Instruments of purer profit

Economic instruments such as tradeable pollution quotas or financial incentives to limit pollution are desirable because they can achieve environmental objectives at least cost. Among the policies available to governments to deal with environmental problems, economic instruments can deliver the best value.

Regulations, on the other hand, have been shown in many studies to be a costly and inefficient way of achieving environmental or other policy goals. Not only are regulations costly, but for every substantial regulation there are those who seek to profit from avoiding the regulation or advising others of ways around it. In his recent speech introducing the new United States policy on air pollution and climate change, President George W Bush put it well when he said the new legislation "will replace a confusing, ineffective maze of regulations for power plants that has created an endless cycle of litigation. Today, hundreds of millions of dollars are spent on lawyers, rather than environmental protection."

The argument supporting the use of economic instruments in policy is based on the principle that, by turning environmental objectives into commodities, market participants, driven by the profit motive, will work out the most effective ways to provide those "commodities" to society. In other words, economic instruments use the profit motive to prompt environmental action.

The underpinning principles are simple but it can be a complicated exercise to put in place economic instruments that can actually achieve environmental goals in the most cost-effective way. The risk is that poor implementation of economic instruments can create bad environmental results at high economic cost. Poor implementation, together with a regulation or two, could easily lead to a worse overall result than if governments did nothing at all.

An example is the mania for tree planting. It is incorrectly assumed by most people that planting trees is always good for the environment. But trees use water, and planting trees in the wrong places can substantially reduce the amount of water available for other environmental purposes. This could lead to expensive damage, such as reduced surface-water flows, higher salt concentrations in rivers and streams, and reduced returns for farmers in affected areas. A naively structured economic instrument that provides incentives to plant trees without regard to where they are planted will almost certainly not be cost effective.

The debate about economic instruments is complicated. And it is further confused by some of the more vocal members of the economics profession. One recent example is the recent pronouncement by the Australia Institute that Australian governments subsidise aluminium production, thereby generating more greenhouse gases. The claim is made on the basis that aluminium producers apparently receive cheap electricity. But this should not surprise anyone with a basic understanding of electricity markets. Aluminium producers buy base-load electricity in bulk. This type of electricity should be cheap because it costs relatively little to produce. A low price is not necessarily evidence of a subsidy.

Economic instruments have the potential to dramatically lower the costs of international controls of green-house gas emissions. The Kyoto Protocol mandates markets in which the right to emit carbon dioxide can be traded around the world. The idea is that greenhouse-gas-emitting industries in countries where it is expensive to reduce emissions to meet the Kyoto targets would purchase emission rights from countries where emission reduction is comparatively cheap. With careful implementation, this system could be the cheapest way to reduce global emissions.

The same result would hold in a domestic pollution-trading market. The US sulphur-dioxide market is often cited as a good example of such a market - and it is. But does the model easily apply to carbon dioxide, the most important greenhouse gas that is subject to the Kyoto Protocol? Much of the economic theory about carbon dioxide trading systems makes strong assumptions about the economic setting in which the system is introduced. For example, little attention is given to transactions costs and the existence of energy price distortions such as energy subsidies or fuel excise taxes.

It turns out that introducing a carbon trading scheme into a market where there are taxes on fossil fuels will not lead to the most efficient results unless all existing tax distortions are removed, or further taxes are introduced to compensate. Given the wide diversity of taxes and subsidies on greenhouse-gas-producing sectors in many countries, this news will perhaps be greeted by the regulators as another excuse for more regulation. But the clear answer is to clean up distortionary taxes before introducing a permit-trading scheme.

Economic instruments, properly implemented, are the best way to encourage good environmental practices but it is not enough to introduce them without thought and assume that the result will be economically efficient.