1.3 Basic design of taxes and emissions trading systems
1.3.1 Tax
Under a tax, the ideal is for emissions of GHGs to be taxed proportionately to the harm they cause the environment, causing agents in the economy to reduce their GHG emissions whenever this can be done at less cost than the value of the tax.
In a theoretical setting, the level of the tax should be set at the price that equates society’s expected marginal cost of abatement (MC) with its expected marginal benefit (MB). Figure 1 illustrates the optimal choice of an emission tax, T2. This results in a quantity of abatement equal to Q2. If the tax is set too high, at value T3, abatement will be above optimal, at the quantity Q3. This results in a net social loss of area CDE. If, on the other hand, the value of the tax is set too low, at T1, abatement is only equal to Q1, and the net social benefits foregone are equal to area ABC.
The amount of abatement carried out by individual agents in the economy depends on the individual marginal cost of abatement curves of these agents. Agents can minimise their total costs by abating until their marginal costs of abatement equal the value of the tax. If all agents follow this optimising behaviour, the marginal costs of abatement are equalised across the economy and the level of abatement is achieved at the lowest total cost to the economy.
Emissions must then be monitored in some manner to ensure that the correct taxes are paid. The way this is done is likely to vary with the GHG being taxed. Carbon dioxide is one of the easier GHGs to monitor and regulate. This is because there exists almost a perfect correlation between carbon dioxide emissions from fossil fuels and the carbon content in the fuels. Thus the sources of fuel, of which there are relatively few, can be monitored rather than the emissions themselves. With a sufficiently competitive market, this leads to the same economic effects as would direct regulation of the emissions.
1.3.2 Emissions Trading
The idea behind tradable emission permits is that the government or an international agreement decides what is an acceptable level of GHG emissions for the country, then the government gives away or sells permits to emit GHGs that add up to this amount. Firms may trade the permits among themselves, with the result that firms that find it very cheap to reduce their emissions do so, whereas firms that find it expensive to reduce their emissions purchase more permits and are required to reduce their emissions very little if at all. As a result, when there are no frictions in the permit market, the marginal costs of abatement will be equalised all through the economy, causing compliance to be reached at the least total cost to the economy. The prices of permits move with what firms are willing to pay for them, and thus they come to reflect the marginal cost of reducing emissions.
A permit system can achieve the same optimal level of abatement as a tax system by choosing a cap equal to Q2 in Figure 1. The permit price would then adjust to T2.
In order to monitor and enforce such a system for carbon dioxide, authorities would need to measure only fossil fuel imports and production, and keep track of the number of permits importers and producers held. If any firm were found to have insufficient permits to cover their fossil fuel sales in any period, they would face stiff fines and would be required to purchase permits to remedy the shortfall.
1.4 Effects on efficiency of abatement in the short and long term
1.4.1 Short term
Market instruments, namely taxes and permits, cause efficient abatement because they provide incentives to equalise the marginal cost of abatement across all firms and all sectors of the economy. This means that the level of abatement that occurs is accomplished at the lowest total cost. The same effect would be impossible to achieve through a command-and-control system because the government would require marginal cost information for all regulated firms in order to make the appropriate decisions. Market instruments, on the other hand, give firms incentives to act optimally given their marginal costs, whether or not the government knows what these costs are.
1.4.2 Investment, innovation and diffusion
The long-run efficiency of abatement of any policy depends largely on the extent to which it encourages firms to invent, innovate and invest in emission-reducing technologies. Because New Zealand is a small country, most new “clean” technologies are developed overseas and adopted by domestic firms. Consequently, incentives to invent and innovate may be less important to our situation, and incentives to invest may be more important.
Price-based instruments provide stronger incentives to innovate than technology standards. Under a technology standard, any firm that identified a cleaner production technology would risk having the use of the technology imposed upon it. Unless the new technology had lower costs than the technology stipulated by the standard, the firm would be disadvantaged by this innovation, thus the innovation would not occur in the first place.
Under a price-based instrument, the incentive a firm has to innovate depends on how easily they can capture the rents from the innovation. This depends on how much of the technology the firm is able to patent, their ability to sell their innovation to other firms, and the ability of competing firms to imitate the innovation.
Sections 3.1 and 3.2 of Kerr et al. (2002) discuss the dynamic efficiency of invention, innovation and diffusion decisions for New Zealand in more detail.
