Friday, November 03, 2006

Saturday Forum: Stern's Greenhouse

The most appropriate Australian political response to this week’s Stern Report on Climate Change came from the Leader of the Greens, Bob Brown. He suggested a Cabinet of National Unity of the kind formed during World War II. He quoted from Stern: “Our actions now and over the coming decades could create risks of major disruption to economic and social activity on a scale similar to those associated with the great wars and the economic depression of the first half of the 20th Century.”

In reality the problem dealt with by Stern is bigger than those facing the world at the time of the wars. It is truly global, intergenerational, and effectively irreversible.

And if you are to believe Sir Nicholas Stern himself, he was unprepared for it. He confessed to an audience in Oxford earlier this year that when he was asked to examine climate change in July 2005 he “had an idea what the greenhouse effect was, but wasn’t really sure.”

In some ways his initial ignorance has been his greatest strength... He examined the problem with no preconceptions. And he examined it as an economist. Most people who have inquired into climate change have done so as scientists. They have had the tools to examine what the problem is, but not to model its broader social consequences or to propose practical ways in which they might be averted.

As Sir Nicholas explained while writing his report, the great strength of economists is that they understand incentives. “And they contribute a great deal more to the world than those people who don’t know about incentives and they think about institutions to support those incentives,” he said.

Originally an academic, Stern learnt about applying the tools of economics to practical problems as the Chief Economist for the European Bank for Reconstruction and Development in the 1990’s and then the World Bank. At the Bank from 2000 to 2003 under the Australian James Wolfensohn, Stern was asked to model the human and financial effects of catastrophes including AIDS, famine and wars. His advice had to be practical. It would be acted on. And he was asked to provide it free of ideological constraints.

He had to do so again in 2004 when as head of the UK Government Economic Service he run the research program for the Commission for Africa which reported to the leaders of the G8 industrial nations. His recommendations took ideas from free-marketeers (he recommended that the G-8 nations end their export subsidies) and from the anti-globalisation movement (he recommended that the leaders write off billions of dollars of bad debts).

But he says the invitation to examine global warming for the British Treasury forced him to stretch the tools of economic analysis to and beyond their limits. “We are talking about areas which are potentially right outside the area of human experience, not just modern human experience, human experience period,” he said.

Along the way he has had to ditch several standard tenets of economics. One is that it is possible to measure the damage that something will do by adding up the amount of money that people will pay to avoid it.

His report says that makes no sense when dealing with a phenomenon that will affect both the world’s richest and poorest citizens. As his report puts it: “a very poor person may not be ‘willing-to-pay’ very much money to insure her life, whereas a rich person may be prepared to pay a very large sum. Can it be right to conclude that a poor person’s life or health is therefore less valuable?” Stern decided to value all lives equally.

And from this decision came one even more radical. Stern decided to value the lives of future citizens equally with those of today. In most types of cost-benefit analysis the future is valued less highly than the present. This is because people prefer to enjoy things now rather than later. A dollar in the future isn’t as valuable.

But Stern says he can find no justification for valuing the lives of future generations less than those of people alive today. He said there might be a justification for doing that when comparing outcomes that can be reversed, or are fairly similar. But where one course of action would devastate a future generation and the other would not the welfare of that generation should be weighed equally alongside that of todays.

Stern finds that if no action is taken to limit global warming within the next few years, after a century or so the annual cost will exceed 5 per cent of global income, most of it borne by the world’s poorest people.

By contrast he finds that the cost of taking action now will amount to 1 per cent of annual global income.

The actions he suggests go beyond those advocated by either Australia’s Government or Opposition.

The Government wants to pour billions of dollars into research into developing new technologies, something Stern regards as vital, but according to a Canberra energy consultant Dr Hugh Saddler, it is less keen to fund the commercialisation of that technology. He says that developing technologies is only the first step. “Ensuring that they can survive commercially is more important,” he says.

The Labor Party has promised to introduce a system of carbon trading, something Stern regards as essential, but it has not specified the way in which the system would work. Stern has come down in favour of a method that would deeply damage the economics of Australia’s coal-fired power stations.

In theory, carbon trading could reduce greenhouse gas emissions even if the permits were handed out to the existing polluters for free, as has happened in the European scheme.

But Stern finds all sorts of problems with handing out permits for free to those industries that are at present the dirtiest polluters. One is that ahead of the scheme being introduced there might be a race to install the dirty technologies that will earn the most permits, and there could also be an incentive to keep dirty plants operating until the scheme comes in. Another is that the free allocation of permits imposes no immediate cost on existing polluters but imposes a significant cost on new (probably cleaner) competitors that might want to enter the industry.

Stern wants governments to auction pollution permits (although he says he can see a case for issuing some permits for free as a transitional measure). It is a measure that will hit existing polluters hard, forcing them to pay the full costs of the damage their operations are causing much sooner. He sees this as an advantage, bringing “management attention to the importance of making efficient decisions that fully account for the cost of carbon”.

Hardest hit would be Australia’s dirtiest power stations, most of them in Victoria burning relatively wet brown coal. Power stations burning black coal would also be hit. Hugh Saddler of Energy Strategies says that it isn’t really possible to add carbon filters to Australia’s presently designed coal fired power stations. The carbon dioxide emissions are too diluted. He says the next generation of “capture-ready” power stations will have that capacity meaning that coal may well play a big part in providing Australia’s energy needs well into the future.

Australia’s coal mining industry is unlikely to be particularly damaged by an Australian decision to require emission permits. Most of the coal mined in Australia is exported. Demand for it will be determined by the carbon-pricing decisions of the countries in which it is burnt, irrespective of what happens in Australia.

On the other hand Australia’s gas industry may well be hit. Although natural gas is a very clean burning fuel by the time it is piped to homes and factories or sent overseas, that is because it has most of its carbon removed at the site where it is mined. The gas mining centers of Moomba in South Australia and the North West Shelf in Western Australia are among Australia’s biggest carbon emitters.

In a study prepared for Australia’s state and territory in August the Allen Consulting Group found that the electricity industry itself would suffer as a result of carbon pricing. Each household could find itself paying an extra two to four dollars a week for electricity and so would cut back on electricity use.

The industries advantaged by carbon pricing were found to be include wind, biogass, and biomass electricity production, as well as electricity plants fired by gas. The exact identity of the winners would depend on the price set for a tonne of carbon and technological developments.

The study prepared for Australia’s states and territories examined a price of $12 per tonne of carbon emitted, climbing over time to around $30 per tonne.

At the other end of the scale is a study prepared by the Australian Bureau of Agricultural and Resource Economics for the CSIRO and a consortium of Australian companies including Rio Tinto, BHP-Billiton, and Woodside Petroleum. It models the effect of carbon tax of around $600 a tonne, which it finds would decimate the Australian economy, cutting GDP by 10 per cent, real wages by 20 per cent, and doubling petrol prices.

The Stern Report takes uses numbers closer to those used by Australia’s states than ABARE finding that the damage done by each tonne of carbon is about $A110 but it can be avoided for a cost of about $A32 a tonne.

The $A32 price nominated by Stern appears to be too low to make nuclear power economic, and also too low to guarantee the success of wind power.

And could be the problem recognised by the government this week and now facing the Opposition. Charging for carbon emissions is policy with identifiable losers, and without easily identifiable winners.

The Treasury Secretary Ken Henry said this week that in an economy like Australia’s running at or near full capacity, for just about every loser there is a winner.

“Almost every day I hear somebody arguing that some activity should be accorded a special taxpayer-funded hand-out, either because it will ‘create’ some impressive number of new jobs or because, if it doesn’t receive taxpayer-funded support, an equally impressive number of jobs will be ‘destroyed’,” he said.

His message is that if any industry, presumably including any polluting industry, is forced to close by a change in circumstances, it will not cost the Australian economy jobs, or even necessarily harm GDP. Another industry will emerge to replace it.

It is a message that time has proved true when it comes to cuts in tariffs. Yes, Australia’s clothing and manufacturing industries have been hurt, but new ones have arrived to replace them.

It required courage for Australia’s policy makers to stand up to the old industries who were saying that Australia would suffer if they suffered. The Hawke government had that courage when it began winding back Australia’s industry protection in the 1980’s. Australia is better off today as a result.

Our leader’s responses to the Stern report will indicate whether they have that same courage.