The case of New Zealand with an international regulation system

New Zealand is a small country and is controlling emissions in the context of an international agreement. As a result, its emissions form only a small fraction of world emissions, and there may be opportunities to trade permits with other countries. Weitzman’s analysis thus needs to be adapted to some extent before it can be applied to New Zealand. The previous analysis remains appropriate for analysing the problem at a world scale, as in the Kyoto Protocol.

New Zealand’s marginal cost curve for abatement captures the domestic cost of reducing New Zealand GHG emissions. This includes costs such as switching to cleaner energy sources, substituting from production technologies with higher emissions to those with lower emissions, and adjusting production. It is likely that the marginal cost curve is positively sloped and convex, indicating increased costliness of marginal abatement as the level of domestic abatement increases. That is, it is probably very cheap to reduce New Zealand’s emissions by a few units, but reductions become progressively more costly as the cheapest methods of emission reduction are exhausted.

The nature of New Zealand’s marginal benefit curve, however, depends on the international situation. Specifically, it depends on whether there is a functioning international market for emissions permits. The essential difference for the marginal benefit curve when an international permit market exists is that a reduction in New Zealand’s emissions will be perfectly offset by an increase in the emissions of another country. In these circumstances, the benefits of abatement are not environmental, but monetary from selling permits. New Zealand is a small country, and thus it is reasonable to assume that it can buy or sell as many emissions permits as it requires on an international market without affecting the permit price, provided such a market exists.

The international permit price is driven by factors at the worldwide level. For instance, a change in the international abatement target would alter the international permit price. Such a change could be motivated by changes in the marginal environmental benefit of abatement.

The marginal environmental benefit of abatement is determined by three factors: the stock of greenhouse gases in the atmosphere, the effect of the stock of greenhouse gases on the climate, and the effect of climate changes on human society. In combination, these three factors determine the marginal damage the world would suffer under higher emissions, and thus the marginal environmental benefit gained by abatement.

The future stock of greenhouse gases in the atmosphere is affected by economic growth (population growth or per capita economic growth) and by technological change. In the absence of sufficient technology improvements, higher economic activity in the rest of the world causes higher baseline emissions. These emissions build up in the atmosphere as a damaging stock of GHGs. If the marginal damage caused by each unit of emissions increases as total GHG stocks increase, higher world emissions increase the marginal benefit of each unit of abatement. Technological advancements in an international setting, on the other hand, may cause world emissions to grow more slowly, or even to fall, without compromising world economic growth.

In the following sections, we consider the differences with and without an international permit market. In each case, we also consider the choice that the policymaker faces of whether to comply with Kyoto or not.

With a functioning international permit market

If the international permit market functions well, the distinction between a tax and a permit system in New Zealand lessens. Because firms can buy or sell permits on the international market, a permit system no longer represents a quantity constraint.[6] Under these circumstances, we find that a permit system is optimal under marginal cost or marginal benefit uncertainty, whereas a tax system is not.

In this case, the domestic marginal benefit curve is horizontal and is equal to the international permit price. The international permit price is a marginal benefit because each unit of abatement that occurs in New Zealand allows either a permit to be sold by the country, or one fewer permits to be purchased.

Figure 3 illustrates the likely appearance of the marginal cost and marginal benefit curves. MB is the marginal benefit curve, and MC is the marginal cost curve. T* is the ex ante optimal domestic tax level as well as the ex ante desirable domestic permit price. It is also equal to the international permit price, T_I. Q* is the ex ante desirable quantity of abatement. The difference between New Zealand’s domestic emissions target under the Kyoto Protocol and the actual quantity of abatement achieved is the permits sold (or bought) internationally by the country.

Figure 3 – Marginal cost and marginal benefit with an international permit market

Under a tax system, the government would set the level of the tax at the international permit price. If the resulting abatement were more than sufficient to meet New Zealand’s emission target, the government would sell the additional permits internationally; if it were insufficient, the government would purchase the required additional permits. Consequently, it is the government that bears any risk associated with a change in the international permit price.

With certainty, a permit system would have the same effect on abatement as a tax at the value of the international permit price. Firms would abate their emissions where this costs less than the price of the permits, and would use permits otherwise. If the government either auctioned or allocated permits equal to New Zealand’s emission target, the buying and selling of permits by firms to cover their own emissions would mean the government would not be required to buy or sell permits internationally to achieve compliance with Kyoto. In this case, private firms would bear the risk of a change in the international permit price.

With a costless international permit market, a tax instrument and a tradable permit system where firms can trade internationally will yield the same environmental outcomes under domestic marginal cost uncertainty. These outcomes will be ex post optimal. This is because both systems effectively set the same emission price (the price which is both ex ante and ex post optimal), and then firms choose their actions to maximise their profits given their realisations of marginal cost.

Under shocks to the international permit price, however, a permit system is strictly preferable to a tax system. This is because the permit price adjusts perfectly to the shock by definition, and thus always yields the ex post optimal outcome. Unless the tax rate adjusts continuously, under a tax system any shock to the international permit price creates a gap between the marginal benefit faced by firms (the tax rate) and the marginal benefit faced by the country as a whole (the new international permit price). Consequently, a tax system will yield inefficient outcomes under marginal benefit uncertainty.

This situation may be complicated if New Zealand stands to gain international favour by reducing its emissions rather than just purchasing permits to cover them. This is the international discussion about supplementarity, which is based on Article 17 of the Kyoto Protocol (United Nations Climate Change Secretariat, 1998). This Article states,

The Parties included in Annex B may participate in emissions trading for the purposes of fulfilling their commitments under Article 3. Any such trading shall be supplemental to domestic actions for the purpose of meeting quantified emission limitation and reduction commitments under that Article.

If New Zealand does stand to gain favour in this manner, our marginal benefit curve is the sum of the international permit price and the marginal benefit of this international favour gained by the country. It seems reasonable for the marginal value of this favour gained to be positive and decreasing, and to become negligible at some level above New Zealand’s compliance level of abatement.

The dollar value of any favour that New Zealand finds internationally is very difficult to quantify, so it is hard to say anything about the relative sizes of the two aspects of marginal benefits.

Early action may have domestic benefits. Even if New Zealand doesn’t need any policies to meet its target in the first compliance period, it may nonetheless gain from starting abatement at this stage. Theory suggests that abatement may be less costly when it is introduced gradually. It is cheaper to replace production technologies with lower-emission technology when they reach the end of their lives and would be replaced regardless, as opposed to replacing capital that still has useful life left in it. Adoption of new technology also takes time, both in terms of the technology itself, and developing policy to deal with these issues. Responding to the international permit price may be sufficient to achieve optimal early action. This would justify additional action only if international prices are artificially low.

If there are significant marginal benefits of abatement other than those associated with buying or selling permits internationally, it might be optimal for the tax on emissions to be greater than the international permit price, or for domestic permits to not be identical to international permits. As previously, the ex ante optimal tax rate and permit quantity are determined by the intersection of the marginal cost and marginal benefit curves.

Under shocks to the international permit price, the relative desirability of a permit system compared with a tax system will depend on how the domestic price is related to the international price. If the domestic price is equal to the international price plus a fixed wedge, relatively flat marginal benefit curves will tend to favour a permit system, whereas relatively flat marginal cost curves will tend to favour a tax system. This is because domestic permit prices respond fully to an international price change, whereas taxes don’t respond at all. The flatter the marginal cost curve is relative to the marginal benefit curve, the less response is desirable.

The government always has the option of choosing not to comply with the Kyoto Protocol. This option is more attractive when the international permit price is very high and lots of other countries have chosen not to comply. Clearly, a high international permit price when New Zealand has to buy permits means high compliance costs. If a large number of other countries have chosen non-compliance, this becomes more attractive because the international disfavour from non-compliance is likely to be less than when most countries have chosen to comply. If international permit prices are very high, this may mean that abatement is just much more costly than the international community expected. It is likely in such a scenario that domestic abatement will also prove more costly than expected.