Carbon tax compensation, part one: You’re doing it wrong

Following the announcement by the Multi-party Committee on Climate Change that there would be a carbon price on 1 July 2012, there has been an increased amount of discussion about compensation. The Chairman of Leighton Holdings, for example, has been reported saying that a carbon tax should be introduced with no compensation, to business or households, “as it simply defeats the purpose of trying to drive behavioural change”.

This outcome appears unlikely, and it seems that households will at least be partly compensated. It is important to look at how this compensation might be delivered, as the various options will have different policy and political implications.

This post looks only at compensation for households, it does not discuss compensation to trade exposed or other businesses. Also, I am biting my tongue about David Mortimer’s apparent ignorance of how low the incomes of some households really are, and therefore what the impact of a rising cost-of-living is on the welfare of those living in, or close to, poverty. Not going to say anything. Aside from pointing out David’s ignorance.

As they represent the biggest impact to households following the introduction of a carbon tax, I will largely address electricity prices.

Given that we have a (nominally) competitive electricity industry with cost reflective pricing, a narrow economic approach to household compensation would be to allow the increases in the cost of electricity supply to be passed through to the consumer, i.e. to let household bills rise alongside unavoidable costs to industry flowing from the carbon tax. Compensation for increased prices would then be provided through distributive measures, such as increased pensions and benefits and through tax cuts.

In theory, this ‘take with one hand and return with the other’ approach would allow for most of the price signal to be felt by households, minus some bleeding due to increased income from compensation. Households should then change their behaviour to reduce their use of carbon. Additional incentive for carbon avoiding behaviour would be provided by the opportunity to pocket the additional compensation money saved through carbon-frugality.

This was the approach taken under the CPRS, and appears in favour with the current Labour Government. However, in the real world, this approach starts to look a little silly.

For a start, we have an Opposition leader running a ‘Great New Tax’ campaign and scaring us with lies about increased electricity prices. So we need to take account of the politics of the issue.

Then there is the low price elasticity in residential electricity use, which indicates that price rises aren’t likely to lead to significant carbon reductions in the household sector. For low-income households, the reason is that they are likely to be already rationing energy use, and can’t afford to replace their energy inefficient old appliances and white goods. For most anyone else, energy is such a small part of overall living costs, that a few dollars a week will not even be noticed.

That’s not to say carbon reductions could not be made in the residential sector. Along with spreading the message (or even better, screaming it) that energy prices will not rise (see part two of this post), the point could be made that households will still be asked to do their bit, and a package of energy efficiency regulations for buildings, white goods and cars could be announced at the same time.

Thirdly, if you still think the price signal will be useful, energy prices are already set to increase by magnitudes above what any seriously proposed carbon price would produce, largely through network expansion and replacement of ageing infrastructure (paid for by consumers, not Government as various Premiers like to claim).

According to information from the NSW economic regulator IPART, the original CPRS carbon price path (starting at $10/t and moving through to a market price expected to be around $25 by 2013) prices were set to rise by roughly twice as much as the projected impact of the CPRS regardless of whether it would be implemented or not (see to table 1.3). And the network charges responsible for the increases are set to continue to increase at similar rates.

As an aside, a similar story could be told about petrol prices, with the medium-term trend pushing ever upwards. This could explain the Greens apparent willingness to negotiate around equivalent reductions in petrol excise following the introduction of a carbon tax.

The implication of this is that if, in spite of the evidence, you believe in the ability of the price signal to drive residential consumer behaviour, you’re not going to need a carbon tax to get it.

That’s not to say that a carbon tax won’t influence the more rational business and industrial sectors, who also have better access to the capital required to make the necessary transformations. For example, the gains to be had by changing the cost stack of coal vs gas vs renewable generation is where the big gains in carbon reduction will come, not to mention energy efficiency within industrial processes and properties.

Which brings us to another point. If we don’t think that a price signal will change household behaviour, is this a major set back in our plans to reduce carbon emissions? Fortunately, not so much. According to the ABS, in 2006-07, household energy consumption made up about 8% of total energy use. This is for all energy, not just electricity as I could not find a source with that level of detail (Also here, scroll down to table D for ABARE’s version).

So, if it was a political necessity, it would not be environmentally catastrophic if households were reimbursed the entire costs that they saw from a carbon tax. There are of course other ways we can achieve reductions in household carbon emissions, however when it comes to compensation we should explore alternative delivery aside from the methods proposed for the CPRS plan.

Geez, once I get started it can be hard to stop. I’ve truncated this post, part two will outline an alternative delivery of compensation.

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2 responses to “Carbon tax compensation, part one: You’re doing it wrong

  1. Pingback: Carbon tax compensation, part two: An alternative | Translations

  2. Pingback: Carbon tax and price shock | Translations

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