Marshall's Thoughts

How and what kind of economic incentives should governments design to slow, halt, and/or reverse environmental degradation?

Lauren Wang YueQin


Environmental degradation and resource depletion are taking place at an unprecedented rate, with anthropogenic factors being identified as the biggest contributing factor. Since humans are the major cause of environmental problems, and human behaviour is largely driven by economic forces considering the pervasive role commerce plays in our daily lives, economic incentives can be a powerful tool to solve environmental problems. Governments around the globe have come up with a multitude of incentives to engineer the behaviour of corporations and individuals in favour of the environment.

Carbon tax

23 countries around the globe have implemented a national carbon tax to reduce carbon emissions, with United Kingdom having the highest carbon tax on coal at $25.80 per ton, and Ukraine the highest carbon tax on natural gas at $25.80 per ton. (Our World in Data, 2022).

A carbon tax is the price emitters must pay for each ton of greenhouse gases (GHG) they emit. It assigns a direct price on the harm created by GHGs in the atmosphere and creates an incentive for firms to lower emissions by adopting greener technologies to avoid paying the tax. The Centre for Climate Change and Energy Solutions claims the government should consider the following factors before implementing the carbon tax policy: 1) point of taxation, 2) tax and escalation rate and 3) equity issues (Centre for Climate Change and Energy Solutions, 2021).

The first factor urges governments to decide which point in the energy supply chain the carbon tax is levied. Levying the tax on “upstream” activities such as coal production is administratively easy since these activities directly discharge a measurable quantity of GHG per tonne of coal produced, allowing regulators to effectively control the major sources of carbon emissions. Levying the tax “midstream” such as on electric utilities or “downstream” on households may be politically unpopular as the electorate are loathe to see their electricity bill increasing. However, economic theory predicts that the incidence of taxation does not change no matter who bears the burden of the tax. The second factor determines the actual price of the tax now and over time.

To achieve allocative efficiency, the carbon tax should be set at the price where marginal benefit (MB) of the polluting firm in producing one more unit of output equals to the marginal cost (MC) of carbon abatement. Firms will find it cheaper to reduce emissions as long as tax is greater than MC. Hence from quantity 0 to e, firms will choose to abate but beyond e, firms will choose to pollute and pay for the tax since the cost of abatement is higher than the tax. The carbon tax reflects the social cost of GHG emissions, which is the present value of estimated environmental damage caused by an additional tonne of GHG emitted today. The tax rate should be increased over time to capture the increasing damage from climate change, as GHGs in the atmosphere accumulate to dangerously high levels.

The third factor forces governments to pay attention to the plight of the disadvantaged groups since an increase in prices due to a carbon tax will disproportionately decrease the purchasing power of the poor, forcing them to forgo consumption of essential goods. In 2013, the Greek government harmonised taxes on vehicle fuel and heating oil, resulting in a 40% increase in heating costs. This prompted many Greek to resort to burning firewood for warmth in winter. Distributors reported that sales of heating oil dropped by nearly 80% in the winter of 2013 as compared to 2012. Although there were rebates for lower-income residents of colder areas, serious problems existed when it came to identification of lower income households and extent of coverage. Panic-stricken Greeks rushed to buy firewood as early as August as they were ‘terrified of the rise in fuel prices’ (CBS News, 2013). Wood burning caused even more generation of greenhouse gases as compared to burning oil, literally ‘choking Athens with smoke’. The Greek example shows that extra care needs to be taken to ensure that the policy does not act as a perverse incentive due to negligence of its impact on the disadvantaged groups. A good example is the Electricity Rebate Program in Canada allowing eligible residents to receive a total of $500 in monthly rebates on their power bills for electricity charges. Governments need to ensure sufficient assistance is given to underprivileged households, while still ensuring the negative externality from carbon emissions is internalised.

Cap and trade

European countries have operated a cap and trade system since 2005. Several Chinese cities and provinces had carbon caps since 2013, and the government is working towards a national programme. Mexico is running a pilot cap and trade programme that the country began on 1 Jan 2020 (Centre for Climate and Energy Solutions, 2020)
Another common measure to regulate excessive carbon emissions is the “cap and trade” system, comprising of negative and financial incentives. Assuming there are 2 equally-sized petrochemical firms in the market. One of them makes use of less polluting resources in its production hence incurs a low marginal abatement cost (green) while the other is a heavier polluter with higher marginal abatement cost (blue). Since these firms have the same scale of production, they are given the same number of tradable permits to pollute by the government, the line representing the perfectly inelastic supply of permits is drawn in the centre. When the cost of permit is less than the cost of abatement, the high-cost firm will buy permits from the low-cost firm. Hence over areas A and B, the blue line represents the demand for permits while the green line represents the supply of permits. Acceptable permit price lies in the difference between the 2 lines. With trade, abatement costs will fall by A, and most greenhouse gases are reduced by the firm that abates carbon emissions using low-cost procedures.

As compared to carbon tax, “cap and trade” has greater certainty in achieving emission reductions as firms cannot pollute past the total stipulated allowance. Comparing the 2 policies, carbon tax relies on firms’ desire to cut costs as they loathe paying the tax at higher production levels. “Cap and trade” provide an incentive for firms to increase their efficiency by improving the production process, since the more efficient firm can sell excess permits to their less efficient counterparts.

Green Research

Both policies have the potential to veer firms into conducting risky R&D even without government subsidies, allowing research on sustainable use of resources to burgeon. Successful research findings, such as the development of photovoltaic cells which convert radiation from the sun into electricity, are powerful tools to slow and halt environmental damage. The largest photovoltaic plant in California can supply power to the entire Los Angeles area with minimal waste production. Similarly, many commercial farms have introduced black fly larvae as an animal feed, which is significantly less carbon-intensive than traditional feed sources. Such technological improvements help to reduce our carbon footprint and slow down the rate of environmental degradation.

Loss aversion

Instead of targeting corporations, some policies target consumers who are also vital contributors to environmental damage. Such negative incentives make use of behavioural economics to design appropriate incentives influencing consumers’ choices. Loss aversion is a theory postulating that “losses loom larger than gains” (Kahneman & Tversky, 1979). Hence, charging people who do not recycle is more effective than rewarding those who do. Hong Kong started charging $0.50 for a plastic bag and, one year later, there was a drastic reduction of 90% in the use of plastic bags. Similarly, deposit funds are more effective than measures that pay people to recycle (incentive to avoid losses is stronger than an equivalent reward incentive). Under such schemes, consumers pay an upfront deposit when they purchase drinks in glass bottles. They can only get back their deposit when they return the bottles to recycling machines. In Denmark and Sweden, deposit-refund-scheme witnessed high return rate at 80%. This measure is successful because consumers loathe losing their deposit if they fail to recycle. By encouraging more recycling, we can mitigate environmental damage.

Image motivation

Can any incentives be powerful enough to reverse the environmental problems humans have caused? The answer could perhaps lie in policies that speak to humans’ “image motivation”. A Malaysian study found that the purchase of a hybrid vehicle is not motivated by fuel-saving concerns but the desire to be seen as a responsible citizen (Wong, 2015). This is not surprising since human behaviour is largely driven by social relationships and our desire for peer acceptance. Under UK’s “zero waste place” project, neighbourhoods that have achieved notable environmental improvements were rewarded by the government and showered in media spotlight, bringing fame to ordinary individuals. While the initial take-up rate of the project was low, subsequent press attention raised the awareness of residents and increased participation rates. Policies that tie environmental protection to personal reputation encourages a permanent change in consumers’ habits and beliefs. A change in the kind of image society values – from materialism to environmentalism – would encourage more efforts to slow, halt and even reverse environmental damages as more people actively take part in conservation efforts such as donating to reforestation causes.


Economists love incentives. Steven Levitt wrote in his book “Freakonomics” that “the typical economist believes the world has not yet invented a problem that he cannot fix if given a free hand to design the proper incentive scheme”. Economic incentives can be wielded as a powerful tool to stop firms and consumers from destroying our planet. Levitt looks at incentives as a key to solving many problems in the real world. I believe that incentives, when designed appropriately, have astonishing power to make our planet a better place for all.

Carbon tax basics. Centre for Climate and Energy Solutions. (2021, August 2).

Chow, C. (2021, June 15). Carbon tax: A shared global responsibility for carbon Emissions: – PAST: Present: Future. Earth.Org – Past | Present | Future.

Kahneman, D., & Tversky, A. (1977). Prospect theory. an analysis of decision making under risk.

MasterClass. (2020, November 8). Understanding incentives in Economics: 5 common types of economic incentives. MasterClass.

Pricing carbon. World Bank. (n.d.).

Ritchie, H., Rosado, P., & Roser, M. (2023, October 23). Which countries have put a price on carbon?. Our World in Data.

This week's thought was by Lauren Wang YueQin

Lauren is a first-year economics undergraduate at Hughes Hall College. Borrowing the words of her favourite philosopher, her motto is ‘to know and not to act is not to know’.

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