Compensation and the ETS

Although the blogs appear to be quite quiet about it, I’ve heard a number of people complaining about the government compensating people for the impact of the emissions trading scheme.

Effectively, people who are unhappy about it are telling me that such compensation appears to be pointless as it “cancels out the effect” of pricing carbon in the first place. Ultimately, we can discuss the issue in a little more detail then that. Lets try to figure out how it works – and discuss what this compensation implies, both in terms of achieving carbon/Kyoto liability funding goals, and in terms of social welfare.

Charging someone then giving them the money back – sounds like a pointless waste!

There is some rudimentary economic analysis at play here when the government looks to compensate people for the higher prices they will face as the result of an emissions trading scheme.

When we introduce an emissions trading scheme, we make the social cost of carbon appear in the price of goods that are produced with some carbon component.  As a result, this increases the “relative price” of goods that involve a lot of carbon production compared to the products that involve very little.

When people face this increase in the relative price of carbon goods individuals change their relative consumption based on an “income” and a “substitution” effect.  Now in of itself the substitution does not reduce peoples welfare, this stems solely from the income effect.

Now Labour would like to ensure that poor people do not end up any worse off than they are now, following the release of the ETS.  As a result, Labour will compensate them to make up for the “income” effect stemming from the higher relative price of carbon products.

As long as the substitution effect is negative (so that people do buy less carbon products when their relative price is higher), the increase in income required to make the poor person no worse off is actually greater than the amount that they are taxed (as the point on the indifference curve was outside their initial budget constraint – in other words the new bundle that would make them indifferent costs more than the old bundle with the new, higher, relative price).  However, if the substitution effect is negative we also know that they will buy less carbon products – even in the face of this increase in income.

The size of the tax, Kyoto funding, and compensation

So low income people are compensated by more than they pay in higher relative prices in order to make them indifferent.  As the ETS sets a “level” of carbon emissions, the greater the compensation, the higher the relative price of carbon products must rise!  As a result, this compensation ensures that the carbon price rises by even more then it would have in the no-compensation state.

Furthermore, if the “level” target is set such that the government makes enough money to pay off our Kyoto liability, then the goal has to be net of any compensation.  As a result, compensating the poor does directly mean charging the “non-poor” more – thereby making the burden for paying the emissions trading scheme fall further up the income threshold.  In actuality – this is the same point as the above one.

Distributional justice

By compensating the poor the government is assuming one (or both) of two things:

1. The poor will suffer a greater welfare loss from the ETS and so should be compensated,
2. The non-poor should have to pay a greater than proportional share of the ETS bill than the poor

If you believe these things, the government plan suits your value judgments.  If you don’t believe these things then it doesn’t suit your feelings.

However, providing compensation to the poor does not imply that the scheme is pointless (something No Right Turn has also said in the past).