation and Development (1994) and Sinden and Worrell (1979). It is difficult enough to obtain point estimates of environmental damage in existing situations, let alone to predict and estimate other points on a damage cost function. Empirically, therefore, estimation of marginal damage costs, on which 'optimal' economic instruments and outcomes should be based, can be expected to provide major challenges for the economic analyst.

The theory explaining how total discharge loads can be controlled at least cost is straightforward, but the conditions for achieving economically efficient outcomes become more complicated where environmental objectives are specified in terms of ambient environmental quality. Under these circumstances, the major problem is identifying the linkages between sources and receptors of environmental damage and implementing effective controls over specific sources. The management of pollution, for example, may call for the use of differential charges or, in the case of tradeable rights, trading rules that apply different ratios between different sources or zones (Bohm & Russell 1985; Tietenberg 1985). When designing systems of instruments, particular attention must be paid to recognising environmental 'hotspots' representing points of intense environmental impact.

It cannot be assumed that the use of economic instruments will automatically result in least cost solutions. There is evidence that poorly designed economic instruments can cost as much as command-and-control systems, as reported in a study on controlling ambient concentrations of nitrogen oxides in the Chicago Air Quality Control Region (Hufschmidt et al. 1983).

A strong argument in support of economic instruments is that they provide incentives for ongoing improved efficiency and environmental performance, for example, in relation to innovation, environmental protection technologies and environmental management practices. The same incentives may not be apparent in command-and-control systems.

However, there are counter-arguments. For example, environmental control costs may not represent a large proportion of total cost, so there may be little incentive to respond to price signals. In the management of some environmental problems, direct regulations have often been needed to provide the stimulus for improvement, economically as well as environmentally. Regulations governing motor vehicle emissions are one example, with significant cost savings and improved energy efficiency resulting from better engine and motor body design, prompted by the need to reduce combustion emissions.

It should be recognised that, in practice, incentive effects may not be the primary objective in using economic instruments. Economic instruments can also be used to cover the administrative costs of regulatory functions, such as standard setting, monitoring and enforcement. In this context, economic instruments are used as a redistributive device.

It is possible to design economic instruments mainly aimed at revenue raising, rather than behaviour modification. Environmental taxes are an example of this kind of instrument. Whether such revenue raising is effective in meeting environmental objectives depends to a large extent on how the revenue is spent. If it is allocated to environmental improvement programs and projects, beneficial effects may be expected. However, if revenue is simply directed to consolidated revenue, environmental benefits may not be achieved.

A possible disadvantage of using economic instruments in managing natural resources and pollution is that they may not guarantee the attainment of management objectives. The effects of the price mechanism, for example, may still not result in sustainable use of resources. With some environmental problems, such as the management of intractable wastes, specific regulations may be the only effective way of ensuring public safety. Another problem with economic instruments is that the distributional effects may be unacceptable, as in the case of taxes on fossil fuels to curb the greenhouse effect or to conserve the use of energy.

Some critics of economic instruments argue that administrative costs will be increased because of an additional overlay of regulation (that is, controls over markets for the environment or natural resources), as well as direct regulations required to support the use of economic instruments.

2.6 Criteria for evaluating instruments

At present there are many uncertainties about how to design appropriate administrative systems for achieving environmental objectives. It is not at all clear that any particular economic instrument is the best one to use; whether combinations of economic instruments can and should be applied; whether direct regulations can and should play a supportive role; or whether economic instruments will necessarily be better than other administrative arrangements for environmental and resource protection.

Although economic efficiency may be one important criterion in evaluating economic instruments for environmental protection, in practice a wide range of criteria must be taken into account. They include the following.

Effectiveness in protecting the resource/environment

This refers to the extent to which environmental objectives are achieved. Performance criteria, monitoring and enforcement are functions that are required to ensure the effectiveness of economic instruments. The type of environmental or natural resource system may be critical in the success or failure of particular instruments. In cases of pollution management, for example, much depends on whether it is a 'uniform mixing' situation or a more complex, dynamic situation. Whether pollutants act as conservative substances in the environment or synergistically or antagonistically with other substances may have a direct bearing on the practicability of using economic instruments.

Efficiency gains (cost savings, added benefits)

The preceding section addressed efficiency aspects of economic instruments. Such gains include reductions in total abatement costs on a regional basis or among a set of dischargers in reaching prescribed environmental quality standards. Benefits may also comprise improvements in the quality of the environment or natural resource stocks, resulting in measurable increases in sustained yields, as in fisheries and forestry. For water resource systems, evidence of improved efficiency may be reflected in the allocation of water to higher valued uses and in increases in productive performance on a regional or sectoral basis.

Incentives for improved efficiency and environmental performance

These refer to incentives to improve technical and managerial efficiency in achieving environmental protection and to continue reducing the costs of attaining environmental objectives. It is contended that economic instruments provide an ongoing incentive to improve environmental technologies and management practices because of cost savings and improved efficiency in the use of natural resources and the environment.

Acceptable burden of costs

A well-designed system of instruments of any kind should take into account the costs imposed on dischargers or resource users, and this will inevitably involve costs of research, administration and enforcement. Sometimes, these costs may be allocated to industry, especially under a policy of self-regulation. To be successful, however, self-regulation must be monitored stringently by impartial industry associations and by government.

Equity aspects (including impacts on industry and consumer groups)

The incidence of benefits and costs can vary significantly for different types of instruments. The equity impacts of economic instruments may be a major impediment to their introduction. Impacts on low-income groups may be a matter of special concern, as well as effects on the profitability and competitiveness of industry. In some situations, the price changes required to achieve incentive effects may be so great that the equity impacts are unacceptable.

Compatibility with existing institutions

To be effective, instruments should fit with existing or proposed legislation, institutional frameworks and administrative structures. Jurisdictional constraints may affect the design and performance of economic instruments. Particular difficulties may be experienced in coordinating instruments at different levels of government, from Commonwealth to State, Territory and local.

Acceptable administrative costs

Administrative costs should not be excessive, and sources of funding for administration should be identified. It is often argued that the information requirements are less for economic instruments as compared with other administrative arrangements because it is not necessary to have complete information on the costs of environmental/resource protection technologies and management practices.

Community acceptance (industry, environmental groups, general community)

Success in implementing systems of instruments will be achieved only if the community understands the functioning of instruments and the objectives that management agencies are attempting to meet. There may be inherent conflict between different interest groups, depending on the allocation of rights and responsibilities that different types of instruments bestow. For example, with emission fees the asset values represented by the assimilative capacity of the environment remain in public ownership, whereas with tradeable permits the asset values are transferred to dischargers. Notions of fairness must therefore be addressed as a prerequisite to any system of economic instruments.

To overcome problems of acceptability, the environmentally beneficial effects of economic instruments (particularly the incentive and efficiency effects) must be demonstrated through public consultation and information programs. Similar programs may be required to persuade industry of the advantages. Where changes in economic instruments are made without warning, the problem of sovereign risk may be encountered - for example, altering the charge rates for effluents or emissions, or reducing the allowable quotas for water use or harvests of natural stocks (forests and fish stocks).

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