Mechanism design for refunding emissions payment

We analyze two mechanism designs for refunding emission payments to polluting firms; Output Based (OB) and Expenditure Based (EB) refunding. In both instruments, emissions fees are returned to the polluting industry, possibly making the policy more easily accepted by policymakers than a standard tax. The crucial difference between OB and EB is that the fees are refunded in proportion to output in the former, but in proportion to the firms’ expenditure on abatement equipment in the latter. We show that to achieve a given abatement target, the fee level in the OB design exceeds the standard tax rate, whereas the fee level in the EB design is lower. Furthermore, the use of OB and EB refunding may lead to large differences in the distribution of costs across firms. Both designs do, strictly speaking, imply a cost-ineffective provision of abatement as firms put relatively too much effort into reducing emissions through abatement technology compared with emission reductions through reduced output. However, this may be seen as an advantage by policymakers if they seek to avoid activity reduction in the regulated sector. We provide some numerical illustrations based on abatement cost information from the Norwegian NOx fund.