Saturday, March 14, 2009

Greenhouse gas emissions and policy instruments

Ross Gittins writes in today's The Age on the relative merits of taxes versus permits.

To cut emissions start by capping windy economists, by Ross Gittins, The Age ... According to a growing band of economists, we'd be better off using a carbon tax to reduce greenhouse gas emissions, not the emissions trading scheme the Rudd Government introduced to Parliament this week......

(I)f there's a reason for economists preferring one system, I think it's which objective they give higher priority: minimising economic cost or maximising environmental certainty.

If your concern is emissions reduction you control emissions quantity; if your concern is minimising economic loss then you control emissions price.

These last two sentences provide a potentially misleading picture of how economists think about greenhouse gas emissions and policy instruments to reduce these emissions.

1. When economists consider the "economic" costs of pollution or pollution control, they not only include the costs of pollution abatement. They also include the costs of environmental damages such as health impacts, lost output from climate change, lost producer and consumer surplus from degradation of environmental resources and amenities etc. As is often the case, if economists are interested in minimising the (unweighted) sum of these costs (formally, this occurs at the level of emissions reduction where the marginal costs of abatement equal the marginal benefits from abatement), policy prescriptions do not depend on economists' vision of a good society, or "which objective they give higher priority".

2. While permits do minimise uncertainty with regards to the level of emissions reduction (with taxes, the level of emissions reduction depends on polluters own cost-benefit calcuations), they do not "maximise environmental certainty". Uncertainty with regards to how rapidly atmospheric greenhouse gas concentrations will grow given the expected level of future greenhouse gas emissions with and without emissions reduction, and how higher greenhouse gas concentrations will affect global temperatures, is a given regardless of which policy prescription is adopted.

3. Taxes and pollution permits are equivalent policy instruments if there is no uncertainty with regards to pollution control costs. If the optimal number of permits are issued, the price will be bid up to the level of the appropriate (Pigouvian) tax. The choice of policy instrument will only yield different outcomes if uncertainty exists. In this case, following Martin Weitzman's classic 1974 paper in the Review of Economic Studies:
- Permits will be preferable if the marginal benefits from emissions reduction are highly sensitive to the actual quantity of emissions (such as the case of tipping points in the case of hazardous waste, when small changes in emissions have a large effect on environmental damages); and
- A tax will be preferable when the marginal abatement or pollution control cost increases sharply with emissions reduction (in this case incorrect costs estimates and subsequent excessive or inadequate supply of permits will have a large effect on total costs); therefore
- If the absolute slope of the marginal cost of abatement curve is greater than that of the marginal benefit from emissions reduction curve, taxes will lead to higher social welfare than will permits.

Of course, many of these issues are empirical in nature, and policy makers often lack the required information. I share Mr Gittins concern that, given the possible existence of tipping points in relation to greenhouse gas emissions and their impact on the environment, an emissions tax would lead to too little emissions reduction if the costs of abatement are higher than policy makers expect.

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