Another approach to Regulation

Much regulation occurs because there is no competitive suppliers of services. This is particularly so in infrastructure industries where it makes sense to have one infrastructure and only one supplier. The electricity industry, the communications industry, roads, water supply are all cases where it makes sense to have one physical infrastructure to deliver the service. In the electricity industry competition is achieved by separating the delivery mechanisms (the wires) from the electricity that is supplied. While this achieves competition it does not bring competition into the “wires” or infrastructure part of the industry.

Competition can be introduced into infrastructure by bringing competition to the investment side rather than to the supply side. For example as a policy decision it might be decided to direct new electricity generation capacity to generating sources that produce little or no greenhouse gas emissions and that the funds to build this capacity or to make savings shall come from existing consumers of polluting energy.

This can be achieved in a competitive way as follows:

Put a fixed surcharge on energy that produces greenhouse gases according to the greenhouse gases produced for each unit of energy. The size of the surcharge will be adjusted according to the outcome and so does not have to be exact. Distribute the surcharge back to consumers but require consumers invest the money in ways to reduce greenhouse gas or to save energy consumption. Any organisation that wishes to obtain access to these funds has to go through an approval process and prove that their technology will reduce greenhouse gas emission.

A true market is now created in the technologies to reduce greenhouse gas emissions. There are a large number of buyers and there will be many ways for them to invest their money and they will each choose the best investment for them. Whatever investment is chosen will reduce greenhouse gases. If the rate at which greenhouse gases are reduced is too slow then the surcharge is increased.

The same process can occur with broadband infrastructure. All existing communications technologies could have a surcharge attached to their use where the slower the speed the greater the surcharge. This money is given back to the consumers but they must invest the money in faster infrastructure. Any organisation can make proposals on how they will achieve higher speeds and the ones approved will then compete for funds from the people holding the money obtained from the surcharges.

This process removes investment decisions from the monopoly suppliers and forces them to compete for investment dollars. The current system with monopoly suppliers is that they charge more to consumers and they may or may not invest in ways to improve their service. With the surcharge approach there is money available to be spent and it will be invested in improving the system even if the monopoly supplier continues as the dominant supplier.

Water Rewards is an implementation of the idea as a way to remove the need for water restrictions and increase investment in water infrastructure. https://cscoxk.wordpress.com/2007/06/16/demand-management-through-pricing/

Transport Rewards is a suggestion on how to use the approach to make better use of existing transport infrastructure. https://cscoxk.wordpress.com/2007/05/14/a-cost-effective-approach-towards-sus/

The approach is superior to other approaches to encourage investment through pricing such as Carbon Trading or Water Trading because it is difficult for the system to be perverted and will result in the lowest cost to achieve the desired objective. For example and Energy surcharge will always result in lower prices than Carbon Trading because with Trading the cost of Carbon credits has to rise to marginal cost of producing green energy otherwise investments will not be made in less polluting ways of generating energy.

All improvements require investment and it is difficult for new technologies to gain a foothold against old technologies without some assistance and support because the immediate return on investment is almost always greater with the old technologies. Rather than giving direct assistance and picking winners the approach of giving many people funds and requiring them to choose between different technologies will bring competition to infrastructure.

The surcharge (or Rewards) approach is superior to a tax approach because taxes do not create a market. The government collects the taxes then decides how to spend the money. In effect there is only one buyer and this does not lead to efficient markets.

Demand Management through Pricing

For commodities in scarce supply pricing is the normal solution to demand management. Pricing is already used for demand management of water with the use of tiered water consumption tariffs. Pricing reduces demand but the reduction achieved depends on circumstances. A common figure for estimation purposes is that 10% increase in the price of water reduces demand by 3%.

However, pricing does not work as well for low demand levels as there is a minimum below which it becomes difficult for consumers to make savings. High prices at low levels of consumption is also socially undesirable as most people feel that everyone should be entitled to a certain level of water consumption regardless of their ability to pay.

Demand management of water simply by increasing the price of water will mean that in times of drought the price of water will have to rise by 200% or 4 times for all to reduce demand by 60%.

Another way to reduce demand is through water restrictions. Water restrictions only work on water usage where the restrictions can be enforced. This is normally water used externally. Thus demand management with water restrictions only works on some water consumption and does not affect indoor use. Other methods have to be found to supplement water restrictions to cover indoor use.

Another method of achieving reduced demand through price increases is Water Rewards.

How Water Rewards work

Water Rewards works by charging high users of water more for their high water consumption and distributing the rewards to low consumers and – in effect – paying low consumers to consume less. In addition Water Rewards directs expenditure of Rewards to the use of water sustainability technologies that fund water savings and water reuse initiatives.

It is assumed that paying people not to consume will be as effective in reducing consumption as charging people more for their high water consumption. This means that increasing the price of water for high consumers when distributed to all users is assumed to have the same effect as increasing the price to all consumers. This along with the requirement for Rewards to be spent on water saving technologies means that the price increase for a few users can achieve the desired demand management outcomes for all users.

The reduction in demand through all three effects is highly dependent on circumstances and on how well the demand program is promoted to the community. The only thing that is certain is that there will be a drop in consumption.

One way to determine the parameters for Rewards is to look at the long term infrastructure expenditure needed to build a sustainable water supply and to set prices to achieve that level. Prices to consumers who consume more than the sustainability level are increased while prices to consumers who consume less than the sustainability level remain the same.

To be socially equitable consumption levels should be set mainly on a per head basis. Rewards should be tradeable so that they will flow to the most cost effective ways of spending Rewards.

This approach is guaranteed to deliver sustainable water infrastructure using price mechanisms for the lowest price increase. It is the lowest price because a market is created for sustainable water infrastructure and all the money collected for Rewards will be spent on reducing consumption. The price increase is estimated to be less than half the price increase required from other pricing approaches.

It is estimated an expenditure of $20M a year will be needed for the ACT to reduce long term consumption by 2 gigalitres each and every year. Collecting this by increasing the top rate of the tiered water tariff will have the highest immediate impact on consumption.

A pilot voluntary Water Rewards scheme will be introduced into the ACT in the second half of 2007. If successful it will be extended to all residents and organisations. It has the potential to remove the need for compulsory restrictions on outdoor use.

The system can be used for any other public policy where governments wish to use markets to achieve a policy objective. To see an essay on this concept visit https://cscoxk.wordpress.com/2006/12/16/rewards-a-market-driven-framework-for-government-provision-of-public-goods/

Rewards Summary

• Rewards are socially equitable because people “earn them” and they are available to all.
• The government administrative costs are essentially zero. It is estimated that in the long term Rewards administration will be around 5% of money distributed.
• Rewards systems are continuous and are easily adjusted by changing the amount of money distributed through the scheme.
• Rewards can be transferred to community organisations, sucha as schools, to spend on community projects.
• Rewards create genuine markets in sustainable technologies and do not distort markets.
• Rewards can be used for household, community or system infrastructure.
• The psychology of Rewards is different from Rebates. Rewards are earned and given. To take advantage of them the householder has to act.
• Rewards provide a rich source of statistics that can be used to discover the most effective use of infrastructure spending.
• Money for Rewards can come from any source. Governments can distribute taxes, businesses can use rewards for promotional purposes (e.g. a hardware store could issue Rewards instead of discounts), high consumers of water can pay extra for their extra water

Contact: Kevin Cox, kevin.cox@edentiti.com
02 62291790

Rewards: A Market-Driven Framework for Government Provision of Public Goods

Rewards: A Market-Driven Framework for Government Provision of Public Goods

 

Author: Kevin Cox and Heather Caufield

 

 

The success of Rewards programs such as frequent flyer and buyer schemes or international carbon credit programs have laid down a blueprint that can be readily adapted to create a new, viable means of financing government investment in Public Goods through revenue generated from current consumption of related goods. The Rewards methodology provides a framework for governments to influence consumer behaviour, direct funds to what they believe are desirable ends and to use market mechanisms to manage the distribution of these funds. This paper discusses ways in which public authorities could implement such programs, using the examples of Rewards to reduce consumption of water and to reverse greenhouse gas emissions.

 

Public Goods are items or services that share two main characteristics: non-excludability, meaning that if the good is available to one, it is equally available to all; and non-rivalry, such that consumption by one entity does not reduce the capacity for another to consume it or benefit from it. A good example is the air we breathe. It remains freely available to all and regardless of how much air one person consumes, it in no way impinges on the availability of air for others.

 

Other often-quoted examples include the defence of a nation, traffic lights and street lighting, and the content of copyright. Global Public Goods, as the phrase suggest are public goods that are not confined by national boundaries, such as peace, health, and financial market stability.

 

On the other side of the coin are Public Bads, where the consumption of some private goods causes an external effect resulting in the cost of the effect being born by the community rather than the consumer. The most common examples are grouped under the term ‘pollution’, whether it be clean air, greenhouse gases, roadside rubbish, plastic bags, destruction of the habitats or salinity.

The production of Public Goods and the alleviation of the effect of Public Bads require investment and the allocation of resources. The problem however arises in determining who pays to provide these goods and services.

 

A Question of Funding

 

By definition when a public good becomes available, it is available to all. For example, where streetlights exist they benefit the entire community. The concern for those funding Public Goods is that without rules and ways of enforcing the rules, some in the community will receive the benefit of the Public Good without paying their fair share. These consumers are known as Free Riders.

 

The existence of Free Riders acts as a deterrent to private sector investment in Public Goods. Why invest when you will not reap a full return? Worse, if only a limited number of consumers pay their share, the investment may fail to break even. The result is underproduction or no production of the public good.

 

There are numerous strategies for minimising the negative impact of Free Riders including:

• dominant assurance contracts, in which participants agree to contribute to a Public Good investment on the proviso that a guaranteed minimum level of contributions is reached;

• the Coasian solution, under which potential beneficiaries of the Public Good combine resources;

• appeals to public spirit and morality;

• funding by privileged groups, those entities that will gain most from the provision of the Public Good;

• privatisation, or the merging or buying out free riders;

• legislated exclusion of free riders, if feasible¹.

 

None completely remove the issue of Free Riders but they do offer ways to improve the viability and attractiveness of Public Goods investment.

 

There is yet another method of funding Public Goods which comes under the broad heading of advertising. That is, where the consumption of a Public Good – such as free to air TV – may result in the purchase of an excludable and depletable good. Advertising is used in news and other information services where the production of information is paid for from the selling of advertising. If the conflicts of interest inherent in the mixing of advertising and information services can be overcome this can be a viable method of funding.

 

 

The Role of the Public Authority

 

The most common approach to the supply of Public Goods and the alleviation of Public Bads is government provision, either through complete government funding or via subsidies.

 

While public funding is the simplest and seemingly the most administratively straightforward it introduces inefficiencies because of the difficulties in determining the allocation of funds to Public Goods, who pays what, and how and where the funds are distributed. With government allocation and control of funds, most of these decisions are made through political and administrative processes rather than market-based and behaviour modification solutions.

Various methods are introduced by governments to assist in allocation, one of the most widespread being “user pays”, where agencies introduce a requirement for partial or full payment for services by consumers and establish exclusion through waiting lists and other rationing devices. Australian guidelines for conduct of government agencies implementing user pays programs were established in the National Competition Council’s (NCC) “Competitive Neutrality Reforms” review of the mid 1990s. Since then the take-up of user pays schemes by Federal, State and Local government authorities has made the user pays philosophy an expected, if not always accepted, part of the Australian Public Goods landscape.

 

The Australian health system is an example of this method, where some of the cost is borne by the user, with health insurance organisations forming a buying cooperative to act for the user. The remainder of the health cost is met by the government, which attempts to control over-servicing.

 

Unfortunately, the user pays economic model frequently falters on a number of counts. It offers little opportunity for consumer choice, the lack of which removes much of the stimulus for market growth and development. It has limited behaviour modification effect, as there is little positive encouragement to change habits. In the health system example, consumers are subjected to the same incentives regardless of whether they are publicly or privately insured, leaving little motivation to pursue one option over another and encouraging Free Riders.

 

A Queensland Parks & Wildlife Service study into best practices within user pays programs noted that such systems can offer government agencies and their customers a number of benefits providing they follow careful design, clearly stated objectives and they achieve cost-effectiveness. However, the study also found that “few agencies were able to give accurate or even rough estimates of the cost-effectiveness or profitability of their user-pays operations. Costs of revenue collection and system administration were generally not known.”²

 

An alternative range of allocation methods that are also designed to restrict consumption may be grouped under the general topic of derivation markets that introduce some market forces. With derivatives, non-cash instruments of exchange are established, in effect becoming a rationing method for Public Goods. Common examples are food stamps, carbon credits and school vouchers or scholarships. These instruments are alternatives to cash and are used by governments to channel expenditure. They introduce choice and a market, allowing restricted options in where the derivatives can be spent.

 

Derivatives increase the flow of money into a particular Public Good and allow distribution of the benefits to a targeted audience. Proponents argue that even limited choice results in active consumer participation and a healthier market. Those against cite concerns that funding of derivatives will be to the detriment of the overall investment in a Public Good, and that a restricted market will naturally become more expensive, with costs rising to take advantage of government subsidies.

 

Current schemes for the funding of Public Goods are far from ideal, as they tend to leave everyone unhappy. Those that include some market component work best but some that purport to be market driven are often distorted markets because either there are not enough sellers, not enough buyers or not enough choice to optimise the allocation of funds.

 

Consumer Preferences

 

A further consideration for any funding model that offers a degree of choice is the influence of consumer preference on spending behaviour.

 

Recent economic thought from U.S. economist David George³ suggests that there may be two kinds of consumer preferences: first-order preferences, which are influenced by immediate demands or circumstances, and second-order preferences, typically involving a greater depth of thought and reflecting the preferences we would like to have or feel we ought to have. The former provide the impetus for impulse purchases and cost-based decisions. The latter tend to be more morally and socially oriented and are most likely to be of influence in appeals for funding of Public Goods.

 

If public authorities can tap into consumers’ second-order preferences when devising Public Good funding schemes, they stand a greater chance of achieving consumer responsiveness and reaching their policy goals.

 

The Rewards methodology

 

Within the private sector, a common method of encouraging and directing consumer behaviour is to use marketing rewards such as “Frequent Flyer points”, the promise of “four cents off per litre” or the gift of a free cup of coffee on every fourth visit.

 

These marketing rewards offer consumers the opportunity to earn a bonus in return for a desired outcome (such as reaching a certain level of expenditure at the one retail outlet). They are structured so that they may only be spent in designated ways that encourage loyalty (or repeat business), further benefiting the sponsoring company. Loyalty programs are becoming ubiquitous in many markets as they can be very effective and are popular with consumers.

 

The Public Goods Rewards methodology combines elements of private sector loyalty programs with public sector derivatives and user pays programs to create a framework for government provisioning of Public Goods and the alleviation of Public Bads. It creates a framework to implement Elkington’s Triple Bottom Line for Public Goods.⁴

 

It provides governments with the ability to direct and encourage change in consumer behaviour while ensuring that the most economically efficient method of providing the Public Good is obtained through a market approach to financing the Public Good.

 

The aim is to offer governments a level of control over policy and consumer behaviour in the provision of Public Goods, leaving it to the market to manage and optimise the allocation of resources.

 

The methodology is as follows:

1. Define the desired outcome as a policy statement

2. Define measures to know when the desired outcome is achieved.

3. Determine the desired behaviours to help achieve the outcome

4. Devise a negotiable instrument (the Reward) that helps achieve the outcome

5. Fund the negotiable instrument with the consumption of a related first-order preference good

6. Specify capital projects in which Rewards may be invested, helping individual consumers to achieve their second-order preference objectives

7. Measure the outcomes and tune parameters to achieve the objective

 

Step 1 will typically involve a Public Good that appeals to second-order preferences, such as public health or availability of education.

 

Step 2 is some measure that tells whether the second-order preferences are being achieved. It could be an increase in environmental flows of water, or a reduction in the greenhouse gases in the atmosphere.

 

Step 3 identifies the consumer behaviours or activities that need to be encouraged or altered to achieve the desired outcome. Such things might be riding to work, or reducing the amount of water used for a garden.

 

In Step 4, the negotiable instrument or Reward will vary according to the desired outcome but could include existing derivative-style mechanisms such as scholarships (encouraging access to education), food stamps (reducing the ill-effects of poverty) and carbon credits. Rewards should be designed to appeal as a mechanism for the transfer of funds between consumers rather than a punitive tax. Rewards are used instead of cash because they offer a way of directing funds towards the desired outcome.

 

In Step 5 a way is devised of funding Rewards through charging more for undesirable behaviour. There are often existing mechanisms in place to achieve this such as higher prices for extra water or carbon credit taxes on greenhouse gases.

 

In Step 6 it is important to try to get Rewards to be spent on investment rather than consumption. Most second-order preferences require ongoing investment to achieve. For water sustainability it could be investment in ways of saving or recycling water. It is also important to make Rewards transferable so as to create a market in Rewards. This will free up funds for those people who think they can spend Rewards in an economically efficient manner to achieve second preference goals. This in turn creates a capital market for second-order preference technologies such as windmills, solar cells or tidal power.

 

Markets exist where there are many buyers and sellers, and buyers can make choices as to where they spend their funds.

 

Using Rewards rather than a general currency is important because Rewards will rarely be worth their face value when converted to cash. By restricting their use to specific investments we create a market and the money will not “leak” to other activities.

 

While it could be argued that governments can allocate taxes collected from greenhouse gas emissions to worthy projects, this does not create a market. It is important to give Rewards to as many people as we can because this then creates many buyers. Most well-meaning taxes collected for specific purposes end up in consolidated revenue and are used for other purposes – which, while worthy, should not be paid for from taxes collected for a particular reason.

 

Schemes such as envisaged in this essay have been difficult to implement until recently. Technology has made Public Goods Rewards practical because of the spread of the Internet, because of public acceptance of this technology and because of the computing power needed to handle the transactions. Common currency is an artifact of necessity because it has been the only efficient way to devise a negotiable instrument. However, the advent of electronic money brings with it the possibility of tagging these new currencies and associating behaviours with the money itself.

 

It is believed that the idea of tagged money can be extended to bring the idea of markets into areas where previously deemed impossible, such as peace between populations – but that is the subject of another essay.

 

The concepts of Public Goods Rewards can be introduced in any society at any level of grouping, providing the members of the group accept the rules and acknowledge the worth of the Rewards. It can be at a household level through to the United Nations.

Example 1: Sustainable Water Use

 

In recent years, water has become one of the most newsworthy Public Goods in Australia. The ongoing drought and rationing have helped to create a high level of awareness among consumers resulting in a widespread acknowledgement of the need to introduce more sustainable practices.

 

Turning that acknowledgement into action requires education and cooperation from water consumers. It requires continuous capital funds investment to develop recycling and water saving systems, which on their own are not economically viable when they compete with free rain.

 

Following the methodology outlined earlier, a Public Goods Rewards program for sustainable water use would be as follows:

 

1. Establish an objective such as removing the need for urban communities to be subjected to water restrictions and ensuring an increase in water flows in natural waterways to an environmentally appropriate level.
2. Establish ways of measuring the outcomes. In this case it may be the removal of the need for urban water restrictions and the increase in the flow of the inland water systems to an environmentally appropriate level.
3. Determine desired behaviours such as reducing unnecessary water consumption for toilets, showers, garden watering, dish and clothes washing.
4. Create Water Rewards, transferable vouchers awarded to individuals who achieve a predetermined reduction in water consumption. The vouchers may only be spent on ways to further reduce water consumption, either within the home or in the community.
5. Finance for Water Rewards would come through consumer water usage charges, with those demanding more water paying a higher premium than those using less than a pre-determined, sustainable quantity.
6. Establish a market for Water Rewards, restricting redemption of the vouchers to equipment and services that further reduce water consumption or give ways of increasing supply through water tanks, grey water reuse, recycling schemes, wet land projects, cloud seeding or even desalination plants, either within the home or in the community. A portion of the funds from the sale of the water could also be retained by the water authority for investment in water conservation measures or water infrastructure.
7. Measure the results and see if the objectives set are being achieved. If they are not then increase the cost of excess water, increase the rewards, and open up the market to better ways to spend rewards.

 

The system would not mandate how water conservation is to be performed and would make no recommendations on the methods used. It would simply offer economic incentives in an equitable and politically acceptable manner.

 

In addition to achieving the primary outcome of a reduction in water use, a Rewards program would provide funds for water-related infrastructure projects. The process offers incentives to assist first-preference decision making as well as appealing ethically and morally, giving weight to consumers’ second-preferences.

 

A self-funding program that could be offered in any community that has metering of water, its success or failure would easily be determined by measuring the decrease or otherwise in water use following the introduction of Rewards.

 

 

Example 2: Reducing Greenhouse Gases

 

Related to the concerns surrounding water, greenhouse gas emissions and their impact on global warming are becoming major issues for governments around the world. Carbon credits and taxes are part of the solution but it is apparent that these measures alone will not solve the problem. With climate change already being experienced, the imperative is for public authorities to begin thinking in terms of negative emissions rather than just a reduction in emissions.

Using the Public Goods Rewards methodology, a government looking to act on reducing the amount of greenhouse gas in the atmosphere may define a desired outcome as ‘the funding of research into ways of increasing natural carbon fixing mechanisms and creating energy sources that remove more greenhouse gases than they put into the atmosphere”.

Existing carbon credit schemes may provide funds for research and development but there remains the need for a market mechanism to direct the flow of funds. In addition, consumer behaviour needs to change if there is to be any hope of removing greenhouse gases from the atmosphere.

 

Greenhouse Gas Rewards would offer public authorities a means of using the money raised through carbon taxes in a positive feedback loop, providing incentives for consumers to change their behaviour while stipulating that the rewards earned must be spent on greenhouse gas reduction investments.

 

This could be achieved by converting carbon taxes into rewards for people demonstrating low greenhouse gas behaviour. For example, a person would earn rewards for buying a public transport annual ticket, by not owning a car, by using less than the average amount of energy per person in their house and so on.

 

As with the Water Rewards example, Greenhouse Gas Rewards would have a value, meaning they could be transferred or sold but they may only be spent on greenhouse gas reducing technologies or activities. Examples include growing trees, developing bio fuels, fixing carbon from the air, or the purchase of solar cells.

 

This approach will produce a virtuous feedback loop. Those people saving greenhouse gases will be rewarded with funds that they can only use on ways of saving more greenhouse gases. Importantly it provides a market mechanism to direct carbon taxes to the technologies that give the best commercial return while still reducing greenhouse gases.

Furthermore, such a system triples the economic effect of the single carbon tax. It provides a disincentive to use dirty energy; a reward for changing behaviour to use clean or no energy; and a source of investment funds to produce energy in less polluting ways as well as funding research into techniques to actually reduce greenhouse gases in the atmosphere. For example, research into biological mechanisms to “eat” CO2 could give a payout from the payment to the inventors and developers of the CO2-eating techniques by allowing rewards holders to invest in the company that implemented the solution. The company would be paid from carbon credits and the people who invested their rewards would be paid in dividends from the company.

Conclusion

Simple market mechanisms based on first-order preferences are unlikely to provide a solution to funding Public Goods and removing Public Bads. Public Goods provision is almost always related to second-order consumer preferences. Rewards based systems offer a means to reward second-order preference choices and give ways of financing the infrastructure needed through market mechanisms to achieve policy objectives. The systems created are fair, equitable but still harness the magic of markets to achieve the economically best allocation of funds. The systems are tunable to give the desired policy outcomes because the levers of control still reside with governments. The systems can be applied to almost any policy outcome that requires the provision of Public Goods.

 

Notes:

The Wikipedia: http://en.wikipedia.org/wiki/Public_goods

² Queensland Parks & Wildlife Service February 2000 Benchmarking and Best Practice Program User-Pays Revenue A report to the ANZECC Working Group on National Park and Protected Area Management http://www.deh.gov.au/parks/best-practice/reports/user-pays/results.html

 

³ George, D 2001 Preference Pollution, University of Michigan Press

 

⁴ Elkington, J. 2003, Cannibals with Forks: the Triple Bottom Line of 21st Century Business. http://www.amazon.com/Cannibals-Forks-Business-Conscientious-Commerce/dp/0865713928

 

References:

 

Coulson, A J 2003 The Citizen’s Guide to Education Reform http://www.schoolchoices.org/index.html

 

Edentiti Pty Ltd, Sustainable Water Project http://www.getmail.com.au/design/water/water.html

 

Groves, Theodore & J Ledyard 1977 Optimal Allocation of Public Goods: A Solution to the “Free Rider” Problem, Econometrica, Vol. 45, No. 4, pp. 783-810

 

Hamilton, C The Worldview Informing the Work of the Productivity Commission: A Critique speech to a Productivity Commission Retreat: May 11, 2006

 

International Task Force on Global Public Goods Meeting Global Challenges 2006 International Cooperation in the National Interest

 

Long, R T Autumn 1994 Funding Public Goods: Six Solutions, Formulations: Autumn 1994

 

Olszewski, W & H Rosenthal 1999 Politically Determined Income Inequality and the Provision of Public Goods

 

A Fat Story

Once upon a time there a country who thought that having a well fed population was a sign of prosperity and a well run economy. The Prime Minister was heard to boast on many occasions on the success of his government’s policies particularly as it related to the consumption of fat foods. The more fat consumed the greater the measure of prosperity that his economists called the GFP (Gross Fat Product). His treasurer was particularly proud because he collected taxes on the fat production and the more taxes the greater the budget surplus.

The country started to perform spectacularly as a highly populated country to its north found that its people also loved fat and could not buy enough of it. They started to import fat in such large quantities that the world wide prices increased and the budget surplus of the lucky country increased even more. This delighted the PM because he knew he would be able to spend much of the surplus advertising his achievements before the next election.

There were a few people who raised warning bells about the effect of the consumption of fat and said that if too much was consumed then the population would start to die prematurely because of overheating. However, the PM remained a fat sceptic.

Not withstanding the PM’s sceptism a world wide movement of people arose who believed that the effects of too much fat were bad and they became known as the Lean Movement or as some called them the Leanies. They invented a way of measuring the bad effect of fat and they called it the BMI for individuals. To measure the effect globally they came up with the term Global Accretions which was derived from the aggregation of all the BMI’s. They were able to convince enough countries that the global community needed to limit Global Accretions and they even managed to get most countries to agree to what become known as the Fato Protocol so named because it was signed in Fato.

The protocol required all countries to limit their BMI’s so that the total Global Accretions were limited. There were exceptions and even though an exception was made for the PM’s country he would not sign it because his best mate would not sign it either and as he said one in all in. The exception was interesting because it allowed the country to count the BMI’s of all animals – not just humans. Even though the people grew fatter and the protocol was not signed the PM was able to boast that they were meeting their Fato targets because his farmers were unable to grow sheep because of a drought and the country was able to support more kangaroos which were leaner than sheep.

All went well until suddenly the population realised that Global Accretions were starting to cause consequences that if left unchecked would cause most of the people in the world to overheat due to the layers of fat.

The PM remained a skeptic but the population become convinced that there was a problem and so the PM became a Fat Realist and finally a Fat Pragmatist.

To solve the problem he formed a task force of all the fattest people in the country and asked them to come up with a scheme to solve the problem. They devised a scheme called Fat Trading. A cap on the amount of fat to be consumed was set and people were given fat permits which permitted them to eat fat. That is, unless you had a Fat permit you were not allowed to eat fat. However people could trade Fat permits and if someone did not want eat fat they could trade their permits to someone who did want to eat fat. If you ran out of permits you could always eat other things. The PM was told by his economists that this must work because of market forces and all the PM had to do was to sit back and let the market do its magic. The Treasurer was also very pleased because he knew that if he ever needed some more money for advertising he would just sell a few more permits for “special reasons”.

The PM duly approved the scheme but he made sure that all the fattest people got free permits. He also made sure that that the total cap was set so that the price of permits would not rise too high. The economists pointed out these problems but overall they were pleased because they had a trading scheme in place. They believed that when the price of permits rose people would change their behaviour and substitute other fat free foods. They knew that it was important to have a market as markets always solved every problem.

Unfortunately it did not work very well. The price rose 100% but this only decreased the overall consumption of fat by 1%. The people with fat permits also became richer as they were able to sell some of their permits and they were able to offset their permits by grazing kangaroos in their back yards. National Accretions rose as on average people continued to get fatter because the fat people put on fat at even greater rate than the Leanies who stopped eating any fat at all. Accretions continued to go up even though the cap continued to drop and many people became both rich and fat through trading permits.

The economists were happy because they saw the market at work as predicted. Fat foods became expensive and Lean foods became cheap and the market had worked its magic. Pity about National Accretions.

Andrew Leigh’s “A Milk Story” was the model for “The Fat Story”

Cap and Trade

The Prime Ministerial Task Group on Emissions Trading states

By placing a price on emissions, trading allows market forces to find least cost ways of reducing emissions by providing incentives for firms to reduce emissions where this would be cheapest, while allowing continuation of emissions where they are most costly to reduce. This underlines the fact that emissions trading is not an objective in itself, but a means of achieving a certain level of abatement at the lowest cost possible.

This is the reasoning behind all cap and trade systems no matter how the systems are designed. On page 45 of the report there is an example of how the system will operate.

Two companies, A and B, each emit 100,000 tonnes of CO2 each year. The government wants to cut emissions by 5 per cent, and it gives each company an allowance to emit 95,000 tonnes. Each company has the option of either reducing its emissions by 5,000 tonnes or buying up to 5,000 tonnes of allowances from elsewhere. Suppose the market price for the allowances turns out to be $10 per tonne.
Company A can reduce its emissions for half this cost per tonne, so it is reasonable for it to cut its emissions by 10,000 tonnes: if it sells the extra 5,000 tonnes of emissions reductions (for $50,000) it will be able to recover its expenditure.
For company B, making reductions is more expensive, at $15 per tonne. It decides not to reduce its emissions, but instead to buy the 5,000 tonnes of surplus allowances on offer from company A. If company B reduced its own emissions, it would cost $75,000, but if it buys them from company A, the cost is significantly lower, at $50,000.
The end result is that both firms are better off by $25,000 compared to their costs without trading. If they are the only two companies in the country, this means the country’s business sector is able to cut emissions by 5 per cent for $50,000 less than if the government forced both companies to reduce their emissions by the same amount. In a scheme with full international linkages, this example could equally apply to trade between companies in different countries.

There is a fundamental flaw with any cap and trade which will result in under investment in clean technologies. It is assumed that there is a company somewhere that is able to invest so that it can produce the same amount of the product (say electricity) without emissions for the current price of electricity plus $10 per tonne of emissions saved. Various industry commentators say that the price of emissions has to rise to $40 per tonne before investment in alternative emissions free generation of energy will become worthwhile. As the price per tonne is going to be limited to less than $40 and will be set by the government the rational response of any company will be to sell their emissions for whatever price they can get and to stop producing energy. This will have the effect of reducing the generating capacity of electricity which in turn will lead to an increase in energy prices until the price of ALL energy rises to be the equivalent of $40 a tonne. Thus all companies with existing polluting generation capacity will obtain excess profits from their permitted production. It is unlikely that much of this excess profit will be invested in producing clean energy as it is to the advantage of polluting companies to keep polluting as long as possible and at as high a price as possible. Investing and making clean technologies more economically viable is not in the interests of existing polluters.

All cap and trade systems suffer from these flaws. That is, the money from selling emissions will NOT go to investing in clean energy until the price of all energy is the same as clean energy production. There is an inbuilt incentive for companies to keep polluting for as long as possible.

The article The Carbon Folly published in Newsweek March 12th 2007 outlines the dismal record of Emissions Trading. It is very easy to pervert the intent of trading particularly if the scheme is a local scheme. To quote from the article.

Since developing countries don’t have any caps on emissions, companies can take the handsome payments they receive from carbon cuts and use the money to build new fossil-fuel and coal factories.

This will be particularly attractive to a coal exporting country such as Australia.

There is fortunately a way to solve the problem. Any money collected by energy companies from selling emissions permits must be spent on approved ways of producing – or saving – energy. Similarly any money collected by governments from selling permits must be spent on approved cleaner ways of producing – or saving – energy. This will then give rise to a market in clean energy sources. That is, the money will go to the companies that can produce the most clean energy within their emission permits. The money can also go to energy savings technologies and because of market forces it will gravitate to the most economically efficient approved way to reduce emissions.

There is an even simpler way of solving the problem that is much more direct and does not require the setting of any arbitrary cap and will be economically efficient at achieving the target of reduced emissions. Whenever any greenhouse gas is produced then there is a cost applied. This cost is a surcharge on the price of the product but the surcharge stays with the purchaser. The surcharge must be spent on approved infrastructure that will reduce emissions. A surcharge is NOT a tax but is a compulsory saving.

The government has to set the surcharge and approve where money can be spent. If emissions do not come down quickly enough then the surcharge is increased. If it is too quick then the surcharge is decreased.

Approving where money can be spent is very transparent. An organisation that wishes to sell its products has to publicly prove that its products will or may reduce emissions.

As a surcharge is NOT a tax it will have a minimal distortion on the economy to achieve the desired outcome of reduced emissions. A cap and trade system can still be left in place and can operate in parallel with the surcharge system but it is unnecessary.

The surcharge approach is particularly useful for those situations where it is not clear how to measure emissions nor clear how to measure the effect of a new technology on emissions. For example it is difficult to measure the emissions from raising live stock and it is difficult to measure the emissions that might be saved from fundamental research that as yet has no immediate application.

There is an even better way to distribute the surcharge. Rather than give the surcharge directly to the purchaser give the surcharge in inverse proportion to those citizens or organisations that through their actions produce less greenhouse gases as measured by the surcharges they generate. Thus if the average surcharge amount per citizen was $x then the person who generated $x-$y would receive $x+$y while the person who generated $x+$y would receive $x-$y. In effect this rewards people for consuming less. (note this calculation assumes a symmetrical distribution so the formula would need to be adjusted for a non symmetrical distribution)

To return to the example above of the two companies but with the surcharge in place. Let us assume that the only way that the energy surcharge could be spent would be with one or other of these companies. The market determines that the company that could reduce its emissions for the least cost would be the company that would attract the investment and hence the most economically efficient outcome is achieved. The system can be easily extended throughout the Australian economy and the world simply by extending the range of approved places where money can be spent.

A major advantage of the surcharge system is that it can be implemented immediately because similar mechanisms that are currently used to collect taxes can be used to collect and distribute the surcharge. Places where money can be spent will be many and will include all the areas where governments now or are proposing to offer rebates and will include all clean energy ventures.

Compliance costs will be low because people who wish to claim the surcharge will be volunteers. That is, surcharges will not be automatic and a person will have to agree to participate in the system. While this will be easy to do it also means that people can be removed from the system for a period if they are found to abuse it. Similarly merchants and businesses who are approved can have their approvals removed and if they abuse the system they will be taken from the system for a period.

Letter to Editor CTMonday 4th on Environmental Flows

Robert Neil (“no wasted water in delicate balance of habitats, June 1 p15) argues for the retention of environmental flows policy.

Critics of the regime are not calling for the removal of environmental flows and are not suggesting that stopping environmental flows will solve the current problem.

They are asking that the regime for environmental flows in years of high rainfall be reexamined and that low flows should be monitored for effectiveness.

The present environmental flow rules means the dams are unlikely to fill.

The policy says that large quantities of water are to be released when dams reach a certain capacity. The release in 2000, 2001 and 2002 below Cotter and Googong totalled about 120 gigaliters.

This is two years consumption at current rates. It is obvious now that this water should not have been released. The reason for the release of large quantities stated in the environment report was to scour the river with large flows and remove sand. If this is the reason then it was not the best environmental strategy. The best strategy to get the occasional scouring is to try to keep the dams full and when there is a rain event to supplement spillway floods with the release of water. This will give less frequent but larger floods and create greater scouring.

********** the following was cut from the letter **************

There would have been an event in 2000.

There is nothing in the reports that I can find that measure the effectiveness of the current low level flow regime. Perhaps an approach of setting objective measures of “health” such as the number of species of different types in the water ways would give more reassurance that the river health was good. Perhaps a better environmental flow policy would be to keep the flows at a minimum during the “good years” because there would be some natural “side” inflows and to release more in the bad years.

Letter to Editor published CT 2nd June 2007

Economists are fixated on cap and trade systems to set a price for carbon. That is, someone sets an arbitrary target for carbon emissions then allocates permits that people now trade. While this might work it is not the best most certain solution to the problem. Another solution is to estimate the amount of money that we need to invest in renewable energy then apply a carbon surcharge where the money raised must be spent on renewable energy technologies. This is certain to work. The surcharge needed to reduce emissions to zero within 20 years with existing technologies is estimated at 15% on existing energy. As the tax on energy now approaches or is greater than 50% on some energy a surcharge (not a tax) of 15% applied to reducing greenhouse gases would not greatly affect the economy. The approach is market based but the market is in technologies that reduce carbon emissions not an artificial easily compromised market in carbon permits.

Rewards versus Trading

Economic Assertions for Rewards versus Permits Trading

Increasingly, trading schemes are advocated as the economic tool of choice to allocate public goods efficiently and to alleviate public bads. Two well known schemes are Carbon Permits for reducing greenhouse gases and Water Permits to allocate water. These schemes work by creating artificial commodities to represent the problem being solved such as the limited supply of water and the high level of green house gas emissions. For water, a cap is set for the consumption of water from sources such as rain and ground water. The cap is then apportioned between members of society and the allocations can be traded. For greenhouse gases, a cap is set on the emission of green house gases and emissions are represented by carbon permits which are allocations that permit people to emit greenhouse gases. These permits can be generated by different activities that either reduce the amount of carbon emissions or that produce energy or other products which are emission-free.

A Rewards scheme works in a different way. People are paid to reduce their consumption and the payment comes from a surcharge on people who use excess water and on those whose activities emit greenhouse gases. Rewards must be spent on ways to solve the problem being addressed.

A measure of economic efficiency for both Permit Trading schemes and Rewards schemes is the total amount society pays to achieve the desired result. For water it is the total amount paid by the community to remove the need for water restrictions and for greenhouse gases it is the total amount paid to reduce greenhouse gas emissions to the desired cap.

It is asserted that a Rewards scheme is at least twice as economically efficient as a Permit Trading scheme, as measured by the total amount of money needed to achieve the desired result.

Rewards schemes are more economically efficient because:

• They pay people to help achieve the desired result. That is, there is a direct economic benefit to the consumer from reduced consumption.
• They change behaviour through both higher costs and through incentives.
• They foster and enhance trading systems for technologies that help solve the problems being addressed.
• They deal in real products that are not subject to manipulation and to abuse which may, in turn, cause economic inefficiences.
• They ensure that money collected over and above the cost of production is spent addressing the problem being solved.
• They cost less to administer.

It is asserted that a Rewards scheme will require between half and one third the amount of money to be spent to solve the problem being addressed, compared with a Permit Trading scheme. For example, if society wishes to reduce carbon emissions to 20% of the current level then a Rewards scheme will produce that reduction for one half of the cost of a Permit Trading scheme. Furthermore, if an urban community wishes to remove the need for water restrictions then a Rewards scheme will achieve the desired result for one half of the cost of a Permit Trading scheme.