Minority Report by
Senator Nick Xenophon
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 the March 2009 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 a 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.
What are the policy
issues that should govern the design of a carbon pollution reduction programme?
1.4
Given
this particular background, what are the particular issues to consider as
important in designing a carbon reduction programme?
1.5
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.
1.6
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.
1.7
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.
1.8
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.
1.9
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.
Critique of the CPRS
and government approach
A weak target
1.10
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 5-25% 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 its 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.
1.11
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.
1.12
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).
Not
one but many schemes
1.13
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.
1.14
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).
1.15
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.
1.16
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.
1.17
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.
Commentary on the
complexity of the CPRS
1.18
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.
Drawbacks
of the CPRS vis a vis objectives sought
Environmental
objectives
1.19
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.
1.20
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 of
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
Government’s approach to remedy this is cumbersome and ineffective). 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.
1.21
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.
EITES
1.22
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.
1.23
For
a start, the granting of subsidies subject to whether an activity is in excess
of a certain emissions threshold is perverse from an abatement viewpoint. 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.
1.24
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.
1.25
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.
1.26
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.
Governance
issues
1.27
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.
Summary
observations on the CPRS
1.28
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.
1.29
There
is significant scope to build on the work done to date and improve the current
design of the scheme.
Alternative approaches
– an intensity-based approach
1.30
There
are various types of scheme architecture that could be proposed as an
alternative to the CPRS. While it is tempting to suggest that work on the
design of a carbon reduction programme should recommence from scratch,
pragmatism suggests that alternatives should build on work that has been done
to date, and adapt existing proposals as far as possible.
Mechanics
of an intensity-based approach
1.31
The
approach proposed is termed an intensity-based approach, as it involves
determining, for a particular activity or sector, an emission intensity
baseline. Baselines across sector and activities in an economy are set at the
level that achieves the desired emissions level. Any producer emitting more
than the baseline has to acquire permits in excess of the baseline. Any
producer emitting below the baseline is allowed to create and sell permits to
those who need to buy permits. The revenue that low emitters earn can help pay
for investing in low emission technology. The scheme works by simultaneously
penalising higher emitters (just as occurs under a cap and trade) and rewarding
lower emitters. In simple terms the scheme is a ‘carrots’ and ‘sticks’
approach.
1.32
Conceptually,
the scheme has similarities and differences with the cap and trade approach
proposed by the CPRS. A cap and trade approach is in effect an intensity
approach with an emissions baseline set at zero. This effectively entails an
impost on all emissions. A higher baseline raises the threshold at which the
cost impost sets in. Changing the threshold does not affect the extent to
which high emitters are taxed relative to low emitters – rather, it simply
means that the latter receive a net subsidy while the former face a net tax. What
has changed is that the absolute level of cost impost is confined to the
portion of emissions above the baseline. This in turn means that the absolute
price effects of the intensity-based scheme are lower than under cap and trade.
A cap and trade scheme could in theory achieve the same result by auctioning
permits and then recycling revenue as a flat subsidy to producers. But this
would involve the governance complexities of hauling revenue into the Treasury and
out again, and the potential for capture that could arise as a consequence.
1.33
As
already noted, the CPRS does indeed employ a variant of an intensity-based
approach in its proposals for EITIs and shielding. Permits are allocated on
the basis of output and subject to an emissions baseline. The main difference,
however, is that subsidies kick in once the baseline is exceeded. Under
the alternative intensity-based approach, the idea would be to create
incentives to reduce emissions below the baseline.
Outcomes
of this approach
1.34
One
of the consequences of confining the cost impost to the proportion of emissions
above the baseline is that it reduces the overall price impact of the scheme.
Figure 1 (below) provides an overview of the relative price effects of this
approach as compared to a cap and trade approach when applied to the
electricity sector.
Figure 1:
1.35
The
lower price effect is an important result as it deals with the principal
adjustment concerns associated with the implementation of emissions trading:
competitiveness effects, carbon leakage and regressive income effects. It also
deals with these issues in a better and more systematic way than the proposals
contained in the CPRS since:
- whereas
the CPRS relies on developing a particular type of scheme for EITES to run in
parallel with the cap and trade mechanism, the intensity approach would apply
across the board to the economy;
-
the
intensity approach couples lower price impacts with incentives for producers to
reduce emissions;
- whereas
the CPRS proposals involve a large degree of revenue recycling to address
adjustment issues, this approach internalises such transfers within the scheme.
1.36
One
question that frequently arises concerns the impact of lower prices on impacts
for abatement. In this context, it is important to distinguish between
incentives on the supply side versus those on the demand side. On the supply
side, incentives for substitution from high to low emissions technologies are
preserved since what matters for substitution is the extent to which high
emissions activities are taxed relative to low emissions ones. While the
absolute value of the impost has decreased, in relative terms high emissions
activities are still taxed relative to low emissions ones in the same manner as
under cap and trade. The lower level of the absolute impost on producers is
what mitigates adjustment issues – particularly for trade exposed activities
where firms are price takers. The relativities in net taxation between high
and low emissions activities is what sustains incentives to abate.
1.37
Concerns
on the demand side are largely related to the effects of lower prices on energy
consumption, and hence emissions. In response to this, it should be noted that
for a start, demand response may well be muted under existing compensation
arrangements for households, in which case the impact of the intensity-based
approach would not be materially different to the CPRS proposals (though, as
emphasised before, the revenue recycling associated with the CPRS would be
avoided). Secondly, existing evidence suggests that demand side abatement is
not particularly responsive to price signals.
1.38
There
are a large number of abatement options that households could currently adopt
on a “no-regrets” basis but that are not taken up, suggesting that other market
failures are at work rather than the absence of a carbon cost in the price of
energy. If so, a better approach to demand side abatement would be to rely
less on the price signals dropping out of emissions trading, and more on a
specific demand side abatement scheme, which would address underlying causes of
market failure such as split incentives. Indeed, the CPRS proposals allude to
the development of such approaches in respect of energy efficiency.
1.39
Demand
side abatement schemes typically function as intensity-based approaches, and
would therefore be a much more logical and natural extension of the intensity-based
approach proposed here than it would be of the CPRS (to which it would be yet
another adjunct mechanism).
Attaining
abatement objectives
1.40
We
already observed that the sum of the emissions baselines across the economy
yields the overall reduction target that could be achieved. One issue that is
frequently raised is that an intensity-based approach does not guarantee a
fixed level of abatement – the worry is that if emissions grow faster than
expected (say, because economic growth exceeds projections) then there is no
quantitative mechanism that will force emissions back to the absolute target
level as would happen under a cap. In theory, this is a valid criticism that
could also be levelled at a tax. In practice, it is of little value since it
presupposes that the alternative to the intensity-based scheme is an absolute
cap. However, as observed earlier, this is not what is contemplated in the
CPRS. There will be a variety of safety valve mechanisms that ensure that the
cap is not a hard and fast one. The existence of these safety valves is in part
a recognition of the higher cost impact of the cap and trade scheme.
1.41
Moreover,
this criticism is turned on its head if we consider the opposite case in which
emissions grow less fast than expected. Here, the cap implied by the intensity-based
approach tightens. One implication of this is that the concerns regarding
additionality raised in connection with the CPRS do not apply to an
intensity-based approach. Another is that if there is a slump in economic
growth, permit prices will not collapse as they would under cap and trade.
1.42
More
generally, an intensity-based approach makes for less volatility in permit
prices than the cap and trade approach, a point emphasised by Dr Frank Jotzo in
his evidence before the Senate Standing Committee on Economics.[4] Smoothing
volatility is desirable from an investment point of view.
1.43
To
sum up, there is no reason to believe that the proposed intensity-based
approach would fare any worse than the CPRS in confining emissions growth to a
set target. Clearly, if the CPRS were to be amended to get rid of its safety
valves then it would perform better in terms of abatement certainty, but this
is unlikely to be adopted given the need for such safety valves to manage the
adjustment issues created by the high cost nature of the CPRS. Moreover, the intensity-based
approach fares better in managing these adjustment issues (on account of its
lower price impacts), in addressing additionality issues, and in managing
carbon cost volatility. Because it is better at managing adjustment issue, it
also offers the prospect of setting stronger targets than the ones proposed to
date.
Implementing
the intensity-based approach
1.44
Clearly,
the central challenge in implementing an intensity-based approach lies in setting
the different baselines. One option would be a linear reduction from
historical levels. Under this approach, a sector or particular sub-sector
would be subject to the same percentage reduction per year. This is the
approach that is essentially adopted by the CPRS in respect of EITIs, though
under the new approach this would be implemented across the board and not as
part of a shielding package for activities that exceed an emissions intensity
benchmark. The advantage of doing this is that it draws on information (carbon
accounting) that will need to be collected as part of any scheme and applies a
straightforward rule for abatement.
1.45
Another
option is to set initial baselines according to world’s best practice, and then
specify a schedule of cuts thereafter either on a linear basis or on a view of
expected abatement opportunities. The advantage of this is that it recognizes
the scope for abatement. The disadvantage is that governments will typically be
limited in their knowledge of expected abatement opportunities, and firms can
take advantage of this asymmetry for rent seeking purposes.
1.46
There
is also an option of setting a zero baseline for some sectors, which in effect
means a reversion to a cap and trade scheme. Indeed, over time, as cuts are
implemented to the baseline, the intensity-based approach will converge to the
cap and trade approach. One way of looking at this is to suggest that the intensity-based
approach will be used to manage the transitional adjustment issues associated
with the introduction of emissions trading and, as these issues diminish (for
example, as the participation of other countries in a cooperative solution is
secured) the baselines can be phased down so that the intensity-based approach
converges on a cap and trade approach. In effect, the intensity-based approach
can be characterised as a “transition and convergence” approach.
Governance
concerns
1.47
Intensity-based
approaches are sometimes criticised on the grounds that they pose various
governance challenges in terms of administrative requirements and dangers from
rent seeking. In response, it is important to note that all schemes are exposed
to these, and that the CPRS proposals are particularly exposed to such concerns
because of the plethora of adjunct instruments that are required to manage the
adjustment costs associated with the scheme (to which must also be added the
risk that the adjustment costs could spill over into governance challenges for
other areas of policy such as trade policy).
1.48
Specifically
in relation to the intensity-based scheme, it should be noted that the
informational base required to run it is similar to the one required for the
CPRS. Both require and draw on information drawn from firms’ carbon
accounting. Under the intensity-based approach, it would be necessary to guard
against efforts to secure baselines that are too generous and that allow
unwarranted gains for producers that perform better than baselines. One can
address this challenge by drawing on a range of objective measures such as
existing emissions levels, and agreed indicators of world’s best practice.
1.49
In
setting the baselines, it would also be necessary to take into account not only
how resources are allocated within particular activities, but also how the
baselines across the economy affect resource allocation across sectors and
activities. This would require some form of modelling. While this is a
demanding exercise, it is no more demanding than (properly) modelling the
impacts of any other type of scheme.
Responses
to critiques of the baseline and credit and intensity-based schemes
1.50
This
note sets out the main criticisms that have been made of the intensity-based
approach, and the responses to them.
1.51
The
intensity-based approach creates a misallocation of resources by diverting a
country’s resources from high polluters in a low-emissions industry to
low-emitters in a high pollution industry.
1.52
The
underlying argument is that the CPRS sends a price signal to consumers: this
encourages both supply side abatement (i.e. switching production from high to
low emitters within a sector) and demand side abatement (i.e. switching
consumption from high emitting sectors to low emitting sectors,
where the end products are substitutes). It is argued the intensity-based
allocation targets the former but not the latter: it mutes price effects and
therefore discourages substitution away from high emissions activities to low
emissions activities.
1.53
The
above is an academic criticism that is of little practical consequence.
- Opportunities
for demand side abatement (or substitution of goods) are very limited, are
generally not very responsive to price signals, and (where applicable) are more
feasible in the long run;
- The
(limited) examples of sectors that may be substitutes are trade exposed, hence
a price signal is not feasible anyway (i.e. Australia is a price taker in
global markets);
- The
muting of the price signal is only transitional: over time the baselines for
each sector fall and the effects of the scheme becomes more like cap and trade
in the long run.
1.54
In
practice, the criticism that intensity-based approaches lead to a serious
misallocation of resources is overblown because it overstates the
importance attached to abatement through demand side responses, and understates
the problems that arise from trade exposure.
1.55
On
the demand side front, the empirical evidence suggests that the most
significant abatement opportunities for Australia are not primarily a function
of demand side responses to product market prices. The McKinsey research into
abatement cost curves shows a significant number of negative cost abatement
options; the fact that these are not exercised at present suggests that there
are market failures at work that are unlikely to be addressed by price signals,
but would be more likely addressed by specific demand side programs. Moreover,
the Government’s own estimates of demand side abatement are based on a flawed
calculus. Its modelling attributes approximately 120Mt of abatement to demand
side response in the electricity sector in 2050. This result overstates the
benefits of demand side reduction since they incorrectly use current emissions
intensity of electricity of around 1tCO2/MWh to calculate emissions avoided
from a reduction in MWh consumed. This is inconsistent with their own
modelling results, since the emissions intensity of the market is around
0.1tCO2/MWh by 2050. This means that emissions avoided through demand side
abatement would be 1/10 of what they suggest.
1.56
The
issue of trade exposure is important since that has a material impact on how
carbon pricing affects product market pricing. To see this, consider the case
where you have one trade exposed sector such as a smelter and another
manufacturer that is not trade exposed and less emissions intensive. Assume
that the smelter is trade exposed and is a price taker in the world market, but
that the other manufacturer is not, then any carbon price effects on the
smelter would translate into an increase in imports and a substitution away
from the goods produced by the other manufacturing industry. The higher the
price the stronger the effect. This simply points to the risks associated with
carbon leakage and the potential distortions that could arise by implementing a
cap and trade scheme in a world where not everyone undertakes reduction
commitments.
1.57
To sum up, while the price effects of the
intensity-based approach have the potential to cause some distortions, they are
unlikely to be severe. This could be tested through modelling. Moreover, the
costs of those distortions that do arise need to be set against the costs of
managing carbon leakage and the distortions this creates; the critique of
intensity-based approaches set out above is essentially one-sided since it
neglects the benefits side of the ledger. Moreover, because the
intensity-based approach converges over time to a cap and trade outcome as
baselines are cut, the initial distortions will diminish over time.
Intensity-based
approaches are difficult to administer because the baselines are difficult to
establish
1.58
There
are a variety of ways of setting the relevant baseline. One would be to adopt
some best practice base. The other would be to introduce linear cuts to
emissions intensity over time. The latter approach has been suggested, for
example, in New Zealand in regard to its proposed allocation for agriculture
(which follows an intensity-based approach). If one were to adopt a linear cut
approach, then the essential requirements are historical – actual emissions
intensity and production data. This is not fundamentally different as a
requirement from what is needed to run a cap and trade scheme, particularly a
cap and trade scheme that also has an emissions intensity-based scheme appended
to it (as is the case with CPRS, given that the approach followed in regard to
trade exposed sectors is an output based allocation system).
1.59
More
generally, this criticism reveals a fundamental misunderstanding of the
complexities involved in running a cap and trade scheme in a context where
competitiveness effects, carbon leakage effects and adjustment effects need to
be managed. If these issues are to be addressed, complexities will inevitably
arise in developing mechanisms that determine which producers are eligible for
assistance on account of trade exposure and how much, or in developing
mechanisms that address household adjustment effects.
1.60
This
is abundantly illustrated by the CPRS, which has had to introduce a number of
additional mechanisms (such as specific scheme for EITE sectors) to manage
these adverse economic effects. These additional mechanisms are a direct
function of the high cost impacts of the CPRS on a small open economy – one
that is avoided under the intensity-based approach.
1.61
The
appropriate comparison is therefore to compare the complexities of
administering an intensity-based approach with the complexities involved in
running a cap and trade scheme and all the add ons that are necessary to make
such a scheme workable. It is somewhat disingenuous to dismiss the
intensity-based approach as complex when the scheme currently on the table is
one of Byzantine complexity.
Intensity-based
approaches are susceptible to rent seeking
1.62
There
is no principled reason as to why the intensity-based approach should be more
susceptible to rent seeking and manipulation that any other scheme. Indeed,
under a cap and trade scheme, such pressures are likely to emerge as a consequence
of the impact such a scheme has on competitiveness and carbon leakage. For
example, if the Government (as it has done) attempts to limit assistance to a
certain subset of EITES that is likely to lead to those who are excluded to
lobby in favour of inclusion. This has been the Government’s experience ever
since the Green Paper came out. More fundamentally, attempts to manage the
trade impacts of the CPRS through approaches that arbitrarily cut off
assistance are likely to be costly since they (i) run the risk of resource
misallocation and (ii) increase the incentives for lobbying.
1.63
More
insidiously, the price effects of a cap and trade scheme are likely to increase
pressure on other areas of policy – notably trade policy. Pressures for
protectionist trade policies are always on the increase globally in times of
recession, and adding the cost impacts of a cap and trade scheme will only make
matters worse.
Intensity-based
delivers less certain abatement
1.64
While
intensity-based approaches allow for more flex in the target if actual
emissions diverge from projected ones, deviations would be expected to balance
out over time as the emissions intensity of the economy falls (hence the link
between emissions and growth becomes marginal).
1.65
Moreover,
unlike to CPRS, the intensity-based approach can accommodate additional and
unexpected abatement by tightening the implied cap. For example, voluntary
abatement would be effective under this scheme (as opposed to simply easing the
burden on other sectors under the CPRS).
1.66
A
more fundamental issue is that this critique implies that the CPRS will deliver
certainty in abatement. It will not. As they stand, the CPRS proposes an
administered price for the first year, followed by the introduction of a price
ceiling in subsequent years. This effectively says that the government is
prepared to deliver abatement, but only up to a particular cost threshold.
Even then, there is a heavy reliance on permit imports to meet Australia’s
target, so there is no certainty over domestic emissions in any case. The
notion that the CPRS would deliver greater certainty in abatement is repeatedly
propounded furphy.
Intensity-based
approaches are not viable in an international context
1.67
The
idea that a cap and trade scheme is viable in an international context but an
intensity approach is not is largely predicated on the notion that the former
will deliver certainty in abatement. As already indicated, this is largely an
illusion, given the inclination to use safety mechanisms such as price caps in
the CPRS. Secondly, even if that issue were to be set aside, the fact is that
worries about the competitiveness effects of emissions trading (which are
aggravated under a cap and trade scheme) have led major developed emitters to
water down their targeted reductions. Thus, even if a cap and trade were to
deliver more certainty, this has come at the expense of environmental
outcomes. Low targets have become the antidote to poor emissions scheme
design. These low targets have, and will continue to, make it difficult to
secure international agreement on emission reduction schemes.
1.68
Fundamentally,
the choice under a cap and trade scheme is between targets that are high but
cannot be sustained, or between targets that can be sustained but are not meaningful.
Consequently, there is no intrinsic value or requirement in pursuing a cap and
trade scheme from an international perspective. On the other hand, because the
intensity-based approach handles the main adjustment issues related to leakage
and competitiveness more efficiently, it offers the scope for pursuing tougher
targets, which enhances the chances of securing international agreement. Moreover,
given that the scheme has attractive properties for economies like China and
India, successfully modelling its implementation can be beneficial to drawing
these countries on board.
Canada’s
decision to abandon the scheme means it has no relevance to Australia
1.69
Canada’s
decision to harmonise its scheme with that of the US is logical given that
Canada’s trade is dominated by the US, and so there are gains to it from close
integration with the US. If anything, the decision illustrates the importance
of choosing a scheme that is appropriate for a particular context.
1.70
The
notion that the intensity-based approach is consigned to the “dustbin of
history” is fanciful and not supported by the facts. As a matter of practice,
if one looks at countries considering emissions trading, many have incorporated
intensity-based proposals to some extent in their approach. The CPRS proposes
an intensity-based approach in addressing the issue of EITES; New Zealand has
proposed an intensity-based approach in respect of agriculture; the EU proposes
an intensity-based approach to deal with sector such as aluminium and cement, both
in its own scheme and in the context of international sector agreements;
Switzerland and Japan have proposed intensity-based approaches.
1.71
The
issue is not that intensity-based approaches have lost their relevance. The
issue is more that countries such as Australia have proposed a piecemeal
approach that combines cap and trade with intensity-based measures, which is
costly and distortive. What proponents of intensity-based approaches suggest
is to adopt an intensity-based approach on a systematic basis, on the grounds
that it can better handle the transitional adjustment issues, and progress over
time toward a cap and trade scheme.
Reduction, Adaptation
& Mitigation
1.72
Much
of the policy discussion surrounding climate change has focused on reducing greenhouse
gas emissions, which is understandable given the imperative of stabilizing
atmospheric concentrations of CO2. However, policies that help societies to
adapt to the effects of climate change are also a vital part of the story.
Both the Stern Review and Professor Garnaut’s review devote important chapters
to the issue of adaptation. By contrast, the topic has generally been
neglected by the Federal Government – there is no mention of it in either the
Green or White Papers.
1.73
The
adaptation story is vital for two reasons. One is that a lot of climate change
is already locked in through the accumulation of GHGs in the atmosphere. We
are already seeing some evidence globally of changed weather patterns. Consequently,
even under the most optimistic assumptions about reduction, we will experience
climate change impacts over the coming years and decades. We thus have an
adaptation issue in the short to medium term.
1.74
Secondly,
even assuming a global agreement on reduction that makes significant cuts to
GHGs, there will still be some residual climate change, given that it is almost
inevitable that sea temperatures will rise by 2 degrees. This creates an
adaptation issue in the longer run.
1.75
Climate
change impacts have the potential to affect a wide range of activities and
assets, from ecosystems to agriculture, to housing and human health. Australia
is particularly vulnerable to climate change given, amongst other things,
the fragility of a number of its ecosystems, its comparative advantage in
international trade in agriculture, and the proportion of its population that
live in low lying coastal areas. Absent adaptation, climate change is likely
to cause severe stress to Australian society, its economy and the environment.
1.76
One
of the important aspects of adaptation policy is that people and businesses are
quite capable of developing adaptive responses. Farmers, for example, have a
long track record of adapting to changing conditions. But that is not a
justification for policy neglect. Individuals and businesses need information
to make decisions, and consequently there is a need for research and
development, as well as the dissemination of information. Sometimes
individuals and businesses do not make decisions that are the most beneficial
for society as a whole since they do not see the rewards from making those
decisions (or the costs of not doing so). And some individuals, notably the
aged, the sick and the poor, have a diminished capacity to adapt. So
there is a role for government to step in. Finally, government itself can be
the main culprit through badly designed policies. For example, if water
resources are not properly allocated or priced, then the damages from climate
change will be greater. There is likely to be considerable scope for government
policy action that delivers a win on adaptation as well as other environmental
and resource management grounds.
1.77
So
there is no question that a reasoned approach to adaptation is required. Thus
far, whatever thinking there has been on adaptation has largely been undertaken
at the state level. While that is not wrong in and of itself – since climate
change will have particular localized effects – it would also be wrong not to
address that challenge at a federal level. An approach where reduction is
tackled federally but adaptation is left to the states can easily perpetuate
what Professor Garnaut calls a false dichotomy between the two. Secondly, many
adaptation issues cross state boundaries – water management being an obvious
example – and consequently will demand a broader approach.
1.78
Further,
adaptation won’t happen immediately – a lengthy and expensive transition will
be required, even if it is pursued with urgency. This will also require the
effects of climate change to be managed, or mitigated.
1.79
Since climate change
will be accompanied by more extreme weather events such as more severe storms,
floods, droughts and coastal erosion, there needs to be a public policy
response to mitigate the effects of these inevitable events.
1.80
As
this is a national problem it needs to be coordinated at a federal level with
adequate resources to ensure a coordinated national approach.
1.81
In
summary, there are three essential elements to an effective climate change
policy. It must involve an effective reduction target based on a well designed
emissions trading scheme that promotes investment certainty on low and zero
emissions technologies, taking into account Australia’s international
competitiveness.
1.82
Further,
there must be an integrated adaptation and mitigation policy that best prepares
Australia for the inevitable aspects of climate change.
Concluding observations
1.83
One
again, it is important to recall what the overarching objective is: to initiate
sustainable domestic policy reforms with a view to securing a global co-operative
outcome without which domestic efforts will largely be in vain. Meeting this
objective requires implementing credible targets and managing adjustment costs
effectively. The CPRS does neither. Its approach to managing adjustment
issues raises all sorts of governance and policy problems, and the Government
tacitly acknowledges the high cost nature of its proposals through the weakness
of its target and measures that do away with the oft-touted abatement certainty
offered by a cap and trade scheme.
1.84
The
intensity-based approach affords a more efficient management of adjustment
costs, while preserving abatement incentives. Its implementation can build
upon efforts undertaken to date; indeed, over time, it could transition and
converge to a cap and trade model as adjustment issues are managed and global
cooperation is firmer.
Recommendations
Recommendation
1
1.85 That
the Bills not be passed in their current form.
Recommendation
2
1.86 That
there be a comprehensive adaptation policy with adequate resources to ensure a
coordinated national approach for managing the effects of climate change.
Recommendation
3
1.87
Revising
abatement targets upwards to a level that is more likely to secure an
effective global agreement on emissions reductions, in order to stabilize
atmospheric concentrations of Greenhouse gases at not more than 450 ppm.
Recommendation 4
1.88 That Treasury produce modelling on other
types of schemes that have been proposed as alternatives to CPRS, including:
- a conventional baseline-and-credit scheme;
- an intensity model;
-
a carbon tax;
- a consumption-based carbon tax;
-
the McKibbin hybrid.
NICK XENOPHON
Independent Senator for South Australia
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