Modelling the Porter effects associated with energy taxes

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A good theoretical model is required in order to estimate the causal subtleties associated with the possible Porter effect of an environmental tax on energy. According to economic theory, the effect of an energy tax will be exactly the same as the equivalent increase in energy prices. Energy price elasticities with respect to energy consumption and output have been extensively documented using a variety of statistical methods in the energy economics literature (for an overview, see Atkinson and Manning, 1995, plus numerous articles in the Energy Economics journal). Panel regression and cointegration analyses have been more successful than older methods at capturing the long-term relationship between energy prices and energy consumption. Typically, the studies report long-term own-price elasticities of industrial energy consumption in the range between -0.3 and -0.6 (Barker et al., 1995). This evidence tells us that energy taxes will have a strong environmental effect in the form of reduced energy consumption and hence less combustion of fossil fuels and lower emissions of air pollution.

But what is the impact of energy taxes on competitiveness and economic performance? Energy is not just some environmental problem, but a major input factor into industrial production. Most evidence indicates that rising energy prices have an adverse impact on economic performance (Longva et al., 1988; Smyth, 1993). The two oil crises during the 1970s speak for themselves (Nasseh and Elyasiani, 1984). Hence, it appears unlikely that energy taxes would be the carrier of a true Porter effect. Indeed, it is hard to believe that energy taxes will make room for so much innovation that it more than offsets the problem of rising input prices. But even if the net effect of an energy tax is a reduction in output, a mitigating Porter effect of substantial size may be involved.

Figure5.1 shows the basic reasoning. Variables that later appear as dependent variables in the analysis are indicated by rectangular boxes and variables that appear as independent variables, or unobserved intermediary causes, are indicated by oval boxes. A number of relevant

Figure 5.1. A causal model of the Porter effects

Figure 5.1. A causal model of the Porter effects independent variables are omitted from the figure, for example government regulation and subsidies to stimulate energy savings, the cost conditions of competitors, etc. The omitted factors are assumed to remain unaltered. There are two separate streams of influences, the first marked by solid lines and the other by dotted.

In the first stream, or chain of effects, the following logic applies. Rising taxes and energy prices will induce firms to substitute towards other input factors (mainly labour and capital), including energy efficiency improvements, which again will lead to lower energy consumption. If the possibilities for innovation and factor substitution are very limited, rising energy prices and taxes may even reduce output since lower energy consumption is not compensated for by other input factors (cf. the relations in parentheses). Factor substitution will, in turn, decrease unit energy costs. On balance, however, unit energy costs are expected to rise because of the higher energy price. The net impact is therefore a reduction in competitiveness on the assumption that competitors (especially foreign competitors) do not experience a similar or higher increase in energy costs. A further implication of increasing unit energy costs (vis-à-vis competitors) is reduced economic output. Overall, the stronger the effect of the mitigating influences in the form of energy savings through factor substitution, the lower the negative impact on economic performance— and the greater the support for the supply-related elements of the Porter idea.

On the other hand, there is a second chain of effects in which rising energy prices and taxes may induce firms to introduce product innovations that minimize the use of resources and other kinds of environmental initiatives that ensure more effective pollution abatement. This may, in turn, stimulate growth either because demand for the specific industrial products increases, or because the initiatives help to create a strong green image, which improves general economic conditions for the firm. This broader green innovation effect is the core of the Porter hypothesis, but it is much more difficult to observe and measure than the first chain of effects.

In the first chain of effects, the Porter element reduces to the mitigating influence that factor substitution has on the original negative economic impact of higher energy prices. One would never expect factor substitution to be so high that unit energy costs actually decline and output grows as a result of higher energy prices and taxes. However, the second chain of effects—the demand-related green innovation effect—introduces the possibility that, on balance, green energy taxes reduce competitiveness and output only slightly or perhaps even lead to improvements.

In the subsequent statistical analyses, we will test whether Porter hypotheses of various degrees are supported by the evidence relating to energy taxes. One of the most interesting questions is, of course, whether the hidden Porter effect is strong enough to offset the expected adverse impact of energy prices on economic performance. Hence, if we find a positive relation between energy taxes, competitiveness, and output, this would indicate the existence of a radical Porter effect. This would indeed be contrary to ordinary economic reasoning and move the scope of the Porter hypothesis beyond its usual application to non-fiscal instruments of environmental regulation.

More likely, there is a chance that Porter effects working through the factor substitution channel and the demand-related innovation channel strongly reduce the original negative effects of energy taxes on unit energy costs and output. If that turns out to be the case, it will indicate the existence of a mitigating Porter effect even with respect to tax instruments of environmental regulation. Finally, if economic performance is severely harmed by rising energy prices and taxes as assumed by mainstream theory, it indicates the absence of Porter effects in this area.

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