3.5 Barriers to implementing market based instruments
One of the key elements of sustainable development involves balancing the environmental damages avoided with the costs of abatement. Section 2 has outlined the necessary conditions for efficiency and it was suggested that instrument choice centres around either a pricing (polluter-pays) or quantity-based (tradable rights) approach. The typical response is to use regulations that have a strong technological content based on BAT. Capture of policy formulation by advocating and adopting technical solutions may give insufficient scope for innovation. One BAT will not satisfy the requirements of heterogeneous firms. Furthermore, burdensome regulations that are not least-cost will emerge if regulators are risk averse. Monitoring and enforcement will increase the cost of CAC. Economic instruments avoid many of these problems.
Why has it proved difficult to introduce MBIs? First, there might be significant income effects associated with environmental charges. Take fuel as an example. A relatively large increase in price (we have noted earlier that it is price inelastic) would be needed to encourage the public to switch to less polluting transport. The tax will have income effects. The political consequences of increasing the fuel tax are immediate while the reduction in pollution is longer term. The second reason is institutional. In the UK, Helm (2000) asserts that institutional structure is responsible for at least two major weaknesses. Targets and standards are set with too little regard to the costs and benefits, and there is a strong bias towards CAC regulation. The British approach to pollution control is characterised as piecemeal, pragmatic, technically driven and conducted by experts largely out of reach of the courts.
The dichotomy between strong sustainability (SS) and weak sustainability (WS) has created a problem for decision-makers by suggesting a two-tier approach to developing policies for sustainable development. There will be uncertainties which current science is unlikely to be able to resolve creating doubts as to whether policy should target SS or WS, which natural assets are critical and which are not. Policy choice is more complex than the simple WS-SS dichotomy suggests. When confronted with uncertainty it is relatively easy for decision-makers to adopt rules such as the precautionary principle (Morris, 2000; Raffensperger and Tickner, 1999) where conservation is encouraged when there is not full scientific knowledge of the consequences or the safe minimum standard approach (Bishop, 1978) which introduces a conservative benchmark into the cost-benefit framework. Both decision rules focus debate on what constitutes compelling evidence.
Typically the returns to investment in the environment are non-market valued and therefore it is likely that under-investment will occur in environmental assets while over-investing in environmentally damaging activities. For example, over the years the quality of water in Auckland’s harbours has deteriorated because investment in storm water infrastructure has not kept pace with urban growth. In other words, environmental capital has been drawn down as a substitute for manufactured capital. The problem is of course not unique to Auckland, nor is it unique to coastal waterways. For this reason, it is important for sustainable development that the values of environmental assets are known at the national, regional and local level.
There is almost unanimous agreement that CAC regulation is an inadequate response to present environmental challenges. Command-and-control instruments are myopic, provide inadequate incentives for innovation, carry higher costs than other approaches and are unlikely to be politically sustainable (Parson, 2000). Markandya (1998) lists the following obstacles to implementing MBIs.
Lack of knowledge. The agency responsible for environmental policy must have the technical knowledge necessary to formulate and implement MBIs. Polluters have the knowledge to respond appropriately. Concerns of elected officials include the distributional implications of using MBIs; implications for output and employment in affected industries and communities; cost of implementation; and impact comparative advantage.
Good governance. The legal structure must define property rights adequately and establish authority to implement and enforce incentive systems.
Competitive markets. If firms are operating under soft budget constraints then they will not respond as effectively to fiscal incentives.
Financial and administrative capacity. The agency must have the capacity to initiate, monitor and enforce programs.
Flexibility of response. Private sector and individuals should have choice in their response.
3.6 Conclusions
Market based instruments provide a basis for shaping sustainable development policy. In Section 2 MBIs were shown to encompass key features of sustainable development viz. total economic value and intertemporal resource use. In addition, the instruments can be designed to account for linkages within the environment. Rather than arguing for universal application it was suggested that instrument selection should be based on rational analysis.
This section established an institutional link between MBIs and sustainable development outcomes or indicators. In the case of environmental externalities we know that information on willingness to pay and opportunity cost will not emerge from the market. Government intervention of some kind is necessary. Market based instruments are included within a set of feasible external institutions – they are an object of choice.
The simple dichotomy implied between strong sustainability (SS) and weak sustainability (WS) is of no particular use in institutional design. For example, a legal framework mandating SS – eg, investment in renewable sources of energy should accompany the depletion of fossil fuels – would neglect relative scarcity and expectations summarised in market prices. Investment in renewable sources of energy is likely to produce contemporaneous and intertemporal externalities too. Similarly, rules requiring administrators to adopt rules such as the precautionary principle may encourage excessive conservation at the expense of growth and the welfare of future generations.
Hierarchies of rules are important in institutional structures because they provide a basis for consistent governance. For example, if tradable rights are implemented then external institutions must be established to provide a basis for protecting property rights, contracting and exchange. This is essential for the predictable functioning of the economy over time.
Hierarchies also provide a level at which externalities are resolved. A simple net-benefit maximising model shows the location of control to hinge on the public good nature of the externality and the cost of information. For example, policy initiatives dealing with global climate change and protection of endangered species is probably best dealt with at a national level. In situations where spillovers are minimal then local decision-making is likely to be more efficient. More weight is given to the argument in favour of local decision-making if we recognise information asymmetries in principal-agent relationships and the benefits of learning from variety at the local level of government. Arguments in favour of more central control include situations where spillovers are significant, scale economies (eg, in research) might limit policy initiatives, increased transaction costs and a race for the bottom. These are of course empirical issues.
When the impacts of pollution are purely local, the costs of information not too great, and all relative preferences are reflected in local politics then the local incentives for environmental protection should be sufficient to achieve welfare maximising levels of protection without distorting prices. Locally determined supply might not be optimal if powerful interest groups capture local government. Combining central direction and local implementation may improve welfare.
The environment is extreme in the extent that it is characterised by overlapping and shared authority. Indeed it is highly probable that some aspect of the environment touches every unit of government in New Zealand. Thus it is highly unlikely that we can match the primary scale of the problem with the primary scale of authority to manage the problem. Decision-making is often simultaneously pulled out toward international management and inward to regional and local management.
Obstacles limiting the use of MBIs will exist in the structure of external institutions. The legal structure must define property rights adequately and establish clear lines of authority to implement and enforce MBIs. Enhancing the coordinative power of institutions and providing a basis for sustainable economic growth is an important aspect of reform. This is about getting the basic building blocks set in place. Path dependency should be recognised. If resources become increasingly scarce users will find ways to protect and enhance the value of their property rights within existing constraints. Empirical studies show that environmental outcomes – water use, fish stock enhancement, water quality – can, in part, be linked to institutional structure.
Policy aimed at introducing specific instruments – such as tradable rights – or providing for the evolution of community initiatives will require adjustments to external institutions. This is necessary but not sufficient. We will see in Section 5 examples where the Resource Management Act provides for the use of economic instruments but administrators have consistently preferred regulation. Thus incentives must exist for administrators to approach instrument choice within a rational framework that is consistent with the goals of sustainable development. This topic is discussed in Section 4.
