Indexing European carbon taxes to the EU ETS Permit Price: a good idea?

We study an environmental policy that (i) tax some emitters while others are covered by a cap-and-trade system and (ii) index the tax level to the permit price. Such a policy could be attractive in a world where abatement costs are uncertain and the regulator has information about the correlation between the cost shocks to the two groups. We show that this index policy yields lower expected social cost than the policy mix studied in Mandell (2008). The value of indexing is higher the stronger the correlation is, the steeper the marginal abatement benefit curve is, and the more uncertain we are about the taxed sector’s abatement costs. The index policy may also outperform the uniform policy alternatives emission tax and cap-and-trade system. The conditions for this are more restrictive, though. Given parameter values plausible for the European climate change policy context, expected net-gains are small or negative.