Paul Young says higher carbon prices can make our tax system fairer and more progressive, while tackling the urgent crisis of climate change

This is the seventh of ten articles in the Public Service Association's "Ten perspectives on tax" series.*

By Paul Young*

The rationale is simple: emissions impose a cost on society, and exposing polluters to this cost will incentivise change. ‘Internalising’ the cost through carbon taxes¹ or emissions trading will reduce demand for carbon-intensive products, make cleaner alternatives more competitive, and spur low-carbon innovation.

Beginning with Finland’s carbon tax in 1990, pricing schemes have expanded to cover 13 percent of global emissions.²

In New Zealand, following a tortuous and ultimately unsuccessful effort to put in a carbon tax, the Fifth Labour Government passed the Emissions Trading Scheme (ETS) late in its reign in 2008.

The failure so far to deliver a strong and reliable price, and to reduce New Zealand’s emissions,³ has eroded support and led to calls to start over with a carbon tax.

In this chapter, I discuss where to from here and argue three main points. First, that a reformed ETS can deliver results with the right political intent. Second, that New Zealand’s overall level of carbon pricing is low. And third, that higher carbon prices – if done right – can not only reduce our emissions, but help us build a fairer and more prosperous country.

A big fat price on carbon

“The appropriate price is what I call very scientifically ‘A Big Fat Price’ on carbon. You have to give very strong signals about the fact that you want to push out carbon.” - OECD Secretary-General, Ángel Gurría⁴

What price do we need? One approach is to determine a ‘social cost of carbon’, which the OECD argues can be “very conservatively” set at EUR 30 (NZ$45) per tonne of emissions.⁵ These assessments are contentious and values-laden; some studies find costs exceeding US$200.⁶ A second approach estimates the price needed to reduce emissions in line with agreed global temperature goals. A recent International Energy Agency study found CO2 prices should rise to US$120 (NZ$170) by 2030 in OECD countries for a reasonable chance of keeping global warming under two degrees.⁷

The price level is key, but so too are price reliability and predictability. Furthermore, even a strong carbon price will not be sufficient alone; it must be part of a broader policy package.

Reforming the ETS

The ETS has delivered neither strong, reliable nor predictable prices to date. This sorry tale has been told elsewhere.⁸ But the root of the problems has been political decisions, not the tool itself.

Most critical was the lack of limits on the quantity of foreign carbon credits participants could use. Since New Zealand was cut off from Kyoto Protocol carbon markets in mid-2015, the ETS has been recovering. With the phase-out of the “one-for-two” subsidy underway, polluters currently face a price around NZ$11.50 per tonne.⁹

Further change is needed. The ETS could be reconfigured as follows to deliver stronger prices and greater predictability, while retaining key advantages of trading:

1. Keep it closed from other markets for the foreseeable future;¹⁰

2. Introduce government auctioning of emissions units up to a fixed cap;

3. Introduce a price corridor with lower and upper limits (managed through auction reserves);

4. Set levels for the cap and price corridor several years in advance, with an indicative range extending further.

In this model, the government, not ETS participants, would lead any purchase of international carbon credits to help meet New Zealand’s commitments.

This model would establish a transparent, shrinking cap on New

Zealand’s emissions. It would give clear future price signals to guide low-carbon investments. Finally, it would generate revenue for the government, who could add it to the public purse, recycle it through rebates or reductions in other taxes, or invest it in targeted low-carbon infrastructure and programmes.

A broader view on carbon prices

Most developed countries have a range of specific taxes on energy use (for example, fuel taxes). Regardless of the reason for implementation, these impose an effective price on carbon.

In all but a few countries, energy taxes currently vastly outweigh explicit carbon prices.¹¹ Overall, New Zealand has among the lowest effective carbon prices in the OECD. This strengthens the case for increasing our carbon price, and for considering a broader range of pricing instruments than just the ETS, such as the following.

Unlike a fuel tax, our unique road user charge system for diesel vehicles doesn’t penalise less efficient vehicles. The OECD has recommended introducing an excise duty on diesel.¹²

It is particularly urgent to avoid investments in long-lived, carbon-intensive assets, such as coal boilers. In the absence of a sufficient ETS price, one idea is a targeted levy on new boilers equivalent to, say, a carbon price of at least $100 per tonne.

While debate rages on about whether and how to include biological emissions in the ETS, we could start with a simple tax on nitrogen fertilisers with revenue used to fund native revegetation.

I would even make the case – at least in the short-term – for a fossil fuel levy on top of the ETS. This could be done relatively easily by charging a ‘surrender fee’ on each emissions unit.

Smoothing the transition

Concerns around rising carbon prices tend to gravitate around two poles: impacts on low-income households and impacts on trade-exposed businesses. Both are legitimate issues, and both can be managed through careful policy design. Current ETS settings are overly generous on the latter, while doing nothing about the former.

Emissions-intensive, trade-exposed activities get a free allocation of emissions units, reducing companies’ price exposure by up to 90%. There are problems with how this is done, but the biggest issue is opportunity cost: free allocation represents foregone revenue. While there is a case for transitional assistance, this must be weighed up against other uses of the money.

Elsewhere, carbon revenues are commonly recycled through rebates or tax reductions targeted at low-income households. Many governments also use a portion of the revenue to invest in a low carbon future. This too can be targeted towards those most vulnerable to the impacts of climate policies – for example, home insulation subsidies for low-income households, and retraining programmes for workers in carbon-intensive industries.

Depending on how the revenue is used, carbon pricing may even boost GDP growth.¹³ Research shows that environmental regulation has significant positive effects on long-run productivity.

With wise implementation, we have nothing to fear and much to gain from higher carbon prices. They can make our tax system fairer and more progressive, while tackling the urgent crisis of climate change.

*Paul Young is a researcher and writer with the Morgan Foundation focused on climate change and environmental issues. He co-founded Generation Zero in 2011. This is the seventh article in the PSA's "Progressive thinking series, Ten perspectives on tax."