Natural Resource and Environmental Economics Notes

Economic Instruments for environment protection and management

a. Policy Instruments

The Polluter Pays Principle (PPP)

It states that if measures are adopted to reduce pollution, the cost should be borne by the
polluters.
OECD council defines this principle as: “The principle to be used for allocating costs of
pollution prevention and control measures to encourage rational use of scarce environmental
resources and to avoid distortions in the international trade and environment is the Polluter Pays
Principle.”
Supreme court of India interpreted the principle as the absolute liability for harm to the
environment extends not only to compensate the victims of pollution but also the cost of
restoring the environmental degradation. Thus, it includes environmental cost as well as direct
cost to people or property.

The User Pays Principle (UPP)

It states that all resource users should pay for the full long run marginal cost of the use of a
resource and related services, including any associated treatment costs. It is applied when
resource is being used and consumed.

The Precautionary Principle (PP)

The main objective is to ensure that a substance or activity posing a threat to the environment is
prevented from adversely affecting the environment, even if there is no conclusive scientific
proof of linking that particular substance or activity to environmental damage.

b. Market-based Instruments
Market-based Economic Instruments are intended to internalize environmental costs and
externalities, and hence influence decisions of agents by sending signals through price and other
variables. These provide financial incentives to make environment friendly decisions. It is in the
economic interest of the polluter or the consumer to reduce pollution voluntarily by using better
inputs and techniques or consume fewer polluting goods by conservation or substitution. The
main strength of economic instruments is the flexibility they allow leading to a reduction in the
overall cost of abatement in comparison to other regulatory approaches. Economic Instruments
call for an overall level of environmental performance in the economy. The private players,
depending on their relative costs, can decide their respective levels of abatement. This ensures
that industries with lower abatement cost abate more than those with higher abatement costs.

Market-based instruments are of three broad types: price-based, quantity-based and

informational-policy instruments.

(i) Price-Based Instruments

The price-based instruments can be further grouped into negative and positive instruments. A
pigovian tax is a typical negative price instrument used when the output produced of a 'bad' is at
the point where the marginal cost of the firm meets the price. The socially optimum output
would have been lesser if the social marginal cost (which is higher than the firm's private cost)
had been considered. Since the firm ignores this externality, a tax is imposed on it to the extent
that its private cost equals the social cost internalizing the externality and inducing the firm to
produce at the socially optimal level. Thus, as resources and emissions become more expensive,
consumers and producers have an incentive to consume lesser or pollute lesser. It works out to be
more efficient than CAC regulations as firms which have a lower marginal abatement cost than
the marginal tax rate will do so and those who do not will simply pay the tax. Subsidies for
environmental 'goods' which are generally under-produced or under-consumed, to encourage
more production and consumption could fall into positive price instruments. The main drawback
of price instruments is that the outcome level is allowed to vary and hence cannot be pre-
determined.

(ii) Quantity-Based Instruments

As opposed to price instruments where price is fixed and output is allowed to vary as decided by
firms' response, in the case of quantity-based instruments the government fixes the output and
the private firms can choose prices to achieve the quantity limit. In a way, quantity instruments
are similar to performance standards except that non-compliance to the limits is allowed if a firm
could buy credits from another firm which has over-achieved the target, that is, reduced
emissions beyond requirement. Such credits can be exchanged through instruments like tradable
pollution permits. Such permits give an incentive for firms to pollute less as they could sell their
permits if they achieve better performance. Such an instrument stems from the Coasean approach
where it is argued that the socially optimal level of outcome will emerge if proper property rights
are defined and it is the state's responsibility to define and enforce such rights. The ultimate
outcome does not depend on who possesses the right as the polluter and the victim will bargain
among themselves and reach the optimal outcome. The main advantage of quantity instruments
is that they ensure the desired environmental outcome. However, the practical implementation of
trade permits requires an effective legal and institutional structure, the lack of which acts as a
major hurdle for its effectiveness especially in developing countries.

(iii) Informational-Policy Instruments

In addition to price and quantity instruments, informational instruments also provide incentives
to pollute less. 'Right to Know' programs require polluters to report the amount of pollution they
generate. For example, in the US, the Toxic Release Inventory forces firms to publicize their
level of toxic chemical use and effluents (Driesen, 2006). Such programs give incentives for the
firm to reduce pollution to the extent it is conscious of its reputation and loss of market demand
as a result of any adverse reputation. Voluntary environmental certification systems and eco-
labeling reveal the environmental attributes of the company or the product to the consumer and
hence the firm is tempted to improve its conduct to attract customers. Other instruments which
provide information about the firm like awareness campaigns and information programs on new
deployable techniques could further help the firm to reduce pollution. However, information
programs may be used complementarily with other instruments and may not be effective if used
alone. In recent international experience, the reliance on using economic instruments has
considerably increased. In this paper, we examine the reasons for this increased dependence on
using economic instruments for environmental management internationally.

Environmental Taxes
Given the environmental concerns, a wide range of environmental taxes have been used. Some of
these taxes are outlined below:
i. A carbon tax on the use of fossil fuels is an eco-tax. It is a tax on energy sources which
emit carbon dioxide. A carbon tax aims at reducing emissions of carbon dioxide and thereby
slow global warming. It can be implemented by taxing the burning of fossil fuels like coal,
petroleum products such as gasoline and aviation fuel, and natural gas, in proportion to their
carbon content. Unlike market-based approaches such as carbon cap-and-trade systems, it has the
benefit of being easily understood and can be popular with the public if the revenue is earmarked
to fund environmental projects.
ii. Effluent charges are also a form of eco-tax, which is levied on effluents, pollution and other
hazardous wastes. These are widely used in Western and Eastern European countries and are
used to control a range of pollutants like carbon monoxide (CO), carbon dioxide (CO 2, sulphur
dioxide (SO2, biological oxygen demand (BOD), Oxides of Nitrogen (NOx), total suspended
solids (TSS), nitrogen (N), phosphate (P), landfill and hazardous waste.

iii. User Charges are the charges levied on those who directly benefit from a service, in order to
finance its provision. Examples are fuel taxes, congestion charges (used for traffic management),
charges for disposing of landfill and hazardous wastes (used for solid waste management),
product taxes on batteries, beverage containers, tyres (the revenue of which is used for its
disposal).

v. Deposit Refund System is used for environment regulation for disposal or recycling of
hazardous waste. Under this system, purchases of potentially polluting products have to pay a
surcharge which is refunded to them when they return the product to an approved centre for
proper disposal.

vi. Tradable Permits: JH Dales proposed the idea of sale of pollution rights. Tradable quotas or
permit assign rights to use resources or emit certain level of pollution. The government sets
limits on the amount of a resource that can be used and allocates permits to users. Users can buy
and sell permits to meet their needs (companies that pollute less can sell their remaining permits
to companies that pollute more and if it produces more pollution it has to buy permits from other
firms or government.
As the diagram below shows, when firms would like to pollute more, the demand for tradable
permits rise. In turn, this increases the price of such permits, reducing their profitability, while
overall market emissions remain unchanged as the supply of tradable permits is fixed. Hence
firms have two incentives to reduce emissions: 1) they can sell of their excess permits for
additional profits to other firms, and 2) increasing emissions would reduce their own profits due
to the increased costs of buying additional permits.

vii. Emission Tax: Under this those who produce emissions face a tax per unit of emission. In
contrast to command and control strategy, this tax doesn’t set limits on emission, instead firms
are either free to emit pollutants and pay the tax or pay for installation of controls to reduce
emissions.
Transaction Cost

 Proposed by Ronald Coase in 1937.

 Transaction costs are the cost of resources used to define, establish, maintain and transfer
property rights.
 In relation to the transfer of a product, transaction costs have been defined as all the costs that
are not directly related to the production of that product.
 Transaction costs arise because of information uncertainty and as a result of the actions that
transactors must take to manage for this uncertainty.
 Transaction costs are particularly relevant in market-based environmental policies, such as
cap-and-trade systems or pollution permits, where there is a need for ongoing coordination
between various stakeholders like governments, businesses, and environmental organizations.
High transaction costs can undermine the effectiveness and efficiency of environmental
policies, as they may discourage participation or lead to delays in decision-making.
 Reducing transaction costs is important for improving the overall efficiency of environmental
solutions, such as establishing clear property rights or creating market mechanisms that
minimize unnecessary administrative burden.
Make short notes (objectives or salient features) on these acts for finals
 The Water (Prevention and Control of Pollution) Act, 1974
 The Air (Prevention and Control of Pollution) Act, 1981
 The Environment (Protection) Act, 1986
 The Wildlife Protection Act, 1972
 The Noise Pollution (Regulation and Control) Rules, 2000
 Forest (Conservation) Act, 1980
 Hazardous Wastes (Management and Handling) Rules, 1989
 The Bio-Medical Wastes (Management and Handling) Rules, 1998
 The Recycled Plastics Manufacture and Usage (Amendments) Rules, 2003
 National Forest Policy, 1988
Difference between Natural Resource and Environmental Economics
Natural Resource Economics Environmental Economics
Subject of interest Economic study of resources Economic study of environment
Focus upon Optimum extraction of resources Externality
Condition for Price = Marginal Cost + Marginal social cost (MSC) = Price =
optimality Opportunity cost of resources not Marginal cost + Cost due to externality
extracted (Rent)
Cost concepts used User cost=royalty=Scarcity Cost due to externality (external cost)
rent (opportunity cost)
Analysis Dynamic analysis (use of Dynamic analysis (use of differential and
differential and difference difference equation)
equation) Dynamic analysis (use
of differential and difference
equation)
Role of markets Well-defined markets may/ may Markets do not exist, a case of missing
not exist. For example, water markets. For example, market for clean
markets, land markets and market air, market for honey bee pollination
for recreation. Since total service. Hence valuation of services
economic valuation is important rendered by environment is more relevant
and markets does not provide full than simply attaching a price for the
valuation of resource and services rendered by environment
therefore, valuation of resource is
more relevant than price.
Stakeholders Resource extractor, user, Entire society, environmentalists and
processor, Resource owner Government
and Government
Policy framework Long term macro-economic Long term macro-economic policy is
policy is must. For example, must. For example, International and
National Water policy, National National Environmental Policy
Mining Policy.