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.

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

Congestion tolls in Sydney

One interesting announcement in yesterday's NSW state mini-budget was the introduction of "congestion tolls" on the Sydney Harbour Bridge and Tunnel: the toll will vary depending on the time of day. Tolls will increase from $3 to $4 during peak travel times, stay the same during a shoulder period and drop to $2.50 at night.

Time of day tolls can be a sensible measure to reduce congestion: they encourage motorists to avoid driving at peak hour. The demand for road space varies throughout the day so a price that also varies to reflect that changing demand is likely to improve efficiency. Commuters accept variable time-of-day charges for rail in Sydney, so why not roads?

A few thoughts on the new tolls:

• The government should closely monitor traffic densities and speeds at different times of day now and after the toll comes in to see what impact the toll has.


• Time of day tolling should also be applied to other Sydney toll roads such as the M4 and M5 (the government has flagged this) - at least if the Sydney Harbour tolls are effective in reducing in congestion.


• The public is cynical about this change and sees it as a revenue grab (which it probably is). If the government genuinely sees this as a congestion measure and wants it to be embraced, they should consider making it revenue-neutral or, more simply, reducing the night toll by the same amount as the peak toll increases. Alternatively, the additional revenue could be clearly earmarked for additional peak hour public transport so that people have a decent alternative to just paying the toll and continuing to drive.


• Isn't there an issue because the toll is only collected from southbound traffic? So there's no new incentive to avoid the peak hour when you're travelling north...

What do you think of the tolls?

Why do we pay people to waste our most precious resource?

It's one year today since the contract to build Sydney's desalination plant was signed and ANU environmental economists Quentin Grafton and Michael Ward have run the numbers on whether it was a good deal.  Their conclusion: the net benefit to Sydney households of the plant is negative one billion dollars.  Ouch.  The decision to build it will cost each Sydney household on average more than $700.

What's the alternative though?  Well how about just letting people pay the actual cost of water so that they have an incentive to economise?

When most things get scarce, their price goes up.  This sends a signal to consumers to economise and find alternatives and a signal to producers to find new sources and ways to produce them.  We don't do this with water though.  Instead we subsidise one of our most precious resources - massively.  We encourage industrial water users to recycle their water or else use recycled water rather than water we've spent millions making fit for drinking.  But why would they when it's so cheap?  Cheap because it's subsidised by every taxpayer.

So why don't we do this?  According to NSW's Water Minister Nathan Rees, that system "would result in gross inequalities and be a nightmare for business":

Any form of sound business planning would be impossible if water prices fluctuated from month to month and season to season.

The current system isn't too equitable either.  Is it equitable that low income earning taxpayers who do their best to save water subsidise big water users to fill their pools and keep their lawns looking lush?  In any case the extra revenue from actually charging wealthy water users for the water they use can be used to provide assistance to low income households.

As for the business certainty argument, businesses deal with price fluctuations all the time.  I'm sure the cafe downstairs from my work would be happier if coffee bean prices didn't fluctuate, but they don't ask the government to nationalise the coffee trade to deal with it.  The prices of rent, employees, petrol, commodities, food and every other business input fluctuate weekly or daily.  And if it's critical for a particular business to know the price of water in advance, I'm sure purchasers and suppliers could negotiate to lock in a price in advance for a set period.  That's what futures markets do with commodities around the world.

The federal government is putting a price on carbon emissions - a challenging and complicated task that involves working out the emissions from a huge range of business activities and creating new and untested markets.  So why can't we allow a realistic price to be placed on one of our most precious resources?  The alternative is pouring an extra billion dollars into an environmentally questionable desal plant that we don't really need.

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.

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.

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.

Blogroll update

I need to update my list of links: some blogs I link to have ceased to be updated or even to exist and there are new blogs on the scene I haven't yet included.

If you think there are any glaring omissions, please leave a comment. Given Oikos' theme, I try to link to really good blogs about environmental economics, Australian economics or Australian environment - or truly outstanding blogs about the environment or economics more generally.

New-ish environmental economics blog

While I've been galavanting around Europe with its surprising lack of wireless internet, I've missed the appearance of a new addition to the healthy and growing stable of blogs around the world with an environmental economics focus.


Common Tragedies is a play on the 'tragedy of the commons' concept, the tendency for overexploitation of common resources. The blog chronicles thoughts on environmental and energy economics and policy from a group of research assistants at Resources for the Future, an environmental policy research centre.

Australian Conservation Foundation looking for Economic Adviser

An illustration of how economics is becoming increasingly important in environmental debates, ACF is advertising for an economist to fill the apparently newly-created position of Economic Adviser.

According to ACF:

ACF’s advocacy to protect the environment increasingly involves economic analysis, and ACF has set a long-term strategic priority to transform Australia’s economy into one that is ecologically sustainable. As a crucial component of this goal, ACF is developing a programme of work to promote alternative economic tools that incorporate environmental values, and challenging mainstream notions of every-expanding growth in consumption of natural resources.

The position of economic adviser is being newly created to assist ACF to develop this area of work rapidly, and to ensure that Australia begins the shift to economic institutions and instruments that fully recognise, account for and protect the environment.

More details. It would be an interesting job!

Kenneth Arrow and Thomas Schelling on Climate Change

The latest issue of The Economists' Voice is out, with two articles on the economics of climate change by Nobel Prize-winning economists.

The first is an excellent primer on climate change by Kenneth Arrow: Global Climate Change: A Challenge to Policy. I'd really recommend reading it as a backgrounder to the issue:

Two factors deserve emphasis, factors that differentiate global climate change from other environmental problems. First, emissions of CO2 and other trace gases are almost irreversible; more precisely, their residence time in the atmosphere is measured in centuries. Most environmental insults are mitigated promptly or in fairly short order when the source is cleaned up, as with water pollution, acid rain, or sulfur dioxide emissions. Here, reducing emissions today is very valuable to humanity in the distant future.

Second, the scale of the externality is truly global; greenhouse gases travel around the world in a few days. This means that the nation-state and its subsidiaries, the
typical loci for internalization of externalities, are limited in their remedial ability.

The detail in the article is on the issue of discounting future costs, which is central to the findings in the Stern Report on The Economics of Climate Change that susbstantial immediate action on climate change is likely to be much cheaper over the long-term than inaction. Discounting is something I need to cover in a future Oikos 101 column, but for now I'll just observe that Stern has been criticised for using a zero rate of pure social time preference - which is consistent with the idea of inter-generational equity but inconsistent with observations by economists of how people actually behave.

Arrow conducts a sensitivity analysis, plugging different social time preference rates into Stern's figures, and finds that using a higher social time preference rate doesn't change the fundamental finding of the Stern Report, that action will cost less than inaction.

Thomas Schelling discusses what uncertainty surrounding climate change implies for policy responses and makes some sensible observations in Climate Change: The Uncertainties, the Certainties, and What They Imply About Action:

In some public discourse, and in sentiments emanating from the Bush Administration, it appears to be accepted that uncertainty regarding global warming is a legitimate basis for postponement of any action until more is known. The action to be postponed is usually identified as “costly.” (Little attention is paid to actions that have been identified as of little or no serious cost.) It is interesting that this idea that costly actions are unwarranted if the dangers are uncertain is almost unique to climate. In other areas of policy, such as terrorism, nuclear proliferation, inflation, or vaccination, some “insurance” principle seems to prevail: if there is a sufficient likelihood of sufficient damage we take some measured anticipatory action.

At the opposite extreme is the notion, often called the “precautionary principle” now popular in the European Union, that until something is guaranteed safe it must be indefinitely postponed despite substantial expected benefits. Genetically modified foods and feedstuffs are current targets. (One critic has expressed it as, “never do anything for the first time.”) In this country the principle says that until a drug has proven absolutely safe it must be deferred indefinitely.

Neither of the two extreme principles—do nothing until we are absolutely sure it’s safe; do nothing until we are absolutely sure the alternative is dangerous—makes
economic sense, or any other kind. Weigh the costs, the benefits, and the probabilities as best all three are known, and don’t be obsessed with either extreme tail of the distribution.

Exposing the hidden costs of pollution

An article in today’s Sydney Morning Herald, which questions whether the Australian states could undermine national action on climate change, illustrates just why a broad-based national emissions trading scheme would be effective.

Environment groups said the Opposition Leader, Kevin Rudd, needed to explain how he would curb rising greenhouse gas emissions at a time when Queensland and NSW were dramatically boosting coal exports and several states were approving big road and power projects that would increase climate change pollution…

The NSW Treasurer [Michael Costa] favours building a new coal-fired power plant to meet the state's energy needs, in contrast to other proposals for more gas-fired generation or energy efficiency and demand management.

New coal-fired power stations would make it difficult for a federal Labor government to reach its target of cutting emissions by 60 per cent by 2050, said the Australian Conservation Foundation campaigner Tony Mohr.

"The really interesting question to ask Kevin Rudd would be if Costa approves a new coal-fired power plant, what will he do about it?" Mr Mohr said. "How is he going to deal with the parochialism of the states?

The power of an emissions trading scheme or carbon tax is that it imposes the same price on greenhouse pollution from any source in any state, so questions like these become irrelevant. Both major parties have now committed to a national emissions trading scheme.

With a trading scheme, the federal government sets a cap on total emissions from all sources and issues permits for that amount. Emitting without a permit is prohibited so total emissions don’t exceed the cap. If you don’t have enough permits for the pollution you wish to create, you need to buy them from someone else. They can only sell them if they’ve taken action to reduce their emissions so that they have surplus permits.

Under an emissions trading scheme, if NSW wants to approve a coal-fired power station, so what? For the station to be allowed to operate, the operator will need to buy enough permits to cover its emissions. It can buy them only if someone else reduces their emissions and so has surplus permits. The total level of emissions is therefore unchanged.

It will no longer be up to the NSW Government to decide whether a new coal-fired power plant, more gas-fired generation or energy efficiency and demand management is the best way to meet the state's energy needs: all those methods will compete side by side on the basis of bang for your cost-of-pollution-adjusted buck.

So what is a parochial state government that wants to encourage coal-fired power production to do? Well it can offer breaks from state taxes and planning restrictions, but that’s not a good look. Importantly, it can’t exempt power stations from emissions trading, because it’s a scheme administered by the federal government. If it really wants to encourage the power station, it will have to agree to buy the permits for it. (Scarily, they’ve already started doing this).

And this is one thing I love about a national emissions trading scheme: it puts a price on pollution for everyone to see. State governments place costs on their citizens every time they exempt a large development from laws that apply to everyone else, but those costs are hidden. Voters don’t notice the cost of a government exemption, but you can bet they’ll notice when their taxes are used to buy permits for a large and profitable energy company.

When we put a price on polluting, we bring hidden costs into the open.

Cheap ways to reduce greenhouse emissions

An interesting article in The Economist last month took a look at the cost of various options for reducing greenhouse emissions (summarised in the graph above).

Two things are particularly notable:

• There are a number of options that have a negative cost. In other words, not only would they reduce emissions, they’d also save us money. The biggest one is insulation and low-energy lighting is also up there.
  
• The solutions we hear a lot about – such as wind, solar and carbon capture – are among the most expensive options.

So why are we not voluntarily making decisions that would not only reduce emissions but also save us money?

The Economist identifies a couple of possible reasons, the most compelling to my mind is that the people who make the choices are not the people who pay the costs of those decisions. For example, property developers have to pay for insulation but they won’t get the benefits of lower electricity bills, so their incentive is to go cheap on insulation. If the property is to be rented out, it’s not even the buyer who pay those bills – it’s a tenant.

How to solve this? In theory, awareness of the issue should be enough: if tenants and buyers of new houses (or other buildings) are aware that good insulation can save them substantial amounts of money, they should demand it and be prepared to pay more for it – in the same way they’d be prepared to pay more for a good bathroom or kitchen.

So why isn't this happening? And seeing as it doesn’t seem to be happening, is there a role for government in mandating it in building standards or requiring developers and sellers to at lease provide understandable information (eg, energy efficiency ratings)?

[HT: RSMG Blog]

Should carbon taxes be linked to global temperatures?

I’ve mentioned before the possibility of creating markets in long-term weather – that is, betting on future climate change – as a method of predicting and insuring against climate change. Betting markets are good at predicting future outcomes – you can look at the odds on horses in a race if you want to get an idea of who’s likely to win. The idea is that allowing climate scientists, businesses, etc to bet on future climate change would be a way of aggregating all the knowledge that people have about likely future climate change in a way that’s more decentralised and independent than say the consensus method of international scientists at the Intergovernmental Panel on Climate Change (IPCC). There are advantages and disadvantages of either way of distilling the information from thousands of climate scientists into consensus estimates of likely climate change.

In an article last week in Canada’s Financial Post, Canadian economist Ross McKitrick proposes a different method of removing scientific uncertainty about climate change from the policy response to climate change. He proposes a carbon tax where the tax rate is linked to average global temperatures over the prior 3 years:

Climate models predict that, if greenhouse gases are driving climate change, there will be a unique fingerprint in the form of a strong warming trend in the tropical troposphere... The Intergovernmental Panel on Climate Change (IPCC) states that this will be an early and strong signal of anthropogenic warming. Climate changes due to solar variability or other natural factors will not yield this pattern: only sustained greenhouse warming will do it. Temperatures in the tropical troposphere are measured every day using weather satellites…

Suppose each country implements something called the T3 tax, whose U.S. dollar rate is set equal to 20 times the three-year moving average of… estimates of the mean tropical tropospheric temperature anomaly [warming], assessed per tonne of carbon dioxide, updated annually. Based on current data, the tax would be US$4.70 per ton...

This tax rate is low, and would yield very little emissions abatement. Global-warming skeptics and opponents of greenhouse-abatement policy will like that. But would global-warming activists? They should -- because according to them, the tax will climb rapidly in the years ahead.

The IPCC predicts a warming rate in the tropical troposphere of about double that at the surface, implying about 0.2C to 1.2C per decade in the tropical troposphere under greenhouse-forcing scenarios. That implies the tax will climb by $4 to $24 per tonne per decade, a much more aggressive schedule of emission fee increases than most current proposals. At the upper end of warming forecasts, the tax could reach $200 per tonne of CO2 by 2100, forcing major carbon-emission reductions and a global shift to non-carbon energy sources.

Global-warming activists would like this. But so would skeptics, because they believe the models are exaggerating the warming forecasts. After all, [the average tropical troposphere temperature] went up only about 0.08C over the past decade, and has been going down since 2002. Some solar scientists even expect pronounced cooling to begin in a decade. If they are right, the T3 tax will fall below zero within two decades, turning into a subsidy for carbon emissions…

Under the T3 tax, the regulator gets to call everyone's bluff at once, without gambling in advance on who is right. If the tax goes up, it ought to have. If it doesn't go up, it shouldn't have. Either way we get a sensible outcome.

It’s an intriguing idea. I suspect its biggest detractors would be energy-intensive industries, who would have no certainty about the level of carbon taxes in the future. McKitrick’s response is that those industries will just have to forecast that as best they can and actually sees this as an advantage:

best of all, the T3 tax will encourage private-sector climate forecasting. Firms will need good estimates of future tax rates, which will force them to look deeply, and objectively, into the question of whether existing climate forecasts have an alarmist bias. The financial incentives will lead to independent reassessments of global climate modelling, without regard to what politicians, the IPCC or climatology professors want to hear.

(This is the advantage too of a long-term weather market. Presumably McKitrick’s proposal would lead to the development of such a market so that energy-intensive industries could assess - and hedge - their exposure).

There are a few potential problems with the proposal that immediately spring to mind.

The first is that it relies on the fact that “climate models predict that, if greenhouse gases are driving climate change, there will be a unique fingerprint in the form of a strong warming trend in the tropical troposphere”. But what if that isn’t the case? McKitrick’s claim is that his proposal takes the scientific debate out of the policy response, but it relies on climate model predictions that troposphere warming reflects man-made emissions and leads other warming. If he’s prepared to accept this finding, why not go the step further and accept the estimates of warming presented by those models and then base the level of tax on those?

It also doesn’t really deal with the problem of lag periods: the tax paid now depends on the level of warming now. But the purpose of the tax is to prevent increased warming in the future: surely its level should be based on an assessment of what’s required to constrain future temperature increases.

McKitrick’s answer is that “investors planning major industrial projects will need to forecast the tax rate many years ahead, thereby taking into account the most likely path of global warming a decade or more in advance”. And that’s no doubt true for major industrial projects. But household consumers of electricity and petrol will make their decisions based on today’s prices.

A related problem is that it doesn’t deal with dangerous thresholds. The tax is linear: it increases by US $20 for every 1 degree rise in temperatures. But damage isn’t linear. What happens if our best science suggests that damage will be moderate up to, say, two or three degrees but that, above that, there will be feedback loops and greatly increased risks of catastrophic damage? If that was the case, we’d want an aggressive tax before those dangerous levels are reached. McKitrick’s tax would only start becoming aggressive once those levels were passed, by which time even much higher tax rates may have become much less effective.

It’s an interesting idea though that deserves some attention and debate. I think it’s interesting that market approaches may help not only with developing effective and low-cost policy responses, but may also help improve our understanding of the science on which policies must be based.

[HT: Lars Smith at Conservation Finance]

Review of Environmental Economics and Policy

The first issue of the Review of Environmental Economics and Policy is out and articles can be downloaded for free.

The Review

...seeks to fill the gap between traditional academic journals and the general interest press by providing a widely accessible yet scholarly source for the latest thinking on environmental economics and related policy...

Looks like there's some interesting articles, with a focus on carbon taxes and emissions trading.

[HT: Environmental Economics blog]

Who do you trust with the challenge of climate change?

That’s what Australia’s Prime Minister John Howard asked yesterday, when announcing his Government’s policy on climate change for the next election:

We must get this right. If we get this wrong, it will do enormous damage to our economy; to jobs and to the economic wellbeing of ordinary Australians, especially low-income households. The question I pose to the Australian people, quite directly, is this: who do you trust to take the vital decisions about our future?

Howard announced yesterday that his government would introduce emissions trading by 2012:

I announce specifically that Australia will move towards a domestic emissions trading system, that’s a cap and trade system beginning no later than 2012.

Secondly, we will as a nation set a long term aspirational goal for reducing carbon emissions but we need to assess very carefully with detailed economic modelling the impact any target will have on Australia’s economy and Australian families, this target will be set next year 2008.

Thirdly, the scheme will be national in scope and as comprehensive as practicable, designed to take account of global developments and to preserve the ompetitiveness of our trade exposed emissions intensive industries.

Fourthly, Australia should not pay higher energy costs than necessary to achieve emissions reductions, in other words, governments need to let the market sort out the most efficient means of lowering emissions with all low emissions technologies on the table and that of necessity must include nuclear power.

First, credit where credit is due. The PM has now committed his government to introducing a domestic emissions trading scheme by 2012. In effect that’s a commitment to reduce our emissions unilaterally even if it’s not required under the next round of Kyoto after 2012 (or some other international agreement). On the other hand, he has deferred setting a target for reducing emissions until next year, ie, after the election. That’s really half a policy. It’s like announcing that you’ll introduce a goods and services tax but you haven’t worked out what the rate will be. Or you intend to give a huge boost to health spending, but you haven’t worked out how much or where it will be spent. (Trust us).

Trust on climate change action is a double-edged sword. We need effective action but at a reasonable cost to the community. The Liberal Government enjoys the community’s trust that it will have broadly sensible economic policies, but I don’t think the community trusts it to deal with climate change effectively. It has spent the last 10 years taking only modest action on climate change and at the same time has damaged the cause of effective action by rejecting the Kyoto Protocol, supporting the world’s biggest polluter - the United States - in its stance to take no effective action on climate change, and publicly expressing its scepticism that climate change is even a problem.

We’re starting to get some reasonable modelling on the costs of emission reduction pathways. Strong targets will impose costs on businesses and households, but are entirely consistent with strong economic growth. Indeed, they make relatively little difference to overall projections for growth. Leaders that we can trust will be those that tell us the truth:

• It’s true we’re a small player in all this. Adopting a strong domestic target won’t in itself save us from the risk of dangerous climate change.
  
  


• However, it’s a likely prerequisite for getting our neighbours to play their part.
  
  


• Strong targets will mean that we’re not as wealthy in 50 years as we would be with no targets. But we’ll be much wealthier than we are now. The economic chaos that Howard fears the ALP’s “reckless and irresponsible” target may inflict is being 169% wealthier on average than we are now compared to 184% wealthier if we don’t set a target.
  
  


• Of course, that doesn’t take into account the dangers that climate change presents to our wealth. I reckon being only 169% wealthier in 50 years is worth it to avoid the (small) risk that climate change will make us much poorer, in nasty ways.
  
  


• Nevertheless, the flipside is also true. On the best estimates, climate change will make people in 50 or 100 years poorer than they otherwise would be – but (unless things go really wrong) still substantially wealthier than we are right now. So don’t be too worried about the people of 2100 – they’ll probably be better off materially than you or me.
  
  


• To a large extent, climate change is an economic issue. Some of the problems of climate change will be dealt with better by spending money on adapting than by spending money on reducing the severity of climate change. For example, we could invest billions on reducing the severity of climate change to reduce the spread of malaria that it will cause as warmer regions expand. But we might save millions more lives by investing that money in research into malaria treatments.
  
  


• But, most importantly of all, climate change is not just an economic issue. It will destroy or radically alter species, ecosystems, landscapes, and communities. The extra wealth we’ll gain from inaction won’t compensate us for that. I hope our leaders can show that that’s something they understand.
  
  

I’m working my way through the PM’s task group’s report and in the next couple of weeks, I’m going to outline what it means, where we are in terms of climate change policy in Australia, and some of the things you need to understand to make some sense of it all, including:

• What is emissions trading?

• How does it differ from a carbon tax?

• What are the main political parties proposing?

• How does Australia fit into the global challenge?

• What are the economic effects of imposing a cost on emissions?

• How do you choose an emissions target?

Are there any other questions you’d like answered? Let me know: leave a comment or email me at ozelaw [at] yahoo [dot] com.

Emissions trading - the report is out

The Prime Minister's Task Group on Emissions Trading has handed down its final report and it is now available.

It recommends an emissions trading scheme based on the following principles:

• a long-term aspirational emissions abatement goal and associated pathways to provide an explicit guide for business investment and community engagement an overall emissions reduction trajectory that commences moderately, progressively stabilises, and then results in deeper emissions reductions over time and:
  · is sufficiently flexible that it can be periodically recalibrated by government to changing international and domestic circumstances through regular and transparent reviews
  · provides markets with the ability to develop a forward carbon price path to guide business investment decisions and help drive longer-term technology development – markets would be expected to establish a low initial carbon price and a forward price curve that rises over time
  

• maximum practical coverage of all sources and sinks, and of all greenhouse gases with permit liability placed on direct emissions from large facilities and on upstream fuel suppliers for other energy emissions with those sectors initially excluded from the emissions trading scheme subject to other policies designed to deliver abatement
  

• initial exclusion of agriculture and land use from the scheme though agricultural emissions should be brought into the scheme as practical issues are resolved
  

• a mixture of free allocation and auctioning of single-year dated emissions permits that:
  · provides an up-front, once-and-for-all, free allocation of permits as compensation to existing businesses identified as likely to suffer a disproportionate loss of value due to the introduction of a carbon price
  · ameliorates, through free allocation, the carbon-related exposures of existing and new investments in trade-exposed, emissions-intensive industries while key international competitors do not face similar carbon constraints, but which also provides ongoing incentives for abatement and adoption of industry best practice allows for the periodic auctioning of remaining permits
  

• a ‘safety valve’ emissions fee designed to limit unanticipated costs to the economy and to business, particularly in the early years of the scheme, while ensuring an ongoing incentive to abate
  

• recognition of a wide range of credible carbon offset regimes, domestically and internationally

• capacity, over time, to link to other comparable national and regional schemes in order to provide the building blocks of a truly global emissions trading scheme
  

• incentives for firms to undertake abatement in the lead-up to the commencement of the scheme, including through the purchase of offset credits from carbon plantations, and potentially from other accredited activities
  

• revenue from permits and fees to be used, in the first instance, to support emergence of low-emissions technologies and energy efficiency initiatives (the focus might shift more toward households and business as the scheme matures).

That mostly sounds pretty good to me but I think the emphasis is clearly on being business-friendly more than being effective (where those two goals conflict).

Will be interesting to delve into some of the detail. Some initial thoughts:

The 'safety valve' fee is potentially worrying

The idea of a cap-and-trade scheme is that the government sets the maximum emissions, issues permits for that level of emissions and then emitters trade the permits. If one emitter can reduce its emissions for less than the market price of the permit, it will do so and sell the excess permits it has. If another emitter wants to expand and that will involve more emissions, it will need to purchase permits. It will then have an incentive to pursue options that involve relatively less emissions so that it doesn't have to buy as many new permits.

If the government stands by ready to charge a 'safety valve' fee to emitters that don't have enough permits, that sets a maximum price on the permits: if it's cheaper just to pay the fee than to buy the permits, you'll just pay the fee, so the permits won't rise above that price.

But that means that the cap on emissions isn't really a cap. If emitters pay the fee rather than buying permits, then the cap will be exceeded. From business's point of view it's a good thing: it means there's a known worst-case-scenario in terms of the costs it will impose. But if it's set too high, the reduction in emissions could be much lower than we anticipate.

The allocation of free permits is controversial

Ideally, you should auction all permits. As Peter Martin says in the Canberra Times:

The best way to distribute permits is to auction them. The firms that need them will pay what they are worth and pass on the costs to consumers in higher electricity prices. The government can use the money it raises from each year’s auction to cut income tax, to cut company tax, or to support the development of low-carbon technologies.

However,

Polluter after polluter that has made a submission to the Prime Minister’s taskforce on emissions trading has said that while it supports the idea of a trading scheme, it wants the price of the permit set low and it wants to be given enough permits - gratis - to cover most of the pollution it already does.As Australia’s most venerable economic modeler and one of the signatories to the economist’s letter Professor Peter Dixon of Monash University told me: “It’s the same as putting a tax on carbon pollution and then instead of doing something useful with the proceeds - like cutting another tax - giving it to the shareholders of the polluting companies”.

It is even better than that for the polluting companies. If they get given for free permits that a would-be competitor would need to buy, they get given a built-in cost advantage. Their would-be competitors might not bother! No wonder they like the idea. (Economists call the idea “grandfathering” and call the result a “barrier to entry”.)

Expect a lot of political argy-bargy over this one.

PM's Emission Trading Task Group - report out midday today

I've just been informed that the report will be posted on the Task Group's website at midday today.

Today's Sydney Morning Herald has a brief summary and the recommendations are a little disappointing (if not surprising). The good point is that it recommends a domestic cap-and-trade system (with fees for exceeding permit requirements - which makes it more like a hybrid cap-and-trade / carbon tax).

Other features of the report according to the SMH:

• The scheme "must not overtly harm the economy" (so it will be restricted to measures that covertly harm the economy??)
• too early to set a target until more modelling has been done
• would not be introduced until at least 2012
• revenue from the scheme should be used to support low emission technologies
• no mandatory renewable energy target.

The Canberra Times has a slightly better summary and Peter Martin has a good piece on the economics.

I'll try and put up a summary of the main recommendations shortly after midday...