Optimal coverage of an emission tax in the presence of monitoring, reporting, and verification costs

Environmental policies often include exemptions for some firms, e.g. the small emitters. This paper explores the implications of such exemptions in the case of an emission tax, and in the presence of monitoring, reporting, and verification (MRV) costs. We develop an analytical framework capturing the trade-off between the cost-effectiveness of a broader tax base, and the savings on MRV costs enabled by a partial coverage. Second-best partial coverage is defined by a threshold value of some characteristic of the firms below which firms are exempted. We characterize the optimal threshold and discuss its welfare implications. Since determining this threshold is demanding in terms of information regarding firm-level MRV and abatement costs, we show how limited knowledge about these costs at the aggregate level can be used in practice to approximate the optimal threshold. We apply this framework to assess the welfare implications of such an instrument in the case of greenhouse gas emissions from European agriculture. The findings indicate that exempting the small emitters may provide significant savings on MRV costs compared to the full coverage, while still incentivizing cost-effective reductions in emissions.