6.5 Solutions: property rights, regulations, and incentive policies  (Page 4/14)

Performance standards also have some drawbacks and limitations, however. It is difficult for a regulator to figure out the cost effective allocation of total pollution reduction between sources and then set different performance standards for each source to reach that cost effective allocation. Hence, performance standards tend to be uniform across individual pollution sources, and so pollution reduction is not done in the cheapest way possible for the industry and society overall. This problem is particularly severe where there is great variation among sources in their abatement costs, and thus the cost-effective allocation of cleanup among sources is far from uniform.

Incentive policies

Other approaches to environmental policy give firms and individuals incentives to change their behavior rather than mandating specific changes. These incentive policies try to make use of market forces for what they do best—allocating resources cost-effectively within an economy—while correcting the market failures associated with externalities, public goods, and common pool resources.

Tax/subsidy

Environmental taxes are based on a simple premise: if someone is not bearing the full social costs of their actions, then we should charge them an externality tax    per unit of harmful activity (e.g. ton of pollution, gallon of stormwater runoff) that is equal to the marginal cost that is not borne by the individual. In this way, that person must internalize the externality, and will have the incentive to choose a level of activity that is socially optimal. Thus, if we think the social marginal cost of ton of carbon dioxide (because of its contribution to climate change) is $20, then we could charge a tax of $20 per ton of carbon dioxide emitted. The easiest way to do this would be to have a tax on fossil fuels according to the amount of carbon dioxide that will be emitted when they are burned.

If a price is placed on carbon dioxide, all agents would have an incentive to reduce their carbon dioxide emissions to the point where the cost to them of reducing one more unit (their marginal abatement cost) is equal to the per unit tax. Therefore, several good things happen. All carbon dioxide sources are abating to the same marginal abatement cost, so the total abatement is accomplished in the most cost-effective way possible. Furthermore, total emissions in the economy overall will go down to the socially efficient level. Firms and individuals have very broad incentives to change things to reduce carbon dioxide emissions—reduce output and consumption, increase energy efficiency, switch to low carbon fuels—and strong incentives to figure out how to innovate so those changes are less costly. Finally, the government could use the revenue it collects from the tax to correct any inequities in the distribution of the program's cost among people in the economy or to reduce other taxes on things like income.

While taxes on externality-generating activities have many good features, they also have several drawbacks and limitations. First, while an externality tax can yield the efficient outcome (where costs and benefits are balanced for the economy as a whole), that only happens if policy makers know enough about the value of the externality to set the tax at the right level. If the tax is too low, we will have too much of the harmful activity; if the tax is too high, the activity will be excessively suppressed.