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Hypothecation and the carbon dividend

Summary:
This week's Newsroom column, now ungated, goes through the happy surprise in last week's budget: ETS revenues will be hypothecated. Well, it could be a happy surprise. It could all yet turn to custard. Treasury hates hypothecation: the ring-fencing of particular tax revenues to particular purposes. And they are almost always entirely correct in that. In New Zealand, petrol excise is hypothecated to the Land Transport Fund as an ersatz road user charge; now that technology has progressed, petrol excise should be abolished and petrol (and electric) vehicles flipped to the road user charging system that's been in place for diesels. That's a reasonable use of hypothecation: when it's the only feasible way of getting something like a user charge.Otherwise, we descend into tin-pot accounting

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This week's Newsroom column, now ungated, goes through the happy surprise in last week's budget: ETS revenues will be hypothecated. Well, it could be a happy surprise. It could all yet turn to custard. 

Treasury hates hypothecation: the ring-fencing of particular tax revenues to particular purposes. And they are almost always entirely correct in that. In New Zealand, petrol excise is hypothecated to the Land Transport Fund as an ersatz road user charge; now that technology has progressed, petrol excise should be abolished and petrol (and electric) vehicles flipped to the road user charging system that's been in place for diesels. 

That's a reasonable use of hypothecation: when it's the only feasible way of getting something like a user charge.

Otherwise, we descend into tin-pot accounting systems that make a mess of everything. 

They make a mess of the allocation of public funds, because at least in principle you'd want that the marginal value of a dollar spent by government goes wherever it can do the most good, regardless of where it came from. 

They also make a mess of politics. A tax on hipster's beard oil, all on its own, just sounds stupid. A government programme to help save the endangered saddleback might or might not make sense - who knows whether there are other conservation programmes that make more sense, or whether conservation programmes are the next best use of government funding in the first place. But if you tie a targeted tax on hipster's beard oil to a programme helping cute birds, well, that leads us to dangerous kinds of things that show up on US referendum initiatives. You look like a jerk for opposing them, even if they're really stupid. Like - a tax on ice cream to help orphans with cancer. Who could oppose that? They're orphans. With cancer. But it absolutely ruins the tax system. If you want to give money to orphans with cancer, do it out of general tax revenues and at least try to minimise the deadweight costs of generating whatever amount of funds the government wants to take from people. 

So it absolutely makes sense that Treasury hates hypothecation.

But it's a problem in this case.

The ETS faces a political problem, not an economic one. 

In a first best, we wouldn't be having this discussion at all. ETS revenues have a negative burden. It's a tax that abolishes a distortion rather than creating one. We like taxes like that. They're good. So in a first best the government would take ETS money, cut other taxes by a little bit (reflecting that we don't need the revenues from a more distortionary source quite as much), and increase other spending by a little bit (reflecting that the optimal provision of government services goes up by a bit when the marginal cost of funding goes down by a bit. So government would have a small bit more money, and would just put it to its next best use.

But we're not in that first best. We have a political problem. The government is behaving in ways consistent with a terror of ETS prices rising. It's resorting to all kinds of just absolutely crazy, costly, and ineffective measures to reduce gross carbon output. None of it makes any darned sense, because of how it interacts with the ETS. If you subsidize early EV uptake, you just free up credits for someone else to use. And same with banning oil and gas exploration, or banning coal-fired process heat, or anything else affecting the covered sector.

You then have a few options. 

Maybe Ministry for the Environment officials are very very thick in matters core to their core area of responsibility. Just simply grossly incompetent. 

Maybe MfE officials don't care about truth and just want to parrot what sounds nice to thick people in Cabinet. 

Maybe neither MfE nor Cabinet are thick, but voters don't get the ETS and don't trust it because they don't understand emergent outcomes and prices. 

Or, maybe, despite what seems like very strong voter support for Net Zero, voters would actually flip their lids if ETS prices went from $38ish to $75ish and blow up the system - and high ETS prices make it harder to figure out how to get agriculture into the system. And officials figure no Minister could stand the pressure of a few news specials showing poorer households having and even harder time paying for stuff. 

The real problem can't just be either of the first two. Those on their own can't do it. If it were just thick officials, Cabinet would have incentive to lean on them to get it right. And if voters understood it, they wouldn't be supporting these kinds of costly and ineffective policy measures. Ultimately voters are the constraint - and I expect it's a mix on fundamentally not appreciating how prices work through the ETS, the effects of the binding cap, and an unwillingness to actually bear higher daily real costs rather than symbolic stuff and the occasional visibly costly hair shirt demonstrating commitment. 

But if that's the real problem, then all the other problems can be floating around in there too because nothing fixes it. 

All of that makes for a political problem in maintaining the ETS as carbon prices rise. Eventually, somebody wins election by breaking the thing and reducing carbon prices. That builds fragility. And risk of it distorts investment decisions - if you think that the ETS buckles before prices hit $60, you don't make investments that only pay off it ETS prices get north of $60 and stay there. 

And that takes us out of the first best. We need the ETS so that we're hitting the net zero targets in ways that don't cost hundreds or thousands of dollars per tonne abated when there are still options on the table costing only $40 per tonne. Orders of magnitude differences in abatement costs make for first-order problems to solve. 

So what to do? Hypothecate the revenues, create a carbon dividend. Start of the year, forecast the government's ETS revenues. Send every household in the country a cheque for their share. Give the first adult in a household a 100% share, the second adult a slightly smaller share, and a slightly smaller share again for each kid. Carbon costs rise in household size but at a decreasing rate. Heating a house for two people doesn't cost twice as much as heating it for one people. If the government expects excess dividends from the power generators because Huntley's burning expensive coal and that's the marginal unit driving prices, throw the government's 51% share of those excess dividends into the pool. 

The transfer would be progressive; richer people spend more money on everything, and carbon is in everything. But if it still isn't progressive enough to make the ETS stick, boost the dividend payments for households with Community Services Cards. You can make the thing as progressive as you want that way, but there could be risk that payments to middle-income households start looking thin relative to what they're paying in carbon charges if you do too much of that. 

Run the carbon dividend correctly and even if voters don't understand anything about how the ETS works, or how prices work, they will understand getting a big cheque at the start of the year, and that the cheque is bigger when ETS prices are higher. 

"Here's your carbon dividend. Use it to start reducing your carbon footprint. The less you emit, the less you'll have to pay into the ETS. But you'll still get your dividend from those who don't reduce their footprint. Put it towards a heat pump. Save it for a deposit on an EV. Put in some insulation. Whatever makes most sense for you and your household. We, as government, simply can't know your circumstances. You do. We're paying you in advance because we know the costs you'll be facing are going up. Petrol prices could go up. Power prices too. Take the money, use it wisely. We trust you."

Being able to say that at the start of the year, and being able to point to it whenever some reporter gives the lazy "Oh, Minister, what do you have to say to poorer households facing rising power prices?" question, gets rid of political fragility in the system. 

Anyway. Carbon dividends make sense. And the sticking point had been Treasury just being stubborn about hypothecation. But the Budget hypothecated the revenues without saying what'll be done with them. I hope it's a carbon dividend. 

But Treasury could yet wind up being right - there's risk that the Minister will want those revenues as a "at his discretion" slush fund for piles of dumb stuff. It's easy to imagine the government preferring to use the money to fund Joe's heat pump, or Jane's home insulation, with application processes ensuring the recipients are worthy and ensuring that they credit the government for having given them a heat pump rather than crediting the ETS for it. None of it would reduce emissions, and none of it would work better in addressing equity and political economy concerns than running the carbon dividend, but I can see how it could be politically tempting. 

If the government is serious about getting to net zero, it needs a way of entrenching support for the ETS. Watch what they do with the ETS revenues. It will tell you whether they're serious about it. 

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