3. Economic Theory
3.3 A comparison of Emission Tax and Tradable Emission Permits
If the permits are auctioned, and there are not any uncertainties, the outcome from tradable permits are equivalent to the outcome from taxes (Tol 2014). Both emission tax and tradable permits are likely to generate dynamic efficiency effects, and will generate incentives to adopt and implement new technology to reduce emissions. The incentives created are tax savings and the possibility of selling permits to spare, as previously mentioned. Therefore, if adapting new technology will reduce the emitters total abatement cost, there will be an incentive to reduce emissions.There also are distributional impacts, where taxes and auctioned permits generate income for the government. Revenues from emission taxes and auctioned permits can contribute to reduce tax expenditures (e.g. on labour and income), while improving environmental quality and stimulating technological innovation. This is known as Double dividend (Perman et al. 2011). Where the first dividend is the environmental impact and the second dividend is removal of distortions in the labour market. However, if the tradable permits are distributed for free, they do not generate income for the government. If the government are to implement such policies, the emitters will have incentives to report lower emission than what they actually emit to pay less taxes or permits than what they are supposed to pay (Ferraro 2008). I.e., environmental policies will also generate cost for the government related the costs of controlling and monitoring emitters to ensure compliance (Romstad 2006).
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As previously shown, both emission tax and tradable permits leads to cost-effective abating. However, in practise, we might have both uncertainties and asymmetric information and other market failures (Tol 2014). Because of these uncertainties, and that MAC may change over time, an emission tax will not give us any guarantee about reaching the specific emission level. Thus, if a specific emission level is more important to achieve than a specific emission price, then tradable permits might be a better choice.
However, if the target is based on today’s economic situation, and what the society is expected to afford, the target might not fit the future movements in the economy. Then it might be better to use emission taxes if there no specific emission level we want to reach (Ibid).
3.3.1 Uncertainties about abatement costs
Achieving a desired level of emissions is easily accomplished if the aggregated MAC function is known, and can be reached at lowest costs. However, if the aggregated MAC function is unknown, an optimal tax level or optimal permit level is harder to achieve. With uncertainty in the MAC function, price-based and quantity-based instruments will differ (Tol 2014; Weitzman 1974). As mentioned previously, deviations from the optimal level can lead to efficiency losses. Both emission tax and tradable permits generate efficiency losses when environmental instrument are based on incorrect abatement costs, i.e., over- and underestimation of abatement costs (Tol 2014), shown in Figure 9. Polluting firms will in this case adjust in a non-optimal way. However, the magnitude of efficiency loss will differ depending on which instrument is chosen (Ibid).
In case (a), the regulator imposes an emission tax at rate thunder an incorrect assumption of MAC, which is too high relative to the optimal tax rate at t*. The emitting firms will emit as long as their true MAC is above the tax, and will therefore emit at Etrue, which results in an efficiency loss equate to the green triangle. However, under a tradable permit scheme, the regulators will set a looser control, i.e., allocate too many permits relative to the optimal level under the assumption that th is the optimal price level.
This results in a smaller efficiency loss (shown by the yellow triangle) compared with the efficiency loss from using an emission tax (shown by the dark orange triangle) (Tol 2014). By using the same reasoning as above, we can see that both an over- and underestimation of MAC will lead to efficiency losses. However, the magnitude of the efficiency loss will depend on which policy is implemented. The uncertainty about marginal abatement costs influences the costs of choosing wrong policy, while uncertainty about marginal damages are irrelevant because the firms only relate to marginal abatement costs.
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Figure 9. Uncertainty about MAC, where
a) MAC overestimated b) MAC underestimated c) MAC overestimated d) MAC underestimated
Source: Based on Figure 7.3-7.6 in Perman et al. (2011, p. 237).
According to Weitzman (1974), under the uncertainty condition, these efficiency losses can be minimized by choosing the right policy. The efficiency losses are determined by the steepness of MD and MAC, where different steepness on MD and MAC results in greater disparity between optimal level and achieved level of emission (Tol 2014). This is illustrated by four cases in Figure 9. If the MD curve is flatter than the MAC curve, case (c) and (d), the regulators should choose taxes due to smaller efficiency loss than when permits are used, and vice versa if MD is steeper than MAC case (a) and (b).
This is known as the Weitzman Theorem (Ibid), and is shown in Figure 9, where the dark orange triangles represent efficiency loss when taxes are used and the yellow triangles represent efficiency loss when permits are used. Should MAC and MD be equally steep, then it does not matter which policy the regulators should choose.
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