Linking Price and Quantity Pollution Controls under Uncertainty

In some cases, linking of policies for the provision of international public goods can increase welfare on a global scale. One example is the international linking of national policies for the reduction of greenhouse gas emissions. By pooling of abatement options, economic efficiency of regulation can be increased since least-cost abatement options can be identified more easily. Linking of policies can lead to situations where abatement costs decrease in one country, but increase in another country. The magnitude of expected changes in abatement costs is an important determinant whether a country is interested in direct policy linking or not. In this paper, we consider the case of two countries that have to produce an exogenously given amount of a public good (e.g. greenhouse gas abatement) under uncertain (abatement) costs or otherwise purchase the good on a market (e.g. international emissions trading). We compare the case when both countries choose regulation by quantities (“quantity-quantity linking”) to a situation where one of the countries is choosing prices (e.g. a carbon tax) while the other country chooses quantities (“price-quantity linking”). To examine the effective costs of regulation for both countries under uncertainty and different policy scenarios, we numerically solve the model where uncertainty is modelled by assuming that abatement costs have a log-normal distribution. It is shown that in most cases, total expected costs increase for the country that chooses prices under international emissions trading when compared to quantity regulation. The only case for which we found that the price-setting country would be better off choosing prices occurred when the quantity-setting country had a much more onerous target than the price-setting country. Countries will further be unable to identify a tax rate that minimizes costs because of uncertainty and unknown correlation of costs between countries. Large economies face higher expected cost increases relative to smaller economies when choosing regulation by prices under international emissions trading. If there are specified quantity targets for the provision of an international public good, and international policy linkages exist, price regulation will usually lead to both higher costs and higher variance of costs when compared to quantity regulation. In this case, price regulation will not serve as a mechanism for cost containment.

Wood, Peter J., Peter Heindl, Frank Jotzo and Andreas Löschel (2013), Linking Price and Quantity Pollution Controls under Uncertainty, CCEP Working Papers, Canberra