Essays on the Design and Enforcement of Market-Based Environmental Policies by Andreas ...

154 Pages·2013·1.3 MB·English

Essays on the Design and Enforcement of
Market-Based Environmental Policies
by
Andreas Marcel Oestreich
A Thesis
presented to
the University of Guelph
in partial fulfilment of requirements
for the degree of
Doctor of Philosophy
in
Economics
Guelph, Ontario, Canada
c Andreas Marcel Oestreich, December, 2013
(cid:13)
ABSTRACT
ESSEYSONTHEDESIGNANDENFORCEMENTOF
MARKET-BASEDENVIRONMENTALPOLICIES
AndreasMarcelOestreich Advisors:
UniversityofGuelph,2013 Rene´ KirkegaardandJohnLivernois
Environmental degradation is one of the key challenges of our times. Economists see
the problem of environmental degradation as one in which economic agents impose nega-
tive environmental externalities upon society in the form of pollution. Market-based envi-
ronmentalpolicyinstruments,suchastaxesortradablepermitsintendtoprovideincentives
for polluters to reduce negative environmental externalities. They seek to incorporate the
external cost of production through taxes or by creating property rights and facilitating the
establishmentofamarketfortheuseofenvironmentalservices.
ThisThesisstudiesthedesignandenforcementofmarket-basedenvironmentalpolicies
from a theoretical and empirical perspective. The special focus is thereby on the often
overlooked strategic interactions and the information asymmetry between the designer of
an environmental regulation and the regulated agents. For instance, when designing an
emissions tax system, regulatory authorities may require polluters to self-report on their
levelofpollution,becauseespeciallyinthecaseofnon-pointemissions,itisnotobservable
to the regulator directly which firm polluted how much. Furthermore, when designing an
emissionstradingscheme,regulatoryauthoritiesmayrequireinformationabouthowmany
tradable permits should be allocated free of charge during the initial allocation to offset
potentiallossestotheindustry.
In both examples, the incentives of the designer of the regulation and the regulated
agentsarenotaligned. Incaseofanemissiontax,agentsmightunderreporttheiremissions
tosaveontaxpayments. Ofcourse,itiscommonpracticetoauditsomefractionofreports
andtoimposepenaltieswhenunderreportingisdiscovered. However,penaltiesarelimited
andauditingiscostlyfortheregulatorandthereforethedetectionprobabilityisdetermined
by its operating budget, which may be tight. In case of an emissions trading system, firms
may demand higher amounts of free permits than actually necessary to offset any losses,
whichmightnotbeeasilyverifiablebytheregulatoreither.
The first chapter is entitled ”Firms Emissions and Self-reporting under Competitive
AuditMechanisms”. Itfocusesontherestrictedauditcapacityofenvironmentalregulatory
authorities to verify whether or not firms are in compliance with environmental policies. I
introduce a novel type of audit mechanism that induces more truthful reporting and lower
emission levels by firms in comparison to the commonly applied audit mechanism. The
second chapter is entitled ”On Optimal Audit Mechanisms” and builds on the analysis
in the first chapter. I derive an audit mechanism that leads to socially optimal emissions
while the commonly used audit mechanism in the literature fails to achieve this first-best
emissionslevelsgiventhesameauditresourcesoftheregulator.
The third chapter is entitled ”Carbon Emissions and Stock Returns Evidence from the
EU Emissions Trading Scheme”. I jointly worked on this chapter with Professor Ilias Tsi-
akas. We investigate the effect of the European Union Emissions Trading Scheme (EU
ETS) on the profits of firms as reflected by their stock returns. Despite facing the burden
of a new regulation, portfolios of firms which were directly affected by the EU ETS sig-
nificantly outperformed portfolios of firms which were not directly affected. We provide
evidence that this is due to the subsidy-like effect of substantial free carbon certificate al-
locations from European Governments to the affected firms. Our new result informs the
environmentalpolicydebateinNorthAmericaandelsewhere,astheEUETSisseenasthe
prototype for a potential global climate policy regime that would be based on emissions
trading.
ToDana
v
ACKNOWLEDGEMENTS
ForemostIliketoexpressmysinceregratitudetomyacademicadvisors,Rene´Kirkegaard
andJohnLivernois,fortheircontinuoussupportduringmydoctoralstudies. Theirwilling-
nesstosharetheirimmenseresearchexperience,theirextensivecommitmentfordiscussion
andtheirhonestandtimelyfeedbackenabledmetogrowandimproveasaresearcher.
I also like to sincerely thank the other members on my advisory and examination com-
mittee. Foremost, Ilias Tsiakas for treating me from the very beginning like a co-author,
rather than a student. My sincere thanks also go to Anthony Heyes, Mike Hoy and Asha
Sadanandfortheirencouragement,insightfulcommentsandthought-provokingquestions.
I acknowledge the financial support from the University of Guelph, my advisors, the
OntarioGraduateScholarshipprogramandSustainableProsperity.
I chose Guelph for my doctoral studies as it offered the open research environment that
enabled me to be successful in my doctoral studies. While I was able to learn from many
people at the Department of Economics and Finance; my special thanks go to Diana Alle-
sandrini, Doug Auld, J. Atsu Amegashie, Kurt Annen, Michael Batu, Bram Cadsby, Jo-
hannaGoertz,ChrisMcKenna,RossMcKitrick,AlexMaynard,JoniMiller,MianaPlesca,
Kathleen Rodenburg, Asha Sadanand, Thanasis Stengos, Fraser Summerfield, Jennifer
TengandHenryThille.
Many more people inspired my work through academic discussions at conferences and
seminars, and through research visits and exchanges. I am especially grateful for com-
mentsandsuggestionsfrom: JeannetteBrosig,UjjayantChakravorty,JeremyClark,Brady
Deaton, Ida Ferrara, Jean G. Forand, Patrick Gonza´lez, Marc Gronwald, Emma Hutchin-
son, Margaret Insley, Kai Konrad, Lester Kwong, Bernard Lebrun, Erin Mansur, Charles
Mason, Tom McCurdy, Dana McLean, Angelo Melino, Gord Miller, Karen Pittel, Ray
Rees,StevenRenzetti,NicholasRivers,BradleyRuffle,CaseyRothschild,BrandonSchau-
fele, as well as from: audiences at the 2013 CREE Conference in St. Catharines, 2013
Shadow Conference in Muenster, the 2013 CEA Conference in Montre´al, the 2012 ALEA
Conference in Stanford, the 2012 EAERE Conference in Prague, the 2012 CREE Con-
ference in Vancouver, the 2012 CEA Conference in Calgary, the 2011 ACEA Conference
in Charlottetown, the 2012 and 2013 UOttawa Workshops on Environmental Economics,
the 2010–2011 Workshop series on Environmental Regulation in Guelph, the seminars of
CES/IfoInstituteinMunichandBrockUniversityinSt. Catharines.
Finally,Iwouldliketothankmyfamilyandfriendsfortheirloveandsupport.
vi
Table of Contents
ListofTables viii
ListofFigures ix
1 Firms’EmissionsandSelf-reportingunderCompetitiveAuditMechanisms 1
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 FurtherRelatedLiterature . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.3 ModelandPreliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.4 RandomAuditMechanism . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.4.1 Stage2:TheReportingEquilibrium . . . . . . . . . . . . . . . . . 12
1.4.2 Stage1:TheEmissionsEquilibrium . . . . . . . . . . . . . . . . . 13
1.5 Imperfectly-discriminatingAuditMechanism . . . . . . . . . . . . . . . . 15
1.5.1 Stage2: TheReportingEquilibrium . . . . . . . . . . . . . . . . . 15
1.5.2 Stage1: TheEmissionsEquilibrium . . . . . . . . . . . . . . . . . 19
1.6 Perfectly-discriminatingAuditMechanism . . . . . . . . . . . . . . . . . . 21
1.6.1 Stage2: TheReportingEquilibrium . . . . . . . . . . . . . . . . . 23
1.6.2 Stage1: TheEmissionsEquilibrium . . . . . . . . . . . . . . . . . 25
1.6.3 RankingofInducedEmissionLevels . . . . . . . . . . . . . . . . 27
1.7 ConcludingRemarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2 OnOptimalAuditMechanisms 55
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
2.2 TheModelandPreliminaries . . . . . . . . . . . . . . . . . . . . . . . . . 60
2.2.1 Stage3: ReportingEquilibrium . . . . . . . . . . . . . . . . . . . 67
ComparativeStatics . . . . . . . . . . . . . . . . . . . . . . . . . 68
2.2.2 Stage2: EmissionsEquilibrium . . . . . . . . . . . . . . . . . . . 69
2.2.3 Stage1: DesigninganOptimalAuditMechanism . . . . . . . . . . 71
CandidatefortheOptimalAuditMechanism . . . . . . . . . . . . 74
vii
2.3 Discussion: OptimalAuditMechanismandthePreviousLiterature . . . . . 83
2.4 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3 CarbonEmissionsandStockReturns: EvidencefromtheEUEmissionsTrad-
ingScheme 99
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
3.2 TheEUEmissionsTradingScheme . . . . . . . . . . . . . . . . . . . . . 102
3.3 TheEffectofFreeCarbonEmissionAllowancesonFirmProfits . . . . . . 104
3.4 DataonCarbonEmissionsandStockReturns . . . . . . . . . . . . . . . . 107
3.4.1 SamplePeriod . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
3.4.2 StockReturns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
3.4.3 CarbonEmissionAllowances . . . . . . . . . . . . . . . . . . . . 109
3.4.4 DescriptiveStatistics . . . . . . . . . . . . . . . . . . . . . . . . . 109
3.5 TheCarbonPremiuminStockReturns . . . . . . . . . . . . . . . . . . . . 110
3.5.1 APortfolioApproach . . . . . . . . . . . . . . . . . . . . . . . . . 110
3.5.2 PortfolioReturns . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
3.5.3 FactorModels . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
3.5.4 IsThereaCarbonPremium? . . . . . . . . . . . . . . . . . . . . . 113
3.5.5 WhenDoestheCarbonPremiumBeginandEnd? . . . . . . . . . . 114
3.5.6 IstheCarbonPremiumRelatedtotheNumberofFreeAllowances
FirmsReceived? . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
3.5.7 IstheCarbonPremiumRelatedtoPriceofCarbonAllowances? . . 116
3.5.8 Can the Value of Carbon Allowances Explain the Size of the Car-
bonPremium? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
3.6 RobustnessandFurtherAnalysis . . . . . . . . . . . . . . . . . . . . . . . 120
3.6.1 IstheCarbonPremiumRelatedtoFirmSizeorValue? . . . . . . . 120
3.6.2 IstheCarbonPremiumRelatedtoIndustryEffects? . . . . . . . . . 121
3.6.3 DoestheSmallSampleSizeCauseaBiasintheAlphas? . . . . . . 122
3.7 DiscussionandConclusions . . . . . . . . . . . . . . . . . . . . . . . . . 122
Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
viii
List of Tables
3.1 DescriptiveStatistics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
3.2 ThePerformanceofCarbonPortfolios . . . . . . . . . . . . . . . . . . . . 128
3.3 TheCarbonPremiumacrossSubsamples . . . . . . . . . . . . . . . . . . . 129
3.4 ThePerformanceofAlternativeDirtyPortfolios . . . . . . . . . . . . . . . 130
3.5 TheCarbonPremiumandthePriceofCarbonAllowances . . . . . . . . . . 131
3.6 FirmPerformanceandtheMarketValueofCarbonEmissionAllowances . . 132
3.7 ThePerformanceofSizeandValuePortfolios . . . . . . . . . . . . . . . . 133
3.8 ThePerformanceofUSIndustryPortfolios . . . . . . . . . . . . . . . . . . 134
ix
List of Figures
1.1 EmissionsandReportingundertheRandomAuditMechanism . . . . . . . 14
1.2 BestResponseFunctions . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.3 EmissionsandReportingundertheTullockAuditMechanism . . . . . . . 21
1.4 EmissionsunderallthreeAuditMechanisms . . . . . . . . . . . . . . . . 29
1.5 FOCwhenB ∈ (1,2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
1.6 FOCwhenB ≤ 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
1.7 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
2.1 TheProposedOptimalAuditMechanism . . . . . . . . . . . . . . . . . . 75
2.2 BestResponseFunctions . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
2.3 MarginalBenefitandMarginalCost . . . . . . . . . . . . . . . . . . . . . 81
2.4 Plotof ∂r2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
∂e1
3.1 TheEffectofFreeCarbonEmissionAllowancesonFirmProfits . . . . . . 135
3.2 Timeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136
3.3 ThePerformanceofCarbonPortfoliosoverTime . . . . . . . . . . . . . . 137
3.4 RollingEstimateoftheCarbonPremium . . . . . . . . . . . . . . . . . . . 138
3.5 ThePerformanceoftheDirtyPortfoliowhenoneStockisDropped . . . . . 139
3.6 ThePerformanceoftheDirtyPortfolioversustheNumberofStocks . . . . 140
3.7 ThePriceoftheEuropeanUnionAllowance(EUA) . . . . . . . . . . . . . 141
3.8 HistogramoftheSampleDistributionofCAPM −α . . . . . . . . . . . . 142
1
Chapter 1
Firms’ Emissions and Self-reporting
under Competitive Audit Mechanisms
1.1 Introduction
Anessentialcomponentinthedesignofpoliciestoprotecttheenvironmentistheabil-
itytoenforcecompliance. Complianceisachievedthroughaneffectivefine-basedenforce-
ment system implemented by environmental enforcement agencies. The fines for non-
complianceinsuchasystemaretypicallycapped.1 Hence,theenforcementsystemchiefly
reliesonsufficientlyhighdetectionprobabilitiesofnon-compliancebyfirms. However,the
detection of non-compliance through auditing is costly for the agencies and therefore the
detectionprobabilityisdeterminedbytheagency’soperatingbudget.
Many environmental enforcement agencies around the globe suffer from ongoing bud-
get cuts which decreases their auditing capacity.2 Using the available limited audit re-
1Foradiscussionofrestrictionsonthemagnitudeofpenaltiesandfinesintheenvironmentalfield,seefor
exampleHarrington(1988). RefertoAllinghamandSandmo(1972)andPolinskyandShavell(1979)fora
moregeneraldiscussiononthemagnitudeoffines.
2See Telle (2013) for a discussion and practice of underfunded environmental enforcement agencies.
AnecdotalevidencefromCanada’slargestprovinceOntarioshowsthattheoperatingbudgetoftheMinistry
of the Environment (MOE) decreased by 45% since 1992/1993, while at the same time the operating bud-
get of the Ontario government increased by 72% (ECO (2011), p.81). Currently, MOE is responsible for