Free PDF Ebooks Files @AcrobatPlanet.Com

Even though consensus has grown on the need for dramatic reductions in anthropogenic emissions of greenhouse gases (GHGs), which contribute to global climate change, considerable debate continues on which policies would best serve that goal. Many academics argue for carbon taxes as the most efficient domestic and global mechanism (Aldy et al. 2008), but few governments are seriously considering a carbon tax as a primary policy for slowing GHG emissions. Many countries, including those of the European Union, have committed to or are proposing caps on GHG emissions. Other countries, including Canada, are instead pursuing intensity targets, which are also the basis for some prominent proposals to include developing countries in a global framework (Herzog et al. 2006). These targets would index emissions allowance allocations to economic output, the idea being that a flexible mechanism would better allow for economic growth (e.g., Pizer 2005).

How much of a boon is this flexibility? From a policy design standpoint, one could equivalently assign caps that follow a growth path or assign declining intensity targets or carbon taxes to meet a cap. Therefore, a growth path is not an inherent feature of intensity targets, nor is a fixed emissions path a defining characteristic of emissions caps. Furthermore, when the ultimate goal is reducing overall emissions and stabilizing atmospheric concentrations, any policy would have to be ratcheted over time. However, in the face of uncertain economic growth, the policies offer different qualities. Holding expected allocations constant, intensity and emissions targets are likely to provoke different economic responses to unexpected productivity shocks. This paper explores the impacts of such economy-wide emissions regulations on the business cycle.

A long literature in environmental economics, beginning with Weitzman’s seminal 1974 paper, has compared price and quantity instruments for regulating emissions. More recently, researchers have begun to also compare intensity-based instruments. Several of these latter works, including Newell and Pizer (2008) and Quirion (2005), follow the partial equilibrium approach of Weitzman. Others have taken a general equilibrium approach, focusing on the role of tax interactions (Goulder et al. 1999; Parry and Williams 1999), the role of multisector and international trade (Dissou 2005; Jotzo and Pezzey 2007), or both (Fischer and Fox 2007). Given that uncertainty about economic growth and the macroeconomic transition effects of carbon policy is driving interest in indexed emissions targets, surprisingly few studies address these aspects directly. Much of the previous theoretical analysis of intensity targets and alternative instruments has focused on variance in abatement and compliance costs as the critical metric. This literature, including Kolstad (2005), Quirion (2005), Pizer (2005), Jotzo and Pezzey (2007), and a pre-publication version of Sue Wing et al. (2009), is reviewed by Peterson (2008) who observes that a common thread is the importance of the correlation between GDP and emissions in determining whether abatement cost uncertainty is lower under an intensity target. This paper takes a broader approach, characterizing the response in a set of macro-level variables to economy-wide emissions regulations via price, quantity, and intensity instruments, operating in the context of an uncertain business cycle.

In contrast to the preceding prices-versus-quantities literature, we use a dynamic stochastic general equilibrium (DSGE) model to compare the dynamic effects of these policy choices under productivity shocks. We specify a dynamic Robinson Crusoe economy, with choices over consumption, labor, capital investment, and a polluting intermediate good. We consider three policies for constraining emissions from the polluting factor: an emissions cap, an emissions tax, and an intensity target that sets a maximum emissions-output ratio. The economy is subject to uncertain shocks to overall productivity. We start with a simple approach to characterizing the response by solving analytically for the steady state following a single, permanent shock; this is our SS model. To implement the full real business cycle, RBC model, we specify a productivity factor that evolves according to a first-order autoregressive process, which includes i.i.d. random shocks each period. To solve the RBC model numerically, we parameterize the model with plausible values from the macroeconomics literature.

Our analysis and an unpublished work by Heutel (2008) are the first attempts of which we are aware to examine climate policy in an RBC framework—that is, in a DSGE model with uncertainty over future productivity. Heutel’s focus is on the optimal dynamic tax or quota policy, which adjusts each period in response to income and price effects. Heutel finds that price effect dominates, driving increased emissions levels and prices during economic expansions. Our approach differs in that we compare the performance of three instruments (tax, cap, and intensity target) in each set to achieve an exogenous and fixed level of expected emissions reduction. Whereas we account for labor market responses to policy and productivity shifts and abstract from considering direct damages from emissions, Heutel sets aside labor fluctuations to concentrate on the interesting dynamics of the optimal endogenous policy. We incorporate labor for two main reasons. First, since labor market impacts are often highlighted in environmental policy debates, labor is a critical outcome variable in its own right. Second, as we will further discuss in the results below, the dynamic impulse response of labor to a productivity shock in the full RBC model is, uniquely, not single-peaked. Our analytical results for variable levels in the SS model and expected variable levels in the RBC model tell the same story.

Implementation of any of the three instruments leads all variable levels to fall, except under the intensity target policy where labor remains unchanged from the no policy setting. This particular consistency occurs because adjustments in response to the intensity target policy in consumption and production exactly offset within the labor optimality condition. In a comparison of levels under the three instruments, we find that deterministic outcomes under the cap and tax policies are identical and, aside from emissions, lower than those of the intensity target. Thus, given an identical emissions reduction constraint, total output is higher with the intensity target than with the cap or tax. This arises because additional production under the intensity target earns additional permits, increasing the returns to production. Consequently, the emissions intensity target must be set below the emissions intensity observed under the cap and tax policies.

Considering volatility, the SS model reveals that the sensitivity of output to a particular productivity shock is dampened by the cap. Similarly, when stochastic productivity shocks are incorporated in the RBC analysis, the cap policy leads to the lowest levels of volatility for each variable and therefore minimal variation in production and utility as well. The tax policy has the opposite effect. Optimal investment under the tax policy is much more sensitive to deviations in the productivity factor than under any other policy. Not surprisingly then, the volatility of each variable, and ultimately production and utility is greatest under the tax. Meanwhile, the sensitivity to shocks under the intensity target is unchanged from the no policy case.

Contents

Introduction
Deterministic Model

No Policy
Intensity Target
Emissions Cap
Emissions Tax
Summary and Comparison

Numerical Model with Stochastic Productivity Shocks

Numerical Solution and Simulation Method
Results for the Deterministic Case
Results with Stochastic Productivity
Sensitivity Analysis: Productivity Growth
Sensitivity Analysis: Developing-Country Volatility and Risk Aversion

Conclusion
References

Download
PDF Ebook Emissions Targets and the Real Business Cycle: Intensity Targets versus Caps or Taxes