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Big carbon cuts need new policy framework

01 December 2015

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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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The best climate policy framework is one that is transparent, simple, where deep cuts can be achieved if it is inexpensive to do so and where costs are bounded relative to other countries if estimates are wrong, writes Warwick McKibbin.

This week’s COP21 meeting in Paris to consider climate policies beyond 2020 under the UN Framework Convention on Climate Change is very different to the other major COP meetings such as Kyoto in 1997 or Copenhagen in 2009. On those occasions the focus was on targets and timetables for emission reductions in a legally binding international agreement.

This was never going to succeed because a key to the climate issue is striking a balance between achieving significant carbon emission reductions at reasonable economic costs. This is particularly important for developing and other fast growing countries.

At the COP21 meeting in Paris, countries have submitted Intended Nationally Determined Contributions (INDCs) which pledge goals for emission reductions post 2020 as well as the types of policies that will be used. This is important because the nature of the policies will determine the costs of cutting greenhouse gases more so than the target itself.

What is important for both the international agreement and for national policy frameworks is that there be a goal for emissions (not a legally binding target). But there also has to be a mechanism to limit costs if the future turns out different to what was expected.

One way for national and international policy to proceed is to design a system with an emissions goal together with a lower and upper bound on carbon equivalent prices. This would mean countries could show they were contributing to the global effort even if their emission reduction turn out to be less than announced if the costs could be demonstrated to be at the upper end of the bound. For example, Australia could pledge a 45 per cent reduction target by 2030 conditional on having effective carbon prices no higher than the developed world average price by 2030.

The Australian government position of a 26 to 28 per cent reduction in emissions relative to 2005 by 2030 is not a position of cuts as deep as other countries. But if measured in estimated GDP losses, it is estimated to be at the high end of what has been offered by other countries. The problem with this estimate is that the precise policies are not spelled out in Australia’s pledge. The costs could be larger or smaller than estimated. The current policy of Direct Action cannot achieve this scale of reduction without significant changes to the way it is designed.

The opposition’s announcement of doubling the cut in emissions is also problematic. When I model a 45 per cent reduction by 2030 over 2005 in the same model I used for the government, I estimate a carbon price of around $200 in 2015 prices. Is that figure plausible? A back of the envelope calculation is that if $23 per ton in 2012 reduced emissions by between 3-5 per cent by 2014 (O’Gorman and Jotzo 2014 study) then it is not surprising that a reduction nine times as large by 2030 would costs slightly less than 9 times more. To call my estimate fanciful shows a lack of understanding of the degree of effort required to transform the economy and the Australian evidence on carbon taxes to date.

The key point, however, is not the size of the target or whether models are right or wrong. Two crucial questions arise if a deep reduction target is proposed: what are the policies that will achieve it? And what will be used to manage the enormous uncertainty around the costs? Labor argues that access to international permits will reduce the cost substantially. This might be right. In my recent report ‘Report 2: Economic Modelling of Australian Action Under a new Climate Agreement’, I used assumptions provided by the Department of Foreign Affairs and Trade where the price of international permits were lower than the cost of emission reductions in Australia. Accessing these international permits reduced the cost by 50 per cent.

However, it is dangerous to rely on anyone’s ability to forecast global carbon prices. The assumption for the carbon price in the original Garnaut Review of 2008 (box 12.2) was a projected international carbon price of $40 per tonne by 2013. The then Labor government’s policy was designed around that sort of estimate. The international price was actually around $8 per tonne by 2013. This was a big difference on the down side because the world changed.

What will be the price of international permits in 2030? Labor appears to assume they will be very low. But what if the world adopts very aggressive targets and therefore drives the price of international permits well above the Australian price, then Australia doesn’t have a low cost option.

What Australia needs is a policy framework that is transparent, relatively simple and where deep cuts can be achieved if it is inexpensive to do so and where costs are bounded relative to other countries if estimates are wrong. Access to international permits is not the best way to do this because of the risk involved. Both the government and opposition need to lay out the specific policies before they commit to large carbon reduction goals.

This piece was also published by the Australian Financial Review and Policy Forum.

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