Refunding Emissions Payments

We analyze two mechanism designs for refunding emissions payments to polluting firms - outputbased refunding (OB) and expenditure-based refunding (EB). In both instruments, emissions fees are returned to the polluting industry, typically making the policy more politically acceptable than a standard tax. The crucial difference between OB and EB is that the fees are refunded in proportion to output in the former but in proportion to the firms’ expenditure on abatement equipment in the latter. We show theoretically that to achieve a given abatement target, the fee level in the OB design exceeds the standard tax rate, whereas the fee level in the EB design is lower. Furthermore, the use of OB and EB may lead to large differences in the distribution of costs across firms. Both designs imply a cost-ineffective provision of abatement, as firms put relatively too much effort into reducing emissions through abatement technology compared with reducing output or improving management. However, maintaining output may be seen as a political advantage by policymakers if they seek to avoid activity reduction in the regulated sector.