Three essays on prices vs. quantities in environmental policy

Abstract: Three Essays on Prices vs. Quantities in Environmental Policy
In three essays, the debate on prices vs. quantities in environmental regulation is addressed and further developed – theoretically and empirically. First, an environmental „Policy à la Carte“, a regulation that simultaneously employs an emissions tax and a system of tradeable permits among which firms can choose their preferred instrument, is theoretically analyzed. Second, the preferences of firms for the instruments is empirically tested under this policy regime. Third, the differential impacts of an emissions tax and permit trading on abatement technology adoption is investigated empirically.
While the performances of single and hybrid instruments are well analyzed in the literature, a Policy à la Carte has not been investigated so far. The simultaneous use of two market-based instruments with the instrument choice delegated to the regulated firms makes this policy design special. The Swiss Confederation implemented such a policy to mitigate carbon dioxide emissions. Under this design, firms can usually choose between paying a tax on their carbon dioxide emissions and participating in a system of tradeable permits. In the former case, they receive a wage-based refund of the tax receipts; in the latter case, they receive free emission allowances based on grandfathering.
The first essay „Environmental Policy à la Carte: Letting Firms Choose their Regulation“ analyzes the Policy à la Carte regime theoretically. The three key assumptions are firm heterogeneity, uncertainty in marginal abatement costs, and information asymmetry between the regulator and the firms regarding their abatement technologies. The regulator offers firms a policy menu that consists of a tax and tradeable permits among which firms choose their preferred instrument. She anticipates that firms choose the instrument under which they expect lower costs and sets the tax rate and the cap accordingly. Furthermore, she grants a tax refund and/or auctions off parts of the permits. The latter two fine-tuning elements ensure that firms choose the instruments that are optimal from a social point of view.
A single-instrument policy (single tax or single permit trading) fails to provide a first-best outcome under uncertainty. The slope of the marginal abatement cost function relative to the slope of the marginal damage function determines the preferability of either instrument. Using both instruments simultaneously (mixed policy) reduces the welfare loss that arises from uncertainty when firms are optimally assigned to either the tax or permit trading. Therefore, the regulator requires information on firms' abatement technology. Firms do not have an incentive to report this information. It is shown that the asymmetric information problem can be overcome by delegating the prices-versus-quantities decision to firms. In this case, those agents choose the instrument who are better informed, thereby signalling abatement cost information to the regulator. Under limited information, a Policy à la Carte is then not only preferable to an optimally designed single-instrument policy, but it performs even as good as a mixed policy in which the regulator assigns the instruments to firms when she knows the firms' abatement technologies. Furthermore, even firms benefit from the option of being able to choose between the instruments. Besides, the policy is comparatively simple to implement.
The second and the third essay both provide empirical research on prices vs. quantities in a way that has not been brought forward so far in the literature. Empirical analysis is applied to an economy where both an emissions tax and permit trading are implemented to regulate harmful emissions. So, instrument-related effects can easily be determined. These unique and ideal conditions are currently provided by Swiss climate policy. Therefore, data from Swiss manufacturing firms were collected.
Based on these data, the second essay „Prices vs. Quantities: An Empirical Study of Firms' Instrument Choices“ investigates firms' preferences between paying a tax and participating in permit trading within the Swiss Policy à la Carte regime. Based on the theoretical model of the first essay and by taking into account specific characteristics of the Swiss policy, a formal decision criterion for firms' instrument choices is derived. Theory identifies the driving forces for instrument choice as being permit allocation, wages, uncertainty in abatement costs and the flexibility of firms' abatement technologies. Empirical evidence confirms the influence of the former two aspects. By contrast, uncertainty and technological flexibility do not affect firms' instrument preferences. Based on the empirical results, uncertainty is revealed as not being crucial when firms chose the instrument themselves. The empirical model has an outstanding high predictive power. Moreover, only little information is required about firms in order to predict their preferences between a tax and permit trading correctly with a high degree of probability.
In the last essay „Abatement Technology Adoption under Different Policy Regimes: Some Empirical Evidence“ empirical analysis focuses on the differential impacts of an emissions tax and permit trading on the adoption of abatement technologies. The analysis compares investment expenditures under a tax regime with those under a permit trading regime, thereby taking into account that there might be a self-selection bias due to firms' instrument choices. The result of the empirical analysis is unequivocal: Compared to a tax, free permits provide stronger incentives for technology adoption, i.e. in enhancing dynamic efficiency, a result which is the exact opposite of the traditional view in the theoretical literature.