Moral hazard in emissions trading

Moral hazard is an interesting concept in economics. It’s the problem that someone protected from risk may behave differently from how they’d behave if they were fully exposed to the risk.

It’s a big issue in finance and insurance. Moral hazard has been blamed in part for the sub-prime mortgage debacle gripping the US and elsewhere. Governments often guarantee banks to protect citizens from losing their savings if banks collapse. But this guarantee to bail out banks can encourage the banks to make riskier loans: if the loans go OK, they make money and if everything goes wrong – well, the government will bail them out to protect the savings of the mums and dads. The government’s guarantee can therefore – perversely – make the financial systems riskier and more unstable.

An environmental example is drought assistance. By helping farmers when they face a drought we may encourage unsustainable farming practices. ‘Should I farm in the drought-prone area? Well, if it rains I’m fine and if it doesn’t, I’ll get drought relief, so why not?’

A proposal in the Garnaut Climate Change Review's latest discussion paper on emissions trading (pdf) is that permits be allowed to be “banked” or “borrowed” from future years. Banking’s not a big issue – if you reduce your emissions more than anticipated, you can “bank” your excess credits and use them in a later year. But “borrowing” is a potential minefield. It allows a company to say “I’ll exceed my allowance this year but it will be OK because I’m planning to reduce my emissions substantially in the next few years so I’ll repay them then”.

What’s the problem? First, we really want to be encouraging emissions reductions now. But that’s pretty easily dealt with – you just charge interest. At a 10% interest / penalty rate on borrowed permits for example, a company could choose to emit 100 tonnes this year and 100 next year or borrow 10 and emit 110 this year but only 89 next year (100 minus the 10 borrowed minus interest of 1 on the 10 borrowed). You could give the same rate of interest as a discount on banked early reductions to encourage those.

The bigger problem is will these borrowed permits ever be repaid? And this is where moral hazard raises its ugly head. Imagine this scenario: coal-fired power plant operators are sure that carbon capture and storage is going to mean they can reduce their emissions massively and cheaply in 20 years. The technology is looking promising. But right now, reducing emissions is hard and expensive. So they borrow from their entitlements 20 – 30 years in the future. They’re sure the investment will pay off when the technology comes on line and they reduce emissions massively and cheaply. And seeing as they’re going to pay an interest or penalty rate for delaying their cuts, everyone will win: the cuts will be delayed but they will be so huge when they arrive that it will more than compensate in the long run.

But, as it turns out, the technology doesn’t deliver. So the power station operators deliver the unfortunate news to the government: "We got it wrong, we can’t afford to make the reductions. And we can’t afford to buy in permits on the open market. You’ve got a few options. You can fund us to buy more permits. Of course, the price of permits will spike, instantly and substantially increasing the costs of any emitting industries, sending some to the wall, increasing energy, food and goods prices to consumers and fuelling inflation, and maybe a small recession. And of course, taxpayers will be paying the debts that we’ve incurred. Or, we can just shut down. Electricity production will slump and energy prices will spike, again increasing the costs to energy users (sending some firms to the wall and hurting households), fuelling inflation, and maybe a small recession. Or you could just issue us with more permits…"

The idea of emissions trading between different companies is that it allows flexibility in who makes the reductions and therefore lowers the overall community costs of achieving reductions – whoever can reduce emissions most cheaply has most incentive to do so. Allowing the trading of emissions between different time periods adds more flexibility (flexibility as to when we make the reductions) and further reduces the total cost to the community. If it works. But we need to be very careful. Because the risk of moral hazard suggests it might not work.

How much should we spend to reward pollution?

New Treasury figures estimate that by next year we'll be spending over $2 billion per year subsidising the use of company cars – nearly twice as much as was previously predicted.

I've talked before about this environmentally destructive tax rort that encourages drivers to drive and drive and drive - the more you drive, the less tax you pay.

Now if car travel is a legitimate business expense, then it's reasonable for allowance to be made for the cost of car travel when assessing tax. But you need to question whether tax breaks are justified for businesses providing personal (private) cars to employees as part of their salary package – cars that they may or may not use for business trips.

The big problem is that it’s hard to work out when a car is needed for business (in which case maybe it’s reasonable for an employee to provide one and for it not to be taxed) and when it’s really just being used for private purposes (in which case it shouldn’t be tax deductible). The Tax Office’s arbitrary solution is to assume that if you drive it far enough, you must have needed it for business – so the further you drive, the less tax you pay. The rate of tax you pay on your car loan repayments ranges from 26% if you drive less than 15,000 km in a year to just 7% if you drive more than 40,000km. This of course encourages driving more, not just for legitimate business, but also to reduce the amount of tax you have to pay, particular if you find yourself near the cusp of one of the tax brackets towards the end of the year.

The Australian Conservation Foundation puts it this way:

These tax breaks are economically senseless, reward environmentally destructive behaviour and increase taxes that the rest of us have to pay. There are much better uses for $2 billion than to hand it out to affluent corporate executives as an incentive to buy cars and drive them as much as possible to get the maximum tax benefit.

I can't say I disagree. The government has pledged to introduce a carbon trading scheme by 2010, at some cost to businesses and consumers. A sensible precursor is to remove the distortions like this one and the tax break for 4-wheel-drives / SUVs - which impose environmental and economic costs.

Maybe one for the Productivity Commission?

Will fuel efficiency laws save motorists money?

With petrol prices in Australia nudging $1.50 a litre, the clamour to 'do something' is growing and even the Australian Conservation Foundation is jumping on the bandwagon. Its solution: mandatory fuel efficiency standards for new cars sold in Australia:

ACF’s Sustainable Australia program manager Alison Cleary... said the introduction of mandatory fuel standards would reduce emissions and save Australian motorists money.

“With petrol nudging A$1.50 a litre, a fuel efficiency standard of 6.8L/100km would save the average Australian driver around A$1,000 on petrol each year.”

The previous Federal Government had a voluntary agreement with the car industry for vehicles manufactured in Australia to achieve an average fuel efficiency of 6.8L/100km by 2010. But almost no progress has been made towards that target, with only one Australian manufactured car model having an efficiency of less than 10L/100km in 2006. The auto industry failed to meet similar non-binding efficiency targets in 1983, 1987 and 2000.

“Mandatory efficiency standards for new cars are needed to help Australians cope with higher oil prices and ensure we remain competitive in international and domestic markets,” Ms Cleary said.

But is this true? There are some clues from the US, which has had mandatory fuel efficiency standards ("CAFE standards") for some time. And in 2004, the Congressional Budget Office examined the cost of using tighter fuel standards to achieve a 10% reduction in fuel use.

Their findings?

Raising [fuel efficiency] standards would impose costs on both the producers and buyers of passenger vehicles. To comply, producers would need to incorporate technologies to boost the fuel economy of their vehicles, which would increase their cost of production. Consumers would face higher prices for new cars and trucks. But consumers would also see lower operating costs for new vehicles because they would use less gasoline, offsetting some of the sting of the higher purchase prices.

CBO estimates that raising [fuel] standards by ... enough to reduce the amount of gasoline consumed by new vehicles by 10 percent would cost the U.S. economy a total of $3.6 billion per year.

That figure translates to about $230 per new vehicle. Consumers would most likely bear about two-thirds of the costs. Although the average price of a new passenger vehicle would go up by nearly $900, fuel savings would lower the additional costs to consumers to roughly $150 per vehicle, on average. Automakers' lost profits would constitute the remaining $80.

Now Australia is not the US and 2008 is not 2004. The costs to Australia's motorists and manufacturers might be higher or lower than those. But there's no reason to think that tighter standards should automatically save motorists money overall. If saving $1000 a year in petrol is important to motorists, they'll buy more efficient vehicles without the need for mandatory standards. And, indeed, more and more are doing just that. But for many motorists, there are trade offs. Not everyone wants a Prius.

A clue to the trade-offs lies in the ACF's two stats: that the average driver would save about $1000 on petrol a year if the 6.8L / 100 km standard was introduced and that only one Australian-produced car gets better than 10L / 100 km (and presumably not 6.8). To achieve that $1000 saving then, either drivers would be prohibited from buying Australian cars or Australian cars would have to get more efficient, fast. Either way, there's obvious costs to both consumers and local producers.

Now don't get me wrong: there are valid environmental arguments for tighter efficiency standards. And if the net cost to the driver over the life of the car is a couple of hundred dollars, the environmental benefits may well outweight the economic costs. But let's not kid ourselves that tighter environmental regulation is always costless. Far from helping motorists save money and making industry more competitive, the opposite is more likely.

As I've said before, environmentalists need to be making environmental claims strongly and eloquently and taking on the economic arguments too. But we should be careful about overplaying economic arguments. A weak economic argument can distract from a strong environmental one. And from where I'm standing, the economic argument for tighter fuel efficiency standards looks like a weak one.

Who should you vote for in the US Presidential elections?

A site that should be of interest to all US readers (and many others) is glassbooth.org.

A non-partisan site, it aims to give you an insight into how the views of the Presidential contenders align with your own views.

First it asks you to assign points to issues that you're most concerned about, then it asks you a series of questions about those issues. Based on your responses, it tells you which contenders align most closely with your beliefs and - importantly - provides references and links to back up that assessment.

In case you're interested, the winning candidate for me was Bill Richardson (Democrat from New Mexico), followed closely by Barack Obama and Hillary Clinton. On environment and energy issues, Richardson was well in front (seems he's more of a greenie than I am), followed by Clinton.

More about glassbooth and some other handy election resources can be found in this Wired article.

Happy new year!

I hope you've all had (or, better still, are having) a refreshing break and I wish everyone a healthy and happy 2008.

It's a good time to reflect and to look forward to a great year and, in that vein, the Sydney Morning Herald has a great article on eco-friendly New Year's resolutions - most of which are pretty cheap and easy to implement.