Tuesday 16 September 2014

A Policy A Day: Carbon Tax

In the lead-up to the election, we are going to examine one policy per (working) day. We've selected policies to be as balanced as possible across a range of policy areas and across the political parties. The idea is to explain the background, analyse the policy to investigate the pros and cons, and give a verdict on the policy at the end. Inevitably, some opinion will make its way in and we make no apology for that - after all, we're voters too. Also, I say 'we' because this series will feature some guest posts from other young people, to share their thoughts and ideas as well. A list of all the articles is available hereEnjoy!

Today's policy comes from the Green Party. Climate Change is a serious issue that faces the entire world, and New Zealanders should play their part in helping address it. The New Zealand Attitude and Values Study (from the Dept of Psychology at the University of Auckland) shows that 72% of New Zealanders believe that climate change is real, and that 62% believe that climate change is anthropogenic (caused by humans). This post assumes that climate change is an issue that we want to make a serious attempt at addressing - if you think that climate change is not a real thing then this is probably not the post (or blog) for you. The question then becomes one of how we address climate change.

In the area of controlling carbon emissions, there are two main systems that have been adopted around the world: cap-and-trade systems and carbon taxes. New Zealand currently uses a cap-and-trade system called the Emissions Trading Scheme (ETS). The Green Party proposes:
- Phase out the failed Emissions Trading Scheme and instead put a meaningful price on carbon through a charge on polluters (full policy document here)
or in other words, scrap the ETS and implement a Carbon Tax instead. They also propose a number of complementary policies, including using the revenue from the Carbon Tax to bring in income and company tax cuts, but this post will focus on the differences between carbon emission control mechanisms rather than what any difference in revenue would be spent on.

With both a cap-and-trade system or a carbon tax system, the idea is to set a "price of carbon" so that some financial cost is introduced for carbon emissions. This disincentivises carbon emissions and helps to reduce the overall level of emissions. Without a price of carbon, companies and individuals could emit as much carbon as they want into the environment at no cost to themselves, but it creates a wider cost to society (an externality in economics jargon) - hence, the government has to step in to regulate carbon. In both systems, companies continue to emit carbon until there is some alternative (such as new technology or a different process) that costs less than the price of carbon. The price of carbon is thus very important, because it essentially dictates whether carbon emissions actually decrease or not, while also being careful not to excessively increase the cost of goods and services which would hurt businesses as well as end consumers.

The existing system in New Zealand is the Emissions Trading Scheme (ETS). In a cap-and-trade system, the government sets a maximum level of carbon that can be emitted throughout the country, and then distributes permits (or "carbon credits") out to companies for free that allow the company to emit carbon up to the value of the permits they hold. Those companies are then able to trade those carbon credits as necessary - some companies will be given fewer credits than they need, and will have to purchase from other companies who hold more credits than they need. Eventually, the government stops distributing permits, as carbon absorbers (such as forest owners) "generate" carbon credits that they can sell into the market. The idea is that carbon emissions are controlled by market mechanisms - supply and demand drives the price of carbon with as little government intervention as possible. With a floating price, carbon generally becomes more expensive over time as the government tries to reduce the overall cap but companies want to grow. As the price rises, companies are increasingly incentivised to find other ways to conduct business without emitting as much carbon, and thus the goal of the government is achieved. There is a dual incentive because as the price rises it also becomes more profitable for companies to plant trees and earn carbon credits to sell on the market. However, because the price is floating it provides less certainty for businesses, especially since the price of carbon can be difficult to predict. This makes it harder for companies to price their products for customers, who generally expect stable prices. This is one of the biggest problems identified by the Green Party in the existing system - companies are generally forced to pass a larger cost onto their customers (for example, the price of carbon might be $22 per tonne of CO2 but the company uses $25 per tonne of CO2 in their pricing - customers would be annoyed if a bottle of milk cost $2 one week and $2.50 the next week and $2.20 the week after due to the carbon price changing) to allow for price fluctuations and a general upwards trend over time (it's better for the company and customer expectations to just keep the price at the upper level).

The Green Party policy is to replace the ETS with a Carbon Tax. In this system, the government sets a carbon price, and then all emitters are forced to pay a tax on their emissions to the government. In comparison to the cap-and-trade system, the price of carbon is fixed, not floating at the whim of market forces, but it is important for the government to get the price right. Additionally, the government increases their revenue and can spend the money from the tax on other policies such as incentivising forestry (and thus tree planting that absorbs carbon) or providing income tax cuts. The intended effect of the tax is to force companies to avoid the tax by changing their processes to emit less carbon, or alternatively to generate enough revenue to reduce carbon emissions in other ways (such as tree planting), thus achieving the goal of the government. However, there is no limit on the amount of carbon emitted - as long as companies (and their customers) can afford the price of carbon, then companies can continue to emit. Ideally, companies will change their processes to reduce carbon emissions if the carbon tax is high enough, but in reality companies generally just pass the cost of the carbon tax onto consumers (similarly to GST), which may not actually incentivise any behavioural or process changes in the carbon emitters. Purely theoretically, there is also no dual incentive to plant trees because there is no reward for doing so, although in reality most carbon tax systems use some of the revenue to give subsidies/grants to forestry. I should note here that some economists advocate for a hybrid design - some mixture of both; for example, a cap-and-trade system that has government defined price floors and ceilings to restrict the market between reasonable values. At the moment, the government essentially has a price ceiling by selling carbon credits at $25/CO2, so that if the market exceeds this price there is always an option for companies to purchase from the government instead of the market, forcing the market price back down.

Analysis of the Policy
The above background gives a reasonably theoretical view of the two main carbon pricing systems. Theoretically, both systems achieve the same ends - they reduce carbon emissions. The cost to carbon emitters is lower in a cap-and-trade system, but the government doesn't get any revenue (and generally ends up paying more money in subsidies and other schemes). The cost to carbon emitters is higher in a carbon tax system, but the government can generate a significant amount of revenue. Which system a country uses therefore becomes influenced by ideology - a right-wing government that is more business-friendly and believes in smaller government favours a cap-and-trade system (as evidenced by NZ's ETS), while a left-wing government that believes in the welfare state and the power of government to help people favours a carbon tax. A right-wing government also tends to believe in the power of the free market to achieve economic efficiency (cap-and-trade), while the left-wing government supports government regulation and intervention to provide better control to ensure that the desired outcomes are achieved (carbon tax). The ETS was actually introduced in 2008 by the Labour government, before being amended heavily by the National government in 2009 and 2012.

Apart from ideology, it is important to look at whether the status quo ETS is working, and whether a carbon tax would resolve any problems. Pricing carbon is a relatively young strategy (the first was a carbon tax in Finland in the 1990s), and while there are now a large number of countries with either a cap-and-trade system or carbon tax, there is insufficient data to declare one system better than the other through empirical evidence. In general (page 12 of this document), European states have opted for carbon taxes while Asian and American states have gone towards cap-and-trade systems. So unfortunately, we can't look overseas for a "correct" answer. For this reason, I feel a little uncomfortable about Russel Norman's claims that the ETS is failed. We have to give these systems a bit more time to see if they will work; prematurely rejecting them would not only be wasteful, but might send us down the wrong track instead. Having said that, there are certainly some signs that the ETS as it stands in New Zealand may not be working.

At the root of the problems with the ETS is that the implementation in New Zealand does not match the theory. In an effort to appease business interests, the government was forced to phase in the ETS gradually, and the exceptions to the scheme just piled up. Right now, agriculture has been excluded from the ETS, which just doesn't make sense when agriculture is responsible for nearly half of all carbon emissions in New Zealand. The original intention was to include agriculture by 2015, but the lobbyists won and date for when agriculture gets included in the ETS is now not set at all. The argument is that forcing agriculture to pay extra for carbon credits (or a tax for that matter) increases the costs of production and hurts our competitive ability in export markets. This is a legitimate argument but goes against the entire point of carbon pricing, which is to force companies to reduce their carbon emissions by finding alternative ways to conduct their business. As indicated in the previous section, the ETS has also brought harm to consumers, as businesses forced to allow for fluctuating carbon prices have passed on higher costs to consumers than the actual costs of the carbon - some businesses are essentially profiting off the ETS. There are issues with the (free) allocation of carbon credits to certain industries, as well as the (previous) trading of carbon credits on the international market that largely undermine the ETS. There are many problems with the existing ETS, and something probably needs to be done to address them.

The question is then whether a carbon tax would resolve those problems or be otherwise more effective than the ETS. This is where the water becomes a lot murkier because there is little real evidence beyond assertions to show that a carbon tax would do a better job than a cap-and-trade scheme. An ideal carbon tax system as proposed might do better than the broken cap-and-trade system we have now, but realistically any carbon tax system is likely to be modified and weakened to meet the demands of businesses and industry. A broken carbon tax system is unlikely to be better than a broken ETS. It then comes down to which party has more resolve to withstand those demands - there is an argument that the Green Party will be more principled and stand stronger than the National Party. Whether this is true cannot be tested until the Green Party is in government, and cynically I'm not sure if the Green Party (as a support partner for the Labour Party) would be entirely immune from lobbyist pressures.

If we are to switch to a carbon tax, then we need to be aware of the side effects. Firstly is the massive cost in phasing out the ETS, re-educating the public and businesses, and re-implementing a new tax. This compliance cost is non-negligible, and would delay progress towards a working system. One of the most common arguments for a carbon tax is that it provides certainty for businesses because they know how expensive carbon will be - but for a carbon tax to be effective it has to be flexible to respond to changes in global markets and the environment, introducing uncertainty. Leaving the price of carbon in the hands of the government could therefore be dangerous - the intention is for the price to be relatively fixed without constant adjustments, which means that it is difficult and slow for the government to respond to change. Additionally, just like how the OCR is a blunt tool for controlling inflation, a carbon tax rate would be similarly blunt as it has less granularity than a market-set price. It is also difficult for the government to know exactly where to set the price - the Green Party has proposed $25/tonne of CO2 (except for agriculture, set at $12.50/tonne of CO2 (and paying out $12.50/tonne of CO2 to forestry)), but we can't be sure whether this number is too high or too low until it is implemented and we see the effects. At least in a cap-and-trade system, the price can correct itself quickly if the price is too high or too low - in a carbon tax, the price is set and difficult to change.

Lastly, the fact that there is no upper limit of emissions set in a carbon tax scheme means that there is potentially no limit to emissions. Yes, businesses are disincentivised from emissions and encouraged to use cleaner processes, but businesses simply pass the costs onto customers (it is probably important to note that the Green Party policy (page 12) to use the revenue from a carbon tax on tax cuts and a tax-free threshold would supposedly leave households better off even after taking the increase in household costs into account). In a cap-and-trade system costs are also passed onto customers (perhaps less efficiently), but at least there is a limitation on the total amount of emissions allowed. In the carbon tax system, companies continue to emit at will (at a flat tax rate), and pass the tax on. In the cap-and-trade system, if they continue to emit at will the price rises and it becomes increasingly expensive to emit more. From this perspective, it seems that a cap-and-trade system will probably achieve the desired end of limiting and reducing carbon emissions better than the carbon tax system. The only way to combat this in a carbon tax system is to set the carbon price very high, which is not responsive and would unfairly penalise all emitters when only some emitters may be increasing emissions.

Verdict: While I agree that the ETS as it stands is broken and untenable, I'm not convinced that a carbon tax is the best alternative - maybe that's my conservative economics coming through. I don't think that starting again is necessarily the right move - I would prefer to see a government make the ETS work like it was intended to by removing subsidies, enforcing the scheme on the agricultural industry, and in general make it more stable. Maybe some government intervention is needed to set price floors and ceilings, but that would be preferable (in my view) to a carbon tax.

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