Pollution taxes when firms choose technologies.

• Author: Amacher, Gregory S.

1. Introduction

   In the past several years, considerable emphasis has been placed on stimulating the adoption of "clean" technologies by polluting firms (National Research Council 1996; Hart 1997). In the United States, an Environmental Technology Initiative was established in 1993 to promote the development and adoption of innovative environmental technologies. Internationally, development and adoption of clean technologies is viewed as instrumental in reducing greenhouse gas emissions from both developed and developing countries (Watson, Zinyowera, and Moss 1996).

   This emphasis on technology has been accompanied by increased use of taxes to limit industrial pollution and achieve environmental goals. Most European and many Asian countries now use pollution taxes to control a range of air and water pollutants. Such taxes have long been advocated by economists and have been studied extensively in the literature on externalities and environmental policy design. A primary focus of this literature has been on examining the properties of pollution taxes in a range of settings that capture, at least partially, the complexities of real-world policy choices. Complexities considered include asymmetric information about firms' control costs, cheating by firms, imperfections in the product market in which firms operate, and nonconvexities in the damages from pollution. (1)

   With few exceptions, neither this body of work nor the larger theoretical literature on environmental policy design explicitly considers firms' technology choices. The bulk of the literature simply assumes that a firm's costs of reducing pollution emissions are given by a smooth convex function, effectively implying that the firm has available a continuum of technologies for reducing emissions. This assumption, though analytically convenient, is not necessarily consistent with reality. Firms' options for reducing emissions are typically discrete, as is observed in the applied literature on pollution control. For example, Palmer et al. (1995) and Fullerton, McDermott, and Caulkins (1997) emphasize the discrete nature of the abatement technology choices available to electric utilities.

   Accordingly, in this paper we develop and analyze a model in which a regulated firm has a discrete choice of technologies with which to reduce its emissions. The technologies differ in terms of the trade-off they embody between the fixed and marginal costs of emissions reductions. There is a "cleaner" technology that has low marginal costs but high fixed costs and a "dirtier" one for which the opposite is true. This trade-off between marginal and fixed costs is not unusual: Firms subject to environmental regulation are often faced with a choice of either modifying/replacing their existing production process with a new, inherently cleaner process or keeping their existing production process and simply adding on pollution treatment equipment. (2) Modifying or replacing a production process entails larger outlays on both equipment and retraining of personnel (Kemp 1997, pp. 11-4, 103-4), leading to higher fixed costs.

   Given this discrete choice of technologies, we consider a firm's behavior when facing a regulator that has perfect information. The regulator imposes the typical linear emissions tax to achieve the socially optimal emissions level. We find that there is a range of emissions levels the regulator is unable to achieve, regardless of the magnitude of the tax it imposes. The first-best emissions level could well lie in this range; thus, the first-best outcome may not be attainable. This finding is rather surprising since it arises from a seemingly minor modification of the standard model of a regulated firm.

   These results are obtained assuming the traditional sequence of play between the firm and the regulator: The regulator moves first by announcing the tax rate, and the firm then follows, choosing its technology and emissions level (Cropper and Oates 1992). Making explicit the firm's technology choice allows for an alternative sequence of play: The firm could now move first by choosing a technology, with the regulator then announcing the tax rate. In some cases, this sequence of play better reflects the actual behavior of firms and regulators. For example, Stavins (2002) points out that some U.S. oil refineries adopted lead emissions-reducing technologies before a ban on lead emissions was instituted by the U.S. Environmental Protection Agency. Similarly, Sterner (2001, chap. 2) notes that in Sweden, paper mills adopted chlorine-free bleaching technologies in anticipation of a possible tax on chlorine emissions. The tax was imposed two years later. More generally, Stavins (1998) argues that as a matter of marke t strategy, firms may have an incentive to invest in cost-saving technologies when faced with the prospect of price regulation.

   Given the usual advantages of moving first, we would expect the regulator to be in a better position to achieve the first-best outcome when it, rather than the firm, moves first. However, we find that this is not necessarily true. Under some conditions, the first-best outcome can be attained only when the firm moves first. Thus, allowing the firm to move first can be socially desirable, bringing forth the possibility that firms should be encouraged to take the lead in regulatory settings.

   As noted previously, the theoretical literature on environmental policy design has focused little attention on firms' technology choices. The primary exception is a small but growing literature that examines the incentives for innovation provided by alternative policy instruments for controlling pollution. Recent contributions to this literature include those by Biglaiser and Horowitz (1995), Laffont and Tirole (1996), Parry (1998), and Denicolo (1999). (3) This literature differs from our work in at least one of two respects. First, it considers innovation rather than adoption, and second, like most of the theoretical literature, it assumes that firms have a continuum of technology choices. An exception is a paper by Requate (1995) that explicitly considers technology adoption when firms have discrete technology choices. However, he does not identify the results we present here. He focuses on the ability of an emissions tax to induce the optimal pattern of technology adoption when there are multiple firms an d the output market effects of technology adoption are recognized.

   A further difference between our work and the existing literature is that the latter restricts attention to the traditional sequence of play--the regulator leading and the firm following. (4) This is also true of an early, and now classic, paper on externalities by Turvey (1963) that is closely related to our work. Turvey considers a setting in which an agent has a choice between two activities (or technologies) both of which generate an externality. The activities yield different marginal benefits to the agent and impose different marginal damages on society. Turvey shows that a Pigouvian tax does not achieve the first-best outcome in this setting. Turvey's model differs from ours in two respects: (i) We assume that the two technologies differ only in terms of abatement costs and not marginal damages, and (ii) we include fixed costs, which are important to technology adoption, whereas Turvey ignores them. Turvey's assumption that marginal damages differ for the two activities is critical to his results. It c an be shown that if marginal damages were the same, a Pigouvian tax would achieve the first-best outcome in his model. (5)

   Both in Turvey's model and in ours, the regulator can unambiguously achieve the first-best outcome if it is able to impose a suitable nonlinear tax or dictate the technology the firm uses. We restrict attention to taxes that are linear in emissions (i.e., a constant amount is charged per unit of pollutant emitted) because the emissions taxes in place are typically of this form (Sterner 2001, chap. 5; Stavins 2002). The reliance on simple linear taxes is due in large part to the administrative difficulties in implementing more complex tax schemes (Sterner 2001, chap. 3).

   In addition, we assume that the regulator is unable to dictate the technology the firm uses. This could be due to legislative restrictions on the nature or extent of regulatory intervention in the firm's decisions. In the United States, this is true under existing policies even when environmental regulations are technology based. For example, the Clean Water Act calls for emissions standards that are based on "best available technologies." Yet firms are free to choose other control technologies or other means (such as process or input changes) to comply with the standards (Freeman 1990).

   The rest of the paper is organized as follows. In the next section we present our basic model. In section 3, we consider the traditional setting in which the regulator moves first. The alternative setting in which the firm moves first is examined in section 4. A comparison of the results for these two settings leads to a discussion of first-mover advantages in section 5. The final section contains our conclusions.

2. Basic Model and Assumptions

   Before describing our model, it would be appropriate to comment on our use of the term "technology." We use the term in its vernacular sense to refer to a specific option available to a firm for reducing its pollutant emissions. An example of such an option is installation of waste treatment equipment. The term could be used instead in a more formal sense to refer to the entire set of options available for reducing emissions. Rather than referring to technologies, we would then refer to abatement options within an existing technology. Our choice of terminology is not critical to our analysis. What is critical is our assumption that there is a discrete set of abatement options rather than the conventionally assumed continuum of options.

   Firm

   The...