Some quick thoughts on the Oz emissions trading scheme

We have a good idea now of what the so-called Carbon Pollution Reduction Scheme is going to look like, after the Government and Opposition hammered out a deal on Tuesday and it was endorsed (barely) by the Liberal Party in a turbulent day yesterday. It seems that the Government now has the numbers to get the Bill through the Senate, with enough opposition senators willing to support it.

Environmentally, it is modest indeed: it should deliver the Government's committment of a 5% greenhouse gas reduction by 2020. The Government has committed to a 15% reduction by 202 if there is an effective global agreement but, first, that looks unlikely and, second, even if there is, after the way the scheme was been watered down and watered down as it goes through the political process, I really don't have much confidence that the Government could get a scheme up that delivers 15% reductions by 2020. It's also probably worth noting that those 5% reductions won't all happen in Australia - under the scheme as it is, most reductions will be achieved by Australia buying credits from overseas schemes. I don't have a big problem with that - it essentially means Australian money driving additional reductions overseas - but a lot of people feel that when we commit to reducing our emissions, we should actually reduce our own emssions rather than paying others to reduce theirs.

Economically, I've heard it described as a "rent-seeker's paradise" and a massive transfer of wealth from households and small business to big polluters and I think those statements are pretty fair. It contains massive compensation for affected industries, and reasonable compensation for low-income households. Everyone else pays. Surprisingly, it is revenue-negative for government.

The questions is whether it's better than nothing at all. I'm not sure. On the plus side, it will drive some reduction in emissions and, probably more importantly, it establishes the machinery for dealing with the problem - we'll gain experience with an emissions trading scheme that can, in theory, be improved in the future. The Greens are adamant, however, that it will "lock in failure" and I think there's something to this argument. They claim it will actually unleash a lot of investment in coal-fired electricity generation and other polluting industry. I think they may be right: carbon-intensive industries have been worried about carbon policy and the CPRS gives them certainty that the policy environment will be very friendly for them for at least a decade. It also showers them with cash - it seems to me the dirtiest industries will actually profit from the scheme. You also have to wonder about the political likelihood of it being strengthened in the future - I think things would have to be looking pretty grim for the climate to get the political impetus to genuinely fix it up.

It's all pretty disappointing for someone who has high hopes in the ability of market-based policies to deliver good environmental outcomes at low cost and spread fairly over the community. If this is what an emissions trading scheme looks like in practice, the fact that I think a purer scheme could work really well in theory is pretty hollow.

Climate Change Blog Action Day

Apparently today is Blog Action Day for Climate Change and I thought I'd throw it open to my wonderful blog readers.

I find myself alternatively optimistic and despairing on climate change. How bad is it going to be? Are we going to do what it takes to avoid the worst? And what do you think is going to be the most help? People and communities and businesses taking action themselves? National governments agreeing on strong action at Copenhagen and setting up strong domestic laws, like emissions trading? Peak oil or economic crisis reducing emissions automatically? Or technological breakthroughs making it easier than we thought? Or will it take some real environmental crisis to get the impetus?

What do you think? Put in your two cents for Blog Action Day - bloggers, regulars, visitors and lurkers!

Cheers

Dave

Red sky in the morning...

Strange weather in Australia recently: record high winter temperatures, bushfires in spring, hail the size of cricket balls overnight and we woke this morning to an apocalyptic orange glow in Sydney.

Meanwhile our Prime Minister is at the UN for climate change talks and the domestic question is whether we should have our emissions trading scheme ready to go for Copenhagen or wait for the outcome of the Copenhagen talks and a post-Kyoto international agreement.

In today's Sydney Morning Herald, economics editor Ross Gittins has a go at both parties about their complacent approach to climate change and then turns his gaze to population growth and to economists for ignoring the environment.

Even the economists who brought us the emissions trading scheme don't adequately appreciate the problem we've got. They think all we have to do is switch to low-carbon energy sources (ideally by capturing all the carbon emitted by burning coal) and the economy can go on growing as if nothing had happened.

Being economists, they see us as all living in an economy, with this thing at the side called the environment that occasionally causes problems we need to deal with. As usual, wrong model. In reality, the economy exists within the ecosystem, taking natural resources from it, using them and then ejecting wastes, including sewage, garbage, pollution and greenhouse gases.

Not much to disagree with there, but I haven't seen Gittins talk about ecological economics before or what the alternative model might look like. (At the risk of caricaturing his columns, they seem to be, while interesting, a confusing mix of very staid conventional economics one day: 'if the politicians studied a bit of economics they'd realise that people will act in their self-interest and supply and demand will ensure such and such happens' with blanket rejection of economic ideas the next 'if economists studied human psychology, they'd realise that people don't act in their self-interest and so supply and demand can't be counted on' etc).

But perhaps we can look forward to some ecological economic analysis from Gittins in the future.

Photo: View from our front door this morning, photo credit Catherine Page

Dealing with uncertainties in carbon price

The main difference between a carbon tax (emissions tax) and an emissions trading scheme is this. With a carbon tax, the price of emitting a unit of greenhouse gases is fixed but the total level of emissions is unknown. With an emissions trading scheme, the level of emissions is fixed (capped) but the price is unknown.

It follows that choosing one over the other is partly an issue of whether you want certainty in your environmental outcome or certainty in the cost to industry.

The experience of the European emissions trading scheme and now it seems the US Regional Greenhouse Gas Initiative (RGGI, pronounce it 'Reggie' - a trading scheme involving 10 States in north-east USA) has been that the cap on emissions was set too high and too many permits made available, with high volatility in permit prices and permit prices crashing after a while. The governments were too worried about the potential cost to indsutry (which isn't known in a trading scheme, but has to be forecast) and so overallocated permits.

Australia's ETS will actually start out as effectively a carbon tax, because the price of permits will be fixed at $10 a tonne for at least the first year. After that it become a trading scheme, with a fixed emissions cap and an unknown permit price.

Actually, it's more like hybrid scheme in one way, because it's proposed that there will be a ceiling price of $40 a tonne: companies can buy unlimited permits from the government at that price, so the permit price will never rise above $40.

A lesson from the EU and RGGI is that it would make sense to set a floor price too, so everyone knows that the permit price will never fall below, for example, $15 a tonne. That gives some certainty to industry, that investments in emissions-reducing technologies that are profitable at a carbon price of $10 a tonne or more can be made with no carbon price risk. It gives some reassurance to renewable energy and similar industries that they can safely invest. And it means that if reducing emissions turns out to be cheaper than expected, some of the benefit goes to the environment in the form of lower emissions and doesn't all go to indsutry in the form of cheaper permits.

Clean Coal on Four Corners

Four Corners tonight is on progress with "clean coal" (also known as carbon capture and storage, CCS): coal-fired power stations that capture the greenhouse gases emitted from burning the coal and store them underground.

The bottom line: coal is a large and growing contributor to greenhouse gas emissions and clean coal technology is a long way from being a commercial reality.

Should be worth watching.

The great give-away: Allocating permits under an emissions trading scheme

One of the bigger areas of debate in emissions trading is how to allocate permits. The purists (eg, Garnaut) suggest they should all be auctioned while political realities suggest a large chunk will be given away to compensate the industries that will suffer most under the scheme (Garnaut suggested that you should give cash compensation so it's transparent).

An important thing to keep in mind is that this aspect of the debate doesn't change the total emissions - it's not an environmental debate; it's about fairness and economics. You get the same emissions whether you auction all the permits or give them all away. What changes is who pays and who gets the revenue. Under auctioning, the government gets the revenue and hopefully uses it to reduce other taxes. If you give permits away, the emitting industries get the money.

A new study has examined the economics of auctioning versus freely allocating permits under the US emissions trading scheme, with some possibly surprising results. They point very much to auctioning a vast majority of permits as a better way.

First, the unsurprising result: the more permits that you auction, if you use the revenue to reduce other taxes, the lower the economic cost of the trading scheme.

Second, the possibly surprising result: you only need to give away 15% of permits to completely compensate the industries most affected by the scheme. I think the proportion the government and opposition are debating freely allocating for the Australian scheme are substantially larger than that*, so think about what that means: these industries will actually profit from the introduction of the ETS. The study suggests that giving away 100% of permits leads to a doubling of profits for many industries.

*Our scheme and industries are slightly different so the numbers from the US won't directly translate, but they should be in the same ball park. Does anyone know if anyone's run the numbers here? Maybe in the Treasury modelling...

Carbon offsets: Oils ain't oils

If you wanted to offset the carbon emissions of a flight, you can buy carbon offsets from any number of providers. But the price for offsets done in different ways or certified under different standards can vary greatly.

Why? A new paper investigates.

Among the findings, providers located in Europe sell offsets at prices that are approximately 30 percent higher than providers located in either North America or Australasia. And, not surprisingly, offsets that qualify for emission reductions under the Kyoto Protocol, sell at a premium of more than 30 percent.

In theory, a project that avoids the emission of a tonne of greenhouse gas should give the same benefit (and have the same price) as the same as any other project that avoids the emission of a tonne of greenhouse gas. But of course you need to have confidence that this is actually what will happen and I'd guess that this is the difference: you're prepared to pay more if you're more confident that the advertised benefits are really being delivered.

Game theory and Kyoto negotiations

I'm not a huge fan of simple game theory analyses of international climate change negotiations (even though I've been guilty of using them myself) because they tend to model each country as being an individual acting in its own interests, when the political reality is rather more complicated.

For example, simple prisoner's dilemma game theory would predict that no countries would take unilateral action on climate because it's not in their national self-interest - the only action would come in the form of a comprehensive international treaty. But domestic politics - for better or worse - often produces results that don't accord with national self-interest.

Anyway, Peter Wood has taken a neat look at the US position in international climate negotiations through a game theory lens. He incorporates domestic politics and looks at it as a 2-stage game where the need to get agreement in the Senate once negotiators get home will have a big impact on what those negotiators will want to get at Copenhagen. It's common sense really but interesting all the same.

Australia's Kyoto negotiation team prepares for Copenhagen (Dilbert - Scott Adams)

Thoughts on the green paper - Part 1: petrol

The government’s green paper on emissions trading is now available. The government’s new phrase for its emissions trading scheme is “carbon pollution reduction scheme”.

The first thing that’s captured everyone’s attention – not surprisingly – is petrol. With all the hoo-ha about petrol prices recently, the government’s proposal is to include petrol in the ETS / CPRS but to reduce the petrol excise by an equivalent amount for at least the first 3 years of the scheme. This is not very different from leaving petrol out of the scheme. And this has the Greens and others up in arms.

There are two ways to look at this – from a practical perspective or from a principle perspective. Either way, my view is that cutting the petrol excise isn’t good but isn’t really all that bad either.

The practical implication of cutting excise and therefore neutralising the impact that the scheme has on the petrol price is that – to meet the target – the price of everything else in the scheme has to go up by more. Then again, the price of petrol has gone up so much recently that that’s done a lot of the work that the scheme will do anyway. But power bills will go up by more than they otherwise would to pay for the cut in petrol excise. Which of these would cause more pain? Who knows. The opposition, motorists and the media seem to be clamouring loudly for lower (or at least not higher) petrol prices but electricity prices haven’t gone up yet – presumably there’ll be some clamouring when that happens too.

Looking at the ‘principle’ of cutting the excise – well this really depends on whether the excise now is too low, too high, or just right (I don’t know which it is). Roughly speaking, the excise on petrol should be enough to cover the costs that it places on the community: motorists shouldn’t be expected to be subsidised by other taxpayers and so the excise should cover the cost of building roads, dealing with car accidents, dealing with air pollution, etc. There’s also GST on petrol as there is on everything else. Anything much more than that is seeing petrol as a revenue raising tool. Seeing as the ETS is going to raise plenty of revenue anyway, there’s a case for easing other taxes. So if excise currently goes beyond the social cost of petrol plus 10%, I reckon there’s a case for cutting it if you’re going to include petrol in the ETS. If the excise doesn’t go beyond that, then there’s no principled case for cutting it. I’d be interested in any comments as to which side of that line fuel excise currently falls.

One other comment I’d make is that I’m not sure about the idea of cutting it for 3 years then reviewing the situation. I’d prefer the government to say that they’re cutting it for 3 years only. Seeing we’re apparently talking about a cut of about 5c a litre and petrol prices fluctuate by that amount weekly, I don’t think people could complain too much if the government said “Petrol excise is going up by 5c in 2011: you’ve got 3 years to get ready”. That seems like a more than generous concession to me and better than just deferring the issue and the uncertainty around it by 3 years.

What do you think?

Government's green paper on emissions trading out today

It's being launched by Climate Change Minister Penny Wong at the Press Club at 12.30.

I'll put up a link when I have one and hopefully some analysis tonight.

Garnaut Review out today

The draft report of Professor Ross Garnaut's Climate Change Review will be released at 12.30 today here.

For overseas readers, this review has been described as the Australian version of the Stern Review. The report will look at the economic impact on Australia of climate change and the design of a domestic emissions trading scheme (ETS), as well as suggestions for Australia's role in international negotiations. The findings will be a major input into the government's ETS which is to be unveiled by the end of the year.

The next 6 - 12 months are likely to be a time of furious debate in Australia about what the ETS should look like. The debate has begun with whether and how petrol should be included in the scheme.

Responses to higher fuel prices

Observing how people are responding now to higher fuel prices gives us some idea about how people will respond to a price on carbon under an emissions trading scheme.

In the short term, we can expect pain on households and businesses as their usual ways of doing things become more expensive. In the slightly longer term, people adjust by finding different ways of doing things: driving less, taking more public transport. And in the longer term, people make bigger adjustments like buying more efficient cars or moving closer to work.

We're definitely seeing the short term pain and the immediate political pressure to do something to bring petrol prices down. And we're also beginning to see people adjust - an interesting example is truckies choosing to take the ferry across the Spencer Gulf in South Australia rather than driving around it:

South Australian ferry operator Sea SA says figures for the June quarter show a doubling in truck traffic compared with the same part of last year.

Justine Day from the company says the main attraction is saving money. "We're being told by people in the industry that this is because the price of fuel which is, as we all know, at record highs at the moment - it's actually making the ferry a more attractive option than driving all the way around the Spencer Gulf," she said.

This also shows an advantage of using prices to drive changes in behaviour to reduce emissions, compared to government-dictated solutions like banning incandescent light globes or subsidising solar panels on roofs: you get a whole lot of unexpected and locally appropriate methods of reducing emissions coming out of the woodwork.

It also shows though that the effects can be somewhat unpredictable - would you necessarily think that a South Australian ferry company would benefit from emissions trading?

Adjusting to higher energy prices will no doubt be painful and difficult, but probably not as painful and difficult as people think: because innovative businesses will come up with ways to ease the transition - earning profits for them and reducing the costs for others.

Lessons from Europe's emissions trading scheme

The Pew Center on Climate Change has released a new report examining what went wrong and what has been going right with the EU emissions trading scheme.

The report finds that the scheme has achieved much of what was intended: establishing a European-wide carbon price; causing businesses to incorporate the price into their decision-making; and creating the infrastructure for a multi-national trading program. As for actually achieving a reduction in emissions - it's been modest but improving.

Some of the key lessons:

• Good information is critical. You need accurate data on baseline emissions.
• Suppliers quickly factor the price of emissions allowances into their business decisions under a cap-and-trade program.
• Price volatility can be reduced by including banking and limited borrowing of emissions allowances.
• The relationship between permit allocation, permit markets, and the electricity market must be understood and addressed to avoid unintended consequences.
• The linkage of 28 separate trading programs in the EU scheme provides a valuable prototype for a globally linked carbon market.

Earth Hour this Saturday night - is it all just a waste of time?

It's the second annual Earth Hour this Saturday night and the wise cynics are once again gleefully reminding us how stupid we are to turn out our lights for one hour in the deluded belief that we're doing something about climate change.

Their triumphant, but I think misguided, crowing about how naive we all are kind of reminds me of a scene from the Simpsons:

Homer takes Lisa to the Springfield Museum and sees the sign, `Suggested donation: $4.50'.

Homer: Eh, what do you mean by `suggested donation'?

Clerk: Pay any amount you wish, sir.

Homer: And uh, what if I wish to pay ... zero?

Clerk: That is up to you.

Homer: Ooh, so it's up to me, is it?

Clerk: Yes.

Homer: I see. And you think that people are going to pay you $4.50 even though they don't have to? Just out of the... ha ha... goodness of their... [laughs] Well, anything you say! Good luck, lady, you're gonna need it!

Lisa's teacher arrives and goes to pay

Homer: No, no! It's a suggested donation. [whispers, smiling as if it's a great revelation] You don't have to pay!

Anyway, last year, before the first Earth Hour, I posted this list of reasons why I'd be turning my lights off for earth hour. It's why I'll be doing so again this year. For me it's not so much about emissions as about connections:

Connection with community

I don’t know if it’s widespread, but I often feel a lack of community in Sydney. And I think a sense of community is wonderful. Events like this connect us. If tens of thousands of people turn off their lights and TVs and sit out on their verandahs, or go for a walk and talk to some of the other tens of thousands of people doing the same thing, I reckon that’s great. Just have a look at some of the events people are organising!

Connection with our own power

Climate change is often presented as a big problem with big solutions needed, to be provided by government and business. To a large extent it is. But there’s a lot that people can do about it themselves, in their households and as part of businesses and communities. When each of us does something personal about the issue, we’re reminded that this is something that we, personally, can influence. And I think that’s very positive and powerful. We don’t have to shake our heads and our fists at John Howard and George Bush, we can do a lot ourselves.

Connection with nature

Again, this might be an inner-city dweller neurosis, but I feel a disconnection with the real world living in the middle of Sydney. I get home, turn the lights on, turn the heater on in winter and have my own comfortable cocoon. We all rely on the environment for our health and wellbeing. But it’s easy to forget that. It will be nice to sit out on the balcony and look at the moon and listen to the breeze in the trees and watch the fruit bats fly past and think about the world. Maybe we’ll even be able to see the stars.

Connection with ourselves and each other

As much as I love Iron Chef, it will be nice to have some quiet time to think and talk to Cat. Maybe we’ll have a candlelit dinner at one of the restaurants which are turning their lights off for Earth Hour.

Business

It’s easy for households to switch off lights and appliances during earth hour. It’s much harder for some businesses, despite the fact that at 7.30 on a Saturday night, many businesses aren’t open. This exercise has been a useful learning exercise for many businesses (including my workplace) that you can’t assume that everything is switched off on a Saturday night. (Have a look at office buildings in the city at night and be dazzled by all the empty offices with all their lights still on).

They have had to put measures in place to achieve this and hopefully those measures will continue to bear fruit in terms of energy and emissions savings long after earth hour is over.

I had a great Earth Hour last year - it was quite cool to see lights go out in so many other apartments. For the people who go through with their oh-so-rebellious, witty and contrarian 'Illumination Hour', although I mock them and they mock me, I genuinely hope they enjoy that too - at least we share the recognition that the issue deserves attention and that symbolism can be important. There's nothing wrong with celebrating electricity - go for it! - but I'll be reflecting on simpler things this Saturday night. I'd encourage you to be part of Earth Hour too.

Garnaut review - emissions trading scheme discussion paper

Professor Ross Garnaut's blueprint for an Australian emissions trading scheme was released last Thursday (pdf). I haven't got past the exec summary yet, but Robert Merkel has an excellent discussion at Larvatus Prodeo today, and econobloggers Harry Clarke, Peter Martin and Joshua Gans had some thoughtful comments over the weekend. And it's received a lot of press over the past few days.

The big issue appears to be whether to auction permits or hand them out to exsiting emitters. More on this from me later, but it seems the debate has finally moved beyond the myth coming from the electricity industry that they need to be issued with free permits or else electricity prices will rise, disproportionately hurting the poor who spend a greater proportion of their income on energy. Electricity prices will inevitably rise under an emissions trading scheme: to a large extent, that's the point. Giving handouts to existing generators in the hope that they pass some savings on to households and not just their shareholders is naive - particularly when their competitors (new entrants to the market) will have to buy permits on the open market. And it's not necessary: the best way to compensate poor households, surely, is to use the revenue gained from auctioning permits to target tax cuts at lower incomes.

On that point, I notice that petrol producers have run the same line in recent days: petrol should be exempt from an emissions trading scheme because families are struggling enough with petrol prices already. Aside from the fact that these kind of suggestions wholly undermine the aim of a trading scheme, there's better ways to help out struggling families than subsidising their energy use. How about reducing their overall tax burden? They can spend their savings on petrol if they so desire but how about we leave it up to them what they spend it on, rather than what petrol or electricity companies think they should spend it all on (oddly enough, petrol and electricity)?

EPA: US can halve greenhouse emissions for the cost of a cup of coffee a day

Alright, that's a bit of an exaggeration, but a report very quietly released by the US EPA (there's remarkably little mainstream coverage of it) has found that if emissions were cut by 56% by 2050, US GDP would grow by 80% between now and then, compared to 81% if emissions were allowed to increase on a business-as-usual basis.

And that comparison doesn't count the costs of allowing emissions to grow unabated.

It seems to me that the US is in a unique position when it comes to fighting climate change: it's the only country where taking unilateral strong action would pay off for it. That's because its emissions are such a big chunk of the global total (more than a quarter) that it can have a real impact on its own - and it faces some big costs from climate change. So if any one country should be leading on this issue, it's the US. And yet, it's the country that up to now has done the most to delay a global solution to the problem.

The EPA's analysis follows other analyses (eg, the Stern Review in the UK and recent McKinsey reports on the cost of abatement in Australia, the US, the UK and Germany) that show that strong action on climate change is compatible with strong economic growth and can be achieved at a more modest cost than is widely anticipated.

Can biofuels help reduce greenhouse emissions?

The answer, from a recent CSIRO study (pdf), appears to be yes - unless it's from a plantation that was established by clearing forest.


The study compared total life-cycle emissions from biofuels from various sources with diesel. Fuel from canola has 49% lower emissions over its life cycle than diesel and, for a waste product such as used cooking oil, emissions can be 87% lower than diesel.


However, total life-cycle emissions from biofuels derived from palm oil plantations established by clearing rainforest or swamp forest are up to 21 times higher than diesel.


The problem is that some biofuels do indeed come from these sources.


The CSIRO report points to other studies that have estimated that a substantial proportion of international palm oil production is established by clearing - and often burning - these forests in Indonesia and Malaysia, which together supply 83% of the world's palm oil:

• It has been estimated that in Malaysia nearly half of all new oil palm plantations involve deforestation, with 87% of deforestation between 1985 and 2000 due to oil palm expansion.

• From 1982 to 1999, about 16,000 square miles of Indonesian tropical rainforest was converted to plantation. Oil palm plantations were responsible for at least 44 percent of that rainforest loss.

And although palm oil hasn't so far been a major source of biofuels, that may slowly change:

with growing demand for biodiesel, especially in Europe, with increasingly large suggested as well as mandatory targets, it has been observed that it is unlikely production will be able to meet future demand without the use of palm oil as a feedstock.

It seems that biofuels do have the capacity to lower greenhouse emissions from transport. But whether their contribution will be good, bad or ugly depends critically on where they come from.

It's true: oils ain't oils.

An important day for climate change action?

With Mike Huckabee withdrawing from the Republican party nomination race, all three remaining US presidential contenders favour strong action on climate change (albeit to varying degrees).

That means - whatever happens in November - we will see a significant shift in US climate change policy in January 2009. Today is an important day for global progress on climate change.

Garnaut Review - interim report now out

The interim report of the Garnaut Climate Change Review is now out and is required reading if you're interested in what an Australian emissions trading scheme will look like. The review was commissioned last year by Australia's State and Territory Governments (and the then federal opposition - now federal Government) to examine the impacts and opportunities of climate change. It will propose "a national framework for action, with recommendations for medium to long-term policy options to minimise the environmental and economic impacts of climate change".

From the press release:

“Contrary to the conventional wisdom which has dominated Australian debate over the past decade, comprehensive global efforts to reduce emissions will play to Australia’s strengths,” said Professor Garnaut. “It is in Australia’s interests for the world to adopt a strong and effective position on climate change mitigation.”...

The Report states that Australia’s interest in strong global action stems from its “exceptional sensitivity to climate change”, and its “exceptional opportunity to do well in a world of effective global mitigation”.

“We have many resources and skills that will allow us to convert strong global action into an economic opportunity,” said Professor Garnaut. “We have a first-rate skills base in areas related to innovation, management and financial services. We have rich renewable energy resources. We are among the world’s largest exporters of uranium and natural gas which can benefit from the low-emissions’ efforts of other nations. And our agricultural sector emits less than other developed countries. By contrast, Australia would be a big loser – possibly the biggest loser among developed nations – from unmitigated climate change. Australia is more vulnerable to climate change than most other developed nations as we are highly sensitive to climate variation, and we are surrounded by mostly developing nations, which are likely to be adversely affected by rising temperatures,” he said.

Professor Garnaut said that due to a sustained period of high economic growth – led by China and India – the world was moving towards high risks of dangerous climate change more rapidly than had been generally understood. “Faster emissions growth makes mitigation more urgent and more costly. The challenge is to end the linkage between economic growth and emissions of greenhouse gases,” he said...

The Interim Report states that Australia should make firm commitments this year to both 2020 and 2050 targets that reflected “similar adjustment cost to that accepted by other developed countries”.

“Australia should be ready to go beyond its stated 60 per cent reduction target by 2050 in an effective global agreement that includes developing nations,” said Professor Garnaut.

The Report also supports the development of bilateral and regional agreements to accelerate domestic and international action. “Unilateral and regional efforts under way in parallel [to global efforts] might make for a ‘messy’process, but it is one which has the highest chance of success in the short time available,” the Report says.

The Interim Report sets out some initial considerations for the design of Australia’s emissions trading scheme (ETS), due to come into effect in 2010. Further detail on the Review’s proposals for ETS design will be released in a discussion paper in mid March 2008. “The emissions trading scheme will need to be supported by measures to correct market failures or weaknesses related to innovation, research and development, to information, and to network infrastructure,” the Report says. “Steady, long-term policies are what Australia needs in order to provide the market certainty for making appropriately large reductions in emissions at the lowest possible costs to Australians’ standards of living,” said Professor Garnaut.

Submissions are invited on the Interim Report and any issues related to the Review by 11 April 2008.

Moral hazard in emissions trading

Moral hazard is an interesting concept in economics. It’s the problem that someone protected from risk may behave differently from how they’d behave if they were fully exposed to the risk.

It’s a big issue in finance and insurance. Moral hazard has been blamed in part for the sub-prime mortgage debacle gripping the US and elsewhere. Governments often guarantee banks to protect citizens from losing their savings if banks collapse. But this guarantee to bail out banks can encourage the banks to make riskier loans: if the loans go OK, they make money and if everything goes wrong – well, the government will bail them out to protect the savings of the mums and dads. The government’s guarantee can therefore – perversely – make the financial systems riskier and more unstable.

An environmental example is drought assistance. By helping farmers when they face a drought we may encourage unsustainable farming practices. ‘Should I farm in the drought-prone area? Well, if it rains I’m fine and if it doesn’t, I’ll get drought relief, so why not?’

A proposal in the Garnaut Climate Change Review's latest discussion paper on emissions trading (pdf) is that permits be allowed to be “banked” or “borrowed” from future years. Banking’s not a big issue – if you reduce your emissions more than anticipated, you can “bank” your excess credits and use them in a later year. But “borrowing” is a potential minefield. It allows a company to say “I’ll exceed my allowance this year but it will be OK because I’m planning to reduce my emissions substantially in the next few years so I’ll repay them then”.

What’s the problem? First, we really want to be encouraging emissions reductions now. But that’s pretty easily dealt with – you just charge interest. At a 10% interest / penalty rate on borrowed permits for example, a company could choose to emit 100 tonnes this year and 100 next year or borrow 10 and emit 110 this year but only 89 next year (100 minus the 10 borrowed minus interest of 1 on the 10 borrowed). You could give the same rate of interest as a discount on banked early reductions to encourage those.

The bigger problem is will these borrowed permits ever be repaid? And this is where moral hazard raises its ugly head. Imagine this scenario: coal-fired power plant operators are sure that carbon capture and storage is going to mean they can reduce their emissions massively and cheaply in 20 years. The technology is looking promising. But right now, reducing emissions is hard and expensive. So they borrow from their entitlements 20 – 30 years in the future. They’re sure the investment will pay off when the technology comes on line and they reduce emissions massively and cheaply. And seeing as they’re going to pay an interest or penalty rate for delaying their cuts, everyone will win: the cuts will be delayed but they will be so huge when they arrive that it will more than compensate in the long run.

But, as it turns out, the technology doesn’t deliver. So the power station operators deliver the unfortunate news to the government: "We got it wrong, we can’t afford to make the reductions. And we can’t afford to buy in permits on the open market. You’ve got a few options. You can fund us to buy more permits. Of course, the price of permits will spike, instantly and substantially increasing the costs of any emitting industries, sending some to the wall, increasing energy, food and goods prices to consumers and fuelling inflation, and maybe a small recession. And of course, taxpayers will be paying the debts that we’ve incurred. Or, we can just shut down. Electricity production will slump and energy prices will spike, again increasing the costs to energy users (sending some firms to the wall and hurting households), fuelling inflation, and maybe a small recession. Or you could just issue us with more permits…"

The idea of emissions trading between different companies is that it allows flexibility in who makes the reductions and therefore lowers the overall community costs of achieving reductions – whoever can reduce emissions most cheaply has most incentive to do so. Allowing the trading of emissions between different time periods adds more flexibility (flexibility as to when we make the reductions) and further reduces the total cost to the community. If it works. But we need to be very careful. Because the risk of moral hazard suggests it might not work.