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Economic policy instruments and mechanisms

In the forward planning for global eco-restructuring, policy designers are faced with the difficult task of determining an optimal mix and sequencing of various policy instruments. The most crucial of all is that national communities are sufficiently convinced of the urgency of the problem and the feasibility of solutions to accept particular targets. Then a plausible policy package ought to include appropriate counteractive tax cuts and other institutional incentives to cope with a host of distributional issues arising with the introduction of any new policy instruments - regulatory or market based. It is also important that the timing of introduction is coordinated internationally so as to minimize perturbative impacts on international trade. Furthermore, the notion of a "social net" must be internationalized so as to enable joint implementation with third world people.

In the next section, I first grapple with the economist's perspective, giving heed to the polluter-pays principle and also to the precautionary principle. I then move on to discuss the question of incentives that are crucial in steering the political process of policy-making toward a judicial blending of public and private initiatives. The question of equity will be dealt with in the section on "International Distributional Implications."

Regulatory vs. market-based measures

A report issued by the OECD working group on Taxation and Environment (OECD 1993a) affirms the merits of economic instruments in environmental policy, particularly taxation schemes that affect the very framework of competitive markets.

Economic instruments, as normally defined, are market based in the sense that they influence indirectly the quantitative supply and demand decisions through altered cost-price relations. They keep the market price-cleared and let those polluters with the lowest abatement costs select themselves in response to the signal provided by a pollution surcharge or tax. Environmental taxes and surcharges are meant to cover the social costs not reflected in private costs and benefits. They normally take the form of specific taxes to be levied on each unit of pollution identified (e.g. on the basis of the carbon content of fuels in the case of the carbon tax), thus serving as an incentive to reduce pollution (carbon dioxide emissions) as they increase the polluters' marginal cost of production.

Subsidies (grants, soft loans, and tax allowances or reliefs) provide a similar incentive on the basis of each unit of pollution abatement being effected. In practice, however, most subsidies tend to be paid not in relation to abatement but rather to encourage the development or use of environmentally friendlier technological alternatives. This is apparently not compatible with the "polluter pays" principle. Yet, most specific taxes or charges that are expected to have incentive effects towards environmental protection have been instituted primarily as a revenue-raising instrument earmarked to finance environment related public expenditures, including subsidies.

Tradable permits function as a price-based instrument, although the size of the permit market is administered as a quantity-based regulatory measure. This approach (currently practiced only in the United States on an experimental scale) can guarantee a quantitative reduction in pollution but leaves uncertain the cost of emission controls to individual polluters. The argument over the plausibility of this approach relative to taxes and charges often stresses the contrast in this respect, because taxes and charges leave the quantitative abatement effect uncertain while fixing the cost to the polluters.

Broader definitions of the market-based approach would include enforcement incentives such as performance bonds (refundable upon assured compliance) and non-compliance fines.

These economic instruments are often contrasted to regulatory instruments, which refer to direct controls through quotas or bans in conformity with legislated standards and enforceable through administrative sanctions and/or litigation. The two mechanisms can in theory be used to equivalent effect. But in practice there are important differences.

Regulatory controls are often preferred by policy authorities on the ground that the effects of regulation are more certain than those of taxes and other economic instruments. Individuals and business firms, too, tend to prefer regulations to the extent that they make planning easier. An often-voiced objection to taxation is that the public revenues derived therefrom may be misappropriated or used directly or indirectly for other unspecified purposes. Besides, industry is familiar with the ways of influencing regulatory processes (which are always susceptible to some special exceptions) through lobbying and negotiation. US environmentalists used to object that the use of market mechanisms (in the form of tradable permits) implied "putting the environment up for sale."

Academic literature abounds with the controversy over regulatory versus market-based measures. Much of it hinges on the notion of "efficiency," i.e. the need to find a balance between the (social) costs of pollution and the costs of restricting pollution. One key argument (mostly among economists) in favour of market-based approaches to environmental policy is related to the information cost of regulatory controls. Different firms have different technologies, some incurring much higher costs in pollution abatement than others to a given emission standard. Similarly, the costs to individual households of reducing their use of particular polluting products vary owing to differences in taste and other circumstances. An efficient regulatory policy would require extensive information on those individual differences in abatement cost in order to ensure that abatement measures concentrate where reductions in pollution can be achieved at least cost. A regulation requiring all polluters to restrict emissions to the same extent would then be more costly than a market-based instrument aimed at the same overall impact (see, for example, Barbier et al. 1994, pp. 178-183).

Interesting as it is academically, this sort of argument does not seem to carry decisive weight in guiding the actual process of public choice between regulatory and market-based policy instruments. For example, in the case of local environmental problems, such as water pollution and waste disposal, the assimilative capacity of the environment may vary from one locality to another. Then a straightforward tax per unit of pollutant emitted may imply that firms in areas of low pollution are charged more than the value of the damage they inflict on the environment. Unless the tax rate is differentiated geographically with adequate information on the assimilative capacity of the environment, it cannot claim to be more efficient than the regulatory alternative.

Indeed, bureaucratic solutions that require the regulators to become too closely identified with firm-by-firm interests may be vulnerable to so-called "regulatory capture." However, market-based instruments are not without similar drawbacks. There is the risk that even "green" subsidies become an indirect or disguised protection to the industries considered. For that reason, the polluter-pays principle, as adopted by the OECD, is based on a baseline of zero subsidy as the most readily identifiable rule (OECD 1991).

In the case of global environmental problems, such as climate change and biodiversity, the question of "threshold values" for ecosystem parameters (i.e. the limits beyond which ecosystems are likely to collapse) complicates the design of appropriate policies. This is certainly a more serious matter than the information cost. The burden of "green" taxes would fall quickly upon consumers in general rather than upon the polluters immediately responsible for eco-degradation. Under uncertainty, people become suspicious that taxes and other economic instruments might not prove effective in countering ecological degradation. If the thresholds are not well known, or if the likely damage is uncertain, regulatory controls, too, can become vulnerable to the suspicion that they might produce more than adequate abatement effects at unnecessary cost to producers and final consumers. In such circumstances, pressure may emerge for deferring any substantial environmental policy change (be it for a new tax or a regulatory standard) in favour of "further studies and research" for greater certainty. This could easily gain political legitimacy on the ground that the expected economic efficiency loss be minimized.

True, both regulatory and market-based approaches require enforcement, which in turn requires effective monitoring systems and administrative and legal apparatuses to ensure compliance. The relative effectiveness of alternative policy instruments depends very much on the institutional effectiveness of the tax authority and environmental authority in each country in managing the process of enactment, enforcement, and compliance. The recently growing emphasis on the use of market-based instruments seems to stem from the reflection that these have in fact been long underutilized in environmental policy.

Even countries relatively more advanced in environmental policy, such as Sweden and the Netherlands, have relied mainly on instruments of the command-and-control type, coupled with a variety of specific-purpose taxes for raising revenues for environment-related subsidies and public expenditures. The environmental taxes introduced in the Swedish tax reform of 1990/91 included carbon dioxide and sulphur taxes on fossil fuels, chosen explicitly for their incentive effects rather than their revenue effects. The US feedstock tax on petroleum and chemical industries serves simply as a revenue source for Superfund operations, and none of the many bills proposing various environmental taxes submitted to the Congress has yet reached the level of support needed for enactment (as in many other countries).

The spate of policy assessments in favour of market-based measures in recent years in OECD countries may well be seen to be contingent on the continuing trend towards "smaller government" with a reformed fiscal package. Various existing taxes for revenue raising purposes with or without environmental objectives may be reconsolidate into a new environmental policy package, such that there may be an opportunity for tax and subsidy cuts elsewhere. The Swedish case may provide a useful model for an extensive package deal that involves simultaneous adjustments of both fiscal and environmental schemes (OECD 1993b).

An outlook on the eco-tax

Proponents of the precautionary principle argue that a first necessary step should be to ensure that the current unsustainable market economy be redirected towards, if not immediately onto, an eco-development path. Knowledge of the social costs of crossing ecological thresholds is crucial for a societal decision on whether a specific limit should be imposed on economic activity. The determination of boundaries to the resilience of the whole complexity of ecosystems is itself a complex - and perhaps intractable - object of study. Hence, a precautionary decision would necessarily involve an ethical judgement concerning a margin of safety on our continued use of natural capital.

The ethical element seems to weigh even heavier in the case of the conservation of biodiversity than in the case of climate control.

The value of biodiversity needs to be established, not just in terms of personal preference. The ultimate decision cannot be based on whether every living entity is worth preserving "in its own right." It must be based on more fundamental scientific criteria, especially with regard to the essential role of biodiversity in assuring the resilience of ecosystems on which our economic activities depend. Biodiversity loss is unusual with respect to both the range of people affected (local, national, and international) and the degree to which it encompasses both unilateral and bilateral externalities. Ecological functions and resilience are sensitive to the mix of species, and a change in the mix can potentially have irreversible consequences. The interrelationships between biodiversity, ecosystem resilience, and the threshold effects of degradation thus remain an important challenge to ecological economics (Barbier et al. 1994).

In the spirit of the Slippery Hill strategy, the first piece of wisdom is, in the context of climate change policy, to put some moderate scale policy into place concentrating on fossil fuel combustion. An example of such a policy might be a carbon (fossil fuel) tax that would reduce carbon dioxide (CO2) by 20 per cent and inadvertently reduce sulphur dioxide (SO2) emissions by 21 per cent and nitrogen oxides (NOx) by 14 per cent (Barrett 1991, p. 68). This would satisfy at least part of the conditions for "efficient" policy. Major sources would automatically be provided with incentives to reduce the marginal unit of net emissions to the point where the cost of doing so equals the emission charge avoided.

Economists are still ill at ease in predicting the power of a carbon tax. The large number of estimates thus far published (Nordhaus 1992, Cline 1992, 1993, Edmonds and Reilly 1983, Ferriter 1993, Manne and Richels 1992, Amano 1992, etc.) are not quite comparable one to another in regard to the modelling structure, the context, and the basic assumptions adopted. Broad agreement exists among mainstream econometric modellers that the higher the tax rate the greater the economic cost in terms of loss of potential GNP growth (Dean and Hoeller 1992). There is also agreement that the feedback effect through technological innovation can make the power of the tax greater in the long run than in the short run (although it is difficult to predict the pace of such innovations). Others (mostly non economists, some represented in this volume) favour the so-called "double dividend" argument: that is, there are many unexploited opportunities to reduce both energy consumption and energy costs, whence, rather than cutting economic growth, the opposite might occur.

In designing an aggressive action programme to reduce emissions by one third from the baseline, Cline (1992, 1993) allowed for a milder first phase with a cutback of 10-15 per cent during the first decade. Manne and Richels (1992) also suggested a cutback by some 12 per cent by the year 2000. The "optimal" cutback emerging from Nordhaus (1992) pointed to the order of 9 per cent by 1995. It is a relief to see a good degree of convergence emerging at least about the first-decade proposals.

The difficulty of determining the power of a tax lies among others in estimating the likely magnitude of the "double dividend" effect of the carbon tax on energy efficiency and substitution technologies. Closer dialogue between technologists and economists may in time dissolve this source of difficulty. Another, possibly less tractable, difficulty relates to the volatility of energy markets in responding to new taxes and other disturbances. Certainly energy markets are complex in terms of the structures of the demand for and supply of the mix of more, or less, substitutable fuel mixes. Their supply systems are dynamically linked to massive capital investments. And their demand systems are heterogeneous from sector to sector and from region to region. They interact with institutional rigidities. Resistance to change is particularly strong on the part of the notoriously conservative automotive transportation and petroleum refining/distribution sectors.

Although OECD countries already have some experience with various policy measures for energy systems management, further learning by doing is needed before the international community is equipped with a consensual knowledge base robust enough to tackle the steep path toward eco-development. The use of any policy instrument has differential effects on different individuals and countries. Even if the overall benefit of introducing a small carbon tax is very small, its short-term distributional implications can generate politically obstructive forces. The time has come for OECD countries, even if limited for the time being to certain "leading coalition" members, to carry through the first-stage socio-political experiments with a modest eco-tax system. (The Scandinavian countries have already started to do so.)

Much greater uncertainty remains from the perspective of the third world. The scenarios based on a target of stabilization of greenhouse gas (GHG) emissions at 1990 levels point to the need for a significant break between what is happening today (doubling energy demand every decade) and what is desirable (doubling only over 30 years, 1990-2020) (Churchill 1993). Much of future energy demand growth is likely to arise from the relatively price-insensitive transportation and heavy industry sectors. Once the capital investments are made, energy demand is locked in for many decades thereafter.

On the other hand, there is greater scope in the third world for improving management systems at both micro and macro levels. This is especially true of the existing, grossly inefficient, public utility sectors. Such basic institutional reforms, coupled with an accelerated transfer of cleaner and more economical technologies from industrial countries, would have a substantial cost-reducing effect. Yet there is a strong suspicion that a reduced energy cost might lead to a higher pace of energy demand growth in developing countries than otherwise (Churchill 1993).

Carbon taxes are likely to have the greatest effect on coal use (coal is the most carbon-intensive fossil fuel). Thus, measures for opening up access to liquefied natural gas (LNG) and other less carbon intensive energy sources, and building the necessary infrastructure such as gas pipelines, would be essential in countries such as China and India (which are among the world top 10 carbon dioxide emitters). Indeed the initial first-decade CO2 abatement effort may have to concentrate in the industrial countries. A more global response will be needed in subsequent decades, including developing regions. But, first, a consensual, politically palatable knowledge base must be developed for assessing the benefits and costs of GHG abatement in developing countries.

Transnational corporations' responses to new environmental agreements: How to "get the incentives right"

The link between causes and effects is often so far removed in space or in time that social and private interests can diverge widely even within a country. The costs and benefits of an environmental regulation fall differently upon different groups. Mancur Olson (1965) pointed out the classical problem of under-provision of public goods: when benefits from a public good are distributed over many people, each of whose contribution is small relative to the total cost of provision, the good will not be supplied in optimal quantity, unless institutional arrangements exist that induce incentives to provide it. The reverse side of this argument runs that public goods may be provided even in the absence of such a political institution, if a small "privileged" group can benefit from providing the goods. George Stigler (1971) elaborated the latter side of the argument in the context of cartel theory and regulation.

The classical Olsonian situation is thus such that the benefits of a regulation are diffused whereas its costs are concentrated on a few (as is the case with regulations on emissions of pollutants for cleaner air and water, and those on habitat destruction for biodiversity conservation). This is contrasted with the so-called Stiglerian situation in which regulatory benefits are concentrated on a few privileged actors while costs are diffused over many. When the benefits of a new regulation for the management of common-pool resources (such as the environment) are concentrated on those firms that are in possession of relevant new environmental technologies that can promise quasi monopoly rents, such firms will be willing to coalesce with the environmentalists pressing for the regulation. A classical Stiglerian illustration is offered by the Montreal Protocol (1987). Its successful adoption only two years after the signing of a framework convention in Vienna (1985) can be said to be due to the concordance of economic incentives, political values, and scientific knowledge (Oye and Maxwell 1995).

Leading producers of chlorofluorocarbons (CFCs), particularly DuPont, followed by ICI, came to recognize incentives to support the Montreal Protocol for the protection of the ozone layer by the time the framework convention was signed in Vienna in 1985. During the decade prior to that, their research on CFC substitutes, initiated in the mid-1970s, had been discontinued on account of the lack of a market, and they had opted to impede the agreement-making process. In 1986, DuPont, having suffered over-capacity since the 1977 US ban on CFC use in aerosols, proposed an international agreement to limit worldwide CFC production to the then existing level. For a while the Montreal negotiation heard debates in which it sounded as though the critical issue was which companies were going to gain an advantage over which others (according to Mustafa Tolba, then the UNEP Executive Director). By 1988, ICI announced its intention to join DuPont in a rapid commercialization of CFC substitutes, prompting the UK and EC commitment to the eventual phase-out of CFCs.

Other examples of Stiglerian solutions can be seen with such regulations as:

- banning the use of leaded gasoline (for higher-profit production of unleaded gasoline);

- restricting the sale of DDT (to prompt a shift from the cheap, easy-to-produce chemical towards safer, more difficult-to-produce substitutes);

- requiring recyclable packaging (suspected of creating a barrier to non-German firms' entry in the German market);

- requiring special procedures and techniques for the handling and disposal of medical wastes (in favour of large waste-disposal firms equipped with special technologies);

- banning the sale of "immature" lobsters in the US market (aimed at raising a barrier to the entry of Canadian lobsters, which attain sexual maturity at a smaller size in cold waters);

- restricting development zones through strict environmental impact assessment (with rents accruing to the owners of previously developed properties at the expense of new developers).

In the Olsonian situation, there is no natural coincidence of business interests with the common good. So, in the absence of subsidies or compensatory payments, those who are the first to be affected by a regulation are likely to be the first to get organized to overturn the regulatory move. In this context, the slow progress on automotive emission regulations in the United States may well be contrasted with the relatively quick adoption of an even more stringent NOx standard (0.25 ppm) in Japan (in 1978).

In the United States, in spite of the adoption of the Amendment of the Clean Air Act as early as 1970, polarized debates have long remained unsettled between the Environmental Protection Agency (EPA), the National Academy of Sciences (NAS), and the automobile industry. Meanwhile, in Japan, the initial coalition of the automobile industry and the Ministry of Trade and Industry resisting the Environment Agency's proposal to adopt the 1970 US Clean Air Act Amendment standards was coaxed away by a skillfully managed incentives package. The Ministry of Finance agreed to reduce motor vehicle purchase taxes and ownership taxes for passenger cars that met the 1975-1978 emission standards. And the Ministry of Transport adopted less demanding test procedures for those cars (Oye and Maxwell 1995).

However, a great deal of care must be exercised to ensure that a policy package is both reasonably efficient and fair. In coping with the Olsonian situation, a general compensatory scheme for all those likely to be affected by regulation would be just too expensive. Besides, compensatory offers do not always reduce the intensity of opposition because, at times, an expectation of greater compensation might just intensify anti-regulatory lobbying. On the other hand, selective compensation aimed at only major burden-sharers in order to drive wedges into anti-regulatory coalitions may be less expensive but is problematic from the standpoint of fairness. A similar problem arises with the Stiglerian solution. The Montreal Protocol did in fact put minor, technologically less advanced producers at a disadvantage. The global ban envisaged at the London revision to the Protocol (1990) required compensation to developing countries in the form of a multilateral special fund to provide financial assistance to their phase-out efforts.

By the same token, the ideological shift toward privatization and market based approaches, now increasingly widely shared in the international community, does not on its own guarantee an efficient and fair industry government partnership towards sustainable development.

Indeed, there now exist numerous international business NGOs (BINGOs) adorned with their own "environmental charters" (e.g. the Coalition of Environmentally Responsible Economies, CERES; the Business Council for Sustainable Development, BCSD; the International Chamber of Commerce, ICC; the International Federation of Consulting Engineering, FIDIC; Alliance Internationale de Tourisme; etc.), along with national industrial confederations such as Keidanren (Federation of Economic Organization) in Japan, the Confederation of British Industry (CBI) in the United Kingdom, and Bundesverband der Deutschen Industrie (BDI) in Germany. However, the BCSD, which contributed an enlightening set of success stories - Changing Course (Schmidheiny 1992) - to the 1992 UN Conference on the Environment and Development (UNCED), draws only on private personal membership. The ICC is known for its ambiguous stance at global environmental forums. Reportedly, it persistently interfered in the drafting of Agenda 21 so as to minimize reference to "transnational corporations" in terms of the allocation of responsibility (Gleckman 1995).

All too often industry proclaims a "self-regulatory" strategy. This is somewhat of a facade, usually consisting of (a) promising "good business practice," (b) pacifying external pressures, and (c) lobbying for favourable governmental incentive measures. The first component stresses a truism that the creation of new markets and improved corporate images (with intra-firm environmental charters and self audit practices) contribute to increased profits. The pacification strategy includes lobbying to delay domestic and international regulatory accords, and guarding consumers against aggressive media. The third component is aimed at settling on a looser regulation than any new tax and justifying specific subsidization and R&D subventions. A recent UNCTAD survey on industry's environmental "self-regulation" concluded that industry commitments still fall short of the provisions of Agenda 21 in the areas of reporting and public disclosure as well as full-cost accounting (UNCTAD 1995).

It is too early to judge yet whether a Stiglerian situation is emerging that is mature enough to propel the protocol-making phase of the global "climate change" regime. A survey study issued by the United Nations on the implications of international environmental law for transnational corporations maintains the hope, on the basis of historical experience, that non-binding instruments, such as intergovernmental declarations, codes of conduct, and guidelines, can be pointers towards future binding international legal instruments. This hope can be sustained as long as those instruments (binding or non-bonding) affect the norms being shared and sooner or later put the states that are parties to them under an obligation to incorporate into their national laws appropriate legislation giving effect to their international legal obligations (United Nations 1993).

The emerging norms are being translated into a series of institutional mechanisms to facilitate market mechanisms to internalize social environmental costs. They include among others:

- public pricing of previously free goods (e.g. waste disposal services);

- national and corporate accounting systems that incorporate social environmental costs in budget forecasts;

- an eco-labelling system that encourages a shift in consumers' preferences towards environment-friendly products;

- a civil liability system that punishes environment- and health unfriendly products and practices;

- a mandated requirement for manufacturers to be responsible for resource preservation over the full life cycle of their products;

- institutionalization of environmental assessment that discourages environmentally unfriendly regional development projects.

Added to these is a more general proposition that includes:

- a reform of national tax systems that is "incentive compatible," with taxes and charges on the use of non-renewable resources rather than on incomes and profits; and

- value-oriented science, technology, and education programmes that enhance the general public's awareness of the requisites of planetary governance, and stimulate research and development for generating new seeds of technology that are of value as (both national and global) public goods.

In order to make the market itself self-correcting, with self regulation and self-reporting on the part of industry, a great deal of institutional innovation will be needed so that the state, consumers, and workers can intervene effectively to prompt the internalization of environmental and natural resource costs into market prices. In both Olsonian and Stiglerian situations, reconciliation and, still better, coalition formation between public environmental interests and private self-interests may be a requisite for climbing up the ever-steeper hill toward the long-term goal of eco-development. There is still a lot of room for further research on the art of designing incentive compatible regulatory systems that are efficient, fair, and welfare enhancing.

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