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Are market-based instruments effective tools for environmental

management?

Article in CABI Reviews · March 2010

DOI: 10.1079/PAVSNNR20105015

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 CAB Reviews: Perspectives in Agriculture, Veterinary Science, Nutrition and Natural Resources 2010 5, No. 015

Review

Are market-based instruments effective tools for

environmental management?
Ben Henderson*

Address: Department of Environment, Climate Change and Water, NSW 1232, Australia.

*Correspondence: Email: [email protected]

Received: 26 July 2009

Accepted: 9 November 2009

doi: 10.1079/PAVSNNR20105015

The electronic version of this article is the definitive one. It is located here: http://www.cabi.org/cabreviews

g CAB International 2009 (Online ISSN 1749-8848)

Abstract

Over the past few decades market-based instruments have enjoyed increasing use in environmental
management. To examine whether market-based instruments are effective tools for environmental
management, a range of evaluations from the literature covering point- and non-point-source
pollution control, along with biodiversity management, were reviewed. As found in other reviews,
the environmental context of the particular issue being addressed is a key determinant of instrument
performance. Market-based instruments have been applied most successfully to the management of
industrial point-source pollution issues. In these cases, emissions have generally proven to be
reasonably easy to measure and have had sufficiently direct relationships with their environmental
impacts. In contrast, the diffuse-source environmental problems commonly encountered in rural
contexts proved to be less amenable to market-based solutions. In these situations, difficulties in
clearly linking management actions with environmental outcomes generally undermined their
effectiveness and efficiency.

Keywords: Market-based instruments, Environment

Introduction superiority of market-based instruments over prescriptive

regulations [10]. This may be related to broader neo-
Over the past few decades, market-based instruments liberal policy trends such as the deregulation of govern-
have enjoyed increasing use in environmental management. ment agencies and services among Organisation for
Following theoretical work beginning early last century Economic Cooperation and Development (OECD)
[1–3], a growing body of ex ante empirical work from countries during recent decades [10, 11]. Increasing
the 1960s helped to underline their potential efficiency familiarity of market-based instruments among policy
advantages [4–7]. holders and a growing number of successful applications
Given these early theoretical and empirical advances, are also likely to have played a role.
much has been made of the long delay in the uptake The purpose of this review is to assess whether market-
of market-based instruments by environmental policy based instruments are effective tools for environmental
makers. This has been attributed to the predilection of management. To address this issue, the theoretical merits
many policy makers for process-based environmental of these instruments are briefly considered along with
standards and controls given their usual engineering, some of their commonly discussed, potential weaknesses.
science and legal backgrounds [8]. Other explanations A broad selection of empirical evaluations is then reviewed
relate to the behaviour of regulated agents, and have to provide direct evidence about their performance. The
centred on their reluctance to accept the perceived review covers a diverse range of environmental manage-
higher costs of market-based instruments [9]. ment issues including industrial point-source pollution
In recent decades, however, there has been wide- control, non-point-source pollution control and bio-
spread, and in many cases dogmatic, acceptance of the diversity management. It is more representative of the

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2 Perspectives in Agriculture, Veterinary Science, Nutrition and Natural Resources

evaluations that are available in the published literature abatement technologies. The greater flexibility of market-
than the full range of instruments that are applied in based instruments can result in significant resource sav-
practice.1 A significant omission from the review is the ings, particularly where there is high heterogeneity in
evaluation of instruments for controlling greenhouse gas abatement costs. Heterogeneity can stem from differ-
emissions. While some market-based instruments have ences in management practices, the age and type of
been implemented (e.g. the European Union emissions technologies that agents use, the quality of their inputs
trading scheme), because of their recent introduction, and location [14]. Flexibility in the range of responses that
there are no thorough ex post evaluations of their perfor- will deliver the desired outcome is also a necessary pre-
mances to-date. For the sake of brevity, applications to the condition for market-based instruments to deliver cost
management of natural resources stocks (e.g. water and savings [15].4 Further, market-based instruments can also
fisheries) are also omitted. generate administrative savings by devolving management
The theory behind market-based instruments emerged decisions from regulators to private decision makers [13].
out of the environmental externalities literature, which These properties of market-based instruments can be
recognized excessive environmental degradation as a very useful, given that environmental problems are usually
market failure, arising from a lack of property rights for characterized by information asymmetry, where agents
environmental goods and services [8]. Market-based ap- are aware of their own abatement costs, but the regulator
proaches for addressing such market failures fall into two is not. In such situations a central planner would need to
broad categories: price-based and rights-based instru- be explicitly informed as to each individual firm’s marginal
ments. The former rely on directly assigning a price to the abatement costs to prescribe the same cost-efficient
environmental externality being managed, and includes allocation as a market-based instrument [17].
fees on emissions, inputs and products, as well as sub-
sidies. The latter operates by assigning property rights
over an allowable quantity of the environmental extern- Potential Challenges for Market-based
ality, and includes tradable permit, bubble and offset Instruments in Practice
schemes. Some exceptions to these two broad categories
include mechanisms to remove market barriers (market While evaluations of market-based instruments commonly
friction instruments) and Coasian solutions, which assign consider a broad range of criteria (e.g. environmental effec-
property rights over environmental goods and permit tiveness, cost effectiveness, dynamic efficiency and wider
bargaining between parties for mutual gain.2 economic impacts) this review focuses on their capacity to
The primary appeal of market-based, compared with deliver environmental goals (environmental effectiveness)
prescriptive regulations, lies in their capacity to achieve as well as their capacity to achieve these goals more cost-
environmental outcomes in a cost-efficient manner. They effectively5 than comparable prescriptive regulations.
do this by assigning a price3 to an externality, allowing There are many factors that influence the capacity of
agents to respond to this price incentive in a way that is market-based instruments to fulfil these dual objectives.
compatible with their individual business structures. Pre- With regard to environmental effectiveness, the style of
scriptive regulations, by contrast, include the assignment market-based intervention is critical. While rights-based
of abatement targets for agents, as well as more inflexible and price-based instruments (in the absence of transac-
approaches such as mandating the adoption of specific tion costs) allocate abatement actions in much the same
way, they differ importantly in their capacity to achieve
pre-determined environmental goals. In the absence of
precise information about the aggregate marginal abate-
1
In contrast to [12], which focused on very limited set of examples to ment cost function of agents, price-based instruments
draw conclusions about practical trade-offs between a wide set of per- cannot deliver precise aggregate outcomes. In contrast,
formance criteria, this review draws on a much larger number of eva-
luations to directly test the effectiveness and efficiency of market-based
rights-based instruments can be applied to directly
instruments. This review devotes more discussion to the recommen-
dations emerging from theoretical analysis and the ex ante empirical
work that laid the foundation for the introduction of market-based 4
instruments. This review also examines non-point-source pollution In an evaluation of prescriptive regulations for reducing sulphur dioxide
control and biodiversity management, whereas [12] does not. Most emissions from power plants in Germany, stringent reduction targets
significantly, this review covers a considerably larger number of ex post and similarities between plants were found to limit the variation in
evaluations (20 instruments compared with 6). abatement costs between plants, providing very little scope for a market-
based alternative to deliver cost savings [16].
2
Coasian bargains are usually only effective when the number of parties 5
involved in negotiation is small, otherwise the costs of bargaining will be This incorporates both cost-efficiency savings and transaction costs.
prohibitively high. As most environmental problems involve large num- Cost-efficiency savings are determined by the instrument’s capacity to
bers of affected parties, these instruments are of limited use in envir- allocate abatement effort in a way that minimizes total abatement costs.
onmental management [13]. Transaction costs include the costs associated with measurement,
monitoring, enforcement, administration and, in the case of tradable
3
The price is assigned explicitly with a price-based instrument, and permit schemes, the costs associated with finding and exchanging with
implicitly with a rights-based instrument. trading partners.

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 Ben Henderson 3

control aggregate quantities of harmful activities and Prescriptive regulation Market-based instrument
outputs, according them much greater appeal in situations Outcome-based
where the dependability of environmental outcomes is
paramount (e.g. in the management of toxic waste). Ambient pollution taxes
Ambient pollution standards (subsidies), tradable permits
Several factors improve the dependability of all regu-

Ease of monitoring
latory instruments; of these monitoring and enforcement
Output-based
are particularly important. However, these activities can
be challenging and can also attract significant transaction Emissions taxes (subsidies),
Emission licences
costs, especially where sources of externalities are diffuse tradable permits
in nature. Given the limitations of scientific understanding
and monitoring technologies, these transaction costs are Production/input-based
usually minimized by relying on surrogates (e.g. inputs, Production quotas, Taxes (subsidies), on
processes and emissions) to approximate environmental technology controls and products, inputs and
externalities. In situations where the spatial distribution input restrictions production processes

of these surrogates matters (i.e. where there is not a direct Heterogeneity in abatement costs
linear relationship between the surrogate and its environ-
mental effect), the capacity of market-based instruments to Figure 1 A simple guide for selecting market-based
secure both environmental benefits and cost-efficiency instruments and prescriptive regulations
savings can be compromised. Using air pollution as an
example, this might arise where pollutants are not uni-
formly mixing and where there are variations in climatic applied to emissions, they also show that large cost-
conditions, population densities and firm locations within inefficiencies can be incurred when the impacts of these
an air shed. In these situations, it has been argued that emissions are ignored. In some cases, emission-based
market-based instruments can lead to significant localized instruments were estimated to be more costly than com-
environmental impacts or hotspots [18]. Where these parable prescriptive regulations. Modifications to market-
localized impacts are ignored, the cost-efficiency advan- based instruments, such as ambient permits, trading zones
tages of market-based instruments can be exaggerated [13]. and zone-based emission fees, have been suggested in
The potential inefficiencies associated with applying situations where pollutants have localized effects [18].6
market-based instruments to emissions instead of their While the use of an ambient-permit system, as proposed
ambient impacts have been estimated by applied econo- by Montgomery 19 can improve cost-efficiency, its re-
mists, using mathematical programming techniques, since quirement for polluters to hold a portfolio of permits from
the 1960s. a range of receptor sites can easily introduce high trans-
Johnson [4] estimated that a hypothetical uniform ef- action costs [13].
fluent fee in the Delaware Estuary (USA) would have been Generally, the more closely market-based instruments
1.5 times more costly than a least-cost benchmark based and prescriptive regulations target environmental out-
on the abatement of ambient pollution. Despite this, the comes, the more complex and costly they tend to be.
uniform fee was still found to be half as costly as existing Most empirical evaluations of market-based instruments,
prescriptive regulations. Several similar ex ante evaluations including those described above, do not estimate trade-
were conducted throughout the 1970s and 1980s, to offs between efficiency and transaction costs. As shown
estimate the costs of prescriptive regulations specified in in Figure 1, an understanding of these trade-offs can help
US State Implementation Plans (SIPs). Atkinson and Lewis guide the selection of instruments and regulations to
[5] found that a market-based instrument targeting am- minimize the costs of environmental management. As the
bient pollution would have been half as costly as com- effort and costs associated with monitoring environmental
parable instruments targeting emissions, when evaluating impacts decline, ‘first best’ instruments that target emis-
particulates management in St Louis (USA). Again, how- sions and ambient pollution levels become more attrac-
ever, the latter instrument was still estimated to be much tive. While increased heterogeneity in abatement costs
less costly than existing prescriptive regulations. improves the attractiveness of market-based instruments
Ex ante evaluations by Seskin et al. [7] and Krupnick [6] compared with prescriptive regulations.
used similar models to compare market-based instruments In some cases, proxies, such as emissions, are linearly
with SIP regulations for NO2 in Chicago and Baltimore, related to their environmental impacts. This is certainly
respectively. In both cases a uniform fee was found to be true for uniformly mixing global pollutants such as
the most costly instrument. These studies demonstrated
that carefully constructed prescriptive regulations could
approximate least-cost ambient benchmarks more closely 6
Despite extensive theoretical work since Montgomery [19], the
than a uniform emissions fee. RECLAIM programme for controlling NOx emissions in California is the
While these empirical studies demonstrate that market- only widely known example of tradable permit scheme with differential
based instruments can generate cost savings even when trading zones [9].

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4 Perspectives in Agriculture, Veterinary Science, Nutrition and Natural Resources

greenhouse gases and ozone depleting chemicals [20]. Rights-based Instruments

However, in many cases divergences between proxies
and their impacts can seriously undermine the capacity Some of the earliest applications of rights-based instru-
of market-based instruments to cost-effectively deliver ments were incorporated in the US Environmental Pro-
environmental improvements. This is the case for most tection Agency’s (EPA’s) Emissions Trading Program,
environmental issues related to agriculture, such as non- which was implemented across a range of jurisdictions in
point-source pollution control [21]. 1974 under the Clean Air Act. By the mid-1980s, the
In practice, political realities can also steer instrument programme’s bubble schemes and internal trading provi-
design away from effectiveness and efficiency objectives. sions achieved estimated cost savings of between $300
The auctioning of emission permits and the introduction million and $12 billion [17, 28]. The programme is also
of emission fees are invariably resisted by regulated considered to have been environmentally effective, as it
agents. In these instances, agents are not only faced with did not result in a significant deterioration in environ-
the cost of abatement, but they also pay a form of rent to mental quality [17].
government for unabated emissions [22]. This resistance Lead permit trading among US gasoline refiners, be-
is often overcome by granting concessions, such as the tween 1982 and 1987, is also regarded as an effective
grandfathering of emission permits, or through the re- market-based instrument, as it successfully achieved its
distribution of fee revenue back to agents to subsidies environmental targets [25]. Ex ante evaluation of this
abatement in the case of emission fees [9]. These com- instrument identified potential cost savings of around 20%
promises often result in cost-inefficiencies and can also compared with more restrictive existing regulations [29].
have transaction cost implications. For example, the free While this has not been verified, trading activity indicates
allocation of permits will result in higher transaction costs the mechanism has been reasonably cost-effective [30].
if permits are subsequently reallocated through trades. Similarly, the cap-and-trade component of the Ozone
Alternatively, free allocation can lead to inefficiencies if Transport Commission NOx Budget Program, which was
transaction costs are high enough to suppress mutually implemented in the USA in 1999, was effective in reducing
beneficial exchanges [23]. NOx emissions by more than half, across multiple north
eastern states [31]. While the expected 40–47% savings
over existing regulations estimated by Farrell et al. [32]
Evaluating Market-based Instruments in Practice have not been verified, actual savings are believed to have
even been larger than this [31].
A range of published empirical studies on instruments in Perhaps the most widely publicized successful instru-
practice are reviewed, to assess whether market-based ment is the US national permit scheme for sulphur dioxide
instruments are effective tools for environmental man- emissions from electricity generators. The scheme began
agement. Most of these provide ex ante estimates of cost in 1990, and by 2001 it had achieved a 40% reduction in
savings and ex post assessments of environmental effec- emissions from 1980 levels [33]. While short of the 68%
tiveness. A more limited number also provides ex post savings over existing regulations estimated by General
evaluations of cost savings from market-based instru- Accounting Office (GAO) [34], ex post evaluation by
ments. There have been several key reviews over the Burtraw and Palmer [33] estimated cost savings from
years [9, 17, 20, 24–27], each comprising a similar emission trading to be 43–55%. High penalties for non-
group of instruments. This reflects the small number of compliance and continuous emissions monitoring system
thorough empirical evaluations that have supported the technology have helped to make the instrument effective.
implementation of new instruments, and the even smaller Potential problems with localized impacts or emission
number that provide evidence about instrument efficiency hotspots, sometimes associated with tradable permit
and effectiveness. schemes, have not occurred. This has been attributed to
This review also draws on a similar range of instru- the presence of concurrent local air quality standards
ments, but it also includes some additional examples from [31]. Moreover, the scheme is reported to have for-
Australia, and gives more attention to diffuse source tuitously led to an environmentally beneficial allocation of
environmental problems that present particular challenges abatement, with larger pollution reductions in more
for environmental management in rural contexts. environmentally sensitive locations [33].
Outside the USA, there are also examples of effective
tradable permit schemes. The NSW Hunter River Salinity
Point-source Pollution Control Trading Scheme introduced in 2002, following a pilot
scheme from 1995 to 2002 [35], successfully addressed
A number of reviews have concluded that market-based the problem of increasing salinity from mining, electricity
instruments have enjoyed reasonable success in cost- generation and agricultural activities, as industrial dis-
effectively controlling emissions from stationary industrial charges no longer caused salinity targets to be exceeded,
sources [25, 27]. Some evaluations of these instruments and average salinity has halved despite drier weather,
are discussed below. which in the past was associated with higher salinity [36].

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 Ben Henderson 5

Further, it has enabled at least four new coal mines, and Bressers and Lulofs [41] econometrically estimated that
additional production worth $1.4 billion per year, without pollution levels from the Netherlands’ major polluting in-
loss to other sectors or water quality [37]. As with the US dustries decreased by 78% over two periods (1975–1980
sulphur dioxide trading scheme, continuous monitoring and 1986–1985), mostly as a result of increases in fees.
technology and high penalties for non-compliance have The cost-efficiency of this instrument was not formally
contributed to its effectiveness [12]. Another effective tested. Effluent fees in other European countries have not
rights-based instrument from Australia is the NSW South been as high as in the Netherlands and have generally not
Creek Bubble Licensing scheme. Nutrient reduction tar- been as effective. An ex post evaluation by the OECD [42]
gets were achieved more quickly than anticipated under on the effectiveness of a similar effluent fee system in
the scheme, which was estimated to have saved Sydney Germany was inconclusive, mainly because of a lack of
Water $45 million compared with the implementation of data, but also because of difficulties in untangling the
more restrictive performance standards [36]. impacts of the fees and co-existing regulatory controls.
The performances of other tradable permit schemes Price-based instruments have also been applied to point
have been more difficult to assess. Prior to its introduc- source air emissions in several of European countries.
tion, the Ozone Depleting Chemicals Allowance Trading These are often ‘earmarked’ tax systems, which return fee
scheme was expected to generate savings of 40% com- revenue to polluters to subsidies abatement initiatives.
pared with prescriptive regulations from 1980 to 1990 Two well-known examples, which have differed in their
[38]. Its actual cost savings have not been estimated, and effectiveness, are from France and Sweden. Millock and
while its environmental goals were achieved, they have Nauges [43] applied an econometric model to evaluate
also been attributed to the introduction of a CFC tax to the ex post effectiveness of nitrogen oxide and sulphur
expedite the phasing out of the pollutant [25]. dioxide emission fees in France from 1990 to 1998. The
Other tradable permit schemes have been ineffective. fees were found to be effective; however, the recycled
An ex ante evaluation of Wisconsin’s Fox River trading subsidy component of the fee system led to increased
scheme, to control effluent emissions from paper mills emissions offsetting these reductions.7
and municipal waste water treatment plants, estimated In contrast, an ex post evaluation by Hoglund [44]
cost savings of 42% compared with existing prescriptive found that an earmarked fee system for nitrogen oxide
regulations [39]. There has, however, been virtually no emissions in Sweden between 1992 and 1998 was effec-
trading [25]. Restrictions on trading and the duration of tive in reducing emissions. The superior performance
permits have been blamed as well as technological changes of the Swedish instrument is believed to have been caused
that have reduced both abatement costs and trading by differences in the subsidy component and the
incentives [17, 25]. monitoring system rather than differences in the fee rates
Santiago’s Program for the Control of Fixed Substances [43]. Importantly, the Swedish system incorporated the
(PROCEFF) implemented in 1992 to manage particulates, installation of precise monitoring equipment, which
was one of the first tradable permit schemes to be applied enabled abatement through the fine tuning of production
in a city outside the Organization for Economic Co- methods.
operation and Development [40]. The scheme has not Several states in Australia employ emission fee instru-
performed well, because of high transaction costs and an ments. Unlike their European counterparts, these instru-
over-allocation of permits. Limitations on the duration of ments generally do not incorporate subsidy mechanisms
permits that are not traded have caused 38% of facilities for redistributing fee revenue back to polluters. While this
to forfeit their permits [40]. A lack of penalties and avoids the potential inefficiencies experienced with the
enforcement has also limited the programme’s effective- French emission fee instrument, politically, it limits the
ness [40]. extent to which fees rates can be raised to drive abate-
ment. The NSW Load-Based Licensing scheme was the
first comprehensive emission fee instrument introduced
Price-based Instruments in Australia and to-date is the largest. The scheme in-
corporates zone-specific fees to account for spatial vari-
Despite their inability to secure precise aggregate out- ations in pollutant impacts and applies higher fees to less
comes, some price-based instruments have been able environmentally efficient producers. No thorough ex ante
to deliver significant environmental improvements. Some evaluations of potential cost savings were found in the
of the earliest applications of market-based instruments literature prior to the implementation of the scheme. The
were effluent fees introduced by several European effectiveness of the scheme in controlling nitrous oxide
countries to manage water pollution. Water pollution fees
in the Netherlands, which are the highest in the world,
have been used since the 1970s [41]. While these fees
have generally been introduced for the purpose of raising 7
This supports theoretical work which suggests that subsidies can be
funds to invest in sewage treatment plants, in some cases inefficient by encouraging the long-run expansion of polluting industries
they have driven abatement. In an ex post evaluation, [13].

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6 Perspectives in Agriculture, Veterinary Science, Nutrition and Natural Resources

emissions has been assessed econometrically by Ancev environmental regulators. Compared with point sources
and Betz [45], who did not find a significant relationship they represent a growing fraction of total pollutant
between fees and emissions from 1999 to 2003. The loads [49].
effectiveness of the scheme in controlling the other 28 Taxes on agricultural chemical inputs have been applied,
pollutants that it also manages has not been assessed. chiefly for raising funds for environmental programmes,
While some of these evaluations indicate that price- in several European countries (e.g. Denmark, Austria,
based instruments can lack the dependability of some Finland and Norway) and in a number of American states
of their rights-based counterparts, in practice they are [21]. While these instruments have delivered environ-
normally only used in conjunction with regulatory safety mental improvements in some cases, they have several
nets. While this can confound ex post assessments of their limitations. A significant deficiency is that they do not
performance, it prevents the risks of elevated pollution reward farmers for undertaking important mitigating
levels when the marginal abatement cost functions, of actions, such improved tillage practices, which might
regulated industries, are unknown. actually be more cost-effective than cutting back their use
of chemical inputs. Moreover, according to Weersink
et al. [21], these instruments have limited influence on
Diffuse-source Environment Issues chemical use, because demand for farm inputs is normally
price-inelastic. An ex post evaluation by Rougoor et al. [50]
In contrast to pollution from point sources, many of the also revealed that nitrogen fertilizer use was relatively
environmental problems that arise from rural land uses price-inelastic in Austria, Finland and Sweden. Hence,
are particularly challenging to manage because of their while measurable, the impacts of nitrogen fertilizer taxes
diffuse nature, complex causal relationships and strong in these countries were found to be modest. In another ex
heterogeneity. Examples include non-point-source pollu- post evaluation, Hasund [51] examined the effectiveness of
tion control and biodiversity management. The capacity of taxes on fertilizers containing nitrogen, phosphorus and
market-based instruments to manage these types of cadmium, as well as biocides, in Sweden. While these
problems is often beset by significant information-related taxes were found to be easy to administer and useful for
constraints that can often only be overcome (if at all) raising funds for environmental R&D (with the exception
either by incurring unacceptably high transaction costs or of a tax on cadmium), they had limited direct impacts
by trading off these costs for unsatisfactory levels of on reducing pollution. Nevertheless, broader reviews of
outcome uncertainty.8 price elasticities for fertilizer use demonstrate that in
some situations fertilizer taxes could be effective [49, 52].
Non-point-source Pollution In the absence of a US national taxation policy for
fertilizers and pesticides,9 Rendlemen et al. [49] con-
Because of the difficulties in directly measuring and moni- ducted an ex ante evaluation of the potential cost savings
toring emissions, ‘first-best’ instruments, such as emission from applying a market-based instrument to reduce
charges or emission trading schemes, are not well-suited to fertilizer and pesticide use by 20%, using a computable
managing diffuse source pollution problems in agriculture general equilibrium model. Compared with a regulation
(e.g. fertilizer-based nitrogen and phosphorus pollution). requiring uniform emission reductions, the estimated cost
Instruments that target fertilizers, pesticides and other saving from using a market-based approach was only 10%.
chemical inputs or processes such as manure management Several studies draw on game theory to demonstrate
and erosion control are often more practical. However, how ambient taxes can approximate the cost-efficient
the savings in transaction costs these instruments provide outcomes of first-best instruments [53–55]. The models
inevitably come at the expense of environmental depend- in these studies are all based on the groundbreaking
ability and cost-efficiency (see Figure 1). Despite these ambient tax instrument developed by Segerson [56]. The
challenges, non-point source pollution problems are re- instrument applies a charge to the ambient pollution
ceiving growing attention as solutions continue to elude levels, which can potentially lower monitoring costs for
the regulator, as well as overcome problems of free-riding
associated with the hidden actions (moral hazard) of
8
farmers. Despite the potential for these instruments to
Regarding biodiversity, these constraints relate, firstly, to difficulties in lower monitoring costs, they still require farmers to have
predicting the outcomes of management actions. Pannell [46] identified
this as perhaps the biggest single issue preventing the application of
a reasonable understanding of the link between their
market-based instruments to deliver more efficient biodiversity man- abatement actions and ambient pollution concentrations.
agement. Secondly, even if this link could be established, the inherent Where farmers have a poor understanding of this link,
heterogeneity of biodiversity virtually eliminates the possibility of ambient instruments can result in inefficient outcomes, as
establishing a common unit or metric to compare biodiversity outcomes
between different areas [47]. While scientists are continually refining
metrics to facilitate this process (e.g. habitat hectares in the Victorian
BushTender trial [48]), there is still considerable doubt about their
9
capacity to deliver sufficiently meaningful trade-offs. Some US states use levies to fund environmental R&D.

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 Ben Henderson 7

some farmers will abate too little and others too much tendering process to share the costs of using formerly
[53]. Based on these considerations Weersink et al. [21] productive areas of their land for conservation [59].
surmised that these instruments would be best suited for While the CRP has enjoyed significant achievements11
catchments with small numbers of similar farmers with it also has a number of weaknesses. One notable weak-
easily monitored ambient pollution. Further, Shortle and ness is that its selection criteria are too broad and can
Horan [57] question the political feasibility of these instru- therefore secure land of little ecological value [59]. In
ments because, in the presence of stochastic contribu- some cases it has also failed to prevent production
tions to ambient pollution from natural sources, they are expanding into other areas to compensate for retired land
unable to eliminate the possibility that farmers who take [59]. Feng et al. [61] conducted a thorough assessment of
on costly abatement actions are penalized for inaction the programme, which included both ex ante and ex post
from other farmers. evaluations, comparing the outcomes from the actual CRP
Empirical work by Spraggon [58] tested ambient tax/ with hypothetical prescriptive regulations, in Iowa. The
subsidy instruments based on this theoretical work in ex- prescriptive benchmarks in that study were not the uni-
perimental settings, and his findings validate the concerns form restrictions that are normally used in market-based
about the efficiency and equity of ambient instruments instrument evaluations, but instead related to the use of
raised by Shortle and Horan [57] and Weersink et al. more inflexible criteria for dispersing conservation funds.
[21]. Significant inefficiencies were estimated, particularly The instruments were compared on the basis of erosion
where agents were heterogeneous. Nevertheless, ambi- control. The CRP was found to be inefficient, as the
ent instruments were shown to be effective at inducing prescriptive alternatives were estimated to deliver more
individuals to abate and, therefore, overcome the pro- environmental benefits at lower cost for a given acreage
blem of moral hazard [58]. [61].
Clearly there are very limited situations where The BushTender trial in 2001 piloted the first bio-
market-based instruments, which target either emission diversity auction mechanism in Australia. While based in
surrogates or ambient pollution levels, can be used to principle on the CRP, the BushTender trial differed in
effectively and efficiently manage non-point source agri- many respects. Instead of assigning fixed prices to en-
cultural pollution. vironmental attributes, the BushTender trial utilized a
price-discriminating auction mechanism to encourage
landholders to reveal privately held information about
Market-based Instruments and Conservation their opportunity costs [48]. A fixed-price scheme was
the only alternative compared to the BushTender trial,
Environmental subsidies, in the form of grants and/or tax and it was estimated to cost seven times more for the
concessions, are one of the most commonly used market- same quantity of environmental benefits. According to
based instruments in agriculture. While there are often field staff, the awarded contracts comprised land of high
legislative controls in place to prevent deterioration in conservation value, which suggests the trial secured
environmental conditions on agricultural land, subsidies important environmental benefits [59].
to landholders are normally required to secure environ- Following the pioneering work of Stoneham et al. [48]
mental improvements. several biodiversity auction trials have been piloted in
Offset instruments have also become increasingly Australia, including BushTender II and the Environmental
popular as a means for allowing the expansion of devel- Services scheme in NSW. Additionally, a National Market-
opment activities, while limiting adverse environmental Based Instruments Pilot Program was established to
consequences. One of the more widely studied offset in- investigate the use of market-based instruments for im-
struments is the US Wetland Mitigation Bank. The scheme proving natural resource management, and funded 11
permits credits from mitigation works to be banked and pilots including four auction mechanisms, between 2003
sold to offset the negative impacts of developers.10 In an and 2005. Each of these auctions was found to be effective
ex post evaluation, Salzman and Ruhl [47] concluded that in achieving their conservation goals. Cost-efficiency
while the scheme satisfied its ‘no net loss’ objective, with was only estimated for two of the trials, and while both
regard to the total areas of wetlands, it failed to stem a were found to generate savings, they were well short
decline in the provision of vital ecosystem services pro- of estimated seven-fold cost savings estimated in the
vided by wetlands. BushTender trial. In the auction piloted for landscape
The Conservation Reserve Program (CRP) is the
largest private lands conservation programme in the USA.
This programme, which was established in 1985, disperses
government payments to farmers via a competitive 11
According to the USDA [60], the CRP reduces soil erosion by an
estimated 450 million tonnes per year, compared with pre-CRP erosion
rates. It also protects surface waters from sediment and nutrient
enrichment with enrolment of 1.8 million acres of streamside grass and
10
USA National Mitigation Banking Association website, http:// forested buffers. Moreover, all 36 million enrolled acres provide wildlife
www.mitigationbanking.org (last accessed July 2009). and wildlife habitat benefits [61].

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8 Perspectives in Agriculture, Veterinary Science, Nutrition and Natural Resources

recovery of land affected by dryland salinity Western has been compromised by failures to adequately assess
Australia, a price-discriminating auction was found to cost abatement costs and by political pressures to minimize
one-third as much as an equivalent uniform-price mech- these costs. For example, emissions caps were found
anism [62]. This study also found that the administrative to be too lax to provide agents with incentives to trade
costs of the auction were very high, but put much of this in both Santiago’s Program for the Control of Fixed
down to the one-off status of the trial. Substances Wisconsin’s Fox River trading scheme.
In an evaluation of the South Australian pilot, Bryan Restrictions on trading, permit duration and a lack of
et al. [63] argued that a uniform price mechanism is not enforcement were also responsible for the ineffectiveness
necessarily the appropriate benchmark for estimating cost of these instruments.
savings of price discriminating auctions. It was argued that In contrast, successful tradable permit schemes such as
this approach severely overestimates benefits, as it is the US national permit scheme for sulphur dioxide
relies on the final, most expensive bid which is often emissions and the NSW Hunter River Salinity Trading
exponentially higher than other bids. Bryan et al. [63] Scheme, have benefited from having effective emission
demonstrated that this approach would have estimated a caps in place, high and well enforced penalties as well
ten-fold cost saving in their South Australian trial. They as continuous emission monitoring systems. In other
recalculated these savings using a more appropriate cases, such as the evaluations of the Ozone Depleting
benchmark, based on pre-existing negotiated payments Chemicals Allowance Trading scheme effluent fee system
for management actions. In this instance, the auction in Germany, it has been difficult to gauge instrument
mechanism was evaluated as being only 23–34% more effectiveness due to the influence of co-existing pre-
cost effective. Given that the administrative costs of scriptive regulations.
auctions are likely to be high relative to simpler subsidy As expected, the style of market-based intervention
mechanisms, these reduced cost savings suggest that the was important, as price-based measures were generally
overall cost-effectiveness is not guaranteed to be higher found to lack the dependability of their rights-based coun-
for auction mechanisms. Nevertheless, in a summary of terparts in controlling aggregate emissions. However,
National Market-Based Instruments Pilot Program, which since these instruments are normally applied in the pre-
included a number of other market-based instruments sence of regulatory safety nets, they do not usually lead to
for environmental management in agriculture (including, compromises in environmental standards.
offset schemes, cap and trade instruments, leverage funds In contrast to the management of point-source pollu-
and conservation insurance) Grafton [64] concluded that tion, the diffuse source environmental problems com-
auction mechanisms showed the most promise. monly encountered in rural contexts proved to be less
amenable to market-based solutions. In these cases, the
inability to clearly link management actions with environ-
Conclusions mental outcomes, usually undermined their effectiveness
and efficiency. There appear to be very limited situations
To examine whether market-based instruments are where market-based instruments could effectively manage
effective tools for environmental management, a range of non-point source agricultural pollution. Innovative ambi-
evaluations from the literature covering point and non- ent instruments for controlling non-point source pollution
point source pollution control, along with biodiversity have shown promise theoretically. However, practical
management, were reviewed. As found in other reviews, considerations and laboratory experiments have demon-
the environmental context of the particular issue being strated that, as with Coasian bargains, these instruments
addressed is a key determinant of instrument perfor- are only likely to be suited to special cases involving small
mance. Market-based instruments have been applied most numbers of agents.
successfully to the management of industrial point source The performance of market-based instruments applied
pollution issues. In these cases, emissions have generally to biodiversity management was generally not encoura-
proven to be reasonably easy to measure and have had ging. While large-scale subsidy programmes such as the
sufficiently direct relationships with their environmental CRP have secured significant environmental benefits, less
impacts. Other factors including instrument design, the market-orientated mechanisms for dispersing subsidies
degree of heterogeneity in abatement costs and options were found to be at least as efficient. A number of trials in
among agents, and the interaction with other policy Australia since 2001 have demonstrated that auction
instruments, were also important.12 Thus, despite the mechanisms can offer potential cost savings over more
general amenability of market-based instruments to point traditional subsidy instruments. However, these gains
source pollution problems, there have also been instances are not likely to be as large as estimated in the initial
of failure. In some cases, the effectiveness of instruments BushTender trial. Nevertheless, given that environmental
improvements will be politically difficult to secure without
some compensation or cost-sharing arrangement for land
12
The relevance of these factors for instrument design and selection are holders, subsidy-based mechanisms will obviously con-
summarized in Figure 1. tinue to play a role in environmental management.

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 Ben Henderson 9

Acknowledgements Instruments (MBIs). CSIRO Working Paper Series 2007-02.

CSIRO Sustainable Ecosystems, Canberra; 2007.
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helpful comments and criticism. I also acknowledge the In: Freeman J, Kolstad CD, editors. Moving to Markets in
Department of Environment, Climate Change and Water Environmental Regulation: Lessons from Twenty Years
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NSW for providing me with the time and resources to do p. 23–40.
this review. The opinions and views expressed in this
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