Climate Change Policy: Measures to address - Agriculture Sector GHG Emissions
3. General classes of policy instrument
3.1 Pricing emissions
The pricing of emission rights enables emitters to evaluate the cost of emitting relative to the cost of achieving emission reduction. In this way, environmental outcomes can be achieved in a way that is also economically efficient, provided of course that emissions are priced appropriately. If, as is envisaged by the Kyoto Protocol, emission rights will be internationally tradable, efficient national interest outcomes would be achieved by pricing local emissions at their world price. New Zealand emitters would then be incentivised to reduce emissions up to the point that the cost of doing so is less than or equal to the cost of New Zealand buying emission rights on the world market.
A charge or a rebate ?
There are always two ways in which the government can price an activity, in this case emitting GHGs either by charging a tax (or fee or levy) on emissions, or by paying compensation (a subsidy, rebate or credit) to those who reduce emissions. Both establish a cost for emitting compared with not emitting. But obviously who pays is different under the two approaches – whether it is the emitters or the wider
Community.
Whether pricing should take the form of an emissions charge or payment of compensation for emission reductions depends on the view one takes about who holds the right to emit. If emission rights are viewed as belonging to society, then it follows that 'society' has a right to charge those who emit. This is the “polluter pays” principle. But if it is considered that emitters have an ‘existing use’ right, then arguably emitters should be compensated for giving up some or all of that right. This approach is consistent with a view that because it is wider society that benefits from emission reductions, wider society should bear the cost.
While both approaches are equivalent in terms of establishing a price for emitting relative to not emitting, the difference in who pays can have economic efficiency implications. If compensation is paid for emission reductions, the compensation payments have to be funded from general taxes. And taxes amount to a price distortion and hence result in an economic efficiency cost. This efficiency cost does not arise if emitters are charged for the cost of their emissions, since that serves to internalize the cost of emissions directly and in a way that corrects, rather than distorts the overall structure of prices. But the efficiency cost of making a compensation payment may be still be justified where emitters could reasonably regard themselves as holding a long-established right to emit. In that circumstance imposing a charge may not fairly and equitably acknowledge that property right. Over-riding property rights can give rise to economic costs over the longer term. Having said that, property rights, even if long-held, do not necessarily last forever. As circumstances change, what had been an unqualified right to emit may appropriately be modified or curtailed, to reflect the changed situation. It follows that, once notice has been given of a change in circumstances, the policy justification for paying compensation for emission reductions, rather than charging for emitting, may be confined to a transitional period.
Pricing emissions or emission proxies?
In the case of agriculture emissions there is a further, practical, matter. Because most agriculture emissions are not ‘point-source’ emissions, it is difficult for them to be attributed, and hence priced, directly to individual emitters. Rather, they can be priced only by imputing emissions to inputs and activities that are known to result in emissions, or emission offsets. These include nitrogen fertilizer, livestock (or production proxies for livestock, eg, milk solids and meat), and nitrification inhibitors. An average emission, or emission offset, factor for each of these can be determined scientifically, which, in turn, can be given a monetary ($) value, for a given a emissions price.
If emitters face a charge on the causes of emissions, or a credit for emission reductions, they face an incentive to manage those particular inputs and activities in ways that achieve emission reductions efficiently. However, the effect of the pricing incentive is confined only to the particular variable to which it applies. For example a charge on nitrogen fertilizer has no influence on decisions about whether or not to apply nitrification inhibitor. By contrast, if N2O (and/or methane) emissions could be measured on a farm-by-farm basis, attaching a charge directly to them (or
paying a credit for reductions) would result in emitters facing an incentive to mitigate across the full range of possibilities, and the ability to trade off amongst them according to which is most efficient for their particular situation. Absent that possibility, the next best approach for achieving emission reductions with maximum efficiency is to attach a price – either a charge or a credit – to as wide a set of sources and offset proxies as possible.
Pricing all emissions or ‘excess’ emissions?
Under the Kyoto Protocol, emission rights up-to-1990 levels are allocated to the government for free: it is only emissions above that level that give rise to a ‘Kyoto responsibility’. Hence, if the government was to apply a zero-based charge to emissions4, including for up-to-1990 levels, that would be fiscally positive:
Emitters would be charged for more emissions that the Government would be liable for.
One way by which an emissions charge can bring about a shift in relative price, without resulting in a fiscal impost greater than the corresponding Kyoto liability, would be to charge, at the world price, but for emissions only above 1990 levels (‘excess emissions’). A pragmatic approach would be to designate a proportion of today’s emissions as the pre-1990 level, to be charged at a zero price, with that proportion for each emitter, or emission source, based on by how much the aggregate level has increased since 1990. Indeed, if the government considered it appropriate for itself to bear some of the cost of the post-1990 increase in emissions, the charging threshold could be set higher, perhaps at today’s level in which case only future increases in emission levels would be charged. Of course, under such a regime, emissions below the chosen threshold would then not face any incentive for reduction, even if some of those emissions could be reduced at lower cost than others above the threshold. That would be inefficient.5 An alternative, that would also avoid a fiscal impost greater than the Crown’s Kyoto liability, would be to set the rate of charge (applied to a zero base) below the world price. However, that would mean marginal emissions would no longer be priced at their marginal cost, and the regime would be even less economically efficient. Almost certainly, some emitting that it would be economic to curtail at the world price would continue.
The counterparts to these two approaches under a compensation (rather than under a charging) regime would be to compensate emission reductions only down to a threshold level, or to set the rate of compensation below the world price of emissions. Both would result in a smaller fiscal outlay than compensating all emission reductions in full (which mirrors how part-charging would avoid an unnecessarily large fiscal impost). But they would also be inefficient in terms of establishing the appropriate marginal price for the marginal emission. Setting a floor below which emission reductions would not be compensated would mean, as in the case of charging only above a threshold, that some emission reduction possibilities may not be taken up even though they could be achieved at relatively low cost. And if the rate of compensation was set below the world price, emitters would not be incentivised to reduce emissions down to the point where marginal cost equals the value of the emission reduction achieved. The most efficient approach overall – that would result in all emissions facing their full price, while also maintaining fiscal balance – would be to charge above the 1990 threshold and compensate reductions in 4 Or, practically, to emission proxies. 5 Although it is a scenario that may be more theoretical than real, at least in the case of a 1990 threshold. In that case, with emissions today mostly well above the 1990 level, there may be few emitters with low cost options for achieving what would have to be deep cuts in emission levels.Emissions below that threshold. Fiscal balance ensues because the government’s liability for any emissions that continue above 1990 levels would be funded by the charge, and the fiscal cost of compensating emission reductions below 1990 levels would be offset by the corresponding diminution in the Crown’s Kyoto liability.
3.2. Cap-and-trade models
An alternative to the government being the pricing intermediary in an emissions pricing regime is for it to allocate a quantity of emission rights and to enable those rights to be traded, and hence priced, in a market – a so-called ‘cap-and-trade’ regime. Under such an approach, those for whom reducing emissions are most costly are prepared to pay the most for the emission rights that are available, and those who can reduce emissions face an incentive to do so and thus make emission rights available to the market, up to the point that marginal cost equals the price at which an emission right can be sold. Under a cap-and-trade regime, the quantity of allowable emissions is set by the government, and the market determines the price. Cap-and-trade approaches, therefore are more apt either when the policy objective is to achieve a quantitative outcome in its own right (for example, a quantitative limit on leaching to a water body, or an absolute cap on GHG emissions), and/or where the government wishes to be able to take something of a step back from on-going direct involvement in the process.
On open or closed market?
The cap-and-trade approach just outlined relates to where the market is “closed” and emission rights cannot be bought or sold outside of it. But if emission rights can be bought and sold internationally, then, given that New Zealand is small relative to the world market, there is no longer any cap on New Zealand’s emissions. In that case, the ability to trade emission rights internationally results in the domestic price of emissions converging on the world price. Thus, an ‘open’ cap-and-trade regime would deliver emissions pricing and hence emission levels essentially the same as would result from the government directly pricing emissions at the world price. The main difference between a cap-and-trade regime and direct government pricing that would remain concerns the role of government: whether it plays an intermediary role, or having once allocated emission rights, steps back from the process and leaves market participants to interact directly.
Emission right allocations
A key issue in the design of any cap-and-trade model is the allocation of initial rights. These can be allocated either for free, typically on the basis of existing use rights, or at a price, for example, through a tendering process. The latter implies that existing use rights are society-owned, and the former that emitters have existing use rights. The issue here is essentially the same as that concerning whether to charge or to provide a credit under an emission pricing regime. Requiring those receiving an initial allocation of emission rights to buy those rights is the economic parallel of levying emitters with an emissions charge (the emission rights can be thought of as being either bought outright, or alternatively as rented and thus subject to a user charge). And a free allocation of emission rights (which can be sold) is the economic parallel of paying compensation to emitters who reduce emissions. Because, under the Kyoto Protocol, up-to-1990 emission rights are allocated to governments free of charge, there may be a presumption in a cap-and-trade regime that rights up to the 1990 level would also be devolved for free, with only allocations above that level having to be bought. That would be the equivalent, under a government pricing regime, of the government charging for emissions only above a 1990 threshold and compensating emission reductions below that threshold (as described above).
Offset schemes
Offset schemes can take a variety of forms but generally entail a requirement that an emitter take actions to offset an increase in emissions with a corresponding reduction in emissions elsewhere. Those actions may be taken by the emitter itself, or might involve a bilateral arrangement under which an emitting activity undertaken by one party is subject to an emission reducing activity being undertaken by another, or might involve one party funding the emission reducing activities of another.
An offset scheme under which the emitter itself is required to undertake emission reducing activities is inherently constraining, and hence economically inefficient compared with broader-based arrangements. To some extent a bilateral offset arrangement, which in effect is a barter transaction, is also constraining. Nonetheless, allowing an emitter to offset emitting activities in these ways is less inefficient than a rigid restriction that allows no such flexibility.
Broadening the scope of an offset scheme to allow required offsets to be funded with money further relaxes the constraints inherent in offset schemes. If full funding of the offset project is required, the remaining constraint would be a financial rather than physical. Greater flexibility still could be achieved if just the value of the offsetting emission reduction had to be funded or, in other words, if an emitter could purchase the emission credits required to offset its own increased emissions. That, of course, in effect, would be a cap-and-trade model.
For any kind of offset scheme to operate, the emission properties of the activities within its scope would need to be determined so as to establish the ratios at which one activity would be accepted as offsetting another, eg, how many trees would offset an additional head of livestock. And in many respects similar administrative machinery as required for a cap-and-trade arrangement also would be required, including for example, a registry of emissions and of their offsets, and of the contracts that tie one to the other. As will be evident, an offsets scheme in which emissions could be offset by purchasing emission credits for money would be little or no different from an emissions cap-and-trade arrangement.
3.3 Mandatory emission standards
Setting mandatory emission standards may be preferred over price-based measures where a quantitative outcome is the overriding objective, and/or the transaction and administrative cost of a cap-and-trade regime would be excessive. The major shortcoming of a mandatory standards approach is that it is more difficult to take account of the cost of achieving the standard mandated. Implicit in quantitative regulation is always a ‘shadow’ price. Without that price being made transparent, there is a risk of interventions that impose costs that are greater than the benefits they deliver. Nonetheless, direct regulation is often considered appropriate. For example, lead compounds in petrol are now prohibited, not priced. In that case the health consequences have been assessed to be sufficiently severe that we can be confident that the benefit from eliminating lead outweighs the cost – without the need for any assistance from a market-based price discovery process. Direct setting of standards can also be more appropriate where the costs are reasonably uniform across all users, for example, the cost of a catalytic converter for one vehicle is much the same as for another. Hence, there is limited scope for the desired outcome to be achieved more cost-effectively by some agents responding more than others. By contrast, within the agriculture sector, and across different industries, conditions vary substantially from one situation to the next, and generally it will be possible for some firms to reduce GHG emissions at lower cost than others.
3.4 Voluntary approaches
There are many examples internationally of programmes that support, or promote, ‘voluntary’ emission reduction efforts. These can draw on firms seeking to establish social responsibility credentials, eg, by way of ‘triple bottom line’ accounting, or wishing to establish baselines should charging, or cap-and-trade regimes, be introduced at a later date. They can also play a role in developing the infrastructure required for cap-and-trade arrangements, for example, by enabling reporting of emissions to emissions registries to be piloted as a forerunner to emission rights becoming a tradable right.
The international evidence indicates that voluntary programmes, at least by themselves, generally have little discernible effect on emission levels without a credible threat of pricing or regulatory action if voluntary’ targets are not met. On the other hand, it is also apparent that over extended time frames, societal norms and expectations can change; what people and firms might have done only under compulsion or threat of penalty a decade ago they may do voluntarily today. It is not difficult to think of examples in other areas of policy where a combination of instruments directed at changing incentives and at shifting societal norms have had a significant impact, eg, drink-driving, and smoking.
3.5 Extension activities
In a similar vein to the role that can be played by voluntary emission reporting programmes, extension and information dissemination activities can reinforce price- and market-based instruments. For incentives, whether positive or negative, to be effective, there needs to be market awareness of them, and of the costs and benefits of emission-reducing options and opportunities. Put more generally, for markets to work well, they need to be well informed.
Dissemination of authoritative and unbiased information can have a role in hastening the uptake of new technologies. Specific examples might include productivity gains that can be achieved from the use of nitrification inhibitor (quite apart from GHG benefits) and from nutrient budgeting by farmers. Such extension activities can be expected to be most effective when designed to support other interventions and/or to bolster industry-based extension-like activities, for example the activities of the field officers of the fertilizer manufacturers and Fonterra’s programme of encouraging its suppliers to use nutrient budgeting.6
3.6 Agriculture sector GHG related research
6 A nutrient budgeting tool, such as OverseerTM accounts comprehensively for nitrogen inputs (eg, fertilizer and bought-in feed), and outputs (animal protein), and hence provides the information required to achieve maximum nitrogen efficiency, as well as estimation of the nitrogen ‘surplus’ retained in the soil, but eventually leached/emitted.
Authoritative research is critical if GHG emissions from agriculture are to be:
• Accurately measured (for GHG inventory purposes);
• Managed and mitigated.
A number of factors point to New Zealand playing a significant research role with respect to agriculture GHG emissions:
• The relative absence of existing mitigation technologies for agriculture emissions, other than by curtailing production;
• New Zealand’s agriculture sector-dominated GHG emission profile;
• The uniqueness of that profile amongst Annex 1 countries, which means that the incentives for research in this area outside of New Zealand are not strong.
If emissions (and emission reductions) were priced, the sector itself would be incentivised to fund research that has a reasonable prospect of payoff. But there can be a ‘catch 22’. For example, if nitrification inhibitors are to be taken into account in the calculation of New Zealand’s GHG emission inventory, further research will be needed. But the incentives for private research will be lacking unless there is some degree of assurance that if the research is successful and establishes the means by which agriculture emissions in New Zealand’s GHG inventory can be reduced, the resulting economic value will flow back, either directly or indirectly, to those who provided the research funding.
Co-ordination problems can also result in less private research than is optimal. These can stem from the decentralized nature of the New Zealand agriculture sector, which comprises a large number of small, independent, farm units. This appears to be one of the reasons why a significant amount of agriculture research in New Zealand is publicly funded, although private research is also funded by fertilizer manufacturers and the dairy and meat processing companies.
Research is inherently risky and, where publicly funded, mechanisms are needed to establish a reasonable prospect of pay-off. Co-funding requirements can play an important role in this regard. Subjecting research projects to the test of whether firms with a direct commercial interest in their success are willing to contribute risk capital can provide a good indication of the prospect of success.
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