5 Options for mixed tax-permit systems
Rather than a pure emission permit system or a pure emission tax system, it is possible to have a system that is a hybrid of the two. In any hybrid system, indeed in any emissions regulation system, it is imperative to avoid double taxation, which is both inequitable and distortionary. In a hybrid system, however, it may be less obvious that double-taxation is occurring, so greater care must be taken to design a system in which it does not occur. One option for a hybrid is a permit system with a safety valve that prevents the marginal cost of abatement from going too high. Another option is to tax some sectors of the economy and regulate other sectors through a permit system.
The option of a hybrid system with a trigger price may be chosen because it limits the permit prices that may be faced by private agents. It involves two components. Permits that add up to target emissions are auctioned or allocated and then traded as in a normal permit system. However, beyond this permit trading there is a trigger price at which private agents can buy unlimited additional permits from the government. When the trigger price is reached, all conversion of domestic permits to international permits must be frozen to avoid firms buying at the trigger price and selling at the higher international price. Consequently, the domestic permit price will never rise above the trigger price, and marginal abatement costs will be bounded from above. If the trigger price is set very low, the system will behave like a tax system; if the trigger price is set very high, it will behave like a permit system.
The effect of such a system is to transfer some of the price risk involved with a permit system from private agents to the government. While this reduces the risk faced by private agents, it increases risk to the government, which must purchase any additional permits desired by agents at the international permit price and sell them at the lower trigger price.
Pizer (1998) evaluates a hybrid system of this type using a global integrated climate economy model. This paper finds that, at a worldwide scale, this type of hybrid system has welfare benefits over a straight tax or straight permit system. However, these results apply to a no-government world economy in which the cost of emissions above target is decreased production caused by environmental damage, thus they may not apply unaltered to New Zealand.
It may also be optimal to have a ‘floor’ price to avoid domestic prices falling to zero if an international market collapse, such as some countries falling out of compliance by massively overselling permits, leads international prices to fall lower than is globally optimal in the long run. If international prices are very low, New Zealand may find that the non-market benefits from international favour from domestic effort, effects of other’s domestic efforts, and maybe early action mean that New Zealand’s marginal benefit does not really fall to zero and the government still wants to induce some abatement effort.
Differences in risk aversion across sectors might also make it worth regulating some sectors by means of a tax and using permits elsewhere. The upstream firms involved in producing carbon dioxide emissions from fossil fuels are fairly few, large, and tend to have a high degree of sophistication. However, in some sectors large upstream firms like these may not exist, and the small, downstream players might be very risk averse and poorly equipped to efficiently use a permit market. If the firms in this sector were taxed rather than included in a permit system, the government would assume the risk of permit price changes that these firms would otherwise face. This system allows the government to protect vulnerable agents. Also, unlike firms, the government has the option of not complying with Kyoto. This could be implemented by making the hybrid system available only to selected small players and not allowing them to sell permits when they buy at the trigger price.
A system in which some sectors are taxed and others are regulated by permits might be useful because of monitoring difficulties in specific sectors or differences in risk aversion. If monitoring in a particular sector such as forestry sinks were especially difficult, it might be preferable to use a blunt instrument such as tax breaks to regulate this sector. This could be combined with a permit system for the rest of the economy to create a mixed system.
This type of combination system fails to equalise marginal costs of abatement across all sectors, and the differential treatment of different sectors may cause political difficulties. A combined tax and permit system may also require more administration than a pure tax or pure permit system. These costs could well be offset by the abatement gains that such a system could yield.
5.1 Transitioning to hybrid permits for carbon dioxide emissions
For reasons discussed previously, it would be politically very difficult to transition to a comprehensive tax system. There are many reasons why New Zealand may want to transition to a comprehensive hybrid permit system. This section outlines the reasons to go to a permit system, specifically a hybrid permit system, and the transitional issues involved in the change.
It would be politically feasible to achieve broad coverage of carbon dioxide emissions under a permit system because there is the option of grand-parenting to some sectors or firms. Given an international permit market and uncertain marginal cost and benefit of abatement, a permit system produces optimal outcomes; a tax system does not. Permits give more flexibility in the allocation of emission regulation risk than taxes. Finally, a domestic permit market would be simple and probably fairly efficient.
A hybrid permit system in which there was a trigger price at which agents could purchase as many permits as they wanted from the government would offer an additional advantage over a pure permit system. If the trigger price were set significantly above the expected permit price, the system would behave like a permit system in normal circumstances, with all the benefits described above. This system would also provide protection against failure in the international market or the collapse of international cooperation. If the international market were to become very illiquid or the international permit price to rise very high, domestic agents would be protected from the extremely high permit prices and marginal abatement costs. At this point, the system would effectively behave largely like a tax system, which yields more efficient outcomes in the absence of an international permit market.
The transition to a hybrid permit system could be eased in several ways. Businesses that were already paying an emissions tax would not find it too great a leap to go to purchasing emission permits at auction or from the international market. They could be required to begin purchasing permits to cover their emissions. It would be a larger step for businesses acting under voluntary emission reduction agreements to be required to start purchasing permits to cover their emissions. These firms could receive permit allocations based on their existing agreements, at least in the short term. They would still face the full marginal incentive to abate until their marginal abatement costs equalled the permit price, but would not suffer the inframarginal damage of having to pay for permits to cover all their emissions. They could sell the grandfathered permits to the upstream firms that require permits. This grand-parenting of permits could be gradually phased out under agreed rules.
Some projects have been awarded emission credits, which can be sold domestically or internationally, under the current system. The existing credits could also be used in the permit market. It may be desirable to replace the current project scheme with policies aimed at learning and information.
