To access the full paper, download the PDF on the left-hand sidebar.
Emissions trading mechanisms have been proposed, and in some cases implemented, as a tool to reduce pollution. Under an emissions trading system ETS), producers must acquire permits equal to the amount of their emissions in a given period. These permits are then remitted to the issuing institution. So far, the results from actual implementations of emissions trading have been mixed, and some policymakers have argued that taxes would be more effective in reducing emissions. Related criticisms have also appeared in academic studies. For example, in a highly publicized recent study, Clò and Vendramin (2012) criticized features of the ETS that have led to low prices for permits. They also point out shortcomings, specifically in regard to the ability of emissions trading to induce investment in new technologies. They advocate a tax as a more e§ective non-distortionary instrument.
We use insights from dynamic mechanism design in monetary economics to derive properties of optimal dynamic emissions trading mechanisms. We argue that efficient tax policies must be "state-contingent," and we demonstrate an equivalence between such state-contingent taxes and emissions trading. Restrictions resulting from the money-like feature of permits can break this equivalence when there is endogenous progress in clean technologies. We argue that these restrictions must be taken into consideration in actual policy implementation.
Our analysis introduces several ingredients that are largely missing in the existing literature. First, if the policy objective is to maximize social welfare, as opposed to simply reducing emissions to a predetermined level, and if the economy is subject to shocks, then it is likely that the optimal path for emissions will be time-dependent. In particular, the welfare maximizing level of emissions will depend on the aggregate state of the economy. Second, our analysis identifies state-contingent taxes as an important tool toward implementing efficient levels of output and emissions. Third, we discuss the optimal permit-issue policy in the presence of shocks.
Our model shows that a state-contingent tax system can do at least as well as a cap-and- trade system in most cases, and it can dominate it when there is endogenous clean technology adoption. More generally, we argue that policymakers should think about permit-issue in a manner similar to that used by central bankers. At the optimum, the price of permits must increase over time. In the presence of aggregate risk, the optimal supply of permits is not constant over time and must respond to the shocks affecting the economy. Finally, when firms can choose the level of technological progress in green technologies, emissions trading cannot implement the optimal allocation if there is a high fraction of "dirty firms." The reason is that emissions trading either makes technology adoption by these firms too slow, or it must distort production levels relative to the first best. Interestingly, fiscal policies do not suffer from this drawback.
This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.
