Wednesday, 2 June 2010

Looking through the ETS [update]

The RBNZ rightly looks past level shifts in the price level as it has an inflation target, not a price level target. So if everyone knew that tomorrow all prices would double but that they'd then not change afterwards, that doesn't count as something that RBNZ needs to worry about. And, when the GST hike comes in October, that also rightly will be looked through: the GST increase doesn't increase folks' expectations of the rate of price increases a year after the GST increase.

I would have thought the ETS a bit different though. As I'd understood it, there would be both a level and a rate effect: implementing the system gives a level shift that RBNZ would rightly look through, but if the thing's going to be effective, it'll also have to have a rate effect. Why? Even if they don't put a declining cap on the trading scheme, economic growth will make the cap increasingly binding and consequently will raise the trading price and consequently will force prices up and consequently will raise inflation expectations in the medium term. But the RBNZ says it'll just be a level shift that they'll look through.

Or are they expecting that the foreign supply of emission credits is infinitely elastic at current prices so folks here needing to buy credits will never see a price increase? If it's infinitely elastic, isn't it a complete nonsense? Sure, New Zealand will never affect the world trading price of credits, but if the system as a whole is effective, then the world trading price has to rise over time.

There's something weird here. The only way that ETS has no ongoing inflationary effect, as best I can reckon, is if New Zealand really really really shouldn't be taking part: that is, the rest of the world is effectively ignoring Kyoto requirements and so the world price of emission permits is not expected to rise. So either RBNZ is saying that the ETS is a crock, or that they're ignoring their job to keep inflation in check, or that the effects of ETS-related price rises are so far in the future as to be ignored over the medium term. In the last case, I'd have expected them to note that it will affect inflation expectations a decade hence and that they'd revise their estimates in a few years though.

Updated: Anon, below, points back to the March Monetary Policy statement:
Headline CPI inflation is likely to be boosted over the coming quarters by implementation of the amended Emissions Trading Scheme (ETS). The first phase of the ETS is scheduled to take place on 1 July and will involve charges on liquid fossil fuels and stationary energy. The initial direct impact on CPI is likely to be via the prices of petrol and electricity, as higher production costs are passed through to retail prices. In addition, an indirect impact is likely on the prices of goods and services which are energy intensive, such as transport. The indirect impact is assumed to be half of the direct impact. These direct and indirect effects are collectively labelled the first-round impact and represent a change in the relative price of energy. This first-round impact is projected to add about 0.4 percent to headline CPI inflation in the year to June 2011. At the start of 2013, ETS energy charges will be increased further, but their effects are mostly beyond the published forecast horizon. In keeping with previous treatment (see Box B in the March 2008 Statement), monetary policy will not act to offset these first-round effects. This is consistent with the Policy Targets Agreement which includes ‘significant government policy changes that directly affect prices’ as reasons why ‘the actual annual CPI inflation will vary around the medium-term trend’. As a result, the inflation projections shown in this Statement exclude these first round effects (figure B1).

But some second-round impacts of the ETS could occur, if these higher relative prices cause consumers and businesses to reassess their beliefs on underlying aggregate inflationary pressure, and therefore change their wage and price setting behaviours. This change in behaviour would have consequences for the medium-term trend of inflation, and consequently interest rates would act to offset these effects.
This is pretty reasonable. But come December 2012, business will have to buy emission permits on the open market rather than at the government-supplied price of $25/tonne. Once that happens, wouldn't the open market price of emission permits will be expected to rise over time, fueling inflation expectations? December 2012 is what, 7 quarters away?


  1. My impression is that the ETS is assumed to be a relative price shock - rather than a demand shock.

    Persistent relative price shocks aren't inflation either - unless we believe they will feed into inflation expectations. As a result, the Reserve Bank is effectively just saying that they don't expect inflation expectations to change markedly in the face of the ETS.

    That is my take on it.

  2. Hi Eric, the RBNZ are aware of these issues, if you go an look at the latest MPS on page 20 they have a box about the ETS and the effects. I would say listen to what they say there than what an article says about what John Key says the RBNZ told him.

    They break the effects down into direct and indirect effects, and 1st and 2nd round effects. I believe it is the 2nd round effects that they may have to respond to.

  3. @Matt: Agree that a persistent relative price shock isn't inflation, but ETS isn't a carbon tax: if this were a carbon tax plus commensurate tax reductions, all would be fine: definitely then just a relative price effect.

    @Anon: Awesome, thanks. Will update post shortly. I agree that RBNZ rightly looks through the first level shift with ETS. But, the price of permits has to increase over time, and that rate of price increase, I'd have thought, would feed into inflation expectations.

  4. I admit I don't really know a lot about how the ETS credits work, but I remember hearing somewhere that perhaps firms may stockpile the credits (was there even some thing about a 2 for 1 deal for a while at $25) and they would use these as required after the prices start floating upwards (assuming they do go upwards). This may delay or at least partially offset the increase in their cost that you are talking about. Assuming agents are rational (such and economist..) I would guess they would pick up on this and factor it into their expectations of inflation.