I'm a bit of an ETS-absolutist. Or at least a carbon-pricing absolutist, in a place the size of NZ. I think the Weitzman reasons for preferring a carbon tax to an ETS are second-order relative to political economy considerations, and any weight at all put on switching costs makes it ludicrous to want NZ to flip from an ETS to a carbon tax.
But if a carbon tax were already in place, I'd be an absolutist about supporting the carbon tax.
There are fun and interesting arguments around tech-forcing, but NZ's not at the scale where that even really comes into play except maybe around ag biotech. So, prices are the way to go.
One of the big things I hear from non-economists pushing back on it is around future generations.
Here's my version of what I get a lot on Twitter, and as pushback from others. I hope I'm not providing a strawman treatment of it here.
The ETS is fine in principle, but it is inequitable. In particular, it does not consider the interests of future generations. If we allowed the ETS to do its work without hindrance, a lot of the countryside would be planted in pine trees. Let's leave aside all of the biodiversity issues with that for now and just focus on one additional problem: intergenerational equity. If you plant trees now, that's a one-off. The land you've planted in trees has to stay in those trees forever as a carbon sink. If you harvest the trees, you have to re-plant them if you don't want to have the carbon released. That locks the land into forestry, unless some future person buys the ETS credits necessary as part of surrender obligations if they take the land out of forestry. So you're locking a future generation out of other uses of that land. Worse, you're only offsetting some current emissions. If gross emissions do not come down, then future generations either have to do more to reduce their gross emissions, or come up with new carbon sinks that could be even more difficult than forestry. This is intergenerationally inequitable.
I hope that's an accurate representation of that particular concern.
I used to cover something similar in my 200-level policy course at Canterbury on intertemporal equilibrium. I don't think that this is at all commonly appreciated outside of economics, although the core paper establishing it is almost a century old.
Imagine that you own a piece of land that's currently a sheep paddock but could be turned into a forestry block. There are only so many of these in New Zealand; it's a big country, but it is finite. When should you run a forestry conversion?
Let's think through the owner's incentives and decision, and then relate it back to the equity issue that non-economists like to beat me up about. It isn't that economists haven't thought about it, it's rather that it's already kinda taken care of by the system.
If I keep the land as a paddock, I can keep earning paddock-related income from it. I can maintain that as long as I like. Carbon prices in the ETS are increasing over time. If I keep the land in sheep, eventually I'll be facing a carbon price for emissions from those sheep. That cost will be increasing, but is reasonably predictable. The current carbon price is about $38/tonne and is capped at $50/tonne plus 2% per year after that. Some price will attach to methane, but that's yet in flux.
If I flip the land to forestry, I face a one-off conversion cost that won't change a lot over time, unless somebody figures out far less costly ways of planting forests. I will get a one-off set of ETS credits for converting the land. I can hold onto those credits, or sell them into the system. I can sell them into the system now, or I can sell them into the system at some later date.
From now until time t when I convert, I get paddock net earnings per year. From time t onward, I get some lumber earnings as forests mature and get replanted, but I have to keep the land in forest. As soon as I fail to replant, I have to surrender credits comparable to the bundle of credits that I got when I planted. I have a bundle of ETS credits when I flip; if I sell them, I get the interest rate as return on that investment. If I hold them, ETS prices could rise or fall; I take on that risk and potential return.
How should I decide when to flip to trees? What sorts of things will matter? This is a rather standard application of the old Hotelling problem.
Howard Hotelling wanted to figure out time paths for prices for non-renewable resources. He showed that those futures prices should be coordinated through the interest rate. How? Let's take a simple example.
You own a paddock that's currently in sheep. You can keep running it in sheep, but methane prices will eventually hit your returns. If you flip it to forestry, you'll get a wad of ETS credits for the forestry conversion, and thereafter you get forestry returns from the land. If you ever flip out of forestry, you have to redeem a pile of ETS credits to do so.
Suppose you think that carbon prices are going to be far higher in future than they are now. If you believe that, you do not want to flip to forestry today, unless the returns from running a forestry block are comparable to the returns in sheep, leaving aside the ETS credits. Why leave aside the ETS credits? You can get those anytime. The opportunity to flip from sheep to forest will be there as long as you own the land. Once you convert, you get that bundle of credits. The credits don't do you any good, really, until you sell them. And, once you sell them, you can earn the interest rate on the money you get from selling them.
Suppose that the returns in sheep are the same as the returns in forestry. The only reason to flip to forestry now, instead of later, would be if you figured that you could earn more by banking interest on your ETS credits than by holding the option until later. And that will only be the case if you're expecting the value of ETS credits to rise more slowly than the interest rate.
And that's an equilibrating process.
Whenever it seems like carbon prices will rise more rapidly than the interest rate, people will want to hold off on forestry conversions until later. If you wait until later, you get a more valuable bundle of ETS credits for the conversion. Fewer forestry conversions now means fewer ETS credits now, which pushes up current ETS prices relative to future ETS prices, which pushes that time path to look more like the interest rate.
Whenever it seems like carbon prices will rise more slowly than the interest rate, people will want to flip to forestry now so they can sell the credits, invest the money, and earn interest. That process means you get more ETS credits now, which pushes down the ETS price now relative to later, which again makes the time path look more like the interest rate.
Interest rates provide intertemporal coordination. They're a law-of-one-price for the future, holding constant riskiness and other stuff.
Expectations about technological change will also matter. If you think new equipment will make future forestry conversions more cost effective than they are now, that will have you leaning against current conversions. If you think regulatory changes will make future conversions more difficult, you'll want to bring those conversions forward before councils ban them or before the Climate Commission mandates something weird about what kinds of trees you're allowed to plant.
So back to our opening worry about relying on tree conversions. The underlying premise there is not just that a lot of land will be flipped to forests as a way of generating ETS credits, but that doing so imposes an uncounted cost on future generations. But if people expect carbon prices, and consequently the value of ETS credits, to be a lot higher in the future, they'll want to wait to exercise that option. They only will want to bring forward that option if current ETS prices seem high relative to futures prices, given interest rates. So the equilibrating process encourages preserving the option to plant later in scenarios when future scarcity in carbon permits seems high, but exercising the option to plant now in scenarios when future scarcity in carbon permits doesn't seem high. And that's exactly the set of incentives that you want, right?
Now there are ways that that can all blow up. If you expect that somebody's going to ban forestry conversions, then you can distort that intertemporal decision. That will make you want to convert sooner rather than later, because later might not be allowed. If you expect that the government will blow up the ETS in future, then you'll want to plant now, sell the credits, and hope that whatever mess of a policy we have in future doesn't hold you to the surrender obligations if you flip out of forestry. Both of those point to the importance of credible reliance on the ETS, and of not continually making noises about future bans on forestry conversions. Talking up future bans brings forward forestry conversions.
If your objection is that investors can err about whether to make the conversion, because they're underestimating future ETS prices, the solution to that isn't banning conversions, it's making sure that the binding cap tightening over time is credible and advertising likely price paths consequent to those conversions.
The usual critique is that people don't think enough about the future because they're too selfish, so they don't think about the opportunities they take away from future generations. But every agent in the Hotelling setup is a pure profit maximiser. They only care about making money. And holding the option to convert later can be better than converting now, if you think that ETS prices in future will be a lot higher, and depending on the interest rate.
And if you think that everybody else is wrong about the likely price path for NZU and that ETS credits are going to be way more expensive in future, you could go and trade in ETS credits to make a lot of money out of it.
I worry a lot about policy initiatives where the underlying problem definition requires that markets somehow can't handle long term investment decisions. It winds up with an arbitrariness - it gets rolled out whenever a market outcome doesn't correspond to some bureaucrat or politician's vision of the good.
Anyway, bottom lines:
- intertemporal prices already provide incentive to consider the value of maintaining the option to convert to forestry later;
- these decisions wind up being guided by and coordinated by overall interest rates;
- expectations about tech and cost paths can also matter, but all else equal it's going to be expectations around future ETS prices and interest rates;
- you can break a lot of that setup by threatening to abolish the option to convert in future, as that will have folks rush to convert earlier. And if you're threatening to abolish that option, it's probably because you don't want them to be converting now, right?
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