Economic Instruments for Environmental Policy:
Solving global environmental problems with local economic action

Hari Srinivas
Policy Analysis Series E-190. February 2023.

The article explores the use of economic instruments for sustainable business specifically how economic instruments, such as taxes, subsidies, and market-based mechanisms, can be used to encourage sustainable business practices. The article highlights the benefits of using economic instruments, such as cost savings, improved resource efficiency, and reduced environmental impact. The article also discusses some of the challenges associated with the implementation of economic instruments, such as the need for political will, the need for effective implementation, and the need for public understanding and support. The article concludes by emphasizing the importance of economic instruments as a tool for promoting sustainable business practices and contributing to sustainable development.

Economic instruments, Sustainable business, Taxes, Subsidies, Market-based mechanisms, Cost savings, Resource efficiency, Environmental impact, Political will, Implementation.

Economic instruments (EIs) are tools that governments and businesses can use to influence economic behavior. Examples of EIs include taxes, subsidies, and regulations. These tools can be used to encourage or discourage certain activities, such as the consumption of certain goods or the use of certain resources. EIs are often used as part of a larger economic policy, and can be a effective way of achieving specific policy goals.

Figure 1: Environmental Impacts of Production Processes

Economic "carrot-and-stick" approaches are necessary, considering the complex nature of production processes that provide goods and services (Figure 1), and the environmental impacts that each stage of the production process generates. This can be solid wastes and residue, but also liquid wastes, waste water, as well as gaseous pollution and GHG emissions.

EIs help in tackling these myriad of impacts using fiscal and other economic incentives and disincentives. Such instruments help incorporate environmental costs and benefits into the budgets of households and enterprises.

The objective of economic instruments is to encourage environmentally sound and efficient production and consumption through full-cost pricing. EIs include effluent taxes or charges on pollutants and waste, deposit-refund systems and tradable pollution permits.

Figure 2: Key Aspects of EIs
* MRV = Monitoring, Reporting and Verification

EIs are not just money-denominated policies, but also include a number of other key aspects (Figure 2) - much of which are required to determine the size of the EIs to be implemented as well as incentives to promote action and verification.

Such an "ecosystem" of aspects include, for example, data and information (and including their monitoring, reporting and verification), environmental laws, government policies, technology solutions, stakeholder participation and commitment, awareness and education, etc.

EIs, such as levies/charges and tradeable permits, when used appropriately can provide least-cost solutions to environmental problems, provide greater flexibility and encourage innovation. EIs can be used on their own or in combination with other measures to improve the efficiency of environmental protection efforts

Major categories of EIs

There are seven major categories of Eis:

  • property rights
  • market creation
  • fiscal instruments - taxes and subsidies
  • charge systems - fines and fees
  • financial instruments - incentives
  • liability instruments - socially responsible behaviour
  • performance bonds and deposit refund systems

Figure 3: Types of EIs

For EIs to be effective we need action to both remove cases of environmental problems and reduce the impacts of such problems (Figure 3). This can include EIs that provide positive incentives to promote good behaviour and action - policies and EIs that are essentially market-based. Conversely, it can also include EIs that provide negative disincentives to reduce or eliminate behaviour patterns or action that are harmful to the environment - policies and EIs that are essentially of the "command-and-control" type..

Some examples of EIs include taxes, subsidies, tariffs, and quotas.

  • Taxes are charges levied by governments on goods, services, income, or wealth. They can be used to raise revenue for the government, but they can also be used to influence behavior. For example, a government might impose a high tax on cigarettes to discourage smoking, or a tax on carbon emissions to discourage the use of fossil fuels.

  • Subsidies are payments made by governments to businesses or individuals to encourage certain behaviors. For example, a government might provide subsidies to farmers to encourage them to grow certain crops, or to homeowners to encourage them to install solar panels.

  • Tariffs are taxes on imported goods. They are often used to protect domestic industries from foreign competition, or to raise revenue for the government. For example, a government might impose a tariff on imported cars to protect the domestic auto industry, or a tariff on imported steel to raise revenue.

  • Quotas are limits on the quantity of a good that can be imported or produced. They are often used to protect domestic industries from foreign competition, or to conserve natural resources. For example, a government might impose a quota on the amount of fish that can be caught to protect fish stocks, or a quota on the amount of oil that can be imported to reduce dependence on foreign oil.

Figure 4: EIs' Target for Action

EIs' targets for action (Figure 4) focus on the entire lifecycle of a product or service - in its production and consumption processes - ensuring that both stationary sources of pollution (i.e. pollution from factories, businesses and homes etc.), as well as mobile sources of pollution (i.e. pollution from transportation - all types of vehicles) are targeted by the EIs.

  • Charges on pollutants discharged in to the atmosphere, water bodies and surface from the stationary sources
  • Charges on the pollutants discharged from the mobile sources, (charge is set on the fuel used)
  • Product charges on goods (tires, lamps, filters, batteries) harmful to the environment
  • Filled packaging (paper, glass, metal, plastic) charges
  • Tax on extracted gravel, sand, and other minerals
  • Tax on water resources
  • Tax on oil and gas

Why do we need EIs?

Why do we need EIs? Global environmental problems (Figure 5) such as climate change of loss of biodiversity have (1) a number of causes - direct and indirect, and also have (2) a number of impacts - short-term and long-term. In such a situation, EIs are used by governments to influence economic activity and tackle environmental challenges.

Figure 5: Why do we need EIs?

Some common reasons for using EIs include:

  • Raising revenue: Governments use taxes and other EIs to raise money to fund public services and infrastructure.
  • Encouraging or discouraging certain behaviors: EIs can be used to encourage or discourage certain behaviors, such as consumption, production, or investment. For example, a government might use subsidies to encourage the production of renewable energy, or impose a tax on cigarettes to discourage smoking.
  • Protecting domestic industries: EIs, such as tariffs and quotas, can be used to protect domestic industries from foreign competition. This can help to preserve jobs and support the domestic economy.
  • Reducing negative externalities: EIs can be used to address negative externalities, which are costs or negative effects of economic activities that are not reflected in market prices. For example, a government might impose a tax on carbon emissions to discourage the use of fossil fuels, which can help to reduce air pollution.

Figure 6: Environmental Policy and EIs

As outlined in Figure 5, the action to remove the causes and to reduce the imacts of environmental problems necessitates the use of money and finance as key policy tools to change behavior - either good or bad.

Purposes of EIs

  • To reduce the pollution in to the atmosphere from the stationary and mobile sources
  • To reduce waste generating and to provide incentives to producers and importers invest in to the waste recycling measures.
  • To create incentives for users to use more friendly goods and products
Japan's "Junkangata Shakai" Junkangata shakai or a "Sound Material Cycle Society" is a society that is designed to promote sustainable use of natural resources. This term is often used in the context of environmental policy in Japan, where it is considered one of the pillars of the country's environmental strategy.

In a Sound Material Cycle Society, waste is minimized and resources are used efficiently. This means that materials are recycled and reused as much as possible, and that the production and consumption of goods and services are designed to be sustainable. This can help to reduce the negative impacts of economic activity on the environment, such as air and water pollution, and can also help to conserve natural resources.

Achieving a Sound Material Cycle Society requires the cooperation of individuals, businesses, and governments. Individuals can help by reducing their own waste and consumption, and by supporting businesses that adopt sustainable practices. Governments can help by implementing policies and regulations that support the efficient use of resources, and by providing incentives for businesses to adopt sustainable practices.

Challenges for EIs

With cost savings a major financial objective for households and businesses alike (besides profit-making for businesses), avoiding costs due to environmental impacts can be a key incentive to take environmental action at the local level. EIs can help in reinforcing positive behavior, while curbing behaviours that have negative impacts on the environment.

Challenges to the effective use of EIs remain. These include the issue of Monitoring,-Reporting-Verification (MRV) to ensure that decision-making related to EIs are grounded in reliable, accurate and timely information. EIs also need consistent commitment and action from all stakeholders - governments, business and industry, and the civil society - targeted at both production and consumption processes.

While a range of actions are needed at the local level to solve the myriad of problems we face, EIs provide a basket of solutions for action to be taken - targeting everyday decisions and consumption/production patterns.

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