Next Generation of Market-Based Environmental Policies

We examine what will be required if market-based environmental policy instruments are to become a major force in U.S. environmental policy. These instruments are by no means a new policy idea. Indeed, over the past two decades they have held varying degrees of prominence on the environmental policy landscape, due, in part, to the fact that they are an attractive policy instrument in both theory and practice. But market-based instruments have failed to meet the great expectations that have often been set for them. They are currently only on the peripheries of environmental policy and, when they have been implemented, they frequently have not performed as predicted. Does this represent yet another breakdown between policy theory and policy practice? Was the effort to transform environmental regulations with these tools nothing more than quixotic tilting at windmills and is it time to return to more established -- if expensive -- policy mechanisms?

We believe the answer is no. Market-based instruments have delivered attractive results where implemented and promise additional benefits. To date, their effectiveness has been undermined by unrealistic expectations, lack of political will, design flaws, and limitations in company skills. These are all remediable.

Thus, rather than abandoning the use of market-based instruments, we believe that policmakers on all levels should direct their efforts to making the next generation of market-based instruments work better than those that came before. By examining the use of market-based instruments, and by highlighting some of their flaws to date, we hope to identify some of the ingredients required for these instruments to become a fundamental and effective part of the next generation of environmental policy.

In this paper, we begin by explaining for the newcomer what market-based instruments are and set forth the basic theory behind their use. We then review those instruments that have been implemented, and assess why their use has been limited and their performance less than predicted. We also review what has been happening on the front lines in firms'' approaches to these instruments. Finally, we argue that policymakers'' energies should be increasingly devoted to developing a next generation of market-based instruments, and we offer some guidance for that effort.

In spite of a history of false starts and unmet expectations, market-based instruments still remain an attractive tool for tackling environmental issues. After re-examining the potential cost-savings and positive societal impact market-based instruments offer, it is increasingly clear that they will need to be an integral part of the environmental landscape going forward. Policymakers and legislators must together develop creative applications for market-based instruments that will make them work.

Our proposed roadmap -- improving design, applying market-based instruments on the state level, and implementing federal market-based programs -- will help the environmental community develop, apply, and implement successful market-based programs. By shifting organizational mindsets, developing new and needed skills, and overcoming resistance of sometimes-competing interest groups, we can make market-based instruments work for our collective benefit and bring environmental policy into the 21st century.