The cost-effectiveness of a policy is a key decision parameter in a world with scarce resources. Given a particular environmental quality goal, the most cost-effective policy is the one which achieves the desired goal at the least cost. There are many components of cost, and these include both the direct costs of administering and implementing the policy as well as indirect costs, such as how the policy drives cost-reducing technological change.
Cost-effectiveness is distinct from general economic efficiency. Whereas cost-effectiveness takes an environmental goal as given, efficiency involves the process of selecting a specific goal according to economic criteria (Sterner, 2003). Consequently, the choice of a particular environmental goal will likely have dramatic impacts on the overall cost of a policy, even if that policy is implemented using the most cost-effective instrument.
Policies are likely to vary considerably in terms of cost-effectiveness, and any estimation of the costs involved can be challenging (Michaelowa, 2003b). While cost-effectiveness estimates traditionally include the direct expenditures incurred as a result of implementing any specific policy, the policy may also impose indirect social costs, which are more difficult to measure (Davies and Mazurek, 1998). Moreover, costs for which data are limited are often ignored. Harrington et al. (2000) provide a summary of commonly excluded costs as well as examples of efforts to estimate these.
Cost-effectiveness can be enhanced with low transaction costs for compliance. This implies limiting the creation of new institutions and keeping implementation procedures as simple as possible while still ensuring system integrity. Studies reported in the literature can be divided into two categories in terms of the economic impacts of the timing of reductions. While some researchers argue that reductions should be postponed until low-cost technologies are available, others argue that necessary decisions have to be made today to avoid a ‘lock-in’ to an emission intensive pathway that would be expensive to leave at a later time point (see also Chapter 11).
A common concern is that ex ante cost estimates may not reflect the actual costs of a policy when it is assessed from an ex post perspective. Harrington et al. (2000) show that the discrepancy between the actual and estimated total costs of 28 environmental regulations in the USA is relatively low and, if anything, that ex ante estimates tend to overstate total costs. While these authors do not systematically evaluate specific environmental instruments, they do find that estimates for market-based instruments tend to overstate unit costs, while unit-costs estimates for other instruments are neither under- nor overestimates.