Economics and the Environment, 10th Edition

15Incentive‐Based Regulation: Theory

15.1 Introduction

A core insight of economics is that we can and should harness market incentives to control pollution. Economic incentives have two advantages over command and control regulation. First, making pollution an expensive activity both directly reduces pollution and induces a search for less‐polluting substitutes. Second, leaving more decisions about how specifically to reduce pollution up to firms and individuals can lower the costs of pollution control and help lead to new solutions.

Incentive‐based approaches come in two basic flavors. The first is 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 SO₂. Alternatively, one might achieve a rollback through a cap‐and‐trade system (also known as tradable permit or marketable permit systems). Here, permits to pollute are issued only up to a certain target level of emissions. These permits could then be bought and sold by companies, 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 ...