Fairness must dictate our emissions policy

Like it or not, New Zealand has ratified the Kyoto Protocol,which means that we need to either reduce our net emissions of greenhouse gases(primarily carbon dioxide, methane and nitrous oxides) back to 1990 levels, orpurchase emission permits from another country under an international emissionstrading scheme.     It seems likely that the latter scenario will eventuate.

If the government introduced no domestic policies to reduceemissions it would be responsible for purchasing a sufficient number of emissionpermits from offshore.   Effectively then, taxpayers pick up the bill and thereis no incentive for anyone in New Zealand to reduce emissions.   Is there a moreefficient and more equitable way for us to meet our international obligations?

The best way to encourage a reduction in emissions is todiscourage the use of products that contain relatively high amounts ofgreenhouse gas emissions – electricity (from thermal generation), aluminium andsteel products, cement, dairy products, some forestry products and of coursemost forms of travel.   This is most simply accomplished by introducing a tax onemissions.   A tax on emissions generates certainty around the price ofemissions, but does not guarantee that any given emissions reduction targetwould be met.   However, even if a tax has no effect on emissions, it is stillfairer to put the cost of emissions on those who cause them than to put the coston taxpayers generally.    

It seems likely that the government will not introduce a taxon emissions, opting instead for an emissions permit trading system.   Undersuch a system the total amount of emissions is capped, and emitters need to buypermits to cover their emissions.   The price certainty of a tax is exchangedfor quantity certainty.   Which would you prefer?

When emissions trading schemes have been introducedoverseas, it is usual for governments to give permits to emitters, rather thanselling or auctioning them to the highest bidders.   While under certainconditions free allocation can deliver the same reduction in total emissions,the wealth distribution effects are very different, with major emitters beingthe biggest beneficiaries.   Why would a government do this?

Political considerations aside, there are two reasons.  Fairness is one.   In the past businesses have invested on the basis thatgreenhouse gas emissions were free.   Subsequently imposing a price on emissionscould reduce the value of such investment, perhaps leading in some cases tostranded assets – structures and equipment that are specific to a certainindustry rendered less competitive by an emissions price.   An example might bea coal-fired power station or a dairy farm, but it is unlikely that the wholeasset would become stranded.   A small reduction in value is more likely.   Eventhen, however, optimal compensation is via a once-only free allocation ofemission permits equal in value to the change in asset value.   There is noeconomic basis for ongoing free permit allocation.   Note too that new firmsshould receive no free allocation, as they have no assets at risk.   Also,existing firms that do receive compensation should still receive it if theyclose.   Their compensation is for a lower value of assets, not for lostproduction.

The second reason why a government might distribute emissionpermits for free is to protect industries that compete, either in New Zealand’s domestic market or in export markets, with industries based in countries thatdo not have a price on greenhouse gas emissions.   For example, an emissionsprice might make cement produced in New Zealand uncompetitive compared toimported cement.   If this led to lower output from, or even the closure of New Zealand cement plants, offshore plants would increase production – a process frequentlyreferred to as "carbon leakage".   New Zealand would more easily meet its Kyoto obligation, but global emissions would not change – hardly the actions of aresponsible global citizen.   Furthermore, an industry once lost to New Zealand might never be re-established, even if at some point in the future mostcountries impose a price on emissions.   Without empirical analysis we simplycannot say which industries are worth protecting from an emissions price andwhich should simply be allowed to wither.  

What we can say though, is that if protection is warrantedit needs to be structured to protect output, not emissions, as it is thepotential loss of output that is the problem.   This immediately suggests anongoing free allocation of permits that is linked to output, given somereference amount of emissions intensity; that is, the quantity of emissions perunit of output.   The reference level could be set with respect to some baseyear, or with respect to world best practice (for that industry), or it mightinclude a prescribed path of declining emissions intensity.   Given a link tooutput, any firm that closes would not receive further compensation, incontrast to the stranded asset scenario discussed above.

It is unlikely that there will be industries in which 100%of output is at risk from a price on emissions.   Only basic commodities thatcompete entirely on price would be at risk.   Given this, and the likelihood offew stranded assets, if the government does introduce an emissions tradingscheme we would expect to see most permits auctioned, not given away.

And if the auctioning of permits leaves some revenue afterthe government has purchased whatever number of permits it needs from offshoreto cover New Zealand’s excess emissions, there are some interesting options foruse of that extra revenue.   Depending on the government’s policy decisions wewill cover these options in a future column.

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