Rate-Based Allocation Mechanisms for Market-Based Environmental Policies: Interactions with Pre-Existing Taxes and UncertaintyEPA 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: Hahn, Intaek
Project Period: June 1, 2003 through May 31, 2005
Project Amount: $62,500
RFA: Market Mechanisms and Incentives for Environmental Management (2002) RFA Text | Recipients Lists
Research Category: Economics and Decision Sciences
Rate-based policies targeting emissions intensity are gaining popularity, as policy makers balance twin goals of environmental protection and economic growth. Examples include tradable performance standards, as used in the U.S. 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 SIP Call for NOx and for some European programs for carbon trading. Also known as output-based allocations (OBA)-since 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 are often important tradeoffs in terms of efficiency.
This project proposes two extensions to work already completed under EPA-STAR. The first extension will investigate how OBAs interact with other tax distortions in the economy. Since 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 taxes on labor or consumption. According to the bulk of the literature on tax interactions, without such revenue recycling, environmental regulations that raise prices can exacerbate pre-existing distortions and raise the overall cost of the regulation. On the other hand, OBAs recycle 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, since the implicit subsidy is not optimized but rather tied to the value of the emissions. Bernard, Fischer and Vielle (2001) investigated when OBA might be appropriate to prevent emissions leakage when some polluters cannot be regulated– this extension will incorporate a revenue requirement and a labor tax into the model. The goal is to evaluate under what market and regulatory conditions OBA might be preferred to standard revenue recycling that lowers labor taxes. The model differs from many traditional “double-dividend” models, in that it allows for incomplete regulatory coverage and does not assume constant returns to scale in production. The latter change means that emission intensity can be reduced by a technology involving additional labor costs, rather than only by using less of a polluting fuel input. Thus, we can evaluate the importance of this variation as well.
The second part of the project aims 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 Weitzman (1974), a literature has developed to compare price-based (tax) versus quantity-based (cap-and-trade) mechanisms, when policy makers 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. Since OBAs affect 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.
Both of these research questions are important for understanding the pros and cons of OBA. Allocation of emission rents is a key aspect of policy design, especially for achieving stakeholder acceptance of new environmental regulations. Thus, it is critical for policy makers to know whether and when that is best achieved through limited grandfathering, followed by greater auctioning of emissions caps (as suggested and Goulder, 2002), or by policies targeting emissions intensity instead.
Bernard, A., C. Fischer, and M. Vielle (2001), "Is There a Rationale for Rebating Environmental Levies?", RFF Discussion Paper 01-31. Washington, DC: Resources for the Future.
Goulder, Lawrence H. (2002), “Mitigating the Adverse Impacts of CO2 Abatement Policies on Energy-Intensive Industries,” RFF Discussion Paper 02–22. Washington, DC: Resources For the Future.
Weitzman, M. L. (1974), “Prices vs. Quantities,” Review of Economic Studies 41(4): 477-491.