Prepared by:

Stratos Inc.
1404-1 Nicholas Street
Ottawa, Ontario
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For
External Advisory Committee On Smart Regulation

December 4, 2003

Executive Summary

This paper is intended to enhance understanding of the opportunities to use economic instruments in Canada. It draws on the lessons learned in other countries and in Canada regarding when to use these measures, how to introduce them and how to design them.

Overview of Economic Instruments

Economic instruments use market-based signals to motivate desired types of decision-making. They either provide financial rewards for desired behaviour or impose costs for undesirable behaviour. Although we use economic instruments such as user fees, tax incentives and "sin" taxes to promote a range of social and economic policies, Canada lags most of the rest of the OECD in its use of economic instruments in support of environmentally sustainable development.

Economic instruments include property rights, fee-based measures, liability and assurance regimes and tradeable permits (see Text Box E1). These measures are highly versatile. Many can be combined, and in many cases they are used as part of a mix of instruments that includes regulations and information programs. Economic instruments also form an important component of ecological fiscal reform (EFR). EFR involves not just taxing environmentally-destructive behaviour, but also: i) reducing environmentally-perverse subsidies, and ii) using the revenues from green taxes to reduce taxes on socially-desirable activities (e.g., labour, savings) or to encourage environmentally-desirable technologies (e.g., renewable energy). For these reasons, EFR is also often described as tax-shifting.

By harnessing the force of the marketplace, economic instruments operate very differently from, and can have important advantages over, other forms of environmental risk management. They can be more efficient – achieving an environmental objective at lower costs than other measures. Studies suggest that the more widespread use of economic instruments could reduce compliance costs by almost one-quarter of the approximately $200 billion that is currently spent annually on pollution control in the U.S. (Anderson, 1999). Economic instruments also can reward continuous improvement and can stimulate the development of new technologies, whereas most regulatory approaches provide little incentive for going beyond a stipulated performance level. They can also address issues for which regulatory approaches may be ineffective. For example, consumption charges, deposit-refund programs and variable charges for waste disposal can influence the behaviour of numerous actors with relatively low transaction costs. Finally, by correcting market signals through the imposition of charges or the creation of a property right, economic instruments send important normative signals about the social value of the environmental commons as well as a financial signal that influences behaviour.

European and Japanese Experience With Economic Instruments

Europe makes much greater use of economic instruments for environmental objectives than Canada. In particular, the European experience illustrates the significant potential to use fiscal policy to promote environmentally sustainable behaviour. Europeans apply taxes and fees to address a wide range of issues, including air emissions, packaging, waste management, water effluent and non-point water pollution. Energy use is taxed heavily in most OECD countries, with fuel taxes 3 to 5 times higher in Europe than in Canada. At least seven European countries have recently introduced carbon taxes focused on reducing greenhouse gas emissions from the consumption of fossil fuels. Japan recently proposed a similar set of taxes on fossil fuels in 2005.

A growing number of European fee-based measures are taking the form of revenue-neutral feebates, which combine a charge based on emission levels or some other measure of environmental risk with a rebate to facilities that demonstrate prescribed types of environmental improvements. Feebates can help attain domestic environmental objectives while minimizing adverse competitiveness impacts and creating incentives for technological innovation and production efficiency gains. Many OECD countries have also moved beyond the use of tax measures for addressing discrete issues to more systematic tax reform. Some of these reform initiatives have focused on opportunities to achieve environmental objectives more efficiently, leading to the application of environmental taxes to a wider range of issues. A growing number are introducing tax-shifting policies to use the revenues from new taxes on pollution or resource extraction to reduce taxes on labour or capital.

All OECD countries use a wide range of subsidies to promote objectives such as renewable energy, energy efficiency, nature preservation, water treatment, alternate transportation modes, and environmental technology research and development. Emissions trading is also becoming increasingly prevalent, particularly as a means of addressing GHG emissions.

As in Canada, Europe has used deposit-refund systems primarily to encourage the return of beverage containers to the point of sale. Recently, Europe has used such measures to address increasingly complex issues, including vehicle return programs and the environmentally sound management of large appliances and electronic goods. European and Asian countries are also exploring opportunities to go beyond simple take-back programs operated through deposit-refund schemes. The objective is to use combinations of economic instruments to create incentives for producers to redesign their products so as to eliminate the source of the environmental problem.

U.S. Experience With Economic Instruments

The U.S. uses economic instruments to address discrete environmental protection and conservation or resource management issues, rather than as part of an overall strategy that emphasizes tax-shifting and correcting market failures. Nonetheless, the U.S. has made much more extensive use of economic instruments for environmental protection than Canada. The U.S. is the leading exponent of marketable permits and other trading programs, with federal, state and municipal level initiatives related to a wide range of pollutants, land use and resource conservation related issues. Although less so than in Europe, the federal, state and local governments all use fees, charges and taxes for a range of issues. Deposit-refund schemes promote the recycling of beverage containers and other consumer products. Performance bonds, liability legislation and information disclosure also form important elements of the overall environmental management toolbox in most US jurisdictions. Incentives and subsidies for reducing pollution or improving the environment include tax benefits, loans, tax-exempt bonds, grants, tax incentives, and preferential procurement programs.

Canadian Experience With Economic Instruments

The federal government makes limited use of economic instruments. It uses tradeable permits to manage some fisheries and to address ozone depleting substances, and has supported pilot greenhouse gas trading projects. It uses tax incentives to promote ethanol, renewable energy and gifts of ecologically significant land. Federal subsidies support a range of environmental and natural resource management objectives. Canada generates only about 5% of its tax revenues from environmentally related taxes. Over three-quarters of these revenues are from the gasoline excise tax, which arguably is designed to generate revenue rather than to reduce fuel consumption. This is in contrast to over 8% for the U.K., over 10% in Norway and over 12% in the case of Netherlands and Korea.

Provinces also use some economic instruments. Ontario has introduced a trading program to reduce emissions from large coal and oil-fired electricity generators. Many provinces require insurance or site reclamation deposits as a condition of receiving a permit to operate facilities such as waste disposal sites and mines. Some impose excise taxes to help fund the reclamation of abandoned sites. Most use deposit-refund schemes and advance disposal fees to promote product stewardship and environmentally sound management of various solid wastes. Many also collect excise taxes related to batteries, solvents, tires, water use, vehicle license fees and forestry preservation.

Winnipeg's proposed "New Deal" provides an example of how municipal fiscal reform could be designed to include environmental, social and economic objectives. The proposed set of consumption taxes would include a sales tax, a fuel tax (to fund transit expenditures), as well as taxes on gas, electricity, and garbage disposal. While other municipalities have introduced pay-per-use, Winnipeg is the first in Canada to recommend a fundamentally new tax system.

The Government of Canada and Environment Canada have repeatedly called for the greater use of economic instruments to address environmental issues. Notwithstanding these policy statements and notwithstanding the examples summarized above, the Canadian experience with economic instruments is quite limited, and lags many European and other countries. We make minimal use of tax and fee-based measures designed to change behaviour. We have little experience with marketable permits, have made little use of economic instruments focused on changing consumption patterns, and have almost no economic instruments for encouraging design improvements for complex products.  Commenting on this, the OECD's 2000 Economic Survey of Canada concluded that: "... there is a need to increase the use of economic instruments (for instance, charges on toxic emissions and waste, and disposal fees for products containing toxic substances) to reinforce the polluter-pays principle."

Overcoming The Barriers To Economic Instruments

Like any risk management tool, each type of economic instrument has limitations. They can be difficult to design in some cases, and may engender political opposition from stakeholders concerned about pricing hitherto free environmental resources or, from the other perspective, about establishing a "license to pollute." Without regulatory baselines, some types of economic instruments will not provide a sufficiently predictable response to be acceptable as the primary mechanism for managing certain risks. In many cases, however, the barriers are not significantly different from those that confront the use of other policy instruments. Lack of awareness and institutional inertia therefore also play an important role in limiting the current application of these valuable tools, and the experiences elsewhere may highlight opportunities for Canada to overcome these barriers.

• Lack of Awareness
  Many barriers to the use of economic instruments relate to lack of awareness and institutional inertia. European efforts to overcome these barriers have included initiatives by academics, environmental agencies and various NGOs to raise awareness of the overall importance of correcting market signals as well as awareness-raising efforts to ensure support for a particular instrument.

• Resistance to "New Taxes"
  One of the main barriers to the introduction of economic instruments in Canada has been opposition to "new taxes." The European experience emphasizes the importance of ensuring that any new economic instrument has a clearly defined and well-understood environmental objective. Another approach has been to introduce environmental taxes in stages and to incorporate temporary relief packages. In some cases, this takes the form of tax shifting (using revenue from environmental taxes to reduce taxation on investment or employment). Europeans are also increasingly utilizing feebates to overcome anti-tax resistance and concerns about competitiveness. One of the key barriers to the design of revenue-neutral measures has been the tendency of departments of finance to oppose the earmarking of tax revenue on the grounds that it may not be the most efficient use of the revenue. Over the past decade, however, earmarking has been used more often in Europe, and the European experience suggests that earmarking can help overcome resistance to fee-based measures.

• Competitiveness Concerns
  Concerns about the effects of economic instruments on the competitiveness of exporting industries are particularly significant for an open economy such as Canada's. The key consideration in addressing these concerns is to assess the potential competitiveness impacts of a proposed economic instrument in comparison to alternative policy instruments designed to achieve the same environmental objective. In many cases, economic instruments will offer the most efficient means of achieving a goal. As a result, for example, recent work by Environment Canada and others suggests there may be opportunities for Canada to "converge" with U.S. environmental performance levels while using more efficient policy measures – such as economic instruments – that reduce Canadian compliance costs, thereby creating a comparative advantage.

  In general, European commentators emphasize the importance of pragmatic design in order to overcome concerns about competitiveness impacts or adverse distributional effects. In addition to recycling tax revenues back to the payers through the use of feebates, countries have addressed competitiveness concerns in various ways, including tax exemptions, reduced tax levels, border tax adjustments, or by emphasizing consumer taxes over production taxes.

• The Need For Supportive Constituencies
  Until recently there have been no strong supporters of economic instruments in Canada. That situation appears to be changing. Over the past three years, the Green Budget Coalition has evolved from a loose coalition of NGOs lobbying for a range of spending and fiscal policy reforms to a coherent umbrella organization representing most of Canada's major environmental NGOs in a campaign for ecological fiscal reform. There is also growing support among the business community for the principle that fiscal policy should shift its emphasis away from the taxation of income and investment and towards consumption.

• Lack of Experience
  Both the European and the U.S. examples point to the importance of overcoming opposition to economic instruments through the incremental accumulation of experience. In the U.S., early successes in a small number of issues have paved the way for subsequent widespread application and innovation. This lesson is particularly apt for Canada. Canada's circumspect approach to the use of economic instruments for environmental protection and conservation appears to be largely the result of a vicious circle, in which our lack of experience feeds an ongoing reluctance to depart from more traditional regulatory approaches. As a result, for example, individual risk managers do not routinely consider economic instruments as options for addressing specific issues. Overcoming this barrier will require political willingness to act, together with a considerable effort to enhance trust in this important set of instruments by publicizing the benefits and lessons learned from successes elsewhere and from Canadian experience as it evolves.

Guiding Principles

Three main considerations are relevant to understanding when to use economic instruments:

• First, in general, economic instruments are most suitable for environmental issues where fundamental, long-term behavioural change is desired; flexibility of response from individual actors is acceptable; an end-point is difficult to define, but the desired direction is known; or the cost of abating pollution differs widely among sources.

• Second, in general, economic instruments are less suitable as the sole mechanism for managing risks for which a predictable and uniform level of response is required because they send directional signals and allow considerable flexibility of response. It is possible to incorporate explicit targets into some types of economic instruments (e.g., cap and trade programs) or to combine an economic instrument with a clear regulatory baseline. In any event, it is generally appropriate to use economic instruments as part of a policy package that includes a mix of approaches. For example, economic instruments can be very useful when used in combination with regulations, with non-regulatory measures or with information programs.

• Third, in assessing the potential merits of an economic instrument, it is particularly important to compare its impacts to those of alternative measures that would achieve the same environmental or human health objective. While an economic instrument may well impose costs, the important question is whether it is the least-cost method of achieving the desired goals.

Finally, each economic instrument should be designed from a pragmatic perspective that reflects both the instrument's objectives, as well as the overarching policy context. Relevant design considerations include:

• Simplicity: clear, unambiguous rules should be defined up-front.
• Degree of Influence: the market signal (the rate of a tax or fee, the cost of a tradeable unit, etc.) should reflect the degree of change desired and the likely market response to the signal.
• Innovation: provide incentives for improved efficiency, innovation, and continuous improvement
• Free-Riders: the instrument or associated measures should prevent free-riding.
• Monitoring and enforcement should be provided for.
• Ensure results in the short-term.
• Consider revenue-neutrality.
• Mitigate adverse economic impacts.
• Coordination: Some economic instruments (such as eco-labels and trading schemes) are most effective when coordinated with adjacent jurisdictions.

Conclusions

Economic instruments can have many advantages over other risk management measures. In some cases they represent the most efficient mechanisms for addressing an issue, and in others they can provide valuable and low-cost incentives for continuous improvement. More fundamentally, as a market-based society, Canada needs to make greater use of economic instruments in order to promote sustainable development. Economic instruments provide one of the most effective public policy tools for addressing the underlying production and consumption challenges we face in a way that stimulates and builds on the innovation and economic development dynamics of the market place.

Canadian use of economic instruments lags many other OECD countries. In seeking to overcome this gap, Canada would do well to draw on the growing international experience. Although legal, geographical and other considerations may limit the direct applicability of some of the foreign experience, there are important examples of economic instruments that have been effective in addressing an issue of importance to Canadians and that could be implemented in Canada without significant law or institutional reforms. International experience also provides many valuable process and design lessons for Canadian efforts to introduce economic instruments.