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Getting better by design

12 August 2014

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Professor Warwick McKibbin is an ANU Public Policy Fellow at Crawford School. Professor McKibbin was a member of the Board of the Reserve Bank of Australia from 2001- 2011. He teaches Modelling the World Economy: techniques and policy implications (IDEC8127).

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Carbon trading markets and carbon taxes both have their problems, but the answer could be somewhere between, writes Warwick McKibbin in this preview from the Spring issue of Advance magazine.

Australian politics is yet again at an impasse on climate policy.

But while the politicians may struggle to find answers, economists agree that pricing carbon needs to be a core part of a comprehensive and low-cost approach to managing climate uncertainty.

The failure of Australia’s carbon pricing mechanism and the problems in the European trading system demonstrate how faulty design can destroy many of the benefits of carbon pricing policy

There are many ways to price carbon, including carbon trading markets and carbon taxes. So far the record of successful carbon pricing mechanisms in many countries has been disappointing. They have failed because of high economic costs and small environmental benefits.

A key feature of any carbon pricing policy is an ability to generate a credible future carbon price to encourage development and adoption of new ways of abating carbon emissions. In addition the markets created need to have appropriate institutions for monitoring and enforcement. The policy should also create constituencies throughout the economy that reinforce the existence of the framework.

Uncertainty and risk management should be at the core of the design of national and global climate policies. Climate policy should be designed to better manage risk by creating a framework that balances expected environmental benefits against the economic costs over time, and inspires innovation in activities that reduce greenhouse gas emissions and encourages adaptation at the lowest possible cost.

‘Science’ doesn’t produce a precise target for concentrations. Even if a global target was available, the way in which each country should share that target is not at all scientific. The entire climate change issue at the national level is a balance of competing interests across a range of areas.

Addressing climate change calls for a whole range of policies but carbon pricing needs to be at the core of the lowest cost approaches. However, the carbon pricing regime has to be designed and implemented very carefully. There is no doubt that a short-term carbon price is a cost to the economy. On the other hand, a long-term carbon price provides an opportunity for potential benefits to the economy. These two time dimensions are frequently not distinguished. Many argue that there should be a high carbon price today because that is the only way to encourage abatement actions, particularly in encouraging the development of alternative energy. A high initial carbon price is more likely going to hurt the economy in the short run.

What matters for alternative energy sources, though, is not the price of carbon today, but the price that people expect over the next many decades. This information will enable individuals and countries to manage their domestic costs of carbon abatement to suit their self-interest.

Effective climate policy should have a short run price goal – a stable price of carbon in the economy - and a long run emissions goal - atmospheric carbon concentrations which when traded through a market would generate a clear long term carbon price that will drive greenhouse gas-reducing technologies and investment. The economy would then transition from the short- term to the long- term adapting to new information over time but incurring minimum economic costs.

This idea is at the centre of the model a colleague and I have developed – the McKibbin Wilcoxen Hybrid. – It’s a model that can be implemented as a global system if countries ultimately agree to take coordinated action, but one that does not require that agreement as a precondition for implementing it as national policy.

The Hybrid model consists of a number of key components: a long term concentration target for a country converted into long term emission permits; and a central bank of carbon within a country which intervenes in a spot market for carbon to maintain pre-announced fixed carbon prices.

For the long term goal, the aspirational emissions target for many years into the future is converted into a number of annual emission permits dated with the actual future year they are valid. Each year there would be fewer permits than the year before. These annual permits would then be bundled together with less annual emission rights included for future years. This bundle of permits would be a long-term emission permit, and the total amount of long term permits would be the long term-emission concentration target.

These long-term permits would be freely allocated to households and to industry within a country - partly as compensation for cost increases and partly as a way to self-fund emission abatement activities. The long-term permits can be traded in a market and are owned by consumers and firms who can sell them to generate the revenue needed to reduce their emissions.

Ownership of the right to emit embedded in a financial asset creates a constituency throughout society who are financially driven to resist any government backsliding on future policy commitment, making the policy more credible. It also enables those who reduce emissions to gain financially from doing so. There is no international trading in these national emission rights.

These long term permits would provide annual coupons equal to a specified amount of carbon that diminishes in quantity every year. Thus, if a company owning these emission rights does nothing to change its emissions, the quantity of the coupons disappears in time and more and more rights would need to be purchased to continue under business-as-usual emissions.

The second component of the policy is a central bank of carbon (CBC) which would manage the entire system independently of government. The CBC would print annual permits in order to maintain a pre-announced price of carbon in the current year. Every few years the price would be reset based on observed emission reductions or as part of a global agreement on the carbon price. If an emitter cannot get enough emissions from the coupons in its long-term permit, it can obtain an annual permit for a fixed price from the carbon central bank for that year. The perfectly elastic supply of annual permits at a fixed pre-announced price acts like a safety valve. It means that in any given year an emitter can reach its legal emissions requirement either by using an annual coupon from the long- term permit or by buying an annual permit - effectively paying a fine - from the CBC.

At a national level, the Hybrid approach controls the short-term cost of carbon abatement policy given uncertainty about global actions. If the rest of the world does nothing, the carbon price can be kept low until action is taken. However, if a global agreement eventuates and countries implement policies consistent with it, the short-term price would be stepped up over time. Coordination of national policies into a global regime would be done through carbon price agreements rather than (or in conjunction with) uniform emission targets.

There are two critical differences between the Hybrid approach and the standard cap and trade approach or a carbon tax. First, the Hybrid creates long-term returns to short-term actions. The existence of the tradable right to emit carbon over a long period means a change in behaviour in the short run which reduces emissions. Second, the Hybrid creates transparent constituencies - corporations and individuals - who own the long-term rights to carbon in the economy.

Thus, any government that tries to change carbon policy is more likely to face the wrath of the voters. Changing of policy has been the biggest reason for the collapse of the Australia carbon tax.

There are better ways to generate carbon prices than the approaches usually proposed either in a conventional carbon trading market or through a pure carbon tax. Trying to avoid a carbon price system through subsidies can also work but it’ll come at an even higher economic cost relative to the alternatives. Any policy needs to be able to ramp up quickly if the evidence suggests more action is needed. The flexibility in the Hybrid approach to adjusting to uncertainty gives it an overwhelming advantage over more popular approaches.

In the end the significant investments that will be required to move Australia towards a less carbon intensive future will be more likely to emerge under the stable and credible policy environment provided by a Hybrid policy approach to carbon policy than any of the more promoted, but so far unsuccessfully implemented, market-based alternatives. And a new solution might be just what’s needed to find a way through the political impasse.

Are you interested in studying with Warwick McKibbin? He teaches Modelling the Global Economy: techniques and policy implications (IDEC8127).

Read more about Environment policy at Policy Forum.

Getting better by design was published at - the website of the Asia and the Pacific Policy Society.

This article will is also featured in the Spring issue of Advance, Crawford School’s quarterly public policy magazine.

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