5 Guiding Principles For The Use And Design Of Economic Instruments

This section consolidates the lessons learned from foreign and Canadian experience with economic instruments and EFR, and identifies various guiding principles to help foster the increased use of economic instruments in Canada. In particular, this section provides guidance to enable decision makers to ensure that they: a) select economic instruments for use in appropriate circumstances; and b) design them carefully, including through the use of processes to build support for the new measure.

5.1 Understanding When To Use Economic Instruments

In general, economic instruments are most suitable for environmental issues where:

• fundamental, long-term behavioural change is desired, and can be supported using market signals to change the information on which decisions are made;
• 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.

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, however, 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.

Working within a broader policy context: economic instruments are rarely stand-alone mechanisms. They should be part of a policy package that includes a mix of policy approaches and mechanisms. As such, economic instruments can be very useful when used:

• In combination with regulations. For example, the New South Wales "load based licensing" (LBL) program imposes differentiated pollution charges that account for the potential harmfulness of various pollutants (including a range of substances managed as toxics in Canada). The program operates on top of a regulated emission threshold for each sector and pollutant, based on the level that can reasonably be achieved using modern technology. LBL fees are doubled for facilities that exceed a relevant threshold. Each licensee also has an annual load limit for each type of pollutant emitted from its premises. The government may prosecute releases above these limits.¹⁹
• In combination with non-regulatory measures. The Association for European Automakers recently signed an agreement with the European Union containing commitments to improve the fuel efficiency of new vehicles. The impacts of this agreement are enhanced by the fact that many European countries impose lower excise taxes on diesel than on the petroleum. This creates incentives for consumers to purchase more fuel-efficient diesel vehicles. In addition, a number of American states offer economic incentives such as reduced permit fees to encourage participation in non-regulatory programs focused on "beyond compliance pollution prevention targets.
• In combination with information programs. Information programs and economic instruments can be highly complementary as both seek to correct market distortions. Disclosure mechanisms – such as programs that provide information about environmental performance to the public, eco-labelling programs, and public reporting requirements – operate on the premise that better information will enhance the efficiency with which the market rewards and penalizes environmental performance. Economic instruments likewise help improve the efficiency of the market by correcting the failure of market prices to account for environmental externalities and by serving as information to consumers in themselves.

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. An economic instrument may well impose costs on certain industries or consumers; the important question is whether it is the least-cost method of achieving the desired goals. Figure 1 provides criteria that can help guide such an assessment.

5.2 Guiding Principles For The Design Of Economic Instruments

Build public support through consultation:

• Ensure relevant stakeholders understand the objective of the economic instrument.
• Ensure relevant stakeholders understand why economic instruments represent the optimal instrument choice to achieve the objective.
• Consult affected stakeholders and give them an opportunity to affect the instrument design.
• Selling an economic instrument as part of a package of measures may be easier than selling it on its own (e.g., a green tax may make possible decreases in other taxes or investments in socially-desirable activities).

Design Considerations:

Each 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: either the instrument or associated measures should include mechanisms to prevent free-riding.
• Monitoring and enforcement: adequate capacity should exist to monitor and enforce the requirements associated the instrument.
• Ensure results in the short-term: economic instruments that have been designed to achieve visible environmental benefits in the short term have retained public support.
• Consider revenue-neutrality:²⁰ demonstrating that a tax or fee does not represent a "tax grab" will increase its legitimacy. On a large scale, this can be done by reducing other taxes. On a smaller scale, the use of feebates to recycle revenues to the targeted sector can both increase political acceptability and enhance environmental impacts.
• Mitigate adverse economic impacts:
  • This may require phasing-in the measure, exempting or imposing lower rates for exporters or recycling revenues.
  • Time the introduction of the instrument to reduce its adverse economic impacts: it may be more difficult to justify increased gas taxes, for example, when oil prices are rising .
  • Try to mitigate adverse distributional effects (e.g., toxic and carbon-intensive industries tend to be concentrated in certain regions; SMEs also tend to be more polluting than larger firms).
  • Commit to monitor impacts and to take remedial measures to correct unanticipated impacts.
  • Ensure the rationale for any exemptions are transparent to all users and the public.
• Coordination: Some economic instruments (such as eco-labels and trading schemes) are most effective when coordinated with adjacent jurisdictions.

¹⁹ New South Wales also authorizes emissions trading schemes to broaden LBL from individual premises to groups of licensees. It has established various trading schemes, including one among sewage treatment plants emitting into the same watershed.

²⁰ The goal should be revenue-neutrality from a government perspective; it is more difficult to make a tax revenue-neutral from an industry sector or consumer point of view.