Economics and the Environment, 8th Edition

CHAPTER 16Incentive-Based Regulation: Practice

16.0 Introduction

Pollution taxes. Cap-and-trade systems. Theoretical economic arguments about both the cost and environmental effectiveness of incentive-based (IB) regulation have been instrumental in shifting government policy more and more in these directions and away from command-and-control (CAC) over the last three decades. Has the economists’ case been proven?

This chapter reviews the record of IB regulation, with an eye toward lessons learned. In the United States, we now have substantial experience, primarily with marketable permit systems. Cap-and-trade programs first began in the late 1970s and were spurred on by the success of a trading system that facilitated the phaseout of lead as an additive in gasoline in the mid-1980s. The 1990s saw the most successful large-scale experiment, with the introduction of a nationwide sulfur-dioxide trading program in the power sector to control acid rain. Then in the 2000s, both California and the northeastern states introduced cap-and-trade systems for the global warming pollutant carbon dioxide. The bottom line from all this experience? Permit systems can work very well, but the two big bugaboos that have emerged so far have been thin markets and price volatility.

Following these multiple experiments, in 2009, the United States debated a move toward a national, economy-wide cap-and-trade system for carbon dioxide—a dramatic, high-stakes test of economic theory in all its complexity. ...