3.3 Allocation of risks and incentives to respond to risk
The risks associated with greenhouse gas emission regulation can broadly be classified as either exogenous or endogenous. Exogenous risks are those that cannot be influenced by either the government or regulated firms. These risks were discussed in Section 3.2. They include events such as changes in technology that reduce the costs of abatement and unexpected domestic economic growth that raises domestic baseline emissions. Dealing with these risks is discussed in Sections 3.3.1 and 3.3.2. These sections consider what the risks are, who should optimally bear them, and how policy should be designed to ensure that these agents do in fact bear the risks. They draw upon material from Kerr (2003a).
Endogenous risks, on the other hand, are the result of the behaviour of either the regulator or the regulated parties. These risks generally involve either an opportunistic change of the rules of the game by the government, or strategic investment or lobbying by regulated firms. Dealing with these risks is discussed in Section 3.3.3.
3.3.1 Optimal allocation of exogenous risk
Identifying uncertainty and defining risk
With either a tax or a permit system, a reduction in genuine uncertainty improves the efficiency of the choices that agents make. Although uncertainty may take a very long time to actually be resolved, in the shorter term it can often be evaluated and the likelihood of specific outcomes established. When uncertainty has been reduced to risk (when the possible outcomes and the likelihood of each has been established) agents can respond optimally to it.
Determining the risks largely involves monitoring relevant developments in other parts of the world and evaluating how they affect the likelihood of specific outcomes for New Zealand. For instance, although New Zealand is unlikely to develop breakthrough “clean” technologies, it is important for firms’ investment decisions and for future GHG regulations whether these are on the verge of becoming economically viable. The decision of the USA whether or not to ratify the Kyoto Protocol has huge implications for New Zealand, and the emission abatement efforts of other countries are also relevant to the New Zealand situation. Information about the state or likelihood of such developments is a public good to New Zealand; therefore, monitoring of relevant world events is unlikely to occur at the desirable level in the absence of government intervention. This means there is a role for government in monitoring and disseminating information on international developments that relate to emissions.
How firms and government should respond to risk
Four types of exogenous risk are associated with emission regulation. The first is ‘wealth’ risk. This is the risk that New Zealand’s domestic emission target will change, meaning a change in the number of permits the country as a whole holds. The second risk is domestic demand risk, or the risk that a shock such as a rise in demand for a firm’s output will cause an increase in the firm’s emissions. It must then either increase its demand for permits or pay more emission taxes. The third risk is asset risk, where holders of existing permits receive capital gains or losses when permit prices change. The fourth risk is price risk, or the change in the opportunity cost of using permits when permit prices change. Asset risk and price risk are negatively correlated with each other. Wealth risk is probably correlated with asset risk and price risk, in that a decrease in the number of New Zealand permits is likely to be associated with an increase in permit prices.
Two main strategies can mitigate or efficiently reallocate some of the types of risk. Price risk can be reduced by certain investment responses. Any one agent can avoid asset risk and wealth risk entirely by not holding any permits, though these risks are then faced by other agents. An agent that does hold permits may be able to efficiently manage its asset or wealth risk through a portfolio.
Firms have a number of possible investment responses to help mitigate the effect of price risk. They choose investment types that allow them the most flexibility to adjust their emissions. This involves choosing capital with a high proportion of variable costs and with a relatively short lifetime and investing in a mix of technologies. Firms are then in a good position to reduce the effects of price risk by adjusting their production level or production technologies at short notice. This changes their emission levels and either permit use or tax payments in response to the shock. Similarly, firms find an option value to waiting when there is uncertainty over future permit prices or carbon tax rates, and may reduce risk to themselves by delaying investment decisions. Research conducted by firms helps to resolve some uncertainty.
When a domestic permit system is operating, firms may be able to partially insure against price risk by the precautionary banking of permits, if this is permitted by the system. The private sector is also well positioned to develop a number of risk-allocation mechanisms such as derivative transactions associated with permit trading (e.g., forward trades or options). These mechanisms allow more risk-averse firms to pass some of their asset risk to risk-neutral firms. The government may also choose to enter these derivative markets.
The government has a limited ability to mitigate exogenous risk. However, it is able to fund research and monitoring that can lead to the resolution of some uncertainty. In its own investments it is able to reduce risk in the same manner as any firm.
Risk allocation considerations
When deciding who should optimally bear certain risks, several factors are important. First, the degree to which agents can control the risk and their ability to mitigate it should be considered. It is clearly more efficient for an agent with a greater degree of control over a risk and the ability to reduce it to be faced with that risk. This induces more efficient risk management than the situation where those facing a risk cannot control it and those who can control the risk have no incentive to do so. This point can be illustrated with an example of an electricity generation company. If this company uses hydro lakes to generate electricity, it should bear at least some of the risk to carbon emissions of these lakes running dry. Otherwise it would not have any incentive to use the lake water wisely, nor to have clean alternative generation methods on hand for dry seasons. If the government were to bear all the emissions risk of the lakes running dry, the electricity company could use all the water and turn to environmentally unfriendly generation methods at no cost to itself. This would clearly be inefficient.
Second, greater risk should be placed with those who can bear it at less cost. That is, those who are less risk averse. In general, the government and large companies are less risk averse than are small companies and individuals. There are two costs to risk-averse agents bearing risk. The first is the direct welfare cost. The second is the undesirable behaviour that may be induced by the agent having to bear the risk. For instance, if risk-averse firms are unable to share the risk of their investments they will invest less than is optimal for society.
The optimal allocation of risk depends on the instruments that parties have available to mitigate risk. One important distinction is between the cases with and without good markets for risk. If perfect risk markets are operating, firms can efficiently reallocate risk amongst themselves so that more risk-averse agents bear less risk, and less risk-averse agents bear more. Good risk markets are possible only if there is an international permit market; potential New Zealand buyers and sellers are too few for such markets to develop without the presence of international players.
If there are good risk markets, the government has no comparative advantage in bearing most exogenous risks. These risks tend to be correlated over the economy, and are not small relative to the size of the economy. As a result, the Arrow-Lind (1970) risk-pooling argument for the assumption of risk by the government does not apply. If the government were to bear a negative exogenous shock, the cost would ultimately be covered through taxation, with the associated distortions that this brings. Private firms, on the other hand, are able to use the risk markets to efficiently allocate risk among themselves.
However, there are reasons why risk markets may not be perfect even if there are international permit markets. Suppose a firm planning to undertake a risky investment manages to share the risk either through debt financing or equity. In either case, the firm no longer bears the entire risk of the investment. Furthermore, under debt financing the firm making the loan faces much of the loss if the investment goes poorly, whereas the investing firm reaps most of the gains if the investment goes well. Consequently, the investing firm has an incentive to choose a much riskier and higher yielding investment than it would if it bore the entire risk itself. The presence of asymmetric information over the risk and expected returns of potential investment projects means the firm making the loan cannot prevent a very risky project being chosen. This is the problem of adverse selection.
Once the investment has been chosen, asymmetric information causes further problems. The investing firm has more control over the investment than do any other firms that take on some of the risk. Because these other firms cannot perfectly monitor the investor, under a risk-sharing arrangement the investing firm has less incentive to take care with the investment than it would if it bore the entire risk itself. This is the problem of moral hazard. As a result of the adverse selection problem and the moral hazard problem, other firms are unwilling to take a share of the risk associated with the investment, and perfect risk markets are unable to develop.
In this situation, although the government really has no comparative advantage in dealing with the adverse selection or moral hazard problems, it may be efficient for the government to bear some of the risk. If the risk were left solely with firms, many of the firms that ended up bearing disproportionately large risk would be small firms that were most risk averse. This is not really an equity issue because firms choose to take on risk when they invest. However, it does mean that firms will invest less than would be socially optimal. By assuming some of the risk, the government encourages more investment and achieves an efficiency gain.
If the government assumes some of the risk, it must choose which investment projects to support, even though it is not in a good position to determine which projects are likely to be the most valuable. Although it risks funding projects that yield poor financial returns, it might value the learning benefits of risky projects enough to make the risks worthwhile.
