2 Design issues common to taxes and permits
This section goes into greater depth about the design of GHG emission tax and permit systems, specifically systems regulating carbon dioxide emissions from fossil fuels. It deals with the stringency of regulation over time, issues about the breadth of coverage of the regulation, defining and measuring emissions, factors that determine who ultimately bears the costs of regulation, and the use of any revenue raised.
2.1 Expected intensity of control over time
The level of intensity of control is, in essence, determined by the price of permits in the international market. The choice faced by the New Zealand government is then whether to absorb some of the cost of control itself and try to impose a different intensity of control upon the domestic economy. Under a tax system, the government could do this by setting the tax rate at a level different to the international permit price. In a permit system, some sort of limitation on trading domestic permits internationally would have to be used. This situation is quite different to a standard permit situation, in which the cap determines the intensity of control.
New Zealand could try to achieve domestic compliance without trading permits internationally. In this case, creating domestic permits at the overall quantity of emissions targeted by New Zealand would achieve the objective with minimal difficulty. The problem of setting and changing the tax rate to achieve the target emissions each commitment period at the lowest possible cost is much more difficult. The path of the tax rate within the commitment period, and thus the distribution of emissions over the period, affects the total cost to the economy of making the emission reductions. The government simply does not have the information required to make optimal tax rate decisions.
2.2 Breadth of coverage
By breadth of coverage, we mean the proportion of the emitting economy that falls under regulation by the tax or permit system. There are considerable potential benefits to broad coverage. Broad coverage implies the marginal costs of emission abatement are equalised across the whole domestic economy, as is efficient. Granting exemptions, on the other hand, often implies that some firms could decrease emissions at lower marginal cost than others, yet are not required to do so. This causes economic inefficiency. The major exception to this generalisation is where firms operate in a competitive international market and are unable to absorb or pass on any extra costs. Imposing costs on them will result in production and emissions simply moving offshore. Thus preferential treatment for ‘competitiveness-at-risk’ firms is theoretically justified. It is difficult to identify competitiveness-at-risk firms. Most New Zealand firms compete internationally to a certain extent. In practice, a differentiated policy may create more problems than it solves.
Broad coverage also means that all businesses face full incentives to develop emission-reducing technology or procedures. The amount of revenue recycling that broad coverage allows could result in considerable tax cuts in other areas. This could give all domestic firms significant competitive advantage over their international competitors. Additionally, broad coverage means permit markets are likely to be thicker, which is important if there is no international permit market.
The proposed tax system is limited in breadth in two ways. First, it only includes specific types of emissions. The tax covers fossil fuel carbon dioxide emissions, yet excludes net emissions from agricultural methane, forest sinks, SF6 and N2O. The rationale for this is that, at least in the short term, the costs of taxing these emissions are too great in comparison with the gains that could be had from a tax. Second, some businesses are negotiating relief from carbon dioxide emission taxes through negotiated greenhouse agreements (NGAs). The economic justification is that these businesses would be unable to compete with international firms that are not subject to New Zealand regulation if they were required to pay the tax. In the absence of exemptions, they might not be able to remain competitive, and may be forced to downsize or liquidate, with negative consequences for their employees and owners. This gives no real environmental gains, because output and emissions are likely to simply move offshore.
However, NGAs aren’t total exemptions from emission regulation. Businesses with NGAs are required to follow some sort of international best practice. This is costly to define and monitor. NGAs still increase the marginal costs of production of firms, and may cause competitiveness issues, though these are not as severe as they would be if the exemptions were not granted. Additionally, exemptions with a stipulation for international best practice remove the incentives of the exempted firms to develop new and improved business practices that reduce emissions but that are not specified in their agreements. Furthermore, while they constrain the production process, they do not pass on any pressure to change consumption or output levels of the good being produced, thus they ignore an important avenue for emission reduction. Exemptions may be very complex to administer, because taxes are levied on upstream firms, but it is downstream firms that are likely to be granted exemptions. Exemptions require the tax embedded in inputs used by the exempted firms to be measured or estimated, which is likely to be difficult and costly.
When a business is exempt from emission taxes or permits, the government must assume responsibility for its emissions. The government must either purchase more permits on the international market or sell fewer, and it cannot recover these costs from the emitting firm through taxes or permit sales. The costs of shocks that change emission levels from the unregulated businesses are also borne by the government and ultimately by taxpayers. The government can only cover these expenses through general taxation, which causes inefficient distortions in the economy.
If NGAs are not wisely granted, several additional problems may arise. The first involves the effectiveness of the regulation. If NGAs are too easy to obtain, the businesses that produce most of New Zealand’s emissions are likely to receive exemptions, and the abatement gains from the emission regulation will be minimal. The second problem is that of leakage. Small firms are less likely to receive NGAs. This is inequitable, and it could also shift production from small firms without NGAs to large firms with them. Consumers may also substitute from included to exempt power sources, such as switching from using electricity for heating to burning wood, which is less efficient and may have local environmental impacts.
Even though the proposed tax system covers only some types of emissions, it is still valuable to use an economic instrument to regulate those emissions that are covered. The existence of exclusions does not affect the effectiveness of regulation in the sectors that remain, unless they compete with non-regulated sectors.
If narrow coverage is initially chosen, it may become desirable at some point in the future to broaden the coverage of the emissions regulation. Thus any scheme that grants exemptions should include a mechanism to bring companies with exemptions into the system at some point in the future.
In ‘projects’, firms are given emission credits for undertaking emission-reducing investments that would not occur without the support. These are one aspect of the current regulatory system that increases its breadth of coverage. They are intended to encourage emission-reducing action before 2007. The project scheme could be regarded as a nascent emissions trading system, but it is not desirable to view them as a transition to a full permit system. They should be used for learning only. For one thing, the credits are given to downstream firms, not the upstream firms that should be regulated in a permit system. Additionality is also a significant difficulty. That is, credits are only supposed to be given for investment additional to that that would occur without the scheme, but this baseline is very difficult to determine. Projects are very complex to administer, and they could never achieve full coverage. Furthermore, they form a dangerous precedent of paying polluters to reduce emissions as opposed to requiring them to cover their emissions with permits.
2.3 Definition/measurement of emissions
2.3.1 What is regulated
For simplicity of monitoring, GHG emissions themselves would not be regulated. Instead, some observable quantity with a direct relationship with emissions would be regulated. This might be inputs of fossil fuels for carbon dioxide, or stock numbers for methane. The definition of the observable that was monitored would not necessarily have to remain constant over time, but could change as technology or monitoring methods evolved.
For an economically efficient policy, equal incentives to abate must be provided at all margins: output, emissions per unit, fuel choice, investment etc. Any firm or individual considering an action that would increase or decrease emissions should take into account the effects of their action on GHG emissions. Firms that are being established or considering closing down should recognize the GHG effects of all their actions. Taxing or requiring permits for all net emissions achieves this outcome and in most cases is also administratively simplest.
In the case of carbon dioxide emissions, nearly all fossil fuel or other carbon source that is imported or extracted will ultimately release a fixed amount of carbon dioxide into the atmosphere. Small adjustments may need to be made for non-combustion uses such as petrochemicals. There is a lag in timing between the import of fuel and its combustion but this is not very large.
2.3.2 Who is regulated?
Any regulation should be imposed at a point where those who are regulated comprehensively (or as much as possible) ‘control’ the pollutant. Those who are regulated may not be the final consumers or emitters who need to change their behaviour but they can completely control emissions because they control the flow of the intermediate product. Their ultimate effect on emissions may be primarily through the price mechanism.
Another issue in choosing the best point of regulation is finding the level at which the costs of monitoring and administering the system (both in terms of reporting costs for firms and costs to government) are minimized. In both a tax and an emissions trading system, emissions must be monitored. In a tax system, tax payments must be matched against emissions while in an emissions trading system the ownership of permits must be tracked and permits must be matched against emissions. There may be legal subtleties. Regulation is simplest when it involves the smallest number of the most sophisticated players.
For some GHGs, the choice of point of regulation may have distributional effects. For instance, if regulation occurs at the downstream firm level, firms may expect permits to be grand-parented rather than auctioned. In the case of carbon dioxide, regulation would occur upstream, and many of the firms involved would be international oil companies, which would not expect grand-parented permits. Auctioned permits may also be more acceptable in a permit system that is preceded by a carbon tax.
The choice of point of regulation could affect the efficiency of regulation if it affected the initial allocation of permits and permit markets did not operate smoothly. If firms are unable to trade easily, the initial allocation affects their ability to emit. However, we expect the permit market to be smooth, so allocation should have little effect on the outcome.
Regulating an emissions trading system in the case of carbon dioxide is not as complex as people may expect. It is clearly optimal to regulate at the highest point possible, that is, where carbon is imported or extracted. At this level there are only a relatively small number of importers and extractors of fossil fuels to be monitored. Relatively good information already exists on their activities. (See Cramton and Kerr (2002) for discussion of the arguments for an ‘upstream’ emissions trading system). This achieves the environmental outcome at close to minimum cost, and minimizes administrative costs and complexity.
