L8: Policy with imperfect information; Criteria 6-9

Question 1

Estimation of costs and benefits is necessary where the info available to the EPA is ___

Why would it not be efficient to search for info?

Answer 1

Estimation of costs and benefits is necessary where the info available to the EPA is imperfect

Those who possess the info may have little incentives to truthfully reveal it

Question 2

Identifying abatement benefit is a two-stage process:???

Answer 2

▪ Identifying abatement benefit is a two-stage process:

(i) the impact of abatement must be established and
(ii) monetary valuations attached. Yet valuation is beset by theoretical & practical problems. Even no consensus on validity of current valuation techniques.

Question 3

Name the 4 criteria for policy instrument choice that depend on certainty.

Answer 3

Dependability
Flexability
Costs of use underuncertainty
Information requirements

Question 4

Dependable if it can be relied on to meet a ___ ___

▪ Emissions quantity controls and price controls will have known _____ outcomes

▪ With full knowledge of the____ _ _ _ function the emissions __ ___can be determined to achieve a target level of emissions

▪ Once that tax rate is introduced, ____ takes place at the desired level, as shown in the top half of the next slide where a single aggregate MCA is drawn with certainty on behalf of the EPA

Answer 4

Dependable if it can be relied on to meet a predetermined target

▪ Emissions quantity controls and price controls will have known quantity outcomes

▪ With full knowledge of the aggregate MCA function the emissions tax rate can be determined to achieve a target level of emissions

▪ Once that tax rate is introduced, abatement takes place at the desired level, as shown in the top half of the next slide where a single aggregate MCA is drawn with certainty on behalf of the EPA

Question 5

Draw the graphs of a comparison of emissions taxes and marketable permissions permits when abatement costs are uncertain

Answer 5

Slide 8

Question 6

▪ Consider one particular form of imperfect info- the EPA does not know the position of the ___ MCA function with certainty. Difference in outcomes between price-based (____ and ____) and quantity-based instruments (____ and ___ ____).

▪ With emissions tax the amount of ____ that results from any given rate of tax will not be certainly known, as it depends on the unknown position of the abatement cost function.

▪ Licences & ____ permits are dependable in terms of abatement (although there will be uncertainty about the size of abatement costs and, with marketability, the ____ of permits).

▪ Uncertainty with regard to the true MCA for a price system translates into uncertainty about the ___ of abatement. Uncertainty with regard to the true MCA for a quantity system translates into uncertainty about ___ or costs. The differing way in which uncertainty
affects taxes and permits is shown in the bottom half of Fig 7.1 (_ possible MCA functions).

Answer 6

▪ Consider one particular form of imperfect info- the EPA does not know the position of the aggregate MCA function with certainty. Difference in outcomes between price-based (taxes and subsidies) and quantity-based instruments (licences and marketable permits).

▪ With emissions, tax the amount of abatement that results from any given rate of tax will not be certainly known, as it depends on the unknown position of the abatement cost function.

▪ Licences & marketable permits are dependable in terms of abatement (although there will be uncertainty about the size of abatement costs and, with marketability, the price of permits).

▪ Uncertainty with regard to the true MCA for a price system translates into uncertainty about the quantity of abatement. Uncertainty with regard to the true MCA for a quantity system translates into uncertainty about prices or costs. The differing way in which uncertainty
affects taxes and permits is shown in the bottom half of Fig 7.1 (3 possible MCA functions).

Question 7

It is sometimes claimed that emissions ____ and ___-_____ licences allow the EPA to control emissions more dependably than ____ under uncertainty

▪ Some __ ___ ___ instruments are not dependable e.g. technology requirements because the emissions outcome cannot be known beforehand.

Answer 7

It is sometimes claimed that emissions quotas and non-tradable licences allow the EPA to control emissions more dependably than permits under uncertainty

▪ Some CAC instruments are not dependable e.g. technology requirements because the emissions outcome cannot be known beforehand.

Question 8

Flexibility:

Where decisions are made with___ ___, the flexibility of an instrument is of little or no value.

▪ But with uncertainty, the EPA might need to learn adaptively by ___ ___ ___, and to change the rates or levels at which instruments are applied as new information arrives.

▪ Generally, the more flexible an instrument is, the better. But it is ____ to find any general conclusions about the relative flexibility of different instruments.

▪ Suggestion that ___-based incentive instruments are inflexible as there is inherently strong ___ to changes in rates.

▪ Changes in ____ and ___ are not subject to such strong resistance

Answer 8

Flexibility:

Where decisions are made with perfect information, the flexibility of an instrument is of little or no value.

▪ But with uncertainty, the EPA might need to learn adaptively by trail-and-error, and to change the rates or levels at which instruments are applied as new information arrives.

▪ Generally, the more flexible an instrument is, the better. But it is difficult to find any general conclusions about the relative flexibility of different instruments.

▪ Suggestion that price-based incentive instruments are inflexible as there is inherently strong resistance to changes in rates.

▪ Changes in licences and permits are not subject to such strong resistance

Question 9

Flexibility:

___ ___ ___ instruments might also be more flexible relative to permit trading. Trading schemes may be ____ to design and it may not be a simple task to ___ such schemes. Piecemeal ____ could be implemented easily using CAC.

▪ Another way of thinking about these issues are whether price changes or quantity changes are ___ less desirable. Quantity changes could incur larger transactions costs

▪ ____ standards can be inflexible. They impose large ____ costs

Answer 9

Flexibility:

CAC instruments might also be more flexible relative to permit trading. Trading schemes may be costly to design and it may not be a simple task to modify such schemes. Piecemeal changes could be implemented easily using CAC.

▪ Another way of thinking about these issues are whether price changes or quantity changes are socially less desirable. Quantity changes could incur larger transactions costs

▪ Technological standards can be inflexible. They impose large capital costs

Question 10

Choices made today using available info may turn out not to be appropriate in hindsight

▪ Such errors generate costs:

(i) Cost of
(ii) Cost of

Answer 10

Choices made today using available info may turn out not to be appropriate in hindsight

▪ Such errors generate costs:

(i) Cost of incorrect target
(ii) Cost of failing to attain target at least cost

Question 11

Draw graph showing the costs of selecting the wrong target

where is the Total Net Social Benefit at that level of emission

Answer 11

slide 14

Question 12

Draw the graph where the assumed MC is outside the True MC and show the loss when the emissions are higher and lower than the optimal level

Answer 12

slide 15,16

Firms abate emissions as long as MCA(true) is
below the tax so they emit Mt.
▪ Efficiency loss is the shortfall of benefits at Mt
compared to the maximum possible M* i.e. the
hatched area
▪ Compared with an emissions licence system, the
EPA thinks that the efficient target is LH (rather
than M*).
▪ Incorrect info leads to an insufficiently tight
control of emissions. Efficiency loss equal to the
solid area

Question 13

Draw graph of the scenairo where there is an underestimation of the abatement cost?

Answer 13

slide 17

Emissions tax results in a loss (hatched area) that
is greater than the loss associated with licences
(solid area)

▪ The loss from a tax exceeds that from licences.
This result is dependent on how we construct the
MCA and MD functions (i.e., the slopes)

Question 14

Draw an underestimation and overestimation of the abatement cost curve for a much flatter Marginal Damage curve

How does the ranking of the instruments change with the steepness of the MD curve?

Answer 14

▪ The above graphs are analogues of the above two situations, but are drawn with a substantially
flatter marginal damage curve.

▪ As before, both instruments generate efficiency losses with mistakes about MCA. However, the
ranking of the instruments changes as the loss is larger with licences

▪ When MCA is flatter than MD, licences are preferred to taxes as they yield smaller efficiency losses. When MCA is steeper than MD curve taxes are preferred to licences- smaller efficiency

Question 15

Conclusions so far do not carry over to damage
costs.

▪ In this case, choice of instrument (quantity vs.
price-based) has no effect on the ___ ____
arising from errors in estimating damage cost

▪ The size of the loss is the same in each case.
Given the estimated MD and the MCA(true),
EPA sets a tax rate t or a quantity control L.
Realised emissions are ____ than efficient
emissions.

Answer 15

Conclusions so far do not carry over to damage
costs.

▪ In this case, choice of instrument (quantity vs.
price-based) has no effect on the efficiency loss
arising from errors in estimating damage cost

▪ The size of the loss is the same in each case.
Given the estimated MD and the MCA(true),
EPA sets a tax rate t or a quantity control L.
Realised emissions are greater than efficient
emissions. Shaded area is the efficiency loss

Question 16

Imperfect info puts restrictions on the EPA to devise efficient targets.

▪ Strong incentives for the EPA to become better informed. Three ways to do this:

Answer 16

Imperfect info puts restrictions on the EPA to devise efficient targets.

▪ Strong incentives for the EPA to become better informed. Three ways to do this:

(i) Undertake its own research
(ii) Build long-term relationships
(iii) Create reward structures for being truthful

Question 17

▪ x2 Limitations of the EPA : (i) Undertaking its own research and Building long-term relationships

Answer 17

(i) research is costly and well before complete
knowledge is gained, the marginal cost of research exceeds its marginal benefit

(ii) regulatory capture where relationship may undermine regulatory independence.

Question 18

Growing preference for EPA to use ___ ___ for being truthful to develop incentive compatible instruments where incentives generate behaviour which are compatible with the objectives of the regulator.

▪ The instruments discussed so far have not exhibited this property.

▪ Where polluters think that the numbers they report can influence the severity of regulation, there is an incentive to lie about the ___ of ____ with abatement targets

▪ Two illustrations of incentive effects:
(i) when firms expect a ___ ____ _____

and (ii) when they expect an ___ ____

Answer 18

Growing preference for EPA to use reward structures for being truthful to develop incentive compatible instruments where incentives generate behaviour which are compatible with the objectives of the regulator.

▪ The instruments discussed so far have not exhibited this property.

▪ Where polluters think that the numbers they report can influence the severity of regulation, there is an incentive to lie about the cost of compliance with abatement targets

▪ Two illustrations of incentive effects:
(i) when firms expect a marketable permit scheme

and (ii) when they expect an emissions tax

Question 19

Draw graphs of when the firm expects a permit system (2)

explain the process behind the plotting of the curves and the incentives for them

Answer 19

slide 22

Firms believe the EPA will set total permits at L. Firms
know the EPA will make its decision on total permits
after they have provided info about MCA. See Panel a
▪ If firms honestly report MCA, L permits are issued and
the price of a permit is mu*. If firms lie and overstate, EPA will think that MP is the efficient target and issues LP

▪ Exaggerating abatement costs is better for firms than
being truthful as more permits are issued, and so they
incur lower real emission abatement costs

▪ EPA expects a permit price of MuP1 but the actual permit price is MuP2 because the true marginal abatement cost function is the demand curve for permits

Question 20

Draw graphs of when the firms expects an emissions tax (2)

Answer 20

slide 23

Firms know the EPA will set the tax rate after they
have provided info about MCA. See Panel b
▪ If MCA(true) is reported then tax rate of Mu* is levied leading to M*. If firms understate, then the EPA
believes that Mu T is the efficient tax rate, yielding MT1
emissions

▪ Firms benefit because they emit more than if they
told the truth because the EPA expects MT2. This info
will prove useful to the regulator. Firms gain overall
because they can emit MT1 and pay a lower tax rate.

Question 21

▪ Whether a ___ or a ____ system is used, untruthful behaviour is revealed ___ the event. EPA observes difference between ___ and ___ permit price (or emissions).

▪ Can also deduce the ____ abatement costs have been misreported. Possible to adopt an iterative process, ____ the number of permits issued (or tax rate) until there is ___ ____ between actual and expected outcomes.

▪ But this may not be politically feasible, or it may involve large costs in making successive adjustments.

Answer 21

▪ Whether a tax or a permit system is used, untruthful behaviour is revealed after the event. EPA observes difference between expected and actual permit price (or between actual and expected emissions).

▪ Can also deduce the direction abatement costs have been misreported. Possible to adopt an iterative process, changing the number of permits issued (or tax rate) until there is no difference between actual and expected outcomes.

▪ But this may not be politically feasible, or it may involve large costs in making successive adjustments.

Question 22

What is the name of an instrument which will encourage truthful behaviour and allow the EPA to achieve its objective?

Answer 22

An incentive-compatible instrument

Question 23

Give an example of An incentive-compatible instrument

Answer 23

▪ Combination of market permits and an abatement subsidy on ‘excess’ emissions reduction

Question 24

The MCA reported by firms have two effects:

Answer 24

▪ The MCA reported by firms have two effects:

(a) they influence the number of permits issued, and
(b) they also influence the subsidy received for excess emissions reduction.

▪ The scheme balances these two influences so as to reward truthful reporting.

Question 25

Combination of market permits and an abatement subsidy on ‘excess’ emissions reduction

The scheme works in the following way:
(i) ____ for any emissions reduction over and above holding of ____

(ii) Subsidy rate set at __ = ____ (reported)
(iii) Permits will be allocated via an ___

▪ Total cost of the scheme to all firms in the industry is referred to as pollution abatement costs (PCC):
How is this calculated?

Answer 25

The scheme works in the following way:

(i) Subsidy for any emissions reduction over and above holding of permits
(ii) Subsidy rate set at MD=MCA(reported)
(iii) Permits will be allocated via an auction

Total cost of the scheme to all firms in the industry is referred to as pollution abatement
costs (PCC):

PCC = Abatement Costs + Permit Costs - Emission reduction subsidy

Question 26

Draw the graphs to Compare the benefits to firms of being truthful with the benefits of:
(i) understating MCA (panel a) and

(ii) exaggerating MCA (panel b)

Answer 26

slide 27 and 28

Question 27

Compare the benefits to firms of being truthful with the benefits of (i) understating MCA (panel a) :

(i) Understating causes permits to be scarce ( rather than
L*). The permit ____ is driven up to , the level determined
by the MCA(true)

Why do total costs rise ? 2

Answer 27

(i) Understating causes permits to be scarce ( rather than L*). The permit price is driven up to , the level determined by the MCA(true)

Total costs rise because (a) there are fewer licences so firm must do more abating (shaded area) and (b) firms have to pay a higher permit price (hatched area). Combined area is
increasing in the permit price. Firms costs are minimised when the MCA(reported) is truthful which drives down the permit price

Question 28

Compare the benefits to firms of being truthful with the benefits of exaggerating MCA might appear to be advantageous to firms

the subsidy rate ___ to SBar

▪ However, the existence of a subsidy puts a ___ on the permit price: the price cannot fall below

▪ If the permit price is equal to S Bar then the number of permits actually bought is MBar, even if a larger quantity LBar is available

▪ As a result of exaggeration, firms incur additional ___ ___equal to the shaded area and a loss as a result of the higher ___ ___ equal to the hatched area.

As MCA(reported) gets closer to MC(true) these \_\_\_\_
disappear

Answer 28

Compare the benefits to firms of being truthful with the benefits of exaggerating MCA might appear to be advantageous to firms

the subsidy rate Increases to SBar

▪ However, the existence of a subsidy puts a floor on the permit price: the price cannot fall below

▪ If the permit price is equal to S Bar then the number of permits actually bought is MBar, even if a larger quantity LBar is available

▪ As a result of exaggeration, firms incur additional abatement costs equal to the shaded area and a loss as a result of the higher permit price equal to the hatched area.

As MCA(reported) gets closer to MC(true) these losses
disappear