The efficiency of decentralized environmental policies under global pollution and tradable emission permits

• Date: 01 August 2018
• Author: Nikos Tsakiris,Panos Hatzipanayotou,Michael S. Michael
• Published date: 01 August 2018
• DOI: http://doi.org/10.1111/jpet.12296

Received: 4 August 2017 Accepted: 8 March 2018

DOI: 10.1111/jpet.12296

ARTICLE

The efficiency of decentralized environmental

policies under global pollution and tradable

emission permits

Nikos Tsakiris1Panos Hatzipanayotou2Michael S. Michael3

1Universityof Ioannina

2AthensUniversity of Economics and Business

3Universityof Cyprus

NikosTsakiris, Department of Economics, Univer-

sityof Ioannina, P.O.Box 1186, 45110 Ioannina,

Greece(ntsak@cc.uoi.gr).

PanosHatzipanayotou, Department of Interna-

tionaland European Economic Studies, Athens

Universityof Economics and Business; 76, Patis-

sionstr., Athens 104 34, Greece, and CESifo

(Centerfor Economic Studies and the Ifo Institute

ofEconomic Research) (hatzip@aueb.gr).

MichaelS. Michael, Department of Economics,

Universityof Cyprus; P.O.Box 20537 Nicosia, CY

1678,Cyprus (m.s.michael@ucy.ac.cy).

We build a two asymmetric regions model with cross-border pollu-

tion related to production. Each region issues emission permits and

revenues from their sales finance public pollution abatement. The

decentralized level of emission permits is efficient when permits are

interregionally tradable and cross-border pollution is perfect. This

result is robust in a variety of cases—for example, when (i) capital is

immobile or internationally mobile or only mobile between the two

regions, and (ii) revenuefrom permits sales is transferred to a federal

authority.

1INTRODUCTION

More often than not, countries are entangled in a “race to the bottom”in environmental policies due to increased com-

petitive pressures resulting from wider and deeper globalization in commodity and factor markets. Nowadays, how-

ever,certain countries question the viability of pathbreaking international environmental agreements aiming at curb-

ing global environmental pollution such as green house gas emissions (GHGs).1In light of the above,the present study

raises the question, “Can decentralized environmentalpolicymaking lead to efficient outcomes in a globalized world?”

We address this question within a theoretical model of a federal economy with two regions, international capital

mobility (ICM), and cross-border pollution. Tradable emissions permits and public pollution abatement are the pol-

icy instruments of curbing production-generated transboundary pollution emissions. The primary result of our paper

is that when transboundary pollution is perfect,2the decentralized policymaking is efficient when pollution is con-

trolled via emission permits that are tradable within and across regions, that is, interregionally tradable, and revenue

from sales of such permits are earmarked to finance public pollution abatement. The crucial model feature driving this

1Recently the U.S.administration declared pulling out from the Paris Climate Agreement, steering away from 194 countries vowing to limit planet-warming

GHGemissions.

2Our assumption of perfectly transboundary pollution emissions is relevant for the case of air pollution due to emissions such as GHG, for example, CO2

pollutants.Air pollution is rather global than local in nature since pollution generated in one region is equally harmful to neighboring regions as it is locally (e.g.,

Fenger,2009; Ramanathan & Feng, 2009).

Journal of Public Economic Theory.2018;20:541–556. wileyonlinelibrary.com/journal/jpet c

2018 Wiley Periodicals,Inc. 541

542 TSAKIRIS ET AL.

result is the way regions use the revenue from sales of such tradable emission permits. In general, if a region which

issues these permits uses the revenue to finance the provision of public pollution abatement, then the decentralized,

that is, noncooperative, setting of interregionally tradableemission permits is equally efficient to the centralized, that

is, cooperative,one. The rationale for this result is that, when one country increases the volume of interregionally trad-

able emission permits by one unit, it affects the other country's welfare negatively due to higher levelof pollution (pol-

lution externality), and positively due to higher production and income (income externality). Evaluated at the Nash

equilibrium, the negative pollution externality is exactly equal (in absolute terms) to the positive income externality

when cross-border pollution is perfect. Thus, the two externalities neutralize each other,rendering the decentralized

policymaking efficient. If,however, emission permits are tradable only intraregionally,then the noncooperative setting

of these permits is always inefficient, as long as the rate of cross-border pollution is nonzero.

Our study accounts for two important features that are used extensively by many countries for controlling pollu-

tion. The first is the use of tradable emission permits, and the second is public pollution abatement. The use of tradable

emission permits was introduced with the Kyoto Protocol on Climate Change in 1997 to reduce GHG emissions over

the period 2008–2012. The agreement provided,for the 39 signatory countries, the setting of binding emission quotas,

and allowed for international trade of these emission quotas among them. The permitstrade was proposed on grounds

that the Kyoto goals could be attained best and at a minimum cost through marketoperations.3Moreover, since 2005

the EU operatesthe so-called Emissions Trading Scheme (EU-ETS), the largest scheme of tradable permits worldwide, for

controlling CO2emissions by large energy-intensiveindustrial sources among its member countries (see, e.g., Ellerman

& Joskow,2008; Gersbach & Winkler, 2011).4At the same time, the EU-ETS system is linked to other compatible “cap-

and-trade” systems in order to enable participants in one system to use units from another for compliance purposes.

In this context, the EU maintains both bilateral emission-tradingagreements with a number of countries, for example,

Australia, China, South Korea, and Switzerland, and multinational ones, for example, the International Carbon Action

Partnership (ICAP).5This partnership brings together countries and regions that actively pursue the development of

carbon markets through the implementation of mandatory cap-and-trade systems. In the United States, since 1990,

interstate emissions of sulfur dioxide (SO2) are controlled bythe Sulfur Allowance TradingScheme (US-SATS). SO2emis-

sionpermits were initially allocated in proportion to historical emissions, but permits were tradable. In 2007, five West-

ern U.S.states, that is, Arizona, California, New Mexico, Oregon, and Washington, created the Western Climate Initiative

(WCI), a multisector market-basedcap-and-trade program of reducing GHG emissions. In 2008, WCI was expanded to

include twoadditional U.S. states, Utah and Montana, and four Canadian Provinces, that is, British Columbia, Manitoba,

Ontario, and Quebec. Other systems of trading emission permits operate or are in the process of being developed in

Canada, China, Japan, New Zealand, South Korea, and Switzerland. Because of such considerations, our analysis uses

tradable emission permits, ratherthan tax instruments, for controlling cross-border pollution. 6

The second feature of our analysis, that of public pollution abatement, is also important nowadays in limiting global

environmental pollution. In particular, among alternative measures proposed by international environmentalagree-

ments aiming at curbing global environmentalpollution is the commitment of federal funding to reduce certain types of

global pollutants, for example, CO2emissions, to protect endangered species. Empirical evidence attests that in many

OECD countries public pollution abatement activities constitute an important part of their environmental policy.7On

3InDecember 2015, in the Paris climate conference (COP21), an agreement within the United Nations Framework Conventionon Climate Change (UNFCCC),

195countries adopted the first-ever universal, legally binding global climate deal regarding GHG mitigation, adaptation, and finance, starting in the year 2020.

4As reported by Gersbach and Winkler (2011), “Its prime objective is to promote cost efficiency in the member states'endeavorto live up to the emission

reduction commitments laid out in the EU Burden Sharing Agreement. Emission allowances are distributed to firms according to National Allocation Plans,

whichare determined by negotiations between member states and firms and then submitted to, and approved by, the European Commission.”

5For details see European Commission (https://ec.europa.eu/clima/policies/ets/markets_en).Also, Schmalensee and Stavins (2015) and Sandler (2017) pro-

videa comprehensive review of major emission trading programs and of international environmental agreements over the past decades.

6Kotsogiannisand Woodland (2013), among others, examine the role of trade policy instruments, for example, trade taxes, on globally efficient carbon taxes

eitherfrom a noncooperative or cooperative perspective.

7Forexample, in December 2016, U.S. President Obama signed a law providing federal funding for drinking water infrastructure upgrades in Flint, Michigan,

where drinking water remains contaminated with lead. In accordance with this law,the U.S. Environmental Protection Agency (EPA) announced an award of

$100million to Michigan's Department of Environmental Quality. A 2007 OECD report (Linster & Zegel, 2007) states governments have designed policies of