Incentive-Based Legislation

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To counteract many problems associated with control-based legislation, many economists propose developing incentive-based (IB) regulations in the form of emission credits, allowable tax deductions, and other incentives. Likewise, those who are not complying will be penalized by paying higher taxes with fewer emission credits. Two schemes have been proposed: 1) to enact pollution tax proportional to the amount of pollutants discharged into the air; and 2) to issue pollution permits (emission credits) that can be auctioned off or freely traded in a pollution market.

Both systems are designed to put a price on pollution and provide incentives to firms and others to seek less polluting alternatives or better cleanup strategies. With taxing, the cost is direct – more pollution means more taxes. As an incentive, some tax breaks may be given to those industries that have met and exceeded the requirements set by law or have invested in research and development of cleaner technologies. With pollution permits (also called emission trading or cap and trade system), a regulatory body--usually the government-- sets an overall cap on the country’s carbon emission that drops annually; less pollution offers the opportunity to free permits for sale, whereas more pollution requires additional permits to be bought from the government or from less polluting competitors. This encourages companies to invest in cleaner technologies or find efficient ways to cut emissions and sell the unused portions of their permits to others. There are, however, sharp differences on how the pollution permits should be allocated. Some economist favor allocating higher number of permits to industries which produce more pollution. The rationale is that as the overall cap tightens each year, the biggest polluters face the largest challenges in cutting emissions. Other economists, propose allocating permits through an auction. Under this system, every company – large or small - would have to buy rights to pollute. As a result, the biggest polluters would have to pay the most - thereby providing them with the greatest incentive to cut emissions right from the start (1).

IB regulations applied to automotive emissions can take several forms that encourage both the fuel efficiency and, at the same time, lower the vehicle-miles traveled. One possibility is an auto emission tax that is adjusted based on the total emission the car has produced over the period of one year since the last smog check. Congestion tax (higher toll-charges for single-occupant cars or during rush hours) discourages traveling alone or during peak traffic. Another solution is to charge auto insurance on a pay-by-the-mile system; less would be charged to smaller cars and to people who drive less. Insurance rates will be higher for bigger cars and individuals that drive higher mileages. The final solution is the imposition of a revenue neutral scheme referred to as feebate; this system penalizes gas-guzzling cars by charging higher tax rates while rewarding high fuel-efficient cars by giving them rebates.

Example: Suppose a city ordinance requires a reduction in total particulate emissions in an industrial area by 100 tons. There are only two polluting firms, A and B, each responsible for producing 150 tons of particulates or one-half of all of the particulate emission in that area. What is the best strategy to achieve the required results in two scenarios in which firms can and cannot trade pollution permits? The cost of pollution abatement is $50 per ton for firm A and $200 per ton for firm B. What is the total cost of reduction in each case?

Solution: Firm B has a much higher cleanup cost than A. If emission trading is permissible, it makes sense for firm B to buy 100 tons of emission by paying firm A $50 per ton for a total cost of $5,000. If emission trading is not allowed or firms do not reach an agreement, then firms must cut emissions by 50 tons each. The cost of pollution abatement is 50x$50 = $2,500 for A, and 50x$200 = $10,000 for B resulting in a total cost of $12,500.

The main objections raised against incentive-based regulations are hot spots, monitoring, and enforcement. Hot spots refer to the elevated concentration of pollution near firms who find it economically advantageous to avoid or defer cleanup by paying a tax penalty or purchasing additional permits. This is particularly important for concentrated pollutants that are not uniformly mixed. Examples are nuclear wastes, toxic wastes, and sulfur dioxide or particulate emissions that can easily buildup in the vicinity of power plant smokestacks. The IB strategies on pollutants like carbon dioxide and chlorofluorocarbons are less important because their impact on the overall air quality depends on the total volume of their emission, not on local concentration of these pollutants. To correct for this problem, it is often suggested that penalties and permits are issued such that the maximum concentration of different pollutants within a given geographical area is not to exceed the state and federal ambient air and water quality standards.

Another problem raised by IB regulation is monitoring and enforcement. Unlike a CAC system where firms are required to install and maintain certain air quality abatement equipment, in incentive-based approaches, no such requirement exists so constant monitoring and precise measurement of concentrations of pollutants in multiple monitoring locations is required to assure compliance. This can be quite complicated and the cost, except under special circumstances, may not be warranted.


(1) Robert Reich online blog, “Why McCain’s “Cap-and-Trade” Won’t Work Nearly as Well as Obama’s,”, May 27, 2008 (

(2) Toossi Reza, "Energy and the Environment:Sources, technologies, and impacts", Verve Publishers, 2005

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