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1.2. Definitions

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Savings from Economic Incentives

In order to bound the subject, economic incentives in this report will be defined broadly as instruments that provide continuous inducements of a direct or indirect nature for sources to make reductions in the pollutants they release. That is, those who release pollutants incur a cost for each unit of pollution that is released, rather than only amounts of pollution in excess of a standard or permitted amount. Market-based instruments are taken to represent the subset of economic incentives that relies directly on markets to transmit price signals regarding the cost of pollution. Under this definition, Market-based instruments include pollution taxes, charges and fees; marketable permit and allowance systems; deposit-refund systems; and pollution control subsidies.

The definition of economic incentives excludes certain mechanisms that sometimes are referred to as incentives. Although such mechanisms may have many admirable characteristics and some of the attributes of economic incentives as the term is often used, they will not be discussed in this report. This class of mechanisms prices (explicitly or implicitly) activities that have pollution as a byproduct. Ride sharing, bike paths, high occupancy vehicle lanes, and parking surcharges provide examples of this type of mechanism. While these mechanisms may lead to a reduction in pollution, the mechanisms place neither an explicit nor an implicit price on incremental units of pollution. Exclusion of these mechanisms carries no implications for whether future EPA actions will or will not consider them to be economic incentives. Rather, their exclusion is primarily for the purpose of limiting the subject of this report to something manageable.

Payments per unit of pollution are the clearest example of an incentive, as the term is used in this report. Because each unit of pollution is costly, sources are penalized financially for increases and rewarded financially for any decreases in their pollution. Some variants on the approach are observed; for example, the payments may apply only on units of pollution above some threshold. Eighty percent of "baseline" levels is the threshold for payments in one instance.

Market-based systems in pollution reduction credits also operate as incentives, albeit less perfectly than pollution fees. Reductions in pollution below permitted or allowed limits earn sources credits that may be sold to firms that are operating above allowed limits (or retained by the source for future use in some cases). While existing markets in pollution reduction credits are often limited in terms of the number of potential buyers and sellers, as well as the number of actual trades, they nonetheless offer direct financial rewards for sources to reduce pollution. Sources with high incremental control costs tend to be buyers of the credits, leading to improved cost-effectiveness in pollution control.

Finally, indirect financial incentives for continuous effort at pollution abatement are created when sources must report publicly the quantities of specified substances they release and thus risk the loss of market share or a lower demand for their products. All of these incentive mechanisms operate through the ingenuity and actions of individual sources, who have an incentive to be on the alert for opportunities to make reductions in their pollution.

The contrast between incentive mechanisms as defined here and traditional "command and control" approaches is that the latter do not provide incentives to reduce the quantity of releases below permitted levels or to improve the quality of the releases of pollutants beyond permitted levels, as illustrated in the table. Under pure command and control approaches, sources view all releases below permitted quantities or above permitted quality as costless. To have gains in environmental quality, the burden is solely on regulators to tighten requirements imposed on individual sources. Sources operating within the limits of existing regulations (the shaded area in the table) have no economic reason to make pollution control investments.
Toxicity of Pollution
Quantity of Pollution
Within Regulatory Limits
Excess Above What Is Allowed by Regulations
Excess above What Is Allowed by Regulations
Fines and Penalties Because of Toxicity
Fines and Penalties For Exceeding Regulations on both Toxicity and Quantity, If Caught and Successfully Prosecuted
Regulatory Limits
No Incentive to
Reduce Pollution
Fines and Penalties on Excess Quantities If Caught and Successfully Prosecuted

Unfortunately, there are a wide variety of definitions of economic incentives in common use, as well as a variety of related concepts. One of these related concepts is "market mechanisms." Generally, this term is used for a somewhat narrower concept involving only those economic incentives which are implemented through mechanisms having direct effects on economic markets. Thus, providing risk information could be an economic incentive but not a market mechanism while pollution fees would be both. Risk information can have an indirect effect on economic markets by shifting either the demand function or the supply function (either through appealing to profit-motivated market share considerations or liablility aversion), but does not directly change prices.

It must be emphasized that although this report makes a careful distinction between command-and-control and economic incentive approaches, these distinctions are often difficult to apply in practice. Some analysts have even argued that prohibitions established by command-and-control regulations operate in part by creating economic incentives to comply (through the proper setting of fines and penalties), while pollution charges and other "market" incentives rely on governmental policing of the market or governmental definition of the goods (i.e, pollution units). In other words, there is a continuous distribution of pollution control measures ranging from the "pure" command-and-control to the "pure" market mechanism. Expressed still another way, the dividing line between command- and-control and economic incentives can be drawn at any number of places; although the definition used above is based on what is probably the most important economic distinction between the two approaches, a case can be made for a number of other definitions.

Another important definition is what is meant by the economic efficiency of economic incentives. Theoretically, the most economically efficient incentive is one which requires the polluter to pay exactly an amount for pollution that just equals the magnitude of damage to others. In theory, the polluter would reduce pollution to the point that the cost of further reductions exactly equals the damage caused to others by the pollution. An economically efficient incentive will therefore be defined as one that either imposes an incentive that meets this criterion or that encourages polluters to act as if it had been imposed.

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