“Welfare Gains from Optimal Pollution Regulation,” J. M. Abito (2012)

Mechanism design isn’t just some theoretical curiosity or a trick for examining auctions. It has, in the hands of skilled practitioners like David Baron, Jean-Jacques Laffont, Jean Tirole and David Besanko (an advisor of mine!), had a huge impact on economic regulation. Consider regulating a natural monopoly that has private information about its costs. In the standard sorting problem, I am going to have to pay information rents to firms that have low costs, since otherwise they will claim to have high costs and thus get to charge higher prices. If funds are costly – and the standard estimate in US public finance is that the marginal dollar of taxation imposes 30 cents of deadweight loss on society – then those information rents are a welfare loss and not just a transfer. Hence I may be willing to sacrifice some allocative efficiency by, for example, randomizing over all firms who claim to be at least somewhat efficient rather than paying a large information rent to learn exactly who the efficient firm is. Laffont’s 1994 Econometric Society address covers this basic point quite nicely.

Mike Abito, on the job market here at Northwestern, notes that few real-world policies actually take account of this tradeoff. Consider a regulator who wants polluting firms to abate their pollution when economically feasible. If the distribution of abatement costs is widely dispersed, then low cost firms have a large incentive to claim high costs and therefore avoid paying for abatement. Especially in this case, it may be worthwhile to sacrifice some allocative efficiency in an optimal pollution abatement scheme, having low cost firms not abate as much as they would if the regulator wanted all information about each firm’s costs. In order to design the optimal pollution regulation scheme, then, we need to know the distribution of marginal abatement costs, which is not something we know immediately from data. In particular, consider regulating SO2 among power plants. Hence, to the world of theory, my friends! (And, briefly, why not just sell pollution permits? If you give away the permits to each plant, then the same informational issue arises, and you do not earn any tax revenue that could offset distortionary taxes elsewhere in the economy.)

Let a power plant, at some cost and effort level, produce some bundle of electricity and SO2. Observed costs alone are not enough if firms have inherently high costs, since firms may appear to have high costs when in fact they are simply exerting low effort. Abito notices that power plants are both rate regulated – meaning that they are natural monopolies whose rates are set by a government agency that estimates their costs – and regulated for pollution reasons. By writing down an auditing game, you see that in the periods the firm is being watched for rate-setting purposes, they exert low effort. They do exert effort in future periods, since any cost reduction comes to them as profits. Indeed, if you look at, for instance, heat generation during years where the plants are being watched, the amount of heat generated declines by roughly the same amount as effort is estimated to decline in the model, so the hypothesized equilibrium of the auditing game is not totally out of line with the data.

What this wedge between cost efficiency in years when the plant is being watched and in other years gives us is an estimate of the cost function, including disutility of effort, which generates some bundle of SO2 and electricity. In fact, it gives us just enough of an exclusion restriction to estimate the distribution of marginal abatement costs of SO2 using techniques from dynamic structural IO. Once we have estimated that distribution, we can solve for numerical estimates of the welfare gain from various abatement policies. Laffont long ago showed that the optimal pollution regulation under this private information, assuming we know the distribution of marginal abatement costs, involves a bundle of type-dependent emission taxes and type-dependent transfers which give the least efficient firm zero profits, but which also lead to less effort and less pollution abatement for more efficient firms that you would get with full information; again, this is just the tradeoff between information rents and allocative efficiency. Such a heterogeneous policy might be tough to implement in practice, however. Welfare gains from the optimal policy instead of a uniform emissions standard, given the estimated distribution of marginal abatement costs, are equal to about 10% of the entire variable cost of the average plant. A uniform emissions tax (rather than a standard which imposes a maximum amount of emissions) captures something like 60-70% of this improvement, and is easier to implement.

More generally, the gain to society of using regulatory regimes that condition on the underlying properties of each firm really depends on properties like the distribution of marginal abatement costs which atheoretically can never be known, but which with the use of proper structure can actually be estimated. What is particularly cool here is that, unlike most earlier work, the underlying firm properties are estimated without assuming that the regulator is already optimizing, an assumption that is simply false in the case of pollution regulation. Good stuff.

November 2012 Working Paper (Not available on IDEAS). There are a number of interesting papers in environmental economics on the job market this year. Lint Barrage at Yale discusses how carbon taxes and other taxes should interact in optimal fiscal policy. In particular, since carbon in the atmosphere lowers the productive capacity of assets (like agricultural land) in the future, not taxing carbon is identical to taxing capital, producing the same distortion. When the economy already has distortionary taxation, the optimal rate of carbon taxation will need to be adjusted. Joseph Shapiro from MIT estimates the environmental damage from CO2 produced in international trade. It is two orders of magnitude smaller than the gains from that trade, and a small carbon tax on international shipping is optimal. In a separate paper, Shapiro and coauthors find that US mortality during heat waves declined massively over the twentieth century, that all of the decline appears to be linked to adoption of air conditioning, and hence that mitigation of some negative health impacts of climate change in poor countries will likely be handled by A/C. Since A/C uses electricity, non-carbon methods of generating that electricity are critical if we want to avoid making climate change worse while we mitigate these impacts.

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