Unit 5 - Climate Change Mitigation Policies 2: Carbon Pricing Instrument Selection Flashcards
When are quantity instruments preferred over price instruments in carbon pricing?
Answer: Quantity instruments work better when the emission damage curve is steep, because:
- It’s more important to have precise control over emission quantities
- Small changes in emission quantities can lead to large changes in environmental damage
- Direct control over emission levels becomes crucial
What are the three main channels of carbon leakage discussed in the text?
Answer:
1. Energy Markets: Loss of EU demand makes fossil fuels cheaper for rest of world
2. Competition: Industry relocates production due to EU climate policy costs
3. Free riding: Other countries see less pressure to act due to EU climate policy
In the game theory analysis, what is meant by a “Suboptimal Stable Nash Equilibrium”?
Answer: It’s a situation where both players would be better off if they both chose to abate (achieving a higher payoff), but the individual incentive to pollute leads to a worse outcome for both. Players remain stuck in this suboptimal equilibrium because neither has an incentive to change their strategy unilaterally.
What are the three main strategies discussed for mitigating carbon leakage?
Answer:
1. Border carbon adjustments (BCA) - levy on imports based on carbon content
2. Free allocation of emission permits (Grandfathering) - based on historical emissions -> reduces the cost burden of companies and makes it less likely for them to relocate to regions with less stringent environmental policies
3. Carbon clubs formation - creating collective benefits for members with protective mechanisms against non-members
How do carbon pricing mechanisms create dynamic incentives for innovation?
Answer:
- Creates incentives for cost-saving abatement technology as firms try to reduce carbon costs
- Leads to positive spillover effects that facilitate sector-wide emission abatement
- May need to be combined with other energy policy instruments due to political obstacles
Explain the difference between importables and exportables cases in international trade of polluting goods.
Importables:
- Domestic market equilibrium and social optimum differ when country imports polluting goods
- Gap between supply curves represents social cost of pollution
- Market equilibrium occurs where domestic price equals world price
Exportables:
- Higher world prices incentivize domestic producers to export
- Production increases while domestic consumption decreases
- Results in increased pollution in exporting country
What factors influence the stability of international climate cooperation according to game theory?
- Payoff structure of cooperation versus non-cooperation
- Number of participating countries
- Existence of protective mechanisms and collective benefits
- Balance between net benefits of pollution (NBP) and net benefits of abatement (NBA)
- Possibility of multiple Nash equilibria (both optimal and suboptimal)
What are the considerations for carbon pricing instrument selection?
- price vs quantity instruments
- international trade & carbon leakage
- dynamic incentives
Explain how abatement cost uncertainty relates to our consideration of picking between price vs quantity instruments.
- different firms have different abatement costs (emissions reduction costs) → also known as marginal abatement costs (MAC)
- need to compare price instruments (e.g. emissions taxes) with quantity instruments (e.g. marketable permits) when MAC is uncertain
- depends on Marginal Benefit and Marginal Cost curves -> if MB is steeper than MC, quantity instruments are preferred.
- if MC is steeper than MB, price instruments are preferred.
Explain what a price instrument is.
- Price instruments (e.g., emission taxes):
- Control over tax level (t) - t is fixed
- Uncertain emission levels
- Example: German fuel tax
- fuel is used by consumers to it’s easy to implement such taxes due to lower transaction costs
Explain what quantity instruments are.
- Quantity instruments (e.g., EU Emission Trading System - EU ETS):
- Control over emission level (L) - L is fixed
- Uncertain permit prices (P) → pL, pH, P*
- permits are either given for free or by auction so firms can trade
Explain the selection considerations for price vs quantity instruments.
- Choice depends on which error is more costly (not knowing emission levels vs not knowing the price)
- Quantity instruments work better when emission damage curve is steep
- as it’s more important to have precise control over the quantity of emissions
- small changes in emission quantities can lead to large changes in environmental damage, so having direct control over the emission level (L*) becomes crucial
- Different outcomes based on whether abatement costs are over- or underestimated
What is game theory in the context of policy?
Game theory can help illustrate individual countries’ decision situation & analyze likely strategic choices
What is a Nash Equilibrium?
- Nash Equilibrium - stable set of strategic choices, where each player is doing the best given what the other player is doing
- the option where no player can benefit by unilaterally changing their strategy while other players keep their strategies unchanged
What is a Dominant Strategy?
Dominant Strategy - strategy that offers the highest pay-off irrespective of the other players’ choice
