3.2.2 When benefit and cost uncertainty are correlated
Weitzman’s results assume that shocks to benefits and to costs are uncorrelated. However, this may not always be the case. Stavins (1996) shows that marginal benefit uncertainty does matter for policy choice when there is a correlation between uncertainty in marginal costs and in marginal benefits. However, when marginal benefits are just the international permit price, a domestic permit system remains ex post efficient under any combination of shocks. Thus in this section we consider correlated uncertainty only in the case of no international market.
Stavins (1996) finds that a positive correlation in the uncertainty in costs and benefits always increases the relative favourability of permits, whereas a negative correlation always increases the relative favourability of taxes.
This result, derived mathematically, makes intuitive sense. With a pollution tax, when the marginal costs of abatement are unexpectedly high, producers reduce their efforts at abatement. If there is a positive correlation between shocks to benefits and costs, at these times the marginal benefits of reducing emissions are also likely to be high. Thus producers tend to reduce their abatement efforts just when these efforts are most valuable. If, on the other hand, cost and benefit uncertainty are negatively correlated, the marginal benefits of emission reduction are likely to be low at the times when producers reduce their abatement effort. Hence, with negative correlation, the response of producers under a tax tends to be appropriate.
Causes of marginal cost and marginal benefit uncertainty in New Zealand
Marginal cost uncertainty
There appear to be two main causes for marginal cost uncertainty: uncertainty in New Zealand’s future economic growth, and uncertainty in future technological inventions, innovations and diffusion. The higher economic growth is in New Zealand, the greater will be the country’s baseline level of unregulated emissions, and the costlier it will be to reduce emissions to any specified target value. This economic growth may stem from population growth or from growth in GDP per capita. Technological progress can change the costs of reducing emissions by offering more energy-efficient production processes and substitutes for emission-producing energy sources. However, there may be some new technologies that actually cause an increase in emissions.
Marginal benefit uncertainty
The causes of uncertainty in marginal benefit are more numerous. Each of the three factors that determine marginal environmental benefit contains uncertainty. The future stock of greenhouse gases in the atmosphere, the effect of the greenhouse gas stock on the climate, and the effect of climate change on society are all uncertain. However, it is only the stock of greenhouse gases and the effect of climate change on society that are likely to have errors that are correlated with the uncertainty in marginal cost.
If either economic growth or technological change occurs at a pace different to that expected, stocks of greenhouse gases in the atmosphere are likely to differ from expectations. Although world economic growth can be forecast, shocks as large as the collapse of the Russian economy can and do occur, leading to large errors in our expectations. Technological progress and its effects over the long term are inherently unpredictable, adding to our uncertainty over future emissions.
We know little about the severity of the effects on society of any given level of climate change. This will depend on how New Zealand’s society and economy develop over time. Specifically, shocks to the importance of our agricultural industry, the geographic distribution of our population, and GDP per capita will alter the strength of the effects of climate change on the country.
These uncertainties apply to domestic marginal benefit, and also, on a world scale, influence global marginal environmental benefits. These global marginal environmental benefits in turn may affect the value of international favour gained from abatement and the effect of New Zealand’s abatement on other countries’ emissions.
The value to New Zealand of the favour gained in international circles for meeting its compliance target is both difficult to estimate and likely to evolve as the international situation changes. The value of this favour may be positively correlated with the marginal global benefits of abatement in the long run. The correlation between global marginal benefits and the benefit for New Zealand of New Zealand’s effect on other countries’ emissions is likely to be positive. If global marginal benefits are higher, the same amount of foreign abatement is likely to be more beneficial for New Zealand.
Correlations between marginal cost and marginal benefit uncertainty
The main causes of cost and benefit uncertainty have thus been established, and it remains to consider which of these are likely to be positively or negatively correlated with one another. For simplicity, we look here at the correlations between marginal environmental benefit and marginal cost.
Figure 5 below illustrates one set of likely correlations. An exogenous improvement to technology could have several effects. First, it could cause global emissions and thus GHG stocks to be lower than expected[8], which could decrease the marginal benefits of domestic abatement by altering the environmental benefits to New Zealand directly. Second, the technology shock might make society more able to cope with the damage caused by climate change, which would also decrease the marginal benefits by decreasing the benefits of reducing climate change. Third, the technology shock could directly decrease the marginal costs of abatement. These relationships imply a positive correlation between marginal cost shocks, which are negative here, and marginal benefit shocks, which are also negative here.
Figure 6 below illustrates a second set of possible correlations. On the left hand side, global economic growth that is not matched by improved emissions technology would cause unexpectedly high global emissions and GHG stocks, which would drive up the marginal benefit of abatement. As above, this change in the marginal benefit would act through direct environmental benefits.
However, shocks to global economic growth are likely to be positively correlated with shocks to domestic economic growth. This domestic growth has two possible effects. First, it could increase the ability of New Zealand to cope with climate change, thus decreasing the marginal benefit of abatement by reducing the benefits of preventing climate change. Second, domestic growth would increase the marginal cost of abatement by driving up domestic baseline emissions. Under the assumption that the positive shock to marginal benefits from higher global emissions is greater than the negative shock from a greater ability to cope, this set of correlations implies a positive relationship between marginal benefit and marginal cost uncertainty.
However, it is also possible that there might be a positive correlation between global economic growth and technological advancements. In this case, marginal costs and marginal benefits both have forces driving them in both directions, and it cannot be determined which are likely to be greater. Consequently, the sign of the correlation between marginal cost and marginal benefit uncertainty cannot be determined in this case.
In the absence of strong proof of a high correlation between global economic growth and technological advances,[9] the above analysis suggests that a positive correlation between shocks to marginal cost and to marginal benefit is more likely than a negative correlation.
Results for New Zealand with correlated uncertainty
In the absence of an international permit market, with no correlation in benefit and cost uncertainty, a steep marginal benefit curve favours permits and a flat one favours taxes. When uncertainty is correlated this result may be slightly modified. Positive correlation increases the desirability of permits, whereas negative correlation increases the desirability of taxes. It appears more likely that New Zealand faces positively correlated shocks to its marginal cost and marginal benefit curves, suggesting a permit system may be more appropriate. However, New Zealand’s marginal cost curve is still likely to be steep enough that taxes are still the preferred instrument.
