OverviewProduction of basic materials like steel and cement are responsible for 30% of global greenhouse gas emissions. Inorder to meet the de-carbonization targets agreen in Paris climate agreements, radical low-carbon innovation inproduction and use of these materials is needed.To induce the private sector to invest in radical green innovation of products and processes, it is often arguedgovernments should set a carbon price sufficiently high to ensure the profitability of such transition. However,carbon pricing is prone to time inconsistency and credibility problems. These arise for mainly two reasons. First,there are multiple and conflicting objectives in the political and regulatory agendas: long-term aimed carbonreductionpolicies conflict with short-term social and economic objectives, such as distributional implications ofhigher carbon price, and public finance constraints. This multi-objective nature of the government social welfarefunction creates a trade-off between climate and redistributive goals and governments are typically biased towardsthe short-term side of this trade-off, both because of electoral concerns and political alternation.The second reason is that the firm and the government take sequential moves, and low-carbon investments areirreversible and specific in nature. The two arguments lead to an ex-post opportunism problem: the former createsmotivation for ex-post opportunism, while the latter creates the scope. The government has an incentive to createexpectations of a relatively high carbon price (e.g., announce the emission of a small number of permits or of a highcarbon tax) in order to induce the firm to invest in radical green innovation (hence achieving the goal of reducingemissions); then, after the firm has sunk the investment costs, the government has an incentive to ex-post lower thecarbon price in order to avoid the negative impact on consumer surplus.However, as rational agents, potential innovators anticipate the risk of such ex-post opportunistic behavior on theside of the government, and do not invest in the first place, so that no emission reduction is realized. This timeinconsistency problem is not new to the economic literature and not specific to climate policy, but common to manyregulatory settings, such as monetary policy (Barro:1983 and Kydland 1977) and rate-of-return regulation (see e.g,Laffont:1993). Some past research has studied the problem in the specific context of climate policy, suggesting anumber of solutions: tax earmarking (e.g., Marsiliani:2000, delegation of environmental regulation to anindependent environmental agency (e.g., Helm:2003), investment subsidies (e.g., Abrego:2002, Golombeck:2010,Montero:2011, pollution taxes (e.g., Biglaiser:1995), options to pollute and procurement (e.g., Laffont:1996).MethodsDifferently from the above mentioned literature, which takes the time-inonsistency problem for granted, we assumethat policy makers are not totally present-biased and have some degree of forward lookingness. In this context,allowing for reputation effects (which can emerge in a repeated relationship) can bring some improvements. Thisexercise was done in the regulatory context (see e.g., Salant:1991, Salant:1992), Gilbert:1994 and Martimort:2006but never specific to the climate policy case.We assume a setting of pricing regulation similar to Laffont:1996. There is a continuum of agents/potential polluterswith demand for a polluting good where p is the carbon price as reflected in the good price (we assume full carbonpass through). The carbon price is "set" by the government at the beginning of a trading periods, in the sense thatthe governemnt can influence the carbon price via setting the number of allowances or a carbon tax. Thegovernment is Nash leader in this setting and the firm Nash follower. Given the sequentiality of the moves betweenthe government and the firm, there is scope for ex-post opportunism on the side of the government: the governmentcan ex-post change the price by manipulating the number of allowances or change the tax rate.ResultsWe investigate whether a repeated relationship between the private sector and the government can alleviate theproblem of time-inconsistency and hold up underlying carbon pricing policies. We represent the time-inconsistencyproblem in a simple model of carbon pricing and we find that reputational forces can bring some improvement onthe committment problem in the long run and partially restore the incentive for the private sector to invest. Wefurthermore investigate whether integrating the carbon price with additional policies can improve on the timeinconsistencyproblem in the short term. In particular we consider the role of project-based carbon-price guarantees,where a carbon price is guaranteed for a share of the project.ConclusionsWe have shown the time-inconsistency problem in a simple model of carbon pricing and found that reputationalforces can bring some improvement on the committment problem and partially restore the incentive for the privatesector to invest. The equilibrium carbon price and the level of investment are distorted downward with respect to thecommitment benchmark, so to ensure that the benefits of investment (in terms of reduced emissions) are spread overtime, therefore increasing the opportunity cost for the goverment of forgoing the relationship with the firm.Furthermore, we have investigated how additional policies can improve on the time-inconsistency problem in theshort term. In particular we considerd the role of project-based carbon-price guarantees. where a carbon price isguaranteed for a share of the project. In this case the time-inconsistency problem is expected to be less severe sincethe government can renege on the announced price only on part of the project. As far as we know we are the first inproviding a formal modelization of carbon contracts. We found that carbon contracts alleviate the timeinconsistencyproblem and partially restore the incentive for the firm to invest.
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