Executive Summary
New Zealand needs to get climate change mitigation policy architecture right because climate change may become a major regulatory issue. The current policy is a good start, but it is not complete or fully integrated. The purpose of this paper is to provide an up-to-date overview of key issues involved in the choice among market-based instruments for climate change policy. Specifically, it examines the potential net benefits from shifting to a permit system for emission reduction, and the preconditions necessary for this change. It also draws out the implications of New Zealand’s specific circumstances and current climate policies for future policy development.
Price-based instruments, i.e., taxes and tradable emission permits, are perfect for homogeneous long-term pollutants such as carbon dioxide. They allow maximum spatial and temporal flexibility at no environmental cost. They enable New Zealand policy to be consistent with Kyoto and future likely agreements, and are efficient in the short and long term.
Any mitigation policy, whether based on taxes or permits, must confront important questions of design along the following dimensions: stringency of control; breadth of coverage; the definition and measurement of emissions; the incidence of costs; and the important possibility of revenue recycling. Tax systems and permit systems behave differently in each of these areas. Under a tax system, pressure from companies or sectors for special treatment can be addressed only by granting exemptions. This reduces the breadth of coverage. In a permit system, however, grand-parenting is a possibility. In contrast, taxing or providing tax rebates for proxies for hard to measure sources and sinks such as nitrous oxide or carbon sequestration in forests might be possible. This would allow breadth across greenhouse gases (GHGs). The difficulties of permit allocation may make integration of these gases slower. The economic incidence of costs in either a tax or a permit system is independent of the legal incidence: i.e., it does not depend on who fills in the tax form but on how price signals are transmitted through the economy. Efficient taxes and permits impose the same costs on the same people, those who engage in emitting activities or consume goods that embody emissions. Goods and services with inelastic demand or supply carry more tax burden.
The economically efficient emissions tax or permit quantity is where the social marginal costs and marginal benefits of abatement are equal. In a world of certainty, taxes and permits can both yield the same optimal outcome. We are unlikely to ever know marginal costs or marginal benefits with certainty, so the tax rate or permit quantity chosen is unlikely to be optimal. Under uncertainty, a tax system and a permit system yield different emissions outcomes with different efficiencies. The quality of the international permit market is critical to the relative performance of each instrument.
A smooth international permit market is not a certainty. However, if firms from a range of countries were able to participate in an international market, the market would probably be fairly smooth and well-functioning. The existing EU permit market is not a good indication of how an international market is likely to evolve after 2008 because non-EU members currently have very limited access to the market. New Zealand would find trading emission permits internationally much easier under the Kyoto rules that are expected to take effect in 2008.
When the international permit market works perfectly and there is a domestic tax system, the government holds all New Zealand’s international permits and sets the tax rate charged on firms’ emissions. In a permit system, firms cover their emissions by buying domestic permits, which can be converted directly into international permits. In either case, the marginal costs of abatement are the costs of changing to cleaner energy sources, increasing energy efficiency, and adjusting production levels. The marginal benefits to New Zealand are just the international permit price. This is because a firm that manages to reduce its emissions by one unit can then sell the permit that would have covered those emissions (or is prevented from having to buy a permit for the emissions). Thus the firm gains the international permit price. Here taxes yield suboptimal results under uncertainty, whereas permits yield optimal results. Fundamentally, this is because permits adjust instantaneously to changes in the international permit price, whereas taxes require a government decision to change.
In the other extreme case, when there is no international permit market, the marginal cost curve is the same, but marginal benefits consist of the domestic environmental benefit, international favour from abatement, and the indirect effect of our abatement on other countries’ emissions. If we assume marginal cost and marginal benefit shocks are uncorrelated, permits are more efficient if and only if the marginal benefit curve is steeper than the marginal cost curve. Otherwise taxes are more efficient. Because of the fuzzy nature of marginal benefits in this case they seem likely to be less responsive to New Zealand’s emissions, so we judge that marginal cost will be steeper, favouring a tax system over permits.
These results, with and without an international permit market, suggest that a hybrid tax/permit system could be a good policy option. A hybrid system is a permit system with a trigger price at which firms can buy unlimited permits from the government. Under normal circumstances this acts like a permit system. However, if the international permit price goes too high, it begins to operate effectively like a tax system.
Two types of risk are associated with emission regulation: exogenous risk, which is caused by factors outside the government or an individual firm’s control, and endogenous risk, the risk of opportunistic behaviour on the part of firms or the government. There are four types of exogenous risk. Wealth risk is the risk that New Zealand’s target under the international agreement might change. This would alter the number of permits New Zealand holds. Demand risk is the risk that firms’ demands for emissions could change as a result of factors beyond their control. Asset risk is the risk permit holders face of capital gains or losses. Price risk is the risk of a change in the opportunity cost of using permits when permit prices change.
Risk allocation matters for efficiency for two reasons. Some agents are able to reduce some types of risk, and will do so if they bear those risks. Agents have different risk aversions, and there are costs to risk-averse agents bearing risk. The costs are the direct welfare cost and induced undesirable behaviour such as reduced investment.
When faced with risks, agents may have the option of reallocating them to less risk-averse parties by using derivative markets, or the agents may make real investment responses to cope better with unexpected changes. If there are good derivative markets, private agents are in a good position to deal efficiently with risk. If good derivative markets do not exist, the government should take on more of the risk to avoid some very risk-averse parties bearing disproportionately high risk.
Under a domestic emissions tax system, risk can be shifted between the government and private agents by changing how frequently the tax rate is adjusted. The more frequently it is adjusted, the more risk private agents bear. Under a domestic permit system, it is important that legal conditions are conducive to the development of derivative markets. Some permits should be allocated in advance to allow asset price risk to be effectively allocated through derivative markets and move some asset risk away from government. The allocation of risk argument suggests that a hybrid tax/permit system would be desirable because firms would then be protected from the risk of very high permit prices that may arise without the global marginal benefit being commeasurably high.
Endogenous risks can arise from either government or firms’ behaviour. The government may act opportunistically by changing the rules of the game; firms may lobby the government for changes that benefit them, strategically under-invest, or misrepresent their costs of abatement. In either regulatory system, policy targets should be made more credible through education and debate. In a tax system, the government can minimise opportunistic behaviour by avoiding granting exemptions and setting out clearly the conditions for a change in the tax rate and a formula for the new tax rate. In a domestic permit system, permits should be defined as percentages of future targets, which would help reduce the incentive for government to interfere with future aggregate targets. In addition, permits should not be grand-parented more than necessary and the government should support clean technologies and tax energy-intensive ones.
With a domestic permit system, market liquidity is important for good information, low transactions costs, fair prices and mitigation of market power. Market liquidity depends largely on the international market, but can be enhanced by having a broad market and simple rules. Market power is unlikely to be an issue unless a large share of permits is grand-parented to one company and the international market does not function.
Permits should be defined for one use, they should be infinitely divisible, advance allocations should be defined as percentages of the New Zealand target, each permit should be marked with a ‘use after’ date, and they should be directly convertible to AAUs. One-use permits are relatively simple to administer and trade. They also make it easier to define bankability and gradually phase out grand-parenting.
Permits should be grand-parented when necessary for political reasons, but grand-parenting should be phased out on a defined basis. The government could simply require all firms to buy permits from the international market. Alternatively, the government could hold periodic auctions with several ‘vintages’ of permit.
We recommend that for fossil fuel carbon dioxide emissions a hybrid permit system with a high trigger price be used. Permits are politically feasible because of the option to grandparent. They are economically optimal if the international market functions. They allow more flexibility in the allocation of risk than taxes, and they would be simple and work well. A hybrid system would protect firms against a failure in the international market, extremely high international prices or the collapse of international cooperation. Carbon sequestration in plantation and indigenous forests should be integrated into the permit system. This would yield huge potential gains, but there are still challenges, primarily in the distribution of permits, which need to be solved. Taxes and subsidies for ‘projects’ for non-fossil fuel emissions should be used temporarily.
