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Regulatory Options

All environmental pollution, including emissions of greenhouse gases (GHGs), imposes costs
on people who did not create the pollution. This is an example of an economic externalitya
consequence or side effect of an action that is not experienced by the individual or entity
from which it originates, and that is not reflected in prices. The damages and associated
costs to society that GHGs cause through climate change (e.g., increased extreme weather
events, rising sea levels, and loss of biodiversity) are not paid for by the entities that emit
those gases, so those costs are not reflected in the market prices of goods and services.
Because polluters do not have to account for the costs associated with the damages that
greenhouse gases create, society produces and consumes too many pollution-creating
products (like fossil fuels) resulting in additional GHG emissions being put into the
Market-based policies aim to correct this form of market failure (an instance where economic
resources are allocated inefficiently). They do this by constructing systems that cause the
external costs associated with pollution to be incorporated in the polluting entitys
decision-making. When firms explicitly see and must pay for the societal cost of pollution,
they are able to determine how best to meet an environmental objective. Moreover, when
prices of products reflect their full environmental costs, consumers also are better able to
make informed purchasing decisions.
Market-based Instruments
Market-based instruments (MBIs) are policy instruments that use markets, price, and
other economic variables to provide incentives for polluters to reduce or eliminate negative
environmental externalities. MBIs seek to address the market failure of externalities (such
as pollution) by incorporating the external cost of production or consumption activities
through taxes or charges on processes or products, or by creating property rights and
facilitating the establishment of a proxy market for the use of environmental services.
Market-based instruments are also referred to as economic instruments, price-based
instruments, new environmental policy instruments (NEPIs) or 'new instruments of
environmental policy.
Market-based environmental policies work by creating an incentive to reduce or eliminate
emissions. Under this structure, each regulated business chooses independently how to
most cost-effectively achieve the required pollution abatement. Notably, some companies
can reduce pollution more cheaply than others (because of the age of their equipment or the
technology they are using), allowing them to reduce their pollution more, to compensate for
those facing higher costs doing less. Taken together, the overall environmental objective will
be achieved at the lowest possible total costs. The key criterion in determining if a policy is
market-based is that it provides a financial incentive designed to elicit a specific behavior
from those responsible for the pollution.
Types of Market-based Instruments
1. Taxes and Subsidies
The most basic form of a market-based policy is a tax that sets a price on each unit of
pollution. By introducing a tax on pollution, the entity producing the pollution incurs
an additional cost based on the amount of pollution emitted. Because of this, the
entity has an incentive to reduce the pollution produced by changing its processes or
adopting new technology. In this way, the tax provides a continuous incentive for
innovation; the more emissions can be reduced, the less tax a company would pay.
Ideally, the cost of the tax would be set equal to the cost to society that the pollution








creates. Subsidy programs that provide government assistance (or tax credits) for
specific types of low-emitting activities or technology applications function in a
similar way to taxes, in that they provide a specific financial mechanism to motivate
a particular environmentally beneficial outcome
Transferable Permits
A market-based transferable permit sets a maximum level of pollution (a 'cap'), but is
likely to achieve that level at a lower cost than other means, and, importantly, may
reduce below that level due to technological innovation.
Cap and Trade Programs
This approach is quantity-based. Instead of setting a price on each unit of pollution,
the regulatory authority determines a total quantity of pollution (a cap) that will be
allowed. Companies buy and sell emission allowances (tradable certificates that allow
a certain amount of emissions) based on their needs. The limited number of these
allowances creates scarcity. The requirement that regulated businesses hold enough
allowances to cover their emissions ensures the cap is met and creates demand for
the allowances. If it is less costly for a company to reduce emissions than to buy
allowances, the company will reduce its own emissions. Similarly, if a company can
reduce emissions below its requirements, so it has excess allowances, those
allowances can then be banked for future use or sold in an open market to a firm that
finds it more difficult (costly) to reduce emissions.
Baseline and Credit Programs
Similar to a cap-and-trade program is a baseline and credit program which
establishes a defined emissions limit either in terms of absolute emissions or
emissions per unit of output. Firms that emit below their baseline limit would be able
to create credits and sell these to firms that emit more than their baseline limit. The
baseline limit creates the scarcity and trading generates a value on those emissions.
Renewable Electricity Standards
Renewable electricity standards are types of electricity portfolio standards typically
targeted to spurring commercialization of less-polluting technologies (often with
specific provisions to favor one or more particular technologies) in the electric power
sector. These standards can be designed so that each utility within a particular
territory must obtain a certain percentage of its delivered electricity from a defined
set of clean or renewable sources.
Energy Efficiency Resource Standards
An energy efficiency resource standardor an energy efficiency targetis a
mechanism to encourage more efficient generation, transmission, and use of
electricity. An energy efficiency resource standard is similar in concept to a clean or
renewable electricity standard, in that the former requires utilities to reduce energy
use by a specified and increasing percentage or amount each year.
CAF Standards
Corporate Average Fuel Economy (CAFE) standards are used for regulating the fuel
economy (i.e., miles per gallon of gasoline) of new light-duty vehicles, which include
passenger cars and light trucks such as pickups. This standard is calculated using the
harmonic mean of the fuel economy of vehicles produced for sale in a year using a
set of fuel economy targets that is based upon each vehicles footprint. The
automaker must meet or exceed this standard (including using optional credit
transfers) or the firm must pay a fine based on the number of vehicles sold and the
magnitude of the difference between the standard and the achieved sales-weighted
Feebates are a regulatory program creating a schedule of fees and rebates (hence
feebates) to the purchase price of a good based on an aspect of the good that
policy hopes to influence. Feebates are most often discussed in the context of

changing the relative prices of automobiles based on their fuel economy, but could
be applied to a wide range of consumer durables.
Key Considerations in choosing a market-based instrument

The type of market failure being addressed;

The specific nature of the environmental problem;
The degree of uncertainty surrounding costs and benefits;
Concerns regarding market competitiveness;
Monitoring and enforcement issues;
Potential for economy-wide distortions; and
The ultimate goals of policy makers.

Internalization of External Costs

Externalities can be positive or negative. Thus, an externality can be a cost or benefit. It
results from an activity or transaction of one economic actor and affects an uninvolved party
(positively or negatively). This uninvolved actor did not choose to incur that cost or benefit.
When a company makes a decision and does not have to pay the full cost of the decision, a
negative externality exists. If a product has a negative externality, then the cost to society is
greater than the cost consumers pay for it. Consumers do not take cost of externalities into
account. In unregulated markets, where producers are not forced to take the responsibility
for external costs or if they do not take the responsibility voluntarily, society is left with the
Many socio-ecological problems result from negative externalities. Thus, in order to reduce
those problems, external costs have to be internalized, i.e. the company has to pay for
them. Internalization can be accomplished either via governmental action or via the
market. Environmental laws attempt to internalize external costs so that people pay for the
true costs of their activities.
Government Failure
Government failure (or non-market failure) is imperfection in government performance.
It occurs when government intervention causes a more inefficient allocation of goods and
resources than would occur without that intervention or whenever the government performs
inadequately, including when it fails to intervene or does not sufficiently intervene.
Causes of Government Failure
1. Political self-interest
The pursuit of self-interest amongst politicians and civil servants can often lead to a
misallocation of resources.
2. Policy Myopia
A tendency to look for short term solutions or "quick fixes" to difficult economic
problems rather than making considered analysis of long term considerations.
3. Regulatory Capture
This is when the industries under the control of a regulatory body (i.e. a government
agency) appear to operate in favour of the vested interest of producers rather can
4. Disincentive effects
When government policies tend to have negative effects on incentives, benefits and
productivity of producers (i.e, higher rates of income tax is deemed to have a
negative effect on the incentives of wealth-creators in the economy and generally
acts as a disincentive to work longer hours or take a better paid job.)

5. Government Intervention and Evasion

A decision by the government to raise taxes on de-merit goods such as cigarettes
might lead to an increase in attempted tax avoidance, tax evasion, smuggling and
the development of grey markets where trade takes place between consumers and
suppliers without paying tax.
6. Policy decisions based on imperfect information
How does the government establish what citizens want it to do in their name? Can
the government ever really know the true revealed preferences of so many people?
Often a government will choose to go ahead with a project or policy without having
the full amount of information required for a proper cost-benefit analysis. The result
can be misguided policies and damaging long-term consequences.
7. The Law of Unintended Consequences
The law of unintended consequences is that actions of consumer and producers
and especially of governmentalways have effects that are unanticipated or
"unintended." Particularly when people do not always act in the way that the
economics textbooks would predict
8. Costs of administration and enforcement
Government intervention can prove costly to administer and enforce. The estimated
social benefits of a particular policy might be largely swamped by the administrative
costs of introducing it.