The effect of production- versus consumption-based emission tax under demand uncertainty

Abstract

Emission tax is an instrument widely adopted by countries and regions to incentivize emission abatement by emission-intensive firms including manufacturers. However, policies differ in how they allocate emission responsibilities among stakeholders. For example, the Chile emission tax directly penalizes manufacturers for the emissions they generate during their production (production-based emission tax), whereas the Sweden electricity emission tax penalizes the consumption of electricity rather than its production (consumption-based emission tax). These two methods have potentially varying implications on manufacturers' profits, their emission abatement decisions, as well as the resulting emission levels, especially when demand uncertainty is involved. In this paper, we investigate the impact of the two distinct methods by studying a profit-maximizing manufacturer facing stochastic demand. Under either production- or consumption-based emission tax, the manufacturer's optimal decisions on its selling price, production quantity and emission abatement investment are derived. Perhaps surprisingly, we show that under either tax, it is possible for an increase in the emission tax to discourage the manufacturer from investing in emission abatement. The impact of tax rate, abatement technology efficiency, and demand uncertainty on the manufacturer's profitability and abatement decision are also studied. Interestingly, higher demand uncertainty may motivate the manufacturer to invest more in emission abatement under production-based emission tax. Using a numerical example of an electricity power generator, we offer further insights into the comparison between the two taxes and find that there exist cases for either tax to dominate the other in terms of both profit and emissions.