Brian Fallow: First steps on the road to Kyoto

Whether you see it as the highway to a sustainable future or a costly, politically correct cul-de-sac, this is the year we turn into Kyoto Road.

The international climate change treaty becomes binding on the countries that have undertaken obligations under it in February, three months after Russia's ratification gave it the critical mass of support to come into force.

For New Zealanders, a tax on the carbon content of fossil fuels will be the main policy measure to give effect to the country's commitment under the Kyoto Protocol.

The commitment is to return the country's net emissions of the greenhouse gases blamed for global warming to 1990 levels by the "first commitment period" 2008 to 2012.

The tax is due to come into effect in 2007. A discussion document on the design issues it presents is expected in the first half of next year and an announcement on the level of the tax around Budget time (usually May).

It is meant to be broadly in line with the world price of carbon credits - tradeable rights created under the Kyoto Protocol to emit greenhouse gases.

Lately, they have been trading at around €8.50 or $16 a tonne of carbon dioxide.

On that basis, drivers would have to pay about 4c a litre more for petrol and residential consumers face a 4 per cent increase in their power bills.

Those are relatively modest increases compared with those consumers faced in the past year - 8.5 per cent for electricity and 12 per cent for petrol.

The Government has already said the tax will be no more than $25 a tonne. At that rate, it estimates it would add 6c a litre to petrol and diesel and raise residential power bills by about 7 per cent.

It would also be a source of inflationary pressure more generally, since most goods and services involve some energy costs.

The Treasury estimates that a carbon tax at the maximum rate of $25 a tonne would push up food prices by 1.3 per cent and public transport by 1.4 per cent.

It would also appear to me regressive, falling more heavily on households with lower incomes since they spend a higher share of their incomes on petrol and domestic fuel and power.

The Government has pledged that the carbon tax would be revenue-neutral - the increased tax take from this source would be offset by reductions elsewhere in the tax system.

But it turns out that Finance Minister Michael Cullen at least regards the more fiscally costly tax relief measures he has foreshadowed, notably a less stringent depreciation regime and scrapping the capital gains tax on managed funds, as part of that recycling process.

This has not stopped him from citing the same measures as an alternative to tax rate cuts as a use of the Budget surplus.

The National Party says it will scrap any carbon tax on the statute books when it next takes office and pull out of the Kyoto Protocol in 2013 if the Government has committed New Zealand to climate change policies tougher than its main trading partners' beyond that point.

The Opposition has a couple of problems with a carbon tax. One is the risk that down the track it it could come to be seen as a useful extra source of revenue regardless of its efficacy in combating global warming. The other is the risk that it will not make much difference to emissions and the Government will have to cover the cost of them anyway.

On the face of it, the levels of tax envisaged send only a faint and feeble price signal, to consumers at least. If the past year's 12 per cent lift in residential electricity prices, as reflected in the consumers price index, has had only a marginal effect on households' energy efficiency, what difference would another 4 per cent make?

However, for large industrial concerns and electricity generators it is a different story. The proposed increases in fuel costs are quite large enough to get their attention.

Industrial plants whose international competitiveness would be at risk if they were subjected to a carbon tax can negotiate a partial or total exemption from the tax in exchange for a commitment to move to world's best practice in emissions for comparable plants.

So far only one negotiated greenhouse agreement, with the Marsden Point oil refinery, has been concluded though several others are under way.

They are complex negotiations. One issue the parties are struggling with is how to calculate the impact of a carbon tax on the electricity charges big users will face.

Uncertainty about the level of the carbon tax is frequently cited as having a chilling effect on investment in new electricity generation. A carbon tax would hit coal-fired plants much more heavily than gas-fired ones, while geothermal and renewable sources such as hydro or wind would escape it altogether.

But since power stations are long-lived assets, there is a limit to how much comfort policymakers can give investors in them anyway.

The key judgments those investors have to make are large: is the world moving to a future in which the right to emit greenhouse gases is rationed or will international free-rider problems stymie that approach?

The geopolitics of climate change remain fiendishly difficult. With the United States and Australia having opted out, only a bare majority of developed country emissions are covered by the Kyoto regime.

And developing countries, whose combined emissions will overtake those of the developed world within 20 years, are wary of undertaking commitments that could retard their development and continue to argue that because most of the man-made CO2 in the atmosphere came from developed countries over the last century or two they should move first.

These divisions were evident at an international meeting in Buenos Aires last month which failed to draw up even the roughest of roadmaps towards progress beyond Kyoto.