Saturday, June 02, 2007

Saturday Forum: Emissions trading Australian style.

First my comment:

The 200 page emissions trading blueprint presented to the Prime Minister is a tour de force.

It will be used for years to come both in this country and overseas as a guide for right way to make deep cuts in greenhouse gas emissions in the most painless way possible.

As a standalone system, not requiring a Kyoto-style international agreement, it may well become the model adopted by the United States. Its President George W Bush yesterday indicated he had had a change of heart about domestic action to combat climate change.

John Howard’s change of heart has been just as dramatic.

He had said he would never agree to a carbon tax or carbon trading unless very other carbon-emitting country did so as well. Just seven months ago he declared that if he did he would be “betraying the interests of all of the resources industry and the future of our children.”

Ironically, it has been the industry representatives on the taskforce, as much as his own bureaucrats that have turned him around.

They have come up with a Australian-designed method of pricing and trading our emissions that has found few critics. The biggest criticism coming from environmental lobbyists yesterday was that it would not start soon enough.

That, and the fact that the taskforce itself has not drawn up the carbon reduction target. It has asked the Prime Minister to get to work on that straight away, and said it expects it within 12 months.

Mr Howard is likely to do it sooner, in time for the election.

Whatever happens Australian emissions of carbon are going to have a price. We are all going to pay more for our electricity unless we change the way it is generated. There will be no going back.

Then what it will mean:

When five months ago the Prime Minister assembled a group of his closest advisors and business leaders and asked them to report on “the nature and design of a workable global emissions trading system in which Australia would be able to participate” his critics sneered.

He had added this rider: “Australia enjoys major competitive advantages through the possession of large reserves of fossil fuels and uranium. In assessing Australia’s further contribution to reducing greenhouse gas emissions, these advantages must be preserved.”

The taskforce would have to conclude that there was no such global emissions trading system. It looked as it he had set it up it that way.

But the taskforce developed a life of its own and in its report answered questions of its own....

Right at the start it declares that, “after careful consideration, the task group has concluded that Australia should not wait until a genuinely global agreement has been negotiated”.

It has decided that Australia should go it alone using a genuinely Australian model for emissions trading (many of the ideas come from the ANU’s Warwick McKibbin) without waiting for the rest of the world.

It is a model that much of the rest of the world is likely to follow, as it has followed other Australian financial innovations, among them the Higher Education Contribution Charge and compulsory superannuation.

Politically the Prime Minister is locked in to supporting it. Not that that is likely to worry him too much. The Chairman of the taskforce, Dr Peter Shergold is the head of his department and they would have been in regular touch. Even better, much of Australian business is locked into supporting the framework set out in the report. The taskforce had on it executives and board members from Xstrata, International Power, BHP Billiton, Alumina Limited, the Australian Pipeline Trust, Qantas and the National Australia Bank.

They have adopted a particularly Australian approach to getting the best out of Kyoto-style commitment to cut greenhouse gas emissions without exposing ourselves to the big costs such an agreement could impose.

Instead of a hard and fast “target” for cutting greenhouse gas emissions, such as the 60 per cent cut by 2050 proposed by Labor or the 80 per cent proposed by Australia’s greens, it has proposed instead a “long-term aspirational goal”.

That goal, be it a 60 per cent cut by 2050 or something else, is far more sensible and robust than might be imagined.

Hard and fast targets have problems. What would happen if it became clear that Australia was not going to reach the target? It would have to either impose punitive measures as the target date neared and run the risk of pushing the country into recession, or abandon the target and with it the credibility of the whole process.

What would happen if it became clear that the effects of climate change were much more sever, or less sever than had been imagined? The hard and fast target would then have to be swapped for another one, again destroying credibility and leaving stranded businesses that had invested in new technology in the belief that there was a hard and fast target.

The beauty of adopting instead a “long-term aspirational goal” is that the inherent uncertainty we have about the future is made explicit.

Businesses planning to invest would know roughly where the carbon price was likely to be in the decades ahead, as well as knowing that they could not know that exactly.

But all the businesses caught up in the scheme would know exactly the cuts in carbon emissions the government had mandated every five years.

The first graph on this page, taken from the report, illustrates the process. Every five years the government would tell everyone by how much carbon emissions had to be cut in the half-decade ahead in order to meet the long-term aspirational goal.

These “caps” as they are called would determine the number of yearly permits to emit carbon that the government auctioned each year. That number would determine the auction price, which itself would help determine the price at which permits were traded on an exchange.

The lower the cap, the higher the permit price and the higher the price electricity generators are going to have to pay to generate electricity from carbon-intensive sources such as coal.

(Please don’t feel too sorry for the electricity generation companies. They will know right from the start the size of the government’s long-term aspirational goal and will be able to plan on that basis, most likely by ensuring that the next power stations they build don’t emit as much carbon. And in the meantime they will be able to pass on their genuinely higher costs to you and me every time we buy electricity. No consumer watchdog will stop them.)

There is a risk that as the government tightens the supply of emission permits each year the price of the permits on the open market will go through the roof. So in its framework the taskforce has put in place a ceiling to ensure that never happens.

Shadowing the likely price of the permits on the market, but usually well above it will be an “emissions fee”, illustrated in the second graph on this page, also taken from the report.

As is often the case with the word “fee” it can be thought of as something else – a fine or a tax.

It too would be set by the government every five years, and as shown in the graph would be initially quite low in order to give businesses confidence to experiment with the new system knowing that they would not be severely penalised for mistakes.

After a few years the fee would “move further away from expected permit prices in order to reinforce the abatement incentive and ensure tighter compliance with the desired emissions cap”.

But it would never be outrageously high, providing “an effective safety valve to protect against unexpected price shocks.”

The combination of a carbon cap and a permit price cap would make the Australian system unique – a “hybrid” scheme in which the government could control neither the exact price or the exact quantity of permits. Things would move in the right direction but we could never be sure exactly where. Quantum physicists are familiar with the concept of uncertainty. Supporters of the Kyoto Protocol obsessed with target would have to get used to it as well.

The idea of “banking” permits would add further uncertainty. If a polluter did not use up all of its permits issued for the year 2011, it could “bank” them for pollution in 2012.

As the report says: “Climate change is a problem reflecting the build up of greenhouse gases over time rather than a function of emissions in any given year.

As long as integrity over emissions is maintained through time (that is, emissions are matched to permits), the banking of permits against future emissions will lead to the same cumulative emissions reduction.”

But the framework stops short of permitting “borrowing”. Businesses that emitted carbon for which they did not have a permit could say they were merely “borrowing” permits they intended to buy later. The taskforce says that would “increase the pressure on a future government to weaken the credibility of the scheme through an opportunistic additional issuance of permits in order to avoid sharp increases in the cost of permits”.

In order to further protect the government from lobbying to issue weaken the scheme it intends to make the grant of free long-term permits to existing polluters “up-front and once-and-for-all”. Existing polluters will be get one big swag of annual pollution permits, some stretching out 20 years into the future. But then that will be in. There will never be a second allocation. Any extra permits they need in the future they will have to either buy at the annual auction, buy from someone who has them, or obtain at a punitive price by paying the “emissions fee”.

Export-exposed industries will also get free handouts. These include not only industries that export, but also industries that are exposed to competition from imports, such as cement manufacture.) They will be doled out every five years, not to existing export-exposed firms, but also to new ones. The catch is they only be given enough to allow the world’s-best low emission means of, say, making cement. And firm not up to the world’s best environmental practice will have to buy extra permits.

As a mechanism for cutting Australia’s carbon emissions in the least economically damaging way possible the taskforce has indeed produced what the Prime Minister called a “benchmark document”.

But a good mechanism doesn’t mean a good system. That depends on the targets that the government adopts. It’ll need to decide on its long-term aspirational goal (the officials group to be set up by the Prime Minister could well pick one close to Labor’s target of a cut of 60 per cent by the middle of the century); it will need to decide on the severity of its short-term caps and the price of its excess emissions fee.

It’ll also need to decide how handsomely to reward or to “compensate” existing polluters with free permits. And to decide what to do with the money it makes at the auctions. A good idea (not canvassed in the report) would be to give to low income earners as compensation for the higher power bills they are about to face.

The taskforce has passed on all of these questions. But it has done its job well. It is up to John Howard or whoever replaces him to make the mechanism it has proposed a reality.