3 What are fundamental and unavoidable differences between taxes and emissions trading?
This section discusses the ways in which taxes and permits are unavoidably different. It begins by outlining the manner in which each regulation system would interact with an international permit market and discussing the likelihood of such a market developing. In a world without uncertainty, permits and taxes are equally efficient. However, uncertainty is real and important. The section goes on to examine how the environmental and economic risks faced are different under each system when regulation occurs in an uncertain world, and how these risks would be affected by the presence of an international permit market. The section then discusses the optimal allocation of the exogenous risks associated with emission regulation and how policy can be designed to achieve this risk allocation. Endogenous risks, risks of opportunistic behaviour by private firms or the government, are then discussed. The section concludes by noting the different cost allocation capabilities of a tax and a permit system, and the possibility of transactions costs in a permit market.
3.1 Interaction with international emissions trading market
This section gives an overview of the way in which a domestic tax or permit system would interact with an international permit system. Further details on the more technical aspects can be found in Kerr (2000).
3.1.1 Tax and an international market
By their very natures, domestic emissions tax systems and emission permit systems interact differently with an international permit market. Under a tax system, the government is fundamentally responsible for achieving compliance with Kyoto for the country. The government sets the level of the domestic emissions tax it considers best, and firms act in their own best interests given the presence of the tax. If, as a result, the country under-complies with its obligations under the Kyoto Protocol, the government is required to purchase sufficient emission permits on the international market to cover the shortfall in abatement. On the other hand, if over-compliance is achieved, the government can sell the surplus permits internationally and generate revenue. In this scenario, in the absence of changes in the emission tax rate, shocks to the international permit price are absorbed by the government.
In the absence of an international emissions trading market, a tax that causes domestic under-compliance will cause the country to not meet its target under the Kyoto Protocol; a tax that causes over-compliance no longer leads to the benefit of revenue from selling permits internationally.
3.1.2 Permits and an international market
With a permit market, the government is able to pass liability for reaching compliance-level emissions in covered sectors to private firms. In the simplest case, a domestic emission permit is defined identically to an international permit, and the two can be freely traded on the international market. The government may choose to allocate (by means of gratis allocation or auction) emission permits that add up to the country’s emission target to domestic firms. Alternatively, it could require all firms to purchase their own permits on the international market, and could sell the country’s allocation internationally. The government theoretically need do nothing to ensure the compliance of the covered sectors of the economy, though it is responsible for purchasing permits for the uncovered sectors. If a covered firm finds itself requiring fewer or more emission permits, it sells or buys these on the international market. When all domestic firms cover their emissions thus, the country automatically finds itself in compliance. The marginal cost of compliance to each firm here will be equal to the international permit price, provided transactions on the international market are costless. Unlike in the tax scenario, here shocks to the international permit price are borne by private firms.
In the absence of an international market, a permit system can still ensure domestic compliance, but no longer places any limit on the marginal cost that achieving compliance may have.
3.1.3 Why there may not be an international market
Whether a liquid international permit market develops depends critically on the behaviour of the European Union (EU). The most likely way for an international market to develop is for the EU’s market to be extended to include other countries. However, this is would require a change in the governance of the EU market, which is not an insignificant step. The EU may also do other things to hinder the development of a full international market, such as refuse to recognise New Zealand credits gained from forest sinks. Now that Russia has signalled its intention to ratify, it may be easier for the EU to allow trading outside the EU under the governance of the United Nations Framework Convention on Climate Change negotiated rules for International Emissions Trading, Joint Implementation and the Clean Development Mechanism.
Beyond the participation of countries, firm participation in an international market is required to achieve liquidity. If only governments participated in the market, trades would be few and infrequent, and no informative price mechanism would develop. With participation by firms, however, the number of players in the market would increase greatly, and trades would be frequent. For firms to trade on an international market, they must first trade on a domestic market. It is not clear how many countries outside the EU plan to implement domestic permit trading schemes.
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.
