The importance of pricing

Dr Eric Crampton
16 July, 2019

Maybe things would be different if somebody had 'invented' prices. We tend not to understand and appreciate institutions, like prices, that emerge spontaneously through human interaction rather than are the product of human design. Because we do not appreciate how they work, it is too easy to miss how they can improve things in areas where they haven’t traditionally been used.

That is especially the case when it comes to climate change. Getting a consistent price on greenhouse gas emissions, and one that is not out of step with our trading partners, is the most effective thing that New Zealand can do to mitigate greenhouse gas emissions. Strengthening the Emissions Trading Scheme and tightening the ETS cap over time to track European prices simply makes more sense than other alternatives.

Economist Alex Tabarrok describes prices as a signal wrapped in an incentive.

Prices signal relative scarcity. If something becomes more scarce relative to demand, prices will rise. That price change signals the change in relative scarcity. At the same time, the price signal provides an incentive. Every user of the good that has increased in price has an incentive to change their own use of the more-scarce good – if they get less value from that good than other users.

It is easy to see in every other area where prices have worked their magic for ages. If the price of aluminium increases for whatever reason, suppliers see it as a signal to increase their own production if they can do so profitably at the new price, and users see it as a reason to economise on their own use.

Some suppliers will not find it profitable to increase production, and some users will not change their behaviour either. But that hardly means that prices do not work: it is not a bug but a feature. When prices are working properly, those who find it easiest to change their behaviour are the ones to do so.

If we tried to achieve the necessary reduction in use via sector-specific quotas, it would be a nightmare. Some who get a lot of value from using aluminium would have to cut back on their own use, while others who could easily shift to other materials would not bother to do so. The same reduction in aluminium use would cost the country a lot more.

The same is true with carbon dioxide emissions and carbon prices. New Zealand has committed to reducing greenhouse gas emissions through international agreement. Strengthening the Emissions Trading Scheme provides the best way of getting there. Fortunately, the government has strongly signalled that it will be doing the necessary work – but there is a fair bit to do to get there.

Under a strengthened ETS, every sector would face the same price for greenhouse gas emissions. All gases would be converted into their carbon dioxide equivalents for trading purposes. The system would have a binding cap. Under a binding cap, it really does not matter whether one household, firm or industry increases its emissions: the total quantity of emissions would be unchanged. Every tonne of emissions quota purchased through the system would mean that someone else in the system has given up the right to emit a tonne of emissions.

The case for other policies in addition to the ETS then becomes rather fraught. Cabinet papers on the government’s proposed tax and subsidy scheme for more efficient vehicles include Treasury’s short reminder that transport is already in the ETS. At a $25/tonne carbon price, every petrol user pays about $0.07/litre in carbon charges at the pump. If carbon prices here rose to European levels of about €30/tonne, the per litre fuel charge would increase to about $0.14/litre. 

That $0.14 per litre may not sound like much. I would not change my own driving practices by much if fuel prices went up by seven cents per litre, and I might not give it much thought when it finally comes time to replace our 2008 Honda Odyssey. But remember that the point of the price is not to make anyone in particular change what they are doing. Rather, it is to ensure that those who are best able to change their behaviour are encouraged to do so. Under a binding ETS cap, every bit of carbon credit that I buy as part of my fuel purchase is a bit of carbon dioxide that is not emitted by someone else.

And while there is visceral appeal to the argument that using prices is harder for the poor, that is hardly an argument against using prices: We do not prohibit winter increases in vegetable prices because of effects on household budgets. It is instead an argument for ensuring that any initial allocation of emission credits is equitable, or for using the tax and transfer system to offset any otherwise-inequitable effects.

More active policies in transport, like mandates on fuel efficiency or subsidy regimes for more fuel-efficient vehicles, risk forcing emission reductions in areas where it is relatively more expensive to reduce emissions. 

The logic extends to other policy areas. Last week’s Local Government New Zealand annual general meeting brought a remit from local governments asking central government to include climate change in the Resource Management Act. If the RMA were so changed, local councils would need to evaluate the effects of consenting decisions on climate change. But where carbon prices are working properly in ensuring that every tonne emitted is paid for through the ETS, then councils here can really add nothing but additional delay and higher consenting costs.

There is complicated work to do in getting there.

Agricultural emissions are legitimately difficult. When some of our major competitors in agriculture do not price agricultural emissions and emit more greenhouse gases per animal than New Zealand does, it is possible to induce perverse outcomes: reductions in agricultural production here would reduce New Zealand emissions, but global emissions could increase. Working out practicable ways of avoiding those outcomes while still encouraging shifts toward less carbon-intensive agricultural practices is important.

Similarly, the politics of getting a workable and comprehensive ETS are difficult. One implication of standard economics is that the initial allocation of carbon emission credits should not have big effects on who reduces their emissions. If the government granted emission credits to existing users, with those granted credits reducing over time to get to the cap, climate outcomes should be about the same as if the government required all emitters to purchase credits through a government auction. Granting credits to existing emitters helps a more just transition and, in doing so, reduces opposition to new sectors’ inclusion. But designing that allocation is also difficult.

In most other areas, nobody has had to design prices. They have simply emerged from the spontaneous interactions of millions of people and, every day, help coordinate between our infinite wants and finite resources.

But no price on carbon would emerge without government either setting a cap on total emissions and coordinating an ETS, or taxing greenhouse gas emissions directly. That work is terribly important. But because it feels less like actively working to reduce emissions to meet the global challenge, it can be underappreciated.

Where government capabilities are also limited, diverting bureaucratic effort away from strengthening the ETS and towards other policies that are far less likely to be cost-effective is doubly damaging. It not only increases the cost-per-tonne of emission reductions directly, but also delays the more important work necessary on the ETS. Strengthening the ETS should be our first priority. 

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