July 2008

The Carbon Pollution Reduction Scheme Green Paper [1] proposes to allocate free permits to “emissions-intensive trade-exposed industries” and “strongly affected industries”. There are many disadvantages to handing out free permits instead of auctioning them. We will discuss some of these disadvantages here. There are also some serious problems with the way that the Green Paper proposes to allocate free permits, which we shall discuss in a later post. Some of the comments here were also used for the description of the facebook group “Free greenhouse emission permits should not be given to big polluters”.

There is a whole host of reasons why it is much better to auction permits than hand them out for free. The ‘polluter pays’ principle is based on the premise that the right to a clean environment is owned by the public. Therefore, if a firm wants to pollute, it should purchase the right to do so from the public. Handing out free permits is also extremely regressive, and effectively represents a transfer of wealth to shareholders, who tend to be wealthier than the general population. When permits are auctioned, the revenue raised can be used for social or environmental purposes, or to offset other taxes. Some economic modeling also suggests that any reduction in GDP from a carbon price is lower if permits are auctioned rather than handed out for free. In other words auctioning is better value for money. Free permits are therefore not ‘least cost’ [2].

Free permits are often allocated through a process known as ‘grandfathering’, where the amount of permits allocated is based on the amount of greenhouse gasses the firm was emitting beforehand. When this occurs, firms generate tidy profits by either reducing emissions or passing costs on to consumers. It has been estimated that for grandfathering to be profit-neutral, the amount of free permits needs allocated will often need to be significantly less than 50% of that firm’s emissions [3].

The most significant energy-intensive industry that would be likely to receive free permits in Australia is the aluminium smelting industry. This industry was responsible for greenhouse gas emissions of around 27 Mt CO2-e in 1998-99, about 5% of Australia’s GHG emissions, and consumed about 15% of Australia’s electricity [4, p.vii]. It has been estimated that the industry is subsidised annually through cheap electricity by at least $A210 million, and probably in excess of $A250 million. This amounts to almost $40,000 per worker [4, p.viii]. Because of the high carbon intensity of electricity production in Australia, the greenhouse gas intensity of aluminium production is approximately two and a half times greater in Australia than the world wide average [4, p41]. The aluminium smelting industry has often threatened to relocate overseas or interstate if governments introduce climate change mitigation policies which increase costs to the industry, or do not receive low electricity prices. There are many other factors in Australia which increase the competitiveness of the aluminium smelting industry including plentiful alumina supplies, low transport costs, economic and political stability, an aluminium recycling industry, and tolerance of foreign ownership [4, p43]. In the unlikely event that the industry was to relocate overseas, there would likely be net global climate change benefits and economic benefits to Australia from reduction of subsidies [4, p45].

An emissions trading scheme which only had permits auctioned would be much simpler to implement than one where there are free permits, and therefore could be introduced much earlier. Money raised from auctioning permits can be spent on activities such as research and development of low emissions technologies, reforestation or avoided deforestation, or reducing the impact of a carbon price signal on people with low incomes by reducing taxes or increasing welfare payments.

Climate change policy provides a significant opportunity for rent seeking. Firms have an incentive to increase their profits by influencing climate change policy rather than reducing their own emissions. It is better to have free permits than to not have a carbon price at all, and better to allocate free permits to a firm then to not include it in an emissions trading scheme. However, there is a significant opportunity cost associated with free permits because money is being spent on what is effectively a form of pork.

[1] Department of Climate Change, Carbon Pollution Reduction Scheme Green Paper, July 2008 http://www.greenhouse.gov.au/greenpaper/index.html

[2] Hepburn, C., Grubb, M., Neuhoff, K., Matthes, F., Tse, M., Auctioning of EU ETS phase II allowances: how and why? Climate Policy 6 (2006) 137–160

[3] Hepburn, C., Quah, J. and Ritz, R. (2006) ‘Emissions trading and profit-neutral grandfathering’, Oxford Economics Department, Paper 295, December. http://www.econ.ox.ac.uk/Research/WP/PaperDetails.asp?PaperID=1045

[4] Turton, H., The Aluminium Smelting Industry – Structure, market power, subsidies and greenhouse gas emissions, The Australia Institute, Discussion Paper 44, January 2002. http://www.tai.org.au/documents/dp_fulltext/DP44.pdf

There are some serious problems with Chapter 4 of the Carbon Pollution Reduction Scheme Green Paper: “Emissions targets and scheme caps”. The preferred positions are that the Government announce a minimum of five years of the indicative national emissions trajectory, and a minimum of five years of the scheme cap at any time. The Green Paper also discusses a number of different options, including both shorter and longer time periods of set caps.

4.3 Preferred position (Green Paper, p174)
The Government would announce a minimum of five years of the indicative national emissions trajectory, to be extended by one year, every year as required to maintain a minimum of five years of guidance at all times after commencement of the scheme.

4.5 Preferred position (Green Paper, p179)
Scheme caps would be set and announced for a minimum period of five years in advance at any one time.
In the event that Australia’s international commitment period extends beyond five years, scheme caps would be extended to the end of the commitment period.

Addressing climate change requires resolving the international prisoner’s dilemma and resolving it quickly. Setting a minimum five years before adjusting Australia’s emissions trajectory risks Australia dragging its feet when it comes to international cooperation on climate change.

We also need to be flexible enough to tighten the trajectory in the case that we approach any tipping points or the science proves to be worse than expected (which seems to be the case). Suppose that evidence emerges that it is likely that the Greenland or Antarctica ice sheets will melt and cause massive sea level rise. Suppose that evidence emerges that permafrost melting in Siberia will melt and release massive amounts of methane into the atmosphere. Will Australia continue along a five year trajectory that has already been set? Some would say that we are already too close to some of these tipping points. The risks are too high for five year delays.

The rationale for five years of scheme caps is that it increases investment certainty. The problem is that the risk and uncertainty are shifted elsewhere. We will have more certainty for investors over five years, but less certainty about achieving international cooperation and less certainty about whether dangerous climate change will be avoided. If the framework for an Emissions Trading Scheme fails to sufficiently reduce greenhouse gas emissions or if it prejudices Australia’s international negotiating position, then there is more uncertainty about whether the framework will be maintained. It would be better for investors to be informed by science and international negotiations than to be informed by an artificial emissions reduction trajectory.

An alternative to shorter periods where the trajectory would be for the weakest trajectory to be set for five years, but for there to always be the option of tightening the trajectory. This way Australia will have the ability to commit to a tighter reduction trajectory if other countries do, which could lead to a speedier resolution of the prisoner’s dilemma.

We argue that the best carbon price signal is a cap and trade system with a price floor. The floor can be maintained by having firms pay an extra fee when they exercise their permits, based on the amount of their emissions. The carbon price then becomes equal to the sum of the permit price and the extra fee. This is similar to having emissions trading scheme combined with a carbon tax.

Stern described climate change as the greatest of market failure we have ever seen. Part of the reason for this market failure is that firms have not had to pay for the damage that they are doing to the planet. Any solution to the climate change problem must therefore involve making the polluter pay, be it through prices, quantities, other forms of regulation, or a combination of these mechanisms.

Price based mechanisms are known as carbon taxes – the regulator sets the price, leading to a reduction in emissions. The main quantity based mechanism is known as emissions trading, or cap and trade. A cap and trade scheme involves the regulator setting the amount of emissions, with the market determining the permit price. One form of cap and trade is carbon rationing, which is a pure application of the polluter pays principle – emission permits are allocated to the public, and polluters are required to buy permits from the public. There is also a form of emissions trading known as “baseline and credit”, which includes schemes like the UN Clean Development Mechanism and the NSW Greenhouse Gas Abatement Scheme. Baseline and credit schemes have problems with establishing a baseline, which means that it is difficult to prove that emissions reductions are real. For the rest of the post, when we discuss emissions trading we will be discussing cap and trade schemes. We shall also discuss hybrid approaches, which combine elements of a carbon tax and a cap and trade scheme.

A cap and trade scheme is not more or less market based than a carbon tax. The key issue is uncertainty — nobody knows how much emission reductions you will get for a given carbon tax level, and nobody knows what the carbon price will be for a given level of the cap. There are two sources of uncertainty – uncertainty in the cost of mitigation and uncertainty in the cost of climate change. It is not too hard to estimate upper bounds for the cost of mitigation (John Quiggin does it for electricity generation here, and some advocates of a very low carbon tax such as William Nordhaus also assume the existence of a “backstop technology” that plays a similiar role). The uncertainties in the costs and impacts of climate change are much greater, involve a whole lot of “long tails”, and cannot be bounded – in the words of Weitzman ( 2008 ) On Modeling and Interpreting the Economics of Catastrophic Climate Change, they have “potentially unlimited downside exposure”. There is also the issue of the discount rate, and of environmental costs, which mean that aggregating costs is also an ethical question.

When choosing a price or quantity, it will either be too high or too low (because of uncertainty), and there will be a welfare loss. Weitzman (1974) Prices vs Quantities discusses the mathematics of this issue. Weitzman argues that the slope of the marginal cost and benefit curves are what matter and that if the cost of abatement goes up faster than the cost of climate change then a tax is better, if it doesn’t (such as when climate tipping point is a risk) then a cap-and-trade system is better. Hepburn (2006) Regulation by Prices, Quantities or both: a review of instrument choice has some good discussion of these issues.

The uncertainty in the science is a very strong argument for more mitigation at a faster rate, issues where the science has not been entirely resolved but have serious impacts on risk include melting ice sheets (Greenland and West Antarctica are worth about 13 meters if they both go), carbon cycle feedbacks, albedo feedbacks affecting carbon cycle feedbacks (a recent paper suggests that melting arctic ice will increase the permafrost melting), and very low probability high impact possibilities of methane hydrates being released. All of this points to getting emissions down to as low a level as possible as quickly as possible at costs that can be managed. It is important that costs are kept as low as possible in order to ensure that the mitigation task continues (this is a political economy issue), as well as reasons of utility and human welfare. The problem with a pure cap and trade scheme is that it is very difficult to choose an emissions reduction trajectory when much of the recent science suggests that it would be prudent to reduce emissions as quickly as possible to a level somewhere around zero.

This brings us to the issue of hybrid approaches. Most hybrid approaches can be thought of as a cap and trade scheme where there is a price floor, a price cap, or both. The Australian Government’s Carbon Pollution Reduction Scheme Green Paper proposes a price cap – firms can always buy more permits at the level of the price cap, this means that the emissions cap is no longer a strict cap. Having a price cap is problematic because is there is a risk that the social cost of carbon is greater than the cap. The issue of long tails in the damage function and of potentially unlimited downside exposure make this risk more significant.

The issue of potentially unlimited downside exposure, the latest science, and the politics of mitigation all suggest that the risk of climate change damages exceeding the costs of mitigation is far more serious than the risk of the costs of mitigation exceeding the damages from climate change. For this reason we should have a price floor and not a price cap. A price floor helps us to choose an emissions reduction trajectory which would reduce emissions as quickly as possible to a level somewhere around zero. The emissions cap should be chosen so that it is sufficient to avoid dangerous climate change and the price floor should be as close as possible to the expected social cost of carbon. Having emissions caps is also useful for international cooperation – it is more likely to be consistent with negotiations under the UNFCCC.

Additional benefits of a price floor are that it manages the risk that the carbon price collapses if the amount of emissions goes below the cap, which happened with the EU Emissions Trading Scheme. A price floor also provides an extra degree of certainty for investors in low emissions technologies.

According to Hepburn (2006) a price floor can be implemented by a commitment by the regulator to buy emissions permits at the floor price. In his Draft Report, Ross Garnaut has criticised this approach. He states (page 344):

A floor price for permits would require the scheme administrator to enter the market to purchase permits whenever the permit price fell below a specified value. A floor price is incompatible with international trade in permits as it would effectively create an unlimited liability for the Australian scheme administrator.

There is another approach to a price floor that does not have this problem. A traditional cap and trade scheme works by firms being required to have purchased enough permits that cover their emissions. When a firm reports its emissions, it surrenders an equivalent amount of permits. We can introduce a price floor by requiring firms to pay an “extra fee” for each tonne of emissions when they report their emissions. The carbon price is then equal to the sum of the permit price and the extra fee. This approach is only slightly more complex than a pure cap and trade scheme. This approach is also very similar to having emissions trading scheme combined with a carbon tax.

Note: An earlier version of this post was included as a comment on John Quiggin’s blog post Carbon Taxes vs Emissions Trading, which also included a comment by Warwick McKibbin where he describes his hybrid approach (where there is a price cap).

The carbon dioxide that plays a role in anthropogenic global warming is either from sediments including fossil fuels and cement production, or from soils and biomass. This relates to the well known carbon cycle. The carbon in soils and biomass can be transferred to the atmosphere via phenomena like fire and drought, while fossil fuels in the ground generally stay there (except for human activity and some volcanos). A planet with more carbon in soils and biomass and less in sediments is therefore for better or for worse different to a planet with more carbon in sediments and less in soils and biomass.

This suggests that the externality of greenhouse pollution from burning fossil fuels is qualitatively slightly different to the externality of greenhouse pollution from land clearing. Another issue is there is often much more uncertainty with measuring emissions from land clearing and deforestation, or CO2 sequestered by planting trees or reducing overgrazing. Other greenhouse gases also play a role – there are also issues with uncertainty when estimating methane emissions from cattle.

Reforestation and avoided deforestation can have huge cobenefits in terms of reducing habitat destruction which is an important driver of extinction. Unfortunately it is harder to measure emissions from activities with strong cobenefits such as biodiversity plantings or avoided deforestation than it is measure emissions from activities with less cobenefits, such as monoculture tree plantations.

Hansen’s recent paper suggests that when albedo and carbon cycle feedbacks are taken into account then climate sensitivity rises to around 6 degrees for a doubling of CO2. Hansen then suggests that “If humanity wishes to preserve a planet similar to that on which civilization developed and to which life on Earth is adapted, paleoclimate evidence and ongoing climate change suggest that CO2 will need to be reduced from its current 385 ppm to at most 350 ppm. … An initial 350 ppm CO2 target may be achievable by phasing out coal use except where CO2 is captured and adopting agricultural and forestry practices that sequester carbon.” It is therefore important that we address both parts of the carbon cycle.

In an emissions trading market credibility is vital, uncertainty in measurement could undermine that. In a submission to the Garnaut review, I argued that some money raised from auctioning permits could be spent on activities such as biodiversity plantings until land use could be included. But perhaps these issues with uncertainty will always be significant. Maybe we need to create a parallel market in emissions related to agriculture and forestry. This could either be price based or quantity based. Perhaps uncertainty issues would mean a price (tax) based approach would be better, with activities that sequester carbon having a negative tax.

While it is relatively easy to measure the carbon sequestered from something like a monoculture tree plantation, it is more difficult to measure the carbon sequestered from restoring an ecosystem, or at least to have the carbon sequestered accredited. Reforestation and avoided deforestation can have huge cobenefits in terms of reducing habitat destruction which is an important driver of extinction. We need to learn as fast as possible how much carbon is sequestered through activities such biodiversity plantings and reducing grazing from cattle.

There is also the issue of emissions from logging and burning old growth native forests. At present only land that is converted from a ‘kyoto forest’ to land which is not a ‘kyoto forest’ or vice versa is included, so if you log an old growth forest, which stores huge amounts of carbon in both its soil and biomass, and then burn it, then because a forest will grow back, the emissions from logging and burning are not included in our greenhouse gas accounts. We need to learn as quickly as possible how to measure the GHG emissions from all kinds of emissions, including forest degradation and grazeland degradation.

Forest degradation and rangeland degradation do not get mentioned in the Green Paper, but it does suggest that carbon sequestered in forest products should be included in an international climate change framework. This is a similar approach to Australia’s reporting to the UNFCCC (which is slightly different to Kyoto accounting), where carbon sequestered in wood products is reported but emissions from forest degradation and rangeland degradation appears not to be. The could be construed as a way that Australia is gaming international climate negotiations. Or it could be a result of the government being influenced by rent seeking from native forest logging industries. Ironically, if forest degradation and rangeland degradation were included, it would probably be much easier for Australia to reduce its emissions.

We also need to learn as quickly as possible how much emissions are sequestered through sustainable land use practices that sequester carbon. We should also consider the possibility that there will always be significant uncertainties about how much will be sequestered. The best way to learn is by doing, so the question becomes how do we fund a whole lot of different environmentally appropriate activities that sequester carbon that we can learn from?

The Australian Government has released its Carbon Emission Reduction Scheme Green Paper. Submissions are due by September 10. It discusses how the Australian Government could introduce an emissions trading scheme in order to do something about Australia’s greenhouse gas emissions.

Here is a summary. A 60% cut in emissions by 2050 is still proposed, so Australia will probably remain among the highest per-capita polluters; the trajectories will be determined by 5 to 10 year gateways which will provide certainty for industry but reduce our flexibility if we decide that we need reduce emissions much more quickly; petrol has no extra price signal for the time being; a price cap but no price floor; emissions from our coal exports not mentioned; emissions from livestock not included until at least 2015; emissions from forest degradation and grazeland degradation are not mentioned (except for in developing countries), so logging and burning old growth forests will probably continue to not be measured in Australia’s greenhouse accounting and reporting unless things are changed at the international level. There will be some compensation for low to middle income households but there may not be so much after the big polluters have been catered for.

Because there is a price cap, the emissions cap is not strict, which means that it is not even a real cap and trade scheme. Banking and borrowing should eliminate the need for a price cap anyway.

There will be big handouts to both “emissions-intensive trade exposed industries” (EITEs) and “strongly affected industries”. These handouts will probably be free permits, but could also be cash. Strongly affected industries are industries that emit more than 1500 tonnes carbon dioxide equivalent per million dollars of revenue and include electricity generation (especially from brown coal), waste, and production of natural gas. Strongly affected industries will receive handouts on the basis for their assets while trade exposed industries will receive handouts that are based on their emissions. There is therefore a strong perverse incentive for firms to emit more than 1500 tonnes carbon dioxide equivalent per million dollars of revenue.

The Green Paper does say some good things household energy efficiency opportunities on page 287, this stuff should be a no-brainer by now but it is still a good thing to remind the politicians about. The Green Paper does have some good comments on market failures but it is nowhere near as comprehensive as the Garnaut Review on this issue.

One difference between the Green Paper and the Garnaut Review is that Garnaut proposes that $3 billion or 20% of auction revenue (whichever is greater) should be invested in technology and RD&D, while the only technology emphasis in the green paper is on carbon capture and storage (as assistance to the coal industry). The extra handouts for big polluters effectively mean that cash would not be available for RD&D, and there will be less available for compensating households.

Garnaut has stated that a carbon tax would be much better than a badly designed cap and trade scheme. In my opinion a carbon tax would be much better than the ‘Preferred Positions’ in the Green Paper. While there are many dodgy preferred positions in the green paper, it is probably better than the Task Group on Emissions Trading report and or the National Emissions Trading Taskforce report. It is in many ways similar to these reports (e.g the stuff about gateways) – this is not surprising, many of the people working on those reports would have also been working on the Green Paper.

What is good is that a green paper on a carbon pollution reduction scheme has been released, and there are now opportunities to comment and make submissions and so on. It is a much better process than a the Howard government’s approach of setting up a rent-seeker task group. Unfortunately the preferred policy positions are a bit of a handout bonanza, which suggests that greenhouse polluters still are dominating climate change policy formation in Australia. Some of the recent science suggests that it would be prudent to reduce emissions to somewhere near zero as quickly as practicable, but some of the policy positions in the Green Paper could easily lock Australia into an emissions reduction trajectory that is far too slow.

There is also a good discussion thread on the Green Paper at Larvatus Prodeo with more links. See also Peter Martin, GreensBlog, and crikey.