Climate Change Talk

Last night I was invited to speak at the University of Melbourne, Department of Economics, Annual Honours Alumni Function. The choice of topic was climate change policy. Over the fold is a transcript of what I said.

Climate Change Policy

Joshua Gans (8th October 2008)

Ross Garnaut calls it a “diabolical problem.” But over the past couple of years, despite decades of warnings, it seems that the time for climate change policy has arrived. Australia is moving towards implementing the most widespread emissions trading regime anywhere in the world. The repercussions are enormous. It will directly impact our top 1000 companies, the government and also create an estimated $20 billion per annum in government revenue. It is hard to identify a point in Australian history where an economic reform of this potential magnitude has been implemented.

In many respects, the rushed green paper, released by the government a few months ago, suggests urgency to ‘tick the box’ on climate change. But we have to be really careful here. This is not some policy – like GroceryChoice or FuelWatch – where success or failure has little consequence. The stakes are much higher. What is more, being able to lead in this policy space requires doing stuff that is ‘guaranteed to work.’

To be sure, market-based interventions, like emissions trading, are elegant and when they work, they can really work. What worries me more is that there are some real risks associated with making it all work. And I wonder, therefore, whether we need to hedge our bets and not rely on a single policy.

In my brief talk today, I want to outline some risks and associated policies where a hedge might be worthwhile even if it undermines or is potentially less efficient than a pure market based solution.

1. Measurement

An emissions permit is a right to release a certain amount of CO2 into the atmosphere. Its beauty is that it defines something that looks like a property right. Now think about what a property right is. It is a right to use something and to exclude others from using it. So when it comes to emissions, it is a right to emit that no one else can utilise.

When stated like this the problem is obvious: our emissions rights are only partly exclusionary. For starters, they are rights to emit that no other large company can utilise. Consumers can emit as much as they want. People in this room are omitting right now. Moreover, even for those companies, it all relies on accounting. For different industries, unmeasured emissions are likely to be differing problems. What is more, if companies can substitute production from CO2 emissions to the emissions of other pollutants, are we really doing our job?

The way to hedge measurement risk is, of course, to move away from relying on trading for reaching any international obligations on emissions. That means more heavy-handed regulations that I will come to in a moment.

2. Trade-exposure

The evidence suggests that a small share of our industries are trade-exposed in that they would be substantially undermined should they face the cost increases imposed by emissions trading. But there are some that do fall into that category.

One issue that people worry about is that there will be lost profits or jobs in those industries. They argue for exemption on those grounds.
Garnaut argues that exemption means that the emissions targets would have to be made up from other sources and that does not seem quite fair.

The Federal government has proposed to give those industries 90 percent of their permits for free. Notice that this may well solve nothing. If those permits are tradable, then I do not have to tell anyone in this room that what that means is that the opportunity costs of those firms (that is, the costs they make their production decisions on) will not have changed and they will curtail production and reduce employment anyway. All this does is preserve shareholder value!
The issue is that trade-exposure is not to do with job losses or harm. It has to do whether we are really contributing to the problem. Let’s face it, if we impose an ETS and industries shut-down with their production going overseas, we have contributed nothing to the GLOBAL level of emissions. And if we don’t do that, what is the point?

So in terms of environmental economics, we can’t ignore this problem. We have to deal with it in a way that forces those firms to economise but not in a way that migrates emissions.

Garnaut proposes a subsidy to output. This is hard to gauge and measure and loses the price signaling aspect of emissions trading.

I think that most of our issues here come with respect to imports, and I know it is an ugly word, but a carbon tariff is a good way forward here. We adjust import prices to take into account an assessment of carbon content. If imports come from countries with an ETS, they can get favourable treatment. So it sends good signals inside and outside the economy. And if you don’t like the word tariff I am sure we can just call it something else. Indeed, Joe Stiglitz argues that these adjustments should be a WTO requirement rather than a penalty. In this respect, we hedge on emissions trading at the border rather than on an industry-by-industry basis as people are currently proposing.

3. Politics and macroeconomics

Last week I got a call at 8am from an editor at The Age. It was the day the financial crisis got worse when the US Congress failed to pass the bailout package. It was also the day the final Garnaut report was released. He had too much news to cover and needed me to write some opinion, any opinion, on one of these topics. I thought about it for a second and said: “why, I’ll do both.”

The issue for me was that climate change policy and the state of the macroeconomy were linked. Let’s face it, the current political traction from environment policy is related to the long economic boom and the fact that the environment is a normal good. People are happy to spend money preserving the environment when economic times are good.

The flip side is obvious. When those times turn bad it is a whole other matter. We can call it emissions trading but in terms of the economy right now, the scheme is a tax with potentially restrictive fiscal policy and dead-weight losses (neglecting the future environmental benefit). We would be naïve to assume that a world-wide constituency to do something will hold water in this environment. I’m not happy about that but it doesn’t make it less true.

So how do we hedge against the political and macroeconomic risk here? One way is, of course, to turn threat into opportunity. Beyond the ETS, many environmental policies could simply involve large government expenditure. We could have a New Environmental Deal that puts the emissions revenues straight back into the economy through infrastructure investment designed to directly reduce emissions. True, it is not necessarily market-based, but it could be a way of maintaining momentum through bad economic times.

Let me give you an example of this. Smart meters. Can anyone tell me where their electricity meter is where they are living? How often do you check it to see what you are consuming?

The total costs of implementing smart meters that provide real time information on electricity use are estimated by NERA (and others) to be between $2.5b and $4.3b so they are not cheap. But the benefits in terms of energy efficient alone are $4.5b to $6.7b. Aside from environmental issues, this might be worthwhile anyway.

But what if we injected some behavioural economics into this? Give people information and some social pressure and that can be more important than pricing. What if the meter was installed right at people’s front door. As soon as you or anyone else comes in, they will see it and be able to form an opinion on your energy efficiency. You can come home and see what power you are consuming when you leave computers and DVD players on. This information alone could lead to large reductions in usage.

4. Innovation

Which brings me to innovation. There are some who argue that ‘getting the prices right’ through emissions trading should do the job. That will provide incentives to develop technologies that economise on emissions.

The problem is: what are those technologies? For instance, make a more fuel-efficient car and it is not necessarily true that the amount of petrol use goes down by much. In contrast, a solar powered car would reduce it to nothing. Basic economics suggests that getting the prices right will stimulate fuel-substituting rather than fuel-augmenting technologies.

But there is a caveat: with the money flowing out of the ‘real’ economy due to emissions trading, there is less money for R&D. My own modeling shows that both types of R&D efforts would go down. That is not good news and suggests that by ‘getting the prices right’ we have to re-double our R&D efforts and not rest on our laurels.

One area however where R&D would be stimulated is in offset technologies – stuff that pulls carbon from the atmosphere. However, that will only be stimulated if you can earn permits by deploying such technologies: something that sadly is currently not on the cards.

Garnaut’s approach here is to put $3 billion per annum of newly found emissions revenue into R&D. The amount comes from contributing our share to world efforts on environmentally friendly technologies and that alone is a welcome change in perspective.

The point here is that we cannot leave innovation to the market. Indeed, the case for public action is stronger as a result of an ETS being put in place.

5. Science

Finally, let me comment on the scientific risk. While the overwhelming consensus is that climate change is here and caused by human action, even the scientists admit that there is some probability that it is neither of those things. This is not a denialist statement, just a statement of scientific uncertainty.

The issue is that we may get information that revises our probabilities downward of the risks being faced. For many business people this is enough to create calls to wait.

For me, the issue is that we are too focused on emissions and not focused enough on pollution per se. Fossil fuels pollute as does traffic. If we dealt with emissions from electricity generation and from traffic congestion, we would get far along our emission task quickly. But what is more, if it turned out that the climate change risk was far lower, we would still have the benefit of reduced pollution and old-fashioned externalities.

For too long, we have focused only on greenhouse gases and not broader externalities. This has meant that we have not really factored in opportunities for ‘two fors’ in our environmental policy. This would lead us to a far more targeted approach than is currently being pursued.

Summary

In summary, the ETS is not a diversified strategy and that is a problem. We need to cover measurement and political issues by investing in other direct ways of reducing emissions. We need to deal in a price-sensitive manner with trade-exposed industries rather than industry-by-industry. We need to cover innovation directly as the economy under an ETS cannot be guaranteed to do so. And finally we need to seek broader pollution abatement opportunities and target them.

4 thoughts on “Climate Change Talk”

  1. As a U of M, D of E, HA, even more a pity I couldn’t make it. (It’s a long trip from Canberra.)

    I like a lot of what you said, but I have couple of quibbles and a question.

    1) On measurement, you talk about the CPRS pricing CO2 and not other pollutants. As you may know, it includes other major ‘forcing’ gases on a CO2-equivalent basis. Is your argument that it should price all externalities (pesticides into water for eg)?

    As it stands, “are we doing our job?” Well you might be choosing to define the job as pricing all pollution. They might define the job as addressing climate change / pollution that has a forcing effect.

    2) On Trade exposure, you have made the ‘free permits doesn’t change incentives’ point a few times. While I agree in principle, as I understand it the permits are allocated each year for one year only. They cannot sell their future free permits. This significantly alters the incentive to just cash out and leave anyway. (Also, I think the Govt may prevent companies from selling free permits if they go offshore.)

    3) The question I have is whether the Government should run stimulus spending (‘green’ or otherwise) given Australia’s environment of still high inflation and close to full employment?

    In theory, if the GFC leads to a downturn in Australia then Govt spending could create jobs to replace simultaneous job losses. Employment doesn’t fall much from now, but increases relative to the counterfactual.

    But how realistic is getting that right? It seems no one really knows what on earth is going on in financial markets, let alone how it’s going to affect the ‘real economy’ (I was tempted to say Wall st and Main st).

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  2. Emissions trading is unlikely to reduce emissions significantly. There are too many ways it can go wrong. The reason is simple. The legislation surrounding emissions trading is trying to codify human behaviour with a set of rules and then get people to change their behaviour to fit the rules. This is not an effective way to change behaviour. A more effective way is to change the system that we use so that the system encourages the behaviour we want.

    We will reduce emissions if we generate a lot of cheap energy without emissions. This is the bleeding obvious. So we need to change behaviour so that everyone is encouraged to use less energy from burning fossil fuel and encouraged to invest in ways to reduce emissions.

    So instead of increasing the price of energy let us give people Rewards if they consume less energy. There are a lot of people in the community who are already consuming little energy (mainly the poor) and we can easily identify them as they are the ones whose mains electricity bills are low. But it is no good just giving them Rewards as regular money because they will probably spend it on using more energy. So let us require them to spend their Rewards they receive for being relatively frugal on building infrastructure to reduce emissions. To encourage them to spend the Rewards let the Rewards earn zero interest if left in the bank. Let us also allow people to sell Rewards for unrestricted money to again encourage the Rewards to be spent.

    Where does the money to pay for the Rewards come from?

    Well it could come from many different places including a surcharge (tax) on Energy but a simpler way is for the Reserve Bank to issue as many Rewards as needed.

    But won’t that increase inflation? Well no. Inflation occurs when there is too much money chasing too few goods. If you create special money called Rewards then inflation might occur with Rewards money but it will not occur with unconstrained money. The price at which we can sell Rewards may drop but that will not affect the rest of the economy. That is we have restricted inflation to Rewards.

    Why won’t the expenditure of Rewards create inflation in the rest of the economy? Remember inflation occurs when we have too much money chasing too few goods. If you spend money creating something that is worth more than you spent then you have more money but you have more goods created than you spent. By definition inflation cannot occur in the regular economy from the expenditure of Rewards.

    So the Reserve Bank can issue as many zero interest Rewards as needed. They can observe the inflation of Rewards money and if there is too much inflation of Rewards then they drop back the amount of Rewards being issued.

    Net result of this system is to reduce the price of energy – because without the capital charges on renewable infrastructure we will find the cost of renewable energy is less than the cost of energy produced from burning fossil fuel.

    Rewards will be spent efficiently because we only allow them to spent in a market place of infrastructure to reduce greenhouse emissions.

    The whole system is voluntary. You do not have to accept Rewards and as a supplier you do not have to accept Rewards. Conversely if you are in the system and you disobey the rules then you are banned from getting or receiving Rewards. This means compliance is easy to enforce.

    This system can start tomorrow. I predict that if enough Rewards are issued then it will also solve the credit crisis and set inflation to zero because inflation will be restricted to Rewards money.

    Certainly it cannot hurt to try it out while we work out how to set up an emissions trading system. The cost of implementing the system will be covered by fees to merchants selling emissions reducing technologies.

    The 90th anniversary of the publication of the Magic Pudding would seem an appropriate time to launch Energy Rewards.

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