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Financial methods in environmental decisions
Financial methods in environmental decisions

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Economic instruments

Economic instruments are market-based incentives such as taxes and subsidies to encourage behaviour change. Examples include:

  • Carbon taxes. India introduced a coal tax (in effect a carbon tax) of 50 rupees (€0.74 at October 2011 rates) for every tonne of coal extracted or imported into the country. The intention is that the tax revenues will be used to fund clean-energy projects.
  • Sales tax reductions. The state of Arkansas, USA, exempts pollution control equipment from its sales tax (the equivalent of VAT).
  • Tax on polluting substances. Arizona has a surcharge on environmentally hazardous substances with the revenues raised being used to fund environmental improvement projects.

Proponents of economic instruments claim that they have the following advantages over regulations:

  • They provide an incentive to go beyond the bare minimum that a regulation may specify.
  • Organisations can respond flexibly to measures and use the most cost-effective method of reducing pollution – although this also applies to regulations if they specify the end rather than the means.
  • They can raise revenue through taxes for investment elsewhere.
  • They are cheaper to administer and enforce than emission-limit-based regulations.
  • They can be fairer in that a prescribed emission limit may be cheaper per unit of output for a large generator to achieve than a smaller operation. However an emissions tax would allow both firms to optimise the trade-off between abatement costs and tax payments.

Whichever approach a government uses – and most governments will use a combination of regulations and economic instruments – methods similar to those mentioned in this subsection can be used to determine a justifiable level of tax or subsidy, or establish an optimum emission limit for a given pollutant.

Activity 11 External costs

Timing: Allow 15 minutes to complete this activity

In 1993 a study for the UK government estimated that the external costs of the atmospheric and water pollution resulting from the landfilling of waste were in the range –£0.80 to £9.02 per tonne – a negative value represents a benefit to the environment. When a landfill tax was introduced in 1996 it was set at £7.00 per tonne; by 2015 it had reached £82.60 per tonne. Why is the tax so much higher than the external costs?


The tax is intended to encourage business and local authorities to change their behaviour. It provides an incentive to reduce waste generation and to use more sustainable waste management methods such as recycling, composting and energy recovery. If the landfill tax was set at £9 per tonne, landfill would still be far cheaper than these environmentally better management processes.

Also, the estimated external costs didn’t include the material resources that would be ‘lost’ from the economy through landfilling.