Portal de Periódicos da CAPES

Policy Considerations for Mandating Agriculture in a Greenhouse Gas Emissions Trading Scheme: Reply

2011; Wiley; Volume: 33; Issue: 4 Linguagem: Inglês

10.1093/aepp/ppr025

2040-5804

Tihomir Ancev,

Economic and Environmental Valuation

In a comment to Ancev (2011), De Cara and Vermont (2011) focus on two points: a) they provide a detailed description of the elasticity of emission abatement in agriculture to prices of emission allowances in a Greenhouse Gas Emissions Trading Scheme (GHG ETS); and b) they argue that the transactions costs of mandating the agricultural sector in a GHG ETS may not be as high as suggested in Ancev (2011). De Cara and Vermont use these two points to put forward an argument that agriculture should be mandated to participate in a GHG ETS, at least, in their view, in the context of the European Union (EU) ETS. In this reply, I posit that point a) above misses a key consideration: the legal requirement to surrender allowances by all entities mandated in an ETS. This legal requirement pertains to those entities that might be able to reduce their emissions at low cost, but also to those entities that will need to expend high costs to reduce emissions, and will therefore look to the market to purchase allowances in order to comply with this legal requirement. As for point b), I refer to the literature on transactions costs in agriculture, on transactions costs in GHG ETS, and the possibilities to reduce them. References to this literature can be found in Ancev (2011). As a very brief summary, this literature shows that transactions costs of regulations in agriculture are likely to be high (for example, Falconer and Sounders, 2002); transactions costs per unit of allowance for small GHG emitters (most agricultural entities) are relatively higher in comparison to larger GHG emitters (Betz et al. 2010); and consolidating allowances in the agricultural sector has its detriments, and is not free of transactions costs (Productivity Commission, 2008). Returning to point a), I will proceed with a simplified stylised setting. Let us say that an economy is currently emitting 100 units of GHGs from the sectors where GHG emissions can be controllable. For argument's sake, assume that agriculture is emitting 10% of these emissions, i.e., 10 units. There is a consensus in society that the emissions from those sectors be reduced by 10% (there will be only 90 units emitted), and that the reduction be achieved through an emissions trading scheme (ETS). Suppose that there are two proposals on the table that are identical in all respects –importantly including the same emission reduction target of 10% – except for the following: Proposal 1: mandates with full liability all GHG emitting sectors as defined above, excluding agriculture, to participate in the ETS. Proposal 2: mandates with full liability all GHG emitting sectors as defined above, including agriculture, to participate in the ETS. The key here is to understand the expression: ‘mandates with full liability’. This expression means that each legal entity that will participate in the ETS will be legally required (or liable) to surrender (or present) allowances to the regulatory agency at the end of each accounting period. The quantity of the surrendered allowances must be commensurate with that entity's emissions of GHGs for that period.1 For the agricultural sector, this means that each entity that is mandated to participate in the ETS has to surrender allowances to the regulator, irrespective of its abatement cost structure. Let us consider the mechanics of the two proposals in some detail. Under Proposal 1, the sum of emissions from all sectors, excluding agriculture, will have to be reduced by 10%. Initial allowances, summing up to 90 units of GHG emissions, will be allocated in some way (auctioning, grandfathering) to each legal entity. As these allowances are tradable, their equilibrium price established in the secondary allowance market will reflect the cost of removing the marginal unit of emissions. Under proposal 2, the sum of emissions from all sectors including agriculture, will also have to be reduced by 10%. Again, initial allowances summing up to 90 units of GHG emissions – but now including emissions from the agricultural sector – will be allocated in some way. Each entity has to surrender allowances in the amount equal to their emissions. Under this proposal, each agricultural entity mandated to participate in the ETS will find itself in one of three possible situations: 1) reducing its own emissions by exactly the required amount and surrendering the initially allocated allowances. This implies no participation in the secondary market for allowances, a situation observed for many small emitters mandated in the EU ETS (Betz et al. 2010). However, this situation still carries the transactions costs to the entity, and to the government. 2) Reducing its own emissions by less than the required amount and buying extra allowances on the secondary market in order to be able to surrender a sufficient amount of allowances. This situation implies that the entity's abatement cost structure is such that it finds it beneficial to buy allowances rather than to abate. 3) Reducing its own emissions by more than the required amount and offering some allowances on the secondary market, as the initial allowances are now in excess of the amount that has to be surrendered. This situation implies that the entity has an abatement cost structure that makes it more beneficial to abate and to sell allowances. On aggregate, the agricultural sector as a whole will find itself in one of three possible situations: i) On aggregate, reducing emissions from the sector by 10%. As the agricultural sector will hold allowances summing up to 9 units of GHG emissions (90% of the original 10 units of emissions, assuming grandfathering), there will be on aggregate no net demand or supply of allowances from/to the agricultural sector.2 The implication for the price of allowances in the overall market is that there will be no change in prices, as the cost of abatement at the margin in the agricultural sector will coincide with the cost of abatement at the margin in all other sectors. In this situation, there is no obvious benefit of mandating the agricultural sector in the ETS. The low cost abatement possibilities in agriculture will exactly offset the high cost abatement activities in agriculture that will either have to be physically undertaken, or will have to be covered by purchasing allowances (from agriculture or from somewhere else). The last point is crucial here, and in my opinion is missed by De Cara and Vermont (2011): there are many agricultural activities where abatement will be very expensive to undertake; if these activities are mandated in an ETS, they will have a legal obligation to surrender allowances for their emissions. To do that, they will either have to abate, which will be expensive, or demand allowances from the other parts of the agricultural sector, or from elsewhere. But if the agricultural sector on aggregate does not have a clear abatement cost advantage relative to the other sectors, the extra demand for allowances from high abatement cost agricultural activities will absorb all low abatement cost possibilities in agriculture, at no net benefit to the overall GHG ETS, or to society. In this situation, there will be no visible benefits in mandating agriculture in a GHG ETS, but there will be transaction costs – however large or small they may be – pertaining both to the government and to the mandated entities. The net outcome is a net welfare loss. In other words, in this situation, mandating agriculture in an ETS does not pass the benefit-cost test. ii) On aggregate, reducing emissions by less than 10%. This situation will occur in the case when on aggregate, the agricultural sector is at clear abatement cost disadvantage relative to the other sectors. In this case, a significant amount of emissions from the agricultural sector will be covered by purchasing allowances rather than by abating. Necessarily, the excess demand for allowances in the agricultural sector will have to come from other sectors of the economy. The effect of this will be an increase in the price of allowances in the secondary market. The magnitude of the increase will be determined by the difference in the marginal abatement cost in agriculture and in other sectors, and by the abatement potential in agriculture. In this situation, mandating agriculture in a GHG ETS only imposes additional costs. These costs are composed of the cost to the overall economy of having higher allowance prices, as well as transactions costs. Mandating agriculture in a GHG ETS under such circumstances is not beneficial from society's perspective. iii) On aggregate, reducing emissions by more than 10%. This situation will occur in the case when on aggregate, the agricultural sector is at abatement cost advantage relative to other sectors. This means that the low cost abatement options in agriculture can more than offset the demand for allowances from high abatement cost agricultural activities, and some excess supply of allowances will be offered from the agricultural sector to the overall market. In turn, this implies a reduction in the price of allowances in the secondary market, the magnitude of which will be determined by the differential in the marginal cost of abatement between the agricultural sector and other sectors, as well as the abatement potential in agriculture. In this situation, mandating agriculture in a GHG ETS can be beneficial from a social welfare perspective. The benefits of reducing the overall cost of GHG emissions abatement by mandating agriculture in an ETS are obvious in this case. However, these benefits need to be balanced with the transactions costs related to the participation of agriculture in the ETS. The relative magnitudes of these benefits and costs will determine whether mandating agriculture in a GHG ETS passes the benefit – cost test. The analysis of the stylised setting above shows that mandating agriculture in an ETS can only possibly be beneficial under certain circumstances. Those circumstances are fundamentally determined by the relative magnitudes of the marginal costs of abatement in agriculture and other sectors. All current indicators on the marginal costs of abatement in other sectors (excluding agriculture) suggest that at current levels of emission reduction targets, the equilibrium marginal cost of abatement (and consequently allowance prices) are likely to be around $15-20 per ton of CO2 equivalent (Ancev, 2011, p 107). At the same time, the lower range of realistic estimates of abatement cost in agriculture indicates figures greater than $20 per ton of CO2 equivalent (Ancev, 2011, p 107). This provides a very strong indication that the situation described under iii) above is not very likely to occur, which in turn offers no support for mandating agriculture in a GHG ETS at current emission reduction targets. Even if a situation like the one described under iii) occurs, the transactions costs will still have to be low for mandating agriculture in a GHG ETS to be considered as welfare improving. Thus, at the current level of emission targets, one could only reasonably expect that mandating agriculture in an ETS will be beneficial if marginal costs are significantly lower than in other industries, so the transactions costs can be outweighed by the benefits derived from low abatement costs. Based on current evidence, this is not the case for the existing emissions targets. In the future, if the targets become more stringent (such as the one proposed in the EU for 2020) this might change. If we start seeing allowance prices in the range of $55-65 per ton of CO2 equivalent (figures roughly comparable with the ones used by De Cara and Vermont (2011) of €39-47 per ton of CO2 equivalent, as €1 ≈ $1.40), then mandating agriculture in an ETS might be reconsidered as a possibly beneficial option. However, it seems that at present we are a long way away from seeing allowance prices of that magnitude. In the meantime, it may be more beneficial to try to engage agriculture in GHG emission abatement via alternative arrangements (for example, offsetting credits) rather than to mandate the sector with full liability in an ETS.