Ec 1661 / API 135 Section Climate Change II: Policy Instruments, Innovation, Leakage

1. Ec 1661 / API 135 SectionClimate Change II: Policy Instruments, Innovation, Leakage Gabe Chan April 15, 2011

2. Climate Policy Instruments

3. Cap and Trade Cost Containment • Floor and/or ceiling on the price of permits • if the floor or ceiling is binding, the policy is a carbon tax • a ceiling on the permit price can break environmental effectiveness of the cap (more permits would be sold) • Permit banking and borrowing • Multi-year compliance periods • Alternative compliance • e.g. domestic and international offsets

4. Cap and Trade Allowance Allocation • The independence property of permit allocation: • The final distribution of emissions and the final marginal abatement cost incurred by firms is independent of the initial allocation of permits • Important political benefits to gain support for policy • Allocation can be used as compensation • Goulder: “freely allocating less than 15% of the total allowances prevents profit losses to … most vulnerable industries … allocating 100% of the allowances substantially overcompensates these industries, in many cases causing more than a doubling of profits” http://www.stanford.edu/~goulder/Goulder-Hafstead-Dworsky_Allowance_Allocation_Paper.pdf

5. Cap and Trade Allowance Allocation • Allowance allocation only has an inframarginal effect • The behavior of firms is not affected (unless they were liquidity constrained) • Allowances that are not freely allocated can be auctioned, generating revenue that can be used for: • compensating poor consumers, job training • rebating citizens (cap-and-dividend) • deficit reduction, tax reduction • research & development

6. Cap and Trade Allowance Allocation under W-M

7. Other Market Failures

8. Principal-Agent • If one person makes the investment decisions for another person, incentives are unlikely to be aligned • Example: landlord – renter • The renter pays the monthly electricity bill and could reduce his/her bill by buying a more efficient refrigerator • However, the “payback” period of the more efficient refrigerator is longer than the renter plans to stay in the apartment, so the renter has no incentive to buy the fridge • The landlord wouldn’t benefit at all from buying the fridge because he doesn’t pay the electricity bill • What are some policies that would reduce this market failure?

9. Ideas are Indivisible • The production of an idea requires a fixed cost (i.e. education, searching, testing, etc.), but subsequent production of the same idea has a very low marginal cost and is often non-rival. • Economic theory suggests that if price > marginal cost, then there will be too little diffusion of the good. • But economic theory also suggests that if price = marginal cost, producers who incur the fixed cost will never recoup their expenditures and will therefore be incentivized to reduce supply of new goods. • Further, the cumulative nature of ideas production and the complementarity of ideas enhances indivisibility (Arrow, 1962), (Stern, 2010)

10. Ideas are Inappropriable • Without intellectual property law that is both deeply and strictly enforced, inventors cannot fully appropriate the benefits of their investment in ideas production (i.e. ideas are only partially excludable). • For example, an inventor might not be able to exclude: • unauthorized users • unauthorized producers • unauthorized use by other inventors • At its essence, the appropriability of innovation is a societal choice, set largely by patent law. (Arrow, 1962), (Stern, 2010)

11. Idea Creation Creates Spillovers • One innovation activity can spur innovation across time, space, industry, technology, etc. • For example • airplane turbine technology is being applied to wind power and fossil power plants • synthetic plastic technology is being applied to algal biofuels • semiconductor technology is being applied to photovoltaic

12. Idea Creation is Uncertain • If idea creation was certain ex-ante, there is nothing to do research on. • How should we make decisions about investing in RD&D if the returns are fundamentally uncertain?

13. Fat-Tailed Uncertainty of RD&D Conditional on being funded by venture capital (VC), a very large proportion of the total returns to VC investment are realized by a small number of ventures. (Stern, 2010)

14. Some Analogies in Innovation & Climate Economics Public good characteristics: non-rivalry: • We share the same climate. • We have access to similar innovations. non-excludability: • I cannot stop someone from feeling climate change. • I cannot fully stop someone from using prior innovation for private gain. Externalities • Greenhouse gas emissions are external to economic activity • Technological spillovers are external to economic activity Uncertainty: • The impact of GHG emissions is uncertain and fat-tailed • The impact of RD&D spending is uncertain and fat-tailed

15. Emission Leakage

16. Leakage Mechanism I – Firm Relocation atmosphere Region 1 Region 2 Greenhouse Gas Policy supply supply $ demand demand 1) Supply meets demand within each region; neither region is subject to regulation 2) Region 1 implements greenhouse gas regulatory policy and Region 2 does not 3) A polluting firm relocates to Region 2, decreasing Region 1’s emissions; total emissions are the same 4) Region 2 exchanges one unit of output for money, returning consumption to initial levels 5) The final steady state; regional consumption and total emissions are the same as in the initial set-up

17. Leakage Mechanism I – Factor Price atmosphere Region 1 Region 2 Greenhouse Gas Policy Region 3 P S $10 $10 $8 D Resource Base 5 6 6 Q 1) Supply of factor inputs in Region 3 meets total demand; no region is subject to regulation 2) Region 1 implements greenhouse gas regulatory policy and Region 2 does not 3) A polluting firm in Region 1 becomes more efficient, decreasing total demand and price of factor inputs 4) The lower price of factor inputs drives Region 2 to increase its production 5) The final steady state; factor input equilibrium and global emissions are the same as in the initial set-up

18. Leakage in Words • Complying with agreement drives up costs of producing goods and services within the coalition (of agreement) countries in proportion to the carbon-intensity of those goods and services, and so comparative advantages in the production of those goods and services shifts outside of the coalition, resulting in an increase in CO2 emissions outside of the coalition • Reduced demand for fossil fuels within the coalition of countries causes fall in world price of fossil fuels, causing increasing in use of fossil fuels (and hence greater CO2 emissions) in the non-coalition countries • Larger Markets mean • lower price volatility • reduction market power each player

19. Leakage with Nash/Cournot Duopoly model with Nash/Cournot Equilibrium Best reply functions for domestic producers and importers Single demand function With emission regulation, best reply function shifts down When only one firm is subject to regulation, production shifts to the unregulated firm  emission leakage

20. Emission Leakage • Leakage will depend on the emission intensity of production of a good • similarly, we might care about jobs instead of emissions • Leakage also requires a “transportable good” • Policies to reduce leakage adjust for the additional cost of complying with (environmental) policy • import allowance requirement • border adjustment tax • setting the border-adjustment to the right level requires a lot of information (to be fair)

21. Consumption-Based Accounting of Emissions • Consumption-based accounting of CO2 emissions reveal that >20% of global emissions are embodied in traded goods Units are Mt CO2 yr-1 (Davis, Caldeira, 2010)

22. Tips for PS #4 • Do research and cite your sources! (but keep it simple, you only have 3 pages) • Some topics to address: (Jack)