Concepts on Economic Instruments

According to Serôada Motta, Huber and Ruitenbeek (1999), no standardized definition of an EI exists. A “weak” EI uses regulations, and is usually denominated as command-and-control (CAC) in the literature, whereas a “strong” EI uses mainly market forces to decentralize decision-making and is commonly referred as a typical market-based instrument.

The strength of an EI depends on the degree of flexibility that a polluter has in achieving a given environmental target. A weak EI uses regulation to dictate the type of process that must be used, and failure to comply results in economic sanctions. A strong EI relies mainly on market forces to determine the best way to meet a given standard or goal.

“Flexibility” refers to the degree to which social (or state) decisions are transferred to the private (individual) level. A strong EI decentralizes decision-making, giving the polluter or resource user a maximum amount of flexibility to select the production or consumption option that minimizes the social cost of achieving a particular level of environmental quality, thus ensuring that profit- or utility-maximizing behavior generates a “lowest social cost” outcome.

There is a broad spectrum of instruments available, all of which have some implicit or explicit incentive effect, from fines to tradable permits. These lie along a continuum ranging from very strict command approaches to decentralized approaches relying on market or legal mechanisms, as is shown in Table 1.

In the case of pricing instruments, such as charges, taxes, and fees, another important feature —apart from flexibility— is related to the pricing criteria. There are three possibilities:

Externality pricing adopts the Pigouvian tax concept of internalizing the full degradation costs into producers’ marginal cost functions in order to equalize marginal social costs to marginal benefit costs, as a first-order condition of market efficiency. In doing so, it is possible, that the market may clear at the social optimum level of pollution. Here, measurement of damage cost functions is essential to set prices. The task of environmental damage estimation is always complex and controversial, particularly with multiple damage sources and variant assimilative capacity.⁵

Behavior pricing moves away from social optimization to individual optimization: it assumes that there is a previously established environmental target, not necessarily the economic optimum that has to be met. Once this target is defined, prices will create the incentive for private agents to behave in such a way that the aggregation of their individual use levels will meet the desired target. Note that in this case, the targets are ambient standards and agents are free of individual standards. Agents will behave according to their own optimization strategies, equalizing their marginal user costs, arising from user prices, to their marginal costs of reducing the use level. In this approach, for example, a polluter will equalize pollution prices to their marginal control costs to determine the optimum pollution level at this price level. Such flexibility allows for cost-effectiveness, since there will be a willingness to abate all pollution with a control cost lower than the pollution price set by the EI. In this case, regulators need to know the agent’s marginal control costs, which may not be easy if there are information asymmetries between regulator and polluters.

Financing pricing is designed to attain certain budget needs rather than to deal with optimal degradation or private optimal control levels. In other words, optimal prices are set to achieve a certain level of revenue and therefore are basically related to the agent’s demand curves for the natural resources being priced. The efficient prices rule⁶ criterion states that prices should be set inversely proportionate to the demand price-elasticity of each user: users with less elastic demand pay more than those with more elastic demand in order to avoid revenue losses. In this case, note that regulators have a budgeting goal to make provision of some services to which an EI will be applied to finance this budget. Once users’ provision marginal costs and demand price-elasticities are known, a price set can be determined. As can be seen, this information requirement is less complex, although the pricing may be politically weak since demand characteristics will be the key pricing factor, without any environmental justification.

Note that any of the criteria presented above can be applied with distributive restrictions on their objective functions, such as ability to pay and minimum free use level. That is, prices may be set with distributive weighting. Revenues from externality and behavior prices can be positive, but they will be tied to use or degradation levels rather than to budget constraints, as in the case of financing prices.

Revenue can also be generated from other market devices. For example, the auctioning of tradable pollution permits would theoretically result in revenues equal to the net present value of the revenue flow generated by the equivalent price device.⁷ Users would be willing to pay for permits the amount of the discounted future payments that the permits would avoid.