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2005 Progress Report: Dynamic Adjustment to Incentive-Based Environmental Policy to Improve Efficiency and Performance
EPA Grant Number: R830990Title: Dynamic Adjustment to Incentive-Based Environmental Policy to Improve Efficiency and Performance
Investigators: Burtraw, Dallas , Palmer, Karen
Institution: Resources for the Future
EPA Project Officer: Wheeler, William
Project Period: June 1, 2003 through May 31, 2005
Project Period Covered by this Report: June 1, 2004 through May 31, 2005
Project Amount: $173,684
RFA: Market Mechanisms and Incentives for Environmental Management (2002)
Research Category: Economics and Decision Sciences
Description:
Objective:Policymakers advance economic efficiency when they set policy goals at levels that equate the marginal costs of additional pollution controls with the marginal benefits of improving environmental quality. Theory and experience indicate that economic efficiency is also advanced when policymakers employ market-based approaches, such as tradable permits, to achieve these goals in a least cost manner. When attempting to set goals, policymakers face a great deal of uncertainty about the costs and benefits to society of achieving a particular goal and, in particular, how those costs and benefits likely are to change over time. Ideally, policymakers would like to be able to update environmental targets specified in legislation or regulation as new information about the costs or benefits of achieving a particular target becomes available.
This project addresses the incorporation of new information about costs into market-based environmental policy. When policymakers adopt the use of market-based policies, they put into place an institution that provides instantaneous information about the costs of compliance. This information may be used to update emission targets.
The objective of this research project is to examine regulatory approaches that extend the use of market-based environmental policy to facilitate the updating of environmental targets to reflect new information about the cost of the policy. We consider several mechanisms that could be used to make regulation more flexible and adjust to new information. We evaluate the robustness of different approaches in different situations and in response to various sources of uncertainty. A secondary focus is to consider the incentives for continual improvement in environmental performance that such an approach may provide. To make the research concrete and relevant to contemporary policy, we focus on emissions of NOx, SO2, and CO2 from the electricity sector, although we aim to draw lessons that have more general applicability.
Progress Summary:The research activity in the last fiscal year involved completion of the modeling capability using Resources for the Future’s Haiku electricity market model and the exercise of that model in a direct comparison of policy instruments, including a symmetric safety valve, a quantity target, and an emissions fee (tax). The symmetric safety valve is a mechanism that adjusts a quantity target in two ways: (1) In the case of unanticipated high compliance costs, it places additional allowances on the market at a predetermined price. (2) In the case of unanticipated low compliance costs, it adjusts the emission target by removing allowances from the market.
The modeling for two scenarios has been completed and currently is being written up into a manuscript. The scenarios involve two pollutants considered separately. One is SO2 and the other is CO2. In each case, we analyze an emission target and run the Haiku model to find a least-cost strategy for compliance on an industry-wide basis. In subsequent analysis, we will integrate the Haiku model with a benefits model, but for the present purpose, we simply take the marginal cost of compliance with the aggregate emission target as a proxy for marginal benefits. This proxy is reasonable under the assumption that the regulator is well informed, marginal benefits are measurable, and the policy aims to be efficient. Substantial literature suggests that for both pollutants, the marginal benefits are roughly constant over a large range. Therefore, we take the marginal benefits of the emission reductions as constant and analyze potential unanticipated events.
One event is a shock that raises compliance costs. Given the quantity constraint of an emission target, the marginal costs of compliance will rise above the constant marginal benefits, introducing inefficiency compared to the baseline (the absence of the unanticipated price shock). We solve a series of models to estimate the inefficiency of the quantity constraint compared to a more flexible mechanism, and we compare the quantity instrument with a safety valve approach.
The least-cost approach to compliance given constant marginal benefits and uncertainty with respect to costs is a tax approach, as illustrated by Weitzman in 1974 and subsequently by many other authors. The advantage of the tax approach is that the tax can be set to equal marginal benefits and, therefore, compliance efforts will adjust so that marginal costs will equal the tax and indirectly equal marginal benefits.
There are a number of reasons, however, that policymakers and advocates have avoided price instruments such as a tax in favor of quantity instruments such as emissions trading. Therefore, the purpose of this project is to ascertain the potential benefits of a symmetric safety valve as a way to improve on the inflexibility of the quantity approach.
We characterized a safety valve, set at an arbitrary level that is part way between the marginal benefits, which are constant, and the marginal costs obtained under the original quantity constraint. The safety valve leads to additional allowances being placed on the market, which increases emissions, but it also leads the marginal cost of compliance activity to better approximate the marginal benefits of compliance.
The example described above pertains to the safety valve as it has been developed in the previous literature. The main point of this research concerns the innovation of adding a symmetric component to the safety valve so that if an unanticipated reduction in costs occurs, the emission target would adjust to remove some of the inefficiency of a fixed quantity target. In the case of an unexpected reduction in cost, the fixed quantity target would lead to a marginal cost that was below the constant marginal benefit as originally constructed. A tax instrument would avoid the inefficiency that results, because if the tax were set equal to marginal benefit, the instrument would provide an incentive for the firm to reduce emissions up to the point where marginal costs were equal to the tax, and marginal costs would, therefore, indirectly equal marginal benefit.
There are two challenging issues in this research at this point. The first issue is the characterization of the institutions that may evolve. Some of the questions that arise are: (1) How is the value of emission allowances that are introduced to the market or removed from the market dealt with? (2) Should they be auctioned? (3) Should the government purchase allowances off of the market? (4) Should compensation be offered to firms that lose allocations of emission allowances?
The second issue is the measure of inefficiency. We rely on two approaches. The first approach is to measure the financial compliance costs, which include the changes in investment in postcombustion controls, fuel use, and investment in generation equipment. The second approach is an economic measure of social surplus as the sum of producer surplus and consumer surplus. The surplus approach is theoretically preferable; however, it introduces a new consideration. In the real world, and in our model, the price of electricity does not equal the marginal cost of providing electricity in most cases. Consequently, changes in costs and prices occur in a setting where there are preexisting distortions of economic efficiency in production. When we solve the model using the symmetric safety valve or any of the other instruments, we find that the measure of economic surplus does not match our expectations a priori. In some cases, the policy amplifies the preexisting distortions. In other cases, the policy diminishes the preexisting distortions. The major issue we face in completing the current manuscript is finding a way to measure efficiency with respect to the pollution problem in a distinct way that is not commingled with efficiency issues stemming from how the price of electricity is determined.; Problems always beget opportunities. In subsequent analysis, we think the commingling of these related efficiency issues would be a valuable extension to the standard analysis.
Preliminary analysis indicates that there are three primary sources of uncertainty that affect model results. These sources are technological change, electricity demand, and natural gas prices. Changes to the model have been completed to enable us to account for each source of uncertainty. For the current manuscript, we are varying only natural gas prices. In subsequent analysis, however, we will look at each form of uncertainty to see how they might interrelate, especially in a dynamic context with investment decisions evolving over time.
Some of the development of modeling capability leveraged restricted support from other public agencies, including the New York State Energy Research Development Authority and the State of Maryland Power Plant Research Program, as we mentioned in a previous annual report. The work for these complementary projects has been completed. Some new complementary funding for questions related to this project has been received from a foundation that is interested in the design of environmental policy.
Future Activities:We have asked for a no-cost extension to complete the research under this grant. We will complete the manuscript that has already been started and initiate one or more followup studies to address key questions. One question concerns the intertemporal value of the symmetric safety valve. To conduct this analysis, we would apply a discount rate and look at welfare changes over time. A second challenge is to attempt to find a safety valve target that follows a theory. Currently, we are hypothesizing the magnitude of the safety valve. Although we can show the advantage relative to the quantity target, there are policy and economic reasons that the symmetric safety valve would not converge all the way to a tax, thereby allowing zero variability in marginal costs.
The simulation modeling can provide convincing results, but it is especially useful for generating hypotheses. Subsequently, we will return to analytical methods to look for general propositions based on the hypotheses that are generated. We also plan to use the model to examine the various institutions that have been proposed in the economics literature and by some state agencies and advocacy groups. We will examine these institutions from the viewpoint of efficiency and distributional consequences.
Journal Articles:No journal articles submitted with this report: View all 7 publications for this project
Supplemental Keywords: air, global climate, integrated
assessment, particulates, public policy, cost-effectiveness, benefit-cost analysis,
pollution controls, environmental quality, emission targets, environmental
policy, emissions reduction,
,
ENVIRONMENTAL PROTECTION AGENCY, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, RFA, Social Science, decision-making, Economics & Decision Making, Reinvention, Ecology and Ecosystems, Economics, Market mechanisms, compliance costs, allowance allocation, decision analysis, incentives, market-based mechanisms, decision making, emissions trading, allowance market performance, cap and trade systems, market incentives, effects of policy instruments, environmental economics, compliance behavior, emission fees, incentive based environmental policy, environmental decision making
Relevant Websites:
http://www.rff.org
Progress and Final Reports:
2004 Progress Report
Original Abstract
Final Report