Tradable Emissions Permits in the Presence of Trade Distortions

Transcription

1 85 Tradable Emssons Permts n the Presence of Trade Dstortons Shnya Kawahara Abstract Ths paper nvestgates how trade lberalzaton affects domestc emssons tradng scheme n a poltcal economy framework. Developng a model n whch the amounts of emssons cap are endogenously determned, we show that a pro-ndustry government ssues too large amount of emssons cap to beneft an ndustry group, whle a pro-envronment government ssues too small amount of emssons cap to beneft an envronmental group. Then, we examne how a country s decson to lberalze trade can affect the equlbrum prce of emssons cap chosen by the corruptble government. In partcular, we show that trade lberalzaton wll ncrease the too low prce of permts chosen by the pro-ndustry government, whle t wll decrease the too hgh prce of permts chosen by the pro-envronment government. Faculty of Economcs, Rssho Unversty, Osak, Shnagawa-ku, Tokyo , Japan. Tel/Fax: E-mal: kawahara@rs.ac.jp. I would lke to thank Toru Nato and sesson partcpants at the 12th Internatonal Conference of the Western Economc Assocatons Internatonal for ther useful comments and suggestons. Ths research was supported by JSPS Grant-n-Ad for Scentfc Research (C) (Grant Number ). Any remanng errors are my own.

2 Keywords Trade Lberalzaton; Poltcal Economy; Tradable Emssons Permts JEL Classfcaton D72; F18; Q56 1. Introducton Tradable emssons permts are a system for achevng target emssons volumes n a cost-effectve manner, n whch the total amount of an emssons cap s dstrbuted, for free or at a cost, to sources of pollutant emssons such as frms, that each trade emssons caps on the market accordng to ther own permts. Whle, n the feld of envronmental economcs, emssons taxes and tradable emssons permts have been regarded as equvalent polcy nstruments n terms of effcency, they could have dfferent mpacts on effcency n the presence of corruptble polcymakers that are nfluenced by poltcal economc ncentves. The purpose of ths paper s to examne how trade lberalzaton affects a domestc emssons tradng scheme n a poltcal economy framework. Frst, we characterze the amount of emssons cap chosen by governments nfluenced by poltcal economc ncentves and compare how they dffer from ther socally optmal levels. We show that a government that cares about ndustry proft chooses too large amount of emssons cap, whle a government that cares about envronmental group s welfare chooses too small amount of emssons cap. Second, we examne how a country s decson to lberalze trade affects the equlbrum prce of the emssons cap and hence ts amount chosen by the poltcally-motvated governments. We show that trade lberalzaton that leads to a decrease n the prce of the exportable good wll rase the too low prce of permts caused by ther too large amount chosen by the pro-ndustry government, whle t wll lower

3 Tradable Emssons Permts n the Presence of Trade Dstortons 87 the too hgh prce of permts caused by ther too small amount chosen by the pro-envronment government. Montgomery (1972) s the frst work that conducted research usng theoretcal frameworks for tradable emssons permts. Sterner and Isaksson (2006) adopt a poltcal economy model to analyze emssons tradng, and demonstrate the poltcal superorty of the grandfatherng system. La (2007, 2008) examnes emssons tradng based on the poltcal economy model developed by Grossman and Helpman (1994), and shows that the grandfatherng system s chosen n order to control the ssuance of emssons permts that exceed effcent levels. Harstad and Eskeland (2010) focus on mperfect nformaton n the emssons tradng system, and show that the government, facng uncertanty n frm s cost of abatement, dstrbutes more permts to hgh-cost frms that purchase too large amount of permts, whch results n too hgh prce of permts. Ths paper s organzed as follows. The next secton sets up a poltcal economy model of emssons tradng that wll be used n the followng analyss. Secton 3 examnes the determnaton of total amount of emssons cap. Secton 4 examnes the effect of trade lberalzaton on the equlbrum prce of emssons permts. The fnal secton concludes the paper. 2. Model Ths secton sets up a poltcal economy model n whch the envronmental polcy s endogenously determned. Consder a small open economy that has three ndustres: a non-pollutng numerare good z and two pollutng goods (an mport-competng and an exportable good) x m and x e. The economy also has a representatve ctzen whom we call an envronmentalst. The producton sde of the economy s descrbed by a specfc factors model of a small open economy that s frequently used n the theory of

4 nternatonal trade. The non-pollutng numerare good z s produced by labor wth constant returns to scale technology; unt nput-output coeffcent s assumed. On the other hand, each pollutng good x ( = m, e) s produced by labor l and an nelastcally suppled specfc factor wth constant returns to scale technology x = f (l ), where f > 0andf < 0. 1 Each unt producton of good x generates one unt of emsson that negatvely affects the envronmentalst s welfare. For each unt of emssons, frms have to purchase emssons permts at a prce τ. If the permt ntally allocated to frm s e, the amount of emssons permts purchased by frm becomes x e. 2 Frm s optmzaton problem s gven by max l p f (l ) wl τ(x e )s.t.x = f (l ). Assumng that all goods are produced n the equlbrum, the equlbrum wage rate becomes equal to one, and hence the frst-order condton for ths optmzaton problem gves the amount of labor l and the supply of good x as l (p τ) andx (p τ). We assume that x =0. 3 Comparatve statcs gve the followng. x = x f 2 x = p (p τ)f > 0, τ = f 2 x = (p τ)f < 0. (1) The reward to the specfc factor n ndustry becomes dependent on e as well as p and τ, and hence can be wrtten as π (p,τ,e )=(p τ)f (l (p τ)) l (p τ)+τe. (2) The applcaton of Hotellng s lemma gves the relatonshp π / p = x and π / τ = x + e. 1 To save on notaton, the specfc factor s omtted from the producton functon. 2 If the amount of emssons by frm s less than the amount ntally allocated, then frm can sell emssons permts n the market for the prce τ. 3 That s, we assume lnear supply functon.

5 Tradable Emssons Permts n the Presence of Trade Dstortons 89 An envronmentalst suffers envronmental damage from emssons by pollutng frms. We denote total amount of emssons as x and the envronmental damage as D ( x ), where D > 0andD > 0. The envronmentalst s utlty s represented by u g = c z + u (c ) D( x ), where c z and c denote the consumpton of goods z and x, respectvely. The subutlty functon u( ) s assumed to be ncreasng and strctly concave. The envronmentalst s utlty maxmzaton problem gves the ndrect utlty as ( ) v g = y + σ(p) D x, (3) where y s the envronmentalst s ncome and σ(p) = u (c (p )) p c (p ) represents the consumer surplus as a functon of p e and p m. The market for emssons permts can be descrbed as follows. Frst, total supply of emssons permts s represented by E. The fracton of those permts dstrbuted free of charge (under the grandfatherng system) s gven by α ( [0, 1]), and the fracton of those obtaned by frm s denoted by β ( [0, 1], β =1);frmthus obtans β αe emssons permts. 4 The amount of emssons permts dstrbuted va aucton system can be expressed as (1 α)e. Revenue from the aucton R = τ(1 α)e s assumed to be unformly dstrbuted to the envronmentalst. Total demand for the emssons permts s the sum of each frm s amount of emssons x. Equlbrum condton for the market can be wrtten as x (p τ) =E. (4) Totally dfferentate (4) and use (1) to obtan dτ de = 1 < 0. (5) x 4 We assume β as beng fxed as t s determned n accordance wth frm s past amount of emssons.

6 That s, an ncrease n total supply of the emssons permts (or the amount of emssons cap) decreases the prce of permts. 3. Total amount of emssons cap n a poltcal equlbrum There are two types of groups n the economy: frms and the envronmentalst. A frm n ndustry (frm ) forms the ndustry lobby. The beneft for frm from formng the lobby, gross of poltcal contrbutons, s represented by Π = π (p,τ,e ). (6) On the other hand, the envronmentalst forms the envronmental lobby. The beneft for the envronmentalst from formng the lobby, gross of poltcal contrbutons, can be expressed as V g = v g = l + τ(1 α)e + σ(p) D(E), (7) where we use the equlbrum condton for the emssons permt market E = x to derve the second equalty. 5 The game n ths model s a Grossman and Helpman (1994) type common agency model among the government and lobby groups. The tmng of the decsons s as follows. In perod 1, frms and the envronmentalst form lobbes and make poltcal contrbutons (C,C g ) to the government, where C ( =1,...,N) denotes poltcal contrbutons by ndustry lobby and C g represents those by envronmental lobby. Based on the poltcal contrbutons, the government n perod 2 determnes the total amount of emssons cap E. 5 Note also that the envronmentalst s ncome conssts of the revenue from aucton R as well as labor ncome l.

7 Tradable Emssons Permts n the Presence of Trade Dstortons 91 The model can be solved by backward nducton as n Grossman and Helpman (1994). The objectve functon of the government can be expressed as G = C + C g + aw, (8) where W denotes aggregate socal welfare W = Π + V g, (9) and a represents the extent to whch the government cares about aggregate socal welfare relatve to the poltcal contrbutons. As n Grossman and Helpman (1994), t s assumed that the contrbuton schedule chosen by any organzed lobby reflects ts true preferences. That s, the organzed lobby always chooses a truthful contrbuton schedule. We focus on the equlbrum n whch the organzed lobbes always make postve contrbutons. Thus, under any truthful Nash equlbra (Nash equlbra n whch the organzed lobbes choose truthful contrbuton schedules), we have C E = Π E, C g E = V g E. (10) The equlbrum amount of emssons cap can be characterzed usng those relatonshps. 3.1 Emssons cap n the presence of both lobbes Suppose that both groups are organzed n perod 2. Then, the government chooses the total amount of emssons cap E so as to maxmze ts objectve functon: max G = C + C g + aw. E The optmalty condton for ths problem s G E = C E + C g E + a W E =0. (11)

8 Usng (10), ths can be wrtten as Π E + V g E + a W =0. (12) E The frst term on the left-hand sde of (12) represents the sum of the effects of E on each frm s proft. Dfferentatng (6) wth respect to E, thsterm canbewrttenas Π E = τβ dτ α + e de x dτ de. (13) The frst two terms on the rght-hand sde of (13) express the effect of E on the value of ntal amount of emssons permts τe by frm. The sgn of the frst term s postve whle the sgn of the second term s negatve from (5). La (2007) nterprets that f the demand for the emssons permts becomes nelastc, then t s lkely that the second term domnates the frst term,.e., the sum of the frst two terms becomes negatve. The thrd term represents the effect of E on the frm s cost of emssons va the prce of permts. An ncrease n total amount of emssons cap decreases the prce of permts, whch ncreases the frm s proft. Thus, the sgn of ths term wll be postve. Next, the second term on the left-hand sde of (12) represents the effect of E on the envronmentalst s welfare. Dfferentatng (7) wth respect to E, ths term can be wrtten as ( V g =(1 α) τ + E dτ ) D (E). (14) E de The frst term on the rght-hand sde of (14) represents the effect of E on the value of transferred ncome from the government τ(1 α)e. Agan, f the demand for the emssons permts s nelastc, then an ncrease n total amount of emssons cap causes a sgnfcant decrease n the prce of permts and, therefore, causes a decrease n the value of transferred ncome. Ths exerts a negatve effect on the envronmentalst s welfare. The second

9 Tradable Emssons Permts n the Presence of Trade Dstortons 93 term represents negatve effect that an ncrease n E has on envronmental damage. Fnally, the thrd term on the left-hand sde of (12) represents the effect of E on the aggregate socal welfare. Usng (13) and (14), ths term can be represented as W E = τ D (E). (15) The above equaton reveals that a government whch ams to maxmze the aggregate socal welfare chooses E such that τ = D (E). That s, the government chooses the total amount of emssons cap E so that the margnal damage and the margnal beneft from emssons become equal. Substtutng (13)-(15) nto (12) gves the optmal condtons regardng the total amount of emssons cap chosen by the government (1 + a)[τ D (E)] = 0. (16) That s, the government chooses the total amount of emssons cap such that τ = D (E). Thus, f both groups are organzed, then a government wll choose socally optmal level of emssons cap E. 3.2 Emssons cap n the presence of ndustry lobby Next, suppose that only the ndustry lobby s organzed n perod 2. Then, the government chooses the total amount of emssons cap E so as to maxmze ts objectve functon, whch gves the optmalty condton as G E = C E + a W E =0. (17) Usng (10), ths can be wrtten as Π E + a W =0. (18) E

10 Substtutng (13) and (15) nto (18) gves the optmalty condtons regardng the total amount of emssons cap chosen by the government [ ] dτ τβ α + e de x dτ + a [τ D (E)] = 0. (19) de From (19), the prce of emssons permts n perod 2 when only the ndustry lobby s formed can be derved as τ b = a (1 α)e dτ a + α D + a + α de. (20) From the equaton above, t can be shown that τ b <D ; therefore, E b > E. 6 That s, when only the ndustry lobby s formed n perod 2, the government that cares about the ndustry lobby chooses too large amount of total emssons cap. Wth too large amount of total emssons cap, ts prce decreases, whch ncreases ndustry profts. 3.3 Emssons cap n the presence of envronmental lobby Fnally, suppose that only the envronmental lobby s organzed n perod 2. Then, the government chooses the total amount of emssons cap E so as to maxmze ts objectve functon, whch gves the optmalty condton as G E = C g E + a W E. (21) Usng (10), ths can be wrtten as V g E + a W E =0. (22) 6 Note that τ b <D follows from dτ/de < 0, and E b >E follows from D > 0 and D > 0.

11 Tradable Emssons Permts n the Presence of Trade Dstortons 95 Substtutng (14) and (15) nto (22) gves the optmalty condtons regardng the total amount of emssons cap chosen by the government ( (1 α) τ + E dτ ) D (E)+a[τ D (L)] = 0. (23) de From (23), the prce of emssons permts n perod 2 when only the envronmental lobby s formed can be derved as τ g = 1+a (1 α)+a D (1 α)e dτ (1 α)+a de. (24) From the equaton above, we have τ g >D ; therefore, E g <E. That s, when only the envronmental lobby s formed n perod 2, the government that cares about the envronmental lobby chooses too small amount of total emssons cap. Wth too small amount of total emssons cap, ts prce ncreases, whch benefts the envronmentalst. The followng result summarzes those obtaned n ths secton. Suppose that the economy conssts of ndustralsts and envronmentalsts. Suppose also that the government ssues tradable emssons permts and ts decson s subject to poltcal pressure. Then, f both lobbes are formed, the government ssues socally optmal amount of emssons permts. If only the ndustry lobby s formed, the government ssues too large amount of emssons permts to beneft ndustralst s proft. If only the envronmental lobby s formed, the government ssues too small amount of emssons permts that generates benefts to envronmentalsts by reducng polluton. 4. Trade lberalzaton and the total amount of emssons cap The precedng secton examned the determnaton of the total amount of emssons cap by governments that are poltcally nfluenced by lobby

12 groups. Ths secton examnes how a country s decson to lberalze trade, whch leads to a prce change, affects the poltcal economc choce of envronmental polcy n the country. In partcular, ths secton examnes how a change n the prce of the pollutng goods affects the equlbrum prce of emssons permts. For smplcty, we assume that the prce of the mportable good s one and let p e = p. Asp represents the domestc prce of the exportable good, removng trade dstortons by the small country wll cause a reducton of p. 4.1 Trade lberalzaton n the presence of ndustry lobby Frst, from (5) and (20) when only the ndustry lobby s formed n equlbrum, the prce of emssons permts can be expressed as τ b = a a + α D ( x ) (1 α) x a + α 1. (25) x Totally dfferentate (25) to obtan dτ b dp = a a+α D x e 1 α x e a+α x 1+ a a+α D x 1 α a+α. (26) The above equaton represents the effect of p on τ b. Ths can be nterpreted as follows. A decrease n p contracts the export ndustry. Ths wll exert two opposng effects. On the one hand, t wll shrnk the demand for emssons permts, whch works for lowerng the prce of the permts. Ths s reflected n the frst term n the numerator on the rght-hand sde of (26). On the other hand, decreasng p reduces the ndustralst s lobbyng effort. Ths wll decrease the supply of permts, whch works for rasng ts prce τ. Ths s reflected n the second term n the numerator on the rght-hand sde of (26). Total effect s ambguous and depends on the relatve magntude

13 Tradable Emssons Permts n the Presence of Trade Dstortons 97 of those effects. However, under the assumpton of lnear damage functon D = 0, the frst effect vanshes, and hence the trade lberalzaton wll lead to an ncrease n the too low prce of permts that was caused by the too large amount of emssons cap. The followng proposton summarzes those obtaned n ths secton. Proposton 1 : Suppose that the economy conssts of ndustralsts and envronmentalsts. Suppose also that the government ssues tradable emssons permts and ts decson s subject to poltcal pressure and that the envronmental damage functon s gven by a lnear form. Then, n the presence of the ndustry lobby, the trade lberalzaton that leads to a decrease n the prce of the exportable good wll rase the too low prce of permts. 4.2 Trade lberalzaton n the presence of envronmental lobby Next, from (5) and (24), when only the envronmental lobby s formed n equlbrum, the prce of emssons permts can be expressed as τ g 1+a = (1 α)+a D ( Totally dfferentate (27) to obtan dτ g dp = 1+a (1 α)+a D x e + x )+ (1 α) x (1 α)+a 1+ 1+a (1 α)+a D x + 1 α x e (1 α)+a x 1 α (1 α)+a 1. (27) x. (28) The above equaton represents the effect of p on τ g. Ths can be nterpreted as follows. Agan, a decrease n p contracts the export ndustry. Ths wll exert two effects. Frst, t wll shrnk the demand for emssons permts, whch works for lowerng the prce of the permts. Ths s reflected n the frst term n the numerator on the rght-hand sde of (28). Second, decreasng p reduces the envronmentalst s lobbyng effort. Ths wll ncrease the

14 supply of permts, whch works for lowerng ts prce τ. Ths s reflected n the second term n the numerator on the rght-hand sde of (28). Thus, the sgn of (28) s postve, mplyng that the trade lberalzaton wll lead to a decrease n the too hgh prce of permts that was caused by the too small amount of emssons cap. The followng proposton summarzes those obtaned n ths secton. Proposton 2 : Suppose that the economy conssts of ndustralsts and envronmentalsts. Suppose also that the government ssues tradable emssons permts and ts decson s subject to poltcal pressure. Then, n the presence of the envronmental lobby, the trade lberalzaton wll, n turn, lower the too hgh prce of permts. 5. Concludng Remarks Ths paper examned how trade lberalzaton would affect a domestc emssons tradng scheme n a poltcal economy framework. We constructed a model n whch the total amounts of emssons cap were endogenously determned, and examned how a corruptble government ssued neffcent amounts of emssons cap to beneft ts preferable group. We also examned how a country s decson to lberalze trade, whch leads to a decrease n the prce of the exportable good, could affect the equlbrum prce of permts chosen by the government. The conclusons obtaned from the analyses can be summarzed as follows. Frst, we showed that f both lobbes were formed, the government ssued socally optmal amount of emssons permts. If only the ndustry lobby s formed, the government ssues too large amount of emssons permts to reduce ts prce, whch benefts ndustry group. If only the envronmental lobby s formed, the government ssues too small amount of emssons permts to reduce polluton emssons, whch benefts an envronmental group.

15 Tradable Emssons Permts n the Presence of Trade Dstortons 99 Second, we showed that trade lberalzaton, leadng to a decrease n the prce of the exportable good, would rase the too low prce of permts that was caused by the too large amount of emssons cap n the presence of ndustry lobby, whle t would lower the too hgh prce of permts that was caused by the too small amount of emssons cap n the presence of envronmental lobby. Reference 1 Grossman G.M., and E. Helpman Protecton for Sale. Amercan Economc Revew 84: Harstad, B., and G.S. Eskeland Tradng for the Future: Sgnalng n Permt Markets. Journal of Publc Economcs 94: La, Y The Optmal Dstrbuton of Polluton Rghts n the Presence of Poltcal Dstortons. Envronmental and Resource Economcs 36: La, Y Auctons or Grandfatherng: the Poltcal Economy of Tradable Emsson Permts. Publc Choce 136: Montgomery, W Markets n Lcenses and Effcent Polluton Control Programs. Journal of Economc Theory 5: