Market-based mechanisms such as ‘cap-and-trade’ have become increasingly popular policy tools for reducing harmful emissions. But designing these schemes so that emissions are curbed efficiently requires understanding key elements of an industry’s structure, notably the degree of market power and the extent to which unregulated foreign producers compete with domestic firms. This research investigates these issues in the US cement industry, an emissions-intensive sector exposed to foreign competition. The findings suggest that the optimal regulatory policy in such industries may be to rebate compliance costs partially on the basis of output or to impose border tax adjustments.

In the absence of a coordinated global agreement to curtail greenhouse gas emissions, climate change policy initiatives based on regional markets are emerging. Examples include the European Union’s emissions trading scheme and California’s greenhouse gas emissions trading program.

In these ‘cap-and-trade’ arrangements, regulators impose a cap on the total quantity of emissions permitted by an industry or group of industries, and distribute a corresponding number of emissions permits that can be traded between market participants. To mitigate potentially adverse effects on competitiveness and to engender political support for these programs, it has become standard to allocate all or some proportion of these emissions permits for free to industrial stakeholders (Joskow and Schmalensee, 1998; Hahn and Stavins, 2011).

A particularly appealing feature of the cap-and-trade approach to regulating industrial emissions is that, provided a series of conditions are met, an emissions trading program designed to equate marginal abatement costs with marginal damages will achieve the socially optimal ‘first-best’ outcome (Dales, 1968; Montgomery, 1972).

Unfortunately, policy-makers do not work in first-best settings, and the conditions required for optimality are often not met. Instead, real-world policy settings are typically characterized by several pre-existing distortions that complicate the design of efficient policy.

Dealing with two distortions: market power and incomplete regulation

Many of the industries currently facing emissions regulation are highly concentrated. In a seminal paper, Buchanan (1969) argues that a first-best policy designed to internalize external damages completely should be used only in ‘situations of competition’. This is because concentrated industries are already producing below the socially optimal level, and the loss of consumer and producer surplus induced by further restricting output can overwhelm the gains from emissions mitigation.

An important counterpoint is offered by Oates and Strassmann (1984), who argue that the welfare gains from a Pigouvian tax (or a first-best cap-and-trade program) will be likely to dwarf the potential losses from non-competitive behaviour. Our study provides an empirical assessment of these opposing forces.

Regional climate change policies are textbook examples of ‘incomplete’ regulation. When a regulation applies only to a subset of the sources of emissions that contribute to the environmental problem, the regulated sources can find it more difficult to compete with producers operating in jurisdictions exempt from the regulation.

Shifts in production and associated ‘emissions leakage’ can substantially offset – or paradoxically even reverse – the reductions in emissions achieved in the regulated sector. This leakage is particularly problematic when the damage caused by emissions is independent of the location of the source, as with greenhouse gas emissions.

These complications have led to a lively policy debate about how to design and implement policies for climate change mitigation. Policy-makers have been exploring several different approaches to (partially) compensating firms for their compliance costs via allocations of free emissions permits.

Designing a policy that strikes the appropriate balance between curbing domestic greenhouse gas emissions and protecting the competitive position of emissions-intensive manufacturing sectors requires detailed knowledge of the structure and dynamics of the industries subject to regulation.

Designing a policy that strikes the appropriate balance between curbing domestic greenhouse gas emissions and protecting the competitive position of emissions-intensive manufacturing sectors requires detailed knowledge of the structure and dynamics of the industries subject to regulation

The case of the cement industry

Our research focuses on an industry that has been at the centre of the debate about US climate change policy and international competitiveness: Portland cement. Cement is one of the largest manufacturing sources of domestic carbon emissions (Kapur et al, 2009). The industry is highly concentrated, making it potentially susceptible to the Buchanan critique.

Moreover, import penetration in the domestic cement market has exceeded 20% in recent years, giving rise to concerns about the potential for emissions leakage (Van Oss and Padovani, 2003; USGS, 2010). But the degree of exposure to imports is asymmetric: while coastal markets in the United States are very exposed to international competition, inland markets are typically not affected by them.

We extend the dynamic oligopoly framework developed in Ryan (2012) as the foundation for our analysis. In our model, strategic domestic cement producers compete in spatially segregated regional markets. Some of these markets are exposed to international trade, whereas other landlocked markets are sheltered from foreign competition.

Firms make optimal entry, exit and investment decisions to maximize their expected stream of profits conditional on the strategies of their rivals. Conditional on capital investments, producers chose quantities of cement to put on the market in each period. Regional market structures evolve as firms enter, exit and adjust production capacities in response to changing market conditions.

We use an empirically tractable dynamic model of the domestic Portland cement industry to evaluate the welfare impacts of incomplete, market-based regulation of carbon emissions. We assess the implications of several alternative policy regimes:

Permit auctioning: Firms have to buy permits in an auction; this is equivalent to a carbon tax in our setting

Grandfathering: A pre-determined amount of permits is allocated to producers for free. In our setting, allocations are based on their historical production. These permits are tradable.

Dynamic allocation updating: Permits are distributed proportional to production. The formulas that determine how these free allocations vary with output are predetermined.

Border tax adjustment: Permit auctioning with an accompanying tax on imports proportional to their average carbon content.

Baseline impacts

We begin by assuming these policies will be designed so that the equilibrium permit price (or tax) is set equal to the assumed social cost of carbon emissions. Under this assumption, we find that all four policy regimes reduce net social welfare for values of the social cost of carbon below $40 per ton. At these lower costs, emissions leakage and the exacerbation of distortions associated with the exercise of market power offset the welfare benefits of imposing the first-best tax.

Losses are particularly acute under the permit auctioning regime in which firms bear the full cost of compliance, which induces the largest reduction in domestic emissions. Policy-induced disinvestment and exit further concentrate the ownership of productive capacity in the product market, and a substantial share of reduced production is offset by equally-polluting imports.

The magnitude of the losses is substantial: $18 billion under permit auctioning when the carbon value is $30. Importantly, permit auctioning and grandfathering are not equivalent in welfare terms. Whereas both regimes are statically equivalent from a production point of view, they generate substantially different revenues for firms, affecting their dynamic decisions.

We find that grandfathering helps to mitigate the rate of firm exit, but does nothing to provide incentives for cement production. This is shown in Figure 1, which depicts the evolution of production capacity and emissions (analogous to production) over time. Despite these differences, grandfathering still results in substantial welfare losses at carbon values below $60 per ton.

Figure 1: Permit auctioning and grandfathering are not dynamically equivalent, with capacity and emissions being reduced more substantially under the former

a. Capacity over time at $45 SCC

b. Emissions over time at $45 SCC

Policies that allocate free permits in proportion to production do substantially better because the implicit production subsidy mitigates both the exercise of market power in the product market and emissions leakage. As damages per ton of carbon rise above $40, these dynamic allocation updating and border tax adjustment regimes become welfare-improving. The border tax adjustment regime outperforms dynamic allocation updating at high carbon values because the tax on imports more effectively mitigates emissions leakage and improves domestic terms of trade.

What are the constrained-optimal policies?

Consistent with the theory of the second-best, policy outcomes could be improved if the social cost of carbon is only partially internalized by firms. Dynamic allocation updating based on output essentially embeds this idea as firms are refunded a fraction of their compliance costs.

We investigate these policy trade-offs from an optimal taxation perspective. We solve for the optimal level of carbon prices, and the associated level of welfare gains, under the various regimes we consider. We find that these market-based policies can deliver welfare gains if the compliance costs (per ton of emissions) borne by firms fall substantially below the true social cost of emissions.

When the social cost of carbon is $45 per ton, we find that the optimal carbon tax should be only $5 per ton for trade-exposed coastal markets, and $15 per ton for inland markets. These substantially lower taxes reflect the presence of the two distortions: market power and incomplete regulation. Augmenting the permit auctioning regime with a border tax adjustment efficiently internalizes the emissions externality associated with foreign production, but leaves the distortions associated with the exercise of market power unaddressed.

In coastal markets, augmenting the permit auctioning regime with a border tax adjustment increases the optimal carbon price from $5 per ton to $25 per ton. Note that this is higher than the optimal price in inland markets because coastal markets tend to be relatively more competitive.

Reducing emissions at the cheapest cost

A natural question arises: which of the regimes performs best from a welfare point of view? To get an answer, it is important first to compare apples with apples, as the regimes can induce vastly different reductions in emissions.

In Figure 2, we compare regimes that are similarly stringent for domestic firms. The figure shows the costs of reducing emissions per ton (y-axis) for a given level of domestic emissions reduction (x-axis), only looking at domestic welfare costs (Panel A), and accounting for the environmental costs of emissions outside (Panel B).

Figure 2: A border tax adjustment is the most cost-effective way to reduce emissions, especially when considering the negative effects of ‘emissions leakage’

a. Abatement average cost (leakage ignored)

b. Abatement average cost (leakage corrected)

Consistent with our previous discussion emissions abatement in the cement sector is least efficient under the permit auctioning regime

Consistent with our previous discussion, emissions abatement in the cement sector is least efficient under the permit auctioning regime. Under this regime, with firms bearing the full brunt of compliance costs, distortions associated with market power are exacerbated and any reductions in emissions that do occur come at the cost of significant surplus reductions. Average abatement costs start at close to $40 per ton once leakage is taken into account.

Abatement under the grandfathering regime is somewhat more cost-effective because the lump sum transfer provides an incentive for firms to remain in the market, reducing market power distortions vis-à-vis permit auctioning. The relatively low average abatement costs associated with the border tax adjustment are striking once the effects of the policy on foreign emissions are taken into account. This reflects both terms of trade improvements and negative leakage.

This article summarizes ‘Market-Based Emissions Regulation and Industry Dynamics’ by Meredith Fowlie (University of California, Berkeley, and NBER), Mar Reguant (Northwestern University, NBER and CEPR) and Stephen P. Ryan (Washington University in St. Louis and NBER), published in 2016 in the Journal of Political Economy 124(1).