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Environmental policy and time consistency - emissions taxes and emissions trading


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  • Kennedy, Peter W.
  • Laplante, Benoit
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    The authors examine policy problems related to the use of emissions taxes, and emissions trading, two market-based instruments for controlling pollution by getting regulated firms to adopt cleaner technologies. By attaching an explicit price to emissions, these instruments give firms an incentive to continually reduce their volume of emissions. Command, and-control emissions standards create incentives to adopt cleaner technologies only up to the point where the standards are no longer binding (at which point the shadow price on emissions falls to zero). But the ongoing incentives created by the market-based instruments are not necessarily right, either. Time-consistency constraints on the setting of these instruments limit the regulator's ability toset policies that lead to efficiency in adopting technology options. After examining the time-consistency properties of a Pigouvian emissions tax, and of the emissions trading, the authors find that: 1) If damage is linear, efficiency in adopting technologies involves either universal adoption of the new technology, or universal retention of the old technology, depending on the cost of adoption. The first best tax policy, and the first-best permit-supply policy are both time-consistent under these conditions. 2) If damage is strictly convex, efficiency may require partial adoption of the new technology. In this case, the first-best tax policy is not time-consistent, and the tax rate must be adjusted after adoption has taken place (ratcheting). Ratcheting will induce an efficient equilibrium if there is a large number of firms. If there are relatively few firms, ratcheting creates too many incentives to adopt the new technology. 3) The first-best supply policy is time-consistent if there is a large number of firms. If there are relatively few firms, the first-best supply policy may not be time-consistent, and the regulator must ratchet the supply of permits. With this policy, there are not enough incentives for firms to adopt the new technology. The results do not strongly favor one policy instrument over the other, but if the point of an emissions trading program is to increase technological efficiency, it is necessary to continually adjust the supply of permits in response to technological change, even when the damage is linear. This continual adjustment is not needed for an emissions tax when damage is linear, which may give emissions taxes an advantage over emissions trading.

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    Bibliographic Info

    Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2351.

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    Date of creation: 31 May 2000
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    Handle: RePEc:wbk:wbrwps:2351

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    Keywords: General Technology; Environmental Economics&Policies; International Terrorism&Counterterrorism; Technology Industry; ICT Policy and Strategies; Environmental Economics&Policies; General Technology; International Terrorism&Counterterrorism; Carbon Policy and Trading; Energy and Environment;


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    1. Laffont, Jean-Jacques & Tirole, Jean, 1996. "Pollution permits and compliance strategies," Journal of Public Economics, Elsevier, Elsevier, vol. 62(1-2), pages 85-125, October.
    2. Milliman, Scott R. & Prince, Raymond, 1989. "Firm incentives to promote technological change in pollution control," Journal of Environmental Economics and Management, Elsevier, vol. 17(3), pages 247-265, November.
    3. Laffont, Jean-Jacques & Tirole, Jean, 1994. "A Note on Environmental Innovation," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 41, Institut d'Économie Industrielle (IDEI), Toulouse.
    4. Jung, Chulho & Krutilla, Kerry & Boyd, Roy, 1996. "Incentives for Advanced Pollution Abatement Technology at the Industry Level: An Evaluation of Policy Alternatives," Journal of Environmental Economics and Management, Elsevier, vol. 30(1), pages 95-111, January.
    5. Malueg, David A., 1989. "Emission credit trading and the incentive to adopt new pollution abatement technology," Journal of Environmental Economics and Management, Elsevier, vol. 16(1), pages 52-57, January.
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    Cited by:
    1. Mirzha de Manuel Armendía, 2011. "Market Efficiency in the EU Emissions Trading Scheme. An outlook for the third trading period," Bruges European Economic Research Papers, European Economic Studies Department, College of Europe 20, European Economic Studies Department, College of Europe.
    2. Nelissen, Dagmar & Requate, Till, 2004. "Pollution-Reducing and Resource-Saving Technological Progress," Economics Working Papers 2004,07, Christian-Albrechts-University of Kiel, Department of Economics.
    3. Fischer, Carolyn, 2008. "Emissions pricing, spillovers, and public investment in environmentally friendly technologies," Energy Economics, Elsevier, Elsevier, vol. 30(2), pages 487-502, March.
    4. Bramoulle, Yann & Olson, Lars J., 2005. "Allocation of pollution abatement under learning by doing," Journal of Public Economics, Elsevier, Elsevier, vol. 89(9-10), pages 1935-1960, September.
    5. von Döllen, Andreas & Requate, Till, 2007. "Environmental Policy and Incentives to Invest in Advanced Abatement Technology if Arrival of Future Technology is Uncertain - Extended Version," Economics Working Papers 2007,04, Christian-Albrechts-University of Kiel, Department of Economics.
    6. Fischer, Carolyn & Newell, Richard G., 2008. "Environmental and technology policies for climate mitigation," Journal of Environmental Economics and Management, Elsevier, vol. 55(2), pages 142-162, March.


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