Economics and the Environment, 10th Edition

16Incentive‐Based Regulation: Practice

16.1 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 Europeans instituted their own EU‐wide CO₂ cap‐and‐trade system back in 2005, called the European Emissions Trading Scheme, EU‐ETS.

The bottom line from all this experience? Permit systems can work very well, but the three big bugaboos that have emerged so far have been thin markets, price volatility, and, in at least one case, a failure to sustain target commitment.

In contrast to broad experience ...