Emissions targets and the real business cycle: Intensity targets versus caps or taxes

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Abstract

For reducing greenhouse gas emissions, intensity targets are attracting interest as a flexible mechanism that would better allow for economic growth than emissions caps. For the same expected emissions, however, the economic responses to unexpected productivity shocks differ. Using a real business cycle model, we find that a cap dampens the effects of productivity shocks in the economy on all variables except for the shadow value of the emissions constraint. An emissions tax leads to the same expected outcomes as a cap but with greater volatility. Certainty-equivalent intensity targets maintain higher levels of labor, capital, and output than other policies, with lower expected costs and no more volatility than with no policy.

Highlights

► We use a real business cycle model to assess policies for reducing greenhouse gas emissions. ► We assess the implications of productivity uncertainty on economic outcomes. ► An emissions cap dampens the effects of productivity shocks in the economy. ► An emissions tax leads to the same expected outcomes as a cap but with greater volatility. ► An intensity target maintains higher levels of labor, capital, and output than other policies.

Introduction

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 [1], 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, China, and India, have announced plans to pursue intensity targets, which are also the basis for some prominent proposals to include developing countries in a global framework [2]. 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., [3]).

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 [4], 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 [5] and Quirion [6], follow the partial equilibrium approach of Weitzman. Others have taken a general equilibrium approach, focusing on the role of tax interactions [7], [8], the role of multisector and international trade [9], [10],1 or both [11]. Given that uncertainty about economic growth and the macroeconomic transition effects of carbon policy are 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 contributions by Kolstad [12], Quirion [6], Pizer [3], Jotzo and Pezzey [10], and Sue Wing et al. [13] is reviewed by Peterson [14] 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 an i.i.d. random shock 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 [15] 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. We conduct a cost-effectiveness analysis conditional on a given abatement target. 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.2 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 change 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 the greatest under the tax. Meanwhile, the sensitivity to shocks under the intensity target is unchanged from the no policy case.

Section snippets

Deterministic model

Although the issues at play involve economic growth and uncertainty, much of the intuition regarding the policy differences can first be derived from a simple, deterministic model without growth, by looking at the steady-state responses to different emissions policies and degrees of a permanent productivity change. Consider a simple Robinson Crusoe economy. Let C be the consumption good, K be capital, L be labor, l be leisure, and M be a polluting intermediate good. The representative agent

Numerical solution and simulation method

Because of the nonlinear form of the first-order conditions, specifically the intertemporal Euler and labor equations, we use a numerical method to calculate a first-order approximation to the equilibrium conditions. To begin, we parameterize the model using standard calculations from the real business cycle (RBC) literature and our own analyses (see Table 2). For production parameters we start with King et al. [16] (hereafter KPR) calculation of mean annual share of GNP to labor (verified with

Conclusion

Stabilizing greenhouse gas concentrations in the atmosphere will require dramatic reductions in global carbon emissions. The choice among policies should be informed both by their expected cost-effectiveness and by how they respond to unexpected events along the path. We find that although a cap and a tax can produce equivalent outcomes in expectation, a cap-and-trade program reduces economic volatility, compared with all other policies and no policy, and a tax enhances volatility. The cap

Acknowledgment

Support from EPA-STAR and NSF/IGERT Program grant DGE-0114437 is gratefully acknowledged

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