Last week my colleague Gareth Kiernan discussed the importance of what economists call allocative efficiency – ensuring that the nation’s resources can flow into those activities where they are most valued. A pre-requisite to achieving such an outcome is clear and consistent price signals. An area where pricing is rapidly becoming neither clear nor consistent is carbon pricing.
In September 2007 the government announced a comprehensive emissions trading scheme (ETS) in which the price of carbon would be linked to the world market for emissions – one unambiguous price for all producers and all consumers. Since then other measures to reduce carbon emissions have also been announced. Foremost amongst these are the mandatory biofuels (such as ethanol or bio-diesel) requirement in transport and the almost complete ban on new thermal power stations. There are also other policies, some still in the developmental stage, relating to areas such as the building code and vehicle fleet fuel economy standards. All of these imply different prices on carbon and have the potential to severely distort 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 mix some sort of biofuel with petrol or diesel, then clearly the carbon price is too low to induce such action. Mandating it therefore implicitly places a higher price on carbon saved in transportation than on carbon saved in other activities such as heating one’s home, manufacturing cement, or producing milk. If greater reductions in emissions than those induced by the ETS are desired by society, the carbon price within the ETS should be raised. This is not just an academic argument. To the extent that mandatory biofuels requirements extend beyond what the ETS carbon price would induce, we are all made poorer. This is manifested in higher prices, caused by more of the economy’s resources being needed to meet those mandated requirements than would be required to reduce emissions in some other way.
We probably do not know precisely what the best means of securing greater reductions in emissions are, but that is the prime justification for the ETS. Consumers and producers acting in response to one price signal are far more likely to pick the next most cost-effective means of reducing emissions than arbitrary policy by government.
Unfortunately the welfare loss doesn’t stop with artificially inflated fuel prices. Most readers will be aware of the debate about the true costs of biofuels and the horrible effects these are generating around the world. Depending on the type of biofuel, their production may involve deforestation (a double negative for global warming), require huge volumes of water (also potentially much scarcer under climate change), consume almost 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 food to growing crops for making biofuels. None of these are necessarily bad if they truly reflect society’s preferences, but they most certainly are bad when they are the result of ill-informed and capricious policy making.
Now consider the ban on new thermal generation. Analogous arguments apply. If the carbon price in the ETS does not induce sufficient generation from renewable sources such as wind and geothermal to achieve some target reduction in emissions, the price on carbon within the ETS is too low. Mandating additional renewables-based generation just raises electricity prices by more than is necessary. Again there are almost certainly better ways to reduce emissions; that is, ways that don’t hit living standards as much. And as with biofuels, other effects can be quite perverse. With the right carbon price a new efficient combined cycle gas-fired power station could produce cheaper electricity than the Huntly power station(New Zealand’s largest single source of carbon emissions) running on coal, but that opportunity is lost under the ban. Where is the logic?
It has been proposed that building regulations should stipulate more insulation. Ignoring the vexed issue of how such regulations should vary across climate zones, there is good evidence that better insulation leads to healthier homes. That may or may not be sufficient reason to tighten insulation standards, but let’s not proceed along that route on the basis of more insulation implying less demand for energy and thus lower carbon emissions. Once again, why are emissions reductions achieved in home heating worth more than emission reductions achieved in some other activity?
We cannot reduce emissions in a manner that causes the least pain to our standard of living when investors and consumers face a myriad of different prices on carbon, prices that may differ by a factor of ten! The uncertainty and consequential risks around the carbon price that will emerge from the ETS are bad enough. Let’s not make things worse. The last thing the economy needs is a whole array of carbon prices.