2 Overview of Economic Instruments

Economic instruments can be defined broadly as measures that use market-based signals to motivate desired types of decision-making. They either provide financial rewards for desired behaviour or impose costs of various types for undesirable behaviour. Governments in Canada and elsewhere already use economic instruments such as user fees, tax incentives and "sin" taxes to promote a range of social and economic policies. This paper discusses their use in support of another policy field – environmentally sustainable development.

Over the past decade, a growing number of jurisdictions around the world have applied economic instruments to an expanding array of environmental issues, including household waste management; water, electricity and gasoline consumption; wetlands management; toxics use; product stewardship; and air and greenhouse gas emissions. The main types of economic instruments include (Appendix A provides more detailed descriptions):

• Property rights: ownership rights, use rights, development rights and transferable development rights can all be used to promote responsible resource management;
• Fee-based measures: fees, charges, taxes, deposit-refunds and revenue-neutral feebates all impose payments of specified amounts, thereby creating an explicit cost associated with environmentally damaging activities and an easily quantifiable incentive for reducing the activity.
• Liability and assurance regimes: liability rules and various types of bonds can provide strong incentives to avoid environmental impacts and to clean-up and restore environmental damage.
• Tradeable permits: provide mechanisms for minimizing the social and private costs of meeting a regulatory cap on emissions.

Economic instruments are highly versatile. Many of the different types of economic instruments can be combined together, and in most 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 pollution or environmentally-destructive behaviour, but also: i) reducing or eliminating environmentally-perverse subsidies, and ii) using the revenues from green taxes to reduce taxes on socially-desirable activities (e.g., labour, investment) 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. In some cases, they can be more efficient – achieving an environmental objective at lower costs than other measures.¹ Studies in the U.S. have suggested that the more widespread use of economic instruments could reduce overall 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. By relying on market signals, economic instruments can 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, economic instruments also play an important normative role. By correcting market signals through the imposition of charges or the creation of a property right, economic instruments send a normative signal about the social value of the environmental commons as well as a financial signal that influences behaviour.

Despite their advantages, economic instruments are not used as widely as some other risk management measures for addressing environmental issues. Like any risk management tool, each type of economic instrument has limitations. They can be difficult to design in some circumstances, 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, these 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 risk management tools.

One of the main purposes of this paper is to ensure that the use of economic instruments in Canada builds on the extensive experience in other jurisdictions with these measures, including enhanced awareness of lessons learned about how to overcome design and other challenges to their use.

¹ By setting standardized emissions, product or technology requirements, for example, regulations tend not to account for the different costs of compliance faced by different sources. As a result, control costs can vary widely due to differences in firms' designs, configurations, the ages of their assets, sources of inputs, or other factors. By contrast, economic instruments allow affected actors to respond in the most economically efficient manner appropriate to their particular circumstances.