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Policy Instruments 
Various instruments are used by regulators to induce consumers and producers to undertake a level of activity (be it pollution control, fishing, reforestation, etc.) that coincides with the level that maximizes social welfare. These include the imposition of standards, the use of economic and financial instruments, etc. A large portion of the literature in environmental economics is devoted to comparing the relative merits of these various instruments. In order to choose among these instruments, a number of criteria are being selected. Considered below are some of the criteria that are implicitly or explicitly used to guide the choice of instruments. 

The policy instruments are designed to internalize the external cost of pollution, making the polluter pay, and at the same time minimize the cost of a given level of abatement under given conditions with regard to tastes, production and abatement costs, etc. These include Command and Control (CAC), Market Based Instruments (MBI) and Price instruments such as various forms of charges, subsidies, deposit refund systems and liabilities which fix prices and let the agents respond through quantity adjustment, or quantity instruments like tradable permits which fix emission quantities and allow agents to clear the pollution through price adjustments. 
We begin our discussion with Property Rights followed by the Command and Control policies for pollution control.

Property Rights The Command and Control (CAC) policies for pollution Control The Normative theory of Externalities and Market Based Instruments (MBI) 
The Pigouvian Prescription 
Pollution Taxes or Pollution Permits, which is better!

Second Best Approaches Involving Mix of Regulation and MBI’s Alternative Economic Instruments 
Direct Economic Instruments
Indirect Economic Instruments

Other Supportive Measures 

Property Rights 
Property rights are important for the well-functioning of a market. Without property rights, even the most ordinary market transactions are difficult. Property rights make big difference in whether a market will allocate goods and bads efficiently. This can be understood with a simple example. Consider two people, a polluter and a victim. The conventional view of the problem is that the polluter is the source of the problem and that blame must fall on the polluter’s shoulders. However, leaving aside any preconceptions of right and wrong, the victim could also be blamed for being next to the polluter. Without the victim, the pollution would not be a problem. Morally, it seems that responsibility for cleaning up the pollution should fall on the factory. This issue can be solved through the allocation of property rights. As we know consumers and producers make decisions on the basis of the private costs and benefits they are facing. Social costs and benefits may differ from the private costs and benefits faced by consumers and producers. Often Private agents base their decision on private costs as opposed to social costs because they do not have to support in any way the external costs associated with their consumption and production activities. Similarly they base their decision on private benefits as opposed to social benefits because they cannot extract a payment from the recipients of the external benefits. 

What happens in the absence of Property Rights? 
The next step in our analysis is the following: why do consumers and producers not have to pay for the external costs their activities generate? Similarly, why can they not extract payment from those enjoying the external benefits? The answer to these questions lies in the absence of property rights. Since many aspects of the environment e.g. a typical fishery or forest do not belong to any private parties, there is no one to compensate for using these goods. The price of using the environment, a public good, or an open access resource is effectively nil. If these goods were to belong to private parties, a price would have to be paid for using these resources. The simple solution to externalities would therefore appear to be to privatize property rights. 

The Polluter or the Victim: Who should have the rights? 
The next issue to be addressed is as to whom should private property rights be allocated? To those generating the external costs (such as the polluters), or to those whose welfare is adversely affected by the external costs (such as those whose health is damaged by the pollution)? Is it possible to allocate the property rights to ensure that the social optimum will be reached? As noted earlier , Ronald Coase (1960) showed that in the absence of transaction costs, the social optimum could be reached (e.g. the optimal level of pollution, the optimal amount of trees cut, of land protected, of reforestation, of environmental protection, etc.) whether property rights are initially allocated to polluters or to those suffering from the pollution. This result has come to be known as the Coase theorem. It is demonstrated below with the help of a specific example. 

Suppose a plant is discharging pollution into a lake, and that the water of the lake is used for consumption and for irrigation by a community living by the lake. Suppose that the benefit for the plant to discharge its pollution in the lake is $1000 (for example, this may mean that it would cost $1000 for the plant to stop discharging in the lake by reducing its pollution or by discharging in some other location). Suppose that the benefit for the community of using the lake is $1200 (for example, this may mean that if the community had to stop using the water of the lake, it would have to pay $1200 to obtain water from some other sources). Given these values, the social optimum in this case requires that the lake be used by the community for consumption and irrigation purposes since it is in this use that the lake creates the largest value. In what follows, we will show that if we allow negotiation between the plant owner and the community, the lake will be used for consumption and irrigation by the community irrespective of who owns the property right over the lake. 

First suppose that the property right is allocated to the polluter. Since it would cost $1000 for the plant to stop using the lake to discharge its pollution, the plant would accept any compensation above $1000 to stop discharging in the lake. On the other hand, it costs $1200 for the community not to use the water of the lake. The community would be willing to pay up to $1200 to be able to use the water from the lake and still be better off. Since the community is willing to pay more than what the plant would require to stop its discharges, there is room for negotiation. Negotiation will result in the community compensating the polluter to induce him to stop polluting the lake. The lake will be therefore be used for consumption and irrigation by the community. The optimum is therefore reached even if the property rights are allocated to the polluter. 

Suppose on the other hand that the lake belongs to the community. Since it would cost $1200 for the community to stop using the lake, the community would accept compensation greater than $1200 to stop using the water of the lake. However, the plant would be willing to pay at most $1000 to obtain the right to discharge in the lake. There is in this case no possibility for negotiation and the lake will be used for consumption and irrigation by the community. 

The Problems with allocation of Property Rights 
As we have seen, the optimum is reached no matter whoever is allocated the property right. For this result to be obtained however, certain important conditions needs to be satisfied. The conditions are as follows first, it must be possible to define property rights precisely. Secondly, this property right must be enforceable, and transferable. Indeed, the property right is of no meaning if abuse of the property right by a third party cannot be prevented. Thirdly, parties to the transaction must be well defined. This may be particularly difficult when today’s actions affect future generations, by definition, these cannot be part of current negotiation. Fourth, those owning the property rights must be able to capture all values associated with the environmental asset they own. In the forestry sector for example, this is generally a problem since the property right is typically defined solely over the wood value of the forest, and not over the entire value of the forest, which goes beyond simply its wood value. Finally, transaction costs must be small. When the number of polluters and polluters is large, this condition will likely not be satisfied. 

For all the above reasons, the conditions under which the allocation of private property rights may restore social efficiency restrict the applicability of property rights in practice. Hence it is necessary to look at other ways of achieving the social optimal solution. 

Command and Control Regulation 
A review of the evolution of environmental policies in developed countries such as the USA, UK, France, and Germany, the Netherlands and in many developing countries including India, shows that historically governments have tended to rely on direct regulation or the command and control (CAC) type policies for pollution control. Although it can take many forms, the basic concept of command and control is for the regulator to specify the steps individual polluters must take to solve a pollution problem. 

The essence of command and control is that the regulator collects the information necessary to decide the physical actions to control pollution, the regulator then commands the polluter to take specific physical actions to control the pollution. The regulator is generally quite specific as to what steps needs to be taken. 

Forms of Command and Control 
Command-and –control regulations can take many forms. By means of regulation, the regulator commands a desired behavior, typically by imposing a limit on the amount of emissions that a polluter can produce. These limits are generally called emissions standards. The regulator then controls and enforces compliance with the desired behavior. Under this regime, the incentives for pollution control take the form of penalties or sanctions that the polluter is faced with if it does not comply with the command. For instance, the clean Air Act requires the EPA (Environment Protection Authority) to determine the minimum pollution control “performance” of new sources of pollution. Command and control may also be combined with significant fines and penalties associated with non - compliance. 

The Pros and Cons of Command and Control 
There are several pros and cons of command and control. Command and Control regulation are more flexible in regulating complex environmental processes and thus much greater certainty in how much pollution will result from regulations. The disadvantage in command and control is that the informational cost is high. The regulator often needs to rely on information from the polluter, either in terms of emissions or costs of control, because of this; the polluter has an incentive to distort information provided to the regulator. 

Due to the drawbacks in the CAC type of regulation we can observe a gradual shift from the CAC type of regulation towards regulation based on use of economic instruments. In India the Policy Statement for Abatement of Pollution dated 26 February 1992 aims at giving ‘industries and consumers clear signals about the cost of using environmental and natural resources’. It expects that ‘market-oriented price mechanisms will influence behaviour to avoid excessive use of natural resources.

The Normative theory of Externalities and Market Based Instruments (MBI) 

The Pigouvian Prescription 
Since 1981 there has been a gradual shift from the CAC type of regulation towards regulation based on use of economic instruments. The Normative theory of externalities, which lays the foundation for use of MBI’s in pollution control goes back to the pioneer work of Pigou (1920). According to his analysis the social optimum and the private optimum differ because while the former is based on the condition of equality between marginal social cost and marginal social benefit, the latter is based on the condition of equality between marginal private cost and marginal private benefit. The divergences between social and private benefits or costs are what economists call externalities. Pigou recommended taxes on activities generating negative externalities and subsidies on activities generating positive externalities as means of internalizing externalities and bringing the choice of the firm in line with what it would have been had it faced the true social cost (benefit) of production. 

Determination of the Pigouvian tax, even in a simple model, involves information about the marginal rate of substitution between income and the pollutant for different individuals and the effect of an additional unit of waste discharge on the level of pollution. Also, the marginal product has to be evaluated at the social optimum point. When there is no pollution control, the firms may be discharging wastes beyond the levels consistent with a social optimum. Hence, it becomes difficult to derive the shape of damage function empirically. 

The market structure and type of regulation will also influence the responses of the firms. If for example, producers’ prices are administered on the basis of retention price formula and if a firm’s capacity utilization exceeds the target level then the firm has no disincentive to incur costs in creating and operating as abatement plant. Even for a profit-maximizing firm in a competitive market, the level of pollution abatement will depend on the nature of institutional mechanisms for monitoring and enforcing pollution control measures. 

Hence these problems make the task of deciding the level of tax and assessing the effect of the tax on pollution abatement in an industry difficult. 

Pollution Taxes or Pollution Permits, which is better! 
As an alternative to the Pigouvian tax, an environmental protection agency can issue tradable pollution permits, equal in aggregate amount to a socially optimal level of pollution, and allow the firms to bid for them. Robert and Spence (1976) recommended a mixture of marketable permits supplemented by an effluent fee and a subsidy when the regulator is uncertain about the marginal abatement cost function of polluters. The scheme is as follows: The regulator issues a number of marketable emission permits and the market determines the equilibrium price of permit. The polluters are allowed to generate emissions without permits or in excess of the amounts allowed by their permit holdings, but they have to pay charges at the rate of f per unit of excess emissions. The polluter gets a subsidy at the rate of s for their unused permits. The rates should satisfy the condition s<=p<=f, where p is the permit price. The mixed system ‘produces levels of the effluents, conditional on costs, that reproduce exactly the effluents that would occur if (1) the polluting firms were merged (and made cleanup decisions centrally) and (2) they faced a piece wise linear penalty function of the form P (X) = sx + p Max (x-1, 0), where x is the level of emission and 1 is the quantity of permit. 

Second Best Approaches Involving Mix of Regulation and MBI’s 
The Command and Control (CAC) policies in the form of direct regulation: bans, setting of standards, etc., have increasingly come under criticism on the ground that they are sub-optimal in terms of social welfare maximization, i.e., they do not in generally yield production-pollution-abatement outcomes which equate the social marginal benefit to abatement with its social marginal cost. 

Economists since the time of Pigou have come up with various designs of market based policy instruments which can satisfy the social welfare maximizing condition as demonstrated earlier. However these properties of MBIs have typically been demonstrated under highly simplified assumptions with regard to information on the tastes of consumers, damage functions (abatement benefits) and the production and abatement costs of firm. 

Alternative Economic Instruments 
As the knowledge about the links between emissions, effluents and the solid wastes generated and the environmental effects on health, crops, assets and ecosystem are very limited, economists have developed methodologies to measure the benefits of goods such as clean air or water that are not sold in markets. Cropper and Oates (1992) classify these methods into two broad categories: (a) indirect methods, which attempt to infer from actual choices, such as choosing where to live, the value people place on environmental goods’ and (b) direct questioning approaches, which ask people to make trade offs between environmental and other goods in a survey context. 

In developing countries like India, the problem of valuation of benefits from environmental protection is very difficult not only because of the nonexistence of markets for most environmental resources also because of many imperfections in the markets for factors and intermediate inputs. There is, therefore, a growing consensus that economic instruments such as charges or permits should be combined with direct regulation measures like standards. 

There are a number of alternative economic instruments which are designed to internalize the external costs of pollution, making the polluter pay, and at the same time minimize the cost of a given level of abatement under given conditions with regard to tastes, production and abatement costs, etc. These include price instruments such as various forms of charges, subsidies, deposit refund systems and liabilities which fix prices and let the agents respond through quantity adjustments, or quantity instruments like tradeable permits which fix emission quantities and allow agents to clear the pollution market through price adjustments. 

  • Direct Economic Instruments

  • Indirect Economic Instruments

The Direct Economic Instruments are 

  • Pollution Taxes/Charges
  • User Charges.
  • Marketable Pollution Permits
  • Deposit Refund Systems
  • Performance Bond
  • Strict liability for pollution

The Indirect Economic Instruments are

  • Product Tax/Charge
  • Input Tax/Charge
  • Taxes on complements and subsidies for substitutes
  • Fiscal incentives
  • Eco certification of products and environmental audit 

The Direct economic instruments are preferred when the costs of observing, measuring and monitoring pollution levels are not high. Interplant variations in effluent/emission levels due to differences in plant vintages, processes, raw materials and energy used and temporal variations, both in quantity and quality of pollution, as well as their damage intensities, raise the costs of measurement and monitoring. 

  • Pollution Taxes/Charges: It is suggested that the polluters should be taxed for the privilege of polluting so that they will want to pollute less. According to Pigou, a tax or charge on a pollutant at the point, where the marginal social cost of pollution equals the marginal damage from pollution, will result in an optimal level of pollution. Thus the charge/tax can force the polluter to pay for the external costs of pollution and to incorporate the added taxes into their business decisions. It also provides incentives for business to develop and adopt improved pollution control technologies. 

  • User Charges: User charges are commonly used for the disposal of water wastes and solid wastes. Water user charges generally follow a two-part tariff structure (a) a flat rate independent of volume of wastewater and 

  •  (b) a charge per unit of wastewater discharged. User charges for disposal of household solid wastes and industrial wastes follow a similar pattern. For household wastes the charge is based on the pollution load. In some countries the user charge is not based on the pollution load but is tied to property tax, the reason being administrative convenience. However, many countries have initiated or are in the process of introducing charges, which vary with the type of waste. 

  • Marketable Pollution Permits: Under this system when the pollution happens to be uniformly dispersed, an environmental authority sets target for a region in terms of a particular air pollutant. The targets are translated into X number of pollution permits. These permits are allocated among the existing enterprises on the historical pattern of emissions (‘grand fathering’) or the permits may be auctioned. These permits are tradable and the prices of permit p, is determined in the market for the pollutant. Polluters with abatement costs below the permit price have an incentive to undertake abatement. The emission reductions by terms with low abatement costs are certified by the environmental certificates (ERCs). These ERCs can be sold to other polluting firms whose abatement costs are higher than the permit price. 

  • Deposit Refund Systems: In this system the potential injurers are subjected to a tax (deposit) in the amount of the potential damage and receive a subsidy (refund) equally large in terms of present value, if certain conditions are met, for example, proof that a product is returned to a specified place or that a specified type of damage has not occurred. 

  • Performance Bond: A production oriented deposit refund system is known as performance bond. The potential entrant in this activity has to deposit an amount equal to the expected restoration costs and the deposit would be refunded when the site is restored in such a way as to meet environmental standards. This scheme is applicable to new chemicals whose environmental effects are known. The producers of the new chemical bear the cost of risk. 

  • Strict liability for pollution: Liability as a policy instrument for damages is recognized in common law. This scheme holds promise in situations where information about potential damage is scarce, the discharges are stochastic, monitoring is difficult and the polluter has financial capability to pay the necessary compensation in the event of damage. As the imposition of such liability shifts the cost of risk to the polluter, he has an incentive to engage in preventive measures. Like a Pigouvian tax, strict liability internalizes the external costs. 

    The Indirect economic instruments are 

  • Product Tax/Charge: If output and pollutant are joint products, i.e., there is a proportional relation between the two, then the environmental objective can be achieved either by a tax on the pollutant or on the output. In many industries, pollution per unit of output varies from firm to firm depending on the vintage of the plant, the process used, the fuel input used and location of the plant. Thus an output tax does not distinguish between a ‘clean’ plant and a polluting plant. As an incentive for a firm to use clean technology or to erect and operate an abatement plant, the firm may be given rebate/exemption from the tax. 

  • Input Tax/Charge: An input tax is a tax on water consumption or a tax on the quantity of energy used or a tax on any input whose use generates pollution. It is easier to measure and monitor than a direct tax on pollution. Along with input tax, exemptions may be given to firms with clean technologies and rebates may be given to plants, which undertake pollution abatement. A gasoline tax is a good instrument for dealing with environment problems related to the burning of gasoline, such as the emission of air pollutants. This tax can provide significant energy-security benefits by reducing a country’s demand for the import of crude oil. Almost all European Countries have fuel taxes. The tax rates vary depending on pollution generating characteristics of different fuels. Taxes minerals, water and other scarce inputs can encourage conservation. 

Taxes on complements and subsidies for substitutes: 
Subsidies for products, which are eco-friendly, e.g., organic manures and organic pesticides can discourage use of chemical fertilizers and chemical pesticides. Similarly taxes on automobiles based on their weight or pollution generating capacity can result in the conservation of energy. 

There is also scope for using the tax/subsidy instrument for correcting existing price distortions. At present prices of items such as irrigation water, electricity for farmers, fertilizers are under priced due to political and other reasons. Underpricing of these goods does not provide any incentive to the users to conserve the scarce resources. Economic pricing of these items will reduce excess demands, encourage conservation and give signals to the users about the social scarcities of these goods. 

  • Fiscal incentives: Fiscal incentives for improving environmental quality include rebates on excise duty/customs duty/sales tax on machinery and equipment used for pollution abatement or adoption of clean technologies, accelerated depreciation allowances to encourage adoption of clean technologies or to erect abatement plans, soft loans/subsidies for setting up common effluent treatment plants and recycling and conservation activities. 

  • Eco certification of products and environmental audit: This method involves labeling ofenvironment friendly products. This scheme operates on a national basis and provides accredition and labelling for household and other consumer products, which meet certain environmental criteria along with quality requirements of the Nations Standards for that product. 

The specific objectives of the scheme are as follows: - 
  1. To provide an incentive for manufacturers and importers to reduce adverse environmental impact of products. 
  2. To reward genuine initiatives by companies to reduce adverse environmental impact of their products. 
  3. To assist consumers to become environmentally responsible in their daily lives by providing information to take account of environmental factors in their purchase decisions. 
  4. To encourage citizens to purchase products which have less harmful environmental impacts. 
  5. Ultimately to improve the quality of the environment and to encourage the sustainable management of resources

Other Supportive Measures 
In many countries adoption of clean technologies is mandatory for new firms. Existing firms are often required to use abatement technologies within specified periods. Development of pollution-free technologies can be encouraged by providing government support for basic research in this area, and by grants and patent policies to the investors. Public good characteristics of R & D and inventions favour government support for these activities. 
Administrative regulation can also take the form of a zoning cum incentive scheme designed to internalize the externalities. For example, an industrial complex consisting of sugar mills, distilleries, paper mills using bagasse as raw material, and farms, which can use wastewater discharged from these factories, can internalize the externalities. The Government can also evolve location policies for polluting industries in a region to facilitate collective abatement efforts. It can also invest in public infrastructure for pollution abatement, e.g., common treatment plants for effluent discharges for small firms and municipal wastes where individual abatement plants are not economically viable. 

The Government can also take a number of measures to strengthen the legal systems in the interest of improving environmental quality. This can be achieved in many ways. It can define property rights for environmental resources, wherever they are feasible. It can create markets for tradeable permits for uniformly dispersed pollutants such as greenhouse gases and water pollutants in a large river basin. It can enforce legal liability or administer a performance bond scheme for large firms, which use hazardous materials. 

There is a growing awareness that many environmental problems are location-specific. It is very difficult for a central agency to collect all the relevant location-specific information for dealing with each environmental problem and then design an appropriate regulation for each unit. Even if it were possible, there would be further hurdles at the implementation stage. The monitoring problem is complicated by temporal and stochastic variations in pollution levels and in the valuation of damages. Continuous monitoring might help in some cases but this is possible only by agencies located in the vicinity of polluters. Hence, there is a strong case for decentralization both in the design and implementation of pollution control policies relating to disposal of solid wastes by firms and households, and the discharge of wastewater by firms onto land, lakes or small rivers. 

The government can also help in the formation of non-governmental agencies (NGOs) for improving environmental quality. These agencies can be effective in reducing the transaction costs in the implementation of policies. Most NGOs are small local groups and in many situations their constituents are the victims of pollution. They can play effective roles in monitoring wastes discharged by large and small firms. They can report non-compliance by the polluting firms to pollution control boards. Pressure can also be exerted on the polluting firms by generating adverse publicity for them or by boycotting purchases of their products. They can also monitor household waste discharge and other non-point sources by creating social and other pressures for improving environmental quality. The government can play an important supporting role for such NGOs by facilitating their access to information relevant to their activities. 

The Following Table provides taxonomy of policy instruments 

Type Direct  Indirect
1.Physical instruments 
Source-specific standards, non-Tradeable quotas for emissions/effluents, ban hazardous materials  Restrictions on products and process, input uses, location of plant 
2.Economic instruments 
Emission/effluent charges, Tradeable pollution permits, user charges, deposit refund system on used bottles/cans, performance bonds, strict liability  Product charge, input charge, subsidies for competitive outputs and substitutable environment-friendly inputs, taxes on complementary outputs/inputs
3.Supportive instruments 
Development of environment-friendly technologies, technologies for conservation of environmental goods. Common sewage treatment for waste treatment, recycling Creation and enforcement of property rights,access to information about environmental problems, cost and damage, involvement of local public institutions and grass root voluntary organizations in solving location specific environment problems


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