Monday, October 16, 2006

Guest Column: Should we trade emissions rather than tax them?

By Brian Easton.

There appears to be a tendency to pose carbon taxes as the only economic way to address carbon emissions. But tradeable emission permits (TEPs) are a serviceable alternative which have both strengths and weaknesses over carbon taxes. Their greatest strength may be that they are politically more feasible.

TEPs, which permit emission of carbon (and without such permits no emissions are allowed), could be started off by grandfathering in recent levels of emissions so that current emitters got permits sufficient to allow them to emit their last year’s level, say. But each year the allowance attached to each TEP decreases so that at the end of the target period we got emissions down to our international target. This would force each emitter to reduce its level of carbon emissions unless it could acquire TEPs from others that had reduced their emissions more. Since the obdurate polluters are forced to purchase the TEPs from the reducing polluters, there would be a market incentive to seek technologies to reduce emissions, together with some demand side effects as the price of the products of carbon emitters would be forced up.

The scheme requires some development, particularly

  1. How to interface with the rest of the world, and
  2. How to deal with carbon sinks (one option is for the government to reward sinks with annual TEPs which they can sell to emitters, in effect offsetting the pollution with a sink).
  3. Administrative mechanisms.

Typically there would also be an annual resource levy to cover the cost of management, enforcement and R&D in the scheme.

This proposal essentially involves a market mechanism, but it does not involve a tax. (The levy is not a tax but user-pays. However, corporate gains from the market value of TEPs may well be treated as income and thereby taxed.) So the rents do not, on the whole, go to the public purse (which many would think a pity). It is easy to show that there would be some inequities (but a tax-based system would generate them too).

The advantage of TEPs over a tax (other than one can target aggregate emissions with precision) is that the scheme is relatively politically stable. Had it been in place last year, the coalition partners would not have asked for a repeal because they would have been destroying the property rights of the holders of TEPs who, despite any doubts about the scheme, would lobby against its abolition (since the alternative might be worse).

Of course the TEP scheme is clumsy. All impure market schemes are – which is why one only advocates them when the market is failing to deliver (big time in the case of carbon emissions). But a tax-based system is also clumsy. My guess is the TEP scheme is not as clumsy as a tax-based one, although it does not have the advantage of revenue raising.

The point of this note, is that sometimes having lost a policy battle, the losers want to fight again on the same battlefield, so sure are they of the justice of their cause. Thus those concerned with global warming seem to want to return to taxation as the mechanism. But sometimes it makes sense to look around for other policy options which give a reasonable chance of the advocates winning the next bout. As TEPs may do. At worse one learns about the strengths and weaknesses of the previous policy and its resolution.


I've been having a fascinating conversation with Brian on this, and many possible comments. The question is where to start.

Firstly, the government seems to be moving towards an emissions trading scheme, though a limited one applying only to the electricity sector. This may incorporate a sinking cap to allow the government to set a "big goal" of "100% renewable or carbon neutral electricity by 2030" (as suggested in its consultation on the national Energy Strategy). It will probably be coupled with a projects mechanism granting credits for verifiable reductions to provide other sectors with an opportunity cost for emissions reductions. I am not sure whether it will include sinks beyond those gaining PFSI credit; IMHO it would be a very bad idea because (assuming the 1990 Kyoto baseline is used) there would be more than enough sinks to cover the electricity sector's emissions.

Given the current political consensus, a limited emissions trading scheme is certainly politically feasible, and would have the desired effect of ensuring that the electricity sector doesn't make the wrong investments (e.g. Marsden B). It would also allow "salami tactics", whereby the requirement for permits is gradually expanded, so as to cover other sectors (major industrial emitters are another obvious target).

The government has been working on emissions trading schemes to tackle climate change since 1995 or so, and they've always seen the major issue as allocation - how the permits are initially distributed. The question is really all about who gets to collect the rents from the new price of carbon - industry (and therefore their shareholders) or government. Naturally, I generally favour the latter (though I think the revenue should be recycled into environmental projects so as to gain "double dividends). However, given the ownership structure of our electricity sector, I think it is less of an issue - the government owns 75% of it (everything but Contact and Trustpower), so any windfall profits will mostly flow to them (particularly through Meridian, which is 100% renewable yet will benefit from higher electricity prices). If the scheme is expanded beyond electricity, I'd be strongly in favour of an auction process however.

Finally, anyone wanting more information on this issue should check out the 2001 working paper on Domestic Emissions Trading [PDF], which gets into a lot of the nitty-gritty about who, where and how.

Posted by Idiot/Savant : 10/16/2006 01:17:00 AM

I think a price based mechanism is likely to work a lot better than the idea of restricting imports of used cars.

I don't quite understand how this is meant to work. The bit about stopping imports of used cars built before a certain date is reasonable, but how do you enforce a fuel emmission average on a fragmented industry like used-car importing. Plus the current measures would stop you importing a 1995 VW Golf Diesel, for instance, which is an economical, low pollution car.

Posted by Rich : 10/16/2006 10:51:00 AM

Rich: I disagree strongly. One of the key criticisms of the carbon tax for example was that it would do very little to shift transport habits. You need a sustained and high price increase (such as we have seen with the current Bush Premium on petrol) to do that. Furthermore, most people aren't engineers, and don't do a cost-benefit analysis on the cost of pollution when buying a vehicle. Other considerations tend to be more important. Against that sort of empirical background, regulation seems to be a better tool than price-based mechanisms.

(Furthermore, petrol prices are a hot button political issue. Regulation is simply more politically feasible, so if we want results, we have to regulate...)

As for how it would work, the government seems to favour a fleet sales-weighted standard as used in the US, EU and Japan. You require importers to add fuel efficiency to their records, and calculate the average fuel efficiency of all vehicles imported or sold. Then you fine the ones who fail to meet a sinking target. Such a standard has had a significant effect on fuel economy in those countries, and would have significant long-term benefits for New Zealand (both in terms of CO2, and in reducing oil imports).

Of all the options, an arbitrary age limit is the one which has received the least investigation. The motor industry favours it because it involves the least work for them, but the government doesn't really seem very keen.

Finally, something which is completely missing from this paper is biofuels. The government has just introduced a biofuels obligation, but one of their worries is that older vehicles will not be able to use any blend over E3.5, which rather limits the long-term possibilities. If we want to change the long-term shape of the vehicle fleet to allow greater use of biofuels, then import standards are the obvious way to do it.

(BTW, the relevant cabinet paper on this is here)

Posted by Idiot/Savant : 10/16/2006 11:18:00 AM

As the report notes, there are difficulties with defining the regulations. I'd say these will be a *lot* more difficult than might be imagined.

You aren't dealing with a few mostly law-abiding corporations as in the case of new cars. There are over 3,000 car importers. By the nature of the used car trade, they're going to vary from sharp operators to out and out crooks. You can be sure that they'll exploit any loophole possible. (Fine? They'll just liquidate the company every year).

And of course all these *scandals* will make the front-page of the NZ Herald - particularly if the perps are "non-white". For any sensible government that in itself would be good reason to steer clear.

(I'm aware this is deeply unconstructive. I do have a better idea which I will prsent shortly on my blog!)

Posted by Rich : 10/16/2006 01:48:00 PM

On the basis that you have to start somewhere, then electricity has obvious advantages - specifically the need to get a carbon-cost signal into the decision making about new plant - but electricity is only a small of NZ's overall emissions profile. Agricultural methane is our big liability - especially if, as some (including James Hansen) are suggesting, the world focusses on methane as an "easy" way to get big reductions in GHG effect quickly, leaving "harder" CO2 measures for later.

It's also important that the cost of carbon in any trading scheme should represent the international cost of carbon. If we were to set a "cheap" price, then other countries might view our products as having an unfair advantage, and set up trade barriers.

Posted by Anonymous : 10/16/2006 02:44:00 PM

i have two questions about the long-term viability of carbon credits.

what confuses me is the how this segues into the issue of ecological footprints, and, if this is supposed to address the much longer term issue of abundance of carbon in the atmosphere.

i've simplified this a lot, but... i live fairly frugally compared to most. my ecological footprint is only 3 planets. i would guess that this means my production of CO2 is relatively low. if i purchase carbon credits to offset my emissions i would presumably need X amount of carbon sinks.

now suppose that in an ideal world everyone also only had a low, 3-planet consumption rate, and also sought to offset their carbon emissions. is it true that there wouldn't be enough land space to soak up the CO2?

my guess is that there wouldn't, so the price of the credits would naturally rise under demand. presumably this would limit emissions because people couldn't afford to purchase credits.

but wouldn't 'persons' just opt out of the scheme? i.e. the cost of any penalties incurred by not being in the scheme might be less that the cost of credits?

and two, could someone clarify, kyoto is all about halting or limiting emissions, yes? not actually getting rid of the excess tonnage of carbon already put into the atmosphere?

where's the scheme for dealing with that?

isn't the actual issue not limiting emissions, but replacing fossil fuels? and permanently?

Posted by Anonymous : 10/17/2006 07:30:00 AM

That ecological footprint thing contains a lot of bogosity. If I buy a $300 pair of shoes that lasts 5 years, how does that use 20 times as much resources as a $15 pair from the Warehouse that wears out in a year?

Posted by Rich : 10/17/2006 09:28:00 AM

Che: emissions trading may or may not have anything to do with ecological footprints; it all depends on how you set your cap. But in answer to your broader question, you have another option besides buying sinks: you could decrease your emissions. You could do this either by altering your lifestyle (take fewer international holidays, don't have air conditioning), or through technology (replace that SUV with a hybrid, install energy efficient light bulbs and gas hot-water heating). If you are unwilling to make such sacrifices, you could always buy credits from those who are willing. Which is easiest for you depends on the relative price of buying extra crdits vs technology (but I'd suggest that in a scenario which set an emissions cap a third on average of what people were actually doing, the price of crdits would skyrocket).

Ideally, you set the penalties of the scheme so that they are more than the cost of credits; 3-5 times higher was the number bandied around in the government's biofuels obligation document.

As for the second bit: Kyoto is about limiting emissions. It's inadequete, but its a start. It already encourages removal of CO2 from the atmosphere - that's what a "carbon sink" is defined as - and as any post-Kyoto treaty is likely to be "Kyoto-like" and involve an international price on carbon, that encouragement will continue. (Note also that "peaking" scenarios, where we start doing this, are less harmful than those where greenhouse gas levels stabilise).

As for how we're going to do it, I've seen several proposals. One, from our very own Peter Read, involves planting fast-growing trees, gasifying them (so, you get biofuel or energy), and burying the resulting charcoal - putting some of the carbon in the ground. It's in a stable form, so it won't release for quite a while, and it will enrich the soil as well. A more complicated solution is to run powerplants with carbon captur and sequestration technology on biomass (wood) - meaning that carbon is likewise effectively buried. Peter's solution is cheaper, and doable today without waiting for any technological miracles. They just need to quantify how much carbon it locks up, and get the international community to agree that it does actually result in carbon being puled out of the atmosphere.

Posted by Idiot/Savant : 10/18/2006 12:37:00 PM

i/s, thanks. in reply to both yourself and rich, i wanted the ecological footprint reference to be a not-entirely-subjective measure of my own carbon consumption (the flash calculators would require me to do some math, which is never my strong point).

what i was trying to drive at is that even when you do make a conscious effort to minimise your emissions, as i do, we're still likely to outstrip the planet's ability to absorb the carbon we're dragging out of the ground.

but, your second example indicates to me that there are (apparently) economically viable means to sequester the carbon relatively permanently. which is good news, because that is my main concern (i read Lovelock in the early 1990s, and it kind of freaked me out).

now the only concern is how to generate enough electricity from renewable means to meet demand. but i suppose 'Go Nuclear' is another argument.

that and enforcing emissions regulations....

Posted by Anonymous : 10/18/2006 02:13:00 PM

Che: what i was trying to drive at is that even when you do make a conscious effort to minimise your emissions, as i do, we're still likely to outstrip the planet's ability to absorb the carbon we're dragging out of the ground.

According to Bert Metz at the climate change symposium, that's not true; we have plenty of technological options now to reduce our emissions to a sustainable level. And one of the goals of an emissions trading regime is to make those technologies economic by forcing polluters to pay for what they are doing.

(Oh, and in the long run, I favour "contraction and convergance" - moving towards a per-capita emissions allocation set at a sustianable level rather than the current one. But the Americans would never go for it, because they'd be forced to acknowledge the rest of the world as moral equals)

Posted by Idiot/Savant : 10/18/2006 02:42:00 PM