Why Australia Should Take Early Action on Climate Policy Warwick J. McKibbin Lowy Lunch Lecture Dec 13, 2006

Acknowledgement Much of this lecture is from joint research with Professor Peter Wilcoxen from Syracuse University

Overview The Climate Policy Issue Key Features Needed in any Approach What makes climate change policy so hard? Key Features Needed in any Approach Price Signals are critical but are not all the same The McKibbin-Wilcoxen Blueprint for national and global action A case for early action Conclusion

Emissions versus Concentrations What matters for the climate is the concentration of greenhouse gases in the atmosphere Concentrations are the accumulation of annual greenhouse gas emissions Emissions is any particular year are not critical but the path over time is

What makes climate policy difficult? Committed warming Need both mitigation and adaptation Geography Broad range of sources of emissions, caused by decisions made by a diverse range of households and firms Many jurisdictions - coordination problem (international, national, state, local) Time scales Exceptionally long-lived problem and policy Uncertainties Numerous, large and intractable

Economic Damages/benefits What’s uncertain? Emissions Levels CO2 Concentrations Temperature Change Ecological Effects Economic Damages/benefits

What to do Given Uncertainty? Uncertainty and Risk management are not new concepts For example if the probability of a bush fire rises significantly, do you?: A) do nothing B) burn down the house so it doesn’t burn down in a fire C) take measures to reduce the probability of a bad outcome including taking out insurance

Some Issues in Policy Design Coverage Equity Politics Institutions Fundamentals Flexibility

Coverage Need major current and future emitting countries involved not necessarily all countries Need all of the economy involved not just a particular sector Need to change the sources of demand and supply of greenhouse gas emissions

Some Issues in Regime Design Coverage Equity Politics Institutions Fundamentals Flexibility

Equity A climate policy will probably lead to winners and losers Need to deal with the distributional issues within countries and between countries Within country distribution is up to governments within countries Need to recognize the differences across countries’ stages of development and relative contributions to current climate problems

Some Issues in Regime Design Coverage Equity Politics Institutions Fundamentals Flexibility

Politics Need to build constituencies across society that support the policy in their own financial self interest Fossil fuel producers facing reduced demand for their products Consumers facing higher energy prices Politicians with an incentive to lobby to reject a policy in favor of a narrow constituency

Some Issues in Regime Design Coverage Equity Politics Institutions Fundamentals Flexibility

Institutions Build on existing national institutions Legal, accounting, financial, market experience Developing new international institutions will delay action and will likely be infeasible

Some Issues in Regime Design Coverage Equity Politics Institutions Fundamentals Flexibility

Fundamentals Need to establish clear property rights over carbon emissions over a long period of time to provide incentives for all involved within a country to want to reduce carbon emissions create a capacity for individuals and companies to manage climate risk Encourage the emergence, adoption and diffusion of existing and new technologies to reduce emissions

Fundamentals Need to Manage the demand side of energy use while waiting for technologies to emerge Enable compensation for those hurt by higher energy prices if technology is expensive or slow to emerge

The Role of Prices

Would raising prices work?

The Role of Prices Price signals should be both short term and long term Price signals should be credible Otherwise investment will not be forthcoming Price signals are crucial for encouraging Demand side management The emergence of alternative technologies The adoption and diffusion of alternative technologies Short run prices can more easily be used than emission targets to line up costs with expected benefits

Flexibility is important Need to be able to start in individual countries with known costs Need to be able to add countries over time Need to be able to adjust the system as information is revealed Need to allow for particular national circumstances

Ways to give price signals: Carbon tax Subsidies Binding targets with penalties for non-compliance Cap and trade Permit trading McKibbin Wilcoxen Blueprint – a hybrid of the above approaches

A carbon tax: A fixed price for carbon with revenue going to the government Emission outcome is unknown in any given year but the cost of carbon is known with certainty Problems Tax payments are enormous If optimal reduction is 20% of emissions, firms must pay tax on 80% of original output. Fossil fuel intensive industries and consumers worse off (depending how revenue is used)

Cap and Trade permit trading: Quantity of emissions is certain and fixed at the quantity of permits Price of carbon is uncertain and depends on marginal abatement costs given the target Benefits: emissions are fixed with lowest costs to achieve those emissions Problems: Price of permits (i.e. cost to the economy) might be very large and highly variable Costs might substantially exceed the benefits

The McKibbin Wilcoxen Blueprint Aim Impose a long term carbon goal for economies Generate a long term price for carbon to guide energy related investment decisions Line up short term economic costs with expected environmental benefits Provide a way for corporation and households to manage climate risk Can be an internationally coordinated system or a national system that evolves into an international system

Components of the Policy National permits Required to embody carbon in energy Good only in country of issue Long-term permits Allow 1 ton of emissions each year Quantity is the long run goal Fixed supply (can be diminishing) Annual permits Allow 1 ton of emissions in year of issue Elastic supply from national government Price fixed for ten years

Why National Permits? Use existing institutions Legal system for enforcing property rights Small loss of sovereignty No need to cede authority to an international body No direct international transfers of wealth Enforcement maintains rights of domestic residents Robustness and stability Easy to join the agreement Robust to withdrawal by some participating countries Compartmentalization lowers transmission of shocks

Why Long-Term Permits? Credibility Additional benefits Build constituency supporting the policy Owners: vested interest in maintaining system Reduce the time-consistency problem Additional benefits Can tailor distributional effects via permit allocation Reduces risks (long term vs. short term bonds)

Why Annual Permits? Acts like a carbon tax at the margin Efficient A price-based policy is preferable to a qnatitative target given flat damage curve Pragmatic Governments don’t have to agree to hit a fixed target in any year regardless of cost Flexible Government can mandate who can issue annual permits

Allocation Those who need permits are not necessarily the same as those who own the permits Allocate long term permits freely to fossil fuel intensive industry and households Only those who embody carbon in energy need a permit each each.

Overall Creates incentives for investment Incentives are credible Raises the marginal cost of emissions into the future Incentives are credible Built-in constituency of long term permit holders Robust to accessions and withdrawals Operates within existing institutions Provides a foundation on which to build Completely consistent with technology policies Provides incentives for adoption and diffusion

Expandable Because it is a domestic system, other abatement activities can be included as a way to generate annual permits with the revenue going to these activities instead of the government

Main Concept The long term permits are the medium term goals for emissions without a timetable of when they are reached The short term permits are the economic costs to the economy Move through a low cost path from the short run to the longer run in decadal steps with profit incentives to reduce emissions wherever cost effective

A Partial Analogy – Bond markets Long term government bond market prices interest rates over long horizons given a stock of government debt (like long term permits) Central banks set the short term interest rate - the supply of financial liquidity is generated by the market (like annual permits). The long term interest rate (which is flexible) is the expected value of future of short term interest rates (which are fixed in any period)

Encouraging Non Fossil Fuel Energy and carbon capture technologies Relative price of carbon higher in the short term and the longer term Clear pricing over long time periods gives a clear signal of the return to investment in non-fossil fuel energy sources or capture of carbon from fossil fuels Could allow non-fossil fuel energy producers and carbon capture to generate annual permits in proportion to the amount of carbon not emitted (does not require international negotiation while the price cap is binding)

Is early action a good idea? Australia could adopt the Blueprint today in advance of the rest of the world both for a direct economic gain and to encourage the rest of the world to adopt similar policies Most models ignore uncertainty and therefore do not incorporate wealth generated from risk management

What about competitiveness? The cost of carbon is not the largest cost even in aluminium production – the cost of capital is more important Under the Blueprint, the cost of carbon that affects direct competitiveness is controlled by the government and is kept low until other countries impose carbon prices in which case the competitiveness issue disappears over time The increased ability to manage asset risk will be more positive for a company’s balance sheet than the negative effect of a slightly higher short term carbon price

What about carbon leakage? Why would a fossil fuel intensive industry move away from an economy in which the risk to their capital is hedged, into an economy with greater political risk and no carbon policy when you know that over the next decade or so carbon policy will be inevitable. A small rise in the carbon price will be more than offset by the gains of risk reduction on protecting capital

Early Action is critical Australia should act now in creating markets with long term price signals that: That enable energy generators and energy intensive industries to protect their capital value against change in the climate and changes in climate policy Give clear profit signals to alternative generating technologies and other technologies such as carbon capture and storage R&D in only a partial but a necessary part of the solution but without a market price there is little incentive for technologies to be implemented and diffused through the economy

Conclusions Substantial climate uncertainty implies responding now in terms of institutional design Need long term price signals to encourage development, adoption and diffusion of carbon saving technologies and to manage energy demand Need short term price signals capped at expected benefits to minimize economic cost

Conclusion The solution to reducing emissions will require a portfolio of different policy strategies not reliance on a single strategy The technological solution will likely involve a range of different technologies all suitable for different circumstances A foundation of clear price signals will help minimize the economic costs of addressing what is probably the most important policy issue of our time

Background Papers www.sensiblepolicy.com

An Example: Australia and China What would the markets look like in Australia versus China? Suppose China receives double versus triple 2002 emissions

The same approach can be applied in countries at different levels of development