How is a “consumption” based ETS different to a “production based ETS”?

Via LP we have a piece by Laura Tingle in the AFR on Tuesday which describes efforts to create a “consumption based” rather than “production based” ETS. I held off commenting until I read the piece itself, but my confusion is still here. Take this paragraph.

Charging people for their
consumption of greenhouse gases,
rather than their emissions, has
potential advantages in that there is
no need to compensate industries
for the cost of their carbon permits
because they simply pass on their
costs to customers.

This jars terribly with the microeconomics I learnt in highschool, and everything since then, and I fear, common sense. I think it is worth describing tax incidence over the fold for anyone who isn’t familiar with it, albeit with diagrams – as well as some other issues I have with the concept.

Paying for carbon increases the cost of a good or service like a tax, so we can study the burden of an ETS for a given product just like one.

The diagram on the left (borrowed from wikipedia)  is a simple supply and demand for a certain product. At high prices only a few people will buy whatever is being sold, but at lower prices, many more are willing to pay, so D, demand, slopes downwards. Supply (S) in this instance slopes up because at becomes more expensive to produce each good the more of them that are produced, so the producers need a higher price to make it worthwhile. Where the two lines meet is where consumers and producers happen to agree on the same price and quantity. these are labeled “P without tax” and “Q without tax” .

If you charge a tax, or make producers pay for carbon, then it becomes more expensive to produce the good, no matter how many they make . This means the producers will need a higher price at all quantities to make it worthwhile – or if the charge is “consumption based” and charged at the final sale, the price that the consumer sees will be higher at every point. This means that the new supply curve “S with tax” had a higher price at all points than the old curve, and the new price and quantity agreed on is higher and lesser respectively.

Have a look at how the price paid by consumers has risen though.  The higher costs have been been passed on all right, but not completely. In the diagram vertical distance between the old price and the new price is less than the difference between the old and new supply curves. Because some consumers have stopped buying the product, the producers have to absorb some of the higher costs themselves. Very neatly the space of the shaded areas equal the amount of tax paid by each group because it is price times quantity.

This is true of any rise in costs- not just tax- and no matter where in the production chain the higher costs are imposed will be shared and producers will still cry foul because they are still taking a loss even when the tax is officially only coming in at the consumer’s end. What can change is how much is shared 1. Look at the diagram on the right. Demand here is steeper because consumers are less affected by price, they buy pretty much the same amount no matter the price, and producers can pass on far more of the higher costs. It’s easy to see that if the line became vertical, than consumers would have to pay all the tax, and quantity would not change.

So the only circumstance in which producers would be able to pass on the entire carbon price is one in which the carbon price has no affect on behaviour. In short, to act the way Tingle’s paragraph suggests, the ETS would have to be entirely useless.

The stated virtue of  charging at the consumption end is that there “will be no need to compensate producers”. This is a political problem rather than a strictly policy problem (since charging for carbon doesn’t necessitate compensation by itself), but I don’t quite understand how it helps. I assume the argument is that producers won’t be able to point to a specific amount of tax paid and demand compensation. I think this will make things worse. Since we don’t know what the slopes of the curves are for each company and their goods, we can only make estimations and modeling. This creates ample opportunity for firms to employ modelling spivs to claim they are paying more than they are, and to demand even greater compensation.

A few of the comments at LP also feel that “consumption based” charging is more righteous because it is consumption that is the root of the problem. Regardless of one’s position on this value statement, this is not an applicable argument to any methods that involves a price on carbon since, as illustrated, the cost will be shared.

The one benefit I can see is that consumers won’t be able to shift to imports made by producers whom don’t pay for carbon. This could be achieved by lopping a such a scheme on to a domestic ETS though. It need not be the universal rule. Afterall, this method would have huge detriments, as described below.

It would require a complex accounting scheme to cover all the carbon that is placed into a good. If you were to map out production chains of a modern goods, with forks out to different suppliers providing all the innumberable inputs and the inputs used in inputs, you’d end up with a fractal. A body capable of accurately following this would also be able to do central planning well, negating the need for market solutions to anything. It also provides much opportunity for shoddy accounting and using two carbon books by crooked firms eager to reduce the final tax on their products as to sell more. If the higher costs were imposed at all these levels, firms wouldn’t need to hide them, since passing them on in part is the only profitable thing to do.

It also takes away much of the  efficiency benefits of a market based solution. The final firm, who sells to the consumer, has an incentive to reduce their carbon to provide a lower tax to consumers and thus sell more, but all their suppliers and their supplier’s suppliers do not. Afterall, the price of their goods won’t change based on how much carbon they produce. The final producer could look around for lower carbon inputs, but they would have the same problem as he accountants. Delving through all that complexity would cost far far more than the extra revenue from the greater sales. Furthermore, all the tiny but innumerable low hanging fruit further up the production line in terms of energy efficiency will go unplucked, because there is no reason to do so. All those little efficiencies add up.

So I don’t really understand the  basis of this idea. It seems to rely on a misapprehension of tax incidence, and a poor solution to a lobbying problem.

1 Anyone wondering why the GST seemd to make everything go up exactly 10%, this easily explained by the fact that since the tax was on (nearly) everyting, consumers couldn’t change to products thatdidn’t have the tax, and thus didn’t. Not all goods produce equal carbon, so this wouldn’t be the case with an ETS

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About Richard Tsukamasa Green

Richard Tsukamasa Green is an economist. Public employment means he can't post on policy much anymore. Also found at @RHTGreen on twitter.
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Ewen Laver
Ewen Laver
14 years ago

So the only circumstance in which producers would be able to pass on the entire carbon price is one in which the carbon price has no effect on behaviour. In short, to act the way Tingle’s paragraph suggests, the ETS would have to be entirely useless. (text corrected)

I don’t see that. The point of the ETS is to internalise in the price the full cost of CO2-emissions value in the good. If it is fully internalised, consumers can choose between consuming the good and paying the price and not consuming the good and avoiding it. That places pressure on the offerer of goods to lower the CO2 content in the goods supplied in order to achieve a competitive advantage.

I accept that it would be tricky to implement because the processes needed to harvest raw materials, manufacture them, package them, distribute and transoport and retail them are in more or less continuous flux. The carbon intensity of a consumer product will probably be different at various times of the year depending on where goods are sourced. In principle though, it does sound reasonable as a method.

There would be some holes in the system of course. Governments are consumers of goods and they are hardly likely to take account of these things. Unless producer goods lead to consumer goods, the link breaks.

Nevertheless, the general claim that humanity ought to be on a CO2e budget and that that budget, whatver it is, represents a quota which should be shared out according to some non-arbitrary process seems a sound one. That in essence is all an ETS really is — a way of rationally apportioning shares of the right to emit.

14 years ago

The idea of using a consumption base is to eliminate carbon leakages. Exports are exempt from the charges and import competing products are levied with a border tax adjustment that covers imports which have not been carbon charged. The charges would be levied on producers to reduce transaction costs but consumers would effectively pay them.

Both John Howard and George Bush opposed Kyoto because of leakages that would damage local industries but lead to no net reduction in carbon emissions. They were right. The response of many governments has been to offer exemptions to exporters but this still leaves import competing producers at risk and provides incentives for firms to shift offshore to seek “pollution havens”.

This never occurs with a consumption base so this is encouragement for countries to mitigate. Once enough countries do so you can switch to a production basis – this is preferable if you don’t have leakages because then you don’t need to work out and implement the BTAs.

I have been arguing the case for a consumption basis for such emissions for many years – a recent version is here. Its a good move that simplifies the task of getting international agreements on charging for emissions.

Nicholas Gruen
14 years ago

From what you have written the Tingle article is silly. The case for a consumption based tax is sensible. See Harry’s comment above. I argued for something similar here suggesting that Australia should set the ball rolling in that direction by committing to meet any reasonable consumption requirements, but not, as an exporter of energy intensive goods to meet any emissions cap we had foisted on us.

RGreen (elsewhere)
RGreen (elsewhere)
13 years ago

Ewen – Note I nowhere oppose an ETS, I merely point out the flaws in this “consumption based” concept of one, particularly as they undermine the benefits of the ETS model, but also as the implied effects don’t make much sense. Tingle appears to be stating that the costs will only be borne by consumers under this particular model, which can’t be true except in the unrealistic situation I described. Whilst (as I stated) the producers will still be looking for lower carbon for competitive advantage, it will be more difficult for them to do because they don’t receive the price signals from their own suppliers.

Harry – The lack of global agreement is a very persuasive argument (as stated), but I still am unconvinced that the tax needs to be levied at the final point of purchase in all instances, including wholely domestic goods, rather than being charged at point of entry and avoiding the described efficiency and informational losses for all domestic emissions. There’d probably be challenges at the WTO, but I think that’d happen no matter how we tried to accoutn for imported carbon emissions.

Nick – What you describe seems rather different in so far that the “consumption based” described by Tingle relates almost entirely the the point at which the charge is levied, rather than whether the consumption is done by us or foreigners.