Market-Based Environmental Laws
100 Ways to Use Prices To Prevent Pollution

William K. Shireman and Clifford Cobb

Toward a New Environmental Policy Agenda: A Summary Of Market-Based Policy Options

A GENERATION AGO, Congress passed the original Clean Air Act of 1970 and Clean Water Act of 1972. Since that time, nitrogen oxide emissions have been reduced seven percent, particulates and sulfur dioxide are down 20 to 30 percent, and twice as many streams meet federal water quality standards.

Despite those marginal improvements, however, environmental pollution has moved from a local to a global threat. Alteration of global climate, the depletion of protective ozone, the slash and burn of global rainforests (and hence of ecosystem diversity) and other threats seem to loom larger today than before.

To some environmentalists, that is a cue to fight for more regulations, tighter laws, tougher enforcement agencies, higher fines, more cops, and more controls. But getting tougher may not accomplish much. Our meager successes so far may reflect not poor motivation, but poor methods. Even environmentalists are growing frustrated with ad hoc policies that try to save the earth one piece at a time. Instead, they are looking for more organic solutions, policies that can evolve a depletion-based economic system into a sustainable one, in which pollution and waste are reduced continually, automatically, toward zero.

Market-based environmental policies that use prices to prevent pollution may provide part of the answer. Although industries were spending billions in the 1970s and 1980s to comply with myriad environmental restrictions, one powerful market-based policy achieved more positive effects in a single stroke than all the controls combined. It led to a 20 percent reduction in solid waste generation, more than a 30 percent drop in energy use, and similar across-the-board reductions in air and water emissions per unit of gross national product in the United States.

That policy was the Arab oil embargo of 1974 and the second oil crisis of 1979. The price spikes produced by those events may have been painful, but they stimulated the innovations throughout the economy, innovations that dramatically reduced United States reliance on physical raw materials as a means to stimulate economic growth.

If one is looking for evidence of the effectiveness of market-based environmental policies, no example makes the case more powerfully than the energy crises--with one stipulation: although the crises of the 1970s required a mammoth transfer of wealth that staggered the United States economy, well-designed market-based policies require no net loss of capital. Market forces can keep the capital here, even expand it, and at the same time create the same powerful incentives to reduce material consumption.

That is why the market-based approach can be looked upon as more than merely a cheaper way to meet environmental mandates. By rewarding people and companies that grow more efficient in their use of finite resources, well-designed market-based environmental policies can serve as a catalyst to promote inventive changes that prevent pollution, increase industrial efficiency, and drive the development of an industrial economy that is both affluent and environmentally sustainable.

It is this latter trait, the ability to meet both economic and environmental imperatives, which may prove the most powerful endorsement for the market-based approach. As industrialized societies enter an era of knowledge-driven economic growth, policies designed to reward the most efficient use of resources and waste reduction can be a natural complement to the economies and institutions of an information-based society.

A Theory of Market-Based Environmental Policy

The modern industrial economy can be likened to a throughput machine that profits by transforming raw materials and energy into products. In a competitive marketplace, individual businesses carry out this function in ways which tend to maximize their individual productive efficiencies. That is, they strive to continually reduce costs of acquiring and using raw materials, energy, labor, and other resources.

In theory, a competitive economy should root out pollution over time, as individual businesses strive to increase profits. "All pollution and all waste is lost profit," according to William K. Coors. In other words, all pollution is a sign of imperfect efficiency: raw materials and energy that have been incompletely transformed into products or services. "A central purpose of any business that seeks profits should be to maximize efficiency, and thereby reduce and ultimately eliminate pollution and waste," writes Coors.

That purpose is thwarted, however, when the costs of acquiring and using resources are not fully accounted for (externalized) by the businesses or individuals directly responsible for them. The classic example of this condition is the "tragedy of the commons" which was presented in a 1968 essay of that title by biologist Garrett Hardin. Hardin's essay described how, in the case of an unmanaged pasture, herders operating in their own self-interest would tend to overgraze the pasture past the point of sustainable yield. In his story, each new head of cattle added to the field reduced the take of all the others. Nevertheless, each individual herder gained more by introducing one more head of cattle than he lost in productivity among his other cattle because he gained the marginal benefits, but the marginal costs were shared by all the other herders. The inevitable result of this pursuit of individual self-interest was the depletion of the field's capacity to support any cattle. "Freedom in a commons brings ruin to all," wrote Hardin.

If freedom in a commons brings ruin, then there are two ways to avoid ruin: restrict freedom or restrict the commons. In the context of the environmental commons (air, water, and land) command-and-control regulations do the former--they tell people precisely how to carry out economic activities. Market-based laws do the latter--they attack the problem of the commons head-on, by using these laws to define it out of existence.

Market-based laws achieve this by isolating externalized cost categories and assigning specific legal responsibility for them. In the modern economy, costs that are externalized by businesses are typically borne by the environment, individuals (the taxpayer or consumer), and future generations. For example, extracting fossil fuels imposes costs on the land and water, and burning them emits pollutants into the air. These impose costs not only on the environment, but on taxpayers and consumers.

In addition, consuming nonrenewable resources today prevents their later use, and thereby imposes costs on the future. If the planet earth is conceived of as a bank, then its physical assets are its natural resources. When a manufacturer withdraws fossil fuels from the earth, it pays the costs involved in extracting them from the ground. But it does not pay the true costs of creating them because fossil fuels have already been manufactured by nature and stored in the earth. Pricing fossil fuels according to their costs of extraction is somewhat like valuing one's life savings according to the cost of driving to the bank to withdraw them.

Moreover, because costs imposed on the earth's commons do not show up in the profit and loss statements of the businesses or individuals responsible for them, they tend to be maximized. As long as the damages are within government-established standards, the manufacturer is free to inflict them, even if eliminating them would be less burdensome for society overall.

Market-based environmental policies plug these leaks in the industrial economy by imposing a cost and extending ownership for each unit of pollution and waste externalized to common resources like air and water. A market-based policy can be defined as any policy which assigns legal and financial responsibility--ownership--for pollution to the entity most direct responsible for generating it, so that any increase in pollution leads to higher costs, and any decrease in pollution leads to lower costs, for that person or organization. Thus, rather than restricting the free market as most environmental regulations do, they seek to broaden its reach.

The definition above suggests three design criteria for market-based laws:

To designate the owner of pollution or waste--the entity legally and financially responsible for it. In all cases, the owner should have direct control over the generation of the waste.

To enable the owner to, in effect, buy and sell those ownership rights, just like any other property.

To empower the owner to decide how pollution should be reduced. Government's role is limited to deciding who must act.

It is not just the costs of pollution, however, that market policies internalize, but the costs of using any physical resource. In other words, market-based policies are intended to more fully internalize the costs of using fossil fuels, raw materials, water, and air.

Market-Based Environmental Laws in Practice

In practice, linking market-forces to environmental regulation may be of concern to some manufacturers playing by today's rules. The concern may be justified, first, if the manufacturer is the beneficiary of existing subsidies, or, second, if the manufacturer is subject to badly designed marketed-based laws.

But for the economy overall, a comprehensive set of market-based environmental laws can serve as a powerful agent for industrial renewal, not only by applying the "polluter pays principle," but also by cultivating the full application of ideas and technologies that can increase the value-added manufacturing, and thereby decrease society's collective appetite for physical resources.

A recent report, written and published by California Futures entitled "Market-Based Environmental Laws: 100 Ways to Use Prices to Prevent Pollution," describes a variety of market-based laws that could have the effects described above at all levels of government and the economy. Some of the policies are pure market-driven laws; others are hybrids that combine command-style regulations with market-based features. Most of the policies presented in the report fall into one of five broad categories that are described below.

Green Taxes on Consumption and Pollution

Present-day taxes often impose higher costs on the "goods" that people tend to want more of (e.g., income and investments). Green taxes take the opposite approach, imposing taxes on things people want to diminish, like consumption, pollution, and waste. By increasing the costs of utilizing raw materials and energy, and of producing pollution and waste, green taxes are intended to drive the development of technologies that increase energy and materials efficiency.

At a time when the public's acceptance of higher taxes is at a low, green taxes may best be considered an alternative to existing taxes, rather than an augmentation to them. For example, a proposal by the Worldwatch Institute would have reduced personal income taxes, making up the revenue shortfall by taxing various pollutants.

A similar proposal by California Futures would reduced the state sales tax by * percent and replaced it with a $16 per ton tax on garbage.

User Fees

Existing laws often charge a fixed fee for the use of common resources, such as roads, highways, dams, and landfills. For example, taxpayers pay the same amount no matter how frequently or infrequently they use freeways. By switching to a user fee, people who use roads, landfills, and other common resources are charged based on their use of these resources and, therefore, have an economic incentive to pursue sounder environmental practices. When Seattle began charging residents for every pound or can of garbage they generated, for example, waste generation rates declined by 60 percent; recycling, reduction, and composting surged.

Pollution Fees

Present law makes pollution free up to arbitrary limits set by the government, then suddenly creates a prohibitive cost that often turns out to be negotiable. Pollution fees are intended to make polluters pay for every unit they discharge. The objective: polluters should profit for every unit they reduce.

The concept could even be applied to the worst of polluters--internal combustion engines. Under one proposal, car registration fees would be set according to fuel economy or average emissions per mile for each model. Another proposal, called DRIVE+, would adjust sales taxes on cars to benefit high-mileage vehicles. A third would scrap today's smog check system, which misses the majority of offenders, and replace it with an electronic roadside monitoring system. This system would enable authorities to detect and fine the 10 percent of vehicles that produce 50 percent of the emissions.

Refundable Deposits

Current hazardous waste laws make it expensive to collect used motor oil, toxic chemicals, and certain auto bodies for recycling. As a result, illegal disposal is often the most profitable option. Illegal dumping can account for as much as 99 percent of these wastes. A report now under preparation by California Futures presents a deposit-refund system on dangerous chemicals or their containers. An effective deposit system could make illegal disposal more expensive than safe disposal, eliminating the profit in toxic waste.

Emissions Trading

Tradable permits have been applied to both air and water pollution control in the United States. A tradable permit establishes ownership of the right to pollute through a system of permits. Generally, a firm is allowed a certain number of permits, based on their existing waste generation. Firms may then trade or sell these permits in order to meet the pollution control requirement in the most cost-effective manner. Doing so can significantly increase the economic feasibility of clean manufacturing. In studies conducted in the 1980s on three waterways--an 86-mile stretch of the Delaware Estuary, the lower Fox River in Wisconsin, and the upper Hudson River in New York--the mandated technology approach cost from 50 percent to 200 percent more than the least-cost approach.

The market-based approach is becoming even more critical as the economy evolves into a system driven as much by knowledge as by physical resources.

In this type of economy, driven by the wealth of new ideas and technologies, market-based policies may be preferable because they accelerate the application of knowledge to replace physical resources. By achieving environmental goals through the use of price signals and similar incentives, market-based laws operate systematically; they change the behavior of businesses and individuals by changing the signals they receive in the economy. Literally, they make the economy, and the organizations within it, smarter. This differs from most command-and-control laws, which operate programmatically, identifying specific behaviors, and attempting piecemeal reform by external force, without dealing with the overall system.

When they are administered effectively, market-based environmental policies tend to drive continuous improvements, not one-time gains. They lead to maximal pollution reductions, instead of stopping at politically acceptable levels. They are designed to be much less expensive than mandates, often saving money rather than imposing higher costs. Finally, they are intended to root out waste systematically, empowering individuals and firms to apply creative solutions.

No economy can completely stop using physical resources. Still, the development and application of comprehensive market-based policies of the type discussed here, in concert with the ongoing application of knowledge-driven technologies, have the potential to expand the resource productivity of the industrial economy by reducing the physical content and increasing the knowledge content of products and services.

Over time, this can reduce demand for raw materials and energy, thereby tending to reduce their price. Pressed far enough, efficiencies could lower the value of many raw materials and fuels toward zero, increasing the likelihood that they will be left in the ground, preserving the living ecosystem, and cultivating the emergence of a human economy characterized by increasing affluence and declining effluence.

For a complete report of Market-Based Environmental Laws: 100 Ways to Use Prices to Prevent Pollution, order through Available Publications, Global Futures Foundation home page.

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