Instrument Choice: Economic Instruments Generally

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Command and control regulations have been criticized as inefficient – because the regulator is unlikely to know the optimal emissions level or technology for a particular firm – and environmental regulatory policy has shifted toward economic instruments in recent years.

The three major forms of economic instruments, or market-based instruments (MBIs), are pollution taxes, tradable permits, and subsidies.  A pollution tax is a tax on an emitter equal to the marginal harm from emissions. Tradable permits set the total level of emissions at a fixed amount but allow firms to trade the right to emit. Subsidies are payments to firms for reducing emissions equal to the marginal benefit from the reduction; in other cases, subsidies may fund research and development of new technologies. In all cases, firms are allowed to choose emissions levels and technology, thereby taking advantage of knowledge held by the firms but not by the regulator.

In order to meet a global emissions target at least cost, coordination of policy instruments at the international level will be required. Three market-based solutions have been suggested to achieve international coordination. One would tax emissions, either through a supranational institution, or through a harmonized domestic taxation scheme. A second would assign signatory countries an emissions quota and establish a regulated market in which emissions credits could be traded among the participating countries; the regulatory policies and emissions goals of individual countries would be set at the national level. The third instrument, joint implementation, would incentivize one country (or firm) to subsidize emissions reduction in a second country (IPCC Technical Paper 1).

Challenges to the coordination of economic instruments at the international level could arise either in the form leakage, or in the form of free riding. Leakage occurs when a reduction in emissions in one or more of the participating countries corresponds to an increase in emissions in one or more non-participating countries. Free riding refers to the fact that non-participating countries benefit from emissions reduction without sharing in the cost thereof.

The literature on economic instruments deals with issues of interaction between various instruments, regulation, and implementation, among others.