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The Basic Economics of Carbon Pricing Explained

January 26, 2010

I hate to be the one to break it to our proud and inviolable climate scientists, but the right policy response to climate change is fundamentally not about the specifics of the science.

 Sensible and rational climate change policy is essentially about finding the least economically disruptive way to insure our current way of life against the distinct probability that the scientists are right.

 Around the world the preferred policy response that is emerging is tellingly similar. The most cost-effective way to insure against climate change starts by putting a price on emitting carbon dioxide.

27 EU member states began the EU Emissions Trading Scheme for greenhouse gases in 2005. New Zealand will start one in July this year. Japan, Taiwan, South Korea, and the US are at various stages of the legislative process with emissions trading. Similarly, the French, Irish, Norwegians and Swedes have taken the route – at least partially – of carbon taxes.

Unfortunately, the policy debate in Australia in particular appears to show a bad understanding of the basic economics of carbon pricing, let alone interpreting the evidence coming from those schemes in place so far. Let’s review the economic fundamentals first.  

Consider how the carbon pricing mechanism works with the example of a carbon tax of $20 per tonne of CO2 emissions. Once a price is in place, each firm facing a cost of emitting has an incentive to compare it to their cheapest options to avoid emitting. It will thus decide whether it is cheaper to reduce emissions (e.g. by investing in cleaner technologies, switching fuels, improving energy efficiency, etc) or, if it less costly, to simply pay the carbon price and continue emitting.

Importantly, as each firm behaves similarly, the globally least costly abatement measures are adopted throughout the economy and the most costly are ignored. In other words, global economic cost is minimized by letting firms to choose whether to abate or not and how – not by the clumsy measure of forcing them all to adopt common standards, as direct regulation would do.

Emissions trading – such as proposed with the Carbon Pollution Reduction Scheme (CPRS) – works almost exactly the same way as the tax, but with one key difference. Instead of setting the price of carbon through the tax level, the government sets the quantity of emissions it wants through a quota or “cap” on emissions each year. It then allocates that number of tonnes worth of CO2 emissions permits to key industries and makes it illegal to emit without a permit.

Since firms want to emit carbon to produce stuff, emissions now have value as a factor of production, and thus a market price exists for permits. Thus each firm looks at the prevailing market price of permits and decides to either reduce emissions or buy permits at the prevailing price. Once again the same global cost-effectiveness logic as with a carbon tax applies.

More importantly, the evidence appears to confirm the theory. A joint research project by France’s CDC Climate Research, MIT University and University College Dublin recently completed the first comprehensive ex-post analysis of the EU Emissions Trading Scheme’s first three years. The results suggest that, despite flaws in the way the EU ETS was initially designed, the scheme has reduced emissions very significantly from business as usual and, that carbon pricing does force emitters to exploit their most cost-effective abatement options.

Which brings us to the current policy debate in Australia over the CPRS.

In some important ways, Australia’s proposed emissions trading legislation has learned from key mistakes made in Phase 1 of the EU ETS. Firstly, the EU learned the hard way that placating industry by freely allocating emissions permits creates undesirable side-effects, which are both unfair and raise the total costs to everyone.

For example, many firms who collected permits for free still passed on much of the cost of those permits to consumers, handing themselves windfall profits. Effectively, consumers were paying them to emit carbon. The CPRS on the other hand, would auction ~65 % of permits from day one. (The sensible exception being for those industries genuinely at risk of international competition, who comprise most of the remaining 35% and have trouble passing through the carbon price to consumers.)

Auctioning a high proportion of permits also allows government to achieve a “double dividend” with the revenue. Other taxes can be removed; deficits reduced; workers in strongly affected industries can be compensated and retrained; and investments in complimentary emissions reductions programs not suitable for carbon pricing can be made.   

Europe is now in the process of shifting to majority auctioning of permits along the lines of the CPRS.

Critics of the EU ETS often point to the large carbon price volatility of the first Phase to say that emissions trading does not provide a clear long term price signal for investment. This is not a sound argument.  The main reason for the volatility was two-fold: firstly, since 99% of permits in Europe were freely allocated, the market was initially completely in the dark about the true market price of carbon permits. Auctioning would change that.

Secondly, Phase 1 of the EU ETS was a very special case: it was a “trial phase” in which permits could not be banked from one year to the next to smooth prices. Phase 2 allows for both easier banking and borrowing – as would the CPRS – and, global financial crisis notwithstanding, EU carbon prices have since followed a much smoother pathway.                                                                                                           

So is the Australian Greens “2-year-carbon-tax-while-we-decide-what-to-do” a good suggestion? Actually, it’s surprisingly not that bad. But the EU ETS has shown that it is ultimately the assurance of a long term carbon price can efficiently drive the kinds of new private sector investments needed to start disconnecting economic growth from emissions.  A 2-year carbon tax would be of limited use if were not accompanied by some policy certainty about what comes next.  

 ETSs or carbon taxes both do the same job in different ways, but either would be a costlier and less effective way to manage climate risk than necessary if not designed well.  

 …and if you want to read the book of research referred to above:

 Pricing Carbon is published by Pearson and is the product of four years of joint work between CDC Climate Research, MIT University and University College Dublin.  It goes on sale February 10th

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