Market-based Instruments for Environmental Protection

As you probably know, today’s international day for Biological Diversity (Mai 22nd, 2023) also commemorates the Convention of Biological Diversity of 1993, – 30 years ago.

Biodiversity, as the variability of living organisms, feeds into ecosystem diversity; for people’s comprehension it is an ecological complexity providing ecosystem services to mankind and giving our plant the resilience, it needs, for instance when landscapes are disrupted through droughts and floods, as observed today due to climate change. In this sense, biodiversity can also be understood as natural capital, including evolutionary capital (as part of resilience) in form of on genetic diversity holding a fast pool of recombinatory biological information. To ensure our quality of life on this plant, it is important to build up natural capital and corresponding natural resources, instead of exploiting these through a one-directional economy.

This requires legal frameworks and market-based instruments to reward environmental services as part of the economic system. Within environmental laws, market-based instruments (MBIs) can be policy instruments for protecting the environment, alternative to the prohibition approach or supplementary to the common command and control legislation (https://ec.europa.eu/environment/enveco/mbi.htm). Fundamentally based on the polluter’s pay principle (PPP [1]), MBIs use specific markets and corresponding pricing mechanisms for environmental goods and services, and other economic parameters, variables and derivates for incentivizing environmental improvements and pollution reduction or elimination, ultimately internalizing negative environmental externalities. MBIs can include for example environmental incentive-taxes, tradable permits or allowances or targeted subsidies for environment-friendly technologies. MBIs are considered a cost-effective way to protect and improve the environment. For MBIs to work appropriately, governments must provide legal frameworks including targets or limits related to the availability of natural resources, environmental goods and services. Within these frameworks the market players trade allowances and additional needs. Correspondingly market prices evolve depending on availabilities and demands.

A good example of MBI implementation is related to the challenge of protecting the climate. We all know that the availability of primary and secondary energy carriers is of central importance for modern societies at all latitudes. Fossil fuels continue to play a major role globally, even though scientists have been warning for decades of the observable accelerated climate change caused by the emission of greenhouse gases. Everybody knows today that huge amounts of the greenhouse gas CO2 are produced every day by the globally widespread burning of fossil fuels as propellants, heating fuels or for thermal electricity production. As in many other countries, Switzerland attempts the reduction of CO2 emissions through executing corresponding laws. A legal framework is very important to be able to introduce market-based instruments for incentivizing the traffic, the economy and households implementing these instruments in an efficient and target-oriented manner.

To this end, Switzerland has developed an incentivizing system, which places the payment of a fee (CO2 tax) against the possibility of being exempt from it (incentive), if defined instruments like the CO2 emission reduction target agreement (ZV) or the CO2 emissions trading system (ETS) are being applied. The ton of emitted CO2 thus receives a price, either through the costs of CO2 emission reduction measures to be implemented, e.g. in industrial production processes, or through the necessary purchase of CO2 emission allowances from the CO2 market to cover operational CO2 emissions. This incentivizing system is a good example of how externalized costs of activities and processes leading to climate change can be, at least partially, internalized into an economic system in the manner of a market-driven polluters-pay principle.

In environmental economics (https://ec.europa.eu/environment/enveco/mbi.htm) it is derived that MBIs could lead in general to a more efficient regulatory frameworks, which in turn could improve achieving more efficient use of natural resources and reduce environmental impacts. On the other hand, one could imagine that MBIs could be laid out for improving the quality of environmental compartments and natural resources, the effectiveness of ecosystem services and lead to an increase of natural capital. While allowing for monetary returns from investments into the environment and natural capital, the inevitable consumption of natural resources could be balanced with an incentivized increase of natural capital. Ultimately, this would counteract the steady and ever-faster loss of natural capital. Undoubtedly a firm regulatory framework would be needed, which should relate on national, realistically achievable targets within a given timeframe.

The market of MBIs must be predictable to prevent distortions through irresponsible market speculations. As an economic element for closing the obvious gap between liberal market activities, irresponsible resource exploitation and sustainable economic mechanisms to preserve life quality, the MBIs can internalize externalities (environmental pollution and damages) into economic systems and, if properly integrated into economic mechanisms as incentives, could even prevent future externalities induced through irresponsible resource exploitation and jeopardizing the future of our planet.

The specific layout of MBIs for generating tradable units/allowances could incentives investments into the environment and natural capital, which would for instance lead to measurable preservation of soil quality and biodiversity, there where corresponding measures could be implemented best. The generated the tradable units/allowances through such project-specific investments would then allow the owner of these units/allowances to convert natural resources, or natural capital respectively, to raw materials or primary produce initiating the classic value chain towards end consumer products. The correspondingly used units/allowances would thereby need be handed over to the authority, which would verify the units and control the stock of units related to the national goals. In this way the status of the national/regional natural capital of the state (i.e. the Swiss people) for preserving our life quality would be ensured. The national stock of units/allowances would be partially held as market reserve by an independent institution (e.g. National Bank) for a potential stabilization of the market in case of disruptions.

If the market price of the tradable units/allowances is high, more investments would flow into increasing natural capital - in turn transferring corresponding units/allowances from the authority to the investor. If the price is low, more investments would flow into the conversion of natural capital to raw materials and primary produce, in turn having to hand in corresponding numbers of held or bought units/allowances to the authority. Reducing the number of units/allowances on the market would tentatively leads to increasing market prices (e.g. in order to achieve national goals), while adding more units/allowances from the market reserve would lead to reversing trends (e.g. for market price reliefs balancing out tightened resource management activities).

Alongside the trading system a specific environmental resource tax should be established. For companies being part of the trading system, the opportunity to become exempt from the tax would be an additional incentive to participate. Possible income from the specific environmental resource tax should flow into a national fund for restoring polluted environmental compartments and lost natural resources.

[1] PPP -https://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:12008E191:EN:HTML - The ‘Polluter-Pays Principle’ calls for pricing the negative externalities of polluting or other damaging activities and processes. Negative environmental externalities are the social costs resulting from pollution of the environment and/or degradation of natural resources through inefficient use and unsustainable practices impairing, hampering or destroying needed regenerative natural forces.