Emissions trading systems with cap adjustments

Emissions Trading Systems (ETSs) with fixed caps lack provisions to address systematic imbalances in the supply and demand of permits due to changes in the state of the regulated economy. We propose a mechanism which adjusts the allocation of permits based on the current bank of permits. The mechanism spans the spectrum between a pure quantity instrument and a pure price instrument. We solve the firms׳ emissions control problem and obtain an explicit dependency between the key policy stringency parameter—the adjustment rate—and the firms׳ abatement and trading strategies. We present an analytical tool for selecting the optimal adjustment rate under both risk-neutrality and risk-aversion, which provides an analytical basis for the regulator׳s choice of a responsive ETS policy.     

Procrastinating reform: The impact of the market stability reserve on the EU ETS

We study the impact of the market stability reserve (MSR) on price and emission paths of the EU ETS. From 2019 onwards, the MSR will adjust the number of allowances auctioned as a function of the size of the surplus, i.e. in times of a large surplus it shifts the issue date of allowances into the future. In a perfectly competitive allowance market the MSR only affects price and emission paths if the baseline equilibrium becomes unfeasible. If the MSR is binding, prices increase in the short run but drop in the medium run relative to the baseline. The MSR increases price variability if uncertainty over future allowance demand is resolved while there is a surplus. The long run cap is unaffected by both the MSR and overlapping climate policies. This contrasts the EU׳s objectives of improving the resilience of the EU ETS and increasing synergies with overlapping climate policies.     

Terminating links between emission trading programs

Links between emission trading programs are not immutable, as highlighted by New Jersey׳s exit from the Regional Greenhouse Gas Initiative in 2011. This raises the question of what to do with existing permits that are banked for future use—choices that have consequences for market behavior in advance of, or upon speculation about, delinking. We consider two delinking policies. One differentiates banked permits by origin, the other treats banked permits the same. We describe the price behavior and relative cost-effectiveness of each policy. Treating permits differently generally leads to higher costs, and may lead to price divergence, even with only speculation about delinking.     

Risk aversion and CO2 regulatory uncertainty in power generation investment: Policy and modeling implications

We consider a simulation of risk-averse producers when making investment decisions in a competitive energy market, who face uncertainty about future regulation of carbon dioxide emissions. Investments are made under regulatory uncertainty; then the regulatory state is revealed and producers realize returns. We consider anticipated taxes, grandfathered permits and auctioned permits and show that some anticipated policies increase investment in the relatively dirty technology. Beliefs about the policy instrument that will be used to price carbon may be as important as certainty that carbon will be priced. More generally, a failure to consider risk aversion may bias policy analysis for the power sector.     

Cost-effective environmental policy: implications of induced technological change

Cost-effective environmental policy generally requires that all emission sources are faced with the same tax. In this paper I discuss how the existence of induced technological change may alter this result, if at least some of the effect is external to the firm. Focusing on Learning by doing (LBD) effects in abatement activities, it is shown that emission sources with external learning effects should be faced with a higher tax than emission sources with only autonomous technological change. By using simple numerical simulations, it is further investigated to what degree a cost-effective climate policy differs from a free quota market, under various assumptions about learning effects, diffusion of technology and environmental targets. The results indicate that optimal taxes may be significantly higher in the industrial world than in the developing world. Moreover, the industrial world's share of global abatement may be much higher in a cost-effective solution than in a free quota market. The global cost savings of a fully flexible implementation of the Kyoto Protocol are further questioned, as potential spillover effects of technological growth in the industrial world are not internalised in the market.     

Comparing policies to confront permit over-allocation

Instability in cap-and-trade markets, particularly with respect to permit price collapses, has been an area of concern for regulators. To that end, several policies, including hybrid price-quantity mechanisms and the newly introduced “market stability reserve” (MSR) systems, have been introduced and even implemented in some cases. I develop a stochastic dynamic model of a cap-and-trade system, parameterized to values relevant to the European Union׳s Emission Trading System (EU ETS) to analyze the performance of these policies aimed at adding stability to the system or at least at reducing perceived over-allocations of permits. Results suggest that adaptive-allocation mechanisms such as a price collar or MSR can reduce permit over-allocations and permit price volatility in a more cost-effective manner than simply reducing scheduled permit allocations. However, it is also found that the performance of these adaptive allocation policies, and in particular the MSR, are greatly affected by assumed discount rates and policy parameters.     

A free lunch in the commons

We derive conditions under which raising costs through a regulatory constraint or a fully expropriated tax can increase the profits arising from a common-pool resource. The basic model assumes a fixed number of identical agents with linear costs selling in a single period at an exogenous price. A necessary and sufficient condition for a cost increase to be profitable is that aggregate output from the resource be locally convex in aggregate effort. We also show that cost increases can be profitable even if price is endogenous, agents are heterogeneous, entry is costless, or agents are playing a Markov-perfect equilibrium of a dynamic game. We also discuss more general welfare implications of the result along with its relation to existing results for a Cournot oligopoly.     

Efficiency of pollution taxation and market structure

This paper looks at the performance of a uniform pollution tax in achieving a given level of pollution abatement at least cost. It is shown that market structure is an important consideration in this performance and that in general least-cost abatement will not result from a pollution tax uniformly applied. The pattern of pollution taxes that will achieve least-cost abatement when differing degrees of market power exist among polluters is developed and discussed.     

Directing technical change from fossil-fuel to renewable energy innovation: An application using firm-level patent data

In this paper we provide an analysis of directed technical change in the sector of electricity generation. We rely on patent data in fossil-fuel (FF) and renewable energy (REN) technologies for 5471 European firms over the 1978–2006 period. The novelty of our approach is in the focus on firm׳s heterogeneity in driving technological change. We make a distinction between small specialized firms, which innovate in only one type of technology, and large mixed firms, which innovate in both technologies, to analyse how REN patents can replace FF ones at the sector level both through a shift in innovation activities within existing firms and through firms׳ entry and exit. We use zero-inflated count data estimation techniques to identify the factors that affect specialized versus mixed firms׳ patenting behaviour both at the intensive (i.e., levels of innovation) and extensive (i.e., technological entry) margins. We further investigate the implications of our firm-level estimations for reducing the gap between REN and FF innovation at the aggregate level. We establish two key findings: (1) a decrease in the FF-REN technology gap mainly comes about through technological entry of specialized REN firms following an increase in REN market size; (2) increases in FF prices, FF market size, and FF knowledge stocks all increase the technology gap by increasing mixed firms FF innovation rates. An important implication of our results is that policies aimed at increasing REN innovation should focus on helping small firms to start and sustain innovation in the long-run.     

Emissions Trading with Shares and Coupons when Control over Discharges Is Uncertain

Two important decisions in designing markets for tradable emissions permits are whether to allow banking of permits (coupons) and whether to allow trading in entitlements to future permits (shares). Banking is predicted to reduce price instability when firms trade in a reconciliation market after the quantity of emissions has been determined. Tradable shares are a common feature in proposals for emissions trading in Canada. We conduct a laboratory experiment to investigate how bankable coupons and tradable shares affect efficiency and prices under uncertainty. Cognitive demands on the subjects are reduced by computerized advice on the optimal allocation of coupons across periods and the implied marginal values of coupons and shares. Banking, share trading, and uncertainty conditions are introduced in a complete factorial design with three observations per cell. High efficiencies are observed across all treatments. Uncertainty in the control of emissions leads to substantial price instability when banking is not allowed. Banking virtually eliminates the instability, but reduces the efficiency of the market institution. Share trading reduces trading volumes, increases price stability, and improves efficiency.     

Implementing optimal taxes using tradable share permits

This paper presents a simple system for efficient regulation under asymmetric information. Each firm's income is controlled by a tax that depends on the firm's own output and on a parameter construed as a share permit. These “shares of total expected output” lower a firm's tax burden and are acquired in a competitive market. By employing this scheme, the planner only requires knowledge of marginal damage to induce the first-best outcome. Relative to a traditional cap-and-trade approach the system increases expected social welfare.     

The environment as a factor of production

This paper uses firm-level data about electric utilities to develop an empirical model of how electric utilities use and bank SO₂ pollution permits under the Acid Rain Program. The empirical model considers emissions, fuels, and labor as variable inputs with quasi-fixed stocks of permits and capital. Consequently, substitution possibilities between the environment and other production factors can be measured and tested. The results reveal substantial substitution between emissions, permit stocks, capital, fuel, and labor. The empirical findings also indicate that firms bank permits primarily as a hedge against uncertainty and for other firm-specific reasons. Overall, the results suggest that cap-and-trade approaches can reduce the cost of meeting environmental goals by providing a mechanism for addressing regulatory and market risks and by signaling an appropriate price for factor use, especially irreversible capital investments.     

The environment as a factor of production

This paper uses firm-level data about electric utilities to develop an empirical model of how electric utilities use and bank SO₂ pollution permits under the Acid Rain Program. The empirical model considers emissions, fuels, and labor as variable inputs with quasi-fixed stocks of permits and capital. Consequently, substitution possibilities between the environment and other production factors can be measured and tested. The results reveal substantial substitution between emissions, permit stocks, capital, fuel, and labor. The empirical findings also indicate that firms bank permits primarily as a hedge against uncertainty and for other firm-specific reasons. Overall, the results suggest that cap-and-trade approaches can reduce the cost of meeting environmental goals by providing a mechanism for addressing regulatory and market risks and by signaling an appropriate price for factor use, especially irreversible capital investments.     

Strategic climate policy with offsets and incomplete abatement: Carbon taxes versus cap-and-trade

This paper provides a first analysis of a “policy bloc” of fossil fuel importers which implements an optimal climate policy, faces a (non-policy) fringe of other fuel importers, and an exporter bloc, and purchases offset from the fringe. We compare a carbon tax and a cap-and-trade scheme for the policy bloc, in either case accompanied by an efficient offset mechanism for reducing emissions in the fringe. The policy bloc is shown to prefer a tax over a cap, since only a tax reduces the fuel export price and by more when the policy bloc is larger. Offsets are also more favorable to the policy bloc under a tax than under a cap. The optimal offset price under a carbon tax is below the tax rate, while under a cap and free quota trading the offset price must equal the quota price. The domestic carbon and offset prices are both higher under a tax than under a cap when the policy bloc is small. When the policy bloc is larger, the offset price can be higher under a cap. Fringe countries gain by mitigation in the policy bloc, more under a carbon tax since the fuel import price is lower.     

Emission control policies under uncertainty

The paper deals with the problem of optimal environmental policy under uncertainty. Usually, when an environmental policy is considered, only the expected values of the parameters of the marginal benefit and marginal cost functions associated with the policy are known. Thus a relevant question is: In the presence of uncertainty, what is the optimal policy mean for achieving the environmental objective? The study addresses itself to the specific objective of improving air quality although the analysis is generally applicable. The policy means are emission taxes and emission quotas. It is shown that under uncertainty neither of these means is generally optimal, and that specific parameter values of the costs and benefits relations and their distributions determine the optimal policy for each situation.     

Implementing optimal taxes using tradable share permits

This paper presents a simple system for efficient regulation under asymmetric information. Each firm's income is controlled by a tax that depends on the firm's own output and on a parameter construed as a share permit. These “shares of total expected output” lower a firm's tax burden and are acquired in a competitive market. By employing this scheme, the planner only requires knowledge of marginal damage to induce the first-best outcome. Relative to a traditional cap-and-trade approach the system increases expected social welfare.     

Do plants’ emissions respond to ambient environmental quality? Evidence from the clean water act

In this paper we show that plants respond to downstream ambient water quality after controlling for permitted levels of pollution. We find if past water quality declines by one percent, plants reduce current pollution by 0.35 percent. The magnitude of this coefficient is comparable to the coefficient on permitted discharge levels i.e. regulatory stringency itself. Results are consistent with two mechanisms. First, a decline in water quality may lead to more stringent permits that would raise the cost of abatement of a plant significantly. Second, the plant is likely to be subject to increased public pressure in response to poor water quality. Indeed, as expected, the impact of water quality becomes stronger in locations with higher median household income, higher percent carpooling to work, or lower percent of manufacturing employment but surprisingly with lower median age of residents, lower percent with bachelor׳s degree or higher percent of families with children.     

Cost‐effective conservation of an endangered frog under uncertainty

How should managers choose among conservation options when resources are scarce and there is uncertainty regarding the effectiveness of actions? Well‐developed tools exist for prioritizing areas for one‐time and binary actions (e.g., protect vs. not protect), but methods for prioritizing incremental or ongoing actions (such as habitat creation and maintenance) remain uncommon. We devised an approach that combines metapopulation viability and cost‐effectiveness analyses to select among alternative conservation actions while accounting for uncertainty. In our study, cost‐effectiveness is the ratio between the benefit of an action and its economic cost, where benefit is the change in metapopulation viability. We applied the approach to the case of the endangered growling grass frog (Litoria raniformis), which is threatened by urban development. We extended a Bayesian model to predict metapopulation viability under 9 urbanization and management scenarios and incorporated the full probability distribution of possible outcomes for each scenario into the cost‐effectiveness analysis. This allowed us to discern between cost‐effective alternatives that were robust to uncertainty and those with a relatively high risk of failure. We found a relatively high risk of extinction following urbanization if the only action was reservation of core habitat; habitat creation actions performed better than enhancement actions; and cost‐effectiveness ranking changed depending on the consideration of uncertainty. Our results suggest that creation and maintenance of wetlands dedicated to L. raniformis is the only cost‐effective action likely to result in a sufficiently low risk of extinction. To our knowledge we are the first study to use Bayesian metapopulation viability analysis to explicitly incorporate parametric and demographic uncertainty into a cost‐effective evaluation of conservation actions. The approach offers guidance to decision makers aiming to achieve cost‐effective conservation under uncertainty.     

Losses from effluent taxes and quotas under uncertainty

Recent theoretical papers by Adar and Griffin (J. Environ. Econ. Manag.3, 178–188 (1976)), Fishelson (J. Environ. Econ. Manag.3, 189–197 (1976)), and Weitzman (Rev. Econ. Studies41, 477–491 (1974)) show that,different expected social losses arise from using effluent taxes and quotas as alternative control instruments when marginal control costs are uncertain. Key assumptions in these analyses are linear marginal cost and benefit functions and an additive error for the marginal cost function (to reflect uncertainty). In this paper, empirically derived nonlinear functions and more realistic multiplicative error terms are used to estimate expected control and damage costs and to identify (empirically) the mix of control instruments that minimizes expected losses.