Why have an Emissions Trading Scheme?

As the mainpolitical parties seem to support the Emissions Trading Scheme (ETS) in someshape or form, one could be forgiven for thinking that the current SelectCommittee review of the ETS by the government is pointless.

Leaving asidecommitments between political parties, however, the review has presented anopportunity to compare the national cost of an ETS to an alternative policy ofgovernment simply raising taxes.   It has also enabled more analysis of the bestway to help industry adjust to a carbon-constrained world.   These issues haverecently been jointly studied by Infometrics and the New Zealand Institute ofEconomic Research.

Under New Zealand’s Kyoto commitment we either have to reduce our carbon emissions to what they were in1990, or we have to purchase emission units from other countries. Both optionscome at a cost to the economy.   Our research shows that the cost of undertakingdomestic emissions reduction is high.   Consequently it makes sense for us tomeet most of our Kyoto obligation by purchasing emission units from offshore. Wethen need to decide how this cost should be distributed.

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

This leadsnaturally to the idea of either a tax on carbon emissions or a price on theright to emit carbon – an emission permit.   Either way those people orbusinesses 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. Themacroeconomic benefit of this is that fewer emission units need to be boughtfrom offshore.   Thus a carbon tax or permit system does not need to raise asmuch revenue as would an increase in income tax.

Accordingly itwould 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 hassome fairly complex effects.

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

An addedcomplication is how other countries respond and how this affects thecompetitiveness of New Zealand based operations.   Assuming our major tradingpartners do not have a similar carbon price, is there some way of retaining theincentive to reduce emissions by having a price on carbon, while minimising thedeleterious effect on exporters?

We looked atthree options, all of which involve general taxpayers taking on more of thecost of meeting New Zealand’s emissions obligation: exempting some industriesfrom a carbon price, holding the carbon price to within a low maximum, orproviding some degree of free allocation of permits (instead of auctioning themall to the highest bidders).   In the limit the first two options approach asituation 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 betweenthem.

In the longerterm, however, the relative costs of the different options change. Anypost-Kyoto agreement is likely to be tougher with regard to emission reductiontargets.   That would raise the international price of carbon.   If someindustries remain excluded from a carbon price, and the price rises,increasingly cost efficient opportunities to reduce domestic emissions would beby-passed.   This is inefficient, implying that having taxpayers bear most of thecost of reducing emissions becomes a more costly option.

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

Taking intoaccount these longer run considerations and the desirability of providing clearsignals to investors, strengthens the case for a carbon price (ETS or carbontax) also applying to the Kyoto commitment period to 2012, again with some freeallocation to selected industries to provide them time to adapt.   This sort ofpolicy mix provides the flexibility to respond to changing policy in othercountries while minimising the economic risks to New Zealand.

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