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Allocating Compensation from Environmental Externalities T. Nicolaus Tidemana, Florenz Plassmannb
Abstract:
In a previous paper we showed how a futures market could be used to price environmental externalities. In this paper we show how complementary institutions could be used to allocate compensation for environmental harm.
Journal of Economic Literature Classification Codes: D84, H23, Q51 Keywords: Pigouvian tax, uncertainty, environmental regulation
a b
Department of Economics, Virginia Polytechnic Institute and State University, Blacksburg, VA 24061 USA Department of Economics, Binghamton University (SUNY), Binghamton, NY 13902 USA
1. Introduction Economists have long understood that a Pigouvian tax on the negative externalities of environmentally harmful activities ensures that people bear the full social costs of their actions. For many types of environmental harm, the practical usefulness of Pigouvian taxes is limited by the, potentially very large, uncertainty about the magnitude of the harm that is caused. In Tideman and Plassmann (2010), we showed that when there is uncertainty about the harm, a futures market in environmental bonds can help to improve upon conventional Pigouvian taxes.3 In this paper, we describe how this futures market can be combined with institutions for allocating the Pigouvian taxes that were collected. The archetypical example of an action with uncertain environmental cost is emission of carbon dioxide (CO2). The mechanism that we described in our previous paper requires that emitters of CO2 post deposits in the form of 30-year “zero coupon” government bonds. The amount of the deposit is the upper bound of the scientifically respectable estimates of the cost of CO2 emissions, perhaps $100 per ton.4 When the bond expires in 2041, its redemption value will be the difference between this deposit plus accrued interest and the 2041 estimate of the social cost of the CO2 emissions in 2011. If it turns out that the 2041 estimate of the social cost of the CO2 emissions in 2011 exceeds the upper bound of the respectable estimates in 2011, then the bond’s redemption value is zero and society bears the cost of having underestimated the maximum harm of CO2 emissions 30 years earlier.
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See T. Nicolaus Tideman and Florenz Plassmann, Pricing Externalities, European Journal of Political Economy 26 (2010) 176–184.
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The IPCC’s Fourth Assessment Report in 2007 reported a range of social cost of CO2 emissions of -$3 to
$95/tCO2, with an average of $12/tCO2. Thus an upper limit of $100 seems reasonable.
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To ensure that liquidity restrictions do not prevent emitters from emitting the socially optimal amount of CO2, there must be a secondary market where the bonds are traded at the discounted present value of their expected redemption price. Thus if market participants in 2011 expect that the 2041 estimate of the social cost of CO2 emissions in 2011 will be, say, $12 per ton, and the bond’s interest rate is 5%, then the bond’s expected redemption value is ($100 - $12) * (1.05)30 = $380.33 and its market price is $88 immediately after emitters bought it in 2011. If in 2021 market participants expect that the 2041 estimate of the social cost of 2011 CO2 emissions will be, say, $20 per ton, and the prevailing market interest rate is 6%, then the bond’s 2021 market price will be ($100 - $20) * (1.05)30 / (1.06)20 = $107.81. If at any time market participants expect the 2041 estimate of the social cost of 2011 CO2 emissions to exceed $100, then the bond’s price will be zero. In this paper we build on this idea by describing how the revenue from such futurespecified environmental taxes might be allocated. The remainder of this paper is organized as follows: In Section 2 we describe the considerations necessary to determine the allocation of compensation from environmental harm. In Section 3 we describe the accounting needed in allocating compensation, and we describe how markets ensure consistency among the market prices of the various rights we describe in Section 4. We conclude in Section 5.
2. Who should receive the proceeds from the Pigouvian tax? There are two main possibilities for allocating the proceeds from a Pigouvian tax: 1. To those who are have been harmed, in proportion to the harm. 2. To all people equally.
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Within each of these possibilities, the proceeds could either be allocated to people directly or to governments and agents of the citizens of nations. We first consider the question of whether to allocate the proceeds in proportion to harm received, and then consider whether governments should receive the money on behalf of their citizens. Equal or unequal division of the proceeds from a Pigouvian tax? If the payments that polluters are required to make are justified on the basis of the harm that their pollution causes, then it seems reasonable to make those payments to those who are harmed. There are several complications. First, such a rule commits the managing agency to a much more extensive determination of costs than what would otherwise be required. This is not impossible in principle because the estimation of the total harm caused by CO2 emissions can be conceived as the harm done to individuals, summed over all individuals affected. But in practice this requires many separate estimates about the variations of the harm, for example, how harm varies with climate in all its dimensions, and how it varies between rural and urban locations, age, income, and who knows how many other things. Such estimations would be quite daunting. Second, Ronald Coase pointed out that when those who are harmed by some externality are compensated according to the harm they experience, they lose the incentive to mitigate that harm.5 A person living in a place where CO2 caused considerable harm to each person would lose the incentive to move to a place where the harm would be less. This mis-incentive can be avoided by allocating the revenue from a Pigouvian tax according to a rule that does not depend on how much each recipient was harmed by the externality, for example, by sharing the 5
Ronald Coase, The Problem of Social Cost, Journal of Law and Economics 3 (1960), pp. 1-44.
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revenue equally. (Individualized compensation without distorting individual incentives to mitigate damages would still be possible as long as the individualized compensation were provided by an initial, lump-sum redistribution among all recipients of compensation, to offset their unequal starting positions.) Although equal sharing of revenue solves the incentive problem in a static world with a single generation, equal sharing entails a failure to internalize the negative externality associated with having children and thereby increasing the harm from emitting CO2. One way of eliminating this mis-incentive is to grant each person a right to be one of the two parents of a specific number of children, with payments required only for the negative externalities of additional children, and compensation provided for having fewer children. But the negative externalities associated with increasing the harm from emitting CO2 is likely to be among the smaller of the positive and negative externalities of having children, so it would not be appropriate to be concerned with it unless one were to attempt to deal with all of the positive and negative externalities of having children, and that is too large a subject for this paper. An alternative way of addressing the unequal harm of CO2 emissions to different people becomes possible if one imagines a world that acknowledges the equal rights of all persons to all natural opportunities. If the revenue from CO2 emissions were divided equally in such a world, there would be a variation in the rent of land in different places, reflecting their different susceptibilities to CO2. Such variations in rent would induce offsetting variations in the claims that people on low-rent land could make on those with high-rent land for unequal access to natural opportunities, thereby rectifying the inequality, to the extent that the inequality is accounted for by differences in location.
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Should payment be made to persons or to nations? In a world of free migration in which nations compete with each other for citizens there is no difference between payments made to persons and payments made to nations. To avoid losing citizens and to stay in power, governments would treat the compensation that was owed to their citizens in ways that were acceptable to the citizens. Any citizen who objected to the way in which his government handled the compensation for CO2 that was owed to him could always find some other jurisdiction where it was more attractive to live. In such a world, paying the proceeds of Pigouvian taxes to governments rather than citizens would be beneficial because the agency concerned with managing CO2 emissions would need to deal with many fewer entities. However, many existing nation-states fall short of this ideal. While some people might be said to live in a realm of competition among nations, there are many others who do not have access to such competition. A useful criterion for the existence of competition among nations for citizens is whether citizens are allowed to leave the country if they wish, without the permission of the government.
If citizens are allowed to leave if they wish, then it is
reasonable to construe their government as their chosen agent. But if citizens are not allowed to leave without the permission of the government, then such a construal is not reasonable. Even in nations that are generally regarded as free, some citizens are not allowed to leave—namely those who are imprisoned. It would generally not be reasonable to construe the government as the chosen agent of those who are imprisoned.
In other countries the
preponderance of the population is not allowed to leave if they wish. For all persons who are not allowed to leave their nations, the CO2 management agency needs to act as conservator,
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keep an account of the compensation that was due to them, and be prepared to transmit it to their respective governments if they should ever become free. Even when citizens are allowed to leave without their governments’ permission, there is generally no provision for individuals to receive the compensation for CO2 emissions that they are owed. A first-level explanation is that anyone who wants to receive the compensation that she is owed can be told to shop for a government that passes out checks to its citizens for their CO2 compensation. However, the would-be recipient is likely to reply, “Competition among governments for citizens is not rich enough for me to do what you suggest. I can’t find a government that offers what I want in a government, will allow me to join them, and passes out compensation checks to its citizens. I am not able to receive the compensation that I am due!” In an ideal world, an appropriate reply to this complainant would be that she does not have the right to whatever government she wants. She has a right to choose among the governments that will have her, or the government that she can from herself, with whatever associates she can find who share her idea of a good government. But this response is meaningful only if there is a way for those who wished to form new governments to obtain territory from existing governments, since all potential territory is already claimed. Perhaps one day governments will recognize an obligation to cede territory to their citizens who want a different form of government. In the mean time, people will need to get by with their choices from among existing governments. In the remainder of this paper, we assume that compensation for CO2 emissions is divided equally among all persons. If the inequities that this entails are to be off-set, the best way to do so is to have a system for equalizing all inequalities in per capita access to natural
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opportunities. For persons who are allowed to leave their nations, the payments due to them can be transmitted to their governments, as their agents. For those who were not allowed to leave their nations, the CO2 agency should keep their compensation and act as their conservator. 3. Accounting for Compensation Carbon dioxide that is released into the atmosphere today has effects for many years. In each year in which there are effects, they persons who are owed compensation are those who are alive at that time, which is a different set of persons each year. A mechanism is needed that will properly account for this. In the pricing mechanism that we proposed in Tideman and Plassmann (2010), a scientific panel meeting in 2041 will determine the price to be taken from the bonds posted by those who emitted CO2 in 2011, as the price of emissions in 2011.
To implement the
compensation mechanism, this price must be divided into time-slice (say annual) components, so the cost of emissions in 2011 will be reported as a cost in 2011, a cost in 2012, a cost in 2013, and so on for as many years as there are harmful effects of the emissions in 2011. To accommodate the possibility that this sequence of time slices continues for an indefinite length of time, the 2041 scientific panel divides the harm from emissions in 2011 into harm in 2011, 2012, 2013, and so on until 2041, and then an amount equal to the present value of harm in all future years. To determine the appropriate payments, the agency that is managing the emission bonds must have a record of the free population claimed by each nation in each year and the number for persons for whom the agency was acting as conservator each year. Once the
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scientific panel has specified the harm in each year beginning in 2011 that is caused by each ton of emissions in 2011, the agency can determine the appropriate payment to each person in each year.
Before the scientific panel meets in 2041, the agency issues “compensation
certificates” that specify that their bearer is entitled to compensation due for the harm that was caused in year X by the emission of one ton of CO2 in 2011. If the nation of Ruritania has 7 million free citizens out of a world total of 7 billion persons (that is, 1/1000 of the world population) who deserve compensation in, say, 2017, and if 25 trillion tons of CO2 were emitted in 2011, then the nation of Ruritania has a claim on certificates for the damages in 2017 of 25 billion tons of 2011 emissions (that is, 1/1000 of the emissions). The compensation certificates permit the agency to allocate the rights to compensation in terms of tons of emissions. While the monetary value of these compensation rights is not known until the scientific panel has met, the compensation rights can nevertheless be traded in advance of the meeting at prices that reflect the compensation payments that traders expect the scientific panel to establish. Thus a nation that wishes to turn the compensation that is owed to its citizens into cash can sell the compensation rights. If the market expects the present value of 2017 compensation for one ton of CO2 emitted in 2011 to be 50 cents, then the nation of Ruritania (with 1/1000 of the world population) could sell its right to compensation for damages in 2017 from 1,000 tons of CO2 emitted in 2011 for 50 cents. Uncertainty about the fraction of the population that each nation represents implies that the compensation certificates for harm in a given year cannot be issued until that year had passed. But any nation that wished to do so could turn its right to compensation into cash as soon as the year has passed. Speculators would not need to wait for the arrival of the year in question,
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because they would be able trade contracts in CO2 compensation for any future year that they wanted. Thus it would be reasonable to expect to find markets in compensation certificates for future years. The component of compensation representing the present value of future harm would require different treatment. Generations”.
This money would need to be sent to a “Fund for Future
This fund would accumulate such revenue and use it to pay appropriate
compensation to persons in future generations. 4. Stitching Rights Together through Arbitrage Arbitrage ensures that prices fall into patterns that preclude profit opportunities. For example, if there are offers to buy British pounds for U.S. dollars and offers to buy U.S. dollars for Swiss francs, arbitrageurs are likely to fulfill these offers until any offers to buy Swiss francs for British pounds do not offer any opportunity to make a profit by using the resulting francs to buy dollars and those dollars to buy pounds. So it is interesting to think about how arbitrage would affect CO2 markets. Suppose that in the year 2018, a market participant bought from a polluter a discounted bond that entitled the holder to the change from paying the cost of one ton of CO2 emitted in 2011, and that the market participant also bought, from recipients of pollution compensation certificates, the right to the compensation for the harm from a ton of 2011 CO2 emissions in the years from 2011 to 2017. Looking to future years, the market participant then bought from other market participants the right to receive the amounts of compensation that would be due in the years from 2018 to 2041, and he also bought the right to receive an amount of money equal to the compensation that the Fund for Future Generations would receive for the present value
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of the harm in the years beyond 2041. With this series of purchases, the market participant would have purchased a collection of rights that was equivalent to a zero-coupon government bond maturing in 2041, and arbitrage could be counted on to keep the sum of the prices of that collection of rights equal to the price of the bond. Markets would ensure that prices were internally consistent, so that neither polluters nor the recipients of compensation were shortchanged by the market process. 5. Conclusion This paper analyzes the considerations necessary to determine how to allocate the proceeds from a Pigouvian tax on environmental harm. Our starting point for the development of a compensation mechanism is that the compensation should go to all persons equally, and that countries can be treated as the agents of their citizens unless the citizens are prohibited from leaving their countries. Because environmental harm occurs over many years, it is necessary to make provision to compensate separately the slightly different overlapping populations of all the years when there was harm. In Plassmann and Tideman (2010) we describe how the magnitude of the harm might be estimated by a future scientific panel, with a market that predicted their actions used to permit current polluters to settle their obligations. In this paper we describe how associated futures markets can be used to permit the recipients of compensation to receive cash for their compensation rights before the amount of compensation has been determined.
Finally, we describe how market arbitrage would ensure the internal
consistency of all of the related prices.
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