Minority
Report by Senator Nick Xenophon
1. Background: nature of the problem that we are trying
to solve
1.1
Anthropogenic
climate change presents us with the most pressing and complex policy problem
that we have faced. It is pressing because the window of opportunity in which
we have to take the sort of abatement action needed to avoid irreversible,
dangerous and potentially catastrophic climate change is small; and, on the
basis of the findings from last month’s conference in Copenhagen, is getting
smaller. It is complex because it has all the features that policy, whether at
a global or national level, usually struggles to deal with. These include the
fact that abatement has large upfront costs, with benefits that accrue in a
relatively distant future and with some degree of uncertainty; the need to
provide for the development aspirations of poorer countries and the emissions
trajectories entailed by these; the uneven spread across the globe of net
benefits from abatement; and the potential for 'free rider' issues created by
the fact that no one country stands to gain from abatement efforts in the
absence of concerted action. These last two issues create what Professor
Garnaut has accurately characterised as a diabolical prisoner’s dilemma
problem.[1]
1.2 This
overall context must inform the design of an emission trading scheme in a
country like Australia with its small, open economy. There is a sensible policy
case, as well as a strong ethical one, for Australia to take early emissions
reduction action in order to break the potential deadlock created by the prisoner's
dilemma and uphold the sort of global co-operative agreement required to
address global climate change. We need to be clear that the brutally honest
position is this: in the short to medium term the success of our domestic
policy (indeed, of all advanced countries) will be a function of the ability to
get all countries (notably the large emitting developing countries) on board,
without which there will be no prospect of addressing climate change. [2]
1.3 In
taking such action, Australia needs to adopt a scheme that is credible
internationally and sustainable domestically. International credibility will be
to large extent a function of the abatement targets Australia sets for itself.
Domestic policy sustainability is to a large extent a function of adjustment
costs, particularly in the short to medium term when there are likely to be
significant gaps in emission reductions efforts globally. Policy sustainability
has an economic dimension – imposing large adjustment costs on the economy with
no prospect of incremental global abatement gain is simply not an efficient
economic proposition. And this impacts on the political dimension of policy
sustainability by eroding support for emissions reduction, particularly in a
time of economic uncertainty.
2. What
are the policy issues that should govern the design of a carbon pollution
reduction programme?
2.1 Given
this particular background, what are the particular issues to consider as
important in designing a carbon reduction programme?
2.2 Clearly
the overarching goal is environmental – the abatement of greenhouse gas
emissions. This is largely contingent on establishing the appropriate
incentives to bring about substitution in production and consumption from
emissions intensive goods and services to ones that are less so, and to prompt
behavioural changes in consumers and producers. Abatement will, fundamentally,
be investment driven. Firms will need to invest in a variety of activities –
whether in R&D, in implementing new process or selling different goods and
services – as they respond to changes in input costs, relative prices and
changes in consumer demand.
2.3 The
second set of issues consists of adjustment issues, which impact
directly on the issue of domestic policy sustainability discussed previously. Adjustment
issues range from the income effects on households stemming from the
introduction of a price on carbon, to the impact on asset values of what the
government has called 'strongly affected' firms. Issues related to carbon
leakage and the loss of competitiveness are adjustment issues that relate
directly to the global nature of the abatement task and the prospect that, in
the short to medium term, countries like Australia will be implementing
emission reductions ahead of others.
2.4 Carbon
leakage and competitiveness cut to the heart of both the economic and
political dimensions of sustainability. While the political is often
emphasised, it is important to underscore the economic efficiency aspects of
both these issues too. Carbon leakage is a net cost to the global economy – it
imposes adjustment costs with little or no return in terms of global abatement.
Competitiveness losses can also be a global cost (and not just specific to
Australia) as well. This will arise if carbon reduction schemes cause the
relocation of activity away from Australia, when that activity would have been
located in Australia had there been a concerted global effort to reduce
emissions. The implication is that the introduction of a price of carbon in
some countries but not in others will cause a distortion to the global
allocation of production along lines of comparative advantage.
2.5 The
third set of issues consists of governance issues. These include the
potential for policy capture. Capture could manifest itself in a number of ways
including: manipulation of the scheme parameters and its implementation; or
manipulation of some other area of government policy (such as trade policy) in
response to the effects (or supposed effects) of the carbon pollution reduction
scheme.
2.6 Given
these policy issues, a carbon pollution reduction scheme will be judged on the
grounds of whether it is:
-
effective
in managing these different concerns, and any trade- offs between them;
-
efficient
in managing these concerns at least cost;
-
ethical
in terms of managing various equity and distributional issues that are raised
by these concerns.
3. Critique
of the CPRS and government approach
3.1 A weak target
3.1.1 Against
this backdrop is a critique of the government’s approach as set out in the
CPRS. Perhaps the most commonly heard criticism of the scheme is the overall
target range of 5-15% that has been set. That target range is largely a
reflection of the adjustment costs that may be expected, but also of the
peculiarly high cost nature of the scheme that has been chosen. In respect of
the former, it is likely that the government’s own modelling has understated
the costs, in the short to medium term, of adjusting to a carbon price. This
in turn is a reflection of the fact that the type of Computable General Equilibrium
(CGE) model uses a full employment rule as it closure rule - that is, the
economy is always at or near full employment levels, and responds to a shock
almost immediately. In other words, for example, retrenched workers in the
Pilbarra or in Newcastle become insurance agents in Melbourne or Sydney
overnight. Clearly, this is unrealistic, and while the full employment rule and
its consequent results can be a useful guide to what happens in the long term,
it simply assumes away some of the most pressing policy problems in the short
term. Indeed, it is quite likely that the Government is aware of the
limitations of its modelling and has thus chosen a cautious approach as a
consequence.
3.1.2 Setting
aside issues of modelling, concerns regarding adjustments costs are also
warranted on account of the high cost nature of the cap and trade mechanism
within the CPRS, as compared to alternatives. This point is explained in
further detail below when intensity-based approaches are discussed. The main
issue is that the cap and trade approach essentially acts as a penalty-only
mechanism: it penalises all emitters as a function of their emissions
intensity, but offers no direct reward to firms that cut emissions.
3.1.3 If
we marry the high cost aspect of the scheme design to concerns about adjustment
that may not be captured in the modelling, then a relatively modest target
range is a predictable outcome. It does, however, raise the question as to
whether a more ambitious target could be adopted if an alternative scheme
design were available that would be more attractive in managing adjustment
concerns because the scheme has lower cost properties. This would be desirable
from an environmental perspective, and in terms of sending a more credible
signal internationally (recalling here that the overarching objective sought
through the early implementation of a carbon reduction scheme is to sustain a
co-operative international agreement).
3.2 Not one but many schemes
3.2.1 The
CPRS is a combination of several mechanisms and initiatives. Ostensibly, its
central feature is a cap and trade mechanism, though it would be more
appropriate to refer to it as a “quasi-cap and trade” mechanism. Under a
standard cap and trade scheme, the quantity of emissions is fixed and the cost
of emissions (i.e. the price of permits) is allowed to vary. In the case of the
CPRS, this fixed quantitative restriction is relaxed. If the permit price
reaches a certain level ($40 per tonne), the government will issue an unlimited
number of permits – as Richard Denniss put it in a recent presentation, the
government will start printing permits as if it were the central bank of
Zimbabwe printing cash.[3]
The price cap, as well as banking and borrowing provisions and gateway
provisions that provide flexibility for the government to adjust the overall
targets in the light of prevailing circumstances reflect a concern on the part
of the government both to cap the overall costs of the scheme, and to limit
volatility in prices. This in turn is motivated by a concern regarding the
adjustment impact of permit price rising to higher than expected levels, and an
acknowledgement that untrammelled volatility in permit prices is undesirable
because of the investment uncertainty this generates.
3.2.2 Mitigating
the transitional adjustment impact of emissions trading also provides a
central motivation for revenue recycling, which under the CPRS would be
undertaken through transfers to households and through tax offsets on
transport. The transfers are mainly motivated on equity grounds, and
specifically to offset the regressive income effect that the introduction of
emissions trading can have through various channels (such as higher electricity
prices).
3.2.3 The
proposals for emission-intensive, trade exposed (EITE) industries differ
significantly from other approaches to managing transitional issues. The method
of permit allocation, which is tied to production and linked to an emissions
intensity benchmark has strong affinities with the intensity based approach
discussed below. The main difference, as we shall see, is that while with
normal intensity based approaches, activities receive a net subsidy to the
extent that they emit lower than a specified benchmark, under the EITES
proposals activities will receive shielding (i.e. an implicit production
subsidy) to the extent that their emissions intensity exceeds a certain
benchmark. It is important to emphasise that under a cap and trade scheme,
attempts to address competitiveness issues and carbon leakage by shielding firms
from the cost of emissions must necessarily take the form of either a cash
subsidy tied to production or a free permit allocation tied to production. An
approach based on the former was recommended by Professor Garnaut, while the
CPRS chose the latter route. Some of the drawbacks with the particular approach
chosen by the CPRS are discussed below, but at this juncture the important
point to note is that the proposals for the EITES involve a scheme that runs
along qualitatively different lines to the central cap and trade mechanism.
3.2.4 The
CPRS also includes as yet undeveloped proposals regarding energy efficiency.
This is almost certainly likely to mirror “white certificate” schemes elsewhere
and follow a baseline and credit approach, which again is substantially
different to the cap and trade mechanism contemplated for the emissions trading
proper.
3.2.5 Though
not part of the CPRS itself, the proposed MRET will also follow a
baseline and credit approach, in keeping with green certificate schemes found
in other jurisdictions.
4. Commentary on the complexity of the CPRS
4.1 The
CPRS is therefore a complex assemblage of different mechanisms. To some extent,
all proposals for carbon reduction in a small open economy like Australia will
have a degree of complexity. This simply stems from the wider, global context
in which such schemes are implemented. Inevitably, reconciling the imperative
for credible early action and domestic policy sustainability – through the
management of adjustment issues – leads to multiple policy concerns and hence
the need for multiple objectives. This is all the more true if the core of the
reduction scheme is a particularly high cost proposal, as embodied by the CPRS.
The critique that may be offered of the CPRS is that it selects instruments that
are ill suited to the wider policy context in which they are implemented, and
to managing the policy concerns that stem from this.
5. Drawbacks
of the CPRS vis a vis objectives sought
5.1
Environmental
objectives
5.1.1 The
CPRS does not perform well even on the one issue where it is often touted as
having a clear advantage over other approaches – namely in providing certainty
in the quantity of emissions reduction. For reasons already explained, the
various safety valves included in the scheme preclude it from offering such
certainty; or at least, what certainty there is exists only up to a certain
point in circumstances when the demand for abatement exceeds projections. In
this respect, the cap and trade proposal is not substantially different to an
intensity based approach or a tax, both of which allow for flexibility in
emissions if the demand for abatement exceeds projections.
5.1.2 Moreover,
the flexibility in the quantity of abatement under the CPRS is asymmetric – the
cap loosens after a certain point on the upside when demand for abatement
exceeds projections, but does not tighten if the demand for abatement
undershoots projections (due to lower than expected emissions growth resulting,
for instance, from economic growth that is lower than trend levels or because unanticipated
abatement having taken place e.g. through household initiatives). This is the
much publicised issue of "additionality" that has been given a
considerable degree of attention, and which means that under the current CPRS,
the billions of dollars injected into funding insulation would lead to no
additional abatement, but would rather shift the overall contribution made to
abatement from large emitters to households. The issue of additionality is not
unique to the CPRS, but arises in all cap and trade schemes where targets are
weak. Indeed, this has led to calls for governments to intervene by putting a
floor on carbon prices through periodic revisions of the overall cap – a form
of intervention that is tantamount to converting the scheme into an intensity
based approach.
5.1.3 In
contrast to the CPRS proposal, intensity based measures and carbon taxes lead
to a tightening of the cap when emissions undershoot expectations. This allows
for a greater degree of smoothness in the carbon price which in turn will
provide a better basis for investment decisions including green industries and
cleaner energy production. Indeed, the CPRS seems to have captured the worst
of all worlds: it is a high costs scheme that, in attempting to contain those
costs does away with the feature (certainty in reductions) touted as its
greatest asset. Moreover, the asymmetrical nature of this modification removes
any possibility of additionality abatement, a feature that has prompted calls
for governments to intervene through target revisions.
5.2 EITES
5.2.1 There
are several drawbacks to the approach used to handle EITES. Generally speaking,
the government is correct to avoid using border measures such as tariffs and
border tax adjustments, as these would be complex to administer, inefficient,
and almost certainly in contravention of global trade rules. The use of
production subsidies would also be litigious from a WTO perspective to the
extent that they are specific to certain firms and contingent on export
performance and/or on the use of domestic inputs. The CPRS has got around that
problem, on paper at least, by making its system of subsidies (“shielding”)
contingent on emissions intensity but this in turn raises other problems.
5.2.2 For
a start, the granting of subsidies subject whether to an activity is in excess
of a certain emissions threshold is perverse from an abatement view-point.
Granted, the CPRS legislation does away with the problem that might have
existed under the Green Paper proposals, namely that firms might be penalised
if they cut emissions because they would drop below the threshold at which
shielding was triggered. However, the proposals still mean that those firms
that have been relatively efficient prior to the cut off date for measuring the
emissions intensity thresholds are not rewarded for their efforts, which can
have adverse dynamic efficiency consequences going forward.
5.2.3 A
second issue is that the decision to selectively shield more emissions
intensive firms or activities increases pressure on those less intensive trade
exposed ones that are not shielded. This is not simply because they do not
receive the financial benefit subsidies. A more fundamental issue is that for
these firms, the shielding approach acts very much like a real exchange rate appreciation
that is imposed specifically on them. To see this, consider that the
introduction of a price on carbon will inevitably increase the price of
non-tradables relative to tradables (that is, the real exchange rate will
appreciate). This is because tradable sectors are able to pass on the costs of
the carbon price to a much greater extent than non-tradables given that the
latter are essentially price takers. The introduction of shielding essentially
carves out a sector of the tradables sector – the more emissions intensive –
and protects them from the effects of this appreciation. But this simply means
that the competitive impact of the price of carbon will fall more heavily on
less emissions intensive activities. In particular, there will tend to be a
shift in resources and factors of production away from these sectors to
shielded sectors and to non tradables. In this manner, the shielding approach
is as much a tax on less emissions intensive activities as it is a subsidy to
the more emissions intensive ones. In effect this creates disincentives for
resource allocation towards activities that should on balance be promoted.
Moreover, it is entirely possible that the disadvantaged sectors will seek
relief through other avenues of policy, such as trade policy. This in turn can
create further distortions that accentuate economic costs, and create trade
tensions that pose an obstacle to securing the type of co-operation required to
sustain a global agreement on climate change mitigation.
5.3 Governance
issues
5.3.1 The
administration of adjustment assistance through transfers, and more generally,
the administration of permit revenues, raise a number of governance issues. For
a start, the fact that revenues are required to mitigate the regressive impacts
of the scheme on income distribution means that at least some of the double
dividend (which could have been reaped through the use of permit revenue to cut
distortionary taxes on labour and investment) will be foregone. Secondly, the
administration of such transfers in a manner that does not affect consumption
decisions is likely to be, at the least, problematic. A more general issue is
that the large amounts of cash that will transit through government coffers
raise all manner of possibilities for wasteful recycling. The modelling of scheme
effects implicitly assumed that all recycling is done perfectly efficiently,
and without creating any costs through distortions. This is unlikely to be the
case. Indeed, experiences with government spending over the last few years
suggest that governments are particularly bad at identifying socially optimal
forms of spending.
6. Summary observations on the CPRS
6.1
In
sum, the CPRS as it stands is ill equipped to initiate sustainable domestic
reform in the realm of climate change policy. In particular, it presents a high
cost approach to reform that creates various transitional adjustment issues.
These have not been fully addressed in the economic modelling, and to the
extent that they have been countenanced, have led to a variety of adjunct
measures that (i) undermine the scheme’s own aspirations to provide certainty
in emissions reductions (ii) add various layers of complexity, notably through
approaches to EITES and the recycling of auction revenues, that are conducive
to serious economic distortions and problematic governance issues.
6.2
There
is significant scope to build on the work done to date and improve the current
design of the scheme. The Select Committee on Climate Policy should shed
further light on alternative approaches.
Senator Nick Xenophon
Independent Senator for South Australia
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