William A. Pizer

Instrument choice for environmental protection when technological innovation is endogenous

This paper presents an analytical and numerical comparison of the welfare impacts of alternative instruments for environmental protection in the presence of endogenous technological innovation. We analyze emissions taxes and both auctioned and free (grandfathered) emissions permits. We find that under different sets of circumstances each of the three policies may induce a significantly higher welfare gain than the other two policies. In particular, the relative ranking of policy instruments can crucially depend on the ability of adopting firms to imitate the innovation, the costs of innovation, the slope and level of the marginal environmental benefit function, and the number of firms producing emissions. Moreover, although in theory the welfare impacts of policies differ in the presence of innovation, sometimes these differences are relatively small. In fact, when firms anticipate that policies will be adjusted over time in response to innovation, certain policies can become equivalent. Our analysis is simplified in a number of respects; for example, we assume homogeneous and competitive firms. Nonetheless, our preliminary results suggest there is no clear-cut case for preferring any one policy instrument on the grounds of dynamic efficiency.

Discounting the Distant Future: How Much Do Uncertain Rates Increase Valuations?

Costs and benefits in the distant future—such as those associated with global warming, long-lived infrastructure, hazardous and radioactive waste, and biodiversity—often have little value today when measured with conventional discount rates. We demonstrate that when the future path of this conventional rate is uncertain and persistent (i.e., highly correlated over time), the distant future should be discounted at lower rates than suggested by the current rate. We then use two centuries of data on U.S. interest rates to quantify this effect. Using both random walk and mean-reverting models (which are indistinguishable based on historical data), we compute the certainty-equivalent rate—that is, the single discount rate that summarizes the effect of uncertainty and measures the appropriate forward rate of discount in the future. Using the random walk model, which we consider more compelling, we find that the certainty-equivalent rate falls from 3% now to 2% after 100 years, to 1% after 200 years, and down to 0.5% after 300 years. The mean-reverting model leads to a certainty-equivalent rate that remains above 3% for the next 200 years, then falls to 2% after 300 years and to 1% after 400 years. If we use these rates to value consequences at horizons of 400 years, the discounted value increases by a factor of 7,000 based on the random walk model and by a factor of 30 based on the mean-reverting model — both relative to conventional discounting. These results are relevant for a wide range of policy questions involving the distant future. Applying the random walk model to the consequences of climate change, for example, we find that inclusion of discount rate uncertainty doubles the expected present value of mitigation benefits. Other applications and alternative beliefs about the random walk–mean-reverting distinction are easily explored with our table of discount factors over time.

The optimal choice of climate change policy in the presence of uncertainty

Considerable uncertainty surrounds both the consequences of climate change and their valuation over horizons of decades or centuries. Yet, there have been few attempts to factor such uncertainty into current policy decisions concerning stringency and instrument choice. This paper presents a framework for determining optimal climate change policy under uncertainty and compares the resulting prescriptions to those derived from a more typical analysis with best-guess parameter values. Uncertainty raises the optimal level of emission reductions and leads to a preference for taxes over rate controls. This suggests that analyses which ignore uncertainty can lead to inefficient policy recommendations.

Balancing Cost and Emissions Certainty: An Allowance Reserve for Cap-and-Trade

On efficiency grounds, the economics community has to date tended to emphasize price-based policies to address climate change—such as taxes or a “safety-valve” price ceiling for cap-and-trade—while environmental advocates have sought a more clear quantitative limit on emissions. This article presents a simple modification to the idea of a safety valve: a quantitative limit that we call the allowance reserve. Importantly, this idea may bridge the gap between competing interests and potentially improve efficiency relative to tax or other price-based policies. The last point highlights the deficiencies in several previous studies of price and quantity controls for climate change that do not adequately capture the dynamic opportunities within a cap-and-trade system for allowance banking, borrowing, and intertemporal arbitrage in response to unfolding information.

Determining Benefits and Costs for Future Generations

The United States and others should consider adopting a different approach to estimating costs and benefits in light of uncertainty. In economic project analysis, the rate at which future benefits and costs are discounted relative to current values often determines whether a project passes the benefit-cost test. This is especially true of projects with long time horizons, such as those to reduce greenhouse gas (GHG) emissions. Whether the benefits of climate policies, which can last for centuries, outweigh the costs, many of which are borne today, is especially sensitive to the rate at which future benefits are discounted. This is also true of other policies, e.g., affecting nuclear waste disposal or the construction of long-lived infrastructure.

Uncertain discount rates in climate policy analysis

Abstract Consequences in the distant future—such as those from climate change—have little value today when discounted using conventional rates. This result contradicts our “gut feeling” about such problems and often leads to ad hoc application of lower rates for valuations over longer horizons—a step facilitated by confusion and disagreement over the correct rate even over short horizons. We review the theory and intuition behind the choice of discount rates now and, importantly, the impact of likely variation in rates in the future. Correlated changes in future rates imply that the distant future should be discounted at much lower rates than suggested by the current rate, thereby raising the value of future consequences—regardless of opinions concerning the current rate. Using historic data to quantity the likely changes and correlation in changes in future rates, we find that future valuations rise by a factor of many thousands at horizons of 300 years or more, almost doubling the expected present value of climate mitigation benefits relative to constant 4% discounting. Ironically, uncertainty about future rates reduces the ratio of valuations based on alternate choices of the current rate.

The Cost of Environmental Protection

Reported expenditures for environmental protection are often cited as an assessment of the burden of current regulatory efforts. However, the potential for both incidental savings and uncounted costs means that the actual burden could be either higher or lower than these reported values. Using a production cost model that considers the possible interaction between environmental and non-environmental expenditures, we directly estimate the dollar-for-dollar incidental savings/uncounted costs arising from a one-dollar increase in reported environmental expenditures. Although recent literature supports the idea that reported expenditures probably understate the actual burden, we find no such evidence in the manufacturing sector based on a large panel of plant-level data. In one industry, we find statistically significant overstatement. In three others, we find no significant deviation in either direction. We conclude that, although cost estimates are not overstated on average, variation and uncertainty exist at the industry level, with some plants experiencing savings and others possibly facing uncounted burdens.

Should governments use a declining discount rate in project analysis

Should governments use a discount rate that declines over time when evaluating the future benefits and costs of public projects? The argument for using a declining discount rate (DDR) is simple: if the discount rates that will be applied in the future are uncertain but positively correlated, and if the analyst can assign probabilities to these discount rates, then the result will be a declining schedule of certainty-equivalent discount rates. There is a growing empirical literature that estimates models of long-term interest rates and uses them to forecast the DDR schedule. However, this literature has been criticized because it lacks a connection to the theory of project evaluation. In benefit-cost analysis, the net benefits of a project in year t (in consumption units) are discounted to the present at the rate at which society would trade consumption in year t for consumption in the present. With simplifying assumptions, this leads to the Ramsey discounting formula, which results in a declining certainty-equivalent discount rate if the rate of growth in consumption is uncertain and if shocks to consumption are correlated over time. We conclude that the arguments in favor of a DDR are compelling and thus merit serious consideration by regulatory agencies in the United States. (JEL: D61)

GREENHOUSE GAS TRADING IN EUROPE: The New Grand Policy Experiment

Abstract The European Union is head and shoulders ahead of the rest of the world as it embarks on its new emissions trading system early next year, but there are still a number of large uncertainties to work out.

How Large Are the Welfare Gains from Technological Innovation Induced by Environmental Policies

This paper examines whether the welfare gains from technological innovation that reduces future abatement costs are larger or smaller than the “Pigouvian” welfare gains from optimal pollution control. The relative welfare gains from innovation depend on three key factors—the initially optimal level of abatement, the speed at which innovation reduces future abatement costs, and the discount rate. We calculate the welfare gains from innovation under a variety of different scenarios. Mostly they are less than the Pigouvian welfare gains. To be greater, innovation must reduce abatement costs substantially and quickly and the initially optimal abatement level must be fairly modest.