Use of economic incentives has been gaining momentum nationally and worldwide for its broad success in "harnessing the power of the market" for environmental protection. Market-based or economic incentives are defined herein as aspects of laws or regulations that provide financial rewards for polluting less and impose costs of various types for polluting more, thus imposing the impetus for polluters to pollute less.

Economic incentives encourage businesses and individuals to undertake environmental protection efforts that not only serve their own best interests but collectively meet policy goals. This topic hub will serve primarily as an introduction to market-based incentives, provide examples of incentives at work, and give you ideas and provide resources about how to use this important tool in pollution prevention.

Harnessing the Power of the Market - A Brief Background on Environmental Economic Theory

Market-based approaches to environmental protection in the form of economic incentives can be a clever form of government regulation. Economic incentives are based on the idea that it is possible to confront businesses with the same kinds of incentives they face in markets for labor, capital, and raw materials. That is, the same motivation that forces businesses to be as efficient as possible in order to be competitive can be harnessed to protect the environment. Properly employed, markets can be used to implement a more sustainable economy. Such market-based approaches would make the market better reflect environmental costs and benefits of business while at the same time promoting environmental protection.

A key principle to understand when looking at environmental economic theory, the foundational basis behind market-based approaches or economic incentives, is the "polluter pays principle (PPP)". This idea was first introduced 80 years ago by the eminent economist Arthur Pigou and has become a principle commonly referred to by environmental economists. The PPP states that when people act in ways that degrade the environment, they should be held accountable for the damage they do. The most direct way for governments to enforce "polluter pays" is to tax activities that hurt the environment. The United States, for example, could tax each kilowatt-hour of electricity generated from coal at a level roughly reflecting its hidden environmental costs. The environmental costs not reflected in the market price include mining degradation, sulfur dioxide and mercury emissions. The tax would make cleaner energy forms, such as wind and solar power, more competitive. Higher electricity prices would also encourage families to replace their less-efficient light bulbs with compact fluorescent bulbs. Other direct and indirect economic incentives that exemplify the PPP are further discussed in the section "Types of Economic Incentives."

Environmental Degradation as a "Market Failure"

Although markets are an incredibly efficient way of allocating resources and determining prices and quantities of consumer goods, it is generally accepted that most market systems fail with respect to protecting the environment. When markets fail to protect the environment in its normal operations, this is recognized as a "market failure" and results from the fact that there is no cost associated with pollution. Without a cost, there is no motivation. Economic incentives, on the other hand, are innovative mechanisms for motivating environmental protection because they do what traditional command-and-control regulations fail to do -- they attach a cost. Businesses and individuals are then forced to treat this cost like any other expenditure.