Oliver Sartor From: The Australian February 23, 2010 12:00AMRATIONAL climate change policy is essentially about finding the least economically disruptive and fairest possible way to ensure our way of life against the risks of climate change. At the moment, the most accomplished scientists from the most accomplished scientific institutions are telling us that we need to reduce greenhouse gas emissions drastically during the next 10, 20, 40 years.
To achieve this, a significant restructuring of the way modern economies produce goods and services will be required. And this means providing sufficient incentives for businesses and consumers to change their behaviour in a way that can de-link economic growth from emissions levels, and in an acceptably fair way. But how to do that?
Across the world governments facing this question are developing a variety of policy measures, but there is an unmistakable trend that comes through the noise: mandatory carbon pricing is indispensable.
Most notably, 27 European Union member states began the EU emissions trading scheme for greenhouse gases in 2005, and New Zealand will start one in July this year. Japan, Taiwan, South Korea, 16 US states and four Canadian provinces, and even the US congress, are at various stages of legislating their own cap-and-trade schemes. Similarly, the Norwegians and Swedes have put in place (and the French, Irish and Spanish soon will) direct carbon taxes for certain economic sectors not covered by the EU's ETS.
So if Australia is alone in wanting to price carbon emissions, why are so many other developed countries imposing "great big taxes on everything", as Liberal leader Tony Abbott calls it?
The theory is no doubt appealing: that is, that carbon pricing harnesses market forces to internalise low-cost incentives to abate. Consider how emissions trading works.
First, the government sets an emissions budget or target for the year. Next, it limits the supply of emissions to the market by requiring firms to hold a permit to emit a tonne of CO2 and it allocates that number of tonnes' worth of emissions permits to key industries.
Finally, since firms want to emit carbon to produce stuff, they need to decide how to allocate the permits among themselves, so they enter a market to start trading with others. They trade based on their relative costs of abatement. In particular, each actor will look at the carbon price in the permit market to decide whether it is cheaper to reduce emissions and sell excess permits or, if less costly, to simply pay the carbon price and buy a permit to emit.
In other words, global economic cost is minimised by letting firms choose, based on their own, privileged, private knowledge and investment strategies, the cost of abating v the price of emitting.
The sum of those decisions is confined to the global goal through the emissions cap. The idea is that the cap is then tightened gradually through time in line with medium and long-term national emissions goals.
The carbon price in an ETS is therefore the stick business needs to move the economy, through time, towards key investments in less carbon-intensive modes of production.
So the theory seems plausible enough, but what about the practice? In fact, a joint research project by France's CDC Climate Research, Massachusetts Institute of Technology in the US and University College Dublin recently completed the first comprehensive ex-post analysis of the first three years of the EU ETS. The results, published this month under the title Pricing Carbon, suggest that despite some significant flaws in the way the ETS was initially designed, the evidence points to the following conclusions.
First, the trial phase did significantly reduce emissions. Using careful econometrics, the authors estimate that the ETS actually reduced emissions below business as usual by between 120 million tonnes and 300 million tonnes of CO2 during the three-year trial phase. That is to say, emissions were 2.5 per cent to 6 per cent below a (conservative) estimate of where they would have been without the scheme. This is an impressive result given that the EU started with very limited emissions data for some countries and so it accidentally set a cap that was above business-as-usual emissions for the period.
Second, the trial phase highlighted the importance of government initially auctioning emissions permits to industry. The study noted that where firms participating in imperfectly competitive markets received permits for free, they gained windfall profits. This is because these firms are able to pass on at least some of the market price of permits to consumers anyway and so they reap a reward for no abatement from the free allocation.
Free allocation also implies that the atmosphere belonged to the polluters in the first instance, when most people would argue it is a public good and they should pay the public through buying permits from government to use it. Europe is in the process of shifting to auctioning of permits for all but those industries exposed to international competition. The carbon reduction pollution scheme, by the way, proposes to start with full auctioning to all but trade-exposed industry and, less gloriously, some power generators.
Finally, it is worth noting that auctioning a high proportion of permits also allows government to realise a double dividend with the revenue. Other taxes can be removed; deficits reduced; workers in strongly affected industries can be compensated and retrained; and public investments in complimentary emissions reductions that are not suitable for carbon pricing can be made.
Thus, looking at the Australian debate on climate policy from Europe, it appears very strange indeed that the debate seems to be over whether to have carbon pricing, or so-called "direct action" measures instead.
The emerging evidence from the EU, the lessons from economic theory, not to mention the global policy trend, is that carbon pricing is an indispensable pillar of equitable, effective and economically responsible climate policy for the long term.
But you need to be flexible, prepared to learn from mistakes and get the policy design right to create incentives for those long-term structural changes.
Oliver Sartor is a research economist specialising in carbon policy at CDC Climate Research in Paris. Pricing Carbon: Lessons from the EU ETS, is published by Cambridge University Press and is the product of years of joint work between CDC Climate Research in France, MIT and University College Dublin.
