Wednesday, February 16, 2011

Don't do it! Julia is walking into a carbon trading trap

Julia Gillard is about to make a massive and avoidable mistake.

What she thinks is clever politics is neither good politics nor economics and will do long-term damage to public support for action on carbon emissions.

Reports suggest that this Friday she will unveil plans for a carbon tax from July 2012 and with it the same incredibly generous compensation for existing electricity generators agreed on by Rudd and Turnbull before each lost his party's leadership.

Worth $7.3 billion to existing generators over 10 years, and doubled at the last minute at their insistence, the free permits were meant to ease the pain of higher electricity prices.

Ross Garnaut pointed out at the time that simple game theory, combined with the statutory obligations of company directors, ensured they would do no such thing.

Here's why...

Imagine that instead the money had been paid to households, a move that by the way would be electorally popular. By definition it would ease $7.3 billion of their pain over ten years.

Exactly how it eased the pain would be up to each household. The payments could either go towards paying their higher electricity bills or be pocketed if the higher bills encouraged them to cut back on electricity.

Now imagine the behaviour of an existing generator. It would be given a gift which it could, but need not, use to keep the price of electricity down.

What it does would be determined by the behaviour of its competitors. If they are new competitors their behaviour is already known. A new coal-fired competitor would not receive compensation and would face extra costs of, say 20 per cent as a result of the need to pay the tax or buy the permits. The new competitor would be forced to charge, say 20 per cent more. A new low-emissions competitor would be forced to charge at least that much more because low-emissions technologies are at the moment much more expensive.

So the existing generator has nothing to fear from a new entrant if it decides to push up its charges, say 20 per cent. It is protected from compensation to the tune of say, 20 per cent in the same way as Australian manufacturers used to be protected from foreign competition by import duties of at times 20 per cent.

Company directors work for shareholders. They are required to maximize revenue. It if is possible to raise prices 20 per cent without retaliation they are obliged to do it.

Of course they may face retaliation. Existing generators have existing competitors who may be squeemish about raising their prices (although if their directors are similarly required to maximise revenue that is unlikely). And higher prices might mean less business as consumers turn away from electricity. But in any business by far the biggest restraint on lifting prices is the threat of being undercut by new entrants.

A carbon tax or carbon permit scheme would remove that threat, leaving existing generators fairly free to pocket $7.3 billion of compensation and lift their prices anyway.

Politically this would be a disaster. It would make action on carbon emissions unpopular when it needn't be.

It is a trap our otherwise politically astute prime minister shows every sign of walking in to.

I should add that none of this means we should not compensate exporting and import-exposed industries. Their claims have merit. Those of existing coal burning generators do not.

Published in today's SMH and Age

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