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Air Pollution

Air Pollution Solutions: Market-Based Policies and their Benefits and Limitations

Dianna Smith

As we move into 2021, we are all hoping to see great strides in solving environmental issues like air pollution. Progress can seem slow, especially on heavy pollution days, but there are several ways governments are tackling air pollution, each more innovative than the last.

bangkok pollution

Since we already took a look at regulatory methods and technology, let’s discuss another way to solve air pollution: market-based policies.

What Are Market-Based Environmental Policies?

When dealing with air pollution, governments have two options: command-and-control and market-based solutions. As their respective names suggest, command-and-control policies rely on government policymaking to set emission limits or enforce the adoption of a specific piece of technology (i.e., smoke scrubbers). These policies certainly have their uses but are generally inflexible for business and don’t promote innovation.

Market-based policies are designed to incorporate the cost of pollution into business costs and decision making. Air pollution is a negative externality, meaning it harms people who aren’t producing pollution. Without market corrections, businesses will continue to pollute, as they aren’t the ones most affected by pollution.

Market-based environmental policies work to add these missing costs into the economy, creating incentives to reduce emissions and economic penalties for heavy polluters. These can include taxes, subsidies, and permit trading programs, which are all designed to lower emissions without simultaneously disrupting economic growth and technological innovation.

What Are the Benefits and Drawbacks of Some Market-Based Solutions?

Market-based solutions to air pollution are alluring to many, especially businesses. These policies solve the disconnect between group and individual interests while acknowledging that some companies will have an easier time lowering their emission levels than others. However, there are some drawbacks to this type of solution, and we will discuss some specific types of market mechanisms and their pros and cons below.

Emissions taxes

As one of the permanent fixtures in all of our lives, taxes on pollutant emissions are certainly an option.

Emissions taxes introduce a per-unit tax on pollution, creating business costs that should incentivize lower pollution levels. For example, carbon taxes (also called carbon pricing) charges polluters for each ton of carbon emitted. These taxes have the added benefit of raising revenue for the government, which can later be used for subsidies on clean energy or lowering distortionary taxes on other markets, a so-called double dividend. Emissions taxes also spur innovation, as businesses might try to find technological solutions rather than pay higher taxes.

Close-up of hoses in a service station-1

Germany recently implemented a new carbon tax on transportation and heating of €25/mt, which may contribute to rising gasoline prices. 

However, these taxes can have some negative impacts on society. While the goal of market-based policies is to add cost to polluters, taxes can end up hurting consumers instead, especially low- and middle-income communities. Businesses can simply raise their prices to counter rising production costs, thus negating the pollution reductions and innovative potential of taxes. Also, setting a correct tax level can be difficult, as assessing the true cost of pollution is an extremely tricky task and the pollution reduction is uncertain.


Subsidies are a common tool used by governments to encourage the adoption of new technology and reduce pollution levels.

Subsidies can work two ways: first, governments can provide financial incentives in exchange for air pollution reductions, and second, governments can offer financial incentives for the adoption of newer, cleaner technology. In the first case, the government pays polluters to not pollute, compensating businesses for the pollution abatement costs. In the second, the government can pay or provide tax credits to companies and individuals alike if they adopt clean technology, like installing solar panels.

solar panels

Like emissions taxes, subsidy programs have the benefit of spurring innovation, but the government loses rather than receives revenue. Businesses won’t raise their prices, however, so subsidies insulate consumers from rising costs. There is the question of ethics; namely, how can we, as taxpayers, allow the government to pay companies not to pollute, something that shouldn’t occur in the first place?

Cap-and-trade programs

Cap-and-trade programs involve two components: setting an overall emission limit, or ‘cap,’ and creating an emission permit market.

Emission permits, or emission allowances, are certifications that allow a specified amount of pollution. When setting up a cap-and-trade policy, governments will hand out a limited number of these permits to companies, with the total number being equal to the target pollution level. Because the number of permits is limited, a market will naturally develop for purchasing permits. Businesses that can reduce their pollution levels easily can sell their permits to other polluters who cannot abate their emissions readily.

Cap-and-trade programs have been successfully implemented many times, including in the Montreal Protocol (reduced ozone-depleting substances) and the Clean Air Act (reduced acid rain). One of the significant advantages of these programs is that the level of pollution after implementation is predetermined, and businesses are economically encouraged to innovate so they can cash in on the permit market.

montreal protocol

The USA, under the conditions of the Montreal Protocol, signed in 1987, created a domestic permit market for CFC and halons, which ended up working successfully to reduce the production and consumption of ozone-depleting substances. 

For polluters, however, cap-and-trade programs are not as preferable, especially for industries where pollution abatement is costly. Unlike taxes and subsidies, where the costs on businesses are fixed, cap-and-trade programs create a market that is subject to market forces, thus creating situations where the price of additional permits can change. This uncertainty can be undesirable for businesses.

For consumers, there is a danger in cap-and-trade programs: pollution locality. While cap-and-trade works great for atmospheric pollutants and GHGs, which we can regulate as a “big picture” environmental issue, local pollutants like particulate matter can still build up under cap-and-trade policies. Let’s say we created a particulate matter permit market in a city and set a threshold for PM2.5. Some polluters in that city will decrease their emissions, but some will not, and the residents living in those areas will still be exposed to unhealthy levels of pollution. This is a considerable drawback of cap-and-trade programs, and cap-and-trade is usually used in conjunction with other command-and-control and market-based solutions for local pollutants.

To learn everything you need to know about air pollution, check out our guide below:

Air Pollution: What You Need to Know