Citation: Sharon Beder, 'Economic Incentives for Environmental Protection', Ecodate, 15(3) July 2001, pp. 6-7.

This is a final version submitted for publication. Minor editorial changes may have subsequently been made.

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Economists argue that environmental assets, because they are free or underpriced, tend to be overused or abused, thereby resulting in environmental damage. Economic incentives seek to correct this situation by setting a price for environmental damage or creating ownership rights to environmental goods.

Some environmental resources–such as timber, fish and minerals–are bought and sold in the market. But their price usually does not reflect the true cost of obtaining them because it does not include the cost of the environmental damage that may ensue from their extraction and processing. Other environmental resources such as the atmosphere and waterways are public or social goods that are not individually owned, or bought and sold, and do not have a market price. Economists argue that there is a strong tendency for people to overexploit and degrade these common property resources.

When individuals or firms make decisions about production, consumption and investment, they generally do not consider the environmental or social consequences because they seldom have to pay the cost of those consequences. For example, a company that discharges its effluent into a river affects fishers and other users of the water downstream. Yet the costs suffered by downstream users are not charged to the company nor built into the price of the company's products. The market does not take account of these environmental costs and they do not appear in the company’s account books. These ‘spillover effects’ of doing business have been called ‘externalities’ by economists, indicating that they are external to normal market transactions.

The presence of these externalities represent a failure of the market to protect the environment. Economists seek to address this market failure by adjusting prices so that the person buying the goods or services causing the external cost is obliged to pay for it. This can be done by means of a tax–for example, on coal mining to cover the medical expenses of those miners who are suffering from black lung disease. The additional costs may also provide an incentive to the coal industry to find ways to prevent miners from getting this disease.

There are other ways of internalising environmental costs without relying on the pricing mechanism. One example is to require a company to take its water downstream from its discharge point. Laws force the polluter to take notice of external costs by prescribing limits to what can be discharged or emitted. Legislation can also cause costs to be internalised if it forces companies to pay for cleaning up their wastes.

Economists argue that this could be done more effectively if people and firms were charged real prices for using the environment. Economic instruments aim to make these external costs part of the polluter’s decision, by adding a charge or by in some way providing a monetary incentive for considering the environmental and social costs. This ensures that environmental considerations are incorporated into market decisions.

While legislation is aimed at directly changing the behaviour of polluters by outlawing or limiting certain practices, economic instruments aim to make environmentally damaging behaviour cost more. Under these market-based policies, polluters are not told what to do; rather, they find it expensive to continue in their old ways and they are presented with a choice about how they can change. Usually, economic instruments are used in conjunction with legal measures.

The Commonwealth Government identifies two main types of economic instruments for providing an incentive to use resources sustainably:

Price-based Measures

Not all pricing and taxation measures employed by the government are aimed at environmental protection. They may also be used to promote other goals and may have an unintended impact on the environment. However price-based measures aimed at protecting the environment are referred to as economic instruments. They include:

Subsidies and bounties

Subsidies are payments from the government to the producer which effectively reduce the price of goods or services, and therefore encourage their sale. Subsidies include tax deductions and rebates. A similar device is a bounty that is paid to the producer for the goods produced (rather than one that is paid when goods and services are bought).

For example, some tax-deductible activities–for money spent on soil conservation, recycling schemes or for donations to environmental groups–are aimed at encouraging environmentally beneficial behaviour. The government can also provide grants for particular programs and projects, including environmental projects such as the National Soil Conservation Program. Another example is grants for environmental technology.


A charge can be considered as a ‘price’ that is paid for polluting the environment. Charges include:

Deposit-refund systems

The most well-known deposit-refund system is that used for soft-drink bottles. This traditional mechanism for encouraging people to return bottles for recycling has largely disappeared, although it is still used in South Australia, and environmental groups such as Friends of the Earth are lobbying for it to be reintroduced into other Australian states. Basically, with such a system, a potentially polluting product is given a price that includes an amount which is refundable if it is returned.

Rights-based Measures

Some economists argue that environmental degradation occurs because of incomplete ownership of rights to use valuable resources. In situations where the environment cannot be privately owned, access rights or user rights can be owned. The idea of rights-based measures is that if people have a right to the use or pollution of natural resources, they will consider the longer term and manage those resources sustainably. The idea is also to create markets so that ‘the power of the market can be harnessed to environmental goals', and individuals or firms can then use their superior knowledge of their own activities to choose the best way of meeting environmental standards.

Tradeable pollution rights (Emissions Trading)

Tradeable pollution rights are an alternative to pollution charges which allow firms to trade the right to emit specific pollutants. The idea is that some firms can reduce their pollution more cheaply than others. Those firms that can most afford to reduce their emissions are able to sell their excess rights or permits to those companies that find it expensive to reduce their emissions.

The two main ways of initially allocating tradeable pollution rights are usually referred to as grandfathering and auctioning. Grandfathering involves allocating permits to firms on the basis of their past emissions. Firms that polluted more in the past would have larger shares. Alternatively a prespecified number of pollution allowances can be auctioned off to polluters. In either case the total allocation can be based on the estimated capacity of the environment to take a certain amount of pollution.

If the permit that a company is allocated or has bought is less than their actual emissions then such firms would have to either try and reduce their emissions or buy extra permits. Similarly they would be able to sell those they don’t need if they reduce their emissions below what they are permitted to emit.


Grandfathering favours existing firms and disadvantages new firms wanting to set up. In order to establish itself, a new firm must buy up enough pollution rights to cover its emissions. Ironically, it is often easier and cheaper to install clean technology processes when a firm is newly established than to refit an older established firm that has outdated and polluting equipment. Alternatively the government can increase the amount of rights available and give the new firm an allocation. This latter option will increase the amount of pollution and defeat the purpose of trying to reduce overall emissions.

Auctioning means that each firm has to bear additional costs just to operate as they have to buy permits at auction to emit gases they had previously been emitting for nothing. This is especially hard for firms that are competing with overseas firms not having to bear these costs. It is for these reasons that auctioning appears to be less acceptable to industry, than grandfathering.

A major drawback of emissions trading is that it can cause some neighbourhoods to get a lot of more pollution than others because the companies in their area are buying up permits rather than reducing their pollution. Also emissions trading tends to protect very polluting or dirty industries by allowing them to buy emission rights rather than meet environmental standards. In this way, trading can reduce the pressure on companies to reduce their emissions, for example by changing their production processes.

Some environmentalists argue that it is preferable in the long run for firms that cannot make the environmental grade to go out of business and make way for other firms that can produce substitute products in a cleaner way. Opponents also argue that emissions trading sends the wrong signals. It sends the message that it is the polluters who should decide what trade-offs should be made between economics and environmental quality.

Theory vs Reality

The evidence of how well tradeable pollution rights have worked in practice is mixed. Whilst proponents claim that a given environmental standard can be met for much less cost, opponents argue that the environment benefits little from such schemes. For example in Los Angeles there are two schemes to improve air quality. One is the Regional Clean Air Incentives Market, RECLAIM, which enables the trading of smog causing nitrogen oxides and sulphur oxides. An internal audit by the South Coast Air Quality Management District found no significant emissions reductions between 1993 and 1997 when the audit was done. James Jenal from Citizens for a Better Environment claims this happened because companies were able to inflate the baseline of allowable emissions, enabling an additional 40,000 tons of air pollution which would not have been allowed under the previous regulatory regime.

The second scheme introduced in Los Angeles, was a trading scheme enabling companies to offset their emissions by scrapping cars, that is, removing older more polluting cars from the roads. Some twenty thousand cars were scrapped in this way, but critics argue that these cars were often barely running and would not have continued to be used much longer anyway.

The introduction of emissions trading as a mechanism for greenhouse gas reductions has the potential to enable similar "phony" reductions. The most obvious is the trading of emissions credits with Russia and other eastern European countries that are in economic decline. Russia’s economic decline has meant that its carbon dioxide emissions have decreased by some 30% below 1990 levels. Now countries such as the US and Japan are looking to buy the right to those emissions which Russia is unable to use so that they don’t have to reduce their own emissions. This will not benefit the environment or help to reduce the global emissions of greenhouse gases in the long-term because the reductions that would have occurred without emissions trading are now being used by affluent countries to avoid their own emissions reductions. They are referred to as "hot air" or "phantom" emissions reductions.

In the case of price-based measures, their effectiveness will depend on whether the prices or charges are high enough. The OECD has found that, in most countries, charges are too low to provide an incentive; instead, they merely act to redistribute money from the polluter to the government. Governments can use the money raised in this way for environmental protection, such as collective treatment and research into pollution control technologies; but often they do not.