Discussion on how to screw up a terms of trade increase II

As promised, I will now discuss Queen Bee’s fear that the Emissions trading scheme will limit our ability to take advantage of the wealth gains New Zealand will get from high food prices.

First we should accept that there is a liability we have to pay. If anyone wants to comment saying we should just not pay our Kyoto Liability, do it somewhere else (If it makes you feel better, we will assume that the world will punish us by more than the cost of the scheme if we drop out). So given that we are looking at the situation where New Zealand has to pay for it, why is there concern around the ETS.

One concern that Queen Bee has, which is of course correct, is that rushing into an emissions trading scheme without thinking about the issues surrounding it is a mistake, but is that what we are doing. Compared to other polices the ETS has had a ton of work done around it, general equilibrium models, real options analysis of forestry stocks, all sorts of stuff. Some of the technical issues surrounding the measurement of liabilities need to be cleaned up, but in the economic sense I’m pretty happy with where we are sitting.

The feeling that we haven’t properly costed the ETS stems from the NZIER GE model on an ETS (something we discuss here). Now I didn’t completely agree with the conclusions that were glenned from the NZIER review, and if you read the review of the review you can see that others feel the same way (*).

However, even if we believed that the NZIER model gave the best representation of what is going to happen, policy is not solely a question of “growth”, it is a question of welfare. This question is important as we cannot just have “high growth” and compensate the losers in this case – as these firms are stating they can’t afford to stay in business if they have too pay the full cost of their carbon emissions.

It is fundamentally fair to make people pay the full social cost of their actions. By increasing income taxes to pay for the liability instead of using an ETS or a carbon tax we are making the result of society pay for a mess that these industries are creating.

I do agree with Queen Bee insofar as uncertainty surrounding the ETS is creating unnecessary problems for our economy, mainly by reducing investment. However, given that we have to take on the liability in the first place, I am not certain that getting the funds through an ETS is much of an additional risk – ultimately, it is the liability that is a cost to society, not the scheme.

What do you think is the major risk?

In terms of policy failure, I’m most worried about the government losing focus of when spending is appropriate and inappropriate. A terms of trade increase increases the whole countries set of resources – completely independently of any government action.

However, if the government views the growth this brings as an illustration of how good their own policies are we could end up with a loss of fiscal discipline. Such action would increase fundamental inflationary pressures and fritter away some of our wealth gains.

Now don’t get me wrong, I agree with parties shifting taxes and spending based on their belief in an equity-efficiency trade-off. However, a loss in fiscal discipline isn’t about a measured trade-off, it is about the potential for waste.

My fear is that our terms of trade boost will lead to the government taking their eye off the ball (no matter what party is in power), as although the government can do very little to influence the rate of economic growth, it still has the ability to throw resources down the toilet (a risk that is highlighted by The Standard’s view of public sector productivity – although I agree that public sector productivity measures are different, such attitudes could be used justification for throwing more an more money at a problem without even thinking about what comes out).

  • Steve Pierson

    It’s simply a statement of fact that all the talk about low productivity in the public sector is flawed. You can’t measure productivity on goods and services that are provided free to the consumer in the way you measure productivty for goods and service that are paid for. There’s no purchase price to set as the value of the goods and services.

    That’s all the statement says. It does not say that we can’t try to get more bang for our buck out of government spending or that there aren’t other measures. I’m simply talking about the applicaiton of the productivity metric.

    I write what I mean to write. Taking a wider inference from my words will tend to lead you down the wrong track.

  • “I write what I mean to write. Taking a wider inference from my words will tend to lead you down the wrong track.”

    I did not need to take any inference from what you wrote to realise that you were defending the negative growth in government productivity in the measured sectors of the economy – by directly saying:

    “Bear in mind also, all the stories you hear about productivity in the public sector being low are just stories”

    I agree that defining value is difficult for some attributes of government consumption, however they do put a whole lot of work into it in order to define some type of value – as a result the statistic is far from useless.

    However the result is so strong that it is unbelievable that you would just blame the productivity measurement instead of looking to see if there are institutional issues in areas such as the health sector (where there very much are).

    Furthermore, as the implicit value of the output is based on what the government values the service at, rather than a market rate, it already incorporates the equity judgment that the government had when it made this policy. As a result, if I wanted to take the measure at face value I would say that falling government productivity implied that it is getting worse at achieving both its equity and efficiency goals.

    As a result, I think that what was written in your post is highly indicative of the type of attitude I was trying to warn against in this post.

    I’m not saying that you meant what you said – but you definitely said what you said. I don’t think any of the political parties really know whats going on with productivity – but that doesn’t mean that the declines in government productivity are “just stories”.

  • Hone

    Two things.

    You say “we should accept that there is a liability we have to pay” and use that as justification for the ETS as currently drafted.

    I am not sure the ETS is about the Kyoto liability. According to the report back to parliament for the second reading of the climate change bill, the point of the ETS is:

    “…supporting and encouraging global efforts to reduce greenhouse gas emissions…”

    And it’s objective is apparently independent of future international arrangements – i.e. independent of future liabilities – seeing as the scheme is being set up to run for the foreseeable future and well beyond the end of existing international arrangements.

    Second, you say “It is fundamentally fair to make people pay the full social cost of their actions. By increasing income taxes to pay for the liability instead of using an ETS or a carbon tax we are making the result of society pay for a mess that these industries are creating.”

    I am not sure that the cost of the liability is caused by the actions of emitters. Another perspective on the liability might be that the social cost of the liability arises from an arrangement negotiated by Government on behalf of all NZ tax payers. Tax payers are the exacerbators of that cost and should therefore pay.

    Taking a wider and more appropriate perspective and accepting that the exacerbators should pay for the global and not NZ specific phenomenon of climate change (and not the Kyoto Protocol liability) there is nothing in economics that I can think of justifying placing costs on NZ emitters in the absence of a tax on other emitters elsewhere in the world. That just leads to a diversion of resources.

    I have often heard people say that other countries ARE putting a price on emissions. I think people should take a second look. US attempts at the bones of an ETS have been dumped by congress. The Aussies are having a crack, but no one knows what their scheme will look like yet (I am willing to wager it will be EU-esque).The EU scheme seems to be going pretty well but covers only something like 40% of their emissions. Maybe they will cover all sectors and all gasses by 2013 as our ETS plans to do but I wouldn’t bet my house on it. I would have to eat my hat if they undermined their massive common agricultural policy with a tax on emissions from agriculture (any time this side of 2050).

    All that means that an ETS should have a default position that says trade exposed emitters shouldn’t face increased costs (and lower returns) until such time as emission prices are reflected in the production of producers that they compete against.

    Seeing as your post is about the terms of trade… If we get the transition right with the ETS – and don’t take on unnecessary costs – we might massively improve our terms of trade. If we don’t get it right, there is no question that we’ll have a worse terms of trade.

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  • Hi Hone, thanks for the thoughtful comment. I will attempt to answer some of the questions now.

    “the point of the ETS is:

    “…supporting and encouraging global efforts to reduce greenhouse gas emissions…” ”

    The Kyoto protocol is the global effort to reduce greenhouse gas emissions. The reason they don’t name it specifically is that they want the scheme to still be applicable should the set of international regulations change. As a result, I think it is fair to assume that the ETS in its current form is meant to deal with our Kyoto liability.

    “I am not sure that the cost of the liability is caused by the actions of emitters. Another perspective on the liability might be that the social cost of the liability arises from an arrangement negotiated by Government on behalf of all NZ tax payers.”

    So fundamentally you are saying that “as a nation” we are willing to pay for our “nations” carbon emissions. My issue with this is that the “nation” is not the appropriate unit to look at when we look at how decisions are made.

    When some firms create a product they produce carbon emissions. If we tax this appropriately then we can make the tax on these emissions equal the cost of the emission in terms of the Kyoto liability. By doing this, only the emissions which society values producing more than the cost they create through the Kyoto protocol will be produced – suggesting that this is a welfare maximising thing to do.

    The ETS is supposed to do the same thing – as the government will get the money from auctioning credits, which it can then use to pay off the liability.

    Steering back to fairness, it is hardly fair that someone who is not receiving benefit from a firm producing carbon emissions, or does not consumer many goods which produce carbon emissions at some point in production or consumption, will have to pay the same amount as someone who produces lots of carbon emissions – as the liability is on the carbon, not a flat fee that the nation would have to pay in any case.

  • CPW

    I don’t entirely agree Matt. Yes, for the reasons you’ve outlined, it’s efficient to have a price on carbon. But that fact isn’t sufficient to conclude that it’s fair that carbon consumers/producers bear all of the burden of the transition from a carbon price of zero.

    Society often takes on the cost of unpredictable shocks (e.g. flood relief, bank bailouts) because it is seen as a fair thing to do. So I think there is a case to be made that society as a whole should absorb some of the cost of reducing carbon emissions. IE, put in a carbon tax/price, but raise the incomes of those affected through a tax funded by everyone.

    Also, I don’t think we want a concept of “fairness” that leads to unambiguous reductions in welfare, which was effectively the NZIER case – a full price for carbon resulting in some cases of NZ suffering lower growth and global emissions increasing as NZ industries move to other countries seeking easier emission regimes.

  • “Society often takes on the cost of unpredictable shocks (e.g. flood relief, bank bailouts) because it is seen as a fair thing to do. So I think there is a case to be made that society as a whole should absorb some of the cost of reducing carbon emissions”

    I think that provides a case for gradually introducing a price for carbon – not for never making the scheme user pays. After all, this isn’t a temporary shock (like a flood), this is a complete change to a new structure for the economy.

    “Also, I don’t think we want a concept of “fairness” that leads to unambiguous reductions in welfare, which was effectively the NZIER case”

    The NZIER case showed a reduction in total economic output – not economic welfare. It didn’t make any claims on the distribution of resources.

    Also our concept of fairness shouldn’t imply lower aggregate welfare in the first place – as long as we accept that the type of fairness we want to promote is that which people value in the first place.

    Furthermore, global emission are not the point – we are only interested in making a scheme that sees us meet our Kyoto obligations at the lowest welfare cost – the NZIER study is the only one to actually conclude that GDP could be lower, and I’m not sure it convinced me of that.

  • CPW

    “I think that provides a case for gradually introducing a price for carbon – not for never making the scheme user pays. ”

    We both support pricing carbon, but as I said before, that belief doesn’t automatically imply that we shouldn’t compensate those who are affected. It would seem to me that a lot of the transition costs are a shock. A better analogy would be the statement “we should have free trade, but we should have social policies that compensate the losers”. It seems like the same principle to me.

    “Also our concept of fairness shouldn’t imply lower aggregate welfare in the first place – as long as we accept that the type of fairness we want to promote is that which people value in the first place.”

    Tautologies don’t advance your case that a carbon price is “fairer” than the alternatives. Leaving aside whether the NZIER study was right or wrong, the point still holds that in the real (messy) world a full carbon price might not necessarily be optimal from a social welfare perspective – in which case society might happily prefer an “unfair” ETS.

    “global emission are not the point”. I strongly disagree. I doubt there would be any public or political support for meeting our Kyoto obligations if the practical result of our policy was costs to us and higher total emissions globally. (of course that is a far-fetched scenario, but still…)

  • “We both support pricing carbon, but as I said before, that belief doesn’t automatically imply that we shouldn’t compensate those who are affected”

    I think we are agreeing that helping to cushion the transition is a good idea, but that, in the long-run, the relative price signals should be appropriate. It is just like the free-trade argument in that regard. I’m sorry but I don’t see where we are differing here 🙂

    “Tautologies don’t advance your case that a carbon price is “fairer” than the alternatives.”

    Agreed (sort of), I was making a value judgment that about what was fair – I don’t see how else I would analyse the policy. My analysis could only be construed as objective if we could compensate the losers and still end up better off than in the tax case – the NZIER analysis debunks this for some potential scenarios.

    Personally, I would prefer us to be in a situation where those who create/consume things that cause emissions pay the cost of it – I inherently gain value from relative prices being efficient. The NZIER analysis was not enough to convince me that any other allocation of burden would be better – if more CGE analysis had reached the same result I would be convinced, but it didn’t.

    “I strongly disagree. I doubt there would be any public or political support for meeting our Kyoto obligations if the practical result of our policy was costs to us and higher total emissions globally”

    It doesn’t matter whether we support the policy or not, we’ve got a liability we have to pay for – off course there are going to be costs. We have to figure out the socially optimal way of paying off this liability – that is the point.

  • CPW

    I was following up Hone’s point that the nation should pay as opposed to the carbon producers/consumers. It wasn’t and still isn’t clear to me when you say things like “those who create/consume things that cause emissions pay the cost of it” whether you mean by “pay the cost”:

    a) make transactions based on prices that reflect the full cost to society; or
    b) suffer the full loss of welfare associated with introducing a true carbon price

    I agree with a) but think there is case against b).

    “we’ve got a liability we have to pay for”

    We are describing a rather Kafkaesque scenario here, but we can always default and face the consequences. In this scenario i would say that the post-Kyoto optimal policy is so uncertain we would be better off not introducing an ETS yet.

  • “a) make transactions based on prices that reflect the full cost to society; or
    b) suffer the full loss of welfare associated with introducing a true carbon price”

    In my view they are the same thing entirely. Accepting the liability ensures that we now face a social cost from our carbon emissions (as it is by unit). The ETS should change prices to reflect this social cost – which will lead to welfare losses.

    “We are describing a rather Kafkaesque scenario here, but we can always default and face the consequences”

    Agreed. The only reason I wanted that put to one side is that it is a whole separate argument. Once we have decided what is the cheapest way to pay the liability, then we can say “is it cheaper to default or pay”.

    I was only against discussing this based on the fact I wanted us to stay on topic – it was a way of avoiding the “global warming is not even happening” hijack.

  • CPW

    My point is that there is no reason why a) and b) have to be the same thing, and arguing that they should be is a different, subjective, argument that has nothing to do with whether a carbon price is efficient. I can see why some people think that the cause of the social cost should bear that social cost (polluter pays) but there are existing precedents for letting society as a whole absorb the social cost of unexpected events. In a world of perfect information this would involve leveling a poll tax on the population and refunding it based on pre-ETS carbon consumption, then introducing an ETS.

  • “My point is that there is no reason why a) and b) have to be the same thing, and arguing that they should be is a different, subjective, argument that has nothing to do with whether a carbon price is efficient.”

    My point is that a) and b) are exactly the same thing in the absence of transfers. If you set the price equal to the socially optimal price you make sure that the total burden is captured by the market transaction. Now this does not mean that the emitter themselves pay the entire burden in shifting – part of it is paid by the consumer (depends on the elasticity).

    Now if the disagreement is on the transfer front, I don’t believe that there is any rational for a long-run transfer of resources between society and industry (which is the only way a and b could be different in the long run) – you can call that subjective all you want, I’m willing to stick to it

    “there are existing precedents for letting society as a whole absorb the social cost of unexpected events”

    Agreed – which is why we should have a “transition period” for the scheme, and why we have grandfathered credits that disappear over time, we are trying to ease the “transition”. We do not disagree on this, and in fact the government is doing this.

    However, when it is a PERMANENT structural change, it will not be in societies best interest to protect industry forever – as you said its the same argument as the free trade argument.

  • CPW

    “I don’t believe that there is any rational for a long-run transfer of resources between society and industry”

    I wasn’t thinking in terms of society and industry (seems like a vague distinction to me), it was just pointing out that this policy will impose higher costs on some people/groups than others. It’s pretty clear that introducing the ETS does not lead to a a pareto superior outcome. In the past you’ve normally indicated that we need to consider the redistributive impacts of such policies, I don’t see how this is a different.

    Any transfer is a PERMANENT claim on resources, so now we’re just arguing about magnitude. The current popular free trade argument is for a PERMANENT transfer from rich to poor via tax and social spending to make up for the (assumed) benefits to high income earners and costs to low income earners of free trade (in developed nations, that is).

    Policy skeptic that I am, I don’t believe there is any consistent set of principles that guides our decisions about when we compensate losers and when we don’t. I think there is plenty of room for debate about the level of compensation required in this case.

  • “It’s pretty clear that introducing the ETS does not lead to a a pareto superior outcome”

    Indeed, as some people are worse off than others – I have already stated that my argument was normative and value-ladden, not objective.

    “In the past you’ve normally indicated that we need to consider the redistributive impacts of such policies, I don’t see how this is a different”

    I guess that depends on how we define fairness. We already have a set of redistributive policies based on income – I don’t see why we have to allow further redistribution based on the loss of value on your endowment (which is effectively what we would need to justify in order to ask for redistribution in this case).

    It appears that our entire discussion here is about transfers. The ETS should, insofar as it acts like the appropriate pigovian tax, lead to the right allocation of resources, we agree on this as well – which means that NEITHER of us believe that flat tax funding of the Kyoto Liability is the right method as relative price signals will be distorted.

    I am assuming that “fairness” would dictate that we don’t need to compensate the losers, you are saying that “fairness” implies that we should. We are never going to solve this as the argument is based solely on value judgments.

    My belief is that since this policy simply reduces the value of some households endowments (the ones that own the carbon emitting resources) and increases the price of purchasing certain products for some houses (energy, fuel), then current redistributive policies based on income are fair enough and so we don’t need to add additional transfers. Any rights based valuation method would find this conclusion abhorrent, but ohh well.

    I realise that such an assumption is implicitly value-ladden, but it is not a pareto-inferior equilibrium, so in a normative sense I am allowed to pick it – as long as I’m explicit about what I think is fair, which I think I have been.

  • CPW

    I think we are in agreement. Yay!