Emissions trading scheme and inflation

Inflation is an important issue for everyone in New Zealand at the moment, with rising food and oil prices driving our annual inflation rate has fallen outside the Reserve Bank’s target band (hitting 3.2%pa in December). The fact that inflationary pressures are elevated will make it difficult for monetary policy to respond to any slide in real economic activity – a definite concern for New Zealand.

At the same time there has been a lot of talk about how the emissions trading scheme will impact on inflation. Both the Reserve Bank and Westpac are telling us that it will lead to a higher rate of inflation, and commentators seem to have accepted that it will – but how does this work?

Before answering this, we need to define what inflation is: Inflation is the rate of growth in the general price level. Inflation describes the underlying tendency of prices to grow over time (currently the RBNZ focuses on the ‘medium term’ when looking at inflation, I’d read that as 2-3 years). This is separate to a change in relative prices (where the underlying value of goods relative to each other has changed), or a change in the price level (which is when we have a sudden, one off, jump in prices)

Next we need to say how the ETS will change prices. Currently the implicit price of carbon is zero. The ETS will, in some sense, set a (variable) price for carbon by making firms buy carbon credits for their carbon emissions. If we take for granted that the ETS will increase the price of carbon alone, then we don’t have to worry about inflation as this is a change in the relative price of carbon.

However, the price of carbon also feeds into the price of other goods. As carbon is a byproduct of the creation of many inputs to the creation of many products, this will drive up the price of these products. However, a one-off increase in the price is not inflation, it is a change in the price level – so this is not the inflationary concern we are talking about either (Although, for the medium term outlook, this increase in the general price level is often seen as important to deal with).

The inflationary impact comes from the effect on peoples inflation expectations. If people believe prices are going to rise 5%, they will try to push for higher nominal wage increase, and firms will then push prices up further (or vice-versa, depending on who holds the expectations). If people see the price level being pushed up over and over by ‘shocks’ (first food, then oil, then the ETS) they will begin to revise up their inflation expectations – leading to more inflation.

So people are concerned that the ETS will feed into inflation expectations causing inflation, fair enough.

There is another inflation related issue to be concerned about with the ETS. One of the main reasons we care about inflation is volatility – we assume that the higher the inflation rate the more volatile prices are (given that some products have ‘stickier’ prices than others). The ETS gives us a volatile price for carbon. As carbon is the result of production for many inputs, this scheme could increase the volatility of prices – which is a concern.

A tax on carbon would have removed this potential source of volatility, however this would have come at the cost of an uncertain outcome in terms of the quantity of emissions created.

Ultimately, the link between the ETS and inflation is a fair one to make. Hopefully what I’ve said makes sense – if it doesn’t quiz me on it in the comments.

  • CPW

    I saw in the Monetary Policy Statement that claim about carbon tax adding to volatility. I don’t know if I fully agree – to the extent that the price for carbon rises or falls with economic activity it might be an automatic stabilizer on output. So the first round effect might be more volatile inflation, the second effect less volatile inflation.

    I don’t know if tax versus cap&trade makes much difference: either way the variable that matters at the end of the day is the firm’s expectations of the future price/tax. Unless you think cap&trade is a more credible commitment to a given emissions level.

  • “I saw in the Monetary Policy Statement that claim about carbon tax adding to volatility.”

    I haven’t actually got past the first few pages of the MPS so I didn’t realise they talked about volatility and the ETS – I should have just linked to that instead of trying to explain it myself 😛

    “I don’t know if I fully agree – to the extent that the price for carbon rises or falls with economic activity it might be an automatic stabilizer on output.”

    Maybe for a large economy, but we will pretty much just face the world price for carbon won’t we? This would imply that their would be no automatic stabiliser effects – beyond any link between our business cycle and world economic growth.

    “I don’t know if tax versus cap&trade makes much difference: either way the variable that matters at the end of the day is the firm’s expectations of the future price/tax. Unless you think cap&trade is a more credible commitment to a given emissions level.”

    True, I think you’re right. The best argument I can put forward to the tax being less volatile is the uncertainty associated with the price of carbon in the ETS case. If prices are uncertain then the realised price is likely to be different to the expected price of carbon – implying that the ‘product price’ may in itself vary as expectations change. I guess this isn’t inflation though is it – however it is price volatility.

  • CPW

    “Maybe for a large economy, but we will pretty much just face the world price for carbon won’t we?”

    I think the current assumption is that the world price is (obviously) the cap on the NZ price, but the NZ price will probably be lower. RBNZ was assuming $25 for NZ vs $40 for EU. I’m not clear myself on why the NZ price won’t converge on the world price.

  • “I think the current assumption is that the world price is (obviously) the cap on the NZ price, but the NZ price will probably be lower. RBNZ was assuming $25 for NZ vs $40 for EU”

    That is very interesting. Maybe they believe that the ETS won’t be fully tradable over the next four years or at least there will be some disconnect that will prevent arbitrage opportunities. It is going to be a pretty thin market after all!