August 2009

The United Nations Framework Convention on Climate Change (UNFCCC) negotiations in the lead-up to the December 2009 Copenhagen Summit have been quite complex. There are two streams to these negotiations: the Ad Hoc Working Group on Further Commitments for Annex I Parties under the Kyoto Protocol (AWG-KP) and the Ad Hoc Working Group on Long-term Cooperative Action under the Convention (AWG-LCA).

For those of us who do not have the time to navigate through the different submissions on the UNFCCC website, the World Resources Institute have produced a nice summary (mainly focussed on submissions for the Long-term Cooperative Action negotiating text).

The Australian opposition and Senator Nick Xenophon have commissioned a report from consultants Frontier Economics on the proposed Carbon Pollution Reduction Scheme (CPRS), and possible modifications. Opposition Leader Malcolm Turnbull has described it as a greener, cheaper, smarter ETS; Minister for Climate Change Penny Wong has stated “It is not a hybrid, it is a mongrel. It is not a credible alternative, it is a smokescreen.”

The main feature of this “intensity based” proposal is that the electricity generation sector is treated in a similar way to “Emissions Intensive Trade Exposed” industries are treated under the CPRS, firms are allocated a large amount of free permits based on their production, so if the amount of the good being produced is reduced, they receive less free permits. Under Frontier Economics’ proposal, electricity generators will receive a large amount of free permits provided that they continue to produce the same amount of electricity.

So if I was to own a brown coal fired power station, I would have less incentive to close it down or generate less electricity, but I would still have an incentive to find ways to make it burn brown coal with less emissions. This will reduce the amount of opportunities to reduce emissions, and increase the cost of reducing emissions. This would increase the carbon price, but Frontier Economics’ modelling assumes that Australia would be part of a well linked global carbon market, and so assumes that the carbon price is completely exogenous. This is why Australia imports more permits from overseas. In practice this would likely mean that we buy more CDM credits, whose additionality properties are questionable.

There is no problem with credible international permits. As far as the earth is concerned, it does not matter where emissions reductions occur. The problem with the Frontier Economics proposal is with why there will be more purchases of international permits. More international permits will be purchased because it will be harder and more expensive to reduce emissions in Australia.

Another problem with shielding the electricity generation sector is that if all countries did this, there will be far less opportunities for emissions reductions, the global carbon price will be much higher, and emissions reductions will be more expensive. Also, by shielding the electricity generation sector, the impact on electricity prices is reduced, dramatically reducing the incentive to reduce electricity usage. The approach in the CPRS to provide payments to households that would offset the effect on prices of the CPRS is much more sensible.

The modelling not only assumes that the carbon price is exogenous, it also assumes that it has no volatility (it increases in real terms by about 4% per year), and there is no uncertainty about what it is. The report therefore has nothing to say about whether an ETS, carbon tax, or hybrid approach (with price ceilings, price floors, or both) is preferable. However, a complex CGE model of the Australian economy is not neccessary to answer this question. The results of Roberts and Spence (1976) and subsequent studies strongly suggests that a hybrid approach with ceilings and floors is the best way of managing this uncertainty.

One more problem with the Frontier Economics report is that it describes its approach to the electricity generation sector as being similar to that proposed in the Waxman-Markey bill that is presently before the US Senate. This is nonsense. Waxman-Markey allocates a large amount of free permits to electricity retailers, who must pass on these benefits to customers, but not in the form of cheaper electricity — payment to customers would not depend on how much electricity they use. The approach of Waxman-Markey is closer to the CPRS, both do not reduce the incentive to decrease electricity usage. The Frontier Economics approach completely distorts this incentive.

Elsewhere: Comments by Ben Eltham at New Matilda, Bernard Keane at Crikey, Robert Merkel at Larvatus Prodeo, Joshua Gans at Core Economics, Andrew Bartlett.

Update: Harry Clarke states “Turnbull’s attempt to give them more to ease electricity prices is not good economics. Make consumers bear the higher prices and give them generalised tax relief. Capture the sought after substitution effects you want but offset the impoverishing income effects.”

Update: Stephen Howes and Frank Jotzo in the Sydney Morning Herald state “Frontier’s modelling fails to establish its claim that it would deliver cheaper mitigation. In fact, it suggests the opposite.”

Frontier’s modelling fails to establish its claim that it would deliver cheaper mitigation. In fact, it suggests the opposite.

After an international treaty is negotiated, it then has to be ratifed by its participants. This can be modelled as a two stage extensive form game. In Stage 1, the players negotiate the treaty; in Stage 2, each country decides whether to ratify the treaty. For some countries, for example the United States, ratification can be difficult. The United States requires 67 out of 100 Senate votes in order to ratify a treaty.

The most important solution concept for an extensive form game is known as a subgame perfect equilibrium. Each stage of the game is treated as a subgame. The subgame perfect equilibirum is an equilibirum which is also a Nash equilibirum for each subgame.

The main technique for calculating subgame perfect equilibria is known as backwards induction. In this technique the subgame perfect equilibria for the “last” subgames are calculated first. Then taking these actions as given, we calculate the equilibria for preceeding subgames and so on.

By backwards induction, for negotiators in Stage 1 to play the subgame perfect equilibrium, they will take into account that a treaty will have to be sufficiently aligned with the domestic interests of the United States, in order for it to be ratified by the United States.  The US Senate has two representatives from each state, so states with low populations (such as those in the midwest) are disproportionately represented. Coal is widely used in the midwest, and agriculture is an important industry. The US Senate is likely to want to see commitments from major developing countries. All of these issues are therefore likely to be important in international negotiations.

The US Senate will most probably consider the Waxman-Markey bill before the negotiations in Copenhagen commence. The Waxman-Markey bill will most likely require 60 out of 100 votes to avoid a filibuster. Issues that will affect the passage of the Waxman-Markey bill through the Senate will also be important for treaty ratification.