Policy instruments available to government in environmental protection are generally classified as either regulatory or economic, although the division is often blurred at the border. The OECD has provided the following definition:

"lnstruments could be labelled as "economic" insofar as they affect estimates of costs and benefits of alternative actions open to economic agents, with the effect of influencing decision-making and behaviour in such a way that alternatives are chosen that lead to an environmentally more desirable situation than in the absence of the instrument." (OECD, 1 989:1 2)

There are two main classes of economic instruments, those which create property rights to environmental resources and those which act on prices. Across these two categories, the OECD has identified the following range of economic instruments:

• tradeable emission rights or permits;
• charges levied on inputs, outputs, users or emissions;
• deposit-refund schemes;
• subsidies including grants, soft loans and tax allowances; and
• financial enforcement incentives such as performance bonds and noncompliance fees.

Economists have argued in favour of economic instruments at least since the early 1960's and, indeed, economic instruments have been used in environmental protection in Europe and the United States over the last 20 years. In most cases economic instruments have been adopted as supplements to, rather than substitutes for, regulation. For example, the European Council of 26 June 1989 in Dublin adopted in its Declaration a chapter on environmental issues containing the following statement:

"Standards designed to ensure a high level of environmental protection will remain the cornerstone of environment policy. But the traditional "command and control" approach should now be supplemented, where appropriate, by economic and fiscal measures if environmental considerations are to be integrated into other policy areas, if pollution is to be prevented at source and if the polluter is to pay." (Commission of the European Communities, 1990:2)

In Australia most of the recent reports on environmental protection have mentioned the potential advantages of economic instruments, at least as an option for consideration. For example, the Commonwealth Discussion Paper on Ecologically Sustainable Development (June 1990) acknowledges that "It would now appear desirable to pay more attention to the contribution that economic analysis and market-based measures could make to achieving environmental objectives efficiently and effectively."

In New South Wales the possible use of economic instruments figures in the "Discussion Paper on Establishing the EPA" (July 1990) and in the companion "Information Paper on the EPA" (January 1991), both published through the Ministry for the Environment. In reality, economic instruments, in the form of increased charges for use of environmental resources have been implemented over the past year by the Water Board and the Waste Management Authority. The SPCC and the Water Board have also introduced the use of performance bonds as a form of financial incentive/disincentive. These bonds provide another economics-based instrument in the absence of an operating property rights model. Tradeable emission permits usually are prominent in a property rights model, and these are considered in the next section, followed by attention to charges and deposit-refund systems.

Tradeable Emission Permits

Tradeable emission permits (TEPs) are quotas, allowances or ceilings on pollution emission levels of specified polluters that, once allocated by the appropriate authority, can be traded subject to a set of prescribed rules. Tradeable permits give the polluter a marketable property right to use a specified amount of the disposal capacity of the land region, water system or air shed.

If the total amount of pollution allowed under the sum of the permits is set by authorities at less than existing pollution levels, then permits have a scarcity value and therefore can be traded at a positive price among firms. Firms whose clean-up costs are less than the market price of the permits may decide to sell their permits and firms whose costs are greater than the price of the permits become potential buyers. In theory this results in a least-cost reduction in pollution while meeting ambient quality goals, at whatever level they are set to meet the community's preferences.

Tradeable permits may be allocated initially by either assigning them to firms in proportion to their existing pollution rates (grandfathering) or by auctioning the quota of allowable permits.

The concept of TEPs first arose in the United States in the 1960's and these instruments are still used mainly in the United States, and to a lesser extent in Germany. Tradeable emission permits currently are a topic of much discussion among policy makers in Australia and it is worthwhile examining their history in some detail.

The United States Environmental Protection Agency (USEPA) began in 1974 to experiment with the use of TEPs to allow firms greater flexibility and to provide efficiencies in meeting national air quality standards. The success of this experience has been reviewed extensively, especially by Professor Robert Hahn and his colleagues. (Hahn 1988, Hahn 1990, Hahn and Hester 1988 and Hahn and Hester 1989)

The US EPA's emission trading program extended rather than replaced the regulatory system established under the Clean Air Act, which assigned responsibility for setting air quality standards to the federal EPA and responsibility for their implementation to the states. Those air quality regions which achieved federally established ambient air quality standards when they were formed were called "attainment areas", with the rest designated "non-attainment areas". Each state was required to develop a State Implementation Plan (SIP) for EPA approval, detailing which sources of pollution would be regulated and how this would be done.

Emission standards state the amount of a given pollutant that a particular type of source may emit. They are generally more stringent for new sources than established sources and for non-attainment compared with attainment areas. States implement emission standards through permit systems described in SlPs.

Emission trading allows the exchange of emission rights both between and within firms. In the United States an intricate program was developed, which featured individual firms generating credits for reducing emissions and then being allowed to trade those credits in a marketplace. The commodities exchanged are emission reduction credits which are, in effect, property rights to emit air pollutants.

Emissions trading encompasses four programs:

• Netting allows a firm creating a new emissions source within a plant to reduce~ emissions from another point source in the plant so that net emissions across the plant do not increase significantly. The firm can thereby avoid the stringent emission limits which would otherwise apply to the new source
• Offsets have been developed as a way of allowing new development in non-attainment areas, while ensuring that emissions continue to fall toward the set ambient standards. The offset rule specifies that new emission sources may be located in non-attainment areas but only if they offset new emissions by even larger reductions from existing sources. Offsets trading may occur within or between firms.
• Bubbles allow a firm to sum the emission limits for individual sources of a pollutant within a plant, and to adjust the levels of control applied to different sources so long as the aggregate level is not exceeded. Bubbles apply to existing sources and can extend across more than one plant or firm in a particular geographic area.
• Banking allows firms to save emissions reduction credits for future use in emissions trading (Hahn and Hester, 1987:49).

The generally agreed evaluation of the TEPs program in controlling air quality in the United States is that it has led to cost savings in the billions of dollars but has had a negligible impact on environmental quality. On this basis, the program could be considered more worthwhile for the economic dimension than for the environmental dimension, with the result that more balanced terms of trade perhaps should be built into the equations.

Other conclusions about the United States experience with tradeable permits include:

• netting is the most frequently used activity, followed by offsets, then bubbles;
• most trading is internal to a particular firm, which is possibly the result of high transaction costs;
• banking is almost non-existent; and
• active markets in TEPs have not developed.

An important constraint to the program has been the lack of information on ambient air quality values as well as existing or baseline emission levels of firms. In order to implement the US EPA's program,states required complete and accurate emission inventories, which were often not available. This is likely to be a major concern for New South Wales, where the quality and extensiveness of the databases are not good enough yet to sustain the operation of tradeable permits.

In November 1990 the United States amended the Clean Air Act so that it now relies more heavily on the use of TEPs. For example, the Act's acid-rain provisions place a cap on sulphur-dioxide emissions from electricity utilities but allow them to trade permits for sulphur-dioxide emissions. Other examples of the use of TEPs in the United States is lead phase-down in petrol, and in the water area the programs for the Fox River in Wisconsin and the Dillon Reservoir in Colorado (Hahn & Hester 1988:43).

Of all the examples of emissions trading, the lead phase-down is reported to have been most effective in reducing the costs of environmental compliance. Success has been linked to previous industry experience in trading products and additives, minimal administrative requirements for trading and the ability to bank lead reductions exceeding EPA standards (Moore et al 1990).

The Dillon Reservoir program is especially interesting in that it allows trading between point source polluters and non-point source polluters. The purpose of the program was to reduce the cost of abatement and thus achieve greater reduction in phosphorus to the reservoir by allowing point sources such as municipal treatment plants to trade discharges among themselves or, alternatively, to pay for reduction of non-point source pollution. A further aim is to avoid treatment capacity constraints, such as septic systems and urban runoff, on local economic growth.

In 1984 the Colorado government adopted a plan requiring that advanced treatment techniques be applied to point sources and that non-point sources, new after 1984, be required to use controls to minimise waste loads. The plan also introduced the following trading mechanisms:

• point sources are allowed to acquire discharge rights in excess of the amounts allowed under the plan;
• rights can be acquired from point sources or non-point sources existing before 1984;
• trading ratios are 1 to 1 between point sources and 2 to 1 for point sources acquiring rights from non-point sources (to provide a margin of safety in light of uncertainty about non-point source controls);
• to implement the trade between point and non-point sources, point sources agree to pay for and install phosphorus reductions at non-point sources, acquiring a property right by the credit they get for phosphorus reduction; and
• after 1990, trading for reductions from non-point sources will be the only way to accommodate future municipal waste loads.

An example of one trade to date involved a developer paying for sewering of some septic systems. The Fox River program in Wisconsin involved a trading system for paper mills and other dischargers. It has not proved effective, reportedly because of restrictions on trading, the time required to get state approval and uncertain tenure of the discharge right (Moore et al 1990).

In Australia experience with TEPs is very limited. Tradeable emission quotas have been introduced in effect at the federal level in the phasing out of ozone-depleting gases (chloroflurocarbons and halons). The Commonwealth Ozone Protection Act 1989 establishes a system of quotas for the import, export or manufacture of CFCs and halons. These quotas may be traded by firms across Australia.

The Commonwealth legislation is complemented by State and Territory implementing legislation. In 1989 the New South Wales Government passed the Ozone Protection Act enabling the regulation of the handling of ozone-depleating substances, and the Gazetted Regulation has effect from 31 March 1991.

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