3.2.3 Environmental vs economic risk: summary
Whether a domestic tax or permit system would yield preferable environmental and economic outcomes when the marginal cost and marginal benefit of abatement are subject to uncertainty depends critically on the presence or absence of a good international permit market. Figure 7 summarises possible scenarios and the preferable control instruments in each.
The optimistic scenario includes a good international permit market and an international permit price that is high enough for the only marginal benefit of domestic abatement to be the international permit price. This scenario is shown on the very left hand side of the Figure. In this case, domestic permits are not only preferable to taxes, but are efficient. If the international price is very low, the marginal benefit of international favour for domestic abatement is important and the solution ceases to be clear-cut.
A less optimistic scenario involves a poor international market, shown by the first right hand fork in the Figure. This puts us in Weitzman’s familiar world. We believe that the domestic marginal cost curve is likely to be steeper than the marginal benefit curve, which implies that a tax would be preferable if marginal cost and marginal benefit shocks were uncorrelated. This is shown by the first right-hand option past the initial right fork in the Figure.
However, we believe that marginal cost and marginal benefit shocks may be positively correlated, which increases the relative favourability of permits, though not necessarily enough to make permits preferable to taxes. This is shown by the left-hand branch of the final fork on the right hand side of the Figure.
In the end, the choice between taxes and permits for domestic regulation returns to whether there will be a good international permit market. With such a market, permits are preferable. Otherwise, taxes are preferable. If there may not be an international market, but we want to be able to take advantage of the efficiency gains of a permit system if such a market develops, a domestic hybrid system of permits with a trigger value could be desirable. This option is discussed in Section 5.
