So beloved are Hong Kong's red taxis that they've inspired t-shirts, art installations, and even recycled watches. But along with minibuses, the city's taxis are responsible for up to 40% of certain kinds of roadside air pollution, says the government.

That makes the city's fleet of 18,000 liquefied petroleum gas-powered taxis one of the biggest culprits behind the mask of white haze that often blankets Hong Kong's skies and leaves pedestrians coughing. Now, through a mixture of carrots and sticks, the government—which already...