Taxes vs Permits: Options for Price-Based Climate Change Regulation

Sin, Isabelle; Kerr, Suzi; Hendy, Joanna Working Paper Taxes vs Permits: Options for Price-Based Climate Change Regulation New Zealand Treasury Working Paper, No. 05/02 Provided in Cooperation with: The Treasury, New Zealand Government Suggested Citation: Sin, Isabelle; Kerr, Suzi; Hendy, Joanna (2005) : Taxes vs Permits: Options for Price-Based Climate Change Regulation, New Zealand Treasury Working Paper, No. 05/02, New Zealand Government, The Treasury, Wellington This Version is available at: https://hdl.handle.net/10419/205567 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Taxes vs Permits: Options for Price-Based Climate Change Regulation Isabelle Sin and Suzi Kerr with Joanna Hendy N EW Z EALAND T REASURY W ORKING P APER 05/02 MARCH 2005 NZ TREASURY WORKING PAPER 05/02 Taxes vs Permits: Options for Price-Based Climate Change Regulation MONTH / YEAR March 2005 AUTHORS Isabelle Sin, Suzi Kerr and Joanna Hendy Motu Economic and Public Policy Research PO Box 24390 Wellington New Zealand Email Telephone Website [email protected] +64 4 939 4250 www.motu.org.nz ACKNOWLEDGEMENTS We would like to thank Steve Rylands, Kevin Guerin, Joanna Smith and Rienk Asscher at the Treasury, Billy Pizer at Resources for the Future and Ross Cullen at Lincoln University for useful comments. This work draws on Motu’s Foundation for Research, Science and Technology-funded project “Land use, climate change and Kyoto”, and involves indirect input from Landcare, Forest Research and AgResearch. The authors are responsible for all opinions expressed and all errors and omissions that remain. NZ TREASURY New Zealand Treasury PO Box 3724 Wellington 6008 NEW ZEALAND Email Telephone Website [email protected] 64-4-472 2733 www.treasury.govt.nz DISCLAIMER This document was commissioned by the New Zealand Treasury. However, the views, opinions, findings and conclusions or recommendations expressed in it are strictly those of the authors, do not necessarily represent and should not be reported as those of the New Zealand Treasury. The New Zealand Treasury takes no responsibility for any errors, omissions in, or for the correctness of, the information contained in this Paper. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION i Abstract This paper provides an overview of key issues involved in the choice among marketbased instruments for climate change policy. Specifically, it examines the potential net benefits from shifting to a permit system for emission reduction, and the preconditions necessary for this change. It also draws out the implications of New Zealand’s specific circumstances and current climate policies for future policy development. JEL CLASSIFICATION Q28 – Renewable Resources and Conservation; Environmental Management – Government Policy Q48 – Energy – Government Policy KEYWORDS climate change; emissions trading; permits; taxation; New Zealand WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION ii Table of Contents Abstract...............................................................................................................................i Table of Contents ..............................................................................................................ii List of Figures...................................................................................................................iii Executive Summary..........................................................................................................iv 1 Introduction ..............................................................................................................1 1.1 Motivation........................................................................................................................1 1.2 Current New Zealand policy ...........................................................................................2 1.3 Basic design of taxes and emissions trading systems...................................................3 1.4 Effects on efficiency of abatement in the short and long term........................................5 2 Design issues common to taxes and permits .......................................................6 2.1 Expected intensity of control over time...........................................................................6 2.2 Breadth of coverage .......................................................................................................6 2.3 Definition/Measurement of emissions.............................................................................8 2.4 Incidence of costs...........................................................................................................9 2.5 Revenue recycling........................................................................................................11 3 What are fundamental and unavoidable differences between taxes and emissions trading? ................................................................................................13 3.1 Interaction with international emissions trading market................................................13 3.2 Environmental vs economic risk...................................................................................15 3.3 Allocation of risks and incentives to respond to risk.....................................................29 3.4 Flexibility in distribution of costs ...................................................................................36 3.5 Transaction costs and permit market inefficiency ........................................................37 4 Instrument-specific design issues .......................................................................38 4.1 The importance of market liquidity................................................................................38 4.2 Effects of possible complexity of permits......................................................................38 4.3 Risks from, and methods to avoid market power.........................................................39 4.4 Recommendations for defining permits........................................................................41 4.5 Allocating permits .........................................................................................................42 4.6 Transaction costs, efficiency and incidence of costs....................................................44 4.7 Design issues specific to taxes.....................................................................................45 5 Options for mixed tax-permit systems.................................................................46 5.1 Transitioning to hybrid permits for carbon dioxide emissions ......................................47 6 Future directions: emissions and sequestration from land use and other greenhouse gases..................................................................................................49 6.1 Carbon sequestration in plantation forests...................................................................49 6.2 Carbon sequestration in reverting indigenous forests..................................................50 6.3 Agricultural methane.....................................................................................................51 6.4 Nitrous oxide emissions................................................................................................52 6.5 Other greenhouse gases..............................................................................................52 References .......................................................................................................................53 WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION iii List of Figures Figure 1 – The optimal level of an emission tax..................................................................................4 Figure 2 – The effect of marginal cost and marginal benefit slopes on the choice between taxes and permits....................................................................................................................16 Figure 3 – Marginal cost and marginal benefit with an international permit market .........................19 Figure 4 – Marginal cost and marginal benefit without an international permit market ....................22 Figure 5 – Correlations caused by a technological improvement.....................................................25 Figure 6 – Correlations caused by global and domestic economic growth ......................................25 Figure 7 – The economic efficiency choice between domestic taxes and permits...........................28 WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION iv Executive Summary New Zealand needs to get climate change mitigation policy architecture right because climate change may become a major regulatory issue. The current policy is a good start, but it is not complete or fully integrated. The purpose of this paper is to provide an up-to- date overview of key issues involved in the choice among market-based instruments for climate change policy. Specifically, it examines the potential net benefits of shifting to a permit system for emission reduction, and the preconditions necessary for this change. It also draws out the implications of New Zealand’s specific circumstances and current climate policies for future policy development. Price-based instruments, ie, taxes and tradable emission permits, are ideally suited to homogeneous long-term pollutants such as carbon dioxide. They allow maximum spatial and temporal flexibility at no environmental cost. They enable New Zealand policy to be consistent with Kyoto and future likely agreements, and are efficient in the short and long term. Any mitigation policy, whether based on taxes or permits, must confront important questions of design along the following dimensions: stringency of control; breadth of coverage; the definition and measurement of emissions; the incidence of costs; and the important possibility of revenue recycling. Tax systems and permit systems behave differently in some of these areas. Under a tax system, pressure from companies or sectors for special treatment can be addressed only by granting exemptions. This reduces the breadth of coverage. In a permit system, however, grandparenting is a possible response to pressure without reducing breadth of coverage. In contrast, taxing or providing tax rebates for proxies for hard-to-measure sources and sinks such as nitrous oxide or carbon sequestration in forests might be possible. This would allow breadth across greenhouse gases. The difficulties of permit allocation may make integration of these gases slower. The economic incidence of costs in either a tax or a permit system is independent of the legal incidence, ie, it depends not on who fills in the tax form but on how price signals are transmitted through the economy. Efficient taxes and permits impose the same costs on the same people, those who engage in emitting activities or consume goods that embody emissions. Goods and services with inelastic demand or supply carry more tax burden. The economically efficient emission tax or permit quantity is where the social marginal costs and marginal benefits of abatement are equal. In a world of certainty, taxes and permits can both yield the same optimal outcome. We are unlikely to ever know marginal costs or marginal benefits with certainty, so the tax rate or permit quantity chosen is unlikely to be optimal. Under uncertainty, a tax system and a permit system yield different emissions outcomes with different efficiencies. The quality of the international permit market is critical to the relative performance of each instrument. A smooth international permit market is not a certainty. However, if firms from a range of countries were able to participate in an international market, the market would probably be fairly smooth and well functioning. The existing European Union (EU) permit market is not a good indication of how an international market is likely to evolve after 2008 because non-EU members currently have very limited access to the market. New Zealand would find trading emission permits internationally much easier under the Kyoto rules that are expected to take effect in 2008. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION v When the international permit market works perfectly and there is a domestic tax system, the Government holds all New Zealand’s international permits and sets the tax rate charged on firms’ emissions. In a permit system, firms cover their emissions by buying domestic permits, which can be converted directly into international permits. In either case, the marginal costs of abatement are the costs of changing to cleaner energy sources, increasing energy efficiency, and adjusting production levels. The marginal benefit to New Zealand is just the international permit price. This is because a firm that manages to reduce its emissions by one unit can then sell the permit that would have covered those emissions (or is prevented from having to buy a permit for the emissions). Thus the firm gains the international permit price. Here taxes yield suboptimal results under uncertainty, whereas permits yield optimal results. Fundamentally, this is because permits adjust instantaneously to changes in the international permit price, whereas taxes require a Government decision to change. In the other extreme case, when there is no international permit market, the marginal cost curve is the same, but marginal benefits consist of the domestic environmental benefit, international favour from abatement, and the indirect effect of our abatement on other countries’ emissions. If we assume marginal cost and marginal benefit shocks are uncorrelated, permits are more efficient if and only if the marginal benefit curve is steeper than the marginal cost curve. Otherwise taxes are more efficient. Because of the fuzzy nature of marginal benefits in this case they seem likely to be less responsive to New Zealand’s emissions, so we judge that marginal cost will be steeper, favouring a tax system over permits. These results, with and without an international permit market, suggest that a hybrid tax/permit system could be a good policy option. A hybrid system is a permit system with a trigger price at which firms can buy unlimited permits from the Government. Under normal circumstances this acts like a permit system. However, if the international permit price goes too high, it begins to operate effectively like a tax system. Two types of risk are associated with emission regulation: exogenous risk, which is caused by factors outside the Government’s or an individual firm’s control; and endogenous risk, the risk of opportunistic behaviour on the part of firms or the Government. There are four types of exogenous risk. Wealth risk is the risk that New Zealand’s target under the international agreement might change. This would alter the number of permits New Zealand holds. Demand risk is the risk that firms’ demands for emissions could change as a result of factors beyond their control. Asset risk is the risk permit holders face of capital gains or losses. Price risk is the risk of a change in the opportunity cost of using permits when permit prices change. Risk allocation matters for efficiency for two reasons. Some agents are able to reduce some types of risk, and will do so if they bear those risks. Agents have different risk aversions, and there are costs to risk-averse agents bearing risk. The costs are the direct welfare cost and induced undesirable behaviour such as reduced investment. When faced with risks, agents may have the option of reallocating them to less risk-averse parties by using derivative markets, or the agents may make real investment responses to cope better with unexpected changes. If there are good derivative markets, private agents are in a good position to deal efficiently with risk. If good derivative markets do not exist, the Government should take on more of the risk to avoid some very risk-averse parties bearing disproportionately high risk. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION vi Under a domestic emission tax system, risk can be shifted between the Government and private agents by changing how frequently the tax rate is adjusted. The more frequently it is adjusted, the more risk private agents bear. Under a domestic permit system, it is important that legal conditions are conducive to the development of derivative markets. Some permits should be allocated in advance to allow asset price risk to be effectively allocated through derivative markets and move some asset risk away from the Government. The allocation of risk argument suggests that a hybrid tax/permit system would be desirable because firms would then be protected from the risk of very high permit prices that may arise without the global marginal benefit being commeasurably high. Endogenous risks can arise from either Government or firms’ behaviour. The Government may act opportunistically by changing the rules of the game; and firms may lobby the Government for changes that benefit them, strategically under-invest, or misrepresent their costs of abatement. In either regulatory system, policy targets should be made more credible through education and debate. In a tax system, the Government can minimise opportunistic behaviour by avoiding granting exemptions and setting out clearly the conditions for a change in the tax rate and a formula for the new tax rate. In a domestic permit system, permits should be defined as percentages of future targets, which would help reduce the incentive for the Government to interfere with future aggregate targets. In addition, permits should not be grandparented more than necessary and the Government should support clean technologies and tax energy-intensive ones. With a domestic permit system, market liquidity is important for good information, low transaction costs, fair prices and mitigation of market power. Market liquidity depends largely on the international market, but can be enhanced by having a broad market and simple rules. Market power is unlikely to be an issue unless a large share of permits is grandparented to one company and the international market does not function. Permits should be defined for one use, they should be infinitely divisible, advance allocations should be defined as percentages of the New Zealand target, each permit should be marked with a “use after” date, and they should be directly convertible to assigned amount units. One-use permits are relatively simple to administer and trade. They also make it easier to define bankability and gradually phase out grandparenting. Permits should be grandparented when necessary for political reasons, but grandparenting should be phased out on a defined basis. The Government could simply require all firms to buy permits from the international market. Alternatively, the Government could hold periodic auctions with several “vintages” of permit. We recommend that for fossil fuel carbon dioxide emissions a hybrid permit system with a high trigger price be used. Permits are politically feasible because of the option to grandparent. They are economically optimal if the international market functions. They allow more flexibility in the allocation of risk than taxes, and they would be simple and work well. A hybrid system would protect firms against a failure in the international market, extremely high international prices or the collapse of international cooperation. Carbon sequestration in plantation and indigenous forests should be integrated into the permit system. This would yield huge potential gains, but there are still challenges, primarily in the distribution of permits, which need to be solved. Taxes and subsidies for “projects” for non-fossil fuel emissions should be used temporarily. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 7 Additionally, broad coverage means permit markets are likely to be thicker, which is important if there is no international permit market. The proposed tax system is limited in breadth in two ways. First, it only includes specific types of emissions. The tax covers fossil fuel carbon dioxide emissions, yet excludes net emissions from agricultural methane, forest sinks, SF6 and nitrous oxide. The rationale for this is that, at least in the short term, the costs of taxing these emissions are too great in comparison with the gains that could be had from a tax. Second, some businesses are negotiating relief from carbon dioxide emission taxes through NGAs. The economic justification is that these businesses would be unable to compete with international firms that are not subject to New Zealand regulation if they were required to pay the tax. In the absence of exemptions, they might not be able to remain competitive and may be forced to downsize or liquidate, with negative consequences for their employees and owners. This gives no real environmental gains, because output and emissions are likely simply to move offshore. However, NGAs aren’t total exemptions from emission regulation. Businesses with NGAs are required to follow some sort of international best practice. This is costly to define and monitor. NGAs still increase the marginal costs of production of firms, and may cause competitiveness issues, although these are not as severe as they would be if the exemptions were not granted. Additionally, exemptions with a stipulation for international best practice remove the incentives of the exempted firms to develop new and improved business practices that reduce emissions but that are not specified in their agreements. Furthermore, while they constrain the production process, they do not pass on any pressure to change consumption or output levels of the good being produced, thus they ignore an important avenue for emission reduction. Exemptions may be very complex to administer, because taxes are levied on upstream firms, but it is downstream firms that are likely to be granted exemptions. Exemptions require the tax embedded in inputs used by the exempted firms to be measured or estimated, which is likely to be difficult and costly. When a business is exempt from emission taxes or permits, the Government must assume responsibility for its emissions. The Government must either purchase more permits on the international market or sell fewer, and it cannot recover these costs from the emitting firm through taxes or permit sales. The costs of shocks that change emission levels from the unregulated businesses are also borne by the Government and ultimately by taxpayers. The Government can only cover these expenses through general taxation, which causes inefficient distortions in the economy. If NGAs are not wisely granted, several additional problems may arise. The first involves the effectiveness of the regulation. If NGAs are too easy to obtain, the businesses that produce most of New Zealand’s emissions are likely to receive exemptions, and the abatement gains from the emission regulation will be minimal. The second problem is that of leakage. Small firms are less likely to receive NGAs. This is inequitable, and it could also shift production from small firms without NGAs to large firms with them. Consumers may also switch from included to exempt power sources, such as switching from using electricity for heating to burning wood, which is less efficient and may have local environmental impacts. Even though the proposed tax system covers only some types of emission, it is still valuable to use an economic instrument to regulate those emissions that are covered. The existence of exclusions does not affect the effectiveness of regulation in the sectors that remain, unless they compete with non-regulated sectors. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 8 If narrow coverage is initially chosen, it may become desirable at some point in the future to broaden the coverage of the emissions regulation. Thus any scheme that grants exemptions should include a mechanism to bring companies with exemptions into the system at some point in the future. In “projects”, firms are given emission credits for undertaking emission-reducing investments that would not occur without the support. These are one aspect of the current regulatory system that increases its breadth of coverage. They are intended to encourage emission-reducing action before 2007. The project scheme could be regarded as a nascent emissions trading system, but it is not desirable to view it as a transition to a full permit system. It should be used for learning only. For one thing, the credits are given to downstream firms, not the upstream firms that should be regulated in a permit system. Additionality is also a significant difficulty. That is, credits are only supposed to be given for investment additional to that that would occur without the scheme, but this baseline is very difficult to determine. Projects are very complex to administer, and they could never achieve full coverage. Furthermore, they form a dangerous precedent of paying polluters to reduce emissions as opposed to requiring them to cover their emissions with permits. 2.3 Definition/Measurement of emissions 2.3.1 What is regulated? For simplicity of monitoring, greenhouse gas emissions themselves would not be regulated. Instead, some observable quantity with a direct relationship with emissions would be regulated. This might be inputs of fossil fuels for carbon dioxide, or stock numbers for methane. The definition of the observable that was monitored would not necessarily have to remain constant over time, but could change as technology or monitoring methods evolved. For an economically efficient policy, equal incentives to abate must be provided at all margins: output, emissions per unit, fuel choice, investment etc. Any firm or individual considering an action that would increase or decrease emissions should take into account the effects of their action on greenhouse gas emissions. Firms that are being established or considering closing down should recognise the greenhouse gas effects of all their actions. Taxing or requiring permits for all net emissions achieves this outcome and in most cases is also administratively simplest. In the case of carbon dioxide emissions, nearly all fossil fuel or other carbon source that is imported or extracted will ultimately release a fixed amount of carbon dioxide into the atmosphere. Small adjustments may need to be made for non-combustion uses such as petrochemicals. There is a lag in timing between the import of fuel and its combustion but this is not very large. 2.3.2 Who is regulated? Any regulation should be imposed at a point where those who are regulated comprehensively (or as much as possible) “control” the pollutant. Those who are regulated may not be the final consumers or emitters who need to change their behaviour but they can completely control emissions because they control the flow of the intermediate product. Their ultimate effect on emissions may be primarily through the price mechanism. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 9 Another issue in choosing the best point of regulation is finding the level at which the costs of monitoring and administering the system (in terms of both reporting costs for firms and costs to the Government) are minimised. In both a tax and an emissions trading system, emissions must be monitored. In a tax system, tax payments must be matched with emissions while in an emissions trading system the ownership of permits must be tracked and permits must be matched with emissions. There may be legal subtleties. Regulation is simplest when it involves the smallest number of the most sophisticated players. For some greenhouse gases, the choice of point of regulation may have distributional effects. For instance, if regulation occurs at the downstream firm level, firms may expect permits to be grandparented rather than auctioned. In the case of carbon dioxide, regulation would occur upstream, and many of the firms involved would be international oil companies, which would not expect grandparented permits. Auctioned permits may also be more acceptable in a permit system that is preceded by a carbon tax. The choice of point of regulation could affect the efficiency of regulation if it affected the initial allocation of permits and permit markets did not operate smoothly. If firms are unable to trade easily, the initial allocation affects their ability to emit. However, we expect the permit market to be smooth, so allocation should have little effect on the outcome. Regulating an emissions trading system in the case of carbon dioxide is not as complex as people may expect. It is clearly optimal to regulate at the highest point possible, that is, where carbon is imported or extracted. At this level there are only a relatively small number of importers and extractors of fossil fuels to be monitored. Relatively good information already exists on their activities. (See Cramton and Kerr (2002) for discussion on the arguments for an “upstream” emissions trading system.) This achieves the environmental outcome at close to minimum cost, and minimises administrative costs and complexity. 2.4 Incidence of costs Who will pay the costs of climate change policy is not immediately apparent. There are four critical points here: 1. Who actually bears the cost is independent of who legally pays the tax or holds the permit. 2. The incidence of cost and wealth transfers is exactly the same in a smoothly operating permit system with auctioned permits as in a tax system. 3. Taxes are borne by those who engage in activities or consume goods that are associated with high emissions. 4. Taxes are borne by those who demand products for which total demand is inelastic. 2.4.1 Who actually bears the cost is independent of who legally pays the tax or holds the permit This is a standard result in public finance where markets operate smoothly. For example, suppose a wholesaler pays the tax. The wholesaler is unable to reduce the amount of carbon in its fuel and it faces competitive international and domestic markets in fossil WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 10 fuels. It has to pass on the full amount of the tax to its purchasers. If the purchaser is a business facing a competitive market with a fixed price (set by an alternative producer that does not use carbon), it is not able to raise its price to consumers who can buy the same good from other non-fossil-fuel-using suppliers at the old price, and the purchaser will absorb the entire price rise on the fossil fuel it uses. Alternatively, suppose the business must pay the tax on every unit of fossil fuel it purchases. If it reduces its demand for fossil fuel, it will not alter the price offered by the wholesaler, although it will reduce the business’s total tax burden. Similarly, it is unable to pass on a price rise to its consumers. Again it bears the full cost of the tax on each unit of fossil fuel it uses. If the consumer were required to pay the tax on the amount of carbon “embodied” in the product, and they face substitute products without carbon, they will only buy the product if the price is the same as before and therefore the business must again absorb the tax. The business will of course reduce the amount of tax it must pay by reducing carbon use until the cost of reducing carbon emissions by one more unit is the same as the tax. 2.4.2 The incidence of cost and wealth transfers is exactly the same in a smoothly operating permit system with auctioned permits as in a tax system If permits are auctioned, every time a wholesaler extracts or imports a unit of carbon (in fossil fuel or other sources), it must buy one permit. The price of this permit will be equal to the tax that would lead to the same level of total emissions. Thus paying for the permit is exactly equivalent to paying the tax and the conclusion from the previous section, that the incidence does not depend on who must buy the permits, holds. If permits are not auctioned, once they are allocated their effect is still like a tax. If a business emits one more unit, either it needs to buy a permit at the market price or it forgoes the opportunity to sell a permit. Either way the emission costs it the same amount as the tax and it will pass part of the cost on and/or increase abatement depending on its elasticity of supply and the elasticity of demand it faces. The allocation of permits by a system other than auctioning is simply a wealth transfer and has no effect on incentives to abate and hence no effect on efficiency. It makes no economic sense to allocate permits to wholesalers that can pass on the costs and hence pay little of the tax or permit cost. This is particularly true when many wholesalers are foreign owned. 2.4.3 Taxes are borne by those who engage in activities or consume goods that are associated with high emissions The incidence of a tax falls upon those who consume goods or services that ultimately required emissions to produce. Kerr (2001) demonstrates this for a petrol tax where she finds that those in middle income ranges will bear the highest tax burden. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 11 2.4.4 Taxes are borne by those who demand products for which total demand is inelastic In a tax system (and hence equivalently a permit system) when a business or individual faces a higher price due to the tax, they can reduce their demand for the good and/or pay a higher price. If enough buyers can reduce their demands significantly, if for example there are close substitutes, the seller of the good will be concerned about losing their market and will be unable to raise the price as much. For example, if an electricity company faces higher input costs due to a rise in the price of coal it could try to increase the price of electricity but this may encourage people to be more energy efficient or switch to gas for heating and cooking. Thus the electricity company may choose not to raise the price too much but may try both to cut down its use of coal and to absorb the input price rise in its profit. The businesses and people who will bear the highest cost from a tax on carbon are those with high demand for energy, who are unable to reduce their energy demand and unable to change to a less carbon-intensive fuel. If they are a business they will lose profits and may be forced to close down. Individuals may suffer noticeably lower living standards. It is extremely hard to identify who many of these people and businesses will be in the long run. The costs of the carbon dioxide policy are both the costs of paying the tax and the real costs of abating the use of carbon and products produced using carbon. The tax payments (or permit costs) are not a real cost to the economy because they are received by the Government as revenue, but they are real costs to firms. The real costs of abatement are the deadweight losses caused by a reduction in the quantity consumed of the products whose production causes emissions.2 2.5 Revenue recycling Both emission taxes and auctioned permits can raise revenue for the Government. If the Government can raise revenue while achieving an environmental goal it can reduce its need to raise revenue elsewhere. Kerr (2001) explains why reducing revenue raised through taxes elsewhere has efficiency gains for the economy: Taxes on labour income and on capital cause inefficient distortions in behaviour. For example, with no taxes, wages will be equal to the marginal productivity of the worker (simplistic but roughly true). Each person will work until the value of the extra amount they produce is equal to the extra cost to them of working – their marginal utility of lost leisure. With a labour tax, this decision is distorted because they are paid only a percentage of the value they produce and thus will stop work sooner or choose not to participate in the labour force at all. This is socially inefficient because the social benefit of their work is unchanged, some benefit simply goes to the Government through taxes.3 The revenue raised through environmental policy should be used to lower overall taxes, or for independently planned spending, depending on the Government’s fiscal priorities. Adolf Stroombergen did some work on revenue recycling in New Zealand in 1994, and 2 Kerr (2001) illustrates these losses (page 8). 3 Kerr, Suzi (2001) "Ecological tax reform", Report prepared for the New Zealand Ministry for the Environment, page 6. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 12 found that GST or income tax would probably be the best tax to cut.4 Not claiming the revenue for Government use exacerbates the competitiveness impacts of climate policy because the cost of carbon regulation is not partially offset by lower taxes or improved government services. Goulder et al (1998) estimate that in the United States, if emission reductions are less than 23%, grandparenting all permits rather than auctioning them would double the cost of the regulation because of the lost opportunity for revenue recycling. For optimal efficiency, revenue should certainly not be used to compensate the sectors that are directly affected, as this would decrease the efficiency of the regulation and lower the environmental benefit. There may be an argument for transitional assistance, but an industry that fails when it faces the full costs of its activities is not economically efficient, and should not be propped up by the Government in the long run. The revenue should also not be used to fund other environmental or carbon policies, which should be considered on their own merits and funded out of general tax revenue. This form of revenue is no different from any other and should be treated as such. Nevertheless, politics may suggest the revenue raised is directed towards climate policies. Public perception of a carbon tax or auctioned permit system may be better if those who pay feel the money is being used for good climate policies. This could be a problem if tax revenue is very high. Under the proposed tax system, net carbon tax revenue from a $15 per tonne tax is estimated to be $660 million per annum. It could be very inefficient to commit such a large amount of money to climate policy. As a compromise, it may be desirable to direct visibly some of the revenue to environmental projects that are desirable in themselves. Some of the revenue could also be used for investments that improve adaptation to climate change. There may also be a case for transitional assistance and retraining of workers affected by industries that are damaged by the policy. If, for social reasons, there are groups toward which the Government would like to direct resources to maintain their standards of living as energy prices rise, such as the elderly, this can be done through increases in superannuation or improvements in health care and other services. 4 Personal communication with Adolf Stroombergen, Infometrics, July 2004. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 13 3 What are fundamental and unavoidable differences between taxes and emissions trading? This section discusses the ways in which taxes and permits are unavoidably different. It begins by outlining the manner in which each regulation system would interact with an international permit market and discussing the likelihood of such a market developing. In a world without uncertainty, permits and taxes are equally efficient. However, uncertainty is real and important. The section goes on to examine how the environmental and economic risks faced are different under each system when regulation occurs in an uncertain world, and how these risks would be affected by the presence of an international permit market. The section then discusses the optimal allocation of the exogenous risks associated with emission regulation and how policy can be designed to achieve this risk allocation. Endogenous risks, risks of opportunistic behaviour by private firms or the Government, are then discussed. The section concludes by noting the different cost allocation capabilities of a tax and a permit system, and the possibility of transaction costs in a permit market. 3.1 Interaction with international emissions trading market This section gives an overview of the way in which a domestic tax or permit system would interact with an international permit system. Further details on the more technical aspects can be found in Kerr (2000). 3.1.1 Tax and an international market By their very natures, domestic emission tax systems and emission permit systems interact differently with an international permit market. Under a tax system, the Government is fundamentally responsible for achieving compliance with Kyoto for the country. The Government sets the level of the domestic emission tax it considers best, and firms act in their own best interests given the presence of the tax. If, as a result, the country under-complies with its obligations under the Kyoto Protocol, the Government is required to purchase sufficient emission permits on the international market to cover the shortfall in abatement. On the other hand, if over-compliance is achieved, the Government can sell the surplus permits internationally and generate revenue. In this scenario, in the absence of changes in the emission tax rate, shocks to the international permit price are absorbed by the Government. In the absence of an international emissions trading market, a tax that causes domestic under-compliance will cause the country to not meet its target under the Kyoto Protocol; and a tax that causes over-compliance no longer leads to the benefit of revenue from selling permits internationally. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 14 3.1.2 Permits and an international market With a permit market, the Government is able to pass liability for reaching compliancelevel emissions in covered sectors to private firms. In the simplest case, a domestic emission permit is defined identically to an international permit, and the two can be freely traded on the international market. The Government may choose to allocate (by means of gratis allocation or auction) emission permits that add up to the country’s emission target to domestic firms. Alternatively, it could require all firms to purchase their own permits on the international market, and could sell the country’s allocation internationally. The Government theoretically need do nothing to ensure the compliance of the covered sectors of the economy, although it is responsible for purchasing permits for the uncovered sectors. If a covered firm finds itself requiring fewer or more emission permits, it sells or buys these on the international market. When all domestic firms cover their emissions thus, the country automatically finds itself in compliance. The marginal cost of compliance to each firm here will be equal to the international permit price, provided transactions on the international market are costless. Unlike in the tax scenario, here shocks to the international permit price are borne by private firms. In the absence of an international market, a permit system can still ensure domestic compliance, but no longer places any limit on the marginal cost that achieving compliance may have. 3.1.3 Why there may not be an international market Whether a liquid international permit market develops depends critically on the behaviour of the EU. The most likely way for an international market to develop is for the EU’s market to be extended to include other countries. However, this would require a change in the governance of the EU market, which is not an insignificant step. The EU may also do other things to hinder the development of a full international market, such as refuse to recognise New Zealand credits gained from forest sinks. Now that Russia has signalled its intention to ratify, it may be easier for the EU to allow trading outside the EU under the governance of the United Nations Framework Convention on Climate Change negotiated rules for International Emissions Trading, Joint Implementation and the Clean Development Mechanism. Beyond the participation of countries, firm participation in an international market is required to achieve liquidity. If only governments participated in the market, trades would be few and infrequent, and no informative price mechanism would develop. With participation by firms, however, the number of players in the market would increase greatly, and trades would be frequent. For firms to trade on an international market, they must first trade on a domestic market. It is not clear how many countries outside the EU plan to implement domestic permit trading schemes. If firms from a range of countries were able to participate in an international market, the market would probably be fairly smooth and well functioning. The existing EU permit market is not a good indication of how an international market is likely to evolve after 2008 because non-EU members currently have very limited access to the market. New Zealand would find trading emission permits internationally much easier under the Kyoto rules that are expected to take effect in 2008. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 15 3.2 Environmental vs economic risk 3.2.1 Tax versus tradable permits under uncertainty Theory in standard domestic regulation situation In a scenario where the Government has complete knowledge about the aggregate costs and benefits to the country of reducing greenhouse gas emissions, producers know their own abatement costs, and where there is perfect certainty, taxes and tradable emission permits achieve exactly the same abatement at the same cost. However, the Government is likely to know less than producers about the costs of emission abatement, and even producers have imperfect knowledge about these. Furthermore, no one is likely to know the true benefits of abatement with any degree of certainty. Constantly developing technology and an otherwise dynamic, changing world mean neither costs nor benefits are able to be learned precisely, as both are perpetually buffeted by shocks. In these circumstances, a price instrument such as an emission tax and a quantity instrument such as emission permits offer different guarantees and different risks. A tax limits the marginal cost of abatement, thus providing more economic certainty while making no guarantee about emission levels. On the other hand, a permit system limits total emissions, thus providing environmental certainty, but does not necessarily limit the marginal cost of achieving the desired abatement level. If the Government chooses quantity regulation, the optimal choice of quantity is that which maximises the expected benefits minus the expected costs. Similarly, the optimal tax under price regulation is that which maximises the expected benefits minus expected costs, given the way producers are expected to respond to the tax. A classic result shown in Weitzman (1974) is that uncertainty in the costs of abatement, but not uncertainty in the benefits, can have significant effects on the choice between emission taxes and permits, provided shocks to benefits and costs are uncorrelated. The intuition behind the idea that marginal benefit uncertainty does not affect the choice of instrument is that with neither a tax nor a permit system do firms change their behaviour in response to a marginal benefit shock. Thus both instruments yield the same social loss when marginal benefits are not equal to their expected values. In the unlikely event that the costs of abatement were known with certainty, taxes and permits would yield the same environmental and economic results. However, the greater the uncertainty over the position and shape of the cost curve, the greater the difference between the outcomes likely to be achieved with a quantity instrument and with a price instrument. Whether a tax or a permit system is preferable depends critically on the slopes of the marginal cost and marginal benefit curves of abatement. In the absence of other considerations, a quantity instrument is preferable if and only if the marginal benefit curve is more steeply sloped than the marginal cost curve. This is illustrated in Figure 2 for marginal cost and marginal benefit curves with different relative slopes. In each panel, MCE represents the expected marginal cost curve, and MB is the marginal benefit curve. T is the value of the emission tax expected to yield the socially optimal reduction in emissions, and Q is the quantity of emission reduction that would be chosen in the case of a quantity instrument. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 16 However, suppose actual marginal costs are unexpectedly high at all quantities of emission reduction, represented by the line MCR, and thus the quantity of emission reduction that is ex post optimal is lower, at Q*. Because producers choose their levels of emission reduction with regard to the realised marginal costs, under an emission tax they choose an emission reduction of QT. Under quantity controls, producers achieve the targeted emission reduction, but at a higher cost than expected. Figure 2 – The effect of marginal cost and marginal benefit slopes on the choice between taxes and permits Case a): Tax preferred QT Q* E D C B A Q emission reduction T $ MC R MB MCE Case b): Permits preferred Q* Q T E D C B A Q emission reduction T $ MCR MB MCE WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 23 international permit price, a domestic permit system remains ex post efficient under any combination of shocks. Thus in this section we consider correlated uncertainty only in the case of no international market. Stavins finds that a positive correlation in the uncertainty in costs and benefits always increases the relative favourability of permits, whereas a negative correlation always increases the relative favourability of taxes. This result, derived mathematically, makes intuitive sense. With a pollution tax, when the marginal costs of abatement are unexpectedly high, producers reduce their efforts at abatement. If there is a positive correlation between shocks to benefits and costs, at these times the marginal benefits of reducing emissions are also likely to be high. Thus producers tend to reduce their abatement efforts just when these efforts are most valuable. If, on the other hand, cost and benefit uncertainty are negatively correlated, the marginal benefits of emission reduction are likely to be low at the times when producers reduce their abatement effort. Hence, with negative correlation, the response of producers under a tax tends to be appropriate. Causes of marginal cost and marginal benefit uncertainty in New Zealand Marginal cost uncertainty There appear to be two main causes of marginal cost uncertainty: uncertainty in New Zealand’s future economic growth, and uncertainty in future technological inventions, innovations and diffusion. The higher economic growth is in New Zealand, the greater will be the country’s baseline level of unregulated emissions, and the costlier it will be to reduce emissions to any specified target value. This economic growth may stem from population growth or from growth in GDP per capita. Technological progress can change the costs of reducing emissions by offering more energy-efficient production processes and substitutes for emission-producing energy sources. However, there may be some new technologies that actually cause an increase in emissions. Marginal benefit uncertainty The causes of uncertainty in marginal benefit are more numerous. Each of the three factors that determine marginal environmental benefit contains uncertainty. The future stock of greenhouse gases in the atmosphere, the effects of the greenhouse gas stock on the climate, and the effects of climate change on society are all uncertain. However, it is only the stock of greenhouse gases and the effects of climate change on society that are likely to have errors that are correlated with the uncertainty in marginal cost. If either economic growth or technological change occurs at a pace different from that expected, stocks of greenhouse gases in the atmosphere are likely to differ from expectations. Although world economic growth can be forecast, shocks as large as the collapse of the Russian economy can and do occur, leading to large errors in our expectations. Technological progress and its effects over the long term are inherently unpredictable, adding to our uncertainty over future emissions. We know little about the severity of the effects on society of any given level of climate change. This will depend on how New Zealand’s society and economy develop over time. Specifically, shocks to the importance of our agricultural industry, the geographic distribution of our population, and GDP per capita will alter the strength of the effects of climate change on the country. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 24 These uncertainties apply to domestic marginal benefit and also, on a world scale, influence global marginal environmental benefits. These global marginal environmental benefits in turn may affect the value of international favour gained from abatement and the effect of New Zealand’s abatement on other countries’ emissions. The value to New Zealand of the favour gained in international circles for meeting its compliance target is both difficult to estimate and likely to evolve as the international situation changes. The value of this favour may be positively correlated with the marginal global benefits of abatement in the long run. The correlation between global marginal benefits and the benefit for New Zealand of New Zealand’s effect on other countries’ emissions is likely to be positive. If global marginal benefits are higher, the same amount of foreign abatement is likely to be more beneficial for New Zealand. Correlations between marginal cost and marginal benefit uncertainty The main causes of cost and benefit uncertainty have thus been established, and it remains to consider which of these are likely to be positively or negatively correlated with one another. For simplicity, we look here at the correlations between marginal environmental benefit and marginal cost. Figure 5 below illustrates one set of likely correlations. An exogenous improvement to technology could have several effects. First, it could cause global emissions and thus greenhouse gas stocks to be lower than expected,7 which could decrease the marginal benefits of domestic abatement by altering the environmental benefits to New Zealand directly. Second, the technology shock might make society more able to cope with the damage caused by climate change, which would also decrease the marginal benefits by decreasing the benefits of reducing climate change. Third, the technology shock could directly decrease the marginal costs of abatement. These relationships imply a positive correlation between marginal cost shocks, which are negative here, and marginal benefit shocks, which are also negative here. 7 This is true even if all Kyoto targets are exactly met, because the Kyoto Protocol doesn’t cover all emission sources or all countries. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 25 Figure 5 – Correlations caused by a technological improvement Figure 6 below illustrates a second set of possible correlations. On the left-hand side, global economic growth that is not matched by improved emissions technology would cause unexpectedly high global emissions and greenhouse gas stocks, which would drive up the marginal benefit of abatement. As above, this change in the marginal benefit would act through direct environmental benefits. Figure 6 – Correlations caused by global and domestic economic growth Global economic growth Increase in global emissions and unexpectedly high stocks Increase in marginal benefits of domestic abatement Domestic economic g rowth Increase in marginal costs of domestic abatement Increase in ability to cope with climate change Decrease in marginal benefit of domestic abatement However, shocks to global economic growth are likely to be positively correlated with shocks to domestic economic growth. This domestic growth has two possible effects. First, it could increase the ability of New Zealand to cope with climate change, thus Exogenous technological improvement Decrease in global emissions and unexpectedly low stocks Decrease in marginal benefits of domestic abatement Decrease in marginal costs of domestic abatement Increase in ability to cope with climate change WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 26 decreasing the marginal benefit of abatement by reducing the benefits of preventing climate change. Second, domestic growth would increase the marginal cost of abatement by driving up domestic baseline emissions. Under the assumption that the positive shock to marginal benefits from higher global emissions is greater than the negative shock from a greater ability to cope, this set of correlations implies a positive relationship between marginal benefit and marginal cost uncertainty. However, it is also possible that there is a positive correlation between global economic growth and technological advancements. In this case, marginal costs and marginal benefits both have forces driving them in both directions, and it cannot be determined which are likely to be greater. Consequently, the sign of the correlation between marginal cost and marginal benefit uncertainty cannot be determined in this case. In the absence of strong proof of a high correlation between global economic growth and technological advances,8 the above analysis suggests that a positive correlation between shocks to marginal cost and to marginal benefit is more likely than a negative correlation. Results for New Zealand with correlated uncertainty In the absence of an international permit market, with no correlation in benefit and cost uncertainty, a steep marginal benefit curve favours permits and a flat one favours taxes. When uncertainty is correlated this result may be slightly modified. Positive correlation increases the desirability of permits, whereas negative correlation increases the desirability of taxes. It appears more likely that New Zealand faces positively correlated shocks to its marginal cost and marginal benefit curves, suggesting a permit system may be more appropriate. However, New Zealand’s marginal cost curve is still likely to be steep enough that taxes are still the preferred instrument. 3.2.3 Environmental vs economic risk: summary Whether a domestic tax or permit system would yield preferable environmental and economic outcomes when the marginal cost and marginal benefit of abatement are subject to uncertainty depends critically on the presence or absence of a good international permit market. Figure 7 summarises possible scenarios and the preferable control instruments in each. The optimistic scenario includes a good international permit market and an international permit price that is high enough for the only marginal benefit of domestic abatement to be the international permit price. This scenario is shown on the very left-hand side of the figure. In this case, domestic permits are not only preferable to taxes, but are efficient. If the international price is very low, the marginal benefit of international favour for domestic abatement is important and the solution ceases to be clear-cut. A less optimistic scenario involves a poor international market, shown by the first righthand fork in the figure. This puts us in Weitzman’s familiar world. We believe that the domestic marginal cost curve is likely to be steeper than the marginal benefit curve, which implies that a tax would be preferable if marginal cost and marginal benefit shocks were uncorrelated. This is shown by the first right-hand option past the initial right fork in the figure. 8 A high proportion of technological breakthroughs are serendipitous, although the diffusion of technology may be linked to economic growth. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 27 However, we believe that marginal cost and marginal benefit shocks may be positively correlated, which increases the relative favourability of permits, though not necessarily enough to make permits preferable to taxes. This is shown by the left-hand branch of the final fork on the right-hand side of the figure. In the end, the choice between taxes and permits for domestic regulation returns to whether there will be a good international permit market. With such a market, permits are preferable. Otherwise, taxes are preferable. If there may not be an international market, but we want to be able to take advantage of the efficiency gains of a permit system if such a market develops, a domestic hybrid system of permits with a trigger value could be desirable. This option is discussed in Section 5. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 28 Figure 7 – The economic efficiency choice between domestic taxes and permits ne g ativel y p ositivel y Is there a good international market? yes no Are there marginal benefits beyond the international permit price? no yes Permits are optimal Assume the domestic permit price is set at the optimal wedge above the international permit price Is MC or MB steeper? MC MB Is MC or MB steeper? Tax is preferable Permits are preferable MC MB Permits are preferable Tax is preferable If MC and MB are uncorrelated If MC and MB are correlated but … Relative favourability of permits increases Relative favourability of tax increases WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 29 3.3 Allocation of risks and incentives to respond to risk The risks associated with greenhouse gas emission regulation can broadly be classified as either exogenous or endogenous. Exogenous risks are those that cannot be influenced by either the Government or regulated firms. These risks were discussed in Section 3.2. They include events such as changes in technology that reduce the costs of abatement and unexpected domestic economic growth that raises domestic baseline emissions. Dealing with these risks is discussed in Sections 3.3.1 and 3.3.2. These sections consider what the risks are, who should optimally bear them, and how policy should be designed to ensure that these agents do in fact bear the risks. They draw upon material from Kerr (2003a). Endogenous risks, on the other hand, are the result of the behaviour of either the regulator or the regulated parties. These risks generally involve either an opportunistic change of the rules of the game by the Government, or strategic investment or lobbying by regulated firms. Dealing with these risks is discussed in Section 3.3.3. 3.3.1 Optimal allocation of exogenous risk Identifying uncertainty and defining risk With either a tax or a permit system, a reduction in genuine uncertainty improves the efficiency of the choices that agents make. Although uncertainty may take a very long time to actually be resolved, in the shorter term it can often be evaluated and the likelihood of specific outcomes established. When uncertainty has been reduced to risk (when the possible outcomes and the likelihood of each has been established) agents can respond optimally to it. Determining the risks largely involves monitoring relevant developments in other parts of the world and evaluating how they affect the likelihood of specific outcomes for New Zealand. For instance, although New Zealand is unlikely to develop breakthrough “clean” technologies, it is important for firms’ investment decisions and for future greenhouse gas regulations whether these are on the verge of becoming economically viable. The decision of the United States on whether or not to ratify the Kyoto Protocol has huge implications for New Zealand, and the emission abatement efforts of other countries are also relevant to the New Zealand situation. Information about the state or likelihood of such developments is a public good to New Zealand; therefore, monitoring of relevant world events is unlikely to occur at the desirable level in the absence of Government intervention. This means there is a role for the Government in monitoring and disseminating information on international developments that relate to emissions. How firms and the Government should respond to risk Four types of exogenous risk are associated with emission regulation. The first is “wealth” risk. This is the risk that New Zealand’s domestic emission target will change, meaning a change in the number of permits the country as a whole holds. The second risk is domestic demand risk, or the risk that a shock such as a rise in demand for a firm’s output will cause an increase in the firm’s emissions. It must then either increase its demand for permits or pay more emission taxes. The third risk is asset risk, where holders of existing permits receive capital gains or losses when permit prices change. The fourth risk is price risk, or the change in the opportunity cost of using permits when permit prices change. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 30 Asset risk and price risk are negatively correlated with each other. Wealth risk is probably correlated with asset risk and price risk, in that a decrease in the number of New Zealand permits is likely to be associated with an increase in permit prices. Two main strategies can mitigate or efficiently reallocate some of the types of risk. Price risk can be reduced by certain investment responses. Any one agent can avoid asset risk and wealth risk entirely by not holding any permits, although these risks are then faced by other agents. An agent that does hold permits may be able to manage its asset or wealth risk efficiently through a portfolio. Firms have a number of possible investment responses to help mitigate the effect of price risk. They choose investment types that allow them the most flexibility to adjust their emissions. This involves choosing capital with a high proportion of variable costs and with a relatively short lifetime and investing in a mix of technologies. Firms are then in a good position to reduce the effects of price risk by adjusting their production level or production technologies at short notice. This changes their emission levels and either permit use or tax payments in response to the shock. Similarly, firms find an option value to waiting when there is uncertainty over future permit prices or carbon tax rates, and may reduce risk to themselves by delaying investment decisions. Research conducted by firms helps to resolve some uncertainty. When a domestic permit system is operating, firms may be able to partially insure against price risk by the precautionary banking of permits, if this is permitted by the system. The private sector is also well positioned to develop a number of risk-allocation mechanisms such as derivative transactions associated with permit trading (eg, forward trades or options). These mechanisms allow more risk-averse firms to pass some of their asset risk to risk-neutral firms. The Government may also choose to enter these derivative markets. The Government has a limited ability to mitigate exogenous risk. However, it is able to fund research and monitoring that can lead to the resolution of some uncertainty. In its own investments it is able to reduce risk in the same manner as any firm. Risk allocation considerations When deciding who should optimally bear certain risks, several factors are important. First, the degree to which agents can control the risk and their ability to mitigate it should be considered. It is clearly more efficient for an agent with a greater degree of control over a risk and the ability to reduce it to be faced with that risk. This induces more efficient risk management than the situation where those facing a risk cannot control it and those who can control the risk have no incentive to do so. This point can be illustrated with an example of an electricity generation company. If this company uses hydro lakes to generate electricity, it should bear at least some of the risk to carbon emissions of these lakes running dry. Otherwise it would not have any incentive to use the lake water wisely, or to have clean alternative generation methods on hand for dry seasons. If the Government were to bear all the emissions risk of the lakes running dry, the electricity company could use all the water and turn to environmentally unfriendly generation methods at no cost to itself. This would clearly be inefficient. Second, greater risk should be placed with those who can bear it at less cost. That is, those who are less risk averse. In general, the Government and large companies are less risk averse than are small companies and individuals. There are two costs to risk-averse agents bearing risk. The first is the direct welfare cost. The second is the undesirable behaviour that may be induced by the agent having to bear the risk. For instance, if risk- WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 31 averse firms are unable to share the risk of their investments they will invest less than is optimal for society. The optimal allocation of risk depends on the instruments that parties have available to mitigate risk. One important distinction is between the cases with and without good markets for risk. If perfect risk markets are operating, firms can efficiently reallocate risk amongst themselves so that more risk-averse agents bear less risk, and less risk-averse agents bear more. Good risk markets are possible only if there is an international permit market; potential New Zealand buyers and sellers are too few for such markets to develop without the presence of international players. If there are good risk markets, the Government has no comparative advantage in bearing most exogenous risks. These risks tend to be correlated over the economy, and are not small relative to the size of the economy. As a result, the Arrow-Lind (1970) risk-pooling argument for the assumption of risk by the Government does not apply. If the Government were to bear a negative exogenous shock, the cost would ultimately be covered through taxation, with the associated distortions that this brings. Private firms, on the other hand, are able to use the risk markets to allocate risk efficiently among themselves. However, there are reasons why risk markets may not be perfect even if there are international permit markets. Suppose a firm planning to undertake a risky investment manages to share the risk through either debt financing or equity. In either case, the firm no longer bears the entire risk of the investment. Furthermore, under debt financing the firm making the loan faces much of the loss if the investment goes poorly, whereas the investing firm reaps most of the gains if the investment goes well. Consequently, the investing firm has an incentive to choose a much riskier and higher-yielding investment than it would if it bore the entire risk itself. The presence of asymmetric information over the risk and expected returns of potential investment projects means the firm making the loan cannot prevent a very risky project being chosen. This is the problem of adverse selection. Once the investment has been chosen, asymmetric information causes further problems. The investing firm has more control over the investment than do any other firms that take on some of the risk. Because these other firms cannot perfectly monitor the investor, under a risk-sharing arrangement the investing firm has less incentive to take care with the investment than it would if it bore the entire risk itself. This is the problem of moral hazard. As a result of the adverse selection problem and the moral hazard problem, other firms are unwilling to take a share of the risk associated with the investment, and perfect risk markets are unable to develop. In this situation, although the Government really has no comparative advantage in dealing with the adverse selection or moral hazard problems, it may be efficient for the Government to bear some of the risk. If the risk were left solely with firms, many of the firms that ended up bearing disproportionately large risk would be small firms that were most risk averse. This is not really an equity issue because firms choose to take on risk when they invest. However, it does mean that firms will invest less than would be socially optimal. By assuming some of the risk, the Government encourages more investment and achieves an efficiency gain. If the Government assumes some of the risk, it must choose which investment projects to support, even though it is not in a good position to determine which projects are likely to WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 32 be the most valuable. Although it risks funding projects that yield poor financial returns, it might value the learning benefits of risky projects enough to make the risks worthwhile. 3.3.2 Policy design and optimal exogenous risk allocation Both an emission tax and a tradable permit system have a degree of flexibility in their design that allows the allocation of risk to be altered. This section discusses the transmission of exogenous shocks and specific design and implementation issues that can be used to allocate risk optimally. Transmission of exogenous risks with a domestic permit market When domestic emissions are regulated by means of permits, exogenous shocks feed through as changes in the price of permits (spot, forward, future and option). When permit prices rise, those holding permits receive capital gains, and everyone faces higher opportunity costs of using permits. Shocks to New Zealand’s emission target are also felt as wealth shocks, whereby some agents face decreases in the quantity of permits they hold. The change in permit prices occurs as a result of a shock to either the supply of or demand for permits. Because supply is of a different nature with and without a functioning international permit market, the nature of exogenous shocks also differs in these two cases. In the absence of an international permit market, the supply of permits is perfectly inelastic. Here, supply shocks include such events as changes in the domestic emission target, which is set internationally, a domestic decision to move either into or out of compliance with Kyoto, or a change in the net emissions from an unregulated sector that is passed on to the permit system. When there is a liquid international permit market, New Zealand can purchase as many permits as it wishes at the prevailing international price, thus the domestic supply of permits is horizontal at this price. Consequently, any shocks to either the international demand or supply of permits affect domestic supply. In this case, supply shocks include a change in international aggregate emission targets, a change in international economic growth or activity, or a change in the abatement technology used internationally. Domestic demand shocks have the same causes whether or not an international permit market exists. They include shocks to the abatement technology used domestically, natural events such as cold weather, and economic growth and business cycles. These shocks are only large enough relative to the total market to affect permit prices when there is no international permit market. However, in every case they affect the total costs of the firms whose demands for permits are affected. Although most shocks are transmitted as changes in the price of permits, the incidence of these changes does not necessarily fall primarily upon permit holders. For instance, firms might be in a market position that allows them to pass cost changes on to their customers or their employees. These people may be extremely risk averse, and thus this situation may be highly undesirable. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 39 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. The 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 its costs of compliance (CMM10) or the company can try to raise the costs to its competitors and hence exclude them or capture market share by raising the price of permits (EM11). 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 expenditure 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 equalised 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. 10 Cost minimising manipulation. Hahn, Robert W (1984) “Market power and transferable property rights.” Quarterly Journal of Economics 99: 753-765. 11 Exclusionary manipulation. Misiolek, Walter S and Harold W Elder (1989) “Exclusionary manipulation of markets for pollution rights.” Journal of Environmental Economics and Management 16: 156-166. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 40 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 firms 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 equalised 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 monopolise 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. 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 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. 12 The increased concentration in the fishing industry was also due to technology changes partly in response to the increased security of fish stocks. There is no counterpart to this effect in a carbon trading market. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 41 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, eg, 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, ie, 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. 4.4 Recommendations for defining permits 4.4.1 Permits defined for one use or in-perpetuity/eternal By “one use” we mean that the permit is defined as the right to emit one tonne of carbon once. For example, a permit might state: “This permit gives the holder the right to emit one tonne of carbon dioxide equivalent after January 1999”. A permit in perpetuity gives the right to emit a flow of permits. For example, the permit might state: “The permit gives the holder the right to emit one tonne of carbon dioxide equivalent each year from the year 1999 to perpetuity”. We recommend permits should be one-use, infinitely divisible, and defined as proportions of the target rather than in tonnes. Defining permits for one use only, as opposed to several uses or “in perpetuity” has the advantages of administrative simplicity relative to the several-uses definition, and increased homogeneity. Homogeneity makes trading more efficient, reduces complexity and makes compliance easier to monitor. With oneuse permits, it would be easier to phase grandparenting out over time. This could have enormous revenue-recycling benefits. In addition, it is harder to define bankability with an “in-perpetuity” permit. With a normal property right it is not possible to use it twice in one period, eg, with land it is not possible to not farm in one period and use the same piece of land twice in the second period. In many environmental tradable permit markets the timing of emissions is critical and bankability is not allowed. In this situation, a permit in perpetuity can make sense because it is the right to emit a flow of emissions each year. In the carbon market, however, we are concerned with the accumulation of emissions. A permit in perpetuity that was not used one year would have to be convertible into a permit that allowed those emissions to be used in a later year. This becomes a “one-use” permit system. Infinite divisibility benefits market liquidity by removing some of the lumpiness of transactions and encouraging small trades. If very small trades are possible, the number of market participants will increase, and small emitters will not be penalised by having to buy more emission rights than they wish to use. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 42 Defining permits as proportions of the target rather than in tonnes has the effect of shifting the cost of reducing the country’s target from the Government to private agents. The country’s target would only change between commitment periods, thus during each commitment period the permits would behave as if they were defined in tonnes. However, firms that banked their permits beyond the end of one commitment period would face the risk that their value in terms of emissions could decrease. Each permit would need to be marked with a date before which it cannot be used. This would ensure that the country is cumulatively in compliance up to any given date. Domestic permits would be directly convertible to assigned amount units (AAUs – the internationally tradable permits created by the Kyoto Protocol). One option would be to simply use AAUs as domestic permits. This would create problems, however, if a hybrid system were used and the trigger price reached. The Government would want to be able to freeze convertibility to AAUs. 4.4.2 Length of bankability of permits By “bankability” we mean that a permit dated January 1999 does not need to be used in January but could be saved (banked) and used in a later period. The Government may want to define a limit on how long the permit can be banked. Thus the permit may be defined as: “This permit gives the holder the right to emit one tonne of carbon dioxide after January 1999 and before January 2009”. Bankability should probably match any international rules on banking of AAUs. The advantage of long allowances for bankability is that it allows businesses individually and the private sector as a whole to find the optimal path for emissions. However, given uncertainty and the relatively short horizons of most businesses, it is probably not necessary to make the bankability infinite to achieve most of the gains from intertemporal optimisation. In actual markets, most banking has been for the purpose of short-run smoothing so that permits are banked for only one or two years at most. This is more a response to limited liquidity and short-term individual shocks than an overall constraint on permits in the market. When the market is actually operational, if there is too high (much more than rising at the rate of interest) a value on future rights relative to current rights, this would be an indication that the limit on bankability is a real constraint and should be reconsidered. The specifications of the Kyoto Protocol allow for permits allocated in the first commitment period to be banked into the second commitment period, so a domestic system in which the same was permitted would seem sensible, and would aid New Zealand’s compliance with Kyoto. 4.5 Allocating permits 4.5.1 Auctioning vs grandparenting Auctioning permits is economically preferred to grandparenting because it is less distortionary. However, some grandparenting may be required for political feasibility. The transition to a permit system would be eased if firms covered by NGAs were to receive grandparented permits in quantities based on best practice levels of emissions at a given date. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 43 It is important to require that at least some firms buy emission permits for two main reasons. First, the revenue gained by the Government would allow the economy to enjoy some of the benefits of revenue recycling. Second, equity would be increased because those bearing the cost would be more widely spread through the economy. Most importantly, this would set a precedent that would make it possible that in the long run, emitters would pay for emissions and revenue would be recycled. It may be desirable to phase the grandparenting out over time, so the Government should ensure that this option is not precluded by the design of the permit system. 4.5.2 How to auction permits In a perfect market with perfect information all permits could be auctioned immediately. The Government could invest the money gained and if it needed to buy back permits simply repurchase them with the return from the investment. Alternatively, the Government could require firms to purchase permits on the international market and sell its own surplus in the same way, essentially using the international market as its auction mechanism. However, given that markets may not be perfect, the Government needs to take into account issues of market power, liquidity and maximising government revenue. If we use “one-use” permits we have a series of permits dated for years out into the indefinite future. The later permits cannot be used for many years but could be sold in advance. One option would be to sell all permits with all dates immediately. Alternatively, the permits for each year could be sold at the time they can be used. We propose a mixed system where all current permits are sold as well as a percentage of the permits from each future year, with the percentage declining for more distant dates. Thus there would be annual auctions of a variety of different types of permit. We recommend that annual auctions sell the remaining current permits and some for each future year out for about 25 years. For example, in 2005, all permits that are dated for use only after January 2005 would be auctioned. In addition 75% of the permits dated January 2006, 50% of those dated 2007, 25% of those dated 2008, 15% of those for 2009 and so on would also be auctioned. In the year 2006, the remaining 25% of permits for 2006 would be auctioned together with an additional 25% from 2007 etc. The percentages chosen here are purely for illustration. The idea would be to have a sizable percentage of permits for each of the current year and immediate future years traded every year. Market power can only arise if one small group gains control of most permits that are available for use in a given year. If not all permits are allocated in advance, the Government can always counteract the market power by auctioning permits and thus making them available to new entrants. With annual auctions of all different types of permit (ie, with different start and end dates), a minimum level of liquidity will be guaranteed in the market. Finally, gradual auctions will allow experience to develop in the private sector, so the uncertainty about permit values will decrease, probably allowing the Government to sell them for higher values and make more revenue. This prevents private companies that have good information about the value of permits making large speculative gains early in the market and buying many permits cheaply. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 44 4.5.3 Fully define rights – minimise restrictions and uncertainty If when or how permits can be used is limited, the permits are less valuable to firms. Some restrictions are necessary to maintain the integrity of the system but each restriction should be evaluated to ensure that it is strictly necessary. Uncertainty increases the risk associated with holding a permit and makes it less valuable. Some uncertainty is unavoidable and cannot be controlled by the Government. This risk should not necessarily be absorbed by the Government to raise prices, because risk bearing has a real cost to the Government as well as to the private sector. However, the Government can create unnecessary uncertainty if it does not design the permits clearly and if it makes the value of those permits overly vulnerable to political changes. 4.6 Transaction costs, efficiency and incidence of costs In a carbon dioxide market among importers and extractors, transaction costs could arise from five sources. Transaction costs are a problem because they mean some firms do not trade efficiently and thus overall costs are increased. They are a direct use of resources. They also may bias against some firms that are less able to trade and hence face higher costs of compliance. One obvious transaction cost would occur if there were expensive administrative procedures that must be followed to have trades approved and to make trades. In this case, players would only trade when they could make a significant gain. Second, both a tax and a permit system involve some cost of optimising. That is, it is costly for businesses to identify their static marginal cost curves. The difference with a permit system is that it is possible to bank permits, so businesses must also predict their future marginal cost curves in order to make good permit-banking decisions. Firms under either a tax or a permit system need to predict their future costs to make optimal investment decisions in any case. Third, there are costs of finding the market distribution of prices and then finding a partner. These can be minimised by creating an anonymous centralised trading mechanism where aggregate price (including the distribution of prices) and quantity information is periodically released and buyers are matched to sellers. The traders would have to have the confidence of the players. They would have to provide information on trading to the Government (though not necessarily price information) for monitoring and enforcement purposes but this function would not need to be carried out by the Government. Large traders may prefer to negotiate directly when they have identified possible trading partners. Fourth, if there is concern about the validity of the rights being traded, transaction costs are created. This is unnecessary and can be avoided by accurate registration of rights in real time (ie, as they are traded) so that buyers can check claims of ownership at low cost. Fifth, negotiation costs between trading partners will depend on the liquidity of the market. If many players become involved in speculating on rights and creating rights (eg, from forestry) the market will be liquid and a market price will emerge. If the market is illiquid, large trades will involve negotiation and bargaining, which could be expensive. However, trades will tend to be repeated between the same partners and as trading patterns and prices become established, costs of negotiation will fall. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 45 4.6.1 International trading and efficiency of permit market Transaction costs will be heavily affected by the presence or absence of international trading of permits. If trading occurs within a liquid international permit market, transaction costs for domestic agents are likely to be very low; if the permit market is limited to New Zealand, participants will be much fewer and transaction costs could potentially be a great deal higher. Without an international permit market, fewer derivatives are likely to develop, trading will be lumpier, the price will be more volatile, and market power may be possible in very specific circumstances. 4.7 Design issues specific to taxes A range of issues is specific to the design of an emission tax system. Unlike permit prices, a tax rate must be adjusted administratively over time. A tax system is likely to raise more money than a permit system in which some permits are grandparented, and thus the question of what to do with the money raised becomes even more pertinent. Finally, additional government intervention may be required to achieve international compliance under a tax system. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 46 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 emission 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 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. The political process of setting trigger prices is conceptually the same as the process for setting a tax but may be easier because the trigger price is less likely to have any real effect than the tax. 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 others’ 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 WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 47 equipped to use a permit market efficiently. 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. If climate regulation becomes more stringent and/or international permit prices rise, the value of incorporating these other sectors in the permit system will rise and may outweigh the costs of incorporating them. 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 grandparenting 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 were 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. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 48 The transition to a hybrid permit system could be eased in several ways. Businesses that were already paying an emission 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 grandparented permits to the upstream firms that require permits. This grandparenting 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. WP 05/02 | TAXES VS PERMITS: OPTIONS FOR PRICE-BASED CLIMATE CHANGE REGULATION 55 Pizer, William A (1998) "Prices vs quantities revisited: the case of climate change," Discussion Paper No 98-02, Resources for the Future, Washington. Stavins, Robert N (1996) "Correlated uncertainty and policy instrument choice." Journal of Environmental Economics and Management 30(2): 218-232. Te Morenga, L and S Wakelin (2003) "Carbon inventory of New Zealand's planted forests." Report for the Ministry of Agriculture and Forestry and the Ministry for the Environment, Forest Research, Rotorua. United Nations Climate Change Secretariat (1998) The Kyoto Protocol to the Convention on Climate Change. United Nations Environment Programme Information Unit for Conventions, Chatelaine, Switzerland. Weitzman, Martin L (1974) "Prices vs quantities." Review of Economic Studies 41:4:477- 491. Whitehead, David, Craig Trotter, Stephen McNeill, Neal Scott, Graeme Hall, Jacob Overton and Ian Payton (2002) "Carbon storage in shrubland and forest ecosystems: A review of research results 2000-2002." Internal Report: No LC0102/153, Landcare Research.