Aldyen Donnelly: The pitfalls of cap and trade

(Jan. 19, 2011) Aldyen Donnelly explains why cap and trade policies are inefficient and regressive.

“Cap and trade” is nothing more than quota-based supply management for carbon-based commodities.  “Cap and trade” is to energy, building products and food products as “dairy quota” is to milk, butterfat and cheese.

I remain quite astounded that so many senior Canadian economists (both academics and bank-employed) vehemently describe quota-based supply management as a measure that will increase market efficiency as we drive up prices in the carbon-based commodity sectors to support uncompetitive supply options, while they actively and accurately report that cap and trade introduces inefficiencies when it is used to drive up prices to support uncompetitive milk, butterfat and cheese supply options.

It is entirely reasonable to debate and disagree about whether or not the benefits out weigh the costs/inefficiencies and market distortions arising from supply management—in particular, the increase in market power that any quota regime inevitably confers on entities that had large shares of the quota-covered market just in advance of the imposition of the quota regime.  But to describe a quota-based supply management regime as a mechanism that increases efficiency in any market context, as Canada’s leading economists often do, is just plainly illogical.

Are we living in some continuous loop Monty Python movie?

What Is the Efficient Regulatory Alternative to Quota-Based Supply Management?  Not Energy/carbon Consumption Taxes

Remember, if a carbon tax generates new public revenues, the tax is, by definition:

  • sub-optimally priced and, therefore
  • highly inefficient.

Carbon Taxes Kill Value Added Export Revenues

Domestic energy consumption taxes increase the price Canadians pay for made-in-Canada energy products relative to the price foreign consumers pay us for their use of those same products.  In this way, carbon taxes cause capital to fly from value-adding production capacity in Canada—remember that 85% of GHG emissions occur in the value-adding and consumption parts of the full fuel cycle—to add value and shift jobs into the markets we increasingly supply with raw resources.

Carbon Taxes are Highly Inefficient Behavioural Change Mechanisms

Energy consumption taxes are also highly inefficient.

As is clearly pointed out in most Econ 101 through 300 textbooks, consumption taxes might efficiently shift consumer behaviour when the point of taxation is the point at which a primary consumption decision is made.  Most personal and corporate energy demand decisions are secondary.

A family’s energy demand is derived from the place they elect to locate their home and—given the transportation demand and transit options arising from that decision—the car(s) they elect to purchase.  This primary home location decision is largely a function of their income, concerns about safety, locations of schools and work, etc.  An energy efficiency-rating weighted tax on home and car sales will still be inefficient, but could change consumer behaviour somewhat, at much lower annualized tax rate than a tax applied to utility bills and gas pumps.

When governments elect to introduce tax measures as “behavioural change” mechanisms and then place the tax on secondary or derived consumption decisions, those governments have (intentionally or unintentionally) expressed a significant preference for new revenues over behavioural change.

Remember, government revenues equal taxed consumption multiplied by the tax rate.  Governments can have the tax revenues or the consumption reduction.  But they can’t have both.

Further contributing the inefficiency of consumption taxes is the well-known and documented tendency of humans to display very high “internal discount rates”.  To a greater and lesser degree across developed societies, even well educated persons will pay very high effective interest rates or pay high expenses to avoid capital expenditures.  This explains why Canadian banks operate vibrant and highly profitable credit card businesses charging 29% interest.

The data clearly suggests that an annual car re-registration tax—weighted to reflect energy efficiency rating, weight and distance travelled since the last registration—would likely shift consumers’ car purchase and use decisions at an annualized tax rate as little as one-third of what the annualized tax rate would have to be to achieve the same behaviour change with a tax that applies at the gas pump—paid in 12 to 30 annual increments instead of once a year.

That is because the annual re-registration/insurance renewal feels, to most consumers, much more like a capital expenditure than an expense.  However irrational it is to prefer to pay more, more often, than less, less often, this human preference is indisputable and strong.

An Income-to-Energy Tax Shift is Unsustainable

Provincial government agencies, Crown corporations, municipal governments, hospitals, universities, schools, churches, social service providers, etc., all pay energy taxes and rarely pay income taxes or grants in lieu of income tax. So, by definition, when a government elects to finance income tax rate cuts with new energy tax revenues, the government initially shifts overall tax burden from private corporations and persons to government agencies, hospitals, schools and other taxpayer-financed public service delivery vehicles.

Therefore, an immediate and direct result of implementing the income-to-energy-tax shift is a need to further cut public service levels and/or increase some other set of taxes or government charges to finance the new energy tax costs that have been shifted to public agents.

An Income-to-Energy Tax Shift Throws Governments Into Revenue Death Spirals

Finally and most importantly, energy consumption taxes are highly regressive, which, in turn, makes them even more inefficient.

When we finance income tax rate cuts with new taxes on energy consumption, we massively shift overall tax burden from high net worth individuals and profitable corporations—who pay energy taxes out of pre-tax revenues and, therefore, offset some or all of their new energy tax liabilities with reductions in their income tax and resource royalty liabilities—to lower income families and marginal small businesses.  Then, as a result, we have to introduce administratively costly public programmes to immediately return the new tax increase we just collected from poor families back to those families in the form of income support payments, rebates or tax credits.

The immediate result is:

  • an increasing share of total tax collections is eaten up by the perpetually increasing costs of administering the lower income family tax recycling regime, and
  • because the costs of collecting and returning the increasing share of the total taxes paid by low income families increases faster than revenues collectable from wealthier families, the income-to-energy-tax shift proves to be an unsustainable public revenue death spiral.

The highly regressive nature of the income-to-energy tax shift, on top of the shifting of the overall tax burden from the corporate to the public sector, inevitably throws government into an unsustainable spiral of continuously increasing public sector costs and declining ability of the private sector to pay.

How Have We Efficiently and Effectively Protected Health, Safety and the Environment in the Past?

In the past, when we have been serious about increasing health, safety and environmental impacts arising from the sale and/or consumption of key products, we have done so by regulating product standards.  A product standard obliges the suppliers/vendors—not necessarily the producers—of products that contain the offending hazardous components or hazard  precursors to regularly report their Canadian sales, the % hazardous/precursor content in those sales, and to demonstrate that the actual % content is under a regulated limit.

Often—as in the leaded gasoline and ozone-depleting substance phase-outs—the regulation creates some certainty for the market by incorporating a % limit that descends over time per a fixed schedule. The % content limits can be more stringent for new market entrants than incumbents, but usually declines at the same rate over time.

Product standards are always more efficient than point-of-production standards, because the product or point-of-sale standard treats all domestic regulated commodity sales equally, regardless where the regulated commodities were made.  There is, therefore, no need to introduce administratively expensive and typically sub-optimally priced tariffs on imports to “level the playing field” for imports relative to regulated domestic production.

The electricity system in every car sold in Canada has to comply with the same Canadian safety standard, regardless where the car was made. End of story.

Can you imagine if Canadian regulators had, in the past, regulated lead in paint in the manner the carbon quota system advocates currently propose we use to address fossil carbon content?

What if Canada’s regulators had: (1) pronounced lead a human and ecosystem health risk, then (2) prohibited or ordered the phasing out of lead in paint manufactured in Canada, then (3) allowed for leaded paint imports as long as the importers paid a lead tariff?  There would have been a public uproar.  But that is the very strategy the environmental movement and most academics are advocating to control and reduce fossil carbon consumption and related dangerous GHG discharges!

It might be worth noting that there is no history to suggest that when we apply tariffs to certain classes of imports that the net result is a sustainable reduction in those imports in the absence of absolute government control of both domestic prices and total sales of the regulated product(s).

Typically, when we have assigned tariffs to commodity imports, the net result has been a delay in the natural rate at which wages paid by offshore suppliers would have otherwise increased over time.  So all the tariff regimes do, most of the time, is effect a wealth transfer from lower wage producers to the government of Canada—a perverse outcome we then try to mitigate with international aid contributions—while import levels remain little changed.

Also, of course, import tariffs tend to spawn an increase in smuggling of the covered goods.

Sometimes—for example, in the Canadian leaded gasoline and ozone-depleting substance phase-outs—our product standards have allowed any combination of regulated entities (the suppliers of the regulated products) to “comply jointly.”  That means they can staple together their sales and content reports and if the sums of the combined reports complies with the % limit, then all of the entities are deemed to have complied with the regulated content limit.

The product standards also can allow entities or combinations of reporting entities to bank any implied right to distribute the regulated content that is not used this year, so that they can use it (add it to their limit) in the future.  Usually this banking right is time-limited, so as not to compromise the overall health and safety objective over the long term and to limit the ability of market participants to artificially inflate market prices by hoarding and banking unused content limits.

Our dairy quota regime limits the amount of production quota any farmer can carry over to the next year to 5% of his total entitlement.  If a farmer banks the full 5% for a number of years in a row, the regulators then limit the amount of quota he is qualified to buy at auction to an amount equal to his actual recent sales levels.  This very high level of government intervention in the quota market is required because of the very significant opportunities that arise to manipulate market prices through quota hoarding.

Obviously, when these joint compliance and entitlement banking options are embedded in a point-of-sale product standard, the private sector can and will create a vibrant, real and relatively disciplined secondary market for bankable regulated content entitlements. This privately operated secondary market fore regulated content will almost always operate efficiently—as long as government is not directly involved in market development, administration or settlement and clearing..

There has been no government creation of a quota supply, quota allocation or auctions, government administration of the settlement and clearing system, etc., associated with our historically successful product standards.  Quota is not necessary to generate secondary market activity.  But quota does introduce significant new market distortions.

To build the quota regime—as well as to develop and administer any carbon tax regime—governments have to do a number of things that governments do not do when they promulgate product standards:

  • Pick the new content/technologies/processes that should replace the content/products that will be phased out
  • Set prices or price limits for the regulated and sometimes even for the new unregulated products.
  • Pick corporate winners and losers (in the quota allocation and/or auction design process).
  • Manage the difficult trade-off between the need for government revenues and the desired health, safety and/or environmental improvements, which trade-off only exists because government elected to implement quota-based supply management or consumption tax measures and would not exist if government elected to implement product standard (point-of-sale, portfolio sales average content-limiting regulations).

Market participants respond to fill new demand created by product standards with new rounds of innovation and price competition.  When governments pick solutions, set prices, cap prices, directly control supply, pick corporate winners and losers or perpetuate market shares with quota allocations, those governments break the only two tools available to the private sector: innovation and price.  Efficient and effective regulation leaves innovation choices and price determination to the market.

What Does a Bad Product Standard Look Like?

An efficient product standard prescribes a health, safety or environmental outcome in content terms and does not prescribe new or alternative technologies.

For example, Canadian regulations that forced the lead out of gasoline and CFCs out of refrigerants were very efficient.  These regulations ordered perceived hazard precursors out of the consumer product supply chains over a defined period, but did not dictate, in any way, what new processes or products would fill the resulting production/supply vacuums.

By comparison, existing US and Canadian fuel standards that dictate minimum ethanol content are highly inefficient.

If governments truly wanted fossil carbon content to decline as a % of total transportation energy consumption, then they should have regulated energy sales portfolio average fossil carbon content limits that decline over time—at the point of sale.  Some market participants would have elected to comply with the new regulation by increasing ethanol content.  Others would have shifted their energy sales mix to cut back gasoline’s share and increase the diesel and/or green power shares of their total sales.

Ethanol suppliers would be successful only if they could compete with the other energy sales portfolio management options.

Another example relates to light bulbs.

In the recent past, Nova Scotia promulgated a regulation that precludes the retail sales of any bulbs that fail to meet certain efficiency (lumens per watt) and longevity (minimum operating hours) standards.  This regulation leaves it to the manufacturers of all kinds of lighting technology—incandescent, CFL, halogen, LED—to innovate and compete to comply with the performance standards and deliver new generations of their products to the market at competitive prices.

By comparison, the BC government legislated a ban on compact fluorescent technology and failed to establish minimum light quality, energy efficiency or longevity performance standards for the bulb technologies that remain legal for sale.

Which of the two examples of light bulb standards do you think will produce the highest new product quality, greatest new investment in innovation, at the lowest market price, over time?  I will give you a hint.  There is a small new highly efficient light bulb manufacturing facility in Nova Scotia.

Read more of Aldyen’s blog postings here.

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