What Will the Emissions Trading Scheme Cost?
As speculated some weeks ago, the government has decided tointroduce a price on carbon emissions in the form of an emissions tradingsystem (ETS), rather than via a carbon tax. Whilst involving higher transactionscosts than a tax, especially with some industries receiving free allocations ofemission rights (the right to emit greenhouse gases for free), the ETS does atleast involve all industries in the economy â€“ eventually. Forestry enters thescheme in 2008, liquid fossil fuels in 2009, stationary energy and industrialprocesses in 2010, and agriculture in 2013, although industries may well beginreducing emissions voluntarily before their entry dates. All industries exceptfor electricity generation and liquid fuels receive generous free allocations.
Various commentators have stated that even with the phasedentry and free allocations, the cost to the economy will be substantial. Theyare wrong. There are two fundamental issues to be considered in understanding thecosts of the ETS:
- The size of the â€˜shock’ to the economy.
- The difference between the cost to the nation and the cost to particular parties.
Firstly, the size of the shock. Over the period 2008-2012the ETS will apply only to carbon dioxide, annual emissions of which are likelyto be around 40 mega tonnes. The future price of carbon is unknown, but manyestimates are around $20/tonne. At this price the value of emissions is about$800 million. New Zealand’s gross domestic product is over $160 billion. Thusthe proportion of GDP accounted for by the value of emissions is less than0.5%. But this portion of GDP does not just disappear. Certainly someindustries are worse off, but others are better off, which brings us to thesecond issue.
A price on emissions will raise the cost of energy andenergy-intensive goods and services such as concrete and travel. That is theintention. Higher prices discourage the use of such goods and encourage thepurchase of alternative fuels and investment in new manufacturing processesthat produce fewer emissions. I may spend less on heating my home when gasprices rise, but I may decide to invest in more insulation instead, or in amore efficient heating system â€“ options which become more economic under theETS.
The gas industry will employ fewer people than it would havewithout a price on carbon emissions, but the manufacturers and installers ofinsulation will be looking for more staff. Of course there are transitioncosts â€“ people cannot quickly move from one line of employment to another. Thephase-in period helps to reduce these costs. More importantly though, theprojected price on emissions is not high enough, especially coupled with thefree allocation, to force large numbers of people and capital resources intounemployment. What will happen is that new jobs and new investment will bedirected into different types of activities than would have been the casewithout a price on carbon emissions.
Thus while some businesses grow more slowly than they wouldhave, others expand faster. Private costs in one area are largely offset byprivate benefits in another area. Our analysis, using a model of the entireeconomy, indicates that total real household spending by 2012 will be only 0.2%lower, or only about a quarter of the initial shock to the economy. To putthis into more meaningful terms, between now and 2012 household spending isexpected to increase from $23,900 per capita per year to around $26,200. The ETSwill have the effect of reducing this to $26,150; not a large cost to meet ourinternational obligations.
This $50 is the net effect on the standard of living of theincreases in the prices of energy and energy- intensive goods. Ideally thecost of other goods and services would fall in price or, more realisticallywith inflation at 2% per annum, not increase as rapidly. So why is the totaleffect not neutral such that in 2012 prices are on average the same as theywould have been without the ETS, with only relative prices changing?
The reason is that the $50 per person per year is notprimarily attributable to the domestic price on carbon emissions. The primedeterminant is the high probability that New Zealand will have to buy emissionrights on the world market to cover our emissions in excess of what we arepermitted under Kyoto.
Emissions permits cost real resources. Purchasing permitsfrom offshore is like giving away some of our exports, meaning that householdsincur a loss in spending power. The more we can reduce this burden, thesmaller the reduction in our national welfare. And therein lies the mainreason for the introduction of the ETS â€“ or any other mechanism that places aprice on carbon emissions. A price on emissions leads to a decline emissions, butalso reduces the exports that we have to give away. That ensures we meet our Kyoto obligations at lower national cost.
Without a policy that puts a price on carbon emissions it islikely that New Zealand would have to buy more emission rights offshore,thereby increasing the national cost of meeting our Kyoto obligation as wewould have to give away more exports.
The ETS as announced has the correct general designparameters, albeit that issues such as the implementation details, permit pricevolatility, and the undesirable possibility of long term free allocation forselected industries have yet to be resolved. Nevertheless the ETS is betterthan many alternatives emission reduction schemes.