Energy pricing and air pollution : econometric evidence from manufacturing in Chile and Indonesia

Sound public policy addresses externalities directly, when possible. Air pollution is best alleviated by policy instruments that internalize the social cost of pollution, making it attractive to reduce emissions. One such instrument might be a tax levied on individual emissions, if they are measurable and if there is an accepted relationship between emissions and the damages to society. But such first-best solutions may not be feasible for many reasons, among them the cost of implementation. When first-best instruments are unavailable, indirect instruments, such as presumptive taxing of polluting inputs, may be a powerful alternative. Energy pricing is, for air pollution, one such indirect instrument. Energy pricing policies affect emissions through fuel substitution and energy conservation. The authors provide an empirical framework for measuring the magnitude of this impact and apply it to two cases: manufacturing in Chile and Indonesia. They find that: 1) the responsiveness of emissions makes energy prices a powerful indirect tool for reducing emissions; 2) there is room for substitution toward cleaner input combinations - both toward cleaner fuels and away from energy, toward labor, capital, and materials; 3) substitution toward cleaner fuels can also be induced without increasing energy prices generally, by increasing the price of the dirtier fuels, thereby reducing the relative price of the cleaner ones. But noncompensated price increases for the dirtier fuels, plus increases for all fuels, will be more powerful since they will also induce firms to reduce their overall energy use. In exploiting interfuel substitution, it is important to assess the relative damage caused by different pollutants. In Indonesia, increases in coal prices could deliver reductions in particulate emissions, but in Chile they would not, because of a small own-price elasticity, a heavily-used source of energy that also produces particulate emissions. Higher prices for pollution-laden fuels will generally reduce demand, as expected, but the net effect on emissions will depend on: a) whether other fuels laden with the same pollutants are spared such price increases; b) whether their cross-price elasticities are positive; and c) which fuel shares are high.