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Final Report: Rate-Based Allocation Mechanisms for Market-Based Environmental Policies: Interactions with Pre-Existing Taxes and Uncertainty

EPA Grant Number: R830991
Title: Rate-Based Allocation Mechanisms for Market-Based Environmental Policies: Interactions with Pre-Existing Taxes and Uncertainty
Investigators: Fischer, Carolyn
Institution: Resources for the Future
EPA Project Officer: Wheeler, William
Project Period: June 1, 2003 through May 31, 2005
Project Amount: $62,500
RFA: Market Mechanisms and Incentives for Environmental Management (2002)
Research Category: Economics and Decision Sciences

Description:

Objective:

Rate-based policies targeting emissions intensity are gaining popularity, as policymakers balance twin goals of environmental protection and economic growth. Examples include tradable performance standards, as used in the United States to phase lead out of gasoline and to promote fuel economy within the fleets of automobile manufacturers; rebating emission taxes according to market share, as with the Swedish NOx tax; or distributing emission permits according to output, as proposed for some states in the State Implementation Plans Call for NOx and for some international programs for carbon trading. Also known as output-based allocation (OBA)—because emission allowances are distributed according to an average intensity multiplied by total output—these tools offer both revenue neutrality and automatic allocation adjustment to changing market conditions. However, there often are important tradeoffs in terms of efficiency because OBA implicitly subsidizes production, unlike conventional lump-sum allocation mechanisms like grandfathering.

This project proposed two extensions to work already completed under the U.S. Environmental Protection Agency’s Science To Achieve Results (STAR) Program. The first investigated how OBA interacts with other distortions in the economy, like preexisting taxes. Because the allocation of permit rents represents potential revenue foregone, the opportunity costs must be considered. One of the potential uses of that revenue could be to reduce the taxes on labor or consumption that discourage work. According to the bulk of the literature on tax interactions, without such revenue recycling, environmental regulations that raise prices can exacerbate preexisting distortions and raise the overall cost of the regulation. On the other hand, OBA recycles the revenue back to the regulated sector, functioning like a consumption tax reduction for that good. The question is how effectively this mechanism mitigates tax interactions, because the implicit subsidy is not optimized but rather tied to the value of the emissions.

The second part of the project aimed to understand how rate-based mechanisms perform when costs and benefits are uncertain. Market-based mechanisms offer certain flexibilities in allowing firms to respond to changing conditions while meeting their environmental obligations. Since a seminal paper by Weitzman in 1974, a literature has developed to compare price-based (tax) versus quantity-based (cap-and-trade) mechanisms, when policymakers cannot predict future compliance costs and environmental damages with certainty. Now it is important to add emission-intensity mechanisms to the analysis, recognizing that they can be designed to incorporate price or quantity-based aspects as well. Because OBA affects the relative incentives for emissions reduction and conservation, these mechanisms can behave quite differently from their traditional price or quantity counterparts. The results will help answer how—and to what extent—OBA can be used to improve the expected performance of market-based mechanisms for environmental regulation in an uncertain world.

Summary/Accomplishments (Outputs/Outcomes):

Mitigating Tax Interactions and Emissions Leakage with Output-Based Allocations

For the first part of the project, the concentration on tax interactions was expanded to include issues of international competitiveness and the leakage of emissions through international trade. Adding this additional market failure has produced results that clarify and to some extent contradict findings of the literature on policy choice under tax interactions alone. Two articles have been written on this subject. One article currently has revise/resubmit status at Land Economics and the other is being finalized as a discussion paper. Both have been presented at conferences and in economics seminars.

Both papers are coauthored with Alan Fox of the International Trade Commission and use a carbon permit trading policy as an example. Because we are concerned primarily with the distributional and efficiency effects of emissions permit allocation mechanisms with taxes and trade, we employ a computable general equilibrium (CGE) model from the Global Trade Analysis Project (GTAP), which offers richness in calculating trade impacts. In particular, we can look in detail at the effects on a more diverse and disaggregated set of energy-using sectors than in most climate models. However, this static model is not designed specifically to study climate policy. It lacks the capability to examine certain issues of import, particularly dynamic responses, because it does not project energy use into the future or allow for technological change. As such, our results should be considered illustrative of the near-term effects on different sectors of implementing a climate policy using different allocation mechanisms for emissions permits. Our impacts of interest include CO2 emissions, production, trade, and employment by sector, as well as overall welfare, both in the United States and abroad, and carbon leakage.

In “Output-Based Allocation of Emissions Permits for Mitigating Tax and Trade Interactions,” we compare different rules for allocating emissions allowances within sectors (lump-sum grandfathering, OBA, and auctioning) and among sectors (such as according to historical emissions or value-added shares). The simulated policy is a domestic carbon emissions cap. First, using a partial equilibrium model, we explore how OBA mitigates price increases, limits incentives for conservation in favor of lowering energy intensity, and changes relative output prices among sectors. Next, we use a CGE model from the GTAP (GTAP-EG), modified to incorporate a labor-leisure choice, to compare overall mechanism performance when income and excise taxes have a distorting effect on the economy. We see how important the rule for distributing emissions permits across sectors is for determining the effect of output-based allocations within sectors. Our main findings include the following:

This last result, which we were able to consider because of the greater sectoral detail in the trade model, raises some concerns about the distributional analysis produced by many climate policy models. Although they focus on the energy-intensive sectors, they tend to aggregate the less energy-intensive sectors together, ignoring the large variation in trade and energy price sensitivity. As a result, significant impacts of environmental policy design on some important downstream industries may be missed. Collectively, these findings indicate that rate-based allocation mechanisms can be useful for combating emissions leakage and tax interactions, although there may be some tradeoff between the two. The results also caution that, when these mechanisms are applied to a multisector pollution problem, the choice of sector-level emissions caps (or intensity targets) must be made judiciously.

A second paper compares the same allocation mechanisms when the domestic policy target is a reduction in global emissions—that is, domestic emissions net of leakage. We also model a more realistic version of the McCain-Lieberman proposal, in which some domestic sectors are not directly regulated. In this case, we find the initially surprising result that auctioned permits do not lead to the highest welfare. The reason lies in that auctioning permits causes the full cost of embodied emissions to be passed on downstream. Although this is efficient in a closed, fully regulated economy, it exacerbates leakage problems when some sectors, whether domestic firms or foreign competitors, are not covered by the emissions trading policy. Thus, we find that OBA with sectoral distributions based on value added outperforms auctioned permits, as well as the other allocation options. Value-added OBA mitigated the real price increase of the affected sectors better than the broad-based tax recycling of auctioned permits. Although OBA with sector distributions based on historical emissions seemed better at reducing leakage in the previous paper, here we find that the economic distortions from subsidizing the emissions-intensive sectors, as reflected in a much higher permit price, far outweigh those benefits.

A theoretical section of this research effort derives optimal rebates accompanying emissions taxes, given both preexisting labor taxes and incomplete participation in the regulatory program. It is an extension of Bernard, et al. (2001), and we hope to complete it with a numerical simulation solving for the optimal sectoral distributions for an OBA scheme in a carbon trading program. The theoretical results state that the optimal rebate both internalizes the marginal damages of emissions leakage and counteracts the tax interaction problem. Thus, a subsidy to the regulated sector is preferred to full recycling of the environmental tax revenues, as we saw in the preceding numerical simulations. Second, when the rebate is optimized, the optimal emissions tax just equals the marginal damages. In other words, it does not need to deviate from the Pigouvian tax to counteract preexisting distortions—the output subsidy is better positioned to do that, because those distortions arise from price increases. This is an important point that is often glossed over in the tax interaction literature, which often assumes that a rebate is not possible or that emissions rates are fixed.

Emissions Targets and Economic Uncertainty

The second part of the project has produced a work still in progress, “Emissions Targets and the Real Business Cycle.” The question at hand is whether rate-based mechanisms can be useful hedges when costs are uncertain. Traditional models that compare prices versus quantities in emissions regulation tend to focus on uncertain environmental compliance costs. This paper serves a niche by addressing uncertainties caused by the business cycle, a more realistic approach for economy-wide environmental regulation like a climate policy.

Targets that index emissions allowances to economic output have been proposed with the idea that a flexible mechanism would better allow for economic growth. How much of a boon is this flexibility? From a policy design standpoint, one could equivalently assign caps that follow a growth path or assign declining intensity targets to meet a cap. Therefore, a growth path is not an inherent feature of intensity targets, nor is a fixed emissions path a defining characteristic of emissions caps. Furthermore, when the ultimate goal is declining overall emissions and stabilization of atmospheric concentrations, either policy would have to be ratcheted over time. However, in the face of uncertain economic growth, the two policies offer different qualities. Holding expected allocations constant, intensity, and emissions targets are likely to provoke different economic responses to unexpected productivity shocks. This paper explores the impacts of such economy-wide emissions regulations on the business cycle.

First, with a single-period model of a simple economy, we show that under intensity targets, labor supply remains insensitive to productivity shocks, although consumption is no more sensitive to productivity shocks than if no policy were in place. A certainty-equivalent cap on emissions makes labor supply more volatile (pro-cyclical), but it may make consumption more stable, because you can substitute from labor toward more emissions-intensive inputs in a downturn. On the other hand, in the absence of a productivity shock, it seems to diminish labor supply (and thereby output) relative to an intensity target, because additional labor affords no additional licenses to pollute. In a next step, we are developing and simulating a dynamic model with capital investment to analyze how the magnitude and duration of business cycles are affected by the choice of emissions caps or intensity targets.

On Modeling Rate-Based Mechanisms

In the meantime, to clarify some of these modeling issues, I wrote a short background paper, “Are Absolute Emissions Better for Modeling? It’s All Relative.” To analyze the effects of rate-based policies, or to evaluate the distributional effects of any regulation on consumers and producers, output must be incorporated explicitly into an economic model of abatement, separately from the emissions variable. Two modeling options are then available. Traditionally, total emissions and output are the independently controlled variables, leaving emissions intensity as endogenously determined. Alternatively, one can make emissions intensity and output the control variables, leaving total emissions as the endogenously determined variable. One is the dual of the other and the problems are equivalent, but the latter method offers more transparency for examining intensity-based policies. This note is intended to show economists and policymakers how the intensity-based model fits into the familiar traditional context. It currently is being edited for the Resources For the Future discussion paper series.

Journal Articles:

No journal articles submitted with this report: View all 7 publications for this project

Supplemental Keywords:

public policy, decisionmaking, social science, global climate, air, analytical, , Economic, Social, & Behavioral Science Research Program, Air, Scientific Discipline, RFA, Air Quality, Social Science, decision-making, Economics & Decision Making, Ecology and Ecosystems, Economics, Market mechanisms, air pollution policy, allowance allocation, market based environemental policy, pollution fees, trading systems, emissions trading, allowance market performance, cap and trade systems, revenue recycling, market incentives, output based allocation, environmental economics, pollution allowance trading, emission fees, economic benefits, economic incentives
Relevant Websites:

http://www.rff.org/Documents/RFF-DP-04-37.pdf exit EPA (PDF, 30pp., 433KB, about PDF)

Progress and Final Reports:
2004 Progress Report
Original Abstract

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The perspectives, information and conclusions conveyed in research project abstracts, progress reports, final reports, journal abstracts and journal publications convey the viewpoints of the principal investigator and may not represent the views and policies of ORD and EPA. Conclusions drawn by the principal investigators have not been reviewed by the Agency.

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