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Second Environmental Economics Round Table Proceedings

Convened by Senator Robert Hill, Minister for the Environment and Heritage, Canberra, 5 July 2000
Environmental Economics Research Paper No. 7
Commonwealth of Australia, 2000
ISBN 0 642 19485 8

Developments in the design and use of economic instruments since 1997

Simon Gordon and Steve Hatfield Dodds
Environmental Economics Unit, Environment Australia

 

Introduction

This paper provides an update on the major developments in the use of economic instruments since the first Environmental Economics Round Table, held in July 1997. While not exhaustive, the information provided is intended to provide a starting point for discussions at the 2000 Environmental Economics Round Table.

The paper is divided into two broad sections. The first section examines advances in the use of economic instruments to address environmental concerns in Australia since 1997. These include the New South Wales load based licensing scheme, and the emerging carbon sequestration market.

The development of a framework for a national greenhouse gas emissions trading scheme, recent work on environmental valuation and integrated modelling, and a summary of existing examples of the use of economic instruments in Australia, are also covered. This section thus effectively updates both Environmental Economics Research Papers 5 and 6 (Environment Australia 1997 and James 1997).

The second section discusses major international developments in the use of economic instruments, including:

Australian developments

The period since 1997 has seen an increase in the use of economic instruments in Australia to address environmental concerns and natural resource degradation. Much of this can be attributed to the growing realisation by policy makers that such degradation imposes a high cost on the Australian economy, along with the awareness that economic instruments are ideally suited to addressing one of the major causes of the degradation–market failure.

Several recently developed schemes and programs that address environmental problems using economic instruments are discussed below. A list of schemes that were implemented prior to 1997 but are continuing to operate within Australia is provided in Box 1.

New South Wales load based pricing scheme

In July 1999 the New South Wales Environment Protection Authority (EPA) introduced a new load based licensing system and load based pollutant charge for the control of pollutants released into the environment. Under the scheme, discharges are controlled by absolute maximum load, or volume, limits accompanied by a new license fee structure. Pollution charges are levied on the annual pollutant load discharged by a firm to provide an ongoing incentive to reduce loads. The objectives of the scheme are:

The scheme has only been operating for a short period and at this stage it is difficult to measure its success.

Carbon sequestration market

In 1998, New South Wales passed the Carbon rights Legislation Amendment Act 1998. This gave legal recognition to the ownership of, and trade in, carbon sequestration rights from State forests in New South Wales. The legislation was aimed directly at facilitating the launch, in August 1999, of the worlds first exchange-traded market for carbon sequestration credits by the Sydney Futures Exchange and State Forests of New South Wales. The intention is for buyers to purchase credits (denominated in one metric ton of CO2 equivalent) as a hedge in a future emissions trading market or bundle them with a product sales to create emission-free products.

In September 2000–after the Round Table–the Sydney Futures Exchange abandoned its proposed carbon sequestration contract, citing commercial imperatives stemming from the Sydney Futures Exchange’s demutualisation as the reason.

Development of a national greenhouse gas emissions trading scheme

Since the Kyoto protocol in 1997, Australia has been one of the strongest proponents of the use of an uncapped international emissions trading system to meet greenhouse gas abatement targets. Australia has put considerable effort into the development of a possible national trading system, using the Kyoto Protocol as a template for the rules, eligibility, and design procedures.

As part of the process, the Australian Greenhouse Office has conducted a public review into the development of a national emissions trading market. This review has covered a broad range of aspects, including greenhouse gas emissions, sectors of the economy to be covered, the issue of permits, the creation of credits, and market design. This review is being followed by the development of a model for emissions trading which is in line with other international frameworks that are being developed concurrently.

Environmental Valuation and integrated modelling

A number of major research initiatives are currently taking place in Australia, which will greatly improve our understanding of the links between economic activity and environmental resources and services. These include:

By alleviating current difficulties in environmental valuation and problems with determining impacts on the biophysical aspects of natural resources these projects are expected to encourage the use of economic instruments.

Box 1 Continuing environmental schemes using economic instruments in Australia

Property rights and market creation

  • Hunter river salinity trading.
  • Murray-Darling Basin Commission salt credit trading scheme.
  • South Creek bubble licence scheme to reduce phosphorus levels in Hawkesbury-Nepean river system.
  • Murray-Darling Basin tradeable water entitlements.
  • Individual transferable quotas in fisheries (Southern bluefin tuna, South east fishery, Northern Prawn fishery).

Charges and Taxes

  • South Australian effluent charges.
  • Load based licensing schemes in Victoria and Western Australia covering air, water and land pollutants.
  • Product tax on ozone depleting substances.
  • Various charges for waste disposal (most local governments).
  • Aircraft noise levy.

Subsidies and tax concessions

  • Local government rate concessions to encourage sustainable land management.
  • Various subsidies and grants to encourage tree planting and vegetation protection.

Other examples of economic instruments

  • Environmental performance bonds for Queensland mines.
  • Great Barrier Reef performance bonds.
  • South Australian beverage container deposit refund scheme.
  • User fees for National parks and Great Barrier Reef Marine Park.

International developments

In the last few years there has been significant progress in the international use and acceptance of economic instruments in environmental policy. In particular, tradeable permits (particularly for addressing greenhouse gas emissions), environmental taxes (as part of ‘green’ tax reform), and the concept of ‘ecosystem services’, have emerged as areas of interest. These are discussed in more detail below.

Greenhouse gas emissions trading and the impact of the Kyoto protocol

Developments in the last two years surrounding the use of economic instruments, particularly tradeable permits, have been driven by the intellectual effort associated with climate change negotiations and the resultant Kyoto Protocol. This process has encouraged consideration of the broad scale application of tradeable permits and the resulting impacts on social welfare and the economy.

The Kyoto Protocol explicitly encourages developed countries to participate in emissions trading for the purposes of meeting their assigned greenhouse gas targets. Although the details of the Protocol are not yet settled, participation in trading is voluntary and is open to public and private entities.

At present the detailed methodologies and mechanisms required to implement the objectives of the Kyoto protocol are still in development. Acceptable procedures for estimating emissions from various activities are being proposed and refined, and rules for flexibility mechanisms such as international emissions trading, are still subject to negotiation.

Whether or not the Kyoto protocol ever enters into force, it has changed both public and private sector attitudes and policies about the potential for trade to reduce emissions. It has had a profound impact on the development of carbon trading schemes and carbon investment funds in many countries. A selection of national, private and global schemes are outlined in Box 2.

In the last several years the debate surrounding tradeable permits has moved from whether or not benefits can be derived from applying tradeable permits to how best to apply them. One of the most significant areas of progress in the design of tradeable permit schemes has been attention to issues around the initial allocation of permits, and the impact that this will have on the participating firms, social welfare and the economy. This interest arises from the recognition of the way in which the impact of emissions trading on individual firms and the general economy will vary significantly depending on the allocation mechanism chosen.

Recent research has evaluated the relative impacts of the three main mechanisms–‘grandfathered’ permits, auctioned permits, and a combination of ‘grandfathered’ and auctioned permits–allowing the following general conclusions to be drawn.

Box 2 International developments in the use of tradeable greenhouse gas emission permits

United Kingdom

The Emissions Trading group (ETG) are aiming to develop a trading market in the United Kingdom by April 2001, where certified emissions reductions can be traded in any international market that emerges from the Kyoto protocol (Cameron 2000). The participants in the trading system are intended to be UK companies, including UK subsidiaries of multinationals. Companies will be given permits to emit a certain level of greenhouse gases (GHG). These can then be traded freely, similar to the US SO2 trading scheme. The International Petroleum Exchange is also in the early stages of establishing a greenhouse gas emissions trading centre in London.

United States

Although the United States has not yet established a clear regulatory framework for the trade of GHG emission reduction credits, it has established frameworks for emission trading, at both state and federal levels, in particular with regard to sulfur dioxide and nitrogen oxide.

As of 2000, all US electric utility units will be required to significantly reduce their SO2 emissions. The scheme awards emission allowances in units of one ton of SO2 per year to all participants. The allowances are bankable and tradeable, thus permitting affected companies to purchase and sell them according to their expected and actual emissions.

Other US initiatives include the Regional Clean Air Incentives (RECLAIM) market in California and the Ozone Transport Commissions NOx trading scheme covering emissions in 12 northeastern states.

RECLAIM has been operating in the Los Angeles region since 1994. Under this system a finite number of emission credits (NOx and SOx) have been assigned based on historical emissions. Facilities which reduce emissions more than required can sell excess credits to other facilities. Fewer credits will be assigned each year until the emissions are capped at 2003 levels. Interest in RECLAIM has gradually increased since its inception and by 1997 the trading market experienced more than 1200 trades (Solomon 1999)

Private sector

BP/Amoco and Shell have developed internal mechanisms for emissions trading among their international divisions (Cameron 2000). The BP/Amoco system started in 1999 with each business unit receiving a basic allocation of emission permit rights for 1999 to 2003. Business units managing to make emissions reductions cheaply can trade excess permits with a unit finding it more costly to meet its target.

Global prototype carbon fund

The Prototype Carbon Fund, established in the World Bank with contributions from governments and companies, is a first attempt to experiment with the creation of a market in emissions reductions under the Kyoto Protocol's 'flexibility' provisions (Prototype Carbon Fund 2000). It will invest in cleaner technologies in developing countries and transition economies, thus reducing their greenhouse gas emissions. These emissions reductions will be independently verified and certified, and then transferred to the fund’s contributors in the form of emissions reduction certificates rather than cash.

Recent research by leading academics Larry Goulder and Lans Bovenberg indicates that less than 20 per cent of emissions permits would need to be ‘grandfathered’ (with the rest being auctioned) to maintain the return to capital in fossil fuel based industries in the United States.

Box 3 Environmental tax reform–achieving ‘win-win’ outcomes and the ‘double dividend’

During the second half of the 1990’s much of the discussion surrounding environmental taxes centred on the possibility of achieving improvements in environmental quality without having to sacrifice non-environmental benefits, such as employment and purchasing power. The underlying logic of those advocating the possibility of 'win-win' outcomes was that environmental taxes could capture the scarcity rents associated with introduced restrictions on previously 'free' activities, such as emissions of CO2 and other greenhouse gases. These rents would thus represent a transfer between different members of society, rather than an efficiency loss to society as a whole. In practice, this meant that increased environmental tax revenue could allow reductions in other taxes, reducing the efficiency losses associated with the tax system.

This logic was challenged by the modelling undertaken by Goulder (1994) and others. Goulder suggests that there are two possible dividends that can be generated from environmental tax reform. The first dividend is the improvement in environmental quality. The second dividend refers to the reduction in the costs of a tax system on non-environmental grounds (or equivalently, the possibility of obtaining an increase in real consumption of goods, excluding the enjoyment of environmental quality). The second dividend could also be reflected in an increase in employment or GDP.

Many analysts originally believed that achieving the double dividend would be relatively straight forward. They believed that if revenue from environmental taxes was used to finance cuts in labour taxes then the tax burden on labour would be reduced and employment and income would rise. Much of the debate on the necessary conditions for a double dividend has surrounded assumptions regarding labour supply and labour demand. Recent work by Bovenberg and Van Der Ploeg (1996) and Lithgart and Van Der Ploeg (1999), suggests that the validity of a double dividend depends on the assumption that in the presence of real wage reductions caused by environmental taxation, labour inputs will rise (backward bending labour supply curve). These conditions, however, are not common and opportunities for achieving a double dividend may be limited.

A second issue, not explored extensively in the literature to date, is the characterisation of the 'efficiency cost' of the environmental tax for the purposes of the second dividend–that is, how to take account of the presumed externality that motivates the tax in the first place.

It is important to realise, however, that even if a second dividend (as defined by Goulder) is not possible, this does not invalidate the case for environmental tax reform. Rather, environmental policy should be based on an assessment of desired social goals, and the most efficient and effective ways of achieving these. The possible second win or dividend was only ever the icing on the cake.

 

Box 4 Recent examples of ecological tax reform

The United Kingdom ‘green tax’

United Kingdom government policy has recently shifted towards environmental taxation. In 1999 the United Kingdom proposed the introduction of a climate change levy. The levy is proposed to apply to non-domestic and non-transport energy usage (that is industrial and commercial users) and would be calculated on energy rather than carbon content of different energy sources. In its first full year (2001—02) it is expected to raise 1.75 billion. The levy is intended to be revenue neutral and to be recycled back in the form of a reduction in employers national insurance contributions and in schemes to promote energy efficiency.

Scandinavian developments

Denmark–Since 1996, part of the revenue of the newly increased carbon dioxide tax on industry has been allocated to reducing employer’s social security contributions.

Finland–Starting in 1997, lower taxes on incomes and labour, offset by new environmental taxes and energy taxation.

Switzerland–Revenue from new environmental taxes on volatile organic compounds and extra-light heating fuels will be redistributed to households in the form of reduced compulsory sickness insurance contributions.

Netherlands–As part of major tax reform in 2001, energy taxes will be raised substantially in the Netherlands, while simultaneously the income tax will be cut.

Sources: Jackson 2000; OECD 1997; OECD 1999.

Environmental tax reform

In recent years policy makers have shown a growing interest in the use of environmental taxation as a means of delivering sustainable development and achieving environmental goals. This wider advocacy of environmental tax reform can be attributed to three main factors:

To date, most environmental tax reform has occurred in Europe and has involved the introduction of a carbon or energy tax along with the use of revenues from the tax for social and environmental programs. Recent developments in the United Kingdom are of particular interest, as they represent the first move of environmental taxes on broad scale outside of traditional users of these taxes, the Scandinavian countries. Developments in both the United Kingdom and Scandinavian nations are outlined in Box 4.

Despite increasing uptake in individual countries, efforts to harmonise environmental taxation across the European Union through the introduction of carbon taxes are yet to make significant progress. This can be attributed to the divergent interests of member states in safeguarding the competitiveness of their energy intensive sectors, uncertainty as to the precise environmental outcomes and budgetary implications, and concerns about distributional impacts and transitional effects.

Box 5 Examples of the practical application of the ‘ecoservices’ concept

The services of water filtration and purification provided by the ecosystems in the catchment of New York City were recently estimated to be worth $8 billion. This figure was the difference between the cost of repairing the ecosystems and building artificial filtration facilities to replace the degraded capacity of the ecosystem services (Cork and Shelton 2000).

A dynamic ecological economic model of ecosystem services provided by mountain systems in South Africa was used to analyse the costs and benefits of removing alien plants. The study determined that water production and genetic storage were the most valuable ecosystem services and the costs of clearing alien plants would be a tiny proportion of the ecosystem service protected.

In Costa Rica, an orange juice company bought a neutral area next to their orchards and factory and converted it into a part of the National Park System as they realised they were receiving $12/truckload of oranges worth of benefits from the forest through pest control, irrigation water, flood control, and waste decomposition (Daily 2000).

Recommendations for timber harvesting regimes in the Melbourne water catchment were based partly on avoiding or minimising the costs of decreased water or timber yields.

The Myer foundation is planning to undertake ecosystem service analysis of four catchments in Australia: an agricultural catchment in temperate Australia; a mixed-use catchment in Tropical Australia; a representative areas of semi-arid rangelands; and a forested catchment supplying water to a major urban centre (Cork and Shelton 2000)

 

Ecosystem services

In recent years ecosystem services have been promoted as a conceptual framework to resolve the trade-offs between the benefits from natural systems and technological substitutes.

The term ‘ecosystem services’ has been used to describe the benefits to humans of nature and its component natural systems. This includes the provision of clean air and water, natural fertilisation and nutrient cycling in soils, mitigation of climate, pollination of plants (including crops), control of pests, provision of genetic resources, production of goods like food, fuel and fibre, and the maintenance of cultural and social values.

Recent attention has been paid to calculating the cost of replacing ecosystem services, or the cost avoided in environmental remediation by conserving these services. Examples of the practical application of the ecosystem services concept are provided in Box 5.

Assessments of the contributions of ecosystem services to human welfare have been done with varying degrees of rigour and has usually required a large number of assumptions to fill data gaps. Most assessments to date have been focussed on the magnitude and value of services delivered under current or past land management regimes.

References

Australian Greenhouse Office (1999), National Emissions Trading: issuing the permits, Discussion paper no. 2, Commonwealth of Australia, Canberra.

Bovenberg, A.L. and Van Der Ploeg, F. (1996), Optimal taxation, Public goods, and Environmental Policy with Involuntary Unemployment, Journal of Public Economics 62, 59-83.

Cameron, J (2000), International Carbon Markets, JI Online Climate change Information Network (http://www.ji.org/whatsnew/000318aa.html).

Cork, S.J. and Shelton, D. (2000), The Nature and Value of Australia’s Ecosystem Services: A Framework for Sustainable Environmental Solutions, Manuscript submitted to the 3rd Queensland Environmental Conference, May 2000.

Daily, G. (2000), The Value of Ecosystem Services, Radio National Earthbeat (http://www.abc.net.au/rn/science/earth/stories/s121042.html.

Environment Australia (1997), Environmental Economics Round Table Proceedings, Environmental Economics Research Paper 6, Environment Australia, Canberra.

Goulder, L.H. (1994) Environmental taxation and the 'double dividend': A reader’s guide, National Bureau of Economic Research Working Paper No 4896, Cambridge, MA.

Jackson, T (2000), The Employment and Productivity Effects of environmental Taxation; Additional Dividends or Added Distractions?, Journal of Environmental Planning and Management, 43(3), 389-406, 2000.

James, D. (1997), Environmental Incentives: Australian Experience with Economic Instruments for Environmental Management, Environmental Economics Research Paper 5, Environment Australia, Canberra.

Lithgart, J.E. and Van Der Ploeg, F. (1999), Environmental Policy, Tax Incidence, and the Cost of Public Funds, Environmental and Resource Economics 13: 187-207, 1999.

OECD (1997) Environmental Taxes and Green Tax reform, OECD, Paris.

OECD (1999) Environmental Taxes–Recent developments in China and OECD countries, OECD, Paris.

PCF (2000), Prototype Carbon Fund, (http://www.prototypecarbonfund.org/home.cfm).

Solomon, B.D. (1999) New directions in emissions trading; the potential contribution of new institutional economics, Ecological economics 30 (1999) 371-387.