Additional Considerations
This section discusses two other factors that are relevant to the choice among emissions
control instruments: the ability of the instrument to address uncertainty, and the nature of
its distributional impacts.
The Role of Uncertainty
Uncertainties are unavoidable: policymakers can never perfectly predict the outcome of
environmental policies. This is relevant to instrument choice, since the choice of instrument
affects both the type of uncertainty that emerges as well as the expected efficiency gains
generated. Instruments also differ in their abilities to adjust to new information.
The Nature of Uncertainty under Different Instruments
Under emissions taxes, the price of emissions (the tax rate) is established at the outset. What
is uncertain is the aggregate emissions quantity that will result after firms respond to the
tax. In contrast, under pure emissions allowance systems, the aggregate emissions quantity is
established at the outset by the number of allowances introduced into the market, while the
emissions price is uncertain because it is determined by the market ex ante.
To reduce the price uncertainty under emissions allowance systems, some have proposed
augmenting such systems with provisions for an allowance price ceiling or price floor. The
idea of establishing a price ceiling has gained considerable attention in discussions of climate
change policy. Here a cap-and-trade program is combined with a “safety valve” to enforce
a pre-established ceiling price (Burtraw and Palmer 2006; Jacoby and Ellerman 2004; Pizer
2002). Under this policy, if the allowance price reaches the ceiling price, the regulator is
authorized to sell whatever additional allowances must be introduced into the market to
prevent allowance prices from rising further. Note that while the safety valve reduces price
uncertainty, it introduces uncertainty about aggregate emissions. Similarly, it is possible to
enforce a price floor by authorizing the regulator to purchase (withdraw from the market)
allowances once the allowance price falls to the pre-established floor price.
Potential price volatility of allowance systems can also be reduced by allowing firms to
bank permits for future compliance periods when current allowance prices are considered
unusually low, and to run down previously banked permits or borrow permits when current
Implications of Uncertainty for Expected Efficiency Gains
Maximizing the efficiency gains from pollution control requires that marginal damages from
emissions (or marginal benefits from emissions reductions) equal society’s (each firm’s)
marginal costs of emissions reductions. However, a regulator seeking to maximize efficiency
gains will not have perfect information about marginal abatement costs, a reflection of the
inability of the regulator to know each firm’s current capabilities for input-substitution and
end-of-pipe treatment. There is even more uncertainty as to future abatement costs, as these
will depend on additional variables that are difficult to predict, such as fuel prices and the
extent of technological change.
In the presence of abatement cost uncertainty, the choice of instrument affects the expected
efficiency gains.11 In a static context, the relative efficiency impact of a “price” policy such as
an emissions tax compared to a “quantity” policy such as an aggregate emissions cap depends
on the relative steepness of the aggregate marginal abatement cost curve and the marginal
damage curve.12 In a limiting case, where the marginal damage curve is perfectly elastic,
expected net benefits are maximized under the emissions tax, with the tax rate set equal to the
(constant) marginal damages. In this case the tax automatically equates marginal damages
to marginal abatement costs, regardless of the actual location of the marginal abatement
cost schedule. In contrast, if an aggregate emissions cap is employed, with the cap set to
equate marginal damages with expected marginal abatement costs, abatement will be too high
ex post if marginal abatement costs turn out to be greater than expected, and too low ex post if
marginal abatement costs are lower than expected. The relative efficiency gains are reversed in
the other limiting case: when marginal damages are perfectly inelastic, expected net benefits
are maximized under the emissions cap. For intermediate cases, either the tax or the cap
could offer higher net benefits, depending on whether the marginal damage curve is flatter
or steeper than the marginal abatement cost curve (Weitzman 1974).
These results carry over to a dynamic setting, where environmental damages depend on
the accumulated stock of pollution. Some dynamic analyses (see Kolstad 1996; Pizer 2002;
Newell and Pizer 2003) suggest that in the presence of uncertainty, a carbon tax (a “price”
policy)might offer substantially higher expected efficiency gains than a cap-and-trade system
(a “quantity” policy).
Uncertainty and Policy Flexibility
The analyses just discussed do not consider differences across instruments in the speed
at which they can adjust to new information. However, an emissions allowance system
that includes provisions for the banking and borrowing of allowances might have a slight
would instantly shift up the trajectory of current and expected future permit prices, before
any adjustment to the future cap is actually made. In contrast, under a carbon tax, it might
take some time to enact a legislative change in the tax rate in response to new scientific
information, which would leave emission control suboptimal during the period of policy
stickiness.
Distributional Impacts
The distributional impacts of alternative environmental policies can be considered across
numerous dimensions, such as regions, ethnic groups, or generations. Here we focus on two
dimensions that have received especially great attention in policy discussions: the distribution
between owners of polluting or energy-intensive industries and other members of society
(consumers, taxpayers, workers), and the distribution across households of different incomes.
These distributional impacts have important implications not only for fairness or distributive
justice but also for political feasibility.
Distribution Between Owners of Polluting Enterprises and Other Economic Actors
Since the combustion of fuels is a major contributor to pollution, an important issue is the
burden that pollution control policies might impose on industries supplying these fuels as
well as industries (such as electricity and metals production) that use these fuels intensively.
Depending on specific design features, different instruments can have very different impacts
on capital owners in these industries.
Consider first the impacts of a cap-and-trade system. As discussed in Section 2, for a given
quantity of allowances, free allocation leads to the same allowance prices and output price
increases as does auctioning of allowances. However, the nature of the initial allocation can
have a significant effect on the distributional burden from regulation.
An emissions allowance system causes firms to restrict the level of production, thereby
causing an increase in the equilibrium output price. Higher output prices potentially generate
rents to firms, in much the same way that a cartel enjoys rents by reducing output.
With free allowance allocation, firms enjoy these rents. In contrast, if allowances are
introduced through a competitive auction, the rents are bid away as firms compete to obtain
the valuable allowances. In this case, what would be firms’ rents under free allocation become
government revenue instead. This benefits the general taxpaying public to the extent that it
reduces the government’s need to rely on various existing taxes for revenue; alternatively, the
public could benefit from additional government-provided goods or services financed by the
auction revenue.
In fact, when allowances are initially given away for free, regulated firms might even
enjoy higher profits than in the case of no regulation: the rents might more than fully
compensate firms for the costs of complying with the program. Whether this occurs depends
on two factors. The first is the elasticity of supply relative to the elasticity of demand for the
industry’s output. The greater the relative elasticity of supply, the greater the price increase
associated with a given free allocation of allowances, and the larger the rents generated to
firms. The second is the extent of required abatement: at low levels of abatement, allowance
rents are large relative to compliance costs, which implies a greater potential for an overall