B1.1.5 Market Instruments
In environmental law and policy, market-based instruments are policy instruments that use markets, price, and other economic variables to provide incentives for polluters to reduce or eliminate negative environmental impacts. They 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.
Examples include environmentally-related taxes, charges and subsidies, emissions trading and other tradeable permit systems, deposit-refund systems, environmental labelling laws, licenses, and economic property rights. For instance, the European Union Emission Trading Scheme is an example of a market-based instrument to reduce greenhouse gas emissions.
Implementing a market-based instrument commonly requires some form of regulation. Market based instruments can be implemented in a systematic manner, across an economy or region, across economic sectors, or by environmental medium (e.g. water).
Market-based instruments do not prescribe that firms use specific technologies, or that all firms reduce their emissions by the same amount, which allows firms greater flexibility in their approaches to pollution management.
Types of Market Instruments
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.
An argument against permits is that formalising emission rights is effectively giving people a license to pollute, which is believed to be socially unacceptable. However, although valuing adverse environmental impacts may be controversial, the acceptable cost of preventing these impacts is implicit in all regulatory decisions.
Taxes
A market-based tax approach determines a maximum cost for control measures. This gives polluters an incentive to reduce pollution at a lower cost than the tax rate. There is no cap; the quantity of pollution reduced depends on the chosen tax rate.
A tax approach is more flexible than permits, as the tax rate can be adjusted until it creates the most effective incentive. Taxes also have lower compliance costs than permits. However, taxes are less effective at achieving reductions in target quantities than permits.