Free allocation within the ETS: a fair and efficient subsidy?

One of the more controversial design features of the Government’s proposed Emissions Trading Scheme (ETS) is the free allocation of New Zealand Units (NZUs) to ‘at-risk’ industries.

The latest proposal suggests gifting such industries an amount up to 90% of 2005 emissions levels, before phasing out these free allocations between 2018 and 2030.

In some quarters, however, the free allocation mechanism has been criticized as being a subsidy and therefore economically inefficient. It has also been labelled unfair, as it contradicts the polluter pays principle and transfers wealth from households to polluters.

But when these criticisms are considered within the global context of climate change policy they do not stack up.

Strictly speaking, free allocation is indeed a kind of subsidy. It provides firms with relief from the tax-like effects of the ETS.

If we assumed a closed economy, free allocation would provide firms receiving it with a competitive advantage over other industries not receiving free allocation.

But we don’t live in a closed economy.

The government’s proposal is to offer free allocation to ‘at-risk’ firms in import-competing or export markets. In this case, free allocation would not provide a competitive advantage to New Zealand firms unless all other countries were also pricing carbon.

Thus while it might meet the textbook definition of a subsidy, free allocation doesn’t provide a competitive advantage, which is perhaps a more practical definition (indeed, the WTO definition requires that a subsidy ‘confer a benefit’).

The efficiency of free allocation can also be defended given that the ETS is supposed to encourage emission-efficient production. In many of our key international and import-competing markets the rest of the world has not implemented any form of carbon pricing.

When New Zealand leads the way with the ETS, our firms lose competitiveness, and production is moved from New Zealand to elsewhere in the world. In cases such as agriculture this means moving production to less emissions-efficient locations, and an increase in total global emissions.

But by protecting the international competitiveness of New Zealand’s firms, free allocation reduces the chance of such an inefficient outcome. In a second best world, relief from a tax is not inefficient if the tax is inefficient. Just as we exempt exporters from GST (a domestic tax), free allocation would exempt New Zealand firms from a cost that international competitors are not facing.

The final argument against free allocation is based on fairness. It is claimed that free allocation is a wealth transfer from households to industry, and therefore unfair.

The problem with this simple analysis is that it draws a line in the sand between business and households. In reality, firms have employees and owners; if firms contract, there are flow on effects to households.

NZIER has done some modelling, using a Computable General Equilibrium model that captures interdependencies of agents within the economy, which suggests that free allocation can actually be beneficial for households.

Why? Because if firms are hit hard by an ETS then households feel the pain of lower wages. In short, without wealth creation, there’s no wealth to transfer.

The arguments against free allocation forget that climate change and emissions are a global problem, not simply a New Zealand problem. Their perspective is wrong.

The rest of the world has signalled and in some places acted already to impose a price on carbon. But in the key international markets that New Zealand firms compete in, such as agricultural markets, no one else in the world has, or is likely to, include agricultural emissions within carbon pricing.

If they do, free allocation is indeed likely to be an inefficient and unfair cross-subsidy, but until then it is neither.

Chris Schilling is a research economist at the NZIER.

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What? You're approving of SUBSIDIES???

I thought subsidies in a Free Market was a dirty word with you chaps? Evidently not.

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