Intergovernmental versus intersource emissions trading when firms are noncompliant

Abstract

This paper analyzes the relative cost-effectiveness of intergovernmental versus intersource cross-border emissions trading when polluting firms are noncompliant. A special focus is placed on the presence of enforcement costs and the associated credibility problem of governmental monitoring. It is shown that without inspection commitment, the intergovernmental system is more cost-effective because the endorsed flexibility in domestic emission taxation serves as a commitment device for building credibility of monitoring.

Introduction

Flexibility is a keyword of the Kyoto Protocol. In the proposed framework of greenhouse gas emissions reduction, participant countries may enact their own domestic regulations to achieve their reduction commitments, in addition to trading emission allowances with one another.¹ Unfortunately, no conclusion about the real architecture has been reached yet after the Kyoto convention. One of the most controversial issues is on the participation of private firms in cross-border emissions trading, to which the protocol made no reference.

The paper addresses whether private firms should be allowed free access to international emissions trade, placing focus on their noncompliance.² The question can be deemed as the choice of trading systems, intersource versus intergovernmental, whose difference lies in the eligibility of sub-national entities (which we call firms). In both systems, before emissions trading, a fixed number of internationally tradable emission permits are issued corresponding to a target level of reductions and distributed among the regulators of participant countries (which we call the governments) according to their reduction commitments. In the intersource system, the governments elect to give the assigned permits to domestic firms by auction or grant, and authorize their free cross-border transaction with no governmental intervention introduced. Firms are supposed to cover their emissions with their own holdings of permits, but if necessary, the governments also hold them to compensate the amounts of gases illegally discharged by noncompliant firms. In the intergovernmental system, by contrast, the governments retain the sole right of cross-border emissions trading, prohibiting participation of firms. Each government must hold as many permits as to cover the whole amount of domestic emissions. To achieve this, it may regulate domestic emissions by introducing environmental measures of its own, such as domestic emission taxes and domestic tradable quotas, as well as trade the permits on an intergovernmental basis. The prohibited private access to international emissions trade enables the governments to hold more flexible regulatory control over domestic emissions; they may levy any tax-prices on domestic emissions, independent of the international price of permits.

To achieve a reduction target most cost-effectively (namely, at the minimal cost), emissions reductions must be allocated across nations to equalize their marginal costs regardless of where they are made. From the standard theory in environmental economics, cross-border emissions trade, intergovernmental or intersource, will attain this goal with the marginal emissions reduction costs equalized to the price of permits, if the following four conditions are met:

• Firms and governments will, respectively, minimize the source- and national-level compliance costs,

• Emissions are traded competitively,

• Governments correctly know the distributions of abatement costs over domestic firms, and

• Any regulations are enforceable at no cost.³

Nevertheless, a popular view in favor of the intersource system points out that the intergovernmental system seems not to satisfy C1–C3 in reality; governments may introduce inefficient regulations because of concerns about income distribution and political support, exercise market power strategically when in the position of large sellers or buyers, or have imperfect knowledge about the distributions of private abatement costs.⁴ In this argument, however, little attention is paid to C4, though it seems no more realistic than the others.

Costly enforcement poses two problems for the cost-effectiveness of emissions trade. One is the problem of enforcement cost internalization. This occurs when the presence of enforcement costs produces a gap between the national- and source-level marginal costs of emissions reduction. Whereas the national-level ones must be equalized across countries for cost minimization, private abatement decisions will care only about the source-level ones, ignoring publicly incurred enforcement costs. The intersource system thus fails to equalize the national-level marginal costs to the price of permits. The other is the problem of time-consistency in governmental monitoring. This occurs when the governments cannot commit to inspection probabilities with which to monitor the compliance status of firms, before their compliance decisions. Without inspection commitment, perfect enforcement is hard to achieve and noncompliance unavoidable, for firms realize that the governments, aware of their full compliance, would not conduct costly inspection. In such a situation the governments can credibly enforce regulation only when it accompanies monitoring with time-consistent inspection probabilities—those that they would have no incentive to change even after firms made compliance decisions.

Assuming costly enforcement and lack of inspection commitment instead of C4 while keeping C1–C3, the paper shows that the intergovernmental system is more cost-effective than the intersource one. A central role is played by flexibility in imposing tax-prices on domestic emissions, which is endorsed only in the intergovernmental system. The flexibility helps to build credibility of governmental monitoring, inducing better compliance performance of firms.

Let me briefly explain the model and the main results of the paper. We will embed the self-reporting model of regulation compliance developed by Montero [16] into a model of competitive international emissions trading, along with the governments' inability of inspection commitment.⁵ In this model, before engaging in gas-emitting activities, firms in each country submit action plans to the government, declaring the way to conform to emission regulation: payment of domestic emission taxes (in the intergovernmental system), purchase of international emission permits (in the intersource system), or reduction of emissions. After receiving the action plans, the government, which cannot monitor emissions without cost, inspects compliance status of those that promised to reduce emissions by random sampling. Noncompliers, if found out, will be not only fined but also forced to reduce emissions as they swore in their action plans.

The case with inspection commitment is a useful benchmark. Not surprisingly, it is shown that the intergovernmental system achieves a reduction target at the minimal cost in the competitive equilibrium. In this scenario, domestic emission taxes, levied independently across countries, play the role of a Pigouvian remedy for enforcement cost internalization. In deciding whether to abate, firms compare the source-level marginal emissions reduction costs with the tax-price of gas emissions, without taking account of the costs incurred by the government from monitoring their compliance status. With free intersource trading allowed, therefore, emissions reductions in each country are led to an excessive level from the point of national-level compliance cost minimization, where the national-level marginal cost exceeds a given international price of permits. To eliminate the gap, firms have to face a tax-price of emissions lower than the permit price, which can be done only in the intergovernmental system.

This argument, however, does not provide a sound justification for intergovernmental trading even if we do not question the assumption of inspection commitment. It is shown that two systems are equally cost-effective in the world with inspection commitment, provided there is no international disparity in unit inspection costs or in legal fines for noncompliance. The failure of enforcement cost internalization in the intersource system is eliminated through the general-equilibrium adjustments of permit prices. Owing to the absence of governmental intervention trying to boost domestic emissions, the intersource system prices the permits lower than the intergovernmental one to clear the markets. As a result, firms may face the same tax-price of emissions and each country may discharge the same amount of gases in the general equilibrium of intersource trading as in that of intergovernmental trading.

In the case without inspection commitment, by contrast, credibility of monitoring affects the cost-effectiveness of emissions trade by changing the compliance performance of firms. After firms submit action plans, the governments have basically two alternative strategies to fulfill their reduction commitments. The one, called full inspection, is to discover and force all noncompliers to cut illegal emissions by inspecting all firms that promised to do so in the action plans. The other, called full purchase, is to conduct no inspection but instead buy as many permits as necessary to legitimize every domestic emission. The governments will choose the more profitable from the national point of view, taking as given firms' compliance status reflected in the submitted action plans.

Credible monitoring must satisfy time-consistency. Given compliance status such that the two strategies are equally profitable, the governments may randomize them and then firms that promised to cut emissions face a certain inspection probability. Time-consistent inspection probabilities, only with which can the governments credibly control domestic emissions, are those generating such compliance status.

Monitoring with a higher time-consistent inspection probability decreases the national-level compliance cost, inducing firms to cut a larger amount of emissions in full compliance. To make it possible, on the other hand, the governments have to increase the profitability of full inspection relative to that of full purchase. As it is greater, the governments lose more from choosing full purchase, and knowing this, firms believe they will police noncompliers in a larger scale. In effect, the greater profitability of full inspection is the governments' credible threat to conduct more extensive monitoring ex post.

Flexible domestic emission taxation serves as a commitment device for building credibility of monitoring, enabling the governments to maximize the profitability of full inspection. It is shown that in the intergovernmental system the governments can conduct monitoring with higher time-consistent inspection probabilities by setting the tax-prices below the international permit price. The reason is as follows. Full inspection makes it unnecessary for the governments to hold permits, while causing the costs of detecting all noncompliers in addition to those of their emissions reduction. Accordingly, it yields the maximal profitability when it cuts emissions to the level where the permit price is equal to the source-level marginal emissions reduction cost plus the marginal enforcement cost, namely, the national-level marginal emissions reduction cost. Establishing this condition, which means enforcement cost internalization under full inspection, needs the tax-prices lower than the permit price. In the intersource system, where the tax-prices are pegged at the permit price, full inspection cannot avoid cutting emissions to the level where the national-level marginal cost exceeds the permit price. Because of failure of enforcement cost internalization, full inspection becomes less profitable, and consequently, only lower inspection probabilities are available to the governments in the intersource system.

Further, the general-equilibrium adjustments of permit prices do not reduce but augment the relative cost-effectiveness of the intergovernmental system in the world without inspection commitment, although a lower permit price is realized in the intersource system as in the case with inspection commitment. Generally, a higher permit price enhances credibility of monitoring as far as the governments are trying to fulfill their reduction commitments. The reason is that it decreases the relative profitability of full purchase, tempting the governments more into policing noncompliers than into buying permits for them. This finding provides a few interesting suggestions for designing the details of an international emissions trading system, such as the reduction target, member countries, and noncompliance fines, whether it is intergovernmental or intersource. For instance, as opposed to the famous Becker logic [1], it is shown that in the intersource system, higher fines result in worse compliance performance of firms and deteriorates the cost-effectiveness of emissions trade.

Lack of inspection commitment not only makes the intersource system less cost-effective. At least as serious a problem, it may make the system unable to have a competitive equilibrium. The reason is related to the credibility-enhancing effect of permit prices. As explained above, a lower permit price tempts the governments more to buy permits from abroad rather than policing illegal domestic emissions. Owing to the presence of enforcement costs, each government has a threshold level of permit price, below which it can no longer credibly regulate domestic emissions and has to rely entirely on buying permits to fulfill its reduction commitment. In the intersource system, because of lack of the flexibility, the demand for permits increases discontinuously when the price falls slightly below the threshold levels. No competitive equilibrium will thus exist, in particular, if the reduction target is sufficiently small. This implies that the reduction target itself may fail to be achieved in the intersource system, no matter how responsible the governments are for their reduction commitments. In the intergovernmental system, on the other hand, no such discontinuity occurs as long as the governments flexibly levy the tax-prices of domestic emissions in response to the changing permit prices.

The paper is organized as follows. The next section explains the model. Section 3 analyzes the optimal time-consistent regulation policies of a small open country in the intergovernmental and intersource systems. Section 4 considers the competitive equilibria of emissions trade between two countries to show the relative cost-effectiveness of the intergovernmental system as well as their possible nonexistence in the intersource system. Section 5 discusses the extensions of the model, such as regulation with inspection commitment, partial governmental compliance, and alternative enforcement schemes. Section 6 summarizes the implications for the design of international emissions trading mechanisms. The appendix contains the proofs of the propositions and lemmas.