The government’s green paper on emissions trading has just been released. There are lots of interesting aspects to it. For instance, at least until 2014, it is a hybrid model with a defined price cap on permits; although surely to make that work it needs an elastic supply of permits at that cap a la Warwick McKibbin. I’ll have to read more to understand that bit.
But on trade-exposed industries, it proposes to allocate free permits. For instance, if you emit a large volume of greenhouses gases per unit of revenue earned, you will receive 90 percent of your permit requirements (based on projected or actual output — it is hard to say) for free. At least this what will occur until 2020.
On my reading, this gets the economics of the situation completely wrong. To show you that look at the following graph of a trade-exposed industry. Notice what happens when you move from the situation today to a situation where there are carbon permits but none are free. Output in the domestic industry falls from Q0 to Q1. What is more, while the emissions reduced by that contribute to Australia meeting its cap, the same emissions are likely to be produced elsewhere in the world and so there is no real contribution to the global environmental situation.
Now suppose that 90 percent of the permits are given to the firm for free. What changes? Absolutely nothing. Why? These are tradable permits. That means if I choose to produce using a free permit, the opportunity cost is the value I could have sold that permit. So Supply (Free) if you sketched it on this graph would be the same as Supply (No Free). Firm profits would have increased but the carbon leakage problem would remain.
Garnaut recognised this and recommended direct output subsidies. That may be appropriate for export industries. For ones exposed to import competition, the alternative would be a tax on the carbon content of imports. That would increase demand up until exactly the point where the firm would be producing their original output level. But to the extent they can save on emissions, they can reduce costs relative to import competition and generate environmentally positive outcomes.
Free, tradable permits do not solve the trade-exposed industry problem which is one of us not meeting our international obligations. In reading the green paper, there is a hint that they might not be tradable with the report saying that if activities are shut down the permits have to be returned. But the issue is quite open.
To be sure, having just free permits that are not tradable may reduce the carbon leakage problem but not fully. Similarly, tying them to past year’s output or something might help a bit. But it is very messy compared to appropriate import price signals.
All that said, there are bits of the scheme that are good: the commitment to low-income households, investment in new technologies and restrictions on the initial industries effected. This is going to be a long two years of design and anticipation.