As the main political parties seem to support the Emissions Trading Scheme (ETS) in some shape or form, one could be forgiven for thinking that the current Select Committee review of the ETS by the government is pointless.

Leaving aside commitments between political parties, however, the review has presented an opportunity to compare the national cost of an ETS to an alternative policy of government simply raising taxes.   It has also enabled more analysis of the best way to help industry adjust to a carbon-constrained world.   These issues have recently been jointly studied by Infometrics and the New Zealand Institute of Economic Research.

Under New Zealand’s Kyoto commitment we either have to reduce our carbon emissions to what they were in 1990, or we have to purchase emission units from other countries. Both options come at a cost to the economy.   Our research shows that the cost of undertaking domestic emissions reduction is high.   Consequently it makes sense for us to meet most of our Kyoto obligation by purchasing emission units from offshore. We then need to decide how this cost should be distributed.

One way is for the government to simply raise income taxes and use the revenue to purchase the required units.   It is a simple option, but is unlikely to be very fair as it doesn’t really make those who generate the most pollution pay more.

This leads naturally to the idea of either a tax on carbon emissions or a price on the right to emit carbon – an emission permit.   Either way those people or businesses that emit the most carbon pay the most.   That seems much fairer.  Furthermore, by placing a price on emissions there is an incentive to reduce them, an incentive that is absent under a general rise in income taxes. The macroeconomic benefit of this is that fewer emission units need to be bought from offshore.   Thus a carbon tax or permit system does not need to raise as much revenue as would an increase in income tax.

Accordingly it would seem to be a no-brainer that a tax or permit system is superior to a risein income taxes as a way of meeting our Kyoto obligation.   What economists calla 'partial equilibrium’ analysis leads to exactly that conclusion, but a 'general equilibrium’ (GE) analysis shows that introducing a carbon price has some fairly complex effects.

The main effect that is taken into account in GE analysis is that the industries that are most affected by a carbon price are also those that produce most of New Zealand’s exports – those that we need to generate the foreign exchange to purchase the international emission units.   So while we need their help, a carbon charge undermines their international competitiveness.   At the same time of course, less output from those industries means fewer emissions. General equilibrium analysis allows us to examine the trade-off.

An added complication is how other countries respond and how this affects the competitiveness of New Zealand based operations.   Assuming our major trading partners do not have a similar carbon price, is there some way of retaining the incentive to reduce emissions by having a price on carbon, while minimising the deleterious effect on exporters?

We looked at three options, all of which involve general taxpayers taking on more of the cost of meeting New Zealand’s emissions obligation: exempting some industries from a carbon price, holding the carbon price to within a low maximum, or providing some degree of free allocation of permits (instead of auctioning the mall to the highest bidders).   In the limit the first two options approach a situation where taxpayers bear the full cost.   For the period of New Zealand’s Kyoto obligation up to 2012 it turns out that there is not much material difference between them.

In the longer term, however, the relative costs of the different options change. Any post-Kyoto agreement is likely to be tougher with regard to emission reduction targets.   That would raise the international price of carbon.   If some industries remain excluded from a carbon price, and the price rises, increasingly cost efficient opportunities to reduce domestic emissions would be by-passed.   This is inefficient, implying that having taxpayers bear most of the cost of reducing emissions becomes a more costly option.

Hence as the carbon price rises the case for a comprehensive carbon pricing scheme such as the ETS or carbon tax becomes stronger.   This is because everyone faces the incentive to reduce emissions, at the international market price, even though some free allocation of emission permits to selected industries should still be provided – generally until other countries adopt similar measures.

Taking into account these longer run considerations and the desirability of providing clear signals to investors, strengthens the case for a carbon price (ETS or carbon tax) also applying to the Kyoto commitment period to 2012, again with some free allocation to selected industries to provide them time to adapt.   This sort of policy mix provides the flexibility to respond to changing policy in other countries while minimising the economic risks to New Zealand.