Pannell Discussions

No. 21, 11 October 2004

Thinking like an economist 4: Who should pay for the environment?

Who should pay for environmental works? Some of the advice we have been given by environmental thinkers has misled us into thinking that there is a clear answer. Rules like "polluter pays" and "beneficiary pays" have acquired an undeserved status as truths.

Environmental works can be expensive, so there is plenty of attention to the question of who should pay for them. Polluters? The beneficiaries from environmental works? Consumers? Taxpayers?

Given the vested interests of each group to ensure that they are not the ones bearing the costs, it would be nice if we could side-step politics and apply some objective rule for resolving the question of who should pay. Three rules often discussed are:

•  Beneficiary pays,

•  Polluter pays, and

•  Sharing costs according to the share of benefits.

The "beneficiary-pays principle", closely related to the "user-pays principle", says that the beneficiary of a good or service should bear the costs of its provision. Perhaps it is fair enough that if a group wants something, they should be prepared to pay for it. After all, that’s the rule that applies to most goods and services.

The "polluter-pays principle" moves the financial burden onto those who are creating the environmental problem. This was recommended as the default position in a well-known report prepared by the OECD. Perhaps it is fair that someone who is causing problems for someone else should be required to make amends. After all, that’s the rule that often applies in law. The guilty must pay!

Proponents of the "cost-sharing principle" recognise that there can be multiple winners from some environmental works, potentially including some benefits to the polluters. Perhaps it is fair that the costs are shared out according to those benefits. There is another obvious example where we bear a share of the costs in order to get a share of the benefits: buying shares in a company.

All of these "principles" are discussed by economists and appear in economics text books, so people are often surprised to learn that they actually have no status at all in economic theory. None of them is really a principle in the sense of a scientific or mathematical principle: a truth that can be proved based on some other truths. Indeed, polluter pays and beneficiary pays are usually in direct contradiction, so they can’t both have the status of truths. In reality they are nothing more than rules of thumb that might or might not be considered fair.

The question of who should pay for environmental works is a good example of something that economists cannot do: provide definitive advice about the most desirable distribution of benefits and costs. Economic theory focuses on how to maximise the size of a cake (which we call "efficiency"), but not on how to share it out. Of course there are plenty of economists interested in the share question, and lots of good thinking has been done about it, but there is no clear-cut answer. In my view, there never will be; it will always be a matter requiring subjective judgement, so the intrusion of politics is inescapable.

Despite this, economists can still make a number of useful contributions to questions about the distribution of benefits and costs from government policies, including the following.

•  Quantifying the distributional effects of alternative policies. Who wins, who loses and how much?

•  Testing the policies against the various rules of thumb that might be considered fair (polluter-pays, etc.).

•  Pointing out what the rules of thumb imply about property rights.

•  Pointing out some practical limitations of trying to apply any particular rule of thumb about who should pay.

The last point is important because there are problems in trying to rigorously implement any of the rules. One of the problems is lack of information. For diffuse environmental problems, we often don’t know in any detail who is the source of the problem. Often the cause-and-effect relationships between any environmental works and environmental outcomes are unknown or highly uncertain. For environmental issues that have non-market benefits and costs (e.g. existence values) we don’t know who the beneficiaries are. Lack of information means that if a government sets out to implement any of the above three rules as being the most fair, it could easily end up with a distribution of benefits and costs that deviates a long way from the chosen rule.

The market will also have an influence on the distribution of benefits and costs, irrespective of government wishes. For example, if farmers’ production costs go up due to legal requirements to protect biodiversity, the farmers may or may not be able to pass on the increase to consumers of their products, a group which may include many of the beneficiaries of the new law. Whether costs can be passed on depends in part on how responsive consumers are to price changes. If consumers of their products are too responsive and dramatically cut consumption as prices rise, farmers lose more than they gain by attempting to pass on the extra costs. In an unregulated market, the distribution of costs between farmers and consumers is completely outside government control as it depends on the responsiveness of supply and demand to price changes, and these depend on producers’ cost structures and consumers’ preferences, not on government policy. The capacity to pass on costs also depends on the market structure in intervening steps of the supply chain. Costs could potentially be absorbed within the chain such that neither polluters nor beneficiaries pay.

Application of any simple rule may be compromised, as governments’ decisions about the distribution of benefits and costs are influenced by a range of considerations. These may include political gain, parochialism, the activities of lobby groups or a wish to benefit particular groups due to perceptions that they are disadvantaged in some way.

In my observation, an approach that is commonly judged to be politically feasible is to give precedence to the status quo. This means that polluter pays would be applied to prevent a change to a more polluting activity, while beneficiary pays (or an approximation of it in the form of government funding) would be used to encourage a change to a more environmentally beneficial outcome. A group with particularly high political power can over-ride this system, but apart from that it often seems to work out this way. Economists couldn’t say they have anything against this system from a distributional perspective. Depending on the issue and how it is addressed, they may have concerns about efficiency. For example, the proposed solution may create high transaction costs or perverse incentives, or do-nothing might be a better option.

Who should pay? There is no easy answer, so we need to be careful that so-called "principles" like polluter pays and beneficiary pays don’t acquire a God-given-truth status that they don’t deserve. In truth they have no real status other than as rules of thumb that can be applied or ignored as circumstances suit.

David Pannell, The University of Western Australia,


Thanks to Allan Buckwell for help with this piece and to Laura McCann for the email discussed below.

Postscript 11 Oct 2004

Laura McCann emailed and called attention to the fact that "polluter pays may mean that the polluters now have a strong incentive to change their production practice or develop new technology". That is a good point. I would make a couple of other points about this technology-change aspect.

1. It relates primarily to the efficiency of the policy, rather than its distributional consequences – who wins and who loses. But efficiency is certainly relevant to the choice between polluter pays and beneficiary pays if differences in efficiency can be identified.

2. The creation of incentives to innovate is not peculiar to polluter pays. Beneficiary pays can also be set up in a way that also creates an incentive, by making the payment sensitive to the benefits generated. This should always be the aim, if practical.

3. Polluter pays and beneficiary pays are not the only options available to a government interested in promoting innovation and new technology development. Another option is direct targeted investment in R&D to generate specific desired innovative technologies. In my judgment, such targeted investment is likely to be a much lower-cost approach to reducing pollution than either polluter pays or beneficiary pays in some important cases (e.g. global climate change/renewable energy, dryland salinity in Australia).

Overall, I don't think that this argument about technology change clearly favours either polluter pays or beneficiary pays from an efficiency perspective, although it probably favours them both ahead of cost sharing.

Pannell Discussions are brief pieces on issues and ideas in economics, science, the environment, natural resource management, politics, agriculture and whatever else.

20.  What is your objective?  4 Oct 2004

22.  Public goods & public benefits in NRM  17 Oct 2004

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