Center for the Study of Energy Markets

This paper investigates whether an emissions tax (equivalent to an emissions cap) is the best policy in the presence of incomplete regulation (leakage) or market power by analyzing an intensity standard regulating emissions per unit of output. With no other market failures, an intensity standard is indeed inferior, although combining it with a consumption tax eliminates this inferiority. For incomplete regulation, I show that under certain conditions an intensity standard can dominate any emissions tax (including the optimal emissions tax). This dominance persists even with the addition of a consumption tax, which ameliorates output distortions and can sometimes help the intensity standard attain the first best (when an emissions tax/consumption tax combination cannot). Comparing intensity standards to output-based updating shows that the latter dominates because of its additional flexibility. Finally, I show that with market power an intensity standard can dominate the optimal emissions tax. The intuition of these results is relatively straightforward. The weakness of an intensity standard is that it relies more on substitution effects than output effects to reduce emissions. With incomplete regulation or market power, this disadvantage may be helpful since leakage may offset gains from reducing output and since market power already inefficiently reduces output.