3.3.3 Strategic incentives
Opportunistic behaviour is possible because it is impossible to write a contract that covers every contingency. Emission regulations are necessarily incomplete contracts, and thus post-contractual opportunism on the part of the government or private firms is possible. The problem is exacerbated by the fact that the government cannot preclude opportunistic behaviour in the future on the part of itself or its successors.
Possible opportunistic behaviour by government
Under a permit system, government opportunism may take a number of forms. This opportunism may be driven by lobbying or political pressures, new information about the costs to government of current regulation, or changes in vested interests. The government’s opportunistic behaviour might include:
- Changing the aggregate target when this is not in response to changes in the optimal target;
- Changing the method of permit allocation (e.g., a shift from auction to gratis allocation or a change in the allocation between firms and sectors if gratis allocation is already used);
- Changing the definition of permits (e.g., from tonnes of carbon dioxide equivalent per year to proportions of the target);
- Confiscating existing permits.
If firms believe that the government may make changes such as these, their tendency to invest more slowly and to invest in less capital-intensive activities when they are faced with exogenous shocks will be magnified. If permit holders believe their permits may be confiscated, they will be reluctant to bank them. This inhibits efficient smoothing of marginal costs over time. If firms believe that the government may be influenced into making these changes, they may pursue rent-seeking activities. That is, they may put resources towards trying to convince the government to make changes that will transfer benefits from others to themselves. These activities consume scarce resources without creating value, and thus are inefficient for society even though they may be in the self interest of the firms involved.
Under a tax system, a major danger is that future governments will view the tax as a source of revenue and will seek to increase it beyond the optimal level. Changes in the international permit price may provide impetus for suboptimal tax setting at levels either above or below the optimal level. If the international permit price falls, the government may choose not to decrease the tax rate similarly because its tax revenue would be likely to fall. Alternatively, if international permit prices were rising the government might succumb to pressure to not increase the tax rate, or to grant exemptions from paying the tax. Any of these behaviours would be suboptimal from an efficiency standpoint.
Possible strategic behaviour by firms
Firms may attempt to influence government decisions, both current and future, by strategic investment, lobbying, or misrepresenting abatement costs.
Abatement can be achieved at much lower cost if the transition to lower emission levels is spread over a longer period of time, rather than being forced in a short period of time. A longer time frame would allow firms to develop and put in place low-emission and energy-efficient technology over the next decade or two. The optimal policy path for this requires a policy tightening in the future. However, the government cannot commit to such a tightening. The future government may find itself agreeing to international targets that are not stringent, or it may opt for non-compliance with Kyoto.
If the government sets a low domestic emission tax rate in the understanding that firms are to invest in emission-lowering technology in preparation for increased target stringency in the future, firms may choose not to do so. They may strategically under-invest in the hope that they will be able to negotiate relief from compliance in the future. The future government, faced with the choice of either granting relief from compliance or potentially causing a serious recession, may well choose to grant relief. One way the government could grant relief is by opting out of Kyoto. Even if the government intends to follow a policy profile other than tightening over time, firms may choose to strategically under-invest in the same manner and cause the same problems.
One other way firms may hope to influence government decisions is through lobbying. This might be sectorally based, where firms in one sector try to pressure the government into putting less of the burden of abatement onto them, and more onto other sectors. If permits are granted by gratis allocation, one easy way a transfer of burden could occur is through a change in the permits allocated to different sectors. Changes of this nature are generally driven by political pressure as opposed to economic efficiency. Firms might also try to make their abatement costs appear much higher than they actually are, or make their competitiveness appear at risk from emission regulation. For many industries, abatement costs are very difficult for the government to estimate with any accuracy. Firms may exaggerate these costs in order to force the government to opt out of Kyoto or to attain emission regulation exemptions for themselves.
Policy design to prevent opportunistic behaviour
Although the risk of opportunistic behaviour cannot be eliminated, it can be minimised by carefully designing the regulatory system with an eye to reducing the possibilities for undesirable strategic behaviour. The government can tackle the problem of strategic under-investment in several ways. Supporting the invention and diffusion of clean technologies would lessen the under-investment problem. Alternatively, under a permit scheme the government could sell permits well in advance, but not allow them to be used in advance. This would create a pressure group that did not want future targets to be looser than expected because it would cause them capital losses. Pressure from this group would help to counteract pressure from other groups that favoured less stringent targets.
If permits are specified as percentages of future targets, there is no pressure group to fight against less stringent targets, but the government is unable to make revenue gains by changing the target.
One important way of decreasing the likelihood of strategic behaviour is by making the emission regulation contract as complete as possible. For instance, with a tax system the conditions under which the tax rate may be changed should be specified; with a permit system, the conditions sufficient to cause a change in the target should be stated. If gratis allocation is used for permits, the method by which this allocation is decided should be clearly defined. Putting the trading system design into legislation makes it more difficult for future governments to make opportunistic changes.
Under a permit system, some policy designs clearly offer less opportunity for strategic behaviour. Auctioning is preferable to gratis allocation because the government does not have the option of changing the allocation between sectors.
Taxes are not vulnerable to pressure to change their allocation. The government cannot alter the design of a tax system to reduce its vulnerability to pressure to lower the tax rate or grants exemptions.
Desirable firm behaviour is more likely if the credibility of policy targets and policy measures is established ex ante. Policy targets are more credible if there is social consensus on the goals of climate change policy, which may be gained through an education programme and broad public debate.
3.4 Flexibility in distribution of costs
Both a tax system and a permit system lead to approximately the same abatement actions by the same individuals and the same incidence of costs. A permit system offers the flexibility to allocate permits to certain groups rather than auctioning all permits. These allocations are transfers of wealth and will not affect incentives to abate. They are costly to government and the economy in the way that all government payments are because of the need to raise tax revenue to cover them. They do however provide political flexibility and the ability to address distributional issues.
3.5 Transactions costs and permit market inefficiency
In an emissions trading market efficiency requires that permits are traded. This is not necessarily a costless or perfectly competitive process. No trades are required in a tax system. In Section 4.6 we discuss the sources and likely significance of transactions costs in more detail.
