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

[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.

[4] Turton, H., The Aluminium Smelting Industry – Structure, market power, subsidies and greenhouse gas emissions, The Australia Institute, Discussion Paper 44, January 2002.