On Emissions Trading and Market Structure: Cap-and-Trade versus Intensity Standards

This paper examines the interdependence between imperfect competition and emissions trading. We particularly analyze the long run equilibrium in a two-sector (‘clean’ and ‘dirty’) model with Cournot competition among firms who face a fixed cost of production. The clean sector is defined as the sector with the highest long run cost margin on emissions. We compare the welfare implications of a cap-and-trade scheme with an emissions trading scheme based on relative intensity standards. It is shown that a firm’s long run equilibrium output in the clean or dirty sector does not depend on the emissions trading format, but only depends on the fixed cost of producing in the respective sector. Intensity standards can result in clean firms selling allowances to dirty firms, or dirty firms selling to clean firms. The former outcome yields higher welfare. It is demonstrated that cap-and-trade outperforms the intensity-based trading scheme in terms of long run welfare with free entry and exit. With intensity standards the size of the clean sector is too large.     

Prices versus quantities: environmental regulation and imperfect competition

By exercising market power, a firm will distort the production, and therefore the emissions decisions, of all firms in the market. This paper examines how the welfare implications of strategic behavior depend on how pollution is regulated. Under an emissions tax, aggregate emissions do not affect the marginal cost of polluting. In contrast, the price of tradable permits is endogenous. I show when this feedback effect increases strategic firms’ output. Relative to a tax, tradable permits may improve welfare in a market with imperfect competition. As an application, I model strategic and competitive behavior of wholesalers in a Mid-Atlantic electricity market. Simulations suggest that exercising market power decreased emissions locally, thereby substantially reducing the regional tradable permit price. Furthermore, I find that had regulators opted to use a tax instead of permits, the deadweight loss from imperfect competition would have been even greater.     

Emission Permit Trading Between Imperfectly Competitive Product Markets

The present paper analyzes the efficiency of emission permit trading between two imperfectly competitive product markets. Even if firms are price takers in permit markets, the integration of permit markets can decrease welfare because of imperfect competition in product markets. If there is asymmetric information between the regulator and firms, the integration of the permit markets could have a positive effect related to the flexibility of an integrated market; this flexibility can justify integrating the permit markets.     

Abuse of EU Emissions Trading for Tacit Collusion

In this paper, we show that loopholes in EU emissions trading law foster tacit collusion that impacts oligopolistic product markets. The abuses originate from the covert misuse of EU emissions trading institutions, such as pooling or project-based mechanisms. We analyse two types of these loopholes by means of game theoretical methods to show how oligopolistic firms establish output restrictions, even if those firms are price takers on the~permit market (which might actually be the case for the majority of obligated firms in the EU). The identified misuse of emissions trading law increases firms’ profits, decreases the consumers’ surplus and has negative effects on social welfare for specified parameter ranges. Consequently, public authorities should not allow emissions trading’s overall good reputation—based upon its efficient abatement of pollution—to blind them to options in European emissions trading legislation that would eventually restrict competition.      

Emissions Trading with Updated Allocation: Effects on Entry/Exit and Distribution

Allocation of emissions allowances may have significant distributional and efficiency effects. It is well known that cost-efficiency may be achieved if allowances are auctioned or distributed in a lump sum manner, e.g., based on emissions levels before the start of the system (‘grandfathering’). Böhringer and Lange (Eur Econ Rev 49:2041–2055, 2005) show that a cost-effective outcome can also be achieved if the base year for allocation is continually updated (‘updating’), given that banking and borrowing are prohibited. In this paper we examine whether updating alters the entry and exit conditions for firms compared to grandfathering, and how it affects profits for new and existing firms. We find that the two schemes function surprisingly similar: First, the incentives to entry and exit are identical. Second, the total value of free quotas to existing firms, based on emissions before the system starts, is also identical without any auctioning. With updating initial claims for free allowances have a shorter lifetime compared to grandfathering, but quota prices are higher as firms anticipate the effect of current emissions on future claims to free allowances. The two effects exactly cancel each other out. If there is some combination of auction and free allocation, the total value of free quotas will always be highest under grandfathering if the auction rate is the same. Entry and exit incentives are still equal.     

Cross-Industry Emission Permits Trading

The present paper examines the effectiveness of emission permits trading across industries. We find that, while permits trading in a competitive environment minimizes costs of compliance, it also enhances product market imperfections. We also find that a standard-setting regulation yields superior welfare results if policy makers have able information. Standard setting allows policy makers the flexibility of taking into account the existing imperfections in each industry. Although not surprising, this result has important policy implications in situations in which policy makers consider establishing permits trading between publicly owned dominant polluters and other industrial polluters. Since policy makers have able information on publicly-owned firms, it might be welfare improving to directly control emissions of the dominant publicly-owned polluters. Given that many of the major polluters in the real world are large firms in heavily concentrated industries many of which are also regulated, our result warrants policy makers' attention.     

Efficiency properties of binary ecolabeling

We investigate efficiency properties of binary ecolabels in a homogeneous good market with heterogeneous consumers. Faced with the minimum technology standard, firms make endogenous entry, certification, and price/quantity decisions. We consider both perfect and imperfect competition with or without sunk fixed costs. Our findings are as follows. Ecolabeling alone does not achieve the first-best outcome and, to achieve the second best, may need to set the standard less strict than the efficient level. Without sunk fixed costs, ecolabeling can achieve the first-best outcome provided that both the technology standard and the complementary pollution tax are set at efficient levels. With sunk fixed costs, however, differential excise taxes that would restore allocative efficiency induce more entry than optimal, and thus, can be even welfare decreasing relative to no tax outcome. Tightening the technology standard may ameliorate such an adverse effect of the corrective tax system by reducing excessive entry and pollution per output by the certified firms.     

Investment Incentives Under Emission Trading: An Experimental Study

This paper presents the results of an experimental investigation on incentives to adopt advanced abatement technology under emissions trading. Our experimental design mimics an industry with small asymmetric polluting firms regulated by different schemes of tradable permits. We consider three allocation/auction policies: auctioning off (costly) permits through an ascending clock auction, grandfathering permits with re-allocation through a single-unit double auction, and grandfathering with re-allocation through an ascending clock auction. Our results confirm both dynamic and static theoretical equivalence of auctioning and grandfathering. We nevertheless find that although the market institution used to reallocate permits does not impact the dynamic efficiency from investment, it affects the static efficiency from permit trading.     

Emissions Trading and Profitability: The Swedish Pulp and Paper Industry

The purpose of this paper is to develop models with and without potential emissions trading and to compare industry profits under the two regimes. The model in which emissions trading is permitted is a nonparametric industry frontier model in the spirit of Färe et al. (1992). It is relative to this model that industry profit is computed. This profit is compared to the profit without emissions trading to give an estimate of the potential gains that can be realised by allowing for emissions trading. The model, which is applied to data for the Swedish pulp and paper industry, suggests that this industry would have had up to 6% (1%) higher profits in 1989 (1990) if emissions trading had been used instead of individual permits to achieve the same total emissions target. Currently there is no permit trading in this industry so our results only model the potential gains that can be made.     

Enforcing Emissions Trading when Emissions Permits are Bankable

We propose enforcement strategies for emissions trading programs with bankable emissions permits that guarantee complete compliance with minimal enforcement costs. Our strategies emphasize imperfect monitoring supported by a high unit penalty for reporting violations, and tying this penalty directly to equilibrium permit prices. This approach is quite different from several existing enforcement strategies that emphasize high unit penalties for emissions in excess of permit holdings. Our analysis suggests that a high penalty for excess emissions cannot be used to conserve monitoring effort, and that it may actually increase the amount of monitoring necessary to maintain compliance.The authors are grateful to Anthony Heyes and three anonymous referees for their valuable comments. Partial support for this research was provided by the Cooperative State Research Extension, Education Service, U. S. Department of Agriculture, Massachusetts Agricultural Experiment Station under Project No. MAS00871.     

Green consumers and environmental policy

The present paper examines how improvements in consumers' environmental awareness influence the choice between output and emission taxes, within a framework of imperfect competition and endogenous choice of abatement level. We first show that in the absence of policy intervention, there exists a level of environmental awareness beyond which welfare is decreasing as market imperfections become more prominent relative to environmental concerns. We also confirm that both output and emission taxes are welfare superior to the free-market case. What is surprising, however, is that the welfare performance of an optimally chosen emissions tax is monotonically decreasing in consumers' environmental sensitivity, while the opposite is true for an output tax up to a certain level. At low levels of consumers' environmental awareness an emissions tax is welfare superior, but eventually, there is a level of environmental awareness beyond which an output-tax welfare dominates an emissions tax. Therefore, an emissions tax is better suited to societies that have not yet developed high levels of environmental awareness, while societies characterized by high levels of environmental awareness should prefer an output tax.     

Welfare‐improving Coordinated Tariff and Sales Tax Reforms under Imperfect Competition

This paper studies the welfare effects of coordinated domestic sales tax reform associated with a reduction of the import tariff under imperfect competition. We set up a simple oligopoly trading model where domestic and exporting firms compete in the home market. We show that, if the initial levels of import tariff and sales tax are positive, there always exist welfare‐improving sales tax reforms. In some cases, a reduction of the sales tax accompanied by a reduction of the import tariff increases social welfare, whereas in other cases, raising the sales tax can increase social welfare.     

The optimal initial allocation of pollution permits: a relative performance approach

The initial allocation of pollution permits is an important aspect of emissions trading schemes. We generalize the analysis of Böhringer and Lange (2005, Eur Econ Rev 49(8): 2041–2055) to initial allocation mechanisms that are based on inter-firm relative performance comparisons (including grandfathering and auctions, as well as novel mechanisms). We show that using firms’ historical output for allocating permits is never optimal in a dynamic permit market setting, while using firms’ historical emissions is optimal only in closed trading systems and only for a narrow class of allocation mechanisms. Instead, it is possible to achieve social optimality by allocating permits based only on an external factor, which is independent of output and emissions. We then outline sufficient conditions for a socially optimal relative performance mechanism.     

Emissions abatement R&D: Dynamic competition in supply schedules

This paper investigates the optimal environmental policy (the mix of emissions tax and research and development [R&D] subsidy) in a dynamic setting when two firms, producing differentiated products, compete in the output market over time. Firms compete in a differential game setting over supply schedules, which encompasses a continuum of imperfect competition equilibria from Bertrand to Cournot. Although production generates environmentally damaging emissions, firms can undertake R&D that has the sole purpose of reducing emissions. In addition to characterizing the optimal policy, we examine how the optimal tax and subsidy, and the optimal level of abatement, change as competition intensifies, as the dynamic parameters change, and as the investment in abatement technology changes. In this setting, competition increases welfare through its impact on the final goods price. However, lower prices result in larger quantities and more pollution. Our key contribution is to show how the impact of increased competition on welfare depends on the extent of the market and the nature of preferences and technology.     

Environmental Taxation and Induced Structural Change in an Open Economy: The Role of Market Structure

Abstract. Studies of structural change induced by environmental taxation usually proceed in a perfect-competition framework and typically find structural change to be quite moderate under realistic emission reduction scenarios. By observing that some of the industries affected are likely to operate under imperfect rather than perfect competition, additional mechanisms emerge which may amplify structural change beyond the extent identified as yet. Especially, changes in economies of scale may arise which weaken or strengthen the competitive position of industries over and above the initial cost effect. Using a computable general equilibrium model for Germany to examine the effects of a unilaterally introduced carbon tax, we find that induced structural change is more pronounced under imperfect competition than under perfect competition. At the macroeconomic level, we find that aggregate losses in economies of scale are larger than aggregate gains, implying that the total costs of environmental regulation are higher under imperfect competition than under perfect competition.     

Irreversible abatement investment under cost uncertainties: tradable emission permits and emissions charges

A major concern with tradable emission permits is that stochastic permit prices may reduce a firm’s incentive to invest in abatement capital or technologies relative to other policies such as a fixed emissions charge. However, under efficient permit trading, the permit price uncertainty is caused by abatement cost uncertainties which affect investment under both permit and charge policies. We develop a rational expectations general equilibrium model of permit trading and irreversible abatement investment to show how cost uncertainties affect investment under permits. We compare the resulting investment incentive with that under charges. After controlling for the assumption that random shocks affect the abatement cost linearly, we find that firms’ investment incentive decreases in cost uncertainties, but more so under emissions charges than under permits. Therefore, tradable permits in fact may help maintain firms’ investment incentive under uncertainty.     

The Cost-Effective Choice of Policy Instruments to Cap Aggregate Emissions with Costly Enforcement

We study the cost-effectiveness of inducing compliance in a program that caps aggregate emissions of a given pollutant from a set of heterogeneous firms based on emissions standards and the relative cost-effectiveness of such a program with respect to an optimally designed program based on tradable discharge permits. Our analysis considers abatement, monitoring and sanctioning costs, as well as perfect and imperfect information on the part of the regulator with regard to the polluters’ abatement costs. Under perfect information we find that (a) the total-cost-effective design of a program based on standards is one in which the standards are firm specific and perfectly enforced, and (b) the total cost of an optimally designed program based on standards is lower than the total cost of an optimally designed transferable emission permits system, except under special conditions. This is true when it is optimum to induce perfect compliance and when it is not. Under imperfect information, nevertheless, it is only by implementing a system of tradable permits and perfectly enforcing it with a constant marginal penalty tied to the price of the permits, that the regulator can surmount the informational problem and at the same time minimize the total cost of the program with certainty.     

Subsidy competition and imperfect labor markets

This study presents a two‐country model of subsidy competition for manufacturing firms under labor market imperfections. Because subsidies affect the distribution of firms, subsidies influence unemployment rates and welfare in both countries. We show that when labor market frictions are high, subsidy competition is beneficial, although subsidies under subsidy competition are inefficiently high. In the coordinated equilibrium, the supranational authority provides a subsidy to firms that equal the expected total search costs, which increases the number of firms relative to laissez‐faire and improves welfare relative to laissez‐faire and subsidy competition. Finally, we find that a rise in a country's labor market frictions raises the equilibrium subsidy rate, affects unemployment rates, and lowers welfare.     

Horizontal Mergers in a Liberalizing World Economy

This paper is concerned with the effect of horizontal mergers in an open economy environment. It is found that, with the presence of economies of scale and imperfect competition, a domestic merger may bring about an additional gain to the country in that it shifts profit from foreign to domestic firms. Consequently, the condition on the degree of economies of scale for permitting domestic horizontal mergers would be weaker under an open economy than under a closed economy. Furthermore, the analysis shows that such mergers can also raise foreign welfare. Finally, the model is used to discuss the need to coordinate merger policies among trading partners in tandem with trade liberalization.     

Ad valorem versus unit taxes: monopolistic competition, heterogeneous firms, and intra-industry reallocations

Real-world industries are composed from heterogeneous firms and substantial intra-industry reallocations take place, i.e. high productivity firms squeeze out low productivity firms. Previous tax-tool comparisons have not included these central forces of industry structure. This paper examines a general equilibrium monopolistic competition model with heterogeneous firms and intra-industry reallocations. We show that the welfare superiority of ad valorem over unit taxes under imperfect competition is not only preserved but amplified. The additional difference between the tools arises because unit taxes distort relative prices, which in turn reduces average industry productivity through reallocations (the survival and increased market share of lower productivity firms). Importantly, numerical solutions of the model reveal that the relative welfare loss from using the unit tax increases dramatically in the degree of firm heterogeneity.