A carbon tax?
Posted on: November 19, 2008
It sounds like the possibility of a “carbon tax” is back on the table. We have written on the topic before – but it does not appear that we have laid out what I see as the primary costs and benefits of the different options. As a result, I will do that now. In the comments, feel free to add some costs and benefits:
Emissions trading scheme
- Quantity certainty: We can make sure that we meet our Kyoto liability. BENEFIT
- Price uncertainty: The cost of a credit is unknown. COST
Tax
- Quantity uncertainty: We do not know the future path of growth, especially in individual industries and technologies, so we do not know if the tax will be too high or too low to meet the liability. COST
- Price certainty: The cost of carbon is known by all participant ex-ante – as it is the tax. BENEFIT
Therefore
The advantage of the ETS is that it ensures that the users of carbon DO pay the full cost of using it! The disadvantage is “uncertainty” which, because firms are risk averse, will lead to a sub-optimal level of investment.
The advantage of the Tax is that the cost of carbon is known, so if the tax is set at the right level we get efficient investment. The disadvantage is that we don’t know if the tax is at the right level, and so we may raise to much tax revenue (which will lead to “too little” activity in these industries) or keep the tax too low (which would mean that non-polluters have to pay some of the liability!).
As a result, the choice of scheme will depend on where we think the biggest inefficiencies will occur – will uncertainty from the ETS retard investment too much, or is the tax highly likely to be in the wrong place?
36 Responses to "A carbon tax?"
November 19, 2008 at 3:58 pm
“Broadly speaking, price incentives make more sense to me when you’re dealing with a ‘quantity’ of something that’s not perfectly measurable”
Trueish – surely it depends on how imperfect is the measurement of carbon emissions are?
November 19, 2008 at 4:14 pm
I think that the price certainty of a carbon tax, as part of an international climate change agreement, is often over-stated.
It’s like saying that a fixed exchange rate is a good idea, because it gives exporters certainty.
The classic article in this field Weitzman, M. 1974. “Prices vs. Quantities,” Review of Economic Studies, 41:4, pp. 477-491 uses a closed-economy model. If you think about what is optimal for a small open economy, where there is an internationally set “price of carbon”, it is unclear to me that a tax would necessarily dominate.
And even if you do know the rate of the tax each tax period, it is likely that the rate will need to change through time to reflect new international agreements. If you are planning a 50 year investment in a power plant, a carbon tax set in this way will give you very little certainty.
November 19, 2008 at 4:25 pm
“Trueish – surely it depends on how imperfect is the measurement of carbon emissions are?”
Given the vast movements in New Zealand’s net Kyoto asset/liability, I’d say there’s quite a bit of imperfection. The following shows how much it’s (the quantum) moved around in just three years:
http://www.treasury.govt.nz/government/liabilities/kyoto
Indeed, if you go back until 2002 we thought we were going to gain from Kyoto obligations!
“New Zealand’s effectiveness in climate change negotiations means it is one of the few developed countries that stands to make a small net economic gain from the first Kyoto Protocol commitment period. This gain arises because the carbon sink credits New Zealand will receive in recognition of the greenhouse gas absorbing properties of its plantation forests will more than offset the emissions reductions required to meet New Zealand’s emissions target.”
November 19, 2008 at 4:43 pm
“I think that the price certainty of a carbon tax, as part of an international climate change agreement, is often over-stated.
It’s like saying that a fixed exchange rate is a good idea, because it gives exporters certainty.”
Hmmm, I’d say it is a little different. There are mature markets with which firms can hedge against the exchange rate, markets that are more efficient than the current carbon market. Also, at least firms have some idea of what “fair value” for the exchange rate is – carbon prices promise to be a lot more uncertain and variable.
I would also note that “inflation targeting” is similar to “price certainty” for households – if we are willing to do it for consumers here, why not also do it for the price of carbon?
“If you think about what is optimal for a small open economy, where there is an internationally set “price of carbon”, it is unclear to me that a tax would necessarily dominate”
Very true.
“Given the vast movements in New Zealand’s net Kyoto asset/liability, I’d say there’s quite a bit of imperfection. The following shows how much it’s (the quantum) moved around in just three years”
Isn’t that a completely different issue to the ETS?
With an ETS we set a number of credits such that there is a “cap” on pollution. Anyone that exceeds their allocation would have to buy carbon credits until they are again under their “cap” – as a result we have quantity certainty, but the price will vary.
The Kyoto target is a quantity target, so using the ETS allows us to reach this target directly – and makes firms pay the market price if they “over-run”.
The uncertainty stems from the fact that firms do not know what the price of these credits will be in the future – so since they are risk averse they will dump some investment that would have still been optimal given the ex-post price of carbon.
However, the fact that the government can’t project what carbon emissions will be does not in any way change the result that an ETS provides “quantity certainty”.
November 19, 2008 at 4:49 pm
As you state, the ETS involves setting a cap on emissions. Given the vast movement on exactly what NZ’s emissions are, I can’t see how we could reasonably set a cap on those emissions.
November 19, 2008 at 4:59 pm
I think one major cost of an emissions trading scheme is all the lobbying and potential corruption that goes into the setting the rules and exemptions for an emissions trading scheme.
A carbon tax is much simpler, cleaner and fairer. It would also keep a few lobbyists out of work, which is no bad thing for our national productivity stats…
November 19, 2008 at 5:28 pm
Bernard
The idea that a carbon tax can be made much simpler than an ETS is, I think, one of the great myths in this space.
A real-world carbon tax, like that proposed in 2002 by the then NZ government, had a set of rules and exemptions just as complex has those required for an emissions trading scheme.
In particular, there was a proposal for an exemption for firms were “trade exposed” and had emissions intensities that were at “worlds best practice” levels. Lobbying followed. Likewise, there was a proposal for firms to be granted Kyoto units for projects to reduce emissions, which also required judgments to be made about where the project would not have proceeded without grant (the so called “additionally” criteria).
We need good comparative institutional analysis here; real world taxes versus real world emissions trading schemes. Both are complex, with potential for rent-seeking.
November 19, 2008 at 6:04 pm
“Given the vast movement on exactly what NZ’s emissions are, I can’t see how we could reasonably set a cap on those emissions”
The Kyoto protocol has already set the value of that cap though – that is why an ETS gives us quantity certainty in the first place! I’m sorry but I don’t think your compliant about our forecast emissions is relevant at all.
“I think one major cost of an emissions trading scheme is all the lobbying and potential corruption that goes into the setting the rules and exemptions for an emissions trading scheme.”
That is a politicial issue – I am sure that the same groups will be lobbying for tax exemptions if we have a carbon tax 
The best way to do the ETS is to just actually do it – instead of sitting around and begging for regulatory capture as we currently are 
Ahhh, I see George has said a similar thing, just better
November 19, 2008 at 6:31 pm
Kyoto gives us “quantity certainty” in that we know what target emissions level we are aiming for. So we have a target. But we do not know if that target is correct or not (what is the optimal level of emissions?). And we are seemingly incapable of accurately measuring emissions (as evidenced by the link I provided). Given that you don’t think there’s a slight problem there and want to “just actually do it” then I’m not sure we’ll ever agree on this. 
November 19, 2008 at 7:06 pm
But the Kyoto protocol implicitly defined what the “optimal” level of carbon emissions produced by NZ an ETS is the most direct way of achieving the “optimal” level of emissions.
The carbon price will adjust such that this is the level of emissions that we ultimately achieve – given that firms can observe their own carbon emissions and government can observe them in real time.
Just because government is not very good at forecasting what emissions will be does not do anything to reduce the efficiency of the ETS.
Now if you are saying that we won’t be able to measure emissions at the time – that is an interesting issue. However, the things you have linked to haven’t been about contemporously measuring emissions – they have been about forecasting them, a point that is irrelevant for discussing the efficiency of a flexible price for allocating the scarce resource that is “carbon credits”.
November 19, 2008 at 7:15 pm
Well I hope the whole thing falls over. Way too much uncertainty for my liking. A carbon tax can GTFO too.
November 19, 2008 at 7:22 pm
“Well I hope the whole thing falls over. Way too much uncertainty for my liking. A carbon tax can GTFO too”
So you think there is zero probability that there is a negative externality directly from the creation of carbon?
November 19, 2008 at 7:27 pm
I think that there is probably a negative externality from the man-made production of “too many” carbon emissions. What exactly is “too many” is still debatable (and indeed is still being debated).
I don’t see any reason in NZ “gaining” a first-mover disadvantage.
November 19, 2008 at 9:20 pm
“I think that there is probably a negative externality from the man-made production of “too many” carbon emissions. What exactly is “too many” is still debatable (and indeed is still being debated).
I don’t see any reason in NZ “gaining” a first-mover disadvantage.”
None of this is relevant though. We have a liability from the Kyoto protocol – the question is, what is the cheapest method of funding this liability. The negative externality in this case stems from the fact that carbon produces a liability, and if we don’t come up with a scheme everyone will have to pay for it – we will effectively be subsidising carbon producers. How is that fair or efficient?
I don’t think there is any such “first mover advantage” either, but now that we have this liability we need to figure out the cheapest way of dealing with it – Labour decided it was an ETS and now National is discussing a carbon tax instead. However, both methods are to deal with the externality stemming from the Kyoto liability – it is truely unrelated to any possible “global warming event”.
November 19, 2008 at 9:41 pm
It’s pretty clear that I am looking at the bigger picture. I think it’s relevant, whether you do or not. You can look at the Kyoto protocol and subsequent ETS/carbon tax in isolation if you wish, but I am not prepared to take it as a given for the reason stated above.
Although I know you’ve deliberately framed the debate in this way, it seems to me you can’t see the forest for the trees (excuse the pun).
November 19, 2008 at 9:52 pm
To look at your points another way, the issue with a tax is that demand elasticity is not known. You don’t know how much people will reduce consumption as a result of the tax. From an environmentalist’s perspective, the best regulation must include a cap or we have no idea what emission reductions we’ll achieve. Annex I countries with binding emissions targets would find it very difficult to plan compliance with using a broad carbon tax.
The uncertainty of the price in cap-and-trade might make investment less efficient, but it doesn’t mean less investment in emission reduction. The companies are just as likely to overestimate the allowance price.
November 19, 2008 at 10:42 pm
Goonix
A few points.
NZ is not the first mover. The EU has an ETS that applies to its major emissions sources that has been in operation since January 2005. The EU did a number of things wrong in their design, especially around the free allocation of permits. We have learned from that. The UK had a domestic cap and trade scheme for greenhouse gases in place for a few years prior to the introduction of the EU scheme. The US has operated permit trading schemes to address externalities in other areas, like acid rain for many years. New Zealand has operated a cap and trade scheme for fisheries management for many years.
It is impossible to know for certain what the “right” level of a price of carbon should be. See my first comment on the other thread re the ETS. We do know that it is not zero.
So, again, it all comes down to comparative institutional analysis: given extreme uncertainty about dangerous things, what is the best real world system that we can design to address that uncertainty?
I think that an ETS linked to an international price of carbon, which is set based on the best that science can tell us — again, certainty isn’t possible — is more likely to be welfare enhancing than either a unilateral domestic carbon tax or doing nothing.
November 20, 2008 at 8:06 am
I am familiar with the other schemes, my comment was more relating to our major trading partners (Australia, US, Japan).
November 20, 2008 at 8:07 am
Hi Goonix
“It’s pretty clear that I am looking at the bigger picture. I think it’s relevant, whether you do or not. You can look at the Kyoto protocol and subsequent ETS/carbon tax in isolation if you wish, but I am not prepared to take it as a given for the reason stated above.”
Looking at the bigger picture aye – isn’t that what people usually say when they don’t have a real argument
New Zealand doesn’t determine the Kyoto protocol and the existence of global warming – I am facing up to what New Zealand actually has to deal with and what we can control to deal with it, rather than pretending we don’t need to price carbon. I haven’t seen any “big picture” arguments from you yet.
Hi Dan
“The uncertainty of the price in cap-and-trade might make investment less efficient, but it doesn’t mean less investment in emission reduction. The companies are just as likely to overestimate the allowance price.”
However, think of it this way. The cost of production will be higher by some undetermined amount. There is risk surrounding how much higher future costs will be, so firms will delay or even scrap entry into the market given this uncertainty. A carbon tax makes the future cost transparent and as a result will lead to a higher, socially optimal, level of investment – if the tax is set at the right level
November 20, 2008 at 8:27 am
“I am familiar with the other schemes, my comment was more relating to our major trading partners (Australia, US, Japan).”
Also we aren’t a “first mover” as other nations are in the Kyoto scheme as well. An ETS or a carbon tax is our way of paying for the Kyoto liability – this first mover stuff from David Skilling is vacuous rubbish. If we don’t react the liability doesn’t just disappear.
November 20, 2008 at 10:07 am
“I haven’t seen any “big picture” arguments from you yet.”
Let me make it a bit more explicit, for your benefit. Taking a step back from whether an ETS or carbon tax is the most efficient way of meeting our Kyoto liability, if one thinks that the liability is rubbish in the first instance, then one is critical of any means of meeting this liability, regardless of how efficient that means may be.
“The best way to do the ETS is to just actually do it – instead of sitting around and begging for regulatory capture as we currently are.”
I would like this point elaborated on. Surely, assuming we must meet our liability (which you are) then the optimal approach for NZ would be to delay meeting it as long as possible, so that we delay the costs of meeting the liability (which aren’t insignificant) and at the same time avoid the primary costs of not meeting the liability. Or do you believe costs such as regulatory capture are greater than the costs of running a scheme earlier than we otherwise might have?
November 20, 2008 at 10:13 am
“if one thinks that the liability is rubbish in the first instance, then one is critical of any means of meeting this liability, regardless of how efficient that means may be”
So you think we won’t have to pay the liability? Not liking a liability is not enough of a reason not to pay it – I am sure most borrowers don’t want to pay back debt, but if they have to they have to.
Now if we truly believe we will not have to pay the liability then this is cool – we wouldn’t need a carbon price. But I don’t think it is a particularly good assumption.
“Surely, assuming we must meet our liability (which you are) then the optimal approach for NZ would be to delay meeting it as long as possible, so that we delay the costs of meeting the liability (which aren’t insignificant) and at the same time avoid the primary costs of not meeting the liability”
You realise that New Zealand will have to “pay” for the liability in some way. If we don’t pay for it through a carbon tax or an emissions trading scheme then the government has to pay – or in other words we need to increase GENERAL taxation to pay the liability.
There is no “delaying payment” – there is just different methods of paying for it. If we sit round delaying the implementation of the ETS then income or consumption taxes will have to be higher in the future – is that what you would prefer?
November 20, 2008 at 10:18 am
I am not familiar with the dates of implementation – but when exactly does our liability ‘kick-in’? Wouldn’t it be best to delay until the last minute (whenever that may be)?
November 20, 2008 at 10:24 am
“I am not familiar with the dates of implementation – but when exactly does our liability ‘kick-in’? Wouldn’t it be best to delay until the last minute (whenever that may be)?”
Yes I agree with that – delay until we have to pay. However, we are in the payment period (http://en.wikipedia.org/wiki/Kyoto_Protocol):
“Kyoto is a ‘cap and trade’ system that imposes national caps on the emissions of Annex I countries. On average, this cap requires countries to reduce their emissions 5.2% below their 1990 baseline over the 2008 to 2012 period”
November 20, 2008 at 10:29 am
Cheers for the info. I’ve also read that it is only from 2008-2012 that the obligation is binding. In the instance that we don’t sign an agreement binding us beyond this date (have we?) then it is possible that it would be less costly to take a ‘hit’ for a few years rather than set up a costly scheme/tax for just a few years?
November 20, 2008 at 10:34 am
“In the instance that we don’t sign an agreement binding us beyond this date (have we?) then it is possible that it would be less costly to take a ‘hit’ for a few years rather than set up a costly scheme/tax for just a few years?”
I completely agree that there is a definite possibility that the scheme may just die in 2012, in fact I thought I had mentioned it as a possibility in one of these two posts (it might have been just from talking to people though ). However, that is why government has done costings for both the “just up to 2012″ case and for the long-run case – and they have determined that an ETS is the cheapest option in both cases.
In Aussie I believe they are talking about putting a tax in first – and then if there is a long-run agreement setting up an ETS, as carbon markets will be more “mature” by then. We may end up with the same sort of thing here with National.
November 20, 2008 at 2:18 pm
I think I’m with Goonix on this one: our liability isn’t like a domestic liability. It can be defaulted on without penalty and, if other countries decide to punish us, it must be done at a cost to them. So our decision is first whether we want to abide by our commitment to reduce emissions before we decide what the most efficient way to reduce emissions is.
That’s why global warming is relevant: it enters into a calculation of the benefits of remaining a part of the Kyoto Protocol. We may not directly affect global warming by being a part of the Protocol, but perhaps we can influence other countries to join by remaining in it despite the cost to us.
November 20, 2008 at 2:25 pm
I completely disagree with:
“It can be defaulted on without penalty”
That isn’t how the government has costed it – and I am pretty sure that European nations would be keen for a reason like this to place further tariffs and quantity limits on our meat.
Of course if it can be defaulted on without penalty then that is an attractive option – but this is a choice to compare to our cheapest way of paying for the liability surely.
“That’s why global warming is relevant: it enters into a calculation of the benefits of remaining a part of the Kyoto Protocol. We may not directly affect global warming by being a part of the Protocol, but perhaps we can influence other countries to join by remaining in it despite the cost to us.”
Ok, but that is still about the binary choice to enter the agreement or not enter the agreement.
Once we have determined that we want to stay in the Kyoto protocol, we want to determine the least cost method of paying off our Kyoto liability.
Global warming is relevant for determining whether we enter and stay in the scheme – not the method we use to pay off our liability that comes from being in the scheme.
November 20, 2008 at 2:33 pm
“So our decision is first whether we want to abide by our commitment to reduce emissions before we decide what the most efficient way to reduce emissions is.”
Also I have already covered this point repeatedly in the debate that has been going on better the two carbon price posts namely here:
http://tvhe.wordpress.com/2008/11/19/missing-the-point-the-emissions-trading-scheme/#comment-4410
November 20, 2008 at 2:39 pm
“Also I have already covered this point repeatedly in the debate that has been going on better the two carbon price posts namely here:”
I know, I read that and I read what goonix said there and I’m voicing my sympathies with his position across both posts. I realise you’ve stated your position on the issue repeatedly and, having considered your position, I respectfully disagree.
Of course there are potential costs to leaving the Protocol, but suggesting that the ETS has nothing to do with global warming I think misses the point — as goonix said.
November 20, 2008 at 2:42 pm
“Of course there are potential costs to leaving the Protocol, but suggesting that the ETS has nothing to do with global warming I think misses the point — as goonix said.”
Interesting. I think treating the ETS as a mechanism to “prevent global warming” misses the point. My criticism is of the idea that if global warming is not happening the ETS is a stupid idea – as even if global warming is not actually happening we will still have to pay a Kyoto liability until people “discover” it is a fraud or international co-operation breaks down.
November 20, 2008 at 3:03 pm
One other thing I would note is that the government stated that the goal of the ETS was to meet our carbon liability at the least cost – they have costed the options in this way and found that the ETS is the least cost option. So it is the best option irrespective of global warming.
Let me flesh this out. The “satisfaction” associated with fighting global warming is a discrete variable that is satisfied by staying in the scheme.
Now I agree that if society suddenly believe that “global warming was not there” there would be a lower “benefit” from being in the ETS. However, when the government costed options it didn’t assume some “psychological benefit” from the scheme – it merely looked at the cost of different options.
The government believes the cost of leaving the scheme is greater than the cost of the least cost option from staying in the scheme (the ETS) – and as a result the loss of the “benefit” associated from staying in the scheme does seem completely irrelevant to be.
As this benefit is the only place where the realistic nature of global warming actually falls into the decision problem (at least until 2012 when the scheme is renegotiated) criticising the ETS based on “global warming not happening” is entirely pointless.
November 20, 2008 at 4:46 pm
This is a long, but I think reasonably clear, statement of why the NZ ETS is good policy.
The prudent response to the accumulated scientific and economic analysis of climate change is a lower amount of greenhouse gases in the atmosphere. Uncertainty is part of this: we simply do not yet know whether there are “tipping points” when it comes to emissions, but there might be. Reducing emissions is buying an insurance policy against a catastrophe.
The only way to reduce total concentrations of CO2 to prudent levels is for all countries to make a contribution. The BRIICs (Brazil, Russia, India, Indonesia and China) have to agree to reduce their emissions. The only way that they will agree to this is if the developed world also agrees to make major reductions in its level of emissions.
New Zealand cannot solve the climate change problem itself (it is too small). But this does not mean that it can opt-out and free-ride. The rest of the world will notice. Already, the EU is calling for trade restriction on countries that are not part of world-wide emission reduction efforts.
The United National Framework Convention of Climate Change (the UNFCCC) and its Kyoto Protocol are not perfect. No international treaty is. But the UNFCCC is the only game in town. Australia is now re-engaged with the Kyoto process, and the US President-elect is much more supportive of international efforts.
The Bali Roadmap points to the developing world having greater obligations than under the Kyoto Protocol.
New Zealand’s record on emissions is not good. Our per-capita emissions are high and growing. This fact is known to the rest of the world.
Reducing emissions will have a cost: there are no free lunches. New Zealand’s largest sources of emissions are agriculture and transport. Reducing these emissions, without just reducing GDP, is difficult, but possible.
Doing nothing is not an option.
Given New Zealand’s record and the possibility that future international agreements will be tougher than the Kyoto Protocol, starting now will avoid higher costs in the future.
The ETS, with its links to the Kyoto mechanisms, means that in the short-term, New Zealand can meet its international obligations and have gross emissions at or about current levels. A carbon tax or regulations could lead to lower emissions, but at a higher cost; because neither allows low-cost emissions reductions from overseas to be part of New Zealand efforts.
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cpworthington
dant03
goonix
metrosideros
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Robbie Allan
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Matt Nolan
November 19, 2008 at 3:52 pm
Broadly speaking, price incentives make more sense to me when you’re dealing with a ‘quantity’ of something that’s not perfectly measurable.