No. 6 December 1994


Application of Economic Instruments to the Environment

by Jyoti Painuly, Indira Gandhi Institute for Development Research, Bombay, India

Market-based approaches that use economic instruments to deal with environmental problems have generated considerable interest in recent times. Economic instruments have been applied in some form in several countries, but their application to address environmental problems has been limited and mostly confined to single developed countries. The possibility of applying economic instruments at the international level is now being explored by several experts. So far the only international application has been within the European Union (EU). Although several issues need to be resolved , the approach offers considerable potential for addressing local and global environmental problems.

Direct regulation or "command and control" is a popular approach all over the world to address environmental pollution problems. In this approach standards are set on pollution levels and these are monitored. Compliance is made mandatory through regulatory measures. The standards can be on discharge limits for pollutants, concentration of pollutants, or a specific low polluting technology could be specified for a production process. In some cases an outright ban could be imposed on toxic pollutants. The command and control approach has been in existence for a long time, pollution control authorities are comfortable with the approach, and in fact several developed countries have been able to control pollution using this approach.

However, regulation requirements have increased rapidly with expansion of economies and by 1980 several developed countries were incurring pollution control costs in the region of 1.25 to 1.65 per cent of their GNPs. At the same time some studies showed that in several cases, using least cost options, the same level of pollution abatement could have been achieved at a fraction of the cost (20 per cent to 50 per cent), because most of the time least-cost options were not available to the polluters under command and control regime. This caused several governments to explore market based approaches (economic instruments) to reduce the pollution abatement costs.

Pollution charges of different kinds like emissions charges, product charges etc. were introduced. In some cases subsidies to switch to less polluting technologies were also provided. Market creation, involving the assignment of tradeable pollution rights, was also introduced in the USA.

Experience on the application of economic instruments has been a mixture of success and failure. Analysis of the failures has pointed to a half-hearted approach in the use of economic instruments. Though the command and control approach may be useful in some

cases, the overall superiority of the market approach in pollution control was established from the experience. The major benefits that the market approach offers are:

One of the most effective uses of economic instruments was that of the market creation programme in the USA, which is estimated to have saved US $ 5 to 12 billion in achieving the desired level of pollution reduction.

Several developed countries like Canada, Sweden, and Norway are in the process of enlarging the role of economic instruments in pollution reduction, but very few developing countries have explored this option. Arguments advanced against introduction of economic instruments on a wider scale are the absence of well developed markets, the immature stage of development, lack of awareness and understanding of market functioning by polluters. The introduction of economic instruments on a modest scale at the market development stage itself, however, can provide valuable experience for the future and accelerate their diffusion. Issues like appropriate institutional mechanisms, monitoring, resource transfers and compensation to victims, type of instrument and level of application etc. can be perfected only if a start is made. Pollution control is a major issue in several developing countries and experience shows that it can be done most efficiently using economic instruments.

Application at international level

Whereas application of economic instruments within a country can reduce pollution at national least cost, application at the international level can achieve global pollution reduction at global least cost. On efficiency grounds and to achieve global cost minimisation, the use of economic instruments is warranted to address global environmental problems.

Some experts suggest that initial application of the approach should be restricted to a few developed countries and subsequently expanded to include developing countries. They argue that developing countries do not have experience or infrastructure for implementing market based approaches. On the other hand, many developing countries regard market-based instruments with suspicion. An application limited to developed countries has disadvantages of inefficiency and higher costs in global pollution reduction. The participants (developed countries) thus turn out to be losers.

Developing countries also lose in this case, because an efficient market approach is based on the "polluter pays principle". Most of the polluters are in developed countries whereas efficient (cost-effective) opportunities exist in both developed and developing countries. In a system that allocates rights to pollute in a fair manner or provides compensation to non-polluters, resource transfer would occur from developed to developing countries. Thus from the global as well as the developing country perspective, the application of economic instruments to global environmental problems is desirable.

Current discussions on economic instruments focus on carbon tax and tradeable permits. Both have a potential to deliver global benefits by reducing global pollution at low costs. However, the resource transfer quantum and its direction may vary depending on the exact mechanism. The only mechanism agreed in principle by the international community is "Joint Implementation" (JI), which is included in the UN Framework Convention on Climate Change (FCCC). Different views on JI and its realisation have been expressed by experts, NGOs and various governments. If framed properly, JI also has the potential to simulate the tradeable emission permit system. Efforts need to be focussed in this direction to maximize global benefits.

The study was carried out while Dr Painuly was a guest researcher at the UNEP Centre in 1993.

Dr. J. P. Painuly's email address: pnl@agni.ernet.in

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