Environmental Sanction Charges
5. Economic Instruments in Sweden
5.1.4 What makes Economic Instruments Effective?
As mentioned above, economic instruments could be used to address market failure and combat negative externalities. They can act either as a carrot or a stick to steer more sustainable actions. But the question is how environmental policy and eco- nomic instruments are to be best designed in order to be effective.
Much of the economic literature in this area suggests that negative environmental impact can be avoided or minimised if appropriate or ”optimal” environmental policy is in place. ”Optimal” environmental policy means that there is full inter- nalisation of environmental externalities and well defined property rights.50 Even though achieving an optimal and perfect environmental policy is highly improb- able51 , experience suggests that countries with comprehensive environmental poli- cies in place (even if not optimal) can do much to reduce adverse effects and to promote economic development that is more beneficial for the environment. How environmental policy and instruments are best designed (to be optimal) has been discussed and described both theoretically and empirically in many different articles and studies. Goulder et al. (1999)52 , for example, suggest that an optimal instrument operates through four main effects, which are:
• the abatement effect
• the input substitution effect
• the output substitution effect, and
• the revenue-recycling effect
“The abatement effect” means the incentive to use less of an input, “the input sub- stitution effect” stands for a substitution among inputs and “the output substitution effect” implies that higher product prices lead to less use of embodied emissions. Finally “the revenue-recycling effect” gives the budgetary effect of taxes collected. All the mechanisms described above are in use when a perfect tax (or an auctioned permit) operates by addressing an environmental problem. This means that a given target can be reached at the lowest possible cost.
50
Schulze & Ursprung (2001), “International Environmental Economics”, Oxford University Press,, New York.
51
One complication is the fact that the effect of economic conditions, eco-systems, and pollution on the recipient and environ-mental resilience varies between different geographical areas, which means that the optimal level of environmental policy also varies. A differentiated environmental policy e.g. a differ- entiated tax between regions can be more environmentally efficient but can e.g. be viewed as unjust by the actors involved.
52
Example from OECD (2006), “Swedish Regulatory Reform and Environmental Policy”, ENV/EPOC/WPNEP (2006)12, OECD, Paris.
Subsidizing the use of renewable energy sources, or research into such sources, can not be considered as optimal and is according to some studies53 , less efficient than raising the true price of carbon (pointed out as the most efficient way to reduce carbon emissions).
A major advantage with say an emission tax on carbon is that it puts pressure on consumers to conserve and on producers to employ more efficient technologies and also gives the untaxed renew-able energy a better chance to expand their share of energy production. However emission taxes are unpopular since they are more visible and governments often fear that the use of these kinds of taxes will reduce the economic growth. Even though subsidies to renewable energy do not burden consumers, they can imply other problems like tax revenues foregone and can be less effective e.g. to reduce carbon etc. Subsidies can however be motivated in some cases which will be described later in this section.54
When introducing economic instruments and policy it is pertinent to study whether some economic instruments and environmental policies have been more effective than others.
There are several ways to evaluate the efficiency and to estimate costs and benefits. For example some criteria could be used to decide whether a political instrument will be considered efficient or not. Brännlund and Kriström (1998)55 for example suggest that environmental policy is efficient if:
• the marginal benefit of the environmental improvement equals the marginal cost56 of the improvement
• the chosen environmental quality is achieved at the lowest possible cost.
The first criterion suggests that emissions should be reduced as long as the cost does not exceed the benefit. This criterion assumes full knowledge of the damage of the emissions, not only the physical damage but also knowledge about the value of the damage. Since this knowledge is rarely available, due to uncertainty in the calculations of the damage and the valuation, the first criterion is seldom fulfilled. A calculation of both the benefit and cost is therefore not often used when envi- ronmental quality goals are established. The ambition is rather that the environ- mental goals should reflect the critical capacity of the environment and what it is economically reasonable to achieve. The environ-mental quality goals may there- fore indirectly reflect a valuation in the sense that an ambitious goal suggests that the environmental improvement has great value.
53
See e.g. Fischer and Newell (2004)
54
OECD (2006), “Swedish Regulatory Reform and Environmental Policy”, ENV/EPOC/WPNEP(2006)12, OECD, Paris.
55
Brännlund and Kriström (1998) “Miljöekonomi”, Studentlitteratur, Lund. (in Swedish)
56
Marginal cost and marginal benefit basically means the cost of reducing emissions with one more unit (based on a certain level) and the benefit of this reduction.
Since the first criterion is difficult to establish57 , the second criterion becomes more important. This criterion, which means that the goals should be attained cost- effectively, can however be measured in different ways. Either the meas-
ures/instruments are chosen that lead to the goal at the lowest possible cost or measures that attain the highest possible environmental benefit in relation to a given cost are chosen. To reach a goal at the lowest possible cost measures are often directed to many different sources and sectors necessary. A cost-effective allocation of measures is achieved when the marginal costs for reducing the emis- sions are the same for all measures. It is desired that economic instruments should to a greater extent take into consideration the difference in effect of measures e.g. depending on the geographical location, which could be done e.g. by differentiating taxes. Measures should be located in areas where they have the largest impact on the goal. Generally market based instruments such as emissions trading or taxes have high potential for reaching a cost-effective allocation of measures.
It is clear that the level of available background information is essential when the effectiveness of instruments is discussed. For example, some environmental regula- tions may not be cost-effective but may have the advantage that they can be used without much information (e.g. about pollution quantities, effect on the recipient etc.) and other ”transaction costs”58. Other instruments may be cost-effective but could have very high transaction costs. The choice of suitable instruments is apart from cost-effectiveness also generally based on available information and the other associated costs that each instrument requires59.
For most economic instruments such as taxes and subsidies, it is difficult to predict the reduction of emissions and they are accordingly not as effective in combating environmental problems if we need to know the exact result of the instrument in- troduced. It may therefore be better to use other instruments e.g. a ban when deal- ing with some very dangerous and hazardous substances that need to be reduced to certain levels60.
It can also be interesting to note that policy instruments can be directed to different groups in society and have different distribution effects. The size of e.g. govern- mental, private economic and business effects depends on the choice of instrument to generate the measures. If subsidies are used in the agricultural sector to stimulate the implementation of certain measures, the costs are allocated to the taxpayers and not to farmers.
57
Sometimes average cost is used as an approximation for marginal cost since in many cases it is, if not impossible at least very resource demanding to estimate the marginal cost.
58
With “transaction costs” here basically is meant the costs that are associated with the introduction and maintenance of an economic instrument where information is an essential part.
59
Green I-M., Scharin, H., Water pollution policies: What do we learn from economic theory and empiri- cal evidence?
60
Regulation that implies e.g. a demand for abatement means that the costs are allo- cated to those who implement the measures. This is also the case for fees and emis- sion allowances that are distributed free of charge (grandfathered).
A tax on emissions or emission permits that are auctioned implies a larger cost for the sector whose activities are controlled since, besides the abatement cost they also need to pay for remaining emissions. On the other hand the government can use the revenues from a tax to compensate groups that are negatively affected by the emissions etc. Taxes and auctioned emissions allowances are the only instru- ments that fulfill the Polluter Pays Principle (PPP) since the polluter has to pay taxes for all emissions even after the desired abatement level is reached.
Subsidies are suitable (and are corrected for market failure), mainly for activities that are associated with positive external effects like wetlands, where the subsidy is given to internalise the positive external effects e.g. biological diversity that a wet- land can generate, in the price for the creation and care of these wetlands. These kinds of subsidies imply, like taxes, cost-effectiveness and dynamic efficiency61 . The financing of subsidies, for example through taxes on some other market may however have negative effects on the economy.62
The economic instruments presently used in Sweden were evaluated and analysed during 200663 based (among other things) on their ability to achieve environmental benefits effectively in the long term. One of the main criteria in this study was the ability to achieve the desired Environmental Quality Objectives64 as quickly as possible and at the lowest possible cost (cost-effective). The use of the instrument was also viewed as effective if it promoted technical development, encouraged the most cost-effective solutions over time and created financial incentives for improv- ing production processes and changing patterns of consumption.
The study also pointed out the advantages of multi-sector instruments (e.g. multi- sector taxes) for example due to the ability of these instruments to effectively re- duce environmental problems in many areas and sectors.65 More results from this study and examples of effective economic instruments in Sweden (according to the study) will be described later. International aspects, trade and competitiveness concerns, which are also relevant for instruments’ effectiveness will be described briefly in the following section.66
61
Dynamic efficiency basically means the capacity of an instrument to generate technological devel- opment and encourage the most cost-effective solutions over time
62
The size of the subsidy should equal the size of the positive externality. With the subsidy the produc- tion cost would better reflect the welfare economic marginal cost of the production.
63
”Economic Instruments in Environmental Policy” (2006), see reference list
64
In the study the environmental objectives are taken for granted and the analysis is focused on the costs to society of the instruments used , which formed the basis for the aim to achieve socio- economically effective environmental policy in the long term
65
For more info about the economic theory see e.g. reference ”Economic Instruments in Environmental Policy” in “For more information”.
66
For more information about what makes an economic instrument effective see also e.g. “Using the market for cost-effective environmental policy” (EEA Report No 1/2006), mentioned in the reference list