Prices and Quantities in a Climate Policy Setting Svante Mandell

Observations and aim

In practice (the EU):● Overarching quantitative target for CO2

● A dual regulation; CaT and emission taxes

Under uncertainty, emissions taxes outperform CaT for handling GHG

Q: (When) is a dual regulation justifiable?

The model

Starts in a classic Weitzman (-74) setting● Linear MAC- and MAB-functions● Uncertainty (additative, symmetric round zero)● Aggregate abatement benefits relevant

Answers if CaT or emission tax is preferable

CO2 causes a stock externality

A flat MAB

Variation in emissions ‘better’ than variation in price Use a tax

The model, cont.

Mandell (2008), JEEM:

Allow for dual regulation● Tax a subset of emitters, the rest CaT

Outcome closer to optimum, but not cost effective

Full CaT never optimal, full tax optimal for (sufficiently) flat MAB-functions

The model, cont.

This paper:● Flat (horizontal) MAB-function● A global cap that may never be exceeded● Two periods

Intuition: ● The global cap may require high tax to be met full tax

may not be optimal

Timing of the model

STAGE 0

Policy maker decides on share to tax and tax level

STAGE 1

Emitters choose emission volumes

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STAGE 2

Emitters choose emission volumes

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Policy goal

Policy maker strives to● Minimize present value of expected efficiency loss● S.t. the global cap must not be exceeded

Thus, we need an expression for E{DWLtot}

Two sources of eff. loss

nNLN

KNNTLQNTLQKNNnNnan

LN

NLQKNfnNnNna

nNLN

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NLQKNfnLQKNfNanNnNnaDWLE tot

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Volume error

Actual emissions differ from efficient amount

Allocation error

Abatement efforts not distributed in a cost effective manner

Per

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d 2

The taxes

As low as global cap permits, but never below the MAB

Less stringent global cap lower taxes

Period 1 is ”sunk” when setting T2

● T2 typically lower than T1, due to surplus

Taxes increase in share of taxed emitters

0

0,25

0,5

0,75

1

-1 -0,75 -0,5 -0,25 0 0,25 0,5 0,75 1

n* / N = 0

 = 0.5

 = 1

”Strict” global caps, i.e., a cap below expected efficient level

Optimal share to tax (n*)

”Lenient” global caps, i.e., a cap above expected efficient level

= discount factor

At =0 the model becomes a one-period model (outcomes in period 2 are given zero weight)

Some intuition for n*

Start in a situation where● Global cap = expected efficient level● All emitters are in CaT

At low MAC realizations – too high emissions

At high MAC realizations – too low● Thus, an expected volume error● But no allocation error

Some intuition for n* (cont.)

Move some emitters to taxed sector● At low realizations; decreased error● At highest realization; emissions equal global cap● Other high realizations; increased error● And also an allocation error

Motivates a small taxed sector

Some intuition for n* (cont.)

Now, consider a higher global cap

A larger set of realizations will yield a decrease in efficiency loss

Motivates taxing a larger share

Thus, n* increases in the global cap

The role of the discount factor

Most likely a surplus in period 1● Policy maker may not destroy permits – increased cap period 2

Lenient cap period 1 even more so period 2 risk for large efficiency loss

Stringent cap period 1 less stringent period 2 may decrease efficiency loss

The role of the discount factor

0

0,25

0,5

0,75

1

-1 -0,75 -0,5 -0,25 0 0,25 0,5 0,75 1

n* / N = 0

 = 0.5

 = 1

More weight on period 2 calls for a lower n* under leninet global cap…

…but a higher n* under stricter global cap

Conclusions

Often, a dual regime is better than full emissions tax or CaT

Even accounting for not cost effective

This depends on● The global cap vs. E{eff. emissions}● Indirectly the slope of the MAC vs MAB● The discount factor

Actual EU policy

Contains both crucial elements● A quantitative target and a flat MAB, but:

The ’global cap’ is not entirely fixed, e.g., CDM● Suggests the model underestimates the optimal share to tax

Trading firms may bank ’individually’● Suggests the model overestimates the optimal share to tax