Using the Market to Fix the Environment

I used to think that the only thing needed for better environmental policy was a government that could stand up to polluters. While this still may be the most effective approach in some instances, these days, I realize the issues are more complex. In some situations, direct financial incentives may be an effective way to improve environmental quality.

I first saw this in Costa Rica: landowners were paid directly to protect forests on their property, in a bid to reduce forest destruction. The results is improved water quality and forest cover in all areas where the programs operate.

We don't necessarily need to pay cash to prevent pollution, but we can shape financial incentives or disincentives for business, landowners and industrial developers. Market-based instruments (MBIs) use price signals or property rights to encourage environmentally-responsible behaviour or  discourage environmentally destructive behaviour.

MBIs have caught the attention of governments around the world, and the government of Alberta is no exception. MBIs present an interesting alternative to the status quo, in appropriate circumstances. These are some typical arguments that I hear, both for and against.

Possible benefits of MBIs

• They may establish new markets where buyers and sellers can trade; each transaction has the potential to lead to an environmental improvement.
• They may create property rights for some goods or services that would otherwise be degraded through over-use, providing some improvements to the tragedy of the commons.
• They give consumers a better picture of the true cost and benefit of the products we buy and use everyday.
• The funds that are raised can be used to achieve additional environmental and conservation objectives, or to reduce taxes in other areas of the economy.
• They create an incentive for continuous improvement of business practices, as changes may bring reduced costs and increased profit .
• Companies and individuals have more freedom of choice as to how they comply with environmental policy
• This freedom of choice may lead to lower-cost compliance with environmental policy as companies seek the solutions that work best for them.
• By putting a cost on "business-as-usual," they may give extra motivation to landowners and businesses who see ethical motivations for undertaking environmentally friendly behaviour, but hesitate at the perceived costliness of changing their current practices.
• In some cases, they can reduce the leeway for businesses and individuals to lobby and influence government in their favour, because once the rules are set the market mechanisms take over.

Nothing comes without a down side, of course

• MBIs may still sometimes require agreed-on limits on pollution levels. Setting limits on pollution is contentious and involves consensus building, which can be costly and time-consuming.
• The process requires strong political leadership - the public rarely supports increases in costs, particularly in the form of taxes where costs become very evident.
• Governments may see MBIs as a way to reduce the size, and therefore costs, of operating government departments as the market "replaces" the need for some types of government functions.
• Often the use of MBIs makes the costs of compliance more transparent, which can discourage further improvements or coverage of environmental policy. 
• For some people MBIs have the potential to crowd out ethical motivations for undertaking environmentally friendly behaviour in favour of the pursuit of financial gain.

As an economist, I often find myself either defending my choice of profession or asked to help make some pretty big decisions, precisely because of the job I chose. More than any other topic these days, market-based instruments really raise some people's hackles - and strike others as an exciting development in environmental policy. At this point, I can see there is no silver bullet to environmental policy. Increasingly, governments are looking for new solutions to address the complex problems we face today. They should be applauded for trying something new - but they should also be held accountable through vigorous public debate.

Here are some examples of market-based approaches worldwide:

• Costa Rica's FONAFIFO
• Oregon's Willamette Partnership 
• Victoria, Australia's Bushbroker Program