Investments in Environmental Protection Technologies and the Paradox of Environmental Taxes and Subsidies

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ABSTRACT

Since the times of Pigou, it has been regarded as common sense in the economic literature that social - and later on environmental - policy can be formulated by using taxes and subsidies. In order to adjust to these policy instruments under the conditions of imperfect markets, this paper presents an approach to valuating investments in environmental protection technologies and to examine the determinants of their price ceiling. This price ceiling depends on the (corrected) net present values of the payments and on the interdependencies arising from changes in the optimal investment and production programs. Although the well-established results of environmental economics can be confirmed for a single investment, environmental taxes and subsidies may have counterproductive effects on investments in environmental protection technologies. In effect, all the (sometimes contradictory and unexpected) consequences of environmental taxes and subsidies can be interpreted in an economically comprehensible manner.

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INTRODUCTION

Since the times of Pigou (cp. Pigou 1932, pp. 172, 174, 183, 224) it has been regarded as common sense in the economic literature that social - and later on environmental - policy can be formulated by using taxes and subsidies. According to related literature, setting a price for the use of environmental resources or capacities leads to their consideration in economical decisions: one compares abatement costs to the costs of using these resources/capacities and, consequently, may avoid potential environmentally harmful behavior. Hence, due to environmental policy applying taxes and subsidies, investments in environmental protection technologies can become economically significant. In this context, the paper explores to what degree changes in environmental policies can actually provide financial incentives for investing in environmental protection. Regrettably, traditional and neoclassical models for investment appraisal (e.g. cost-oriented approaches, NPVor DCF-methods, or real options approaches), can only partially cover the particular nature of such investments and their alternatives.

Since investments of this kind influence production, it is necessary to derive the payments and constraints required for a financial valuation from production planning, with special regard to environmental taxes/subsidies and joint production. On this basis, a valuation model for an investment in environmental protection technologies will be developed - and be used to examine the determinants of the price ceiling for such an investment. This model considers activity level-dependent and -independent payments and treats the indivisibility of the investment to be valued. Due to the fact that many of the impacts of pollution on the environment have yet to be explored - and because of changes in environmental policy and in ecological awareness - this analysis also takes uncertainty into consideration.

Applying duality theory of linear programming, it can be shown that the price ceiling depends on the (corrected) net present values of the payments and on the interdependencies due to changes in the optimal program. Sensitivity analysis provides information about the (sometimes) contradictory and unexpected consequences of changes in environmental policy. Nevertheless, all these effects can be interpreted in an economically comprehensible manner and are demonstrated in an example. A conclusion summarizes the main results.

FINANCIAL VALUATION OF INVESTMENTS IN ENVIRONMENTAL PROTECTION TECHNOLOGIES

Background - Financial Evaluation on Imperfect Markets under Uncertainty

In the economic literature, several studies have examined the consequences of environmental policy on investments in environmental protection technologies (cp. Reinaud 2003; Zhao 2003; Chakraborty 2004; Gerlagh and Lise 2005; Knutsson et al. 2006; Laurikka 2006; Laurikka and Koljonen 2006; Buchner 2007; Sekar et al. …