Anytime you are trying to make sure externalities are borne by the one creating them, the easiest way to do it is to simulate a use tax. A gas tax (or as one person suggested, a road tax), is a proxy for use.

Emissions = usage x efficiency. By employing a gas tax, you punish people for driving cars, and driving inefficient cars. This gets at what you want.

The big complaint people have with market-based solutions is that they are often regressive. Gas could run $10 a gallon and I would still drive an SUV. On the other hand, some poor guy with a 1982 Monte Carlo would be getting screwed just b/c he can't afford a new Civic.

Tax law always has these trade offs, i.e., tax neutrality, progressivity/regressivity, etc. Im with you in generally favoring market neutral, non-distortive taxation, but then again, I could care less about tax progressivity, and in fact I believe the very concept of progressive taxation is immoral.

Going back to your hybrid vehicle discussion, my main point was to indicate that the purpose of the credit is not internalization of costs. It is to create a government subsidy to drive the introduction of new technology by building demand.