4  Instrument-specific design issues

This section examines a number of design issues that are specific to either a tax system or a permit system for controlling greenhouse gas emissions. Most of the issues are important only if the international permit market does not function well. The section begins by discussing the importance of market liquidity, which is one of the goals of many aspects of the design of permits. It then examines possible difficulties that could arise if permits are complex and are not well understood. The section considers the possibility of market power developing in a permit market and methods to avoid this. It covers and gives recommendations regarding the issues that relate to defining and allocating permits. The section then addresses the question of transaction costs in a permit market. It concludes by recognising the design issues that are specific to taxes.

4.1  The importance of market liquidity

It is important for a permit market to be as liquid as possible, and thus many design features of permits are directed towards achieving this objective.

Liquidity is important for the efficient operation of a market for many reasons. If a market is liquid there are many trades and prices are observed frequently. This gives good information on the value of carbon permits both to the government and to other possible users and/or purchasers of the permits. Improved information combined with the ability to buy and sell permits at any time at the market price makes it easier for companies to manage their risk and makes it possible for players to specialize in holding the permits and absorbing risk. If the market is not liquid, some players who would like to buy permits at the current price will not be able to and will be forced to reduce their economic activity. At the same time others will have too many rights, which they will either not use at all or use without much economic gain. Limited liquidity could have equity implications. In a liquid market it is much less likely that the difficulties arising from concentration will arise. Any firm will be able to enter the energy market by buying permits and it will be difficult for existing players to maintain high prices when many units are traded by many players.

Improving the liquidity and information flows in the market not only improves efficiency but in many cases it seems to raise the initial auctioned value of the rights. Lack of information reduces the number of bidders and creates tremendous uncertainty, which appears to lower permit values (it could theoretically raise them). In the ITQ market permit values were initially very low and rose faster than the rate of interest as the market became established. If the government is selling the rights it gains less revenue from the low prices, thus has less ability to lower distortionary taxes.

4.2  Effects of possible complexity of permits

If permits are complex and not well understood various problems could arise and need some consideration. Complex permits could create transaction costs in trading if not all traders understand the permits and brokers do not develop to facilitate trading. If permits are so complex they are non-transparent it could create enforcement difficulties. Highly complex permits also raise administration costs.

There is probably a trade off between a theoretically perfectly designed permit system and the ease of implementing it. The difficulties involved should be borne in mind when designing the permit. If only a few sophisticated players are required to hold permits the complexity is not such a constraint. Government will simply have to hire some sophisticated analysts to maintain and operate the system.

Carbon dioxide permits do not need to be complex. The government should endeavour to avoid the complexities that could arise if the permit system overlapped with NGAs or projects.

4.3  Risks from, and methods to avoid market power

If there is no international permit market, it may be possible for a large New Zealand firm to strategically influence a domestic permit market to its benefit. However, if the international market is functioning, no domestic firm will be large enough to cause the problems discussed in this section.

4.3.1  Strategic Manipulation of Permit Markets

There are two possible forms of manipulation. A company can try to lower the price of permits to reduce their costs of compliance (CMM[10]) or the company can try to raise the costs to their competitors and hence exclude them or capture market share by raising the price of permits (EM[11]).

Cost-minimising manipulation

A firm can lower the price of permits in a static one period market (such as an auction) by reducing its demand for permits. It will only do this if the price reduction it causes is sufficient for its total expenditures on permits to fall by more than the increased abatement cost it incurs. To be able to have a significant effect on price the firm (or firms) must make up a considerable share of potential buyers.

If one firm reduces its demand for permits to lower prices, the government loses potential revenue and other firms that hold permits lose. Marginal costs of abatement are not equalized because the firm lowering permit prices must over-abate to reduce its demand for permits and other firms will only abate until their marginal costs equal the new lower permit price. This means there is a higher cost to the economy as a whole. It also means that there is less of an incentive for the non-manipulating firms to innovate to reduce abatement costs so there is dynamic inefficiency.

If permits are initially allocated by auction and major players can collude during the auction to reduce bids the government will receive little revenue. After the auction the firms could freely trade permits at their true price to achieve allocational efficiency. Every firm would gain from this because they would buy their initial permits at lower prices. However, the government must compensate for foregone revenue through smaller reductions in distortionary taxes.

Exclusionary manipulation

Under very specific circumstances, a firm or group of firms acting in collusion may be able to manipulate the permit market in order to prevent a potential entrant from entering their product market. This requires that this firm (or firms) owns most of the permits in the market. Consequently, it cannot occur if permits are spread across a range of industries. If the required conditions are met, the firm can bid up permit prices by under-selling or by over-buying relative to its true supply/demand. In order to enter the product market, the new firm must purchase permits to cover all its emissions. If the permit price has been pushed too high, this may be prohibitively expensive, and the firm may be prevented from entering the product market. This effect is unlikely even in a domestic programme because so many different sectors are involved.

The very nature of permits may encourage permit ownership to concentrate. Concentration might occur because, as an asset, permits have certain risk / return characteristics that are more attractive to some players. In addition some players have better information about the value of permits, which reduces their risk and makes them more likely to hold permits. Players that are involved in the energy market will be likely to place higher value on permits because of the “option value” they carry in an illiquid market. Permits provide the firm with security that they can emit carbon dioxide even if it is difficult to find a seller of permits. Therefore these firms may buy up a high percentage of the permits. If some players see the possibility to control the market they will be willing to pay more for permits because of the possible benefits they will gain from oligopoly or monopoly power in either the permit or energy markets. The concentration of permits was observed in the ITQ market with increased concentration in the industry as a whole.[12]

Under this type of manipulation, marginal costs of abatement will not be equalized so that there will be a higher overall cost of compliance. There will in this case be excessive incentives to innovate and invest. The government will gain revenue but at the expense of distortions and other firms will face higher abatement costs.

Most importantly, this form of manipulation can be used to monopolize a product market so the effects go beyond the carbon dioxide market. If a company is able to exclude its competitors, then standard welfare losses, reduced innovation, lower quality and higher consumer prices will result. Consumer prices would tend to rise, quality would fall, and innovation in energy production would decrease.

4.3.2  How can strategic manipulation be avoided?

1. Do not limit who can hold permits. There may only be a small number of firms that are required to surrender permits at the end of each period, but they should not be only ones allowed to hold or trade permits.
2. Do not allow permits to become too concentrated. Existing law may be sufficient to prevent this from occurring. However, if it is not, some limitation on concentration should be introduced. For example, do not permit any one company to hold more than 20% of the permits available for use in any one year.
3. Auction some permits each year so existing firms never hold too high a percentage. If they have to buy a lot of permits for different time periods in the auction it becomes expensive in the short term to push the price up.
4. Expand the permit system to cover more sectors, e.g., forestry, to increase responsiveness of supply to changes in price due to reduced supply from existing holders.
5. Make permits bankable so there are more out there to sell - i.e. increase price responsiveness.
6. Make trading anonymous to make cartels difficult to sustain.

Strategic manipulation of the price in permit markets could only be an issue with no international trading, and is unlikely in any case.