Economics and the Environment, 8th Edition

CHAPTER 15Incentive-Based Regulation: Theory

15.0 Introduction

In the late 1960s, when major new environmental legislation was being contemplated, economists had a bit of advice to offer: why not harness market incentives to control pollution? The basic idea was twofold. First, make polluting an expensive activity. This would both directly reduce pollution and induce a search for less-polluting substitutes. Second, lower the costs of pollution control by leaving decisions about how specifically to reduce pollution up to firms and individuals.

Two schemes were widely discussed. The first was a pollution tax (also known as an effluent or emission charge or a Pigovian tax).¹ For example, to reduce the acid rain caused by sulfur dioxide emissions from power plants, one could impose a tax on emissions of, say, $200 per ton of ${\text{SO}}_2$. Alternatively, one might achieve a rollback through a cap-and-trade system (also known as tradeable permit or marketable permit systems). Here, permits would be issued only up to a certain target level of emissions. These permits could then be bought and sold, again putting a price tag on pollution. These two regulatory approaches—pollution taxes and cap-and-trade systems—are referred to as incentive-based (IB) regulation, because they rely on market incentives to both reduce pollution and minimize control costs.

As we saw in Chapter 13, the recommendations of economists were largely ignored in the drafting of the major environmental legislation of the early ...