Environmental Policy and the Business Cycle: The Role of Adjustment Costs on Abatement

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1 al al Cycle: The Models: Tor Vergata University Fourth IAERE Annual Conference February 11-12, 216

2 Models: Motivation al Models: al-dynamic Stochastic General Equilibrium Models: in recent years quite a few works use standard DSGE models to address questions of environmental policy design. An explicit integration of environmental policies with macroeconomic fluctuations allows to: observe the dynamic behavior of the economy under different policy regimes

3 Models: Motivation al Models: al-dynamic Stochastic General Equilibrium Models: in recent years quite a few works use standard DSGE models to address questions of environmental policy design. An explicit integration of environmental policies with macroeconomic fluctuations allows to: observe the dynamic behavior of the economy under different policy regimes evaluate the costs of the different policies in terms of economic volatility

4 Models: Motivation al Models: al-dynamic Stochastic General Equilibrium Models: in recent years quite a few works use standard DSGE models to address questions of environmental policy design. An explicit integration of environmental policies with macroeconomic fluctuations allows to: observe the dynamic behavior of the economy under different policy regimes evaluate the costs of the different policies in terms of economic volatility show instruments resilience to shocks

5 al Models: Angelopoulos et al. (21) Fischer and Springborn (211) Dissou and Karnizova (212) Heutel (212), Grodecka and Kuralbayeva (215) Bosetti and Maffezzoli (214a,214b) Annicchiarico and Di Dio (215)

6 al Our main contribution is the analysis of the role and the impact of abatement rigidities on the performances of three different environmental policies. Models:

7 al Our main contribution is the analysis of the role and the impact of abatement rigidities on the performances of three different environmental policies. why? Models:

8 al Models: Our main contribution is the analysis of the role and the impact of abatement rigidities on the performances of three different environmental policies. why? Previous literature assumes an immediate adjustment of the abatement level in response to business cycle fluctuations. In reality, changes in abatement choices represent a cost for the firms.

9 al Models: Our main contribution is the analysis of the role and the impact of abatement rigidities on the performances of three different environmental policies. why? Previous literature assumes an immediate adjustment of the abatement level in response to business cycle fluctuations. In reality, changes in abatement choices represent a cost for the firms. The second contribution is the analysis of the combined effects of an irreversible abatement effort and an occasionally binding cap on emissions.

10 al Models: Our main contribution is the analysis of the role and the impact of abatement rigidities on the performances of three different environmental policies. why? Previous literature assumes an immediate adjustment of the abatement level in response to business cycle fluctuations. In reality, changes in abatement choices represent a cost for the firms. The second contribution is the analysis of the combined effects of an irreversible abatement effort and an occasionally binding cap on emissions. why?

11 al Models: Our main contribution is the analysis of the role and the impact of abatement rigidities on the performances of three different environmental policies. why? Previous literature assumes an immediate adjustment of the abatement level in response to business cycle fluctuations. In reality, changes in abatement choices represent a cost for the firms. The second contribution is the analysis of the combined effects of an irreversible abatement effort and an occasionally binding cap on emissions. why? To understand the behavior of emissions and permits price in the presence of negative shocks.

12 al Models: Domestic emissions e t are function of the output y t and of the abatement effort µ t : e t = (1 µ t )y 1 γ t. The pollution stock x t evolves according a natural decay rate η (, 1) and on the basis of current period domestic emissions and emissions of the rest of the world e row t : x t = ηx t 1 + e t + e row t.

13 al Models: act in competitive markets and choose the amount of capital, labour and abatement that maximizes their profits. MAX k t 1,l t,µ t π t = y t p e,t e t r t k t 1 w t l t z t, Production function: y t = (1 d(x t ))a t k α t 1l 1 α t, a t = ae ua,t u a,t = ρ a u a,t 1 + ɛ a, < ρ a < 1 ɛ a i.i.d. N(, σ 2 a), d(x t ) = d + d 1 x t + d 2 x 2 t.

14 al Models: The existing capital depreciates over time at a fixed rate δ (, 1). The law of motion for capital is given by k t = i t + (1 δ)k t 1. The abatement costs z t are function of the firms abatement effort and output: [ γ µ z t = g(µ t ) + 2 ( µ ] t 1) 2 y t µ } t 1 {{} abatement adjustment costs, where γ µ > and g(µ t ) = θ 1 e ɛz,t µ θ 2 t θ 1 and θ 2 : technological parameters of abatement cost.

15 al Models: ɛ z,t : specific abatement technology shock. ɛ z,t = ρ ɛz (ɛ z,t 1 ) + u ɛz. From the solution of the profit maximization problem we obtain the following first order conditions: FOC : k t 1 FOC : p e,t y (1 γ) t µ t r t = αψ t (1 d(x t ))a t kt 1 α 1 l t 1 α θ 2 θ 1 e ɛz,t µ θ 2 1 t y t γ µ ( µ t 1)y t µ t 1 + γ µ E t Q t,t+1 ( µ t+1 µ t 1)y t+1 µ t+1 µ 2 t FOC : l t = w t = (1 α)ψ t (1 d(x t ))a t k α t 1l α t FOC : Ψ t y t = (1 d(x t ))a t k α t 1l 1 α t 1 µ t 1 +

16 al Models: Preferences of households are defined over consumption c t and hours worked l t E β t U(c t, l t ) = E β t [ c1 ϕc t lt 1+ϕl ξ l 1 ϕ c 1 + ϕl ] t= β (, 1): discount factor ϕ c:coefficient of relative risk aversion ξ l relative weight of the labour t= ϕ l is the inverse of Frisch elasticity of labour supply Budget constraint: τ l : labour income tax rate Tr: public transfers c t = r t k t 1 + (1 τ l t )w t l t + Tr t + π t i t

17 al Models: Household s first order conditions are: FOC λt FOC kt FOC lt FOC : c t c ϕc t = λ t : λ t = βe t λ t+1 [r t+1 + (1 δ)] : ξ l l ϕ l t + λ t w t (1 τ l t ) = : c t = r t k t 1 + (1 τ l t )w t l t + Tr t + π t k t + (1 δ)k t 1

18 Public Sector al Models: The budget constraint for the public sector is Tr t = p e,t e t + τ l t w t l t. The revenues come from environmental fiscal policies and from the tax on labour income. The government can decide among three different kinds of environmental policies: Intensity target: e t /y t = (1 µ t )y γ t Cap and trade: e t = e Carbon tax: p e = tax

19 al Models: Parameter Value Description Source α,36 technology parameter β,98267 quarterly discount factor γ,34 elasticity parameter of emissions to output Heutel (212) γ µ 3/4 parameter of abatement costs rigidities δ,25 quarterly capital depreciation η,9979 pollution decay Reilly (1992) θ 1,68 scale coefficient of abatement cost function θ 2 2,8 abatement cost function parameter Nordhaus (28) φ c 2 coefficient of relative risk aversion φ l 1 inverse of the Frisch elasticity of labor supply d 1,395e-3 damage function parameter Nordhaus (28) d e-6 damage function parameter Nordhaus (28) d e-8 damage function parameter Nordhaus (28) ξ l 11,7272 disutility of labour ρ a,95 persistence of productivity shock Heutel (212) σ a,7 standard deviation of productivity shock Heutel (212) ρ ɛz,95 persistence of abatement costs shock σ ɛz,7 standard deviation of abatement costs shock a,85954 Total factor productivity Tr,116 public transfers

20 Effects of a Technology Shock al Technology Output Consumption Models: Investment Capital cap and trade tax intensity target 2 4 Labour.2 2 4

21 Effects of a Technology Shock al Labour tax Emissions Effort Models: Cost Permit Price Pollution 2 4 cap and trade tax intensity target

22 Summary Statistics al Models: µ(x ) sd(x) sd(x)/sd(y) Corr(X,Y) y c i l Cap and trade τ l e.2891 µ z pe Welf y c i l Intensity target τ l e µ z pe Welf y c i l Tax τ l e µ z pe.6674 Welf

23 Correlated Shocks al Models: We assume a negative correlation between the TFP shock and specific abatement shock: We modify the abatement shock equation in order to consider the potential effects of a productivity s improvement on abatement: ɛ z,t = ρ ɛz ɛ z,t 1 ωu a,t 1 + u ɛz,t. We test the implications of the correlation between the shocks under three values of the cross prsistence parameter ω:.25,.3 and.9.

24 Correlated Shocks: Effects of a TFP Shock Under a Cap Regime al Emissions ω=.25 ω=.3 ω= Effort Models: Cost Permit price

25 Correlated Shocks: Effects of a TFP Shock Under an Intensity Target Regime al Emissions ω=.25 ω=.3 ω= Effort.4.2 Models: Cost Permit price

26 Correlated Shocks: Effects of a TFP Shock Under a Tax Regime al Emissions ω=.25 ω=.3 ω= Effort Models: Cost Permit price

27 Irreversible abatement effort al Models: We provide a new more flexible policy equation that allows for the possibility to have a level of emissions lower or equal to the level imposed by the cap: e t e and we assume there is a lower bound value for the abatement effort, imposed mostly by the irreversible component of investments in emissions reduction: µ t µ where µ is the equilibrium level for the abatement effort, namely the minimum level that, in the absence of shocks, allows firms to respect the cap on emissions.

28 Irreversible abatement effort al Output Emissions Effort Models: Cost positive shock Permit Price x 1 3 Pollution negative shock

29 Summary al Models: Main results: Dynamics in the abatement technologies sector play an important role in the evaluation of different policy instruments. Ignoring possible abatement rigidities leads to an overestimation of the stabilising effect of the cap-and-trade mechanism. Assuming abatement rigidities inevitably affects CO 2 market price. A higher degree of rigidity produces higher volatility in the permits price. Introducing abatement rigidities the intensity target becomes the policy that reduces volatility the more, while the cap turns out to be the policy that tends to generate more volatility.

30 Summary al Models: Introducing a lower bound on abatement and relaxing the standard assumption of a binding cap, the model is able to describe a more realistic path for emissions during economic downturns. Secondary results: Under the tax regime emissions are higher in expectation and more volatile. The degree of elasticity of emissions to output seems to play an important role on the intensity target performance in terms of volatility. From a welfare point of view, the cap-and-trade appears as the worst policy. Under this regime welfare is lower and more volatile. The tax is the policy that grants the higher level of welfare.

31 Main References al Models: [1] Adjemian,S., et al.(211), Dynare: Reference Manual, Version 4, Dynare Working s, 1, CEPREMAP. [2] Angelopoulos, K., Economides, G., Philippopoulos, A., 21. What is the Best al Policy? Taxes, Permits and Rules under Economic and al Uncertainty, CESifo Working series 298, CESifo Group Munich. [3] Annicchiarico, B., Di Dio, F., 215. al policy and macroeconomic dynamics in a new Keynesian model. J. Env. Econ. Manag. 69, [4] Bosetti, V., Maffezzoli, M., 214. Taxing Carbon under Market Incompleteness. IGIER Working No. 513, July. [5] Bosetti, V., Maffezzoli, M., 214. Occasionally binding emission caps and real business cycles. IGIER Working No. 523, July. [6] Dissou, Y., Karnizova, L., 212. Emissions Cap or Emissions Tax? A Multi-sector Cycle Analysis. Working No. 121E, University of Ottawa, Department of Economics. [7] Fischer, C., Springborn, M., 211. Emissions targets and the real business cycle: intensity targets versus caps or taxes. J. Env. Econ. Manag. 62, [8] Grodecka, A., Kuralbayeva, K., 215. The Price vs Quantity debate: climate policy and the role of business cycles. Centre for Climate Change Economics and Policy Working No. 21, January. [9] Heutel, G., 212. How should environmental policy respond to business cycles? Optimal policy under persistent productivity shocks. Rev. Econ. Dyn. 15, [1] Long, J., Plosser, C., (1983), Real business cycles, Journal of Political Economy, 91, No.1, [11] Nordhaus, W.D., 28. A Question of Balance: Weighing the Options on Global Warming Policies. Yale University Press, New Haven and London. [12] Kydland, F. E., Prescott, E. C., (1982), Time to Build and Aggregate Fluctuations,Econometrica, 5(6). [13] Schmitt-Grohé, S., Uribe, M., 24. Solving dynamic general equilibrium models using a second-order approximation to the policy function. J. Econ. Dyn. Control 28,