The Emissions Trading Scheme – Higher Prices are Better than Higher Taxes

During the last few weeks many interest groups have criticised the Emissions Trading Scheme (ETS) for making us all poorer.   There seems, however, to be considerable confusion between New Zealand’s commitment under the Kyoto Protocol and the ETS.   It is the former that imposes an economic cost; the latter is a way of meeting that cost.

New Zealand has signed an international agreement to take responsibility for annual greenhouse gas emissions during 2008-2012 above what we emitted in 1990.   Essentially this means that New Zealand must buy emission permits from other countries.   Parliament ratified the Kyoto Protocol in 2002, which means that New Zealand has accepted its Kyoto obligations.   Whether we should have signed the Protocol, whether the world should reduce greenhouse gas emissions, or what difference New Zealand can make are all irrelevant to the discussion below.

The obligation lies with the government.   It could meet this obligation by raising tax rates on households and using the proceeds to buy the permits.   Or it could offset the cost of the permits by on-selling them to New Zealand businesses and requiring businesses to surrender a permit for every tonne of emissions they produce.   The latter is effectively what the ETS does.   To see why this produces a lower overall economic cost than simply raising taxes, consider the accompanying diagram.

 

 

 

The curve shows that the more abatement New Zealand undertakes the higher the cost of each unit of abatement.   For example, if the price of petrol increases one might use one’s car a bit less at little personal cost, but to make larger savings would involve greater costs such as replacing your car with a smaller car.

The horizontal line represents the price at which New Zealand can buy emission permits on the world market.   Thus the shaded area represents the reduction in cost that New Zealand can achieve by undertaking some domestic abatement, rather than just buying permits offshore.   By placing a price on emissions the ETS provides the incentive to reduce emissions in New Zealand, up to the point where the cost of doing so equals the world price of permits.  In the diagram this is where the curve and the horizontal line intersect.   Tithe right of that point it is better to buy permits offshore than to pursue further emission reductions in New Zealand.

Because New Zealand’s current annual emissions are greater than just the excess over 1990 emissions, if the government auctioned emission permits it would have more than enough income to purchase the required offshore emissions permits to meet New Zealand’s Kyoto obligation.   The extra income could be used to reduce income tax rates.   The net effect would be that the higher energy prices faced by households would be largely offset by lower tax rates.   However, both this government and the previous one have shown themselves reluctant to adopt such a policy mix.   Instead of auctioning emission permits, many will be given away to businesses for free.   Every dollar’s worth of emission permits that is given to business is one less dollar available for income tax cuts.  

Furthermore, every dollar’s worth of emission permits that is given to business blunts the incentive to reduce emissions, not because businesses won’t face higher energy costs (which they will), but because the free allocation reduces the pressure on businesses to raise the prices of emissions- intensive goods such as dairy products and cement.

This all makes the current ETS rather half-hearted; the more so because businesses will in fact have to surrender emission permits for only half of their emissions, effectively therefore halving the price of emissions that they face.   That measure alone transfers costs from producers and consumers of emissions-intensive goods to taxpayers.  

Most of us, of course, are simultaneously taxpayers and consumers of petrol, concrete, milk, and gas.   So one way or another we will be worse off, but again the reason for this is our commitment under the Kyoto Protocol.   The ETS reduces that cost.   In other words, it is better to face higher prices for emissions-intensive goods than to face higher taxes.

An argument for allocating free permits is that, for a few industries, the potential decline in output resulting from the ETS will cause greater economic harm than the cost of free allocation of emission permits.   However, the trouble with the ETS as it stands is that it seems likely that many industries will claim to be in such a position, implying so much free allocation of emission permits that taxpayers will not just have to forego tax cuts, but may actually face tax increases.

Those industries will certainly benefit from free allocation, but there is no free lunch in most cases their gain will be households ‘loss.  

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