International environmental economics and policy
Topic III: Policy instruments
Bruno Lanz
Graduate Institute of International and Development Studies
Motivation
The Coase theorem: Regulatory intervention may not be needed for localized externalities with a limited number of affected parties
Nice theoretical result about how property rights can generate an efficient outcome through private negotiation
Most contemporary environmental externalities (e.g. air and water pollution) concern large population and are spatially diffuse
Transactions costs: Private negotiation prohibitively expensive
Roadmap
Emissions and technology standards
Market-based instruments:
Emissions tax Abatement subsidies Emissions permit market
Selected topics:
Standards / “Command and control”
Polluters are required to carry out a prescribed action to reduce pollution
Emission limits over a given period of time Adopt specific technologies
Widely used in practice:
Costs imposed on the polluters can be evaluated quite precisely The impact on environmental performances can be evaluated in advance (hence good to regulate complex environmental processes) Relatively low monitoring costs
Efficient standards: Require firms to emit no more thanej∗
−Cj0(ej∗) =D0(E∗)
Uniform standards: issues
Issues with the above:
Must know individual firms abatement costs (no revelation incentives) Firms with low abatement costs should face tighter constraints: Discriminatory policy difficult to implement politically
A more realistic policy option: uniform standardej ≤eˆ,∀j
However if firms are not identical total abatement costs will not be minimized
Marginal abatement cost is not equalized across firms
No incentives for R&D
Market-based instruments: Emissions tax
Aim: Create a price signal as a substitute to the missing market
Denote the tax per unit of pollution asτ
A firm’s total pollution-related cost under taxation is now
TCj(ej) =Cj(ej) +τej
Cost minimization leads to: −Cj0(ej) =τ
As long as the incremental cost of abatement is lower than the tax, reduce emissions
Equilibrium: the marginal abatement cost is equal to the tax rate Polluters with costlier abatement options will voluntarily pay for the right to emit more pollution
Emissions taxes: efficiency
If all firms face the same marginal tax rate, then the marginal abatement costs will be equalized across firms
−Cj0(ej) =−C
0
k(ek), ∀j 6=k
Aggregate abatement costs are minimized
No incentive revelation problem: firms have more information about their costs and decide whether to pay the tax or abate
As long as the marginal abatement cost curve declines with emissions, increasing τ will reduce emissions
Thus under full information about firms abatement costs, any aggregate emission levelE =P
jej(τ) can be achieved
A Pigovian tax (Pigou, 1920) is the optimal tax: The tax rate equals the aggregate marginal damage cost evaluated at the efficient level of pollution
Emissions taxes: revenues
Taxing pollution can generate very large revenues for the state
Issue: revenue recycling
Using the revenue on environmental protection (‘hypothecation’) or to compensate the victims is usually a bad idea
Taxing energy to subsidize energy efficiency
Instead revenues should be allocated to maximize the rate of return
Examples:
Reduce other taxes (e.g. labor tax): double dividend? Reduce the budget deficit?
Environmental subsidies
Under an emission tax abatement expenditures are the responsibility of the polluting firms
To foster political feasibility the government may rather want to provide subsidies for abatement activities
“Buy off” oppositions
Implicit structure of property rights: Firms have the right to dispose of the environment
The public at large must purchase improved environmental quality from polluting firms
If the government subsidizes pollution abatement equipment at less than a 100% rate, remaining expenditures are still unnecessary costs
Can only be used as a complement to other incentives
Marginal subsidy: efficiency
Denote the payment received per unit of pollution abatement below ej byζ
A firm’s total cost of emissions reduction is then
TCj(ej) =Cj(ej)−ζ(ej −ej),ej ≤ej
FOC:−Cj0(ej) =ζ
Same behavioral implication as an emission tax: equate the marginal abatement cost to the per unit subsidy
Emissions have an opportunity cost
The reference emissions can either be based on historical emissions or on some standard
Abatement subsidy: issues
Taxes and subsidies induce the same impact at the margin, but under a subsidy the government has to make paymentsζP
j(ej −ej)
One solution is to define ˆej so that emissions above are taxed and
emission reduction below are subsidized
The term (ˆej−ej) can be positive or negative, the marginal incentive is preserved
Other important issue: in the long-run subsidies may attract new firms in the industry
The average production goes down, so that the size of the industry is inefficiently high: see board
Pollution permits: Cap-and-trade
For a given time period the government issues a fixed number of rights to emit a unit of pollution (aka emissions permits or allowances)
Firms have to surrender permits for every unit of pollution
A market for the pollution permits is created and firms can buy or sell permits on the market: cap-and-trade
A cap-and-trade program implements the Coase Theorem at large scale
Recall main insight from Coase: Assign property rights and keep transactions costs low
Allowing participants to trade permits ensures that they end up with firms who value them most
If the price of permits is larger than the marginal abatement cost, the firm sell permits
Pollution permits: Setup
Denote the number of permits (the “cap”) available by L: The constraint on total emission makes the shadow value of emissions explicit
In equilibrium firms equalize their marginal abatement cost with the price of permits
Static efficiency: The existence of a single price signal equalizes marginal abatement cost across firms
Dynamic efficiency: Incentive to reduce over time (improve technology) to avoid giving up valuable permits
Theoretically equivalent to an emissions tax, but:
Total damages are fixed by construction
Pollution permits: Auction
The government auctions Lemissions allowances
Denote the market clearing price byσ
The polluters must purchase the right to emit from the public at large
If firms behave as price takers then the total cost is
TCj(ej) =Cj(ej) +σej
Cost minimization leads to: −Cj0(ej) =σ
Similar as a pollution tax: The firm is effectively purchasing an input when it bids for permits
Pollution permits: Free allocation
The regulator sets the total amount of pollution and endows individual firms with emission permits totaling the aggregate pollution goal
Free permits act as a subsidy or “windfall” profits
“Grandfathering”: Allocate pollution rights based on historical emissions
Output-based allocation: permits distributed in proportion to output
Firms are not constrained by the initial endowment: they can buy or sell allowances on the market
Pollution permits: Outcome under free allocation
Firmj receives ej permits for free, total costs are:TCj(ej) =Cj(ej)−σej +σej
FOC:−Cj0(ej) =σ
Permit trading ensures that the marginal (optimality) condition is met
The initial endowment of permits is like a lump sum transfer to the firm, and does not impact the firms marginal decisions
Firms reduce emissions up to the point where the marginal abatement cost equals the marginal opportunity cost of an emission permit The firm will be a net buyer or a net seller of permits depending on initial endowment and abatement cost structure
At the aggregate level market clearance constraints choices: L=PJ
j=1ej(σ)
L=E ⇒σ(L) =τ(E)
Cap-and-trade: Some practical issues
Setup costs (trading platform) and transaction costs (Coase)
Use an auction to generate an initial price signal
In theory efficiency of the scheme does not depend on the initial distribution of permits (independence claim), but in practice it m matters:
Distributional outcome: Who owns the right to pollute?
Free permits could create a barrier for potential entrants: Extra profits for incumbents
Imperfect competition on either output market or permit market Transaction costs high if initial distribution far away from optimal allocation
For firms it’s a new financial instrument: disconnect between traders and process managers
Taxes and permits
In an idealized setting taxes and cap-and-trade systems are equivalent in terms of efficiency
Fixing the price or the quantity yield the same marginal condition
One fundamental uncertainty is associated with information
The schedule of damages and abatement costs are not observed
The seminal paper by Weitzman (1974) demonstrated how imperfect information affects the choice between price and quantity regulations
Basic insight:
If regulate the price of emissions with a tax, the cutback in emissions is uncertain
Imperfect information: Regulator’s problem
Consider a setting in which the regulator has to estimate the marginal damage and the marginal abatement cost functions
Estimation implies some error: imprecise policy
The aim of the regulator: given the uncertainty about estimation, minimize minimize ex-post inefficiencies
Under what circumstances should either of the market-based instrument be preferred to the other?
Second best policy making
Need to distinguish between the source of uncertainty
Notice the hypothesis that remain:
The firms know their own cost function Emissions are perfectly observed
Case 1: Damage function uncertainty
The “true” damage function D(E) is estimated with error: ˜D(E)
The regulator is assumed to knowC(E) with certainty
The government sets an emissions target by minimizing total costs, giving: ˜D0(E) =−C0(E)
In general ˜E 6=E∗; if marginal damages estimated are systematically lower than true damages ( ˜D0(E) < D0(E),∀E)
Emissions are too high ˜E >E∗
Marginal abatement cost is too high
Welfare loss: see board
Conclusion: For damage uncertainty, whether the regulator fixes the price or the quantity of emissions does not matter for welfare
Case 2: Abatement cost uncertainty
The “true” aggregate abatement cost curveC(E) is estimated with error: ˜C(E)
The regulator is assumed to knowD(E) with certainty
The government sets D0(E) = −C˜0(E) If the regulator overestimates the true marginal abatement cost curve (−C˜0(E) > −C0(E),∀E)
Emissions are too high ˜E >E∗
Marginal damages are too high
Welfare loss: see board
Weitzman’s theorem: intuition
What features of the cost and damage functions determine the distance between the optimal and realized emission level?
The relative slope of marginal damage and marginal cost function
Extreme cases:
If the marginal damage curve is vertical, the welfare cost of the quantity instrument is always zero
Conversely if the marginal damage curve is horizontal, the welfare cost of the price instrument is always zero
If going above some threshold has disastrous consequences,
misestimating the marginal abatement cost could create a lot of harm
Weitzman’s theorem
Write the damage function asD(E, η), where η determines the slope (∂2D(·)/∂E∂η=DE,η(·)>0)
Suppose the regulator estimates−C˜0(E) 6= −C0(E) and defines the pollution target as −C˜0( ˜E) = DE( ˜E, η)
Consider a class of marginal cost functionsDE( ˜E, η) and tax level
τ( ˜E)
For a steeper marginal damage curve (largerη)
1. Under a permit policy|E∗(η)−E˜|and the welfare cost decline 2. Under a tax|E∗(η)−E˜(τ)|and the welfare cost increases
Combining price and quantity regulations
The regulator is not limited to either price or quantity regulations
Classic paper by Roberts and Spence (1976): Introduce bounds on the price of permits
Intuition: Announced prices act a safety valve against the consequences of abatement cost uncertainty
Firms start with some amount of transferable permits are required to cover emissions
Implications of the price bounds
Consider a regulator that is uncertain about the marginal abatement cost function
Given what he estimates and what he knows about marginal damages he fixes the aggregate amount of emissions to L= ˜E
He then issues the corresponding number of permits
Denote the price of permits by σ and the amount of permits held by firm j after the market for permits clears by ˆej
If a firm does not hold enough permits to cover emissions (ej >eˆj), it
has to pay τ(ej −eˆj)
Hybrid policies: equilibrium
In equilibrium, arbitrage impliesζ ≤σ ≤τ
1. Ifζ < σ < τ firms setej = ˆej and−C
0
j(ej) =σ
2. Ifσ =τ firms set−Cj0(ej) =τ: marginal abatement cost curve
underestimated, but the tax limits how high firms’ marginal abatement cost can climb (safety valve for firms)
3. Ifσ =ζ firms set−Cj0(ej) =ζ: marginal abatement cost curve
overestimated, but the subsidy assures that there are still incentive to reduce emissions (safety valve for the environment)
Imperfect competition and market-based instruments
We consider three cases:
Monopoly on the output market “Monopoly” for emissions
Polluting monopoly
In the standard case a monopolist will compare marginal cost to marginal revenues, so that the outcome is not Pareto optimal
The monopolist set the price too high and produces too little
If pollution is proportional to output then the monopolist emits less than the market outcome
Putting a price on the monopolist’s emissions will induce a welfare cost
1. Subsidize output to get to efficient level of production 2. Charge for emissions to induce abatement
Monopoly for emissions
Consider a setup where there is only one source of pollution
Could emit a local (non-mixing) pollutant and be part of a competitive industry
“Monopolist” for an environmental bad
If the regulator announces that he will tax emissions based on damages, the firm has an incentive to manipulate its emissions
The firms controls the damages and hence influence the level of the tax
Imperfect competition on a permit market
Up to now we have assumed that the price of permits is independent from firms’ individual behavior
Ensures that the equilibrium marginal abatement cost is independent of the initial permit allocation
If a firm has an impact on the price of permits it can strategically manipulate the outcome of the permit market
Seminal paper: Hahn (1984) assumes there is one dominant firm and a competitive fringe
The problem differs if the firms is a net buyer or seller of permits If the dominant firm is a net buyer of permits, it will optimally buy less permits to depress the equilibrium permit price
If the dominant firm is a net seller of permits, it will retain some to increase the equilibrium permit price
