Distributional Effects of Environmental and Energy Policy: An Introduction

Is it true that many of the effects of environmental policy are likely regressive? According to this, the answer is yes, but rebates to low-income households can offset the regressive effects. “This makes it important to use emissions taxes or the auction of permits, to raise revenue enough to cover the cost of those rebates”:  

Distributional Effects of Environmental and Energy Policy: An Introduction, by Don Fullerton, NBER Working Paper No. 14241 August 2008: Public economics has well developed tools for analyzing the incidence and distributional effects of … taxes. … Yet most pollution policy does not involve taxation at all. Instead, it employs permits or command and control (CAC) regulations such as technology standards, quotas, and other quantity constraints. …

CAC environmental restrictions do impose costs, and an important question is who bears those costs. Moreover, those restrictions provide benefits of environmental protection, and another important question is who gets those benefits. Thus, full analysis of environmental policy could address all the same questions as in the tax incidence literature. …

This introduction discusses some initial literature on distributional effects of environmental and energy policy. … To identify the major effects around which this introduction is organized, consider a simple requirement that electric generating companies cut a particular pollutant to less than some maximum quota. This type of mandate is a common policy choice, and it has at least the following six distributional effects.

First, it raises the cost of production, so it may raise the equilibrium price of output and affect consumers according to spending on electricity (uses side).

Second, it may reduce production, reduce returns in that industry, and place burdens on workers or investors (sources side).

Third, a quota is likely to generate scarcity rents. Take the simple case with fixed pollution per unit output, so the only “abatement technology” is to reduce output. Then a restriction on the quantity of pollution is essentially a restriction on output. Normally firms want to restrict output but are thwarted by antitrust policy. Yet in this case, environmental policy requires firms to restrict output. It allows firms to raise price, and so they make profits, or rents, from the artificial scarcity of production. Just as tradable permit systems hand out valuable permits, the non-tradable quota also provides scarcity rents – to those given the restricted “rights” to pollute.

Fourth, if it cleans up the air, this policy provides benefits that may accrue to some individuals more than others. The “incidence” of these costs and benefits usually refer to their distribution across groups ranked from rich to poor, but analysts and policymakers may also be interested in the distribution of costs or benefits across groups defined by age, ethnicity, region, or between urban, rural, and suburban households.

Fifth, regardless of a neighborhood’s air quality improvement, many individuals could be greatly affected through capitalization effects, especially through land and house prices. Suppose this pollution restriction improves air quality everywhere, but in some locations more than others. If the policy is permanent, then anybody who owns land in the most-improved locations experience capital gains that could equal the present value of all future willingness to pay for cleaner air in that neighborhood. Similar capitalization effects provide windfall gains and losses to those who own corporate stock: capital losses on stockholdings in the company that must pay more for environmental technology, and capital gains on stockholdings in companies that sell a substitute product.

Capitalization effects are pernicious. A large capital gain may be experienced by absentee landlords, because they can charge higher rents in future years. Certain renters with cleaner air might be worse off, if their rent increases by more than their willingness to pay for that improvement. Moreover, the gains may not even accrue to those who breathe the cleaner air! If households move into the cleaner area after the policy change, then they must pay more for the privilege. The entire capital gain goes to those who happen to own property at the time of the change, even if they sell it at the higher price and move out before the air improves. Similarly, new stockholders in the burdened company may be “paying” for abatement technology in name only, with the entire present value of the burden felt by those who did own the stock at the time of enactment, even if they sell that stock before the policy is implemented.

Sixth, strong distributional effects are felt during the transition. If workers are laid off by the impacted firm, their burden is not just the lower wage they might have to accept at another firm. It includes the very sharp pain of disruption, retraining, and months or years of unemployment between jobs. These effects are analogous to capitalization effects, if the worker has large investment in particular skills – human capital that is specific to this industry. If the industry shrinks, those workers suffer a significant loss in the value of that human capital. They must also move their families, acquire new training, and start back at the bottom of the firm hierarchy, with significant psychological costs.

Using these six categories in six sections below, this introduction covers research in economics that has begun to analyze distributional effects of environmental and energy policy. Particular emphasis is given to the twenty-one papers published in economics journals that are reprinted in this book. To set the stage for that discussion, however, the rest of this preliminary section reviews some earlier papers.

The classic text in the economic analysis of environmental policy is the book by Baumol and Oates (1988), which devotes a whole chapter to distributional effects. … A … challenge in … Baumol and Oates (1988) is related to the idea that many effects of environmental policy are likely regressive. Consider the six categories just listed. First, it likely raises the price of products that intensively use fossil fuels, such as electricity and transportation. Expenditures on these products make up a high fraction of low income budgets. Second, if abatement technologies are capitalintensive, then any mandate to abate pollution likely induces firms to use new capital as a substitute for polluting inputs. If so, then capital is in more demand relative to labor, depressing the relative wage (which may also impact low-income households). Third, pollution permits handed out to firms bestow scarcity rents on well-off individuals who own those firms. Fourth, low-income individuals may place more value on food and shelter than on incremental improvements in environmental quality. If high-income individuals get the most benefit of pollution abatement, then this effect is regressive as well. Fifth, low-income renters miss out on house price capitalization of air quality benefits. Well-off landlords may reap those gains. Sixth, transition effects are hard to analyze, but could well impact the economy in ways that hurt the unemployed, those already at some disadvantage relative to the rest of us.

That is a potentially incredible list of effects that might all hurt the poor more than the rich. The second challenge for subsequent literature, then, is to determine whether these fears are valid, and whether anything can be done about them – other than to forego environmental improvements! …

VI. Conclusion: Costs of Transition and Remaining Issues

…Papers in this volume show that environmental protection does likely raise the price of goods such as electricity and transportation that constitute high fractions of low-income budgets. In addition, pollution permits handed out to firms bestow scarcity rents on the well-off individuals who own those firms. Yet some of the papers in this volume show how rebates to low-income households can offset those regressive effects and allow for environmental protection without adverse distributional consequences. This point makes it important to use emissions taxes or the auction of permits, to raise revenue enough to cover the cost of those rebates.

Other papers in this volume estimate whether high income individuals get more benefits from environmental protection, because of higher willingness to pay. Results are mixed. Certainly high income families have more ability to pay, and thus may have higher demand for recreation and other environmental amenities, but the actual valuation by different groups depends on what amenity is being valued. Thus, environmental policies can be designed to provide sufficient protection to low-income neighborhoods. Some of the most pernicious effects of environmental policy, however, are the capitalization effects that provide windfall gains and losses. Those who own land or corporate stock at the time of environmental damage suffer a capital loss, and they may sell that asset before the abatement policy is implemented. It then provides gains to others who did not suffer the loss. Capitalization effects also apply to human capital, with even greater proportional gains and losses to individuals. These effects also are a challenge to the economics profession.

Originally published at Economist’s View and reproduced here with the author’s permission.