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4.2 Price-based measures

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4.2 Price-based measures

4.2.1 Context – international and domestic

Introduction

Emissions of greenhouse gases pervade the economy: they come from every industry sector, every business (including farms) and from every household. There are a number of possible policy approaches to reducing emissions, including legislation and regulation, government funding to set positive price signals, information and promotion to remove barriers and support voluntary initiatives, and taxes or trading mechanisms to establish the price (cost) of emissions. All of these policies will have different strengths and weaknesses, and no single policy will be able to resolve the challenges of climate change on its own. Hence, a well-designed climate change policy package is likely to involve a mix of negative and positive policies – a mix of “carrots and sticks”. Likewise, there are limits to the ability of legislation and regulation alone to put controls on particular technologies or equipment or on setting firm-based, industry-based or household-based performance standards, even if the focus is on the largest emitters. Other things being equal, price-based instruments should have an important role in any climate change policy package.

The advantages of price-based measures in addressing environmental externalities are generally well rehearsed. Ekins and Barker (2001) surveyed literature on carbon taxes and carbon emission permits and concluded there is general agreement that market-based instruments of carbon control achieve a given level of emissions reductions at a lower cost than regulations. Sin and Kerr (2005) note that price-based measures are well suited to addressing homogeneous long-term pollutants such as carbon dioxide, as they allow maximum spatial and temporal flexibility and provide incentives to equalise the marginal cost of abatement across all firms and all sectors of the economy. The intention of price-based measures is to allow markets to determine the least expensive way of reducing emissions. The same effect would be impossible to achieve through a command and control system, as the Government would need marginal cost information for all regulated firms in order to make the appropriate decisions.

In practice, the desirability of different types and designs of price-based measures depends to a large degree on the context in which they are expected to operate. It is important to design a measure that is both sustainable and flexible over time to take into account changing contexts. This section discusses issues that need to be clarified to provide the context for soundly-based design and assessment of price-based measures.  

Broad options for domestic mitigation policy

New Zealand is clear about its obligations to 2012 under the Kyoto Protocol and the review takes as a given that New Zealand will not resile from those obligations. However, as discussed in Section 2.3, there is considerable uncertainty about the international context post-2012. The review takes it as given that New Zealand should continue to participate in and contribute to the international discussions about regimes for post-2012.

One objective for New Zealand’s domestic mitigation policy is to meet our obligations at the lowest cost. In this respect, the cost will include the economic and social impacts of the mitigation policies. This suggests a number of principles to guide policy design.

A principle of good policy design is that policy should be sustainable, or robust, in the face of the changes that are likely in the medium term. This reduces the risk that they will be unstable over time and the need for governments to undertake substantive policy reviews within relatively short timeframes.

A second principle of good policy design is that, where there is uncertainty about the future, consideration should be given to the benefits and costs of delaying a decision. If a decision is made to delay, then there are choices ranging from doing nothing, through explicitly adopting a temporary policy, to adopting a policy that avoids commitments now but puts in place sustainable policies that can adjust to future events.

Taking into account the substantial uncertainty about the future, and these two principles, the Government has two main options in regard to price-based measures – a carbon tax or emissions trading. The relative merits of these two options are considered below.

In addition, the Government has three possible broad approaches to a carbon tax. These are assessed in detail in Section 4.3.3, and can be summarised as follows:

1. continuing the current policy settings (carbon tax reflecting international price and NGAs, with the option of changing to emissions trading at an appropriate time)

2. a low-level carbon tax, removing NGAs.

This approach is one that avoids significant early commitments but provides a stable policy framework for the future. It would also allow a transition to domestic emissions trading at some point in the future.

This would involve a policy package that, in the short term, does not require or expect significant slowing of the rate of growth of domestic emissions. It would put in place a set of policies that best positions New Zealand over the long term to significantly slow the rate of growth of, or reduce in absolute terms, domestic greenhouse gas emissions. The idea is that the core policies would be able to be adjusted (not completely recast) over time, as more information about the costs of emissions reductions in New Zealand and certainty around the international context became clearer. In practice, this would mean removing the current NGA/carbon tax policy

3. defer a market mechanism in New Zealand until at least 2013

This approach explicitly adopts a temporary policy package that avoids significant early commitments that, if made, might be regretted later.

This would involve replacing the current carbon tax and NGA regime with a “holding pattern” policy package for CP1 of the Kyoto Protocol. This package would not require or expect significant slowing of the rate of growth of domestic emissions. At an appropriate time, when there is better information about international regimes and their implications for New Zealand and the cost of emissions reductions in New Zealand, the Government would develop appropriate domestic mitigation objectives and adopt a policy package consistent with these.

A risk-management approach is likely to be important, given the range and size of uncertainties about the future. It is also important to note that New Zealand’s emissions are small relative to global emissions and that our domestic policy settings are unlikely to impact on global emission levels. However, there are differing levels of risk to the New Zealand economy, depending on the domestic policy choices made.

The economic impacts of mitigation policies are likely to include shifts in the composition of the economy, as some activities will become relatively more profitable and productive than others – eg, low-emissions activities may expand as emissions-intensive activities decline. Patterns of consumer demand may also shift – eg, consumers may choose to purchase more energy-efficient products. There will also be an international dimension, as the differing climate change commitments and policy responses in different countries will mean that some New Zealand exports will face stronger competition in export markets, and some New Zealand producers will face stronger competition from imports. At the same time, other New Zealand products are likely to be more competitive at home or abroad.

As many of New Zealand’s competitors are unlikely to face a price on carbon for some considerable time, some parts of the New Zealand economy will face a greater exposure to this lower-cost competition, where the Government is unable to manage the price of carbon in our economy and where there are binding commitments on emissions levels.

These considerations suggest policy settings should be such that the Government can manage the price of carbon in the New Zealand economy in the short and medium term but the option of full participation in emissions trading is kept open in the longer term.

These factors also suggest that there may be a need for early strategic choices about the approach to those emissions that, if unchanged, would severely constrain New Zealand’s ability to make substantial emissions reductions in the long term; eg, agricultural emissions, transport emissions and, possibly, emissions from the heating and cooling of buildings and from fossil-fuelled power stations.

Emissions trading or a carbon tax?

The main types of price-based instruments are taxes (which apply a price to emissions) and permits (which limit emissions quantities [A domestic permit regime linked to the international market would not limit the quantity of emissions, as permits could be purchased internationally.]). New Zealand has currently opted for a carbon tax regime, although has left open the option of moving to domestic emissions trading such as a permit regime should the international emissions market develop sufficiently.

The key feature of a tax-based policy is that it sets the price of emissions (ie, the tax rate). Within a tax-based policy, therefore, there is no certainty about the volume of emissions to be undertaken. In contrast, under a permit-based scheme, there is the potential to set the volume of emissions and leave the market to determine the price. However, it is unlikely in a New Zealand context that the quantity of emissions would be controlled (see the section on emissions trading for more detail). There is, however, no certainty about the price involved, as this will be determined by a variety of factors in the emissions-permit market.

Tax and permit systems can result in different emissions outcomes with different efficiencies. With a well-functioning international permit market, a permit regime is more likely to yield an optimal result, as permits adjust instantaneously to changes in the international permit price, while taxes require a government decision to change [Setting the optimal tax would also require government to have perfect information about factors such as price elasticities of demand and marginal costs and benefits, so, in practice, may not be achieved. However, a wide range of factors will determine how important optimality is, and how far a nearly optimal (well-designed) tax will differ from the optimal outcome.]. A permit regime would encourage industries to respond appropriately to changes in the world price of carbon, whereas under a tax system, any shock to the international permit price creates a disparity between the marginal benefits faced by firms (the tax rate) and the marginal benefit faced by New Zealand as a whole (the new international permit price). [Sin and Kerr (2004) “Taxes vs permits: Options for price based climate change regulation.”]

There are other important differences between a taxation system and a permit-based approach. In particular, if the Government wished to reduce the initial impact of the carbon price on firms that are already emitting, it could exempt emissions up to a specified threshold (under a tax system) or “grandparent” (ie, give free) permits up to the specified threshold (under a permit system), but the incentives faced by firms would not be the same in each case. Conventionally, tax thresholds have value to a firm only for as long as it is producing emissions, whereas permits are an asset that the firm does not lose if it stops producing emissions. This can be important for firms considering reducing their emissions.

A permit-based scheme is a far more complicated policy than a tax-based policy, so set-up costs, timeframes required, and overall difficulties are greater.

There is a need for high levels of public and political buy-in to both a tax-based policy and a permit scheme. The difficulties and timeframes involved in setting up a permit scheme imply that the need for widespread buy-in is even greater in the case of a permit scheme. [Especially as firms and individuals need to actively trade in a permit market for the market to operate effectively.]

Under some possible future scenarios (as outlined in Section 2.3), emissions trading may better serve the Government’s objectives than a carbon tax would. Any proposed carbon tax option would ideally provide a good platform for a possible move to emissions trading in the future.

The implementation of either a carbon tax or emissions trading, or changing from a tax to trading, would be a major exercise for the Government, involving significant legislation. Ideally, such exercises would be undertaken infrequently, probably not more often than once a decade. This suggests that the likelihood of an emissions trading system, rather than a tax, best serving the Government’s objectives within the next, say, 10 years should be an important consideration when deciding whether a tax or emissions trading, or neither, should be implemented in the short term. This question is addressed in Section 4.3.4.

Broad options for maintaining international competitiveness

Internationally, countries are adopting a range of responses to reduce or slow the growth of emissions. In some cases, price-based measures are being applied – the European Union Emissions Trading Scheme being the most significant example – but, in general, a liquid international emissions market is yet to form and domestic price-based measures vary greatly in terms of coverage and rate.

In agriculture, it is very unlikely that many of New Zealand’s competitors will face a price for their methane and nitrous oxide emissions within the next 15 or 20 years. This may also be the case for some industries with respect to their CO2emissions. This situation raises issues of international competitiveness for these industries [Note that some other countries might reduce their agricultural emissions as a by-product of non-climate change policy changes. For example, changes to the European Union Common Agricultural Policy might reduce emissions in Europe.]. In other industries, New Zealand may gain international competitiveness – eg, if we become world leaders in emissions-reduction or low-emissions technologies.

The current carbon tax/NGA policy links the level of the tax to the international carbon price, with a cap of $25 per tonne of CO2e. The Government has decided that the initial level of the tax will be $15 per tonne of CO2e. With a tax that starts as high as $15 per tonne and may rise to $25 per tonne, the impact on some emission-intensive activities is likely to be substantial in a situation where many of their competitors do not face such a price. Current climate change policy includes NGAs to address international competitiveness issues among other objectives.

NGA policy sets a firm-based threshold (usually 10% reduction in earnings before interest and tax) for eligibility to negotiate an NGA and thereby avoid a significant amount of the increased costs that eligible firms would otherwise face. The rationale for this is that, if such firms did not have the opportunity to negotiate an NGA, they would reduce (and in some cases cease) production in New Zealand and production would increase in other countries. This is referred to as “economic leakage”. NGA policy is designed to minimise the risk of economic leakage.

[withheld under OIA s6(a), s9(2)(j)]

If the new production outside New Zealand were not less greenhouse gas intensive than the New Zealand production had been, there would be no associated reduction in global emissions. This is referred to as “carbon leakage”. NGA policy is designed to address economic leakage, irrespective of whether it is accompanied by carbon leakage.

Markets and the economy are dynamic. Change is continually occurring in the economy in response to a host of both internal and external factors and, over time, some businesses and some sectors expand while others contract. Relative price changes are an everyday occurrence in business and responding to them is part and parcel of managing a business. A low-level tax on greenhouse gases that is increased gradually provides an alternative approach to managing the risks to New Zealand businesses and economic growth, rather than introducing a (higher) tax on greenhouse gases and offsetting this with NGAs (the announced approach).

The third option for addressing international competitiveness is to dispense with both a tax and emissions trading for the time being and reconsider these instruments at an appropriate time in the future, when there is more adequate information about international regimes and their implications for New Zealand and the cost of emissions reductions in New Zealand.

The “international carbon market”

Once commitments, or obligations, to reduce emissions have been agreed, allowing the parties to buy and sell emissions reductions will help to ensure that the emissions reductions are made at least cost. If there is a market for emissions reductions, parties for whom it would be costly to reduce emissions have the opportunity to buy cheaper reductions from other parties.

Over the last five years, several greenhouse gas emission markets have emerged, trading in a variety of carbon “products” (emission units or allowances). Some of these products can be used to fulfil obligations under the Kyoto Protocol, and others cannot; only the former (termed “Kyoto-compliant” units) are relevant to New Zealand’s commitments under the Protocol. Kyoto-compliant units include AAUs (Assigned Amount Units – allocated to countries by the Kyoto Protocol), ERUs (Emission Reduction Units - generated by JI projects), CERs (Certified Emission Reductions – generated by CDM projects) and RMUs (Removal Units – generated by sink projects). The trading of ERUs and CERs is growing.

Earlier this year, the European Union established an emissions trading scheme (EU ETS) based on emission allowances for the period 2005 to 2007. These allowances (EUAs) are not Kyoto compliant.

There are two different circumstances under which New Zealand might participate in the markets for Kyoto-compliant units.

Where New Zealand’s obligations have not been devolved to firms, the Government might seek to buy units to help meet its obligations (any purchasing by New Zealand firms would be driven by the opportunity to make a profit from trading the units). Purchase by the Government of units in the international markets needs to be considered as part of the Government’s management of its Kyoto liability.

Where New Zealand’s obligations have been devolved to firms, New Zealand firms, rather than the Government, would be potential purchasers of units.

In either case, New Zealand firms that had been allocated units under the PRE might seek to sell these units in relevant carbon markets.

In considering whether New Zealand should implement an emissions trading scheme, key features of international markets that need to be considered include:

  • whether New Zealand firms would have relatively low transaction costs associated with buying and selling units
  • whether New Zealand firms could access low-priced emission-reduction units from overseas
  • whether the prices of relevant units would be reasonably stable.

It would not be necessary to have an international market that covers all countries or all countries that have ratified the Protocol.  

The “international price” of carbon in the New Zealand economy

How important is it that the “international price” is reflected in the New Zealand economy in the short term (to 2012) and in the medium term (to 2020)?

The Kyoto Protocol was structured to facilitate the emergence of an international market in emissions of the greenhouse gases covered by the Protocol (the international carbon market). Such a market has begun to develop and a variety of “carbon products” are now bought and sold in it. Of these carbon products, CERs, ERUs and AAUs are the most relevant to New Zealand, as these are the products that New Zealand could purchase to meet its obligations under the Protocol. [The Government used CER and ERU prices when it recently put a value on the Crown’s liability under the Kyoto Protocol.]

A central principle of the current policy settings is that the carbon price in the New Zealand economy should reflect the international price. However, most of the options discussed earlier in this section involve a decoupling of the domestic price from the international price in the short term (to 2012), and some options would continue this into the medium term and perhaps even longer. Does this matter?

When New Zealand has specific quantitative commitments, as it does for CP1, the benefit of having the domestic price approximating the international price is that the Government would have to buy units on the international market only if it was cheaper to do so than to reduce emissions in New Zealand. If the domestic price were lower than the international price, there would be less reduction in domestic emissions and the Government would have to buy more units on the international market. In addition, the Government would pay more for some of those units than it would have cost emitters to make the reductions in New Zealand. This would mean that taxpayers would pay more and emitters would pay less to meet New Zealand’s commitments. However, the benefit of a reduced fiscal cost would have to be weighed against any adverse effects from a reduction in international competitiveness and, ultimately, in economic growth. As long as New Zealand’s commitment to fulfilling its obligations under the Kyoto Protocol was credible, it is unlikely that the country’s international credibility would suffer if the domestic price of carbon were below the international price.

Beyond CP1, if New Zealand had specific quantitative commitments, the issues would be the same. However, if New Zealand did not have such commitments, and did not intend to have such commitments in the foreseeable future, there would be no benefit from having the domestic price reflecting the international price.

On the other hand, there could be a situation where New Zealand had no quantitative commitments but foresaw that it might well take some on in the future. In these circumstances, having a domestic price below the international price would mean that, if the domestic price was not ramped up to the international price before the commitment period, the Government would have to buy more units and pay more for some of them than it would have cost emitters to reduce the emissions in New Zealand. Again, emitters would pay less and taxpayers would pay more than if the domestic price were equal to the international price. This would have to be weighed up against the costs (in terms of loss of international competitiveness and possibly lower economic growth) of increasing the domestic price to equal the international price.

Is a concern for either global efficiency or global equity a reason for New Zealand emitters to face the international price of emissions? First, consider global efficiency. As New Zealand’s contribution to global emissions is very small, the extent of the emissions reductions undertaken by New Zealand will not have a material impact on the quantity (or cost) of emissions reductions undertaken by other countries. And, as long as New Zealand is not a significant buyer in international carbon markets, the quantity of New Zealand purchases in international carbon markets will not change the price that other purchasers pay. That means that the price of emissions in New Zealand has no material bearing on global efficiency in emissions reduction.

Secondly, consider global equity. As long as there is a diversity of approaches to international regimes, and this is expected to be the case for the foreseeable future, comparisons of equity between New Zealand and other countries will be far more complex than whether or not New Zealand faces the international price(s) of emissions.

For these reasons, the possible constraints on increasing the tax up to the level of the international price of carbon do not give rise to material issues of global inefficiency or inequity.  

Revenue recycling

In assessing the overall impact of a price-based climate change measure on New Zealand, it is important to recognise that revenue derived by the Government through the measure will not be removed from the economy entirely. Rather, revenue generated will be available for other government spending, which, in turn, will bring economic and social benefits. Decisions on how to recycle revenue will therefore influence the total impact of the price-based measure.

It is generally considered that using revenue to offset other distortional taxes assists in minimising adverse economic impacts of the price-based measure. Hoerner and Bosquet [Hoerner, J A and B Bosquest (2001) Environmental tax reform: The European experience. Washington, DC : Centre for a Sustainable Economy.] undertook a com prehensive survey of literature assessing the economic impact of environmental tax reforms (predominantly focused on energy emissions). Based on 44 studies containing 104 distinct simulations of environmental tax reform, they found that where revenue from environmental taxes is used to reduce other distorting taxes, the economic outcome (in terms of impacts on both employment and GDP) is better than where revenue is not used for this purpose.

In general, it is considered undesirable for the revenue derived from a tax to be “tied” to spending on government initiatives in the same policy area. In the context of climate change, this will mean that revenue from a price-based measure should not be tied to funding other climate change policies and measures, despite the fact there may be intuitive appeal in developing a policy package of tax plus spending. There are two key elements to this argument:

  • in general, government spending should be allocated on the basis of value for money, not source of revenue. Following a decision to recycle revenue from a price-based measure, the Government should look across all portfolios and all spending options to seek out the best value for money spending. This ensures highest total value is achieved from available government funds. Similarly, spending in portfolio areas should not depend on revenue generated in that area. For example, we do not spend less on public education because it does not happen to have a related intervention that raises revenue
  • furthermore, linking revenue to spending can create conflict. For example, connecting revenue from a price-based measure designed to discourage emissions to spending designed to encourage energy efficiency creates a conflict between effectiveness of the tax in changing behaviour (which will reduce revenue) and sustaining revenue to continue encouragement.

Under the announced carbon tax policy, re venue is to be recycled through a package of changes to the business tax regime, including changes to fringe benefit taxes and depreciation rules. No modelling of this specific recycling scenario has been undertaken, so it is difficult to estimate macroeconomic impacts. If a different price-based measure were to be adopted in the future, it may be worthwhile reviewing current decisions on revenue recycling to ensure they will minimise adverse economic impacts.

Three key messages from this are relevant to the assessments of price-based measures in subsequent sections:

  • using revenue from a price-based measure to reduce other distortional taxes assists in minimising adverse economic impacts arising from the measure
  • revenue derived from a price-based measure should generally not be “tied” to spending in that policy area, but should be allocated to the greatest-value use across portfolios
  • decisions have already been made that revenue from the announced carbon tax will be recycled through a package of changes to the business tax regime. If a different price-based measure were to be adopted in the future, it may be worthwhile reviewing current decisions on revenue recycling to ensure revenue use will minimise adverse economic impacts.

Transition to a lower-carbon economy

Significant reductions in global emissions of greenhouse gases by the middle of this century would reduce the risk of dangerous climate change. For this to happen, the major emitters in the world would have to be well advanced by then on a transition to lower-carbon economies.

New Zealand’s emissions are so small in global terms that its emissions will have no effect on the rate of global emissions reductions (or increases). A key question, therefore, becomes: How much emission reduction should New Zealand undertake, over what time and at what cost?

If the Government decided that New Zealand, too, should make a transition to a lower-carbon economy over a long term, one important requirement for achieving a relatively smooth, least-cost transition would be