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

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

3. 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

4. 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

5. 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

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

7. 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

8. Some Issues in Policy Design
Coverage
Equity
Politics
Institutions
Fundamentals
Flexibility

9. 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

10. Some Issues in Regime Design
Coverage
Equity
Politics
Institutions
Fundamentals
Flexibility

11. 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

12. Some Issues in Regime Design
Coverage
Equity
Politics
Institutions
Fundamentals
Flexibility

13. 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

14. Some Issues in Regime Design
Coverage
Equity
Politics
Institutions
Fundamentals
Flexibility

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

16. Some Issues in Regime Design
Coverage
Equity
Politics
Institutions
Fundamentals
Flexibility

17. 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

18. 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

19. The Role of Prices

22. Would raising prices work?

23. 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

24. 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

25. 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

26. 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)

27. 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

28. 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

29. 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

30. 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

31. 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)

32. 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

33. 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.

34. 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

35. 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

36. 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

37. 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)

38. 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)

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. Background Papers

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

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