148 – The Economics of Environmental Payments

Payments to people or businesses to undertake environmentally beneficial works have become more common in recent decades. From an economic perspective, are they a good idea? How big should they be?

Why would a government consider paying someone to do something that benefits the environment? One answer is that, in some situations, environmental payments can be highly cost-effective — they can lead to improved environmental outcomes that are worth much more than the environmental payments. In other words, in the absence of payments, there is what economists call a “market failure”, and the payments overcome that failure.

But why payments rather than regulation? If environmental payments are made, the costs of the environmental improvement are borne by the public (or more specifically by tax payers), consistent with the so-called “beneficiary-pays principle”. An equally valid approach would be to apply the “polluter-pays principle”, requiring people to undertake the environmental works at their own cost. In PD#21 I noted that there is no economic theory to help us choose between these options. The choice is essentially political. In practice, policy makers tend to use a polluter-pays approach when trying to stop people changing to a practice that is worse than current practice, and a beneficiary-pays approach when trying to encourage people to adopt a practice that is better than current practice.

It is important to recognise that, in many situations, neither of these approaches is appropriate. In Pannell (2008) I point out that there are many environmental projects for which the most appropriate policy mechanism is extension (meaning education, training, persuasion, information provision, …), technology change, or no action.

How much to pay?

Looking at different environmental programs around the world, there are three or four different strategies used, in terms of how much governments look to pay people for improved environmental works.

1. Small temporary grants to encourage people to trial the environmental works. In Australia, these grants usually go by the name of “incentive payments”. The hope is that, after trialing, people will decide to adopt the works permanently and at large scale. This can be the most cost-effective policy strategy in certain cases: if the action is win-win, and likely to be adopted at sufficient scale, but is not yet adopted. The market failure being addressed in that case is that people lack accurate information about the works (with the possibly brave assumption that the government has better information). Unfortunately, in Australia incentive payments have mainly been used in situations that don’t match the required combination of circumstances, with the result that they have often delivered far less than hoped.

2. Larger grants, to fully compensate people for the losses they would make by adopting the environmental works. Such losses need not be purely financial. They could include risk, inconvenience, or time, for example. In Australia, these sorts of payments are sometimes called “stewardship payments”. They make sense in situations where the public benefits of environmental works are high enough, and private costs are not too large. The market failure being addressed in this case is a positive externality. If pitched correctly, participants should not make a profit from such payments. (Or to be clear, they shouldn’t make a greater benefit overall than they would have done if they did not participate in the scheme. The benefits of participation might include non-financial elements.) That is the case, for example, if conservation tenders are used to determine the levels of payment. Well targeted stewardship payments can be very cost-effective, but are under-used in Australia relative to smaller “incentive payments.”

3. Larger-still grants, designed to provide a net profit to recipients. These have never been used in Australia, but they are the norm in Europe and the US in environmental programs for agriculture. Payments at this level are not justified on a market-failure basis. They reduce the potential environmental gains that are possible from the program for a given budget.

Another approach to determining how much to pay is “cost sharing” – a concept with pitfalls. I’ll cover that next week.

David Pannell, The University of Western Australia

Further Reading

Pannell, D.J. (2005). Thinking like an economist 21: Using incentives to buy land-use change in agriculture for environmental benefits, Pannell Discussions, No 66, 17 Oct 2005. Here

Pannell, D.J. (2008). Public benefits, private benefits, and policy intervention for land-use change for environmental benefits, Land Economics 84(2): 225-240. Here

One comment

  • Allan Buckwell
    5 December, 2011 - 3:40 pm | link

    I enjoy your articles, but I wonder what is the basis for the strong statement you make in the most recent note on environmental payments. [“Payments at this level are not justified on a market-failure basis.”] Are there no circumstances where the supplier of an environmental service should not receive the full opportunity costs of the delivery of the service? Are environmental services different than other public services? If I’m a bed manufacturer and I supply beds to public hospitals to their specification am I not entitled to make a normal return on all the resources I use to supply this service? Is so, why are environmental services different? If we don’t offer the supplier payments sufficient to pay the opportunity costs of supply how could we expect to get the service delivered?

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