Environmental Economics and Improving Environmental Policy

Economics has become less a series of doctrines than … an engine of analysis in which techniques, ranging from the theory of public goods and externalities, ideas about the role of property rights, negotiation, incentives, and mechanism design, are used together with ideas from other disciplines to work out possible solutions to very difficult problems.[1]

Roger Backhouse

Economics is the study of the allocation of scarce resources. This central focus, as much as anything else, makes it eminently suited to analyzing environmental problems. Let’s take a concrete example. The Columbia and the Snake Rivers drain much of the U.S. Pacific Northwest, providing water for drinking, irrigation, transportation, and electricity generation and supporting endangered salmon populations. All these activities – including salmon preservation – provide economic benefits to the extent that people value them.[2]

Nathaniel Keohane and Sheila Olmstead

 

While this publication is focused on considering the foundational economic issues connected with environmental protection, achieving a reasonable position requires some understanding of the pragmatic issues. For instance, the two related questions of into which issues the state should intervene to alter market outcomes and how it should do so depend in part on empirical questions about relevant alternatives. There are myriad existing regulatory mechanisms that attempt to improve outcomes. Do insights from economic analysis of their performance and the theories presented in the Chapters 1 and 2 present ideas about potential improvements?

Contemporary concerns are increasingly focused on climate change. This is because of the risks and costs associated with climate change and because of the success of environmental regulation, private actions and technological improvement in mitigating other environmental harms over the past decades. Despite the understandable focus on climate change, such comparatively mundane issues as air and water quality, habitat and species protection and fisheries management are still vital and register considerable interest.[3] In many cases climate change can be reduced with better management practices on these issues – a topic returned to in the short penultimate section on climate change.

Before getting into some specific environmental issues that show both the potential and limits of markets in assorted policy areas, it is necessary to provide some context for both the development of environmental policy and its economic analysis. The two quotes above are representative of the widely held view of economics as a policy science combining notions of efficiency, economic theory and rigorous empirical evaluation. While there is some question about the declining role of economists in policy discussions (such as climate policy in the Biden administration), economics manages to sit astride many topics and provide a framework for thinking about them.

Recent academic literature has attempted to reckon with the shift in policy in the last quarter of the twentieth century towards enabling markets and the rise of economic thinking over a broader period. Most of the work is on the United States and the United Kingdom; the focus in what follows will be on the former context. The term ‘neoliberalism’ is often but inconsistently used; the basic argument is that markets that were curtailed (or never existed) were freed (or created) by reforms beginning in the 1970s. To some degree these ideas were proposed by economists addressing the contemporary failures of their time, but they were also taken up by policy experts and political figures, on the left as well as the right. Nascent environmental policy is one example of a field where this was rampant, as Elizabeth Popp Berman details in her recent book, Thinking like an Economist.[4] This consensus broke down in the 2000s and the 2010s as the right shifted away from the more active policies involved in market-based regulation (while retaining a focus on deregulation), and the left became increasingly focused on distributional issues (what is called ‘environmental justice’) and green industrial strategy.[5]

Standard accounts rightly focus on the rise of the environmental movement in the middle decades of the twentieth century. It was then that major pieces of legislation were passed to regulate industrial polluters and clean up the environment. As Berman and others note, the language used in them – and the public debate around their passage – was markedly radical.

As one example, the Clean Water Act promised to end all water pollution. To show how far this was from the view of professional economists, Berman recounts:

Harvard economist Marc Roberts told the National Journal in 1972 that he was ‘a radical, a Democrat, and an ardent hater of Richard Nixon,’ yet continued, ‘There isn’t a single respectable economist in the country who would back the no-discharge goal adopted by the Senate [in the Clean Water Act]. It will waste billions of dollars for no useful social or environmental purpose.’[6]

 

These topics are popular both because of interest in the time period and a desire by interested parties to similarly reform policy. Many with environmental concerns hold that radical reform of state policy is needed to limit markets. This includes, at the extreme, those who think the consumption of resources and emissions of harmful substances generated by a wealthy society require degrowth. In her popular book Not the End of the World, Hannah Ritchie pushes back against the most pessimistic and doctrinaire claims of this kind with data on the progress made in the last decades.[7] Despite the pressing concerns of climate change, many of these ideas are not new, and earlier policy debates provide interesting context for contemporary ones, as does the performance of more idealistic regulation in the twentieth century.

Relevant for this chapter is how interventions for environmental purposes were conceptualised by both policymakers and economists. The through- line is that at least conceptually, reforms that enable markets to perform better (in efficiency terms) and in more dynamic ways, rather than direct command-and-control interventions, became more central to policy discussions over time (even if never that popular). Legislation passed at the time forbade some economic considerations but was rather based on concerns about health and a framework of creating rights to limit pollution irrespective of cost–benefit analysis. Initial proposals to introduce economic considerations were considered repulsive.

After a few decades the benefits of market reforms were more widely recognised, but for reasons connected to interest-group dynamics and politics generally, this conceptual victory has not led to the degree of reform many economists think desirable.[8] On the most important environmental issues, the last 15 years have witnessed a turn away from the standard economic advice of academic economists and towards a range of mandates, subsidies and other regulations. These are meant to enable an energy transition and combat climate change, while most economists support carbon pricing.

 

Potted History: Rise of the Environmental Movement and Economic Analysis of Policy

 

The 1960s was a decade of growing awareness of environmental issues, especially concerning air and water pollution and agrochemical toxicity. At the same time, the young field of environmental economics was developing as a specific focus among economists, separate from natural resources economics.[9]

Nathalie Berta

 

In 1960, a Gallup poll showed that just 1% of Americans saw ‘pollution/ecology’ as an important problem. By 1970, 25% did.[10]

Alec Stapp and Brian Potter

 

While earlier regulation attempted to address environmental harms (and legal judgements enshrined in common law created constraints on action), much of the existing legislation governing environmental harms dates only from the last five or six decades. Although environmental harms are frequently discussed in the language of standard economics, this was rarely the case at the time. Over the nineteenth and early-to-mid-twentieth centuries, environmental concerns were often couched in terms of either resource constraints or public health.

For issues like air or water pollution, their categorisation as either an environmental or a public health problem was unclear. In many cases pollution was the result of situations in which noxious output was paired with weather conditions that caused acute crises, such as London’s Great Smog of 1952. While earlier reforms attempted to clean the air, it was this acute crisis that led to the Clean Air Act of 1956, which represented a real political effort to limit pollution. The Great Stink a century earlier had resulted in direct government action to deal with sewage polluting the Thames. In both situations the science of the general health effects was initially contested but the acute public health crisis spurred lasting environmental benefits.

The scale of these issues was new because of the total numbers of people involved and the new forms of polluting technology. The smoke from isolated chimneys may cause little harm but in much of the developing world or in historic centres such as London, wood smoke alone (not to mention new pollutants) can create widespread health issues. Economic growth, population growth and the technological innovations that empowered both may have led to new harms, but the wealth generated by cities also enabled the capacity to pay for improvements.

 

The Rise of Economics as a Policy Science

In their textbook on environmental economics, Nathaniel Keohane and Sheila Olmstead emphasise the standard contemporary approach to considering policy: cost–benefit analysis. As they write: ‘The basic approach is simple enough: Measure the costs and benefits of each possible policy, including a policy of doing nothing at all, and then choose the policy that generates the maximum net benefit to society as a whole (that is, benefits minus costs).’[11] At a minimum, a policy must ‘pass’ cost–benefit analysis; that is, generate net benefits. Similar statements occur in a number of textbooks. While much of the popular discussion and political efforts are still driven by broader concerns, formal policy analysis focuses on cost–benefit analysis.This is relatively new: when the crises above emerged, there was little role for economic analysis in broader policymaking.

In the United States, legal cases and local ordinances provided some protections even before wider legislation. There was logic in the processes by which these rules were made and adjudicated but prior to the formalisation of cost–benefit analysis, much public debate took place without quantified estimates of the benefits of pollution abatement.

In the nineteenth century the growing ability of the state to raise revenue – and assumption that it should step in – led to increased state action, but again, much of this took place before the widespread emergence of public policy practices attempting to deliver net value. While some major projects, such as turnpikes, canals and railways, were largely private in the United Kingdom (though carried out via private acts of parliament), the rise of public infrastructure projects led to the formalisation of cost–benefit analysis of some kind.

The great nineteenth-century engineers and social reformers such as Jules Depuit in France and Edwin Chadwick in England were forerunners of thinking about economic incentives and processes and a form of cost- benefit analysis even began in eighteenth-century France.[12] Over the nineteenth and twentieth centuries, increasingly formal efforts sought to understand the nature of harms.[13]

As currently practised, however, formal analysis can be traced to the American federal infrastructure projects to control flooding as part of the Flood Control Act of 1936.[14] Over the twentieth century, analysis of this sort became formalised in government decision-making, beginning with flood control efforts and water projects in the American West. From there it developed both within government and think tanks such as RAND and Resources for the Future, and within federal agencies. As one historian writes: ‘It is not a story of academic research, but of political pressure and administrative conflict.’[15] By the late twentieth century, executive orders issued by presidents of both parties compelled regulatory agencies to do a form of cost–benefit analysis – regulatory impact analysis – on any rule changes.[16]

Yet within this approach there are key questions about how benefits can be measured – and therefore whether they count – and how to consider future benefits properly. Spencer Banzhaf’s recent history of the field shows how the broader accounting for benefits such as recreation and health transformed resource economics into environmental economics.

 

 

Environmental Economics and the Difficulty of Accounting for Benefits

[E]conomists began to measure abstract indices like Gross Domestic Product and inflation as well as the benefits and costs of public investments. When they similarly turned to quantifying natural resources and the environment, economists realized that if they limited themselves to those resources traded in markets, which come with a readily observed market price, they would omit much of what society holds dear.[17]

Spencer Banzhaf

 

Prior to the rise of the contemporary environmental movement in the 1960s, much of what would now be considered environmental economics was focused on questions of natural resource economics. The questions emphasised were those of how to ensure resources weren’t wasted and new resources were developed.[18] Over the course of the twentieth century, new methods allowed quantification of some of ‘what society holds dear’ and so allowed policy analysis that included relevant benefits of environmental protection.

In his book Pricing the Priceless, Banzhaf draws on the standard contrast used to sort environmentalists: conservationists who emphasise the use of resources prudently and preservationists who emphasise the purer protection of nature as a thing set apart from human uses. The earlier twentieth-century economists didn’t think about the environment beyond the conservationist approach. This approach also fits historically into a Cold War continuation of the mobilisation of resources for armed conflict and post-war economic growth. The 1952 Paley Commission published a report entitled ‘Resources for Freedom’, which detailed the potential material risks of the next decades and emphasised ways to ensure material plenty.[19] The goal was to enable economic growth and war-making ability. Out of the commission the influential think tank Resources for the Future was founded. Over the course of the 1960s, attention shifted from the lack of natural resources towards questions of how to respond to the degradation of the environment.

Up to this point the mechanics of economic analysis were geared towards a particular conservationist approach almost by design. In the formalisation of cost–benefit analysis during the mid-twentieth century, projects and policies were evaluated by their productive economic impact, with little room in the analysis for the value consumers might place on environmental preservation. What economists call the ‘amenity value’ of things that individuals enjoy and might even be willing to pay for – but generally don’t directly – can be difficult to estimate in situations far removed from standard markets. Banzhaf argues that part of the revolution in the evaluation of these benefits – like using water to support endangered salmon in the Snake River in the quote at the start of this chapter – is tied to the reorientation of economics away from crude output and towards applied welfare. As economic analysis gets further away from working markets, welfare analysis becomes more difficult. Contemporary environmental economics seeks to find robust ways of estimating the value of environmental benefits. By doing so it can inform policymaking that relies on cost–benefit analysis.

Cost–benefit analysis of environmental harms seeks to reduce their varied and complicated forms to a financial figure. Distilling harms to a figure may be subject to dispute but allows comparisons across areas. It might be clear that it isn’t worth devoting resources – whether actively expending money or restricting potential uses – to garner benefits if the net benefits are small, but this can also be true if alternatives have much higher net benefits. While mostly focused on future policy, cost-benefit analysis also allows a look back at some of the regulation passed in the 1960s and 1970s. Pairing economic theory and applied economic thinking about environmental harms, it is possible to see some of the potential for market-based regulatory reforms. The history of cost-benefit analysis reveals the intellectual difficulties of rigorous applied economic thinking apart from the standard notion that politics is the constraint on good policy.

To make this difficulty more apparent, consider the management of a section of national forest in the American West. If the forestry officials are tasked with deciding between allowing the forest to be used by logging companies or continue being used for recreation, it is easy to assess a value for the flow of timber that can be harvested but more difficult – though far from impossible – to impute a value for the walks and picnics that people use the forest for. In part, because of this difference between the legibility of use value, government policy can discourage uses that contemporary environmentalists seek. While amenity values or use values can be estimated with contemporary methods, so-called ‘existence values’ or ‘passive use values’ are more difficult to estimate. These are the values that one places on, for example, glaciers in Switzerland or polar bears in the Arctic whether or not one observes (or directly uses) them.

For these, economists have developed ‘contingent valuation’ methods that allow some estimates for goods such as the preservation of Half Dome in the Yosemite National Park, biodiversity and the damages caused by widespread harms like the Exxon Valdez oil spill. Despite this, they continue to disagree about the estimates and whether they are valuable.[20] The standard view of economists is that survey methods to estimate preferences or willingness to pay are far inferior to market situations where individuals must confront trade-offs directly. The use of surveys to estimate value fails to yield robust results because revealed preferences in markets (i.e. people’s preferences as manifested by their behaviour) often vary considerably from self-reported preferences. The methods can be useful in the same way that market analysis is useful to companies prior to launch of a new product – something with notable failures for the same reason.[21]

Apart from the more controversial aspects of economic analysis of environmental degradation, it is worth stressing the related development in estimating the health benefits of reductions in pollution. Many of the public health benefits of improvement in, say, air and water pollution rely on the notion of the value of a ‘statistical life’ to quantify the value of the lives saved by the marginal reduction in, for instance, particulate matter smaller than 2.5 micrometres in diameter (μm 2.5). These tiny pollutants were not directly targeted by conventional attempts to reduce air pollution (including twentieth-century attempts to reduce things like sulphur dioxide). Contemporary estimates of the cost-benefit ratio of air pollution policies find that many of the benefits come from the health benefits associated with the fall in μm 2.5 pollution. These estimates required measurement of this pollution and the notion of the value of a statistical life to account for the benefits. Like contingent valuation, the value of statistical life is a construct with a long history and the subject of much debate, from both an ethical and applied economic perspective.[22]

Despite these difficulties, contemporary empirical research attempts to create precise estimates of the benefits of removing types of pollution via different mechanisms. This includes research on a wide range of matters, such as how much individuals are willing to pay to escape polluted neighbourhoods and how much air pollution harms health outcomes, to name but two. One standard finding is that the marginal abatement cost of pollution rises; that is, it becomes more costly to lower pollution by additional units.

 

The Rigidity of Standard Environmental Policy and the Opportunity to Create Markets

By the late 1950s, both economists and policymakers had formed quite well developed and deeply entrenched visions of how pollution-control policy should be constructed. Unfortunately, these two visions were worlds apart.[23]

Tom Tietenberg

 

The US government sets abatements standards, enforces them, and sometimes even prescribes the technology to be used, without attempting to equate marginal costs across pollution sources or provide incentives for technical progress … The blame for this lies, in our judgement, partly with the Congress and executive agencies for ignoring economists, and partly with economists for recommending impractical policies and for not offering compromises.[24]

Anthony Fisher and Frederick Peterson

 

Despite the growth of environmental economics in the 1960s, little of this approach filtered into the contemporary American regulatory framework. This section outlines some of this framework’s key features and explains why economists have advanced policy proposals that seek to rationalise the existing environmental protections. These proposals include methods of regulation that seek to reduce pollution in line with the costs and benefits of abatement. Economists argue that better regulation can provide a given level of environmental protection at a lower cost. As Nathalie Berta shows, in making these claims about efficiency, the argument for expert policy slipped from ivory tower notions of an optimal amount of pollution to reducing pollution in a least-cost way.[25] Despite successful intellectual arguments, gaining activist support and some legislative successes, there are still large gains to be made from adopting more market-based mechanisms for environmental protection. The failure of more of these policies to be adopted (and in some cases existing wins were rolled back) is discussed later in this chapter.

One example of an area of environmental policy with the most substantial reforms inspired by economics is the regulation of air pollution in the United States, much of which is via provisions originally passed in the 1970 amendment of the Clean Air Act (CAA). As part of these provisions, the Environmental Protection Agency (EPA) sets emitter National Ambient Air Quality Standards, which are emissions limits for the six targeted pollutants. These standards are set without consideration of abatement costs – though regulatory attempts to achieve these standards do consider costs. The

CAA also requires a State Implementation Plan for how states will reach those limits. Areas out of compliance generate additional regulations on existing and new polluters. Additionally, the act sets out that new industrial polluters are to be regulated according to technological standards via New Source Performance Standards issued by the EPA. These vary based on a number of factors, often but not always including cost. The 1970 amendment substantially altered the original 1963 legislation, and two major amendments took place in 1977 and 1990 (discussed below). The legislation also allows the discretion of the executive branch; since the 1980s executive orders have been subject to cost-benefit/regulatory impact analysis.

In the years since the passage of the 1970 CAA, the major pollutants have fallen in response, though causal estimates are difficult to generate. There is a consensus in the literature that the CAA reduced pollution relative to the baseline and passes retrospective cost–benefit analysis.[26] Much of the benefit derives from the health impacts of the reduction of the major pollutants. Despite the scale of the legislation and the active work of researchers, many of the aspects one would need in order to set optimal policy remain unknown. There is no reason to think the reductions were achieved at least cost, and there are clear examples of unintended consequences.

One example is from the 1977 amendment to the CAA that prescribed the technical requirements of new coal-based power plants to reduce emissions of noxious sulphur dioxide (SO₂). This technical standard was in the interest of coal producers in the Eastern United States because they sold higher-sulphur coal, something not lost on them or their political allies.[27] Once industrial users met the standard by implementing the technology, they were free to pollute and therefore they were also free to minimise costs by using the cheaper, easier-to-transport eastern coal rather than the cleaner coal from the Western United States. The technical standard had no mechanism to govern the amount of SO₂ generated. The absurdity of the rule is that even were a power plant able to achieve a reduction in the pollutant without the costly technology by using coal with less sulphur, the regulatory standard would rule them out of compliance because they didn’t install the technology. Furthermore, the height of the smokestacks increased in response to efforts that sought to improve local air quality. By increasing the height, industrial polluters were able to pollute in a way that generated acid rain miles away – including over international borders – as the pollutants fell back to earth. This is an example of public choice problems– dirty coal producers concentrated in politically important districts – combining with imprecise rules to result not just in a failure to solve existing environmental problems but also the generation of a new one in the form of acid rain. These failures of the conventional regulatory approach and the constrained fiscal space provided the political interest for an experiment in market-based reforms in 1990, explored under ‘Creating Markets in Practice’ below, preceded by the following discussion of the theoretical framework.

 

Creating Markets in Theory

By the middle of the 1960s the waning focus on the importance of material resource constraints was being replaced by concern for the ill effects associated with material prosperity.[28] Economists at Resources for the Future and other organisations spearheaded efforts to address environmental degradation via more efficient approaches. Despite the association with Arthur Pigou, contemporary ideas about taxing pollution stem from Allen Kneese. Together with economists thinking about trading mechanisms, it was Kneese who sought least-cost ways to address environmental concerns. Achieving a given target at least cost was both more attainable than the idealised approach of taxing pollution at its marginal social cost and more efficient than heavy-handed regulation.

Kneese’s foundational work focused on the governance of water resources.[29] Here, a number of related questions arise about alternative uses and the impact of one use on another. In response to the complicated, interrelated system, Kneese argued – in line with Pigou – that a theoretically optimal solution would be ‘a system of spatially differentiated effluent fees, ideally set at the marginal damages of emissions’.[30] However, because this was untenable (at least for the time being), Kneese proposed a system whereby emitters were charged when water quality dropped below a regulatory standard (or emissions went above a certain level). Regulators could adapt prices in response to the observed reduction. But the logic of the tax would mean that emissions were reduced by those who could do so at a cost cheaper than the tax, while those for whom the tax was cheaper would continue polluting. As Banzhaf mentions in his treatment, ‘[Kneese] stressed the fact that with effluent charges, the market – not a planner – would find the way to reduced pollution.’[31]

Considering the difficulty – and cost – of estimating the benefits of abatement, Kneese showed that taxes could be applied over a politically determined level of emissions, with the benefit that the market would choose how to achieve it.[32] This represented the beginning of contemporary attempts to achieve environmental goals at least cost, rather than seeking an impractical optimal policy that achieves the economically ideal amount of reduction at least cost. While the level selected by the political process may be too high or too low (as compared to the textbook ideal), the process for achieving the level ensures that it does so in a way that doesn’t suffer from the waste of command-and-control regulations. This standard-and-tax approach was further developed by William Baumol and Wallace Oates.[33]

Such an aspect of the appeal of market-based regulations brings up a fundamental question about the nature and role of markets. While recent decades have seen an expanded understanding of what constitutes a marketplace, including domains previously considered outside market frameworks, this broader perspective has introduced important tensions in how we approach environmental challenges. Most advocates of market mechanisms take a moderate position, acknowledging that pure laissez-faire approaches may be insufficient for addressing contemporary environmental problems, particularly the most pressing issues of the twenty-first century. This moderation reflects a nuanced understanding that while conventional markets may emerge naturally, environmental issues often require some form of intervention to address market failures.

The key insight is that environmental policies, though preferable to no regulation at all, frequently achieve their pollution reduction goals at unnecessarily high costs. This has led to the development of market- based regulations that attempt to mimic the efficiency benefits of market mechanisms while addressing the inherent challenges of environmental management. More committed free-market environmentalists, while potentially sceptical of extensive regulation, often acknowledge that such market-based reforms represent an improvement over traditional command-and-control approaches.

Apart from the standard-and-tax approach, regulators can also generate trading by explicitly creating property rights to emit via a cap-and-trade programme.[34] Here a regulator puts an upper limit (‘cap’) on something like units of pollution and allows those affected by the cap to buy and sell (‘trade’) their rights or permits among themselves. Many ascribe the direction of travel in economic thinking about environmental regulation involving tradeable rights to Ronald Coase and set market-based regulations against both idealised Pigouvian taxes and command-and-control approaches. As a historical claim this argument runs into difficulties, but there is much similarity between Coase’s thinking and cap-and-trade approaches.

Coase’s foundational ideas about market mechanisms for managing spillover effects emerged not from his famous 1960 paper discussed in Chapter 1 but from his earlier work on radio spectrum allocation,[35] which bears closer resemblance to pollution trading markets. In examining the Federal Communications Commission’s (FCC) approach to managing broadcast frequencies, Coase challenged the conventional wisdom that government regulation through licensing was the only solution to managing signal interference between broadcasters. The existing system in the United States had evolved into a complex regulatory regime whereby the FCC awarded narrow frequency bands with wide buffer zones, allocating these valuable licences through arbitrary ‘beauty contests’ that consumed substantial resources from potential broadcasters.

Coase argued that the radio spectrum was not fundamentally different from other resources that markets successfully managed. He proposed replacing the discretionary licensing system with an auction mechanism in which the government would define clear usage rights and sell them to the highest bidders, allowing subsequent free trading of these rights. This proposal faced fierce resistance from both politicians and FCC regulators,but when spectrum auctions were implemented in the 1990s they not only generated significant revenue for the federal government but facilitated the rapid development of mobile phone technology, validating Coase’s insight that market mechanisms could efficiently allocate even complex resources with spillover effects (the interference). Taken together, estimates of these efficiency improvements are around $17 billion dollars.[36]

Shortly after Kneese’s first developments of his effluence fee scheme (and nearly ten years after Coase’s FCC paper), two economists – Thomas Crocker and John Dales – are generally credited with proposed emissions permits schemes whereby regulators would set a cap of total emissions and divide this cap into permits to pollute.[37] Thus, instead of setting (and re-setting) a tax in order to achieve an emissions target (as companies could choose to pay the tax instead of reducing emissions to the level desired), emissions would be reduced by way of a cap-and-trade system. As in Coase’s article on tradeable spectrum rights, Dales considers the foundational issues before arguing for a property rights scheme:

Economists tend to assume implicitly that it is impossible to own water and therefore seek to devise artificial price systems that are identical to what prices ‘would be’ if ownership were possible. The alternative strategy is to devise an ownership system and then let a price system develop. The purpose of this article is to suggest that there are very considerable advantages to attacking our water problems by means of a system of property rights.[38]

 

Cap-and-trade combines some of the benefits of the purer taxation approach with the political – if not necessarily welfare-enhancing – benefits of the command-and-control approach. Without examining any issue in detail, it is possible to think about some benefits that – an economist would point out – flow from this system as opposed to more standard command- and-control approaches. For one thing, the system is beneficial when the abatement costs that firms face vary. As shown in Chapter 1, this is one of the benefits of the tax approach as well. In the case of cap-and-trade, firms that engage in production that results in less pollution on the margin will be encouraged to continue producing – and perhaps even expand production – while those that engage in production that results in more pollution on the margin will be encouraged to produce less. It also maintains the incentives for firms to invest in known means of reducing pollution, as well as in research and development into new methods.

For policymakers, a benefit of the cap-and-trade mechanism is that it ensures a certain level of emissions can be achieved. In practice, when for scientific or political reasons achieving the target is of utmost importance, this is a drawback of the tax strategy because policymakers may choose to set the tax at a certain level hoping to achieve a certain result, yet find that the tax is too low to achieve it. This benefit of the cap-and-trade system is even more evident over time, as the permits market adapts to

changing circumstances without explicitly changing the rate of tax. In theory, politicians could vary tax rates in pursuit of efficiency, but this runs into obvious political difficulties. The system also spurs innovation as companies look for new ways to reduce emissions when permits become valuable.

While conceptually clear, there are of course specific questions about implementation. The level of geography (whether local, regional, or national) and timespan for permits matter, both in theory and in practice. Additionally, theory suggests that assigning permits via auction is the most efficient outcome, while the political constraints of the situation generally result in their being allocated to existing polluters. Caps can also be designed to become progressively tighter as permits are retired. As the cap tightens over time, permit prices tend to rise, creating stronger incentives for developing – and adopting – cleaner technologies.

In the most important contemporary issue, the distinction between tradeable property rights and taxation is perhaps the least emphasised, instead falling under the combined concept of ‘carbon pricing’. This can occur via a cap on emissions and a resulting price being generated via market trading, or via a tax. As discussed below, the benefits of each are still debated,[39] but first, it is worth looking at how this theoretical development was adopted by regulators.

 

Creating Markets in Practice

The first generation of American environmental regulations did not take advantage of the benefits of market-based mechanisms. Some later reforms have introduced them, in part because of the theoretical argument being won but also as a result of increased political interest in market-based mechanisms. Some of this interest was due to the increasingly fractious politics surrounding tightening environmental reforms in the slower-growth 1970s and the general political environment, but also to the success of incremental reforms at meeting targets that would otherwise not have been politically achievable. This section considers examples from the development of regulations emanating from the CAA,[40] most notably the SO₂ trading scheme.

A consensus around the type of least-cost mechanisms discussed above formed in academic economics, but in some cases the market-based mechanisms were, surprisingly, proposed by political and regulatory figures in the early 1970s. For instance, the Nixon administration had sought to regulate SO₂ with them from the outset. In other cases, as with an early attempt to allow emissions trading in California via state regulators, political pressure shot it down, or the ethical arguments over the right to pollute and the proper role of cost-benefit analysis in environmental/health regulation stymied early efforts. But Charles Halvorsen showed how regulators themselves increasingly turned towards market-based mechanisms.[41] Some of the successful programmes included so-called ‘bubbles’, which allowed polluters to aggregate their emissions between the plants that they owned, and offsets, which allowed new plants – which would have otherwise been banned – to gain approval by reducing existing emissions at a ratio of more than 1:1. Despite this opening-up to market mechanisms, regulators required approval for each scheme and otherwise limited the extent of adoption.

The development of market-based regulatory environmental mechanisms by the EPA and policymakers in the late twentieth and early twenty-first centuries represented shifts in regulatory strategy. After a few smaller-scale experiments (including removing lead from gasoline), the most notable example is the SO₂ emissions market enabled by the 1990 amendments to the CAA.[42] A key milestone was Project 88, sponsored by Democratic Senator Timothy Wirth and Republican Senator John Heinz, and directed by the economist Robert Stavins, which proposed using market principles to address environmental challenges.[43] The project report covered a number of environmental issues, including ones that hadn’t been directly targeted by regulation. In line with the move from determination of optimality to achieving goals by efficient mechanisms, the report states:

This study is not about setting environmental goals by the use of economic criteria. It does not recommend the use of benefit-cost analysis, or setting dollar values on environmental amenities or human health. Indeed, for the most part, the report eschews judgement on goals and standards. It does not suggest how much air pollution is acceptable, how many acres of wilderness are needed, or how to balance the need for controlling emissions of toxic chemicals with the costs of such controls. These are important – even crucial – questions. But there is a need to set aside ongoing debates over specific environmental standards, in order to carry out a separate examination of effective mechanisms for environmental protection.[44]

 

One of its case studies set out a proposal that eventually became the SO₂ emissions trading programme in the 1990 CAA amendments, creating a cap-and-trade system for reducing the emissions that were causing acid rain. Its adoption was influenced by the Environmental Defense Fund (EDF) and renewed interest in environmental outcomes among Republicans after a mainly deregulatory focus at the EPA under President Reagan. This approach, championed by EDF and economists-cum-policy entrepreneurs like Stavins, allowed companies to buy and sell pollution credits, providing financial incentives for more efficient emissions reduction. The programme has been studied by many scholars, and in line with theory, research has found that it achieved reductions at costs between 15% and 90% lower than command-and-control regulations. Furthermore, the incentive to achieve reductions at a lower cost spurred innovation in burning processes and technology.[45] Subsequent market-based mechanisms for carbon dioxide and other pollutants have built on this framework, California’s carbon cap- and-trade programme serving as a prominent example in the mid-2000s.

 

Comparative Analysis and the Political Nature of Market-Based Regulation

While market-based regulations, such as those creating trading programmes, offer efficiency gains over standard command-and-control, it should be remembered that political forces impact the nature, timing and existence of market-based regulations, which is relevant both for questions of assessment and for the viability of future schemes. For instance, one point of contention in the SO₂ trading scheme was that EPA administrators – and environmental activists – insisted on classifying the tradeable rights as allowances and not a form of property subject to protections against later changes.[46] This type of insistence and the resulting uncertainty about the permanence of trading schemes has scuppered other markets.

Despite the importance of comparative institutional analysis in determining the relative performance of alternative regimes, Gary Libecap argues that: ‘In general, transaction costs are not examined in depth in the environmental economics literature. This is particularly the case for the costs of political bargaining and lobbying that arise from implementing and administering government regulation and tax policies, although these costs have received somewhat more attention with cap-and-trade regimes.’[47] Yet even here it is important to be clear that the caps are the result of a political process. Insofar as the cap is informed by economic analysis, it is often fairly casual. As Stavins writes of the SO₂ cap:

When the policy was enacted, no credible estimates of economic benefits of alternative target levels were available … Instead, the target was selected based on what was believed to be the ‘elbow’ of the abatement cost curve – that is, a level of abatement that was possible at relatively low costs, and above which the marginal costs of reducing emissions would climb dramatically.[48]

 

While economics can inform and improve policy, both electoral and bureaucratic politics shape even market-based policy. Government policy and taxpayer money should be devoted to the environmental protection that is most needed. In some cases, privatisation can generate revenue and improve outcomes by empowering market mechanisms. In many of the most difficult cases, such as air pollution caused by disparate sources, the issues are likely to result in government policy improving outcomes when compared to a laissez-faire approach. Status quo (command-and-control) regulation can benefit from basic economic thinking about the issues, and as seen in the reforms presented in this section the stars can align and improve policy. While this section has focused on air pollution, the logic of other regulatory systems is discussed in the next.

 

Additional Policy Examples: Matching Policy Solutions to Environmental Problems

 

While regulation cannot be analysed in detail here, it is worth offering a few examples of the status quo regulatory attempts to limit environmental harm across different policy areas, along with realistic market-based proposals to improve them. The examples are presented by topic area but underlying this they are broadly organised by order of increasing difficulty. Later proposals move towards increasingly involved regulations to create markets – as has been attempted in efforts to limit air pollution – rather than expecting them to emerge. Environmental problems represent a spectrum of issues that vary in their amenability to market solutions.

When thinking about how to address environmental issues, there are various factors to consider, from the origins of harms to their effects and reach, and how policies relate to each. For the most difficult issues, such as climate-change policy, there are myriad levers and policies that influence both the generation of the environmental harm and the scale of damage caused by it. For some pollutants the threshold for harm is clear – amounts below it cause little harm and marginal harm increases above it. In some cases, such as climate change, the emissions have the same impact on the issue at hand wherever they are released in the world. But even for regulatory schemes targeting climate emissions, the underlying behaviour generating greenhouse gases also generates local emissions. Policies can be adjusted to account for these concerns, including those of environmental justice activists and organisers.[49]

It is perhaps easiest to think about this variation in amenability to market mechanisms in terms of the transaction costs, which are to an extent determined by the nature of the resources involved in the environmental problem at hand. At one end are resources with clearly definable property rights and relatively localised impacts, such as timber production or riparian fishing, where private ownership can effectively align incentives for sustainable management. Moving along the spectrum there are resources with increasing complexity in terms of spillover effects and measurement challenges, such as watershed management and open-water fisheries, where hybrid approaches combining market mechanisms with regulatory oversight have merits. And at the extreme end lie greenhouse gases that threaten climate stability and atmospheric quality, where the global nature of impacts, scientific uncertainty and inability to exclude users make purer market solutions impractical and state involvement all but necessary.

This framework helps policymakers identify where market-based tools might be sufficient on their own, where they need to be supplemented with other approaches and where alternative policy instruments might be more appropriate. The basic point throughout the following examples is that state solutions to environmental problems are often suboptimal and can be improved with economic thinking.

 

Land

[T]ransaction costs … tend to be at their lowest in the case of land-based issues… Other stationary resources, such as oyster beds and water-based assets such as rivers and inshore fisheries that are excludable with existing technology also exhibit relatively lower bargaining and enforcement costs. Although in many cases such assets are amenable to private ownership of one form or another, the political/ideological framework often prevents the development of environmental markets even where they have considerable potential to improve resource allocation.[50]

Mark Pennington

 

Over the past decades, private lands have increasingly been brought into conservation. In the United States these include lands purchased by such trusts as The Nature Conservancy and many smaller organisations. Apart from explicitly charitable organisations, land is being conserved by private owners such as Ted Turner, among others. More complex contracting mechanisms allow landowners and environmentalists to interact in mutually beneficial ways. Perhaps chief among these are conservation easements, which have grown to cover millions of acres.[51] These allow land to be held privately with restrictions that prevent certain environmentally harmful uses, such as, most obviously, building on them but also farming that generates nutrient pollution, or harvesting trees. Parties customise the easements depending on the nature of their goals, but it is difficult to remove easements once they are placed on the property. These efforts show the capacity of private individuals to conserve land with taxpayer support via tax credits introduced by governments.[52]

But for reasons discussed earlier, the public-interest argument for leasing public lands was to encourage their cultivation. There are binding rules either to use the land or forfeit the right to the lease. Conservation activities are not classified as uses of the land so in practice, this has led to a situation in which public lands can’t be leased by those wishing to use the land for conservation, while private lands can be. The rules thwart efforts to lease the land directly and to enter into agreements with those who have leased government land for myriad activities ranging from cattle ranching to logging. This is of importance in much of the American West, where a large share of land is held by different federal agencies.

In discussing the recent reforms to the Bureau of Land Management (BLM) rules to allow new leases to be issued for conservation, Shawn Regan writes of the general principle:

A better, market-based approach would allow competing groups to negotiate with or bid against each other to determine which use has more value to prospective leaseholders – mining, for instance, or restoration. This would streamline the lengthy and contentious battles that often pit extractive industries against conservation interests over certain tracts of land.^[53]

The 2024 reforms still make it difficult for conservation groups to bargain with existing leaseholders in extractive industries, and while the BLM manages about a tenth of the land in the United States, the National Forest Service and other agencies still manage large swathes that are unaffected. Reforms and targeted incentives would allow markets to conserve land efficiently.

Water

Some of these same features apply to waterway management, particularly in places like the Western United States where natural rainfall is low. Large populations rely on water collected in major reservoirs, transported long distances and taken from aquifers. This is also true of irrigation for agricultural users. There is a large degree of government involvement both within the legal system of water rights – where there is wide variation – and in public utilities.

Somewhere like the Colorado River basin involves millions of users over numerous jurisdictions. Water is used for recreation, direct consumption, agricultural production and the generation of power, among other things. Chief among these, of course, is the water left within the system for fish to live in, large mammals to drink and natural vegetation to grow. These so- called ‘instream’ uses have received increased attention in recent years as drought has caused levels to fall.

Two striking features of water governance are, first, how difficult it is to exchange property rights, and second, how little price mechanisms are used to ration water. In parts of the American West, water concerns prevent valuable residential development despite the marginal economic value of the water to the new residents being high enough to compensate existing users who value the marginal unit of water less. (The uses of water they would reduce first if the price were higher would likely include things like reducing the size of the front lawn). The nature of the system of allocation often means existing users have little interest in stewarding the water they use because they face lower – or in some systems zero – marginal cost; in the extreme, use-it-or-lose-it allocations encourage waste. More generally, without metering and charging a cost per unit, there is little reason to reduce use. This is true of many agricultural users but also residential users in water districts with earlier rights to water. For illustration, Sheila Olmstead cites research from 2008 showing that ‘farmers in Arizona’s Pima County pay $27 per acre-foot, and water customers in the nearby city of Tucson pay $479–$3267 per acre foot.’[54] For some farmers, their most valuable asset may be their water rights. While some trades do take place, the regulatory complexity in sales or leases adds unnecessary complexity, raising transaction costs.

More than just charging different rates to different users, when faced with drought, water authorities routinely engage in public appeals to conserve water and, for example, turn off fountains in parks and museums. In California, citizens are encouraged to report neighbours who let water run off their lawns. Yet as Olmstead cites, these types of rationing rules are costly.[55] Technology standards like low-flow toilets or mandating certain types of appliances are also less efficient than simply raising prices. They also suffer from a rebound effect whereby consumers use more as efficiency improves – which is also true of insulation and heating improvements.

Economists find this type of regulation – as opposed to charging higher marginal rates above a certain threshold of use or rebating some basic level of use for low-income users – rather bizarre. Regulation can be warranted in places where the market is expected to face difficulties, but in many cases the regulation is what limits the capacity of markets to do social good.

The differential treatment of agricultural users is not just a feature of the water prices they face. Increasingly stringent regulation on American waterways has meant there are few point sources of pollution left; that is, most pollution results not from drainage pipes from industrial users but from accumulated runoff from fields and roads that drains into watersheds.[56] The Clean Water Act leaves much of this pollution to the states, and while some have made efforts to reduce it, agricultural interests and the difficulty of regulating such disparate pollution have resulted in relatively little progress. Increasingly large sums of money are spent to further reduce some sources of water pollution while little is done to reduce pollution in cheaper ways because the two sources of water pollution are regulated differently. Recent judicial rulings in Europe have resulted in cost- prohibitive restrictions on the nutrient runoff from new polluters such as housing developments.[57] In the United Kingdom, potential exchanges were allowed but faced high transaction costs. Recently proposed reforms seek to allow new polluters to pay into a fund that the government uses to abate pollution in lower-cost ways.[58]

Instream uses of water rights have faced a similar challenge to the example above, of land used for conservation not falling into the standard of use set out by legal rules or regulations. Water-use rights in much of the American West depend on so-called ‘use-it-or-lose-it’ rules. Absent changes in the law, water rights purchased by conservation groups to leave water in rivers and streams for riparian habitats – rather than remove it for use on fields or human consumption – wouldn’t be classified as a use and would therefore risk being lost. This has occurred in some states including notably the Oregon Water Trust (later the Freshwater Trust) which has traded with local users to acquire water rights that allow them to improve and maintain salmon habitats among other things.[59]

Particulate Pollution

Air pollution was discussed above, but a recent experiment in India – the first to apply industrial emissions trading to μm 2.5 particulate matter regulation – is worth mentioning here.[60] As additional research shows, the harms of this type of pollution, and many countries seek to improve air quality with the least economic harm, this experiment may prove influential. The researchers found that the cost of achieving the existing target for pollution via a cap-and-trade mechanism was 11% lower than the pre- existing plant-level controls. As it happened, the targets could be more aggressively set because polluters could achieve reductions at a lower cost. This made it politically viable to maintain lower targets. Compared to the control groups, the treatment group of plants regulated by the cap-and- trade system produced between 20% and 30% less pollution in practice because caps could be tightened. While theoretically targets could be set too low and reduce pollution below an optimal level, in this instance the cost–benefit analysis suggests that the benefits were around 25 times higher than the costs. One important feature of this experiment is that it also reduced the administrative cost of lowering pollution – something particularly valuable in contexts where past efforts to enforce regulation have failed.

Fisheries

Chapter 2 introduced the economic root of the environmental problem with fisheries: the high transaction costs involved in establishing property rights create an incentive to catch more fish than is sustainable. This is a classic collective action problem because any one person who seeks to limit overfishing has no means to stop others from acting in their own interests. Despite government policies to limit overfishing, poorly designed policies mean that resources are wasted as fishing enterprises invest in faster and bigger boats, for example, to maximise the catch during the short fishing seasons mandated by regulators. Ecologically determined seasons don’t solve the fundamental economic problem of fisheries management, with the result that seasons become ever shorter while fish stocks continue to be at risk.

While Elinor Ostrom showed that self-governance mechanisms can emerge in some settings, in higher transaction-cost settings, market-based regulations in fisheries have proved successful.[61] These typically operate through systems such as Individual Transferable Quotas, where fishers receive tradeable rights to harvest specific amounts of fish based on the sustainable yield (or the shareholders in a collectively owned fishery can themselves set the allowed catch).

This creates a property rights system that incentivises long-term sustainability, as quota holders have a vested interest in maintaining healthy fish populations to preserve the value of their quotas. The transferability allows more efficient operators to acquire additional quotas, potentially leading to better resource management while reducing overcapacity in fishing fleets. Competition occurs in the marketplace for the property rights rather than in open waters. Despite emerging in the literature in the 1970s, political challenges have slowed take-up of property rights systems in fisheries management, though there has been notable progress.[62]

Fish with widespread migration patterns, such as Atlantic tuna, provide a uniquely challenging fisheries management issue.[63] While domestic fisheries management similarly grapples with monitoring, enforcement and biological sustainability, international management must address these concerns across multiple jurisdictions, political systems and economic contexts. The added layers of international law, varying enforcement capabilities and cross-border transaction costs create a level of complexity that makes even successful domestic fishery management frameworks insufficient. In the late twentieth century the extension of Exclusive Economic Zones sought to reduce the number of international disputes, but for many migratory open- water fish species the issues remain severe.

These challenges foreshadowed many of the difficulties now faced in implementing global climate policies such as cap-and-trade systems. The larger the geographic range of the fish migration and the higher the number of governments involved in the negotiations, the more difficult have governance mechanisms been to negotiate. Like the efforts of climate-change agreements to address global emissions, these suffer from collective-action problems.

Wicked and Nested Problem: Climate Change

Most countries, including the United States, do not place an economy-wide tax on carbon, and instead have an array of greenhouse gas mitigation policies that provide subsidies or restrictions typically aimed at specific technologies or sectors … In the world of a Pigouvian tax, markets sort out the most cost-effective ways to reduce emissions, but in the world we live in, economists need to weigh in on the costs of specific technologies or narrow interventions.[64]

Kenneth Gillingham and James Stock

Climate change is the result of centuries of emissions generated by the very things that allow humans to achieve gains in their standard of living. Both the nature of climate change (multi-causal and wide-ranging) and the nature of the actors (diverse and under myriad legal systems with no worldwide decision-making body) make it not just the ‘greatest market failure ever known’ but perhaps the most difficult social problem to solve.

Many of the concepts presented throughout this publication apply to climate change. The atmosphere is the extreme example of a common-pool resource hard to protect with property rights that enable exclusion. Climate change stems from the global emissions produced by industrial users and individuals all around the world. While the results of the marginal increase in temperature may harm some regions more than others, whether they come from China or Norway, the pollutants have the same effects. Finally, even the results of the added pollutants today will not be felt for years. Other global environmental externalities, such as those of migratory fish stocks, are difficult to solve, but climate change is the most difficult. All humans benefit from solving the collective-action problem, but that only makes it more difficult because of the coordination needed.

Economists generally see the ideal solution as one of pricing the pollutants, ideally according to their social cost. For greenhouse gases they have created – and debated – the Social Cost of Carbon, which attempts to calculate the negative value of a unit of carbon dioxide (and equivalents).[65] It represents the value of the damage, so within this are the health and environmental costs of carbon, including in the future (which are discounted into a present value). Climate change generates changes in the future that must be accounted for in the present. Analogous to how firms discount their future streams of revenue and expected costs according to standard practices in corporate finance (because revenue in the future is worth less than revenue today), policy analysis uses assumptions about a social discount rate set by government to consider policy with implications in the future.[66]

Unsurprisingly, the Social Cost of Carbon is susceptible to many open debates about the values to be placed on parameters such as discount rates and a ‘statistical life’, not to mention the myriad scientific relationships relied on to estimate the relationship between emissions and events that cause damage. Given this, estimates vary, but a recent paper finds a value of $185 per ton.[67] This is notably higher than existing pricing schemes.[68]

Beyond the tricky question of what the price should be, of particular importance in relation to climate change is the epistemic function of markets. Pricing leads market participants to act in a new way based on information revealed by the price system. Pricing pollutants leads producers and consumers to mitigate the harm they occasion by more obviously incentivising the reduction of use but also, and perhaps more importantly, by adjusting behaviour on various margins – such as adopting new methods of production or spurring innovation. As many have noted, the considerations that consumers engage in with respect to the effect of their actions on the climate are particularly hard to work out. Are imported vegetables better or worse? Are the fewer resources needed to grow mature tomatoes in Morocco and Spain offset by the transportation miles? Beyond the core economic issues, well-meaning and well-informed consumers may attempt to act responsibly – even more so than some might predict – but the difficulty of knowing the right answer frustrates their efforts. A price on pollution, even if not the optimal price, performs a function that voluntary actions have difficulty achieving. Even if the price of carbon were too low as compared to the optimal price that reflected the social cost of the effects on the atmosphere for present and future generations, any price would lead to producers and consumers economising as relative prices changed. For instance, the price of the climate impact would filter into the decisions made along the tomato supply chain and the market would determine the trade- offs.

The political debates around both taxes and tradeable permits bring to the fore issues about take-up. While prices vary in typical markets, the inherently political nature of carbon markets means that businesses and green entrepreneurs are subject to political change. Governments want flexibility to change policy without legal constraints but market participants – especially in carbon credit schemes) – want the legal protections of real property rights.

Despite the growth of carbon pricing across the world, the United States has not followed suit. As Libecap writes:

Despite early optimism among some economists that cap and trade would become the template for US greenhouse gas (GHG) emission controls, that too has not been the case. The various federal and state regulatory efforts to address GHGs generally do not follow the national market-based approach in the SO₂ phase-down, for example. Rather, the EPA, Congressional legislation, and Presidential executive orders outline a myriad of non-tradeable standards and restrictions on emissions from oil and gas use, coal and natural gas-fired power plants, industrial facilities, pipelines and other surface transport, along with subsidies and related tariffs for green energy development and electric vehicles.[69]

 

At least in terms of emissions reductions, climate-change prevention is a global public good: individuals cannot be excluded from the benefits of the reduction in emissions and the benefits that accrue are non-rival. This has led most to focus on binding legal actions between nations and regional groups. Despite this obvious logic, Ostrom has pointed out that many of the externalities are nested; that is, the control of pollution at the local level has benefits that accrue to the wider global populace.[70] This is of relevance for attempts to limit local air pollution.

In the absence of the ideal economic approach of taxing the pollutants themselves, these different features increase the difficulty of dealing with global warming in terms of reducing both the warming that occurs, and its impact, in some globally coordinated way. Much of the focus has understandably been on such agreements as those struck at Kyoto and Paris, but just as the warming outcome is the result of many varied decisions that take place without accounting for their negative effects, the limits to continued warming may result from decisions made at a less than global level (mainly national and subnational) and from technological developments achieved by entrepreneurs (both with and without the help of government policies).

Beyond the different responses to limit climate change, it is also worth considering that many of the mechanisms to limit the impact of natural disasters depend on subnational governance decisions and market actors more than national governments or international agreements. This is obvious at the time of the disaster and in the preparation for disasters but is also true of the broader framework of regulation that ensures reasonable decisions by individuals and firms. For instance, state policy should allow insurers to price according to risk, ensuring that both policyholders and insurers make the right investments,[71] yet in many cases insurance markets face politically motivated regulation. There is much room for improvement in management practices in resources where public bodies are in control, be that flood walls, firefighting equipment or controlled-burn policies in forests.[72] The cost of climate change will depend on the amount of warming but also on adaptation and preparation.

The last decade has seen large sums of money invested in the transition to green technology. Some of these investments are simply just market actors adopting new technology where profitable, and little different from the energy sector moving away from coal generation towards cleaner natural gas in the wake of the fracking revolution. Others are the result of state support, both explicitly as subsidy or implicitly as requirements on energy producers. Economists generally predict these acts of industrial strategy to prove poorly targeted and inefficient at reducing emissions; that is, achieving reductions at a greater cost than pricing the pollutants themselves via trading or tax. Research shows these inefficient ways of reducing greenhouse gases to be often more politically popular than relatively efficient alternatives.[73] Even in the United States the rollout of green energy generation has been hampered by environmental regulation in the form of the National Environmental Planning Act (1970) and state and local planning difficulties. If anything it has proved more difficult in the United Kingdom, despite the commitment to net zero.

In a period of increased fiscal strain across developed countries, market- based regulations can improve outcomes at greater efficiency by changing the incentives of regulated industries and disparate individuals. In much of the world, economic progress is still more important to many citizens than limiting environmental harm, especially when those reductions in harm accrue globally. The consequences of climate change are becoming clearer, and improvements must move from mere potential. The high-level approach to multinational agreements has much merit, but this section has emphasised some other elements of policy response that can help solve this difficult and complex problem.

Conclusion

The short answer is that command-and-control instruments have predominated because all of the main parties involved had reasons to favor them: affected firms, environmental advocacy groups, organized labor, legislators, and bureaucrats.[74]

Robert Stavins

Despite the theoretical advantages of a market-based approach to environmental problems that stresses property rights and market-based regulation, it often loses out in the political arena. For a time, these solutions seemed ascendant. A simplified version of this triumphant narrative is familiar to students of economics, but even with the rise of the economic framework for understanding and debating policy in the late twentieth century, much of the regulatory apparatus evolved prior to these developments. The continuing existence of much of the pre-existing regulatory framework is not the sole problem; in spite of new market-based regulation, much contemporary environmental policy suffers from the basic problems of command-and-control regulation.

This chapter has built on the work of historians of economics to show how those working in environmental economics in the past responded to theoretical and applied problems to craft market solutions to environmental issues inadequately addressed by regulatory measures. It has also pointed out some of the tendencies within the political sphere that have limited potential market solutions to environmental problems. While the topic is vast, two aspects of the stagnation can be identified.

One is at the intellectual level: despite the consensus for carbon pricing within economics, increased attention has been devoted to more radical transformations of the economy. At the level of more local pollution, political energy has shifted from technocratic reforms towards environmental justice, despite there being potential for many improvements to existing policy.

More generally, the incentives facing politicians and policymakers – shaped in part by the views of citizens and market participants – have limited the take-up of market-based reforms. Policies suggested by the framework are unpopular with politicians, regulators, and diverse interest groups, ranging from environmental activists and regulators to industry groups, as noted by Stavins in the mid-2000s. As with the FCC spectrum auctions mentioned above, market-based environmental policies often weaken policymakers’ control by reducing their discretionary authority and opportunities for visible regulatory intervention.

Environmental activists often prefer the perceived certainty of direct regulation, while regulators may resist mechanisms that diminish their bureaucratic role, and industry groups frequently favour targeted subsidies over market-wide pricing mechanisms. However, the continued effort towards limiting carbon emissions via a complex array of subsidies, mandates and bans risks the worst situation of all: spending enormous sums and constraining economic growth without achieving the emissions reductions that more efficient market-based approaches could deliver at lower economic cost.

Notes to Chapter 3

[1] Roger E. Backhouse, The Penguin History of Economics (London: Penguin, 2023), p. 412.

[2] Nathaniel O. Keohane and Sheila M. Olmstead, Markets and the Environment, 2nd edn, Foundations of Contemporary Environmental Studies (Washington, DC: Island Press, 2016), p. 2.

[3] Gallup Inc., ‘Seven Key Gallup Findings about the Environment on Earth Day’, Gallup.com, April 2024, https://news.gallup.com/poll/643850/seven-key-gallup-findings-environment-earth-day.aspx.

[4] Elizabeth Popp Berman, Thinking like an Economist: How Efficiency replaced Equality in U.S. Public Policy (Princeton, NJ: Princeton University Press, 2022).

[5] Richard Schmalensee and Robert N. Stavins, ‘Policy Evolution under the Clean Air Act’, Journal of Economic Perspectives 33, no. 4 (November 2019), pp. 27–50, doi:10.1257/jep.33.4.27; Coral Davenport, ‘Claims of “Bleak” Environmental Justice Record Appear to Fell a Biden Favorite’, The New York Times, December 2020, https://www.nytimes.com/2020/12/14/climate/mary-nichols-epa.html

[6] Berman, Thinking like an Economist, p. 193.

[7] Hannah Ritchie, Not the End of the World: How we can be the First Generation to build a Sustainable Planet (London: Chatto & Windus, 2024).

[8] Gary D. Libecap, ‘Williamson and Coase: Transaction Costs or Rent-Seeking in the Formation of Institutions’, NBER Working Paper 32603 (Cambridge, MA: National Bureau of Economic Research, 2024), http://www.nber.org/papers/w32603

[9] Nathalie Berta, ‘Efficiency without Optimality: Environmental Policies and Pollution Pricing in the late 1960s’, Journal of the History of Economic Thought 42, no. 4 (December 2020), p. 539, doi:10.1017/S1053837219000579.

[10] Alex Stapp and Brian Potter, ‘Moving Past Environmental Proceduralism’, Institute for Progress, April 2024, https://ifp.org/moving-past-environmental-proceduralism/.

[11] Keohane and Olmstead, Markets and the Environment, p. 2

[12] Robert F. Hébert and Robert B. Ekelund, Secret Origins of Modern Microeconomics: Dupuit and the Engineers (Chicago: University of Chicago Press, 1999); Robert B. Ekelund, The Economics of Edwin Chadwick: Incentives Matter (Northampton, MA: Edward Elgar, 2012).

[13] H. Spencer Banzhaf and Randall Walsh, ‘Smoke from Factory Chimneys: The Applied Economics of Air Pollution in the Progressive Era’, NBER Working Paper 32328 (Cambridge, MA: National Bureau of Economic Research, 2024).

[14] H. Spencer Banzhaf, ‘Objective or Multi-Objective? Two Historically Competing Visions for Benefit-Cost Analysis’, Land Economics 85, no. 1 (2009), p. 3, doi:10.3368/le.85.1.3

[15] Theodore Porter, Trust in Numbers: The Pursuit of Objectivity in Science and Public Life (Princeton, NJ: Princeton University Press, 1995), p. 149._

[16] Berman, Thinking like an Economist, p. 212.

[17] H. Spencer Banzhaf, Pricing the Priceless: A History of Environmental Economics (Cambridge: Cambridge University Press, 2024), p. 3.

[18] Banzhaf, Pricing the Priceless.

[19] Banzhaf, Pricing the Priceless, p. 26

[20] Jerry Hausman, ‘Contingent Valuation: From Dubious to Hopeless’, Journal of Economic Perspectives 26, no. 4 (November 2012), pp. 43–56, doi:10.1257/jep.26.4.43; Richard T. Carson, ‘Contingent Valuation: A Practical Alternative when Prices aren’t Available’, Journal of Economic Perspectives 26, no. 4 (November 2012), pp. 27–42, doi:10.1257/jep.26.4.27.

[21] Banzhaf, Pricing the Priceless, pp. 98–120; NOAA Panel on Contingent Valuation, ‘Report of the NOAA Panel on Contingent Valuation, January 11, 1993’, (1995), https://repository.library.noaa.gov/view/noaa/60900.

[22] Banzhaf, Pricing the Priceless, pp. 149–68.

[23] Tom Tietenberg, ‘Cap-and-Trade: The Evolution of an Economic Idea’, Agricultural and Resource Economics Review 39, no. 3 (October 2010), pp. 359–67, doi:10.1017/S106828050000736X.

[24] Anthony C. Fisher and Frederick M. Peterson, ‘The Environment in Economics: A Survey’, Journal of Economic Literature 14, no. 1 (1976), p. 26; Berta, ‘Efficiency without Optimality’, 544.

[25] Berta, ‘Efficiency without Optimality’.

[26] Janet Currie and Reed Walker, ‘What do Economists have to say about the Clean Air Act 50 Years after the Establishment of the Environmental Protection Agency?’, Journal of Economic Perspectives 33, no. 4 (November 2019), pp. 3–26, doi:10.1257/jep.33.4.3.

[27] Bruce A. Ackerman and William T. Hassler, Clean Coal/Dirty Air: Or How the Clean Air Act Became a Multibillion-Dollar Bail-out for High-Sulfur Coal Producers and What Should be Done about It (New Haven, CT: Yale University Press, 1981).

[28] Banzhaf, Pricing the Priceless, pp. 120–46.

[29] Allen V. Kneese, The Economics of Regional Water Quality Management (Baltimore, MD: Johns Hopkins University Press, 1964); Allen V. Kneese and Blair T. Bower, Managing Water Quality: Economics, Technology, Institutions (Baltimore: Resources for the Future/Johns Hopkins University Press, 1968).

[30] Banzhaf, Pricing the Priceless, pp. 125.

[31] Banzhaf, Pricing the Priceless, pp. 126.

[32] Berta, ‘Efficiency without Optimality’.

[33] William J. Baumol and Wallace E. Oates, ‘The Use of Standards and Prices for Protection of the Environment’, The Swedish Journal of Economics 73, no. 1 (1971), pp. 42–54, doi:10.2307/3439132.

[34] Thomas H. Tietenberg, Emissions Trading: Principles and Practice, 2nd edn (Washington, DC: Resources for the Future, 2006).

[35] R. H. Coase, ‘The Federal Communications Commission’, The Journal of Law & Economics 2 (1959), pp. 1–40.

[36] Thomas W. Hazlett, ‘Assigning Property Rights to Radio Spectrum Users: Why Did FCC License Auctions take 67 Years?’, The Journal of Law and Economics 41, no. S2 (October 1998), pp. 529–76, doi:10.1086/467402.

[37] Thomas D. Crocker, ‘Structuring of Atmospheric Pollution Control Systems’, in The Economics of Air Pollution, ed. Harold Wolozin (New York: W. W. Norton and Co., 1966), pp. 61–86; John H. Dales, Pollution, Property and Prices: An Essay in Policy-making and Economics (Toronto: University of Toronto Press, 1968).

[38] J. H. Dales, ‘Land, Water, and Ownership’, Canadian Journal of Economics 1, no. 4 (1968), p. 792; Berta, ‘Efficiency without Optimality’, p. 552.

[39] Robert N. Stavins, ‘The Relative Merits of Carbon Pricing Instruments: Taxes versus Trading’, Review of Environmental Economics and Policy 16, no. 1 (January 2022), pp. 62–82, doi:10.1086/717773

[40] Schmalensee and Stavins, ‘Policy Evolution under the Clean Air Act’.

[41] Charles Halvorson, Valuing Clean Air : The EPA and the Economics of Environmental Protection (New York: Oxford University Press, 2021).

[42] Richard G. Newell and Kristian Rogers, ‘The U.S. Experience with the Phasedown of Lead in Gasoline’, Discussion Paper (Washington, DC: Resources for the Future, 2003).

[43] Robert N. Stavins, ‘Project 88: Harnessing Market Forces to Protect our Environment: Initiatives for the New President’, December 1988, https://scholar.harvard.edu/sites/scholar.harvard.edu/files/stavins/files/project_88-1.pdf.

[44] Stavins, ‘Project 88’, p. 2

[45] Richard Schmalensee and Robert N. Stavins, ‘The SO2 Allowance Trading System: The Ironic History of a Grand Policy Experiment’, Journal of Economic Perspectives 27, no. 1 (February 2013), p. 107, doi:10.1257/jep.27.1.103

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[66] In the United Kingdom this is 3.5% whereas in the United States it is higher at 7%. Discounting the future at a higher rate means that fewer projects to limit the cost of climate change pass the hurdle. The first Trump administration adopted a 7% discount rate and limited the benefits of abatement captured in the social cost of carbon to those that accrue domestically, thus demonstrating the political nature of the current process.

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