Environmental 6: Policy in practice

Question 1

Is it a good idea to subsidise deployment of clean technology as well as research?

Answer 1

If deployment leads to ‘learning-by-doing’ effects and reduces costs, subsidies fund the public good of cheap, clean technology. However, if costs fall for other reasons, research should be subsidised instead.

Question 2

Are transaction costs a reason to deviate from the law of one price?

Answer 2

No. Transaction costs simply add to the costs in a sector, which we did not expect to be equal across sectors.

Question 3

What is a rebound effect?

Answer 3

Increases in efficiencies or reduced energy demand elsewhere can lead to reduced running costs, which can lead to substitution into more of the polluting activity.

Question 4

Does the EU ETS price seem to reflect marginal abatement costs? Why or why not?

Answer 4

No. Koch et al 2014 find that only 10% of allowance price changes can be explained by changes in short-term abatement costs. Instead, prices seem to be linked more strongly to perceived credibility of the scheme.

Question 5

What consequences do myopic participants have on an emissions trading market?

Answer 5

Myopic participants only consider the next few years, and so only consider some fraction of total supply, leading to much lower prices. If the government is committed to the cap, prices must then rise steeply. This can cause the government to do what had been anticipated - renege on the cap.

Question 6

Why is government credibility a problem in emissions trading schemes?

Answer 6

If participants think the cap will be raised or removed, they work to this reference, decreasing permit prices. This both disincentivises efficient abatement measures and adds additional volatility to the permit price.

Question 7

Is a price collar a sensible addition to an emissions trading scheme?

Answer 7

It can reduce the myopia problem and eliminate tail risks for investors. However, it cannot eliminate the problem of credibility risk.

Question 8

When, in the Weitzman (1974) model, should we use a cap-and-trade scheme rather than a carbon tax?

Answer 8

When marginal damages are steeper with respect to emissions, choosing the wrong tax level leads to much more marginal damage; whereas choosing the wrong cap level is much less of a problem.

Question 9

What practical considerations make carbon taxes difficult in practice?

Answer 9

• Carbon taxes can be manipulated for short-term political gains
• Carbon taxes are harder to set internationally
• Needs to be uprated with inflation, exchange rates, etc

Question 10

What practical considerations make cap-and-trade schemes difficult in practice?

Answer 10

• Price volatility disrupts investment incentives
• Large costs of running the scheme
• ETS may have low prices early in a phase leading to dynamic inefficiency

Question 11

What is grandfathering? Is it a good idea?

Answer 11

Grandfathering is the free allocation of permits to existing polluters. Economically, this is a bad idea, since it grants a resource rent to these polluters, incentivises low abatement if it is likely to recur, increases market power, and represents a transfer from citizens to firms. However, it may be the only way that firms will buy-in to an ETS.

Question 12

Is it easier to determine the optimal carbon tax or the optimal number of emissions permits?

Answer 12

Both require the same information: the marginal abatement cost curve and the marginal damages curve.

Question 13

What is the weak double dividend hypothesis? Is it true?

Answer 13

The weak DD hypothesis states that welfare is greater when revenues raised via environmental policy are used to reduce distortionary taxation, rather than refunded in a lump sum.

Question 14

What is the strong double dividend hypothesis?

Answer 14

The strong DD hypothesis states that the welfare improvements from reducing distortionary taxation with environmental tax revenue are so large that environmental taxes should be set above the point where marginal abatement cost equals marginal damage.

Question 15

What is the marginal revenue effect? When is it positive?

Answer 15

The marginal revenue effect is the welfare effect of changes to government revenue. If demand for pollution is relatively elastic, small changes to the tax will lead to large changes in pollution levels. So, small reductions in the tax will lead to more revenue, and the MRE is negative. If the demand for pollution is relatively inelastic, higher taxes will lead to more revenue, and the MRE is positive.

Question 16

What is the marginal interaction effect? When is it positive?

Answer 16

The marginal interaction effect is the welfare effect of changes to consumer surplus in other markets when the environmental tax changes. This is usually negative, but can be positive when leisure and the polluting good are complements, for example.

Question 17

When might political and informational constraints make the weak double dividend hypothesis false?

Answer 17

If we cannot target more efficiently than a lump-sum redistribution, the weak DD is false. Alternatively, the political salience of the rebate may increase the political acceptability of the policy to a critical level.

Question 18

Why are carbon taxes typically regressive?

Answer 18

Energy is an essential good, and so poorer households tend to spend a larger fraction of their income on dirty goods. Higher-income households spend more on services, which are less carbon-intensive.

Question 19

Are tax-and-dividend policies progressive? Who do they make worse off?

Answer 19

Yes. As well as the richest, they make poorer people who use abnormally high amounts of energy worse off - such as those living in poorly insulated houses.

Question 20

Can carbon taxes be made horizontally equitable?

Answer 20

No. Although the poorest who use the most energy are hurt by carbon taxes, compensating them directly for this undoes the point of the carbon tax.

Question 21

Why do marketplaces work better for emissions reduction than for biodiversity enhancement?

Answer 21

Emissions reductions have identical benefits everywhere, need no other nearby action to work well, and are easy to quantify. Biodiversity, by contrast, is highly heterogenous, difficult to measure and relies on coordinated efforts and ecological complementarities.

Question 22

How can marketplaces be run for biodiversity enhancement?

Answer 22

Complementarities can be taken into account only in a one-off marketplace where all trades are simultaneously evaluated. Auctions for biodiversity subsidies can therefore generate efficient ways to cultivate habitats.