Environmental Taxes on Exhaustible Resources

Diplomarbeit von Jan Angenendt

Introduction:

The link between greenhouse gases and global warming is scientifically well established nowadays. The burning of fossil fuels causes a large part of the world’s greenhouse gas emissions. For example, the burning of a ton of coal leads to the release of a certain amount of carbon dioxide into the atmosphere where it adds to the presently already increased stock of greenhouse gases. Consequently any further burning of coal is exacerbating the problem of climate change. This externality calls for political intervention on resource markets and the question arises which policies should be implemented. In this thesis, the multitude of optimal solutions taxation offers is derived.

Any analysis of possible policy options on this topic has to consider that fossil fuels are no normal goods. Their total supply over time is determined only by nature. The owner of a resource deposit earns profit by extracting a given stock in time. Correspondingly, the value of the resource deposits is being determined by the discounted stream of future profits that can be expected from selling the stock (which can be affected by future changes in regulation). This implies that a regulator should pay special attention to the reactions of the supply side of fossil resource markets to his policies, but it also allows him to use a broad range of regulation policies regarding taxation. The clue is to set different incentives to extract the resource at different points in time. The resulting multiplicity of policy options can be used to correct different kinds of market failure. Sinn summarized the relationship between political intervention and supply side reactions against the background of climate change in his theory of the ‘green paradox’. It states that a lenient gradually tightening environmental policy leads to the counterproductive effect of falling resource prices and an increase in resource extraction in the present and the near future. This effect and the insight that gradually relaxing measures set the right incentives led Sinn to recommend falling tax rates as the optimal regulation policy to slow down climate change.

Another aspect that threatens the future profits of resource owners is the development of substitutes to fossil resources, for example alternative methods of energy production. The availability of those technologies sets an upper limit to the market price of fossil fuels and leads to a faster depletion of the (economically extractable) resource deposits in finite time. The faster the development of such technologies progresses, the faster fossil resources are extracted resulting in an increased speed of climate change. But the (now finite) period of resource use can be prolonged by the implementation of falling tax rates.

The geographical spread of fossil resources favors the development of oligopolistic or monopolistic market structures. Abstracting from any other distortions, market power alone would be a reason for the regulation of resource markets due to the deadweight loss in consumer’s rent it causes. In the context of global warming, market power on fossil fuel markets has to be reconveived. Because fossil resources are being extracted too fast without political intervention and market power slows down the extraction of exhaustible resources, the welfare loss due to higher resource prices might be offset by gains due to lower climate-change-related damages. It will be shown that also in the context of a backstop technology, market power still decelerates resource extraction. Furthermore (as market power can be corrected by a whole family of tax/subsidy-schemes), it is possible to correct the effects of market power by using rising strict taxes and to minimize the costs of regulation if extraction costs are sufficiently low. This finding supports the presumption that the necessary incentives for the resource owners to postpone extraction of their stocks could possibly be less strong than under perfect competition. Tax rates could be less falling in time -- which might facilitate the political implementation of an optimal policy.

Concerning the optimal taxation of the externality, the regulator needs to be able to calculate the discounted stream of future damages resulting from the burning of an additional unit of fossil fuels. In a theoretical model, the resulting path of the optimal carbon tax then depends on the design of the damage function and the question whether stock or flow externalities are being taxed. In any case, taxation is an especially powerful instrument that can induce resource owners to follow the optimal extraction path. A whole family of optimal tax paths exists that can correct the influence of several sources of distortions at the same time; the optimal tax schemes differ in the splitting of the resource rent between resource owners and the regulator, but all follow the same movement. In this thesis, a family of optimal tax schemes for a resource path that is deviating from the optimal path due to market power and externality is being derived -- examplarily for the capability of resource taxation to induce any optimal extraction path desired by the regulator.

Table of Contents:

Text Sample:

Chapter 4, OPTIMAL TIME PATH OF A CARBON TAX:

In the paper in which he points out the ‘green paradox’, Sinn uses a model with an implicit stock-depent damage-function of cumulative resource extraction assuming that the damage caused by climate change is irreversible. This assumption is a possible one and I won’t be able to sufficiently discuss it in this thesis, but a dynamic stock of pollution seems to be a more realistic approach to look at the development of atmospheric greenhouse gases. Albeit assuming a dynamic pollution stock with a constant rate of carbon decay is still a simplified way to model the stock effects caused by accumulated atmospheric greenhouse gases, it will be done in the following. An even more proper modeling would require non-linear decay functions.

Another aspect often ignored in publications on optimal carbon taxation is that the social costs caused by climate change do not only depend on the stock of greenhouse gases, but also on the rate of change of atmospheric pollution. Rapidly changing temperatures are associated with high adaption costs as ecosystems and society have to continuously readjust to new conditions. As stated in, most papers on the time path of optimal carbon taxes consider either stock or flow externalities and respectively study the development of tax paths depending on both kinds of externalities separately. This will also be done in this section. In the first part a stock-depent damage function will be assumed and carbon-taxation in three different cases will be analyzed: Dynamic stock of pollution 1.) with and 2.) without backstop as well as 3.) irreversible damage from carbon burning. To illustrate the different implications of the externalities for carbon taxation, a flow-dependent carbon tax will be derived in the second part.

Of course there are several models with dynamic stock effects. Their designs are rather diverse and the underlying assumptions differ from paper to paper. Ulph and Ulph find that the level of an ad valorem carbon tax can have an inverted U-shape, while Tahvonen as Hoel and Kverndokk proposes the same movement for the absolute level of taxation (if the initial pollution stock is low enough). Farzin finds that abatement should increase over time while Sinclair proposes falling ad valorem taxation. The approach taken by Hoel and Kverndokk will be presented in the following.

4.1, Stock externality:

The stock externality presumed in the present case is the social damage resulting from the level of the atmospheric stock of greenhouse gases. Resource consumption is assumed to be the only source of carbon emission.