As I noted yesterday, the debate about the CPRS has come down to a few things. First, the amount and form of compensation to electricity generators. Second, the level of international trade in permits. And, finally, how quickly the price signals are put in place. What it apparently is no longer about is whether a trading system is superior to a carbon tax as was clearly described by Mankiw’s NYT piece.

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Compensation to electricity generators: On the score, Mankiw is clearly against the direction the US is taking. The Coalition here is going in that direction and explicitly notes the similarities between its approach and the current US legislation. I have long shared these concerns and thought that electricity generators should not receive compensation at all.

In electricity, the Green Paper argues that we should give coal-fired plants free permits to compensate them for being in the wrong place in the wrong century. It is not at all clear that this will send an appropriate signal nor actually change anything in terms of emissions from that sector. Let’s face it what we need is for investment in capacity to take place that is above coal in the merit-order — the 5 minutely order of which plant gets to run or not. The higher you are in that order, the more likely you are to run.

Nonetheless, both the Government and Coalition are unwaivering in their desire to compensate electricity generators. I may not like it but something tells me that the politics is rock-solid on that issue and there is just no point in making it the ‘make or break’ part of an ETS. It is better to have emissions trading with compensation than to have no emissions trading. Full stop.

That said, there are issues to do with the form of compensation. The Frontier Economics proposal, which they appear to have been pushing for some years (well before the Coalition got interested), is a different compensation mechanism to the government. It is hard to tell either if it is more favourable or whether it is harder to get rid of once in place. But if I were to speculate, I think that the electricity industry would prefer the Frontier Economics approach to the Government’s. I suspect that our electricity generators who are, in many cases, vertically integrated into regulated retailing are worried that the CPRS’s increases in wholesale prices will not get fully reflected in higher prices to consumers. And that will hit their bottom line. The Frontier approach ensures that there is no need for that regulatory risk.

I’m sympathetic to regulatory concerns with large scale change but I am suspicious as to whether it is worth going to a special-treatment model than a far simpler requirement that all generators purchase permits leaving compensation of them and households to other measures. That said, I think we can probably be more imaginative if we are going to ‘go special’ on electricity. As I wrote last year:

Here is a better way forward. Let’s raise the regulated price cap to final consumers by 20 percent over the next few years. In return for that, retailers will have to put in smart meters into households. The twin effect of that will get some behavioural changes at the user end. But the short-run effect will be to see more money available in the electricity sector and so a big incentive to move quickly on new investment. And what new investment will that be: ones that economise on emissions in the long-term.

This was something to put in, in conjunction with a widespread emissions permit requirement but no direct compensation.

Level of International Permit Trade: The big factor driving the Coalition’s potential ‘free lunch’ of tighter emissions and lower costs were measures to allow for more trade in international permits. These are a good thing. In my mind, it is the single biggest reason we need a good, workable and widespread international agreement. But let’s be clear. Allowing more of this in the future is not a ‘make or break’ issue for the Government’s legislation. That legislation can be passed without this and have precisely the same short-term effect. The Coalition can then run on permitting the change later and having a real debate. To knock down the legislation on this issue is a mistake. That said, if the Government wants to allow for more trade contingent on international agreement and this will secure Coalition support. Why not do it?

Gradualism: The other part about Frontier Economics’ electricity compensation mechanism is that price signals on energy come in gradually rather than a big bang. They argue, and this is consistent with Treasury modeling, that electricity demand does not change in the short-run but after that it can change as people buy energy efficient equipment. So, as a matter of economics, it is tomorrow’s electricity price signal that matters and not today’s. Hitting people today is like some sort of tax with short-run economic costs.

I’m not sure about that whole logic on several grounds. First, if short-run demand is truly inelastic, then a hike in prices hits household budgets but presumably that is what the compensation to households was supposed to cover. So we can either not have the hike and forego permit auction revenues for household compensation or we can have it and compensate households using those revenues. I can’t see where the cost arises.

Second, I like the economic model whereby future price signals drive decisions but I don’t have enough faith in it working that way. Short-run price signals matter and, as I noted above, combined with good information they can work to change behaviour now. It isn’t all about durable appliances but how we use electricity at the moment. I agree with Harry Clarke that shielding users from those signals is likely to be a risk not worth taking. It is better to get prices right and soften the income issues with compensation. That is the standard economic approach that we know and love.

In the end, the Government and Coalition are too close together to have politics block this. Do a deal and let us get on with it.

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