Green Growth and New Models of Prosperity Policy Instruments (Part 1) Berlin, 21 June 2013 Vorlesung im SS2013 an der Technischen Universität Berlin Fakultäten Planen, Bauen Umwelt & Wirtschaft und Management Prof. Dr. Ottmar Edenhofer Contents: Lecture Plan Date Topic 12.4. 19.4. 26.4. 03.5. 10.5. 17.5. 24.5. 31.5. 7.6. 14.6. 20.6., 4-6 pm, Over-/Underinvestment H1012 Commons 21.6. Policy Instruments (Part 1) 26.6., 2-4 pm, Policy Instruments (Part 2) H1012 28.6. (cancelled) 5.7. (cancelled) 12.7. Horizontal and Vertical Fiscal Federalism 2 Contents Part I Policy Instruments and the Commons (Part I): Foundations and Static Analysis • Externalities and Market Failure - Definition - Public good (commons) problem • Instruments to Control Pollution - Instruments & selection criteria - Prices vs. quantities • Rent Taxation and Public Investment - Basics of (land) rent taxation - Are (land) rents sufficient to finance a public good? 3 Bibliography for this Area Perman et al, Natural Resource and Environmental Economics, Chapters 5-8 Edenhofer, Ottmar; Linus Mattauch and Jan Siegmeier (2013). Hypergeorgism: When is Rent Taxation as a Remedy for Insufficient Capital Accumulation Socially Optimal?. Cesifo Working Paper 4144. George, Henry (1879/1912) Progress and Poverty: An Inquiry into the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth: The Remedy . 4th edition. [Available at: www.econlib.org/library/YPDBooks/George/grgPP.html] Mattauch, Linus; Jan Siegmeier; Ottmar Edenhofer and Felix Creutzig (2013). Financing public capital through land rent taxation: A macroeconomic Henry George Theorem, mimeo 4 Motivation Consider the case of climate change: global cost-benefits-analysis delivers optimal emission-path. Does this mean we are done ? 5 Motivation Consider the case of climate change: global cost-benefits-analysis delivers optimal emission-path. Does this mean we are done ? The implementation of this emission-path calls for policy instruments. 6 Contents Part I Policy Instruments and the Commons (Part I): Foundations and Static Analysis • Externalities and Market Failure - Definition - Public good (commons) problem • Instruments to Control Pollution - Instruments & selection criteria - Prices vs. quantities • Rent Taxation and Public Investment - Basics of (land) rent taxation - Are (land) rents sufficient to finance a public good? 7 Externality: Definition “An external effect, or an externality, is said to occur when the production or consumption decisions of one agent have an impact on the utility or profit of another agent in an unintended way, and when no compensation/payment is made by the generator of the impact to the affected party.” (Perman) 8 From Externality To Market Failure Example: Smoking person, individual optimization mC mB S* Indivdually optimal level of smoke 9 From Externality To Market Failure Example: Smoking person, individual optimization Level of smoke S* mC + mC(others) incures cost for mC another person mB S* Indivdually optimal level of smoke ⇒ Social planner would choose lower level of smoke 10 From Externality To Market Failure - Definition externality: private costs social costs - Positive vs. negative externality - In the presence of externalities, markets do not lead to socially efficient outcomes = market failure Source: Perman 11 Externalities & Market Failure 12 Externalities & Market Failure: Consequences If unregulated, externalities can influence the provision of goods: Externality Good Harvesting of a fishery Fishing grounds in international oceans Emission of sulfur oxides etc. Air quality Emission of free radical catalysts Ozone layer Emission of Greenhouse gases Stable climate system Much of these exhibit the properties of public goods. 13 Public Goods Problem Classification of goods Rivalrous Non-rivalrous Excludeable Private Good Congestible Resource (Car) (Wilderness Area) Non-excludeable Open-Access Resource Public Good (Ocean fishery) (Stable Climate) “Much of environmental and resource economics .. is concerned with identifying and correcting market failure in relation to the services that the environment provides to the economy.” (Perman) Stern (2006) has called climate change the result of the „greatest market failure that the world has seen“ 14 Public Goods Problem The efficient level of supply for a public good. £ MRUSA + MRUSB = MWTPA + MWTPB MC = MRT MRUSB = MWTPB MRUSA = MWTPA Source: Perman et al X 15 X* Public Goods Problem For an efficient provision of the public good, “the government needs to know the preferences, in terms of marginal willingness to pay, of all relevant individuals. It is in the nature of the case that those preferences are not revealed in markets.” (Perman) 16 Contents Part I Policy Instruments and the Commons (Part I): Foundations and Static Analysis • Externalities and Market Failure - Definition - Public good (commons) problem • Instruments to Control Pollution - Instruments & selection criteria - Prices vs. quantities • Rent Taxation and Public Investment - Basics of (land) rent taxation - Are (land) rents sufficient to finance a public good? 17 Instruments to Control Pollution Solutions implemented by the government can be classified: I. Command and Control - prohibition - mandatory targets - technology standards I. Market-Based Instruments - price instruments: taxes, subsidies - quantity instruments: tradable permits, tradable performance standards - mix of price & quantity: permit trade with safety valve 18 Policy Instruments in Climate Change Source: IPCC 2007 19 Example: Pigouvian Tax Figure 5.14 Taxation for externality correction. £ SMC PMCT PMC PY t Source: Perman et al Y 0 20 Y* Y0 Examples of Policy Instruments Currently in Use Source: Perman et al 21 Policy Instruments: Selection Criteria Source: Perman et al 22 Policy Instruments Score Differently Under the Different Criteria 23 Source: IPCC 2007 Policy Instruments: Selection Criteria Command & Control vs. Market-Based Instruments: - Social costs increase gradually / steeply - Firms have heterogeneous costs - Information asymmetry: firms hiding private costs - Few / many regulated firms - Enforcing regulation: may be easier/cheaper with technology standard than with target 24 Policy Instruments: Selection Criteria Command & Control vs. Market-Based Instruments: • Market based instruments use markets to ensure cost effectiveness • A given reduction target is reached in a cost-effective way only if marginal abatement costs across all regulated entities are equalized. 25 Policy Instruments – Emissions Trading € MAC B MAC A € B P A P Reduction by A Reduction A Reduction B Reduction by B 26 Policy Instruments – Emissions Trading € MAC B MAC A € P P Reduction by A Reduction A Reduction B Reduction by B 27 Policy Instruments: Selection Criteria Command & Control vs. Market-Based Instruments: • Market based instruments can be powerful when information of regulator (government) is incomplete • BUT there are also circumstances in which markets will fail to be efficient (market power, firms‘ influence on allocation, time inconsistency) 28 Contents Part I Policy Instruments and the Commons (Part I): Foundations and Static Analysis • Externalities and Market Failure - Definition - Public good (commons) problem • Instruments to Control Pollution - Instruments & selection criteria - Prices vs. quantities • Rent Taxation and Public Investment - Basics of (land) rent taxation - Are (land) rents sufficient to finance a public good? 29 Role of Uncertainty Source: Perman at al (2003) 30 Policy Instruments – Emissions Trading vs. Tax Under ideal conditions, in particular when costs and benefits of abatement are known with certainty, price instruments (=tax) and quantity instruments (=emissions trading) are equivalent. Outside such a deterministic world, this symmetry breaks down. This is the prominent „prices vs quantities“ debate. 31 ‚Prices vs. Quantities‘ under Uncertainty Both benefits from pollution and cost of abatement may be uncertain (for regulator, even for firms) Regulator faces dilemma: - price instrument would fix (marginal) costs, but leaves quantity uncertain - quantity instrument fixes level of pollution/emissions, but leaves cost uncertain 32 ‚Prices vs. Quantities‘ under Uncertainty Weitzman (1974): if slope of marginal costs > slope of marginal benefits, then choose price instrument (and vice versa) - Relevance in Climate Change? - Second-best if “lock-in” of cap-and-trade? (safety valve) 33 Prices vs. Quantities: Weitzman Argument Source: Perman at al (2003) 34 Prices vs. Quantities: Short-Run vs. Long-Run Short-term Long-term Source: Stern Review (2006) 35 Why the Weitzman Argument Falls Short • The Social Planner plays against uncertainty of nature and technological development • For the design of policy instruments, the game between firms and regulator is much more important: – Design intertemporal, dynamic incentive structure – Consider asymmetric and costly information for firms and regulators – Consider the role of (incomplete) future markets for long-term planning decisions • Conventional (linear) price instruments fail: – To be discussed soon: Supply side dynamics and intertemporal arbitrage condition -> The Green Paradox (Sinn 2008) 36 Tax vs. Cap-and-Trade – Political Economy • Only taxes and auctioned permits raise government revenue double dividend effect • Financial sector interest in trading powerful interest group • Tradable permits are an asset. Permit owners have vested interest in continuation of the scheme • Grandfathering enhances