Pricing Carbon, Taxes and the ETS

OK - so I haven't posted for a VERY long time...

I HAVE been busy, producing a theatre show - but, excuses aside - here we go, finally:

For years I have been saying I wanted to write a post in defence of the ETS. Many people - many intelligent and knowledgeable people - have asked me why the Australian Government (and this goes back to the days of PM Howard here) supports an ETS over a carbon tax.

I actually think an ETS is a good idea. I think it's the only practical idea, in the long-term. I think it's the only effective idea, given the practicalities of government and I think it's the most efficient solution economically speaking. I'm THAT convinced.

But, as we all know, the Rudd government did an AWFUL job of explaining themselves.

We can excuse the Howard government for not explaining it properly, because, if you probed far enough, the truth was, they didn't want to do anything about the problem. They just proposed the ETS as their preferred option ... "if we have to choose something I guess we'd prefer an ETS".

But Rudd - that's where it really failed. He really wanted to do something (didn't he?).

In 2007/08 we had the Rudd-Slide - and I thought I'd missed my opportunity to explain why it was good idea, because it would just happen. Then in 2009 I thought I missed my chance to explain why it was a good idea because Copenhagen was going to ignite interest in the issue... then in 2010... well that’s when I should have got around to it - because it was damn clear the government wasn't going to explain their own policies to anyone.

So here we are, at the end of 2010 - and STILL no one is clearly explaining why an ETS would be a good idea. So I'm going to try, in my own little way, to do just that...

Before I try to lay it all out though... I must pre-empt the end of the story. Another idea has occurred to me, which I believe nullifies the only good argument I've ever heard against the ETS (that of the difficulty of getting people to report clearly in the lead-up years). But you'll have to read to the end, to follow the argument.

The Argument

Any possible solution for the problem of Global Warming (I'm taking that problem as a given, by the way... if you need to discuss that topic first, this probably isn't going to be a very useful discussion for you) should be judged on 3 basic measures:

1. Effectiveness: It's ability to reduce carbon emissions
2. Efficiency: It's cost to the overall economy
3. Practicality: It's likelihood of succeeding in the given political system

In a broad sense there are 3 basic models put forward:

1. Direct legislation to limit carbon emissions
2. A carbon tax
3. An ETS

Effectiveness

So basically, the question is - how effectively does your plan reduce carbon emissions? How well does each given plan reach the particular goal of desired carbon output? And the answers are as follows:

1. Direct legislation: quite effective, actually, but sometimes unknown or unpredictable (can go over the top and damage the industries involved more than necessary - but that's not what we're discussing at this point)


2. Carbon Tax: completely unknown - depending on the level of the tax, it can completely kill the industries involved, have no effect on emissions or, if you get the value just right (and I mean "just right"), reduce emissions the amount you want.


3. ETS: This is where the ETS really shines - you set the amount of maximum carbon output for the economy as a whole, and the market makes it happen by setting the right price for carbon. No more, no less - you get exactly the amount you said you wanted (ignoring illegal output, which applies to all 3 plans anyway).

For a really clear summary of the mechanisms involved, from some industry experts, listen to ABC Radio National - Australia Talks episode on carbon pricing. [I will add a link to the specific section I'm talking about, when I get time to edit the file]

The whole talk is quite interesting, in fact, and includes parts near the beginning where an expert from an energy production company actually makes an argument for putting a price on carbon! Who would've thought?


Efficiency

Here, the question is - how efficiently does the given plan reduce carbon emissions (to the desired amount)? How much does it cost, in total, for the economy to adjust to the changes and find a new equilibrium? And the answers are as follows:

1. Direct legislation: There is some disagreement about this - but in essence the argument against it being efficient comes down to one idea: Government and Independent Bodies can't predict far enough in advance how best to reduce emissions. Don't legislate how it should be done... create incentives and let the cut-and-thrust of commerce and innovation work it out. Direct legislation seems, by all reports, the least efficient option.
   


2. Carbon Tax: While a Carbon Tax is not the least efficient, it does seem to have one particular inefficiency. It allows the worst polluters (often the polluters with the highest profit margins) to keep paying to pollute. A carbon tax then, also, has the greatest financial impact on the (often lower-level) polluters who don't have the same high-margins. [N.B. While some people complain about an ETS that it allows the worst polluters to quickly make money on the cap-and-trade market by making reductions that were easy to make and should have been done already... this is exactly why it's more efficient than a carbon tax - it gets the attention of those who can most easily (for "easily", read "efficiently") reduce their carbon output.]


3. ETS: By all reports, an ETS IS the most efficient way to reduce emissions across the whole economy. A similar scheme (to the one proposed for Australia) was introduced to reduce SO2 emissions in the US, in 1990. It was reasonably effective - and when the efficiency (total cost per reduction in emissions) is calculated it stands clearly above previous attempts to do similar things via other methods. For a more detailed summary of this program and the findings / lessons: http://www.aph.gov.au/library/pubs/bn/eco/EmissionsTrading.htm#_Toc240944120

Practicality

And finally, the last question is - how practical is the given plan? How likely is it to succeed (in the long-term) given the changeable nature of politics and the personalities and pressures involved? And the answers are as follows:

1. Direct legislation: The problem for direct legislation, in the political arena, is that it's too easy to make a general argument that "that's not fair on me because X" - and it's too hard to balance out the differences for everyone involved. The moment you make a concession for one part of the economy, another will jump up and make a reasonable (sounding) argument for their own part of the economy. The only "fair" solution is one in which each area of the economy takes a chunk of the responsibility based on a range of sliding parameters. And politicians will never be able to wade through the sea of barriers that individual interest groups will put in their way (even if those politicians didn't have any self-interest involved, which of course they do).
   


2. Carbon Tax: A carbon tax, by comparison, is simple and much more likely to get through, in the first place. But what about after that? What about in 5 years time, when, by some miracle, the politicians managed to set exactly the right tax level, and have reduced our emissions to 90% of 1990 levels, but now the emissions are creeping up again, because innovation means it's much cheaper to produce carbon, and carbon producers can afford to pay more tax to do so... You've got the remember, it's the total carbon output, not the total cost, or revenue we're interested in here... who's going to guarantee that the next government would make the argument to increase the tax by the required amount to keep us on track to a sustainable level of output? No one, that's who... we'd be in the same boat, all over again - right back where we started... fighting the same fights.
   


3. ETS: In comparison, an ETS is a self-regulating system. Set-it-and-forget-it. Well, not quite, I hear you say... you still need to make the political argument to reduce the emission levels... Ah yes! But saying, to the voting populace, "we need to reduce emissions further, let's set the dial on emissions a little lower" is a MUCH easier political position than "let's increase taxes again". You tell me which you think is going to be more sustainable... Besides which, you could set-in a program of clearly defined year-by-year reductions, right now - and they are much less likely to need adjustment than tax levels... because when we set the level on an ETS we're saying exactly how much carbon we are going to allow, not guessing how much carbon a particular tax level will generate.

The Only Problem

The problem, with an ETS, that I have seen examples of, is this: how do you work out how many permits to create in the first place?

This problem was faced by the introduction of an ETS in Europe. And they failed to avoid it.

They asked people to report how much carbon they produced... and of course, they over reported, so that there would be too many permits - and permits would therefore be cheaper.

Conversely, a carbon tax has the opposite problem. It asks people to report - and they under report, in order to avoid tax.

And that's what brought me to the solution:

A carbon tax can be introduced much faster and more easily than an ETS... a carbon tax encourages under-reporting... an ETS encourages over-reporting.

So:

1. Introduce a carbon tax - in the next budget
   • A small introductory one, with indications that it will rise over the next 3 years.
2. Ask people to report their emissions, as they would need to, in order to calculate a tax
   • Obviously some form of auditing would need to check-up on people's self-reporting - as is the case for any form of tax or trading system.
3. BUT - and here's the important bit - make it very clear that there WILL be an ETS introduced at the end of that 3 year period

And, so what? Where does that leave you?

Well, it leaves you with companies, across Australia who all have a vested interest in reducing the reporting of their emissions, over the next 3 years, in order to avoid tax - but who are also clearly aware that any attempt to do so will mean not enough permits to go around and much more expensive permits, in 3 years time.

You have 3 year to prepare for the introduction of an ETS. The tax level can be adjusted in the s2n and 3rd years, as its effect becomes clearer over time.

You might still get some under reporting... and you might even get some over-reporting in the last year, on the calculation that paying a bit of extra tax, in the last year is worth getting more permits into the system eventually... but on balance I think most people will recognise that the most efficient way to report is honestly.

Thus, in my opinion, reducing one of the only major difficulties with the initiation of an ETS.

Until then, let's hope we can get SOME price on carbon soon - so that it starts getting factored in to future growth and planning.

It's sad to reflect that, after all this time... this blog post is still as relevant today as when I first started writing it in my head... more than 5 years ago...

Can we move on now?



Other References:

• http://www.mygreenaudit.com/arguments-in-favour-of-an-emissions-trading-scheme/