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2.3.2 Incentive-Based Strategies

Incentive-based environmental policies require that public authorities set the targets of emission reductions and the rules and leave the polluters adopt costeffective emission control measures. There are basically two categories of incentive policies: (1) charges and subsides and (2) transferable emission permits. Polluters, in general, do not take into account the damage to the environment that their emissions cause. In an emission charge system, polluters are allowed to discharge any amount of emissions they want, but are required to pay a certain amount of money for each unit they emit and in a subsides system they receive money for each unit that they do not emit. Thus, the basic idea behind incentives is to design a system with private flexibility to achieve the desired public objectives set by the regulators.

In the quest to reduce emissions, economists mainly favor emissions taxes following the idea of Pigou (1920) that by charging for every unit of emissions released, polluters will tend to reduce their emissions. Note that obtaining all necessary information to impose the ideal tax is quite costly and, in practice, regulators determine the charge by using a trial-and-error process. The most important problem of such a system is effective monitoring.

On the other hand, tradable emission permits allow the voluntary transfer of the right to emit from one firm to another. In this system firms are allocated a number of emission permits and are entitled to emit one unit per permit but these permits are transferable. A market for these permits will eventually develop and firms that can reduce emissions at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost (Field & Field, 2009). 'Cap-and-trade' programs work a little bit different since the first step is to make a centralized decision on the aggregate quantity of total emissions. The permits are then distributed among the emitters and, in general, some emitters, if not all, receive less permits than their actual emissions. The permits are traded in an overall market and will flow from firms with relatively low marginal abatements cost to those with higher marginal costs. Thus, there will be a constant trading among emitters and an incentive for them to look for ways to reduce emissions.

Those emitters who can reduce their emissions more cheaply are able to sell extra allowances to others who would otherwise have to pay more to comply and because of this, a cap-and-trade system helps assure that we can achieve an overall cap at the lowest possible cost.

One may notice that these two systems lead to equivalent results in the long term

but with different uncertainty for the outcome see Figs. 2.6 and 2.7. A comparison between a carbon tax and the cap-and-trade approach comes down to the issue of certainty. A tax provides for cost certainty; the cost is fixed because of the Pigovian tax. Trading permits, on the other hand, provides for environmental certainty. What's fixed is the cap itself—and it is based on an assessment of the level of

Fig. 2.6 Illustration of Pigovian Taxes – Adapted from Mankiw (2006)

Fig. 2.7 Illustration of Pollution Permits – Adapted from Mankiw (2006)

emissions you need to get to in order to protect the climate. In that sense, if the cap is set too high, permit prices will be low and the incentive effect will be weak. If the cap is set too low, permit prices will be very high and that can lead to the disruption of economy and trade.

For a practical application of the policies described above the reader is referred to Chap. 8 of this book that introduces the concept of Market Based Measures (MBMs) to reduce GHG emissions from ships, and reviews several distinct MBM proposals that have been under consideration by the IMO.

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