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

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Objective:
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.

Approach:
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.
Expected Results:

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.

References
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.

Supplemental Keywords:
emissions trading, output-based allocation, emissions permit allocation, revenue recycling, double-dividend, tax interaction effects, cap-and-trade, incentives, emission intensity

Metadata

EPA/NSF ID:
R830991
Principal Investigators:
Fischer, Carolyn
Technical Liaison:
Research Organization:
Resources for the Future
Funding Agency/Program:
EPA/ORD/Incentives
Grant Year:
2002
Project Period:
June 1, 2003 to May 31, 2005
Cost to Funding Agency:
$62,500
Project Status Reports:
2004 Progress Report
Rate-based policies targeting emissions intensity are gaining popularity as policymakers balance twin goals of environmental protection and economic growth. Examples include: (1) 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; (2) rebating emission taxes according to market share, as with the Swedish NOx tax; and (3) distributing emission permits according to output, as proposed for some states in the State Implementation Plan 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. There are often important tradeoffs in terms of efficiency, however, because OBA implicitly subsidizes production, unlike conventional lump-sum allocation mechanisms like grandfathering.

The first objective of this research project is to investigate how OBA interacts with other distortions in the economy, such as pre-existing 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 pre-existing 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 instead tied to the value of the emissions.

The second objective of the project is 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. After a seminal paper by Weitzman in 1974, 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 and recognize 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.

Progress Summary:


Substantial progress has been made on the first part of the project, OBA and tax interactions. One article is complete and was placed in the Resources for the Future (RFF) discussion paper series; it has been presented at two major conferences and soon will be submitted to an economics journal. Additional applications also are underway. The concentration on tax interactions has expanded to include issues of international competitiveness and the leakage of emissions through international trade. Early work towards an extension of a previous theoretical paper with another author (Alain Bernard) was abandoned when that coauthor became unavailable. Consequently, the empirical work was refocused with Alan Fox, a computable general equilibrium (CGE) modeling expert at the International Trade Commission. Although potentially less elegant than Bernard’s stylistic CGE model, the trade model is more detailed and generates equally (if not more) useful information for understanding the welfare effects of different allocation mechanisms. Furthermore, it offers much better opportunities for practical applications, such as exploring the sector-specific effects of economy-wide environmental policies (e.g., a carbon emissions cap-and-trade program).

In “Output-Based Allocations of Emissions Permits: Efficiency and Distributional Effects in a General Equilibrium Setting With Taxes and Trade,” we compare different rules for allocating emissions allowances within sectors (e.g., lump-sum grandfathering, OBA, and auctioning) and among sectors (e.g., according to historical emissions or value-added shares). The simulated policy is a 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 Global Trade Analysis Project, 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:

    • The output subsidies implicit in OBA mitigate tax interactions, which can lead to higher welfare than grandfathering.
    • When the sectoral distributions are based on value added, OBA generates effective subsidies that are similar to a broad-based tax reduction, performing similar to auctioning with revenue recycling, which generates the highest welfare.
    • When sectoral distributions are based on historical emissions, OBA supports the output of more polluting industries to a greater extent, which more effectively counteracts carbon leakage but is more costly in terms of welfare.
    • Industry production and trade impacts among less energy-intensive sectors also are shown to be quite sensitive to allocation rules.
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 and ignore 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; however, 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. Possible extensions are discussed in “Future Activities.”

A background theoretical paper has been produced to address the second part of the project, which is less complete. 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 environmental compliance costs. A recent paper by Philippe Quirion retains this focus on abatement costs but considers relative caps by allowing business-as-usual emissions to vary; however, he adopts a restrictive assumption regarding the form of abatement costs. I believe that to consider rate-based mechanisms properly, one must include production costs and output explicitly, as well as emissions. To this end, a theoretical model has been developed. Currently, I am experimenting with different kinds of cost shocks and functional forms to derive results that map sensibly into the previous literature. An important research question is how rate-based mechanisms perform under different kinds of uncertainty. For example, does it matter whether the uncertainty lies in production costs (and thereby the baseline levels of economic activity) or in the costs of emissions reduction? What is the role of uncertainty in the demand for output? These questions seem particularly relevant for the design of long-run environmental policies that apply to energy industries.

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 then are available. Traditionally, total emissions and output are the independently controlled variables, leaving emissions intensity as the endogenously determined variable. Alternatively, one can make emissions intensity and output the control variables, leaving total emissions as the endogenously determined variable. The problems of each option are similar, 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. Currently, it is being edited for the RFF discussion paper series.

Future Activities:

Alan Fox and Carolyn Fischer are considering two potential extensions using the CGE model. One extension involves solving for the “optimal” sectoral distributions of allowances to be allocated based on output to maximize welfare and/or minimize emissions leakage given the concerns of labor tax distortions and international competitiveness. We will determine what kind of output support is preferred for each kind of sector when reductions of the global pollutant must be truly additional compared to when the country seeks to minimize the costs of complying with a domestic emissions cap. A second extension would capitalize on a relative strength of the trade model and consider the effects of restricting the emissions cap policy to cover only certain energy-intensive sectors. Thus, the potential for leakage exists not only through international trade, but also through the redistribution of economic activity among domestic sectors. We aim to address the extent to which OBA can mitigate these problems and determine the appropriate rules for distributing allowances at the sector level. I expect substantial further progress to be made and hope at least one additional paper in this area will be finalized.

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

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