HarvarD Pustic Poticy REVIEW Innovative Policies for Sustainable Development: The Role of Economic Incentives for Environmental Protection Robert N. STAVINS, The United States and the world at large continue to face major environmental threats—both ongoing prob- Iemsand newly recognized ones. Although conventional regulatory policies have sometimes worked well, they have tended topit economicandenvironmental goalsagainst each other, toooften producing paralysisrather than progress Market-oriented environmental protection policies an enable nations toachieve theirenvironmental goalsat lower overall cost to society. Furthermore, such policy mechanisms can provide powerful incentives for the development of new pollution-control technologies and expertise. But economic-incentive mechanisms will not ft every envi- ronmental problem. The best set of policies will nvotvea mix of market and more conventional regulatory approaches. ‘Most incentive-based policies fall within one of five major categories: pollution charges, marketable permits, deposit refund systems, market barrier reductions, and government subsidy elimination. This paper, originally presented to the United Nations Economic Commission for Europeand the U.S. Environmental Protection Agency's “Workshop on the Economics of Sustainable Development” in January 1990, briefly describes these five types of policy mechanisms. In addition, 16 individual policy initiatives are described for 13 specific natural resource and environmental problems. During the past two decades, a host of envi- ronmental laws and regulations have been en- acted in the industrialized nations, and substan- tial gains have been made in environmental pro- tection: in many spheres, the environment is cleaner now than it was before. But the United States and the world at large continue to face major environmental threats—both ongoing problems, such as local smog, ground water pollution, and regional acid rain, and newly rec- ognized problems, including the awesome possi- bility of global climate change. As the decade of the 1980s draws toa close, increased attention has been given by political leaders on both sides of the Atlantic to a promising set of new policies which recognize market forces, not only as part of the problem, but also asa potential part of the so- SpriNe 1990 lution. In the United States, the nature and tone of political debate has evolved rapidly, culminating with the Bush administration proposing in the early summer of 1989 a major overhaul of the Clean Air Act to include a market-oriented ap- proach to controlling acid rain.’ One catalyst for these changes in Washington was a bipartisan study, initiated and sponsored the previous year by twoU S. Senators—Timothy Wirth of Colorado and John Heinz of Pennsylvania—to find innova- tive solutions to major environmental and natural resource problems. Their “Project 88” report? described a variety of innovativemeasurestoenlist the forces of the marketplace and the ingenuity of entrepreneurs to help deter pollution and reduce waste and degradation of natural resources. Prac-tical employment of economic forces to achieve heightened environmental protection at lower cost to society was emphasized throughout.” Inthe United Kingdom, the Thatcher govern- ment has embraced a study directed by David Pearce of University College, London,‘ which ree- ‘ommends increased reliance on economic-incen- tive mechanisms for a host of environmental and natural resource problems.’ Most recently, as ‘massive political and economic changes have gripped the Soviet Union and Eastern Europe, a By channelling the forces of the mar- ketplace into environmental pro- grams, economic-incentive mecha- nisms can make the everyday eco- nomic decisions of individuals, busi- nesses, and goverament work effec- tively for the environment. number of East Bloc nations have expressed inter- est in market-oriented environmental policies.* Within the United States, these changes in the politics of environmental policy represent a dra- maticdeparture from long-term trends. Justa few years ago, the only serious consideration given to market-oriented environmental protection poli- cies was by economists at universities and re- search institutions. Now a new environmental- ism has emerged which embraces these innova- tive approaches.” The Environmental Defense Fund was the first of the major environmental organizations to advocate incentive-based poli- cies; now there is growing support for these ap- proaches by other groups as well’ Because of the important political role played by the major envi- ronmental advocacy groups in the United States, such support is of major consequence. ‘The Context of Change in the United States: Environmental and Economic Conditions, Public Opinion, and Current Policy US. environmentaland natural resource poli- cies have evolved over the past twenty years in 4 response toan array of perceived risks. Now, new threats have arisen,’ the cost of enforcing existing policies has escalated, and the issue of how to share that burden frequently has become a brake ‘on needed action. Its less and less likely that we can increase environmental protection simply by spending more money on programs and policies already in place.”” Moreover, the costs of environ- mental compliance to the economy as a whole continue to increase." Itis therefore important to censure that investment in environmental protec- tion is cost-effective if the country is to build and maintain international competitivestrengthalong with a better environment. The approach that ‘seems most promising is one of harnessing mar- ket forces to spur both technological advance and sustainable management of natural resources. By channelling the forces of the marketplace into environmental programs, economic-incen- tive mechanisms can make the everyday eco- nomic decisions of individuals, businesses, and government work effectively fortheenvironment. This does not suggest using economic criteria, exclusively or otherwise, to set environmental goals. There is no recommendation here of using benefit-cost analysis or setting dollar values on environmental amenities or human health. In- deed, in many cases, there is a need to set aside ongoing debates over specificenvironmentalstan- dards, in order to carry out a separate examina- tion of effective mechanisms for environmental protect Developing such proposals in detail and put- ting them into action will be a complicated and difficult enterprise, but this is a challenge that must be met. Public demand in the United States for a quality environment has been strong and consistent.” Yet it is unlikely that either the Federal government or the US. economy as a whole will be able to afford higher environmental standards unless means are found which achieve themost protection possible forevery dollarspent The conventional “command-and-control” ap- proach of setting uniform standards or requiring specific control technologies is an increasingly difficult and expensive method to achieve envi- ronmental improvements. Market forces can supplement the regulatory power of the govern- ment and create a setting for private sector inno- Hava Pustic Pouicy ReviewEconomic Incentives for Environmental Protection vation and initiative in the pursuit of environ- mental quality. Criteria for Enlightened Public Policy: Identifying Innovative Solutions to Environmental Problems In order to identify appropriate policies for specificenvironmentaland natural resource prob- lems, a variety of criteria need to be considered, including the following: © Will the policy effectively achieve environ- mental goals? © Will the policy approach be cost-effective, ie., willitachieve environmental goals atleast cost to society at large? © Will thestrategy provide relevant government agencies with the information they need? © How easy (or costly) will monitoring and en- forcement be? © Will the policy be flexiblein the face of change? When changes occur in tastes, technology, or resource use, will the policy accommodate these changes and remain effective or will it become ineffective (or even counter-productive)? © Willthe policy give industry positive, dynamic incentives? For example, will it encourage firmstodevelopnew,environment-saving tech- nologies, or will it encourage firms to retain ex- isting, inefficient plants? ‘© Will the economic effects of the policy be equi- tably distributed? © Will the purpose and nature of the policy be broadly understandable to the general pub- lic? © Will the policy be truly feasible, in terms of both enactment and implementation? Based upon these criteria," effective new ap- proaches to recognized problems can be devel- oped. Economic Incentive Mechanisms: What They Are and How They Work A key to reducing inefficient natural resource use and environmental degradation is to ensure that consumers and producers face the true costs, SpRING 1990 of their decisions—not just their direct costs, but the full social costs and consequences of their actions. Economic-incentive systems provide various ways to do this. Most such approaches can be viewed as falling within one of five major categories: pollution charges, marketable per- mits, deposit-refund systems, market barrier reductions, and government subsidy elimination. Pollution Charges. Charge systems impose a fee or tax on pollution (not simply on pollution- generating activities). Asa result, it pays firms to reduce pollution (up to the point where the mar- ginal cost of pollution control is equal to the pollution tax rate). Thus, firms wind up control- ling different amounts (the high-cost controller controls ess;thelow-cost controller controlsmore), butall firms tend to experience the same marginal cost of pollution control. Theresultis that the total costs of pollution control are minimized, as com- pared with other allocations of the pollution- control burden across firms. Under this and other economic-incentive approaches, additional pol- lution-control efforts are in the financial interests of firms, as long as the costs of controlling pollu- tion are sufficiently low. Hence, these mecha- nisms provide ongoing incentives for firms to develop and adopt newer, better (cheaper) pollu- tion-control technologies. Examplesof water pollution chargesare found in several European nations, including France, the Netherlands, and West Germany. One fre- quently discussed application is a carbon tax to help control global warming. ‘One potential problem with emission charge systems is that governments do not know in advance what level of clean-up will result from any givencharge. Tradeable permit systems elimi- nate this particular problem. ‘Marketable Permit Systems. Tradeable or mat ketable permits can achieve the same cost-mini- mizing allocation of the pollution-control burden, but do so in ways which avoid the aforemen- tioned problem of uncertain firm responses. Under a tradeable permits system, the allowable overall level of pollution is established and then allotted in the form of permits among firms. Firms that keep emission levels down (below the allotted level) may sell their surplus permits to other firms or use them to offset excess emissions in other 1sRobert N. Stavins parts of their own facilities. Thus, low-cost con- trollers have an incentive to control more. High- cost controllers have the option of buying permits instead of undertaking expensive control meas- ures; and so high-cost controllers control less. As with a charge system, the marginal cost of control is identical across firms, and thus the total, socie- talcostofcontrol is minimized (for any given level of total pollution contro). Neither taxes nor permit systems need begin or stay at the status quo level of pollution (or pollution control); permit systems, for example, ‘can issue initial permits for some fraction of cur- rentemissionsand establish deadlines forachieve- ment. They can likewise be used to move toward stricter standards. The primary application of such mechanisms has been in the United States, both under the Environmental Protection Agency's (EPA) Emis- sions Trading Program and the nationwide lead- phasedown (which allowed fuel refiners to “bank’ and “trade”). Congress is currently considering a marketable permit system for acid-rain control. Other potential areas of application include: local air pollution, point and non-point source water pollution, chlorofluorocarbon (CFC) reduction, and control of global warming through interna- tional trading in greenhouse gas permits and offsets. Deposit-Refund Systems. Under this approach, surcharges are paid when potentially polluting, products are purchased. When the product's consumers/users return the product to an ap- proved center (for recycling or proper disposal), their deposit is refunded. This approach has already been used successfully in a number of states in so-called "bottle bills” to reduce littering, with beverage containers and to reduce the flow of solid waste to costly landfills. Deposit-refund systems can also be used for containerizable haz- ardous waste and for certain forms of solid waste. Lead-acid batteries, used motor vehicle oil, and tires are obvious candidates. One advantage of the deposit-refund system is that it eliminates the incentive for illegal “mid- night dumping” which exists under a simple waste-end tax or fee. There are proposals in the Congress for applying the deposit-refund con- cept to new problem areas. Also, Denmark has 16 such a plan for mercury and cadmium batteries, and Norway and Sweden have successful de- posit-refund systems on car hulks. Removing Market Barriers. In some cases, sub- stantial gains can be made in environmental pro- tection simply by removing existing, government- mandated barriers to market activity. For ex- ample, measures which facilitate the voluntary exchange of water rights can promote more effi- cient allocation and use of scarce water supplies, while curbing the need for expensive and envi- ronmentally disruptive new water supply proj- ects. Negotiations are underway for a major market-oriented water exchange in southern California. Other applications of the general conceptincludecomprehensiveleast-cost bidding at electrical utilities, a measure which would promote economically rational energy conserva- tion. Eliminating Government Subsidies. Several existing subsidies promote inefficient and envi- ronmentally unsound development. A major example is provided by the existence of “below- cost timber sales'—where the Forest Service does not recover the full cost of making timber avail- able. The result of this set of subsides has been ‘excessive timber cutting, thereby leading to sub- stantial losses of habitat and damages to water- shed values. Gradual removal of these subsidies would foster environmental protection and in- crease net Federal revenues. Other examples of subsidies which are both economically inefficient and environmentally disruptiveinclude thoseassociated with US. Army Corps of Engineers flood-control projects, USS. Bureau of Reclamation projects, and agricultural price supports. ‘Comparing Market-Based Mechanisms with Con- ventional Policies. Ata time of concern about inter- national competitiveness, incentive-based ap- proaches can provide huge savings and increases in productivity. For example, a market-based approach to acid-rain reduction could save up to $3 billion per year, compared with the cost of a dictated technological solution."* And, incentive- based approaches need not be any more expen- sive for the government to administer than con- ventional, regulatory methods. In fact, funds from tradeable-permit auctions could be used to help Harvarp Punuic Poucy ReviewEconomic Incentives for Environmental Protection finance an expanded EPA budget."® Also, such systems provide incentives for one firm to moni- tor theactivities ofother pollutant-emitting firms— another manifestation of the discipline of a com- petitive market. This is not to suggest, however, that environmental protection can be achieved without significant government expenditures, Because investments in pollution control lead to tangible, positive effects on profits under incentive- based systems, these policiescan pro- vide significant inducements for firms to adopt pollution-control technologies. since no program of controls can be effective without a commitment by government to moni- toring and enforcement. Most importantly, economic-incentive ap- proaches allow greaterlevelsof protection for any given aggregate cost of control. Rather than dic- tating to enterprises how they should manufac- ture their products, incentive-based systems impose a cost on pollution-causing activities, leaving it to individual firms to decide among themselves how to achieve the required level of environmental protection. Market forces willdrive these decisions toward least-cost solutions and toward the development of new pollution-con- trol technologies and expertise by the private sector. Market forces also lead to powerful incentives for the development of new pollution-control technologies and expertise by the private sector. Because investments in pollution control lead to tangible, positive effects on profits under incen- tive-based systems, these policies can provide significant inducements for firms to adopt pollu- tion-control technologies. In tur, incentives are created for those same firms or others to carry out research and development of cheaper and better pollution-abatement techniques."® Incentive-based approaches have an added benefit; they can make the environmental debate Sprine 1990, more understandable to the general public. Be- cause they do not dictate a particular technology, these approaches can focus attention directly on what our environmental goals should be, rather than on difficult technical questions concerning technological alternatives forreaching those goals. Market-oriented policies, however, will not fit every problem. On the one hand, incentive- based approaches are virtually tailor-made for problems such as acid rain, where concern fo- uses on aggregate pollution levels within an air- shed. As explained above, economic-incentive mechanisms, such as tradable permits, allocate the pollution burden across firmsin such away as tominimize total expenditures for any given level of aggregate control. On the other hand, with environmental problems which display local and threshold effects, concern focuses on the level of pollution emitted by individual sources. In this case, a conventional, command-and-control ap- proach, such asa uniform emission standard, may represent the preferred policy.” The best set of policies will probably involve a mix of market and more conventional regula- tory processes. To design and implement eco- \entive programs, it will be necessary to adapt, not abandon, present programs and build step-by-step on US. and other industrialized nations’ initiatives with market-based policies. Previous U.S. Experience With Incentive- Based Environmental Policies Asnoted above, market-based approaches for environmental protectionhavebeenimplemented ‘ona limited scale in the United States and several European nations, Three of the U.S. experiences are described in more detail below. EPA's Emissions Trading Program. In 1974, EPA began to experiment with “emissions trad- ing” as part ofits program for the improvement of local air quality." Firms that reduce emissions be- low the level required by law have been allowed to receive “credits” usable against higher emis- sions elsewhere. Under programs of “netting” and “bubbles,” firms have been permitted to “trade” emissions reductions among sources within the firm, so long as total, combined emis- sions comply with an aggregate limitFirms have also traded emissions credits. Under the “offset” program, begun in 1976, firms which wish to establish new sources in areas which are not in compliance with ambient stan- dards have been required to offset their new emissions by reducing existing emissions by a greater amount, This can be done with their own sources or through agreements with other firms. Finally, under the “banking” program, firms may store earned emission credits for future use, 10 allow either for internal expansion or fora sale of credits to other firms. ‘These programs were codified in EPA’s Final Policy Statement on Emissions Trading in 1986, but their use to date hasnotbeen extensive. States are not required to use them, and uncertainties about the future course of the programs have made firms reluctant to participate. Neverthe- less, companies such as Armco, Du Pont, USX, and 3M have traded emissions credits, and a limited market for transfers has arisen. Even this degree of participation in EPA’s programs has resulted in more than $4 billion in savings in control costs, with noadverse effect on air quality. Tradeable Permits for Water Pollution Control. Nonpoint sources, particularly from agriculture and urban runoff, now constitute the major ‘American water pollution problem. The experi- ence of Dillon Reservoir, the major source of water for the city of Denver, Colorado, provides an ‘example ofa trading approach fornonpointsource water pollution. In past years, nitrogen and phosphorus loading was turning the reservoir eutrophic, despite the fact that point sources from. surrounding communities were controlled to best- available-technology standards. In order to pre- serve and protect water quality in the face of rapid population growth, a “point/nonpoint source control optimization” program was developed to cut phosphorus flows mainly from nonpointurban and agricultural sources. ‘The point/ nonpoint source trading plan was developed with active participation of environ- mental groups, industry, and local and state governments, and was approved by Colorado and EPA in 1984. The program allows for publicly ‘owned sewage treatment works (POTWs) to fi- nance the control of nonpoint sources in lieu of, upgrading their own treated effluent to drinking- 18 water standards. ‘The program is effective be- cause the cost per pound of phosphorus removed via trading is $67, versus $824 per pound for the cheapest advanced treatment alternative devel- coped for the POTWs. EPA has estimated that the plan has made aggregate savings of over $1 mil- lion per year, compared with the conventional ‘workings of four fairly small POTWs. Voluntary Water Exchanges. One effective ap- proach to water supply problems is to allow the voluntary exchange of water rights in order to increase efficiency—most notably by creating economic incentives for water conservation. In the Imperial Irrigation District (1ID) of California, farmers are paying as little as $10 for water to irrigate anacre of cotton, while justa few hundred milesaway in Los Angeles, local authorities of the Metropolitan Water District (MWD) are paying up to $200 for the same quantity of water. A free market in water rights, allowing voluntary ex- changes, would make both parties better off; farmers would have a financial stake in conserv- ing water, urban needs would be met without shrinking agriculture and without building new dams and reservoirs, and environmental protec- tion would gain, In March of 1983, the Environmental Defense Fund (EDP) published a proposal calling for MWD to finance the modernization of IID’s water sys- tem in exchange for use of conserved water. In November, 1988, after five years of negotiation, the two water giants reached agreement on a historic§230 million water conservationand trans- fer arrangement," which closely parallels EDF's original proposal of “Trading Conservation In- vestments for Water.” This southern California water swap may be the harbinger of more enlightened western water policy, since it demonstrates that such trades can beexecuted ona significant scale, Such optimism seems to be validated by reports of greatly in- creased interest in water marketing in Colorado, New Mexico, Arizona, Nevada, Utah, and Cali- fornia.” Other Examples. Despite the fact that itis only during the past year that increased attention ona national level has been given to incentive-based environmental protection strategies, additional examples exist of policies which are already op- Harvanp Punic Pouicy ReviewEconomic Incentives for Environmental Protection erative. Among these are EPA's tradeable permit system for implementing the Montreal Protocol's stratospheric ozone-depletion restrictions, the nationwide lead phasedown, and some “experi- mental” use of comprehensive least-cost bidding by electrical utilities.” Also, as noted above, sev- eral European nations have had significant expe- riences with theuse of economic-incentivemecha- nisms.” Policy Recommendations for Sustainable De- velopment Based upon the criteria described above and building upon the experiences which the United States and other nations have already had with innovative, incentive-based policies, itis possible to suggest specific mechanisms for individual problem areas. In the following sections, policy recommendations are offered for thirteen major environmental and natural resource problems faced by the United States: (1) the greenhouse effect and global climate change; 2) _ stratospheric ozone depletion; (3) _ local air pollution; @) acid () indoor radon pollution; (6) _ threatstoenergysecurity and environmental quality; (7) inefficient use and allocation of water sup- plies; (8) degradation of surface and ground water quality; (9) solid waste management; (10) presence of toxic substances in the environ- ment; (11) management of toxic and infectious waste; (12) public lands management; and (13) depletion of wetland resources. In each case, the problem is briefly defined and one or more promising, policy measures are de- scribed.” 1) The Greenhouse Effect and Global Climate Change. The single most important environ- ‘mental threat our planet has faced since the begin- ning of the industrial revolution may be global Spaine 1990 climate change due to the greenhouse effect, asso- ciated with emissionsof carbon dioxide, methane, nitrous oxide, and chlorofluorocarbons (CFCs). Consequent global temperature increases are predicted to produce climate changes unprece- dented for their speed of occurrence, including massive changes in global precipitation patterns, storm intensities, and ocean levels." Recommendation: Fund research on causes and consequences of global warming and on specific adap- tation and prevention strategies. Increased support Of basic scientific research on the greenhouse ef- fect and climate change is needed. The long-term goal should be to identify the most effective, efficient, and politically viable strategies—whether based upon prevention,adaptation, or, morelikely, some combination of the two approaches. Recommendation: Modify current policies to encourage energy efficiency. Encouraging efficient ‘use of energy resources can reduce the burning of fossil fuels for electricity and increase energy- efficiency in transportation and other sectors of the economy. One example of a policy change to consider would factor social—especially environ- ‘mental—costs into the calculations used in the Public Utilities Regulatory Policy Act (PURPA) of 1978. Recommendation: Prevent deforestation through debt-forest swaps. Common interests among de- veloped and less developed nations could be furthered by extending the concept of “offsets” into the international arena through “debt-for- forest swaps,” several of which havealready been arranged by the World Wildlife Fund and other organizations." Maintaining (rather than bun- ing) tropical forests can constitute a significant source of greenhouse gas reductions; and volun- tary debt-forest swaps will benefit debt-burdened LDCs." 2) Stratospheric Ozone Depletion. Anthropo- genicemissionsof CFCsand other potential ozone depleting chemicals are causing the depletion of stratospheric ozone. Asa result, increased ultra- violet radiation will reach the earth’s surface, potentially elevating human skin-cancerincidence, promoting cataracts, suppressing immune re- sponses, and causing other adverse effects to animals, plants, and valuable materials. Recommendation: Phase out potential ozone de-Robert N. Stavins _ ‘Recommendation: Phase out potential ozone de- pletors with tradeable permits. To implement the Montreal Protocol's restrictions, EPA has prom- ulgated asystem of nationwide tradeable permits to achieve specified control levels at far less cost and with less disruption than direct bans or con- trols. This market-based approach will stimulate firms to adopt measures tailored to specific cir- cumstances, and will provide industry with in- centives to develop substitute chemicals, indus- trial processes, and consumer products.” 3) Local AirPollution. Asa result of twenty years, of Federal attention to local air pollution prob- lems, there have been substantial improvements inair quality in most parts of the country. Never- theless, more than 100 million Americans remain exposed to excessive smog (ambient ozone) levels and some 70 urban areas still lack adequate local plans to reduce them. Recommendation: Implement tradeable permits for stationary sources. EPA's initiatives with “emissions trading” have already saved the coun- try an estimated $5 billion in air pollution control costs over the last several years, with equal or better environmental progress, according to the US. General Accounting Office." A logical exten- sion is a comprehensive system of marketable emissions permits” Sources which can reduce discharges below their permit levels would be allowed to sell part of their permitted surplus to others; firms for whom compliance is relatively costly could control to the point where it makes more sense to buy additional permits instead, Under this approach, sources will have continu- ous financial reasons toreduce beyond (not merely to) required levels. Air quality goals will be achievable at lower cost overall.” 4) Acid Rain. The environmental consequences of acid rain appear to be escalating, but with the exception of the Clean Coal Technology and re- lated programs, Congresshasbeen unable toenact explicit and effective policy responses. Though many factors lie behind this failure, a major one is cost considerations and attendant social disrup- tion, especially for high-sulfur coal mining and burning communities in Appalachia and the Midwest. Recommendation: Initiate an Acid Rain Reduc~ tion Credit program." Patterned after EPA’s emis- 20 sions trading program,® this economic-incentive approach to acid rain control offers a cost-effec- tive and equitable solution to this seemingly in- tractable problem. Any sources of emissions contributing to acid raincould use or sell “excess” reductions (beyond those required by law) to meet further emission reduction requirements applicable to other sources. With this approach— which would complement, not replace, the tradi- tional approach—acid rain reduction goals could be met at much lower cost than would otherwise bbe possible, saving up to50% annually, according to EPA.” If initial permitsare auctioned, revenues can be used to finance the installation of retrofit ++ more than 100 million Americans remain exposed to excessive smog (ambient ozone) levels and some 70 urban areas still lack adequate local plans to reduce them. and clean coal technology through Federal cost- sharing arrangements (in areas which currently utilize high-sulfur coal) and finance research and development efforts on the same technologies, The efficiency properties of the program can thus be combined with equitable protection for com- ‘munities whichare economically dependent upon the high-sulfur coal industry. 5) Indoor Radon Pollution. EPA has identified radon as one of the most serious environmental risks facing the nation, causing 5,000 to 20,000 lung cancer deaths each year.” Because radon exposure occurs largely in private homes, it has not been feasible to use the conventional regula- tory approach of setting and enforcing health- based exposure standards. Recommendation: Give consideration to a variety of Federal actions. Consideration should be given toanumber of possibleapproaches, including tax Incentives and subsidized Ioans, construction codes, soil tests, testing requirements for real es- tate transactions, and accelerated information dis- semination." 6) Threats to Energy Security and Environmental Quality. Crude petroleum accounts for over 40% Hakvano Pustic Pouicy Reviewof the nation’s energy needs; during the past twenty years, an increasing share of the crude oil used in this country has been provided by im- ports. Attempts to obtain domestic energy secu- rity through higher production of fossil fuels will run up against serious environmental problems, Instead, the United States can make significant gains in energy security and environmental pro- tection by pursuing strategies of increased energy efficiency. Recommendation: Increase energy efficiency through comprehensive least-cost bidding at electrical utilities. Opening U.S. power markets up toallow methods of demand-management to compete head to head with power production is a market- oriented approach which some states have al- ready taken. Systems of comprehensive least-cost bidding will substantially increase the efficiency of energy production.® 7) Inefficient Use and Allocation of Water Supplies. If current practices continue, water shortages may become commonplace inthe United States during the next two decades. Current policies do not give users appropriate incentives to take actions consistent with economic and environmental values of water resources. The lack of appropriate incentives results in grossly inefficient use of existing supplies, since decision- makers do not experience the true costs of their water-use decisions." Recommendation: Remove barriers to water mar- kets. Measures which facilitate voluntary water transfers will promote more efficient allocation and use of scarce water resources and curb the need for more expensive and environmentally disruptive water supply projects.” The govern- ment should begin to remove barriers to volun- tary water marketing by validating that voluntary transfers of water are permissible and by estab- lishing rules to protect public and other third- party uses of water." 8) Degradation of Surface and Ground Water Quality. Most water pollution control laws and regulations in the United States have been di- rected exclusively at point sources, such as facto- ries and municipal waste-treatment facilities. Dispersed, nonpoint sourees—including farms and urban runoff—have not been adequately addressed, in part because such sources are much SpRine 1990 Economic Incentives for Environmental Protection more difficult to control, particularly by conven- tional methods. An increasingly serious problem is the contamination of ground water supplies by seepage of hazardous chemicals stored in dump sites and municipal landfills; leaks from under- ground storage tanks; highway runoff; and infil- tration of pesticides and fertilizer residues. Recommendation: Focus USDA's Conserva- tion Reserve Program (CRP) on water quality problems. This would be an important step to- ward control of nonpoint source water pollution from agricultural runoff. Eligibility criteria for the CRP should be broadened to include lands which are important in terms of water pollution. States and private trusts should be encouraged to pay bonuses above Federal contributions to at- tract lands into thereserve which meetstate water- quality goals” Recommendation: Implement tradeable discharge permit systems for point sources. Existing approaches to point source control, while holding each source tospecified limits, donot restrain the total volume of discharges within a basin. In situations where this a concern, the establishment of an overall watershed limit and the implementation of tradeable permits within it will be the most effec- tive and efficient way of achieving water quality oals. 5) Solid Waste Management. ‘Throughout the country, old landfills are filling up, and it is be- coming more and more difficult to find sites for new landfills. Giant garbage incinerators are bringing with them equally-giant bond issues representing burdensome investments for many communities; and now it is becoming clear that incinerators produce their own set of significant environmental hazards. Recommendation: Implement policies which al- ow recycling to compete. The vast majority of our ‘garbage is recyclable. The critical question is Whether recycling makes economicsense, and the answer is that recycling’s most important eco- nomic benefits are typically from reducing the quantity of garbage which must otherwise be collected and disposed, not from revenue due to sales of recycled materials.” If communities are to adopt efficient solutions to their solid waste management problems, recycling must be consid- ered on an equal basis with other alternatives. 21Robert N. Stavins The bidding process for municipal waste man agement should be opened to all techniques, by specifying outputs and results rather than specific techniques. 10) Presence of Toxic Substances in the Environment. Although Federal legislation nominally encourages toxic-waste source reduc- tion, the actual focus of regulation has been on controlling pollution at the “end of the pipe.” Recommendation: Provide incentives for source reduction. To finance the cleanup of hazardous waste sites, the Superfund program imposes a “front-end” tax on the chemical and petroleum industries, unrelated to the toxicity of products or services. This tax provides no incentive for firms to switch to less hazardous substances or to re- cycle wastes. A “waste-end” tax could induce industries to reduce the toxicity of their products and processes, and could also provide an incen- tive to consumers to substitute safer products. But waste-end taxes provide incentives for illegal dumping. In some cases, the answer to this quan- dary will be a deposit-refund system, discussed below. Another approach to source reduction is through labelling requirements, which compel producers to inform consumers about the pres- encein products of known toxicsubstances which may present significant risks.” This approach must beused only in limited cases, however, since excessive labelling may simply cause people to ignore signs or labels which warn of genuine risks. 11) Management of Toxic and Infectious Waste. Among the most difficult of hazardous waste problems are those posed by wastes generated in quantities smal! enough that they can be stored, shipped, and dumped more or less anywhere in the environment. Recommendation: Implement a deposit-refund system for containerized wastes. A front-end tax which works as a deposit, with a refund payable when quantities of toxic substances are turned in to designated facilities, whether for recycling or disposal, would provide important incentives for toxic management" first, there is an incentive to follow rules for proper disposal and to recapture would-be losses from the production process; second, there is an incentive for producers to look for non-hazardous substitutes; and third, agen- 2 monitoring problems will no longer include nearly impossible task of preventing illegal dumping of small quantities at dispersed sites in the environment. 12) Public Lands Management. The Federal lands of the United States contain valuable natu- ral resources, suchas timber, minerals, oil, natural gas, and forage for livestock, and also hold a preciousendowmentof environmental resources, including wilderness, fish and wildlife and their habitats, watershed values, free-flowing rivers and streams, scenic beauty, outdoor recreational opportunities, and untapped scientific informa- tion. Atthe least, publiclandsshould be managed to provide benefits which private lands are un- likely to produce in our market economy. Sound management of these public lands is seriously impeded, however, because costly subsidies exist fora few extractive industriesat the expense of the public's interests in environmental values and ‘outdoor recreation, Recommendation: Reduce government subsidies. ‘The largest subsidy, and the one most in conflict with environmental values, is that given to timber sales in remote, unroaded areas of the national forests. Low-value timber is frequently sold in environmentally and recreationally valuable ar- eas where roadbuilding to reach and harvest timber is expensive and damaging," Below-cost timber sales—where the Forest Service does not recover the full cost of making timber available— have cost the Federal Treasury more than $400 million annually over the past six years. Gradual removal of the subsidies would foster protection of the environment, decrease Federal expendi- tures, and increase net revenues. 13) Depletion of Wetland Resources. For 200 years, wetlands have been drained, cleared, and filled for agricultural, municipal, and industrial uses. In their natural state, however, wetlands also produce significant benefits—regulation of water flows, filtration and purification of water, and provision of habitat for flora and fauna. Wetland losses now average 450,000 acres annu- ally, an area half the size of Rhode Island, with agriculture accounting for nearly 90% of recent Recommendation: Improve use of environmental impact statements. Federal flood-controlanddrain- Harvaro Pusuic Poucy ReviewEconomic Incentives for Environmental Protection age projects provide financial incentives for pri- vate landowners to convert their wetland hold- ings to dry croplands.* Such impacts should be candidly assessed through the Environmental Impact Statement process. Impact areas must be correctly defined to include areas where drainage and clearing are (economically) induced. Recommendation: Institute market incentives to reflect wetland values. Government subsidies which promote economically inefficientand envi- ronmentally unsound development should be re- moved. Among the policy initiatives to consider are: ending totally subsidized construction of Federal flood-control and drainage projects; eliminating favorable tax treatment of wetland conversion; and implementing cross-compliance legislation linked to receipt of Federal commodity program payments. Market-Based Environmentalism: ‘A New Era From an Old Idea? ‘Across the United States and throughout the industrialized world, there continues tobeastrong, consensus in favor of effective environmental protection. In many cases, environmental goals are clear—the question is how to achieve those goals. The policy tools chosen do make a differ- ence. Although conventional regulatory policies havesometimes worked well, they have tended to pit economic and environmental goals against each other, too often producing paralysis rather than progress. But in the long run, economic and environmental goals must complement one an- other if either is to be achieved. This dis can be addressed by applying economi tive mechanisms to the work of environmental protection, In fairness to future generations, itis essential to begin now to deal with long-term economic and environmental problems. Sustainable solu- tions to today's problems are required, because the debts we incur today—whether economic or environmental—will some day have to be paid. Robert Stavins is Assistant Professor of Public Policy at the Kennedy School of Government, and a University Fellow at Resources for the Future in Washington, D.C. ‘SPRING 1990 End Notes 1. OnJune 12,1988, President Bush proposed “tradeable permit system” for acid-rain control as part of the ‘Administration's Clean Air Act amendments. This pro- posal wassenttoCongresson july21, 1989,asTitleV ofthe ‘Administrations bill. In early April, 1990, the Senate passed its version of the Clean Air Bill (5.1630) with the “radeable permit system.” 2, Stavins,Robert N,, ed. Project 8 Hamessing Market Forces to Protect Our Environment — Initiatives for the [New President. Public Policy Stady sponsored by Sena- tor Timothy E. Wirth, Colorado, and Senator John Heinz, Pennsylvania. Washington, D.C, December 1988. 3. Several studies have followed the Project 88 report. For ‘example, see: Moore, John Let. al. Using Incentives for tal Pro ew. Congressional Research Service Report to the Congress # 89-360 ENR. Washington, D.C. June 1989;and Anderson, RobertC. et al. The Use of Economic Incense Mechanisms in Environ: mental Management. Draft report. Washington, D.C. ‘American Petroleum Institute, September 1989. 4, See: Schoon, Nicholas, "Markets in ‘permits to pollute" proposed.” The Independent. London, August 16, 1989; and Shoard, Marion. “Clearing the air with a tax” The Times. London, September 15, 1989, 5 Pearce, David, AnilMarkandya,and Edward. Barbier. Blueprint fora Green Economy. London: Earthscan Pub: lication, 1989. 6. Within theSoviet Union the Cental Institut of Mathe- 1atiesand Economics (semi) ofthe Academy of Sciences hasadvocate the use of pollution taxes for a variety ofen- vironmental problems; while in Poland, goveramentoff- als have endorsed marketable permit programs to help address air and water pollution problems (John Palm- isano, personal communication, December 8,1989), 7. See: Krupp, Frederic D. “New Environmentalism Fac- torsin Economic Needs” Wal Stret Journal, November 20,1986, p. 4. 8. Among the leading environmental advocacy groups, theWildemess Society, the National Audubon Society, the Sierra Club, and the Natural Resources Defense Council have comet support selective use of economic incentive rechanisms. The recent endorsement of the Natural Re- sources Defense Council —a leader on clean ar issues — fora tradeable permit system for acid-rain controls par ticularly important See: Wald, Matthew L. "Searching for Incentives to Entice Polluter.” New York Times, October 8, 1989, 8. A discussion of future environmental challenges is provided by: Russell, Milton. "Environmental Protection forthe 1990s and Beyond.” Environment 29(1987):12-38 10, Federal expenditures forall environmental and natu- ral resource programs in 1985 were about $13.4 billion 23Robert N. Stavins (1.4% ofall Federal outlays). See: US. Office of Manage- ‘mentand Budget. BudgetoftheU S. Government, Histori- cal Tables, Fiscal Year 1987. Washington, D.C. US. Gov- ernment Printing Office, 1986; and U.S. Council of Eco- nomic Advisors, Economic Report ofthe President Wash- ington, D.C. US. Government Printing Office, 1986. 1. In 1984, total US. expenditures on pollution control amounted to about $65 billion — 63% by businesses, 21% by all levels of government, and 16% by consumers. Total pollution control expenditures were about 1.8% of GNP. Sec: Farber, KitD.and Gary L. Rutledge. “Pollution Abate- ‘ment and Control Expenditures.” Survey of Current Busi- ess 66(1986):100-103, 12. Public opinion polls consistently show that public concern over environmental quality has remained firm during energy crises, economic downturns, and tax re- volts. See: Dunlap, Riley E. “Pols, Pollution, and Politics, Revisited: Public Opinion on the Environment in the Reagan Era.” Environment 29(1987): 7-37; Ladd, E. C. “Clearing the Air: Public Opinion and Public Policy onthe Environment.” Public Opinion, February/March 1982, pp. 16-20; and Lamm, Richard D. and Thomas A. Barron. “The Environmental Agenda forthe Next Administration” Environment 30(1988)17-29 13. This set of criteria i based partly upon a similar set of criteria described by: Bohm, Peter and Clifford. Russell “Comparative AnalysisofAltemativePolicy Instruments” 3k of Natural Resour. 7 nomi Volume Leds. Allen V.Kneese and James , Sweeney, pp. 395-460. Amsterdam: North Holland, 1985 14. ICF Resources, Inc. Analysis of Six and Bight Million ‘Ton 30-Year/NSPS and 30-Year/1.2 Pound Sulfur Diox= ide Emission Reduction Cases, Washington, D.C, Febru- ary 1986, Recent cost estimates indicate that the current ‘Administration's proposed marketable permit program for acid-rain control would save between $13 and $16 billionby the year2010,compared withaconventionalap- proach. See: Hahn, Robert W. “Designing Markets in Tradable Allowances for Reducing Acid Deposition.” Dratt manuscript. Washington, D.C, December 1989. 15, For furtherdiscussion of such possibilities, see: Acker- rman, Bruce A. and Richard B. Stewart. "Reforming Envi- ronmental Law The Democratic Case for Market Incentives.” Columbia Journal of Environmental Law. 16. In general, the relative superiority (in terms of induc- ing technological innovation and diffusion) of incentive- based approaches, compared withconventionalcommand- and-control approaches, is cleat. See: Milliman, Scott R and Raymond Prince. “Firm Incentives to Promote Tech- nological Change in Pollution Control.” Journal of ronmental Economicsand Management 17(1989):247-265. Under certain circumstances, however, emission credit trading may reduce firms’ incentives to adopt new tech- nology. On this, see: Malueg, David . “Emission Credit ‘Teadingand the Incentiveto Adopt New Pottution Abate ment Technology.” Journal of Environmental Economics 4 and Management 16 (1989):5: 17. Even in the former case, witee concern focuses on aggregate pollution levels, there are situations in which command-and-contol approaches may turn oat to be ‘moreetficien than incentivebased approached ithe oo approaches accomplish different levels of pollution com- trod, See: Oates, Wallace E,Paut A. Poriney, and Albert M. MaGarttand. “The Net Benefits of Incentive Based Reguladon: A. Case Study of Environmental Standard Setting” American Economie Reviw 71989) 1233-1282. 1B, Forarecentdescription of EPA’s(and some European) experiences with incentive-based policies, see: Hahn, Robert W. “Economic Prescriptions for Environmental Problems How the Patient Followed the Doct sOnders.” journal of Economic Perspectives 31949)95-114. A quite different perspective is provided by Levin, Michael H “New Directions in Environmental Policy The Case for Environmental Incentives.” Proceedings of Anna Mid- winter Meeting, American Bar Associaton, Keystone of Natural Resource Law. Keystone, Colorado, March 18-2, 1988, 19, Morris, Willy, “TID Approves State's Firs WaterSwap swith MWD." Imperial Valley Press, November 9,198. 20, Atchison, Sandra D. "Where Water is Money in the Bank” Business Week, August 15,1988, p50. 21, Maine held one such action earlier this year; Massa- chusettsand New York have announced their intentions to hold similar auctions in the near future 22, SeeOpschoor, J.B. and Hans B, Vos. The Application ‘of Eoonomtc instruments for Environmental Protection in ‘OECD Countries. Final Report of the Environment Com- mittee. Paris Organization for Economic Cooperation and Development, 1988. A brief overview is provided by Spellman JamesDavid. "Environmental NeedsChallenge the Global Marketplace." Europe Magazine, September 1569, pp 18-20. 23. The Project 88 study of Senators Hein and Wirth olfered 36 policy recommendations for these enviton- ‘mental and natural resource problem areas. Based largely tipon that study, a sample of 16 recommendations are briefly summarized inthis paper 25, Dudek, Daniel J. “Assesing the Implications of Changes in Carbon Dioxide Concentrations and Climate for Agriculture inthe United States.” Preparing far Cli mate Change, pp. 428450, Proceedings ofthe First Nowth “American Conference on Preparingior ClimateChange: A Cooperative Approach. Government Istitates Ine, Apri 1988 25, Developing and developed nations have cooperated, toa limited dgree on international approsch to defores tation sues, Anaction plan hasbeen co-sponsored by the World Bank, the United Nations Development Program, the Food and Agricultural Organization, and other agen. cies, See: World Resources Insitute. Tropical Forest: A Callfor Action. Washington, D.C, 1985 26, Debtfrest swaps carried out between the US. gov- Harvaro Pustic Pouiey Review«ernment (directly or through commercial banks)and LDCs can produce intended, beneficial environmental effects only if LDCs are able to monitor and enforce the local ‘execution of forest saving plans, Related localadministra- tive costs should therefore be included in designs of debt- forest swaps. 27. Hammit, JK. Timing Regulations to Prevent Strato- ‘spheric-Ozone Depletion, R-3495-JMO/RC. Santa Monica ‘The RAND Corporation, April 1987;and Miller, A.S, and LM. Mintzer. TheSky isthe Limit: Strategies for Protecting the Ozone Layer, Research Report #3. Washington, D.C. ‘World Resources Insitute, November 1986, 28, A critical examination of EPA’sexperienceis provided by: Liroff, Richard A. Reforming Air Pollutions Regula- tions: The Toil and Trouble of EPA's Bubble. Washington, D.C: The Conservation Foundation, 1986. Some of the shortcomings in EPA’s emission trading rules have been remedied; on this point, see: Dudek, Daniel J., and John Palmisano.”Emissions Trading, Why isThis Thoroughbred Hobbled?” Columbia Journal of Environmental Law 13(1988):217-256. 29. Hahn, Robert W. “Innovative Approaches for Revis- ing the Clean Air Act.” Natural Resources Journal 28(1988):171-188 30. Some environmental groups continue to express con- cerns regarding emissions trading and similar incentive based approaches. Foracomprehensive response see:Ste- wart, Richard B. "Controlling Environmental Risks ‘Through Economic Incentives.” Columbia Journal of Environmental Law 13(1988):153-169 31. This recommendation is embodied in the Bush ‘administration's Clean Air Act amendment proposals, now under consideration by the Congress. 32, Tietenberg, Tom. Emissions Trading: An Exercise in Reforming Pollution Policy. Washington: Resources of the Future, 1985. 33. ICF Resources, Inc. Economic Analysis of Title V (Acid Rain Provisions) of th V's Proposed Clean AiAct Amendments H.R3030/S, 1490), Prepared forthe US.Environmental Protection Agency. Washington, D.C. September 1988. 34, Johnson, F, Reed and Ralph A. Luken. “Radon Risk Information and Voluntary Protection: Evidence from a Natural Experiment.” Risk Analysis 7(1987)97-107. 35. Cicchetti, Charlesand William Hogan. "Including Un- bundled Demand Side Options in Electric Utility Bidding, Programs.” Energy and Environmental Policy Center Dis: cussion Paper E-88.07. Cambridge: Harvard University, August 1988, 36. A timely and comprehensive study of Federal water projects and the potential for market-oriented reforms is: Wahl, Richard W. Markets for Federal Water Subsidies, Property Rights, and the Bureau of Reclamation. Wash- ington, DC: Resources for the Future, 1989. 37, Stavins, Robert N.and Zach Willey. "Trading Conser- vation Investments for Water.” Regional and State Water SpRinc 1990, Economic Incentives for Environmental Protection Resources lanni sted. R.J.Chubeneau, pp. 223-230. Bethesda, Maryland: American Water Re- sources Association, 1983, 38, Willey, Zach and Tom Graft. “Federal Water Policy in the United States — An Agenda for Economic and Envi- ronmental Reform.” Columbia Journal of Environmental Law 13(1988); 325-356, 38. Phipps, Tim. “The Conservation Reserve: A One Year Progress Report.” Resources, Winter 1987, 40, ‘Environmental Defense Fund. Coming Full Circle: Successful Recycling Today. New York, NY, 1988. 41. Foralternative perspectiveson the use of labelling, see Roe, David. “Barking Up the Right Tree: Recent Progress in Focusing the Toxics Issue.” Columbia Journal of Envi- ronmental Law 13(1988)275-283; and Haag, Melinda “Proposition 65's Right-To-Know Provision: Can It Keep Its Promise to California Voters?” Ecology Law Quarterly 1401987): 685-712. 42. Russell, Clifford S. “Economic Incentives in the Man- agement of Hazardous Wastes.” Columbia Journal of En: vironmental Law 13(1988)257-274, An earlier and more general inquiry is provided by Bohm, Peter. Deposit Refund Systems: Theory and Applications for Environ: ‘mental, Conservation, and Consumer Policy. Washing- ton, D.C: Resources for the Future, 1981 43. Bowes, Michael D. and John V. Krutila, Multiple-Use “Management: The Economics of PublicForestlands Wash- ington, D.C: Resources for the Future, 1989. 44. Stavins, Robert N. and Adam B. Jaffe. “Unintended Impacts of Public Investments on Private Decisions: The Depletion of Forested Wetlands.” American Economic Review, 80(1990), in press. 45, Stavins, Robert N. “Alternative Renewable Resource Strategies: A Simulation of Optimal Use.” Journal of Environmental Economics and Management 18(1980), in ress. 25