An array of carbon prices

Last week my colleague Gareth Kiernan discussed the importance of what economists call allocative efficiency – ensuringthat the nation’s resources can flow into those activities where they are mostvalued.   A pre-requisite to achieving such an outcome is clear and consistentprice signals.   An area where pricing is rapidly becoming neither clear norconsistent is carbon pricing.  

In September 2007 thegovernment announced a comprehensive emissions trading scheme (ETS) in which theprice of carbon would be linked to the world market for emissions – oneunambiguous price for all producers and all consumers.   Since then othermeasures to reduce carbon emissions have also been announced.   Foremost amongstthese are the mandatory biofuels (such as ethanol or bio-diesel) requirement intransport and the almost complete ban on new thermal power stations.   There arealso other policies, some still in the developmental stage, relating to areassuch as the building code and vehicle fleet fuel economy standards.   All ofthese imply different prices on carbon and have the potential to severelydistort economic activity and reduce our standard of living.

Consider the biofuels requirement.  If the carbon price that emerges in the ETS does not lead producers to mixsome sort of biofuel with petrol or diesel, then clearly the carbon price istoo low to induce such action.   Mandating it therefore implicitly places ahigher price on carbon saved in transportation than on carbon saved in otheractivities such as heating one’s home, manufacturing cement, or producing milk.  If greater reductions in emissions than those induced by the ETS are desired bysociety, the carbon price within the ETS should be raised.   This is not just anacademic argument.   To the extent that mandatory biofuels requirements extendbeyond what the ETS carbon price would induce, we are all made poorer.   This ismanifested in higher prices, caused by more of the economy’s resources beingneeded to meet those mandated requirements than would be required to reduceemissions in some other way.      

We probably do not know preciselywhat the best means of securing greater reductions in emissions are, but that isthe prime justification for the ETS.   Consumers and producers acting in responseto one price signal are far more likely to pick the next most cost-effectivemeans of reducing emissions than arbitrary policy by government.    

Unfortunately the welfareloss doesn’t stop with artificially inflated fuel prices.   Most readers will beaware of the debate about the true costs of biofuels and the horrible effectsthese are generating around the world.   Depending on the type of biofuel, theirproduction may involve deforestation (a double negative for global warming), requirehuge volumes of water (also potentially much scarcer under climate change), consumealmost as much energy in their production as they save in petrol and diesel,and lead to higher food prices as land use changes from growing crops for foodto growing crops for making biofuels.   None of these are necessarily bad ifthey truly reflect society’s preferences, but they most certainly are bad whenthey are the result of ill-informed and capricious policy making.

Now consider the ban on newthermal generation.   Analogous arguments apply.   If the carbon price in the ETSdoes not induce sufficient generation from renewable sources such as wind andgeothermal to achieve some target reduction in emissions, the price on carbonwithin the ETS is too low.   Mandating additional renewables-based generationjust raises electricity prices by more than is necessary.   Again there arealmost certainly better ways to reduce emissions; that is, ways that don’t hitliving standards as much.   And as with biofuels, other effects can be quiteperverse.   With the right carbon price a new efficient combined cycle gas-firedpower station could produce cheaper electricity than the Huntly power station(New Zealand’s largest single source of carbon emissions) running on coal, butthat opportunity is lost under the ban.   Where is the logic?  

It has been proposed thatbuilding regulations should stipulate more insulation.   Ignoring the vexedissue of how such regulations should vary across climate zones, there is goodevidence that better insulation leads to healthier homes.   That may or may notbe sufficient reason to tighten insulation standards, but let’s not proceedalong that route on the basis of more insulation implying less demand forenergy and thus lower carbon emissions.   Once again, why are emissionsreductions achieved in home heating worth more than emission reductions achievedin some other activity?

We cannot reduce emissions ina manner that causes the least pain to our standard of living when investorsand consumers face a myriad of different prices on carbon, prices that maydiffer by a factor of ten!   The uncertainty and consequential risks around the carbonprice that will emerge from the ETS are bad enough.   Let’s not make thingsworse.   The last thing the economy needs is a whole array of carbon prices.

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