1. Sensible Climate Policy
Warwick J. McKibbin
The Lowy Institute for International Policy
& Center for Applied Macroeconomic Analysis (CAMA) Australian National University
& The Brookings Institution
Presentation for the Victorian Dept of Premier and Cabinet, 23 March 2005

2. Overview What is the climate change policy issue?
Managing Uncertainty in a sustainable way
Features of a Sustainable System
What is Wrong with the Kyoto Protocol?
Problems with pure Cap and Trade Permit Systems
An Alternative Approach: The McKibbin Wilcoxen Blueprint?
Where to go from here?

3. We need to distinguish between two separate questions:
Should the world take action against the threat of climate change?
Should the world implement the Kyoto Protocol?

4. What is Climate policy about ?
We know that carbon concentrations in the atmosphere have risen 30% since the industrial revolution.
We know the science of the greenhouse effect.

5. Uncertainty is everywhere :
Uncertainty about link between carbon dioxide emissions and the timing and magnitude of climate change
Uncertainty about costs and benefits of climate change
Uncertainty about costs and benefits of abatement
Uncertainty about the policy responses

8. Some Illustrations of the uncertainties

12. What should be done given uncertainty?
Some proposals:
Do nothing Problem may be small, avoiding it may be expensive
(what if the problem is large and avoiding it is cheap?)
Do something drastic Problem may be enormous, avoiding it may be cheap
(what if the problem is small and avoiding it is expensive?)
A prudent policy would avoid extremes

13. Features of a Sustainable System
Extensive - all major carbon emitters need to participate
Implementable in key countries
Equitable - across a range of dimensions
Efficient - minimum economic cost
Flexible - need to adjust as new information is revealed
Adding countries/regions easily
Low cost of implementation/administration

14. Features of a Sustainable System
Must establish clear property rights over a long period of time to provide the right incentives for all involved
households, industry, governments
Should be in all participants interest to commit current and future participants within each country involved
Should create a capacity for individuals and companies to manage climate risk

15. Global versus regional
Need a system developed from the bottom up which is a coalition of regional responses implemented in self interest but coordinated at the global level (how far down can this go – nations/states/regions/cities?).
Rather than a system imposed from the top down where all countries must participate and it is built on sanctions and threats

16. Expected Impacts of Kyoto on Australia
The McKibbin (2002) study for the Australian government on the cost of Kyoto ratification (not the Australia Institute press release that is the source of many misquotes!) found:
Costs depend significantly on the scenario for the future projection of the global economy but best guess is a cost for Australia of around 0.5% of GDP every year.
Most of the costs to Australia caused by the actions of our major trading partners.
In many scenarios Australian ratification is not the issue but Australia needs to find an alternative to Kyoto because costs are significant.

17. Problems With Kyoto and the Cap and Trade System
Based on targets and timetables
What is the correct target for each country and the world?
What is the optimal period?
targets impose unknown cost for given outcome for emissions
permit trading gives greater flexibility across countries but no flexibility in total

18. Problems With Kyoto Approach
If costs are low we miss the opportunity to cut emissions quickly (in total) because we have a fixed target
If costs are high we might create severe problems that would destroy the commitment to Kyoto

19. 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

20. Problems With Permit Trading Internationally
Permit trading more widely implemented could cause economic and political problems with large wealth transfers between economies and large fluctuations in trade balances and real exchange rate
Some historical examples
Dutch Disease – e.g. North Sea Oil Discovery in 1970s
Keynes classic “transfer problem” related to German Reparations after WWI

21. Problems With Permit Trading Internationally
If one large country reneges the permit system would likely collapse since the price depends on all countries supply and demand
This requires a very strong monitoring and enforcement mechanism in all participating countries.
If developing countries participate in permit trading the price of carbon would be the same as in industrial countries – why would they want this structural shock even with payments for permits?

22. Problems with Cap and Trade Domestically
Some advocate cap and trade before entering a global system
Australia is estimated to have high marginal abatement costs
A domestic system would have a higher price that the price pertaining in a global system
Significant short run economic costs and capital losses to permit holding when national systems are integrated.

23. Alternatives to permit trading?
Carbon taxes
Subsidies to technologies
Mandatory targets for renewables

24. A carbon tax:
A fixed price for carbon with revenue going to the government
Emission outcome is unknown but the cost of carbon is known with certainty
Problems:
Emissions targets may not be met
Tax payments are enormous
If optimal reduction is 20% of emissions, firms must pay tax on 80% of original output.
Very unpopular with industry and politicians!

25. Subsidies for the Best Technology ?
Clean Coal?
Renewables?
Problem is that the solution will be technological but are governments the best placed to pick the winners?
The subsidies will likely go to those with the greatest lobbying power
This only addresses one part of the climate problem even if you pick the best technology
What about the demand side?
What about individual risk management?

26. Mandatory Targets for renewable energy
Evidence is that this is a high cost approach
Targets and timetables approach yet again

27. Are there any other alternatives?
Need a policy with best features of permits, taxes and subsidies
Like a tax:
Should guarantee that costs won’t be excessive
Like permits:
Should avoid huge transfers to the government
Like subsidies:
it should encourage the search for technological solutions
Importantly it should make property rights clear over a long period and provide incentives for industry,households and governments to reduce emissions at low cost

28. The Blueprint (a hybrid policy)
Each participating country would:
Require that producers of energy within their borders have an annual emission permit for each ton of carbon embodied in their energy produced and sold domestically or imported (rebates for exporters)
Issue long term emissions permits equal to a specified fraction of a base period emissions.

29. The Blueprint (a hybrid policy)
Each participating country would:
Be allowed to sell additional annual permits to firms within its borders at a stipulated price ($P per ton of carbon), where $P could be $US10 per ton of Carbon ($US2.72 per ton of CO2).
Create 2 new domestic markets
long term permits
annual permits

30. Looking at the policy in more detail:
Allows one unit of emission per year for a
long period
Distributed once at enactment
Can be leased or sold within a country
Quantity can set by treaty: QT
Price will be set by the market
Long Term
Permit
Annual
Permit
Allows one unit for one year
Sold by government as demanded
Price set by treaty: PT

31. Supply of each type of permit (for use in a given year)
Long Term permits for lease SL $ QP QT SS QP
Annual permits for sale $ PT

32. Overall supply of permits (for use in a given year)$ PT S QT QP

33. If abatement is easy: MAC rise slowly Low D for permits
P below threshold
No annual permits
Hit target QT $ PT S P D
Revenue to permit owners QT
Q Permits

34. If abatement is difficult:
MAC rises rapidly
High D for permits
P at threshold PT
Annual permits used
Emissions exceed QT $
Revenue to government
P, PT S
Revenue to permit owners D QA QT
Q Permits

35. 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
We can move through a low cost path from the short run to the longer run with profit incentives to reduce emissions wherever cost effective

36. An 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)

37. Key Points
Each system is run within a country using that country’s own imperfect monitoring and enforcement mechanisms and its own legal and accounting systems
No international trade in the assets
only domestic markets and domestic actions
Short run efficiency guaranteed by a common price (no need to trade)
Long run efficiency driven by structural change
Incentives for all actors are focussed within countries

38. Advantages of the Blueprint policy
Guarantees that compliance costs would not be too high
Passes the test that Kyoto fails
Can be justified on cost-benefit grounds
Current knowledge about climate risks justifies slowing emissions at low cost

39. Advantages of the Blueprint policy
Avoids huge transfers to the government
Each government can decide how to hand out long term permits but once these property rights are distributed they are not revisited (like land contracts)
Permits act as transition relief for industries (and affected workers) and will reduce opposition
Also, easy for industry to understand -- like grandfathering
Reduces emissions wherever cost-effective
Prudent: eliminates emissions where possible below a fixed price

40. Important for US and developing country participation
More advantages ...
Maintains national sovereignty
Important for US and developing country participation
Creates a future market in carbon (the long term permit market)
Gives a long term price signal but with a fixed short term cost
Allows individual risk management

41. Trading is national, rather than international
More advantages ...
No direct international transfers of wealth
Trading is national, rather than international
Less disruptive to exchange rates and foreign aid budgets

42. Annual permits generate government revenue
More advantages ...
Built-in incentives to monitor and enforce
Annual permits generate government revenue
Owners of long term permits do not want permit prices to erode
Credible
Less draconian so more likely to be enforced into the future

43. Can raise or lower the world price as risks become better known
Still more advantages ...
Relatively easy to modify as information arrives
Can raise or lower the world price as risks become better known
Easy to add countries over time
Does not require re-negotiation of treaty
New countries joining don’t hurt existing permit owners

44. Developing Countries (or states who want commitment and time to adjust without the competitiveness cost)
Negotiate a long term permit allocation that is larger than current emissions
Price of annual emission permits (or economic cost) is zero in the short run because more permits than needed
Price of long term emission permits will be non zero giving important signals for investment projects
Over time the permit price in countries will equalize as developing countries “ability to pay rises”

45. “ Climate Change Policy For India”
Example from
“ Climate Change Policy For India”

48. Advantages for Developing Countries
Create long term property rights that can be used to encourage foreign investment
Don’t pay short run costs until their ability to pay rises
Encourage alternative energy technologies over time through the long term price signal

49. Where to go from here?
The current approach as embodied in the Kyoto protocol does not deal with uncertainty and is not sustainable
The Blueprint dominates in terms of
the extent of emissions reductions;
risk management;
sustainability.
The Blueprint can be implemented within countries and is consistent with moving towards Kyoto if a country ever wanted to.
Just have the government pull out of the annual permit market and allow these assets to be traded internationally

50. A conventional permit scheme at the State level is problematic
Why would any State want to introduce a pure permit trading system with a flexible price without in practice having something like the Blueprint mechanism to prevent the costs rising well beyond the benefits?
First best would be to have the Blueprint with all countries involved
Second best would be to have the Blueprint with only Australia involved (but then use this to convince the world to adopt)
Third best would be to have the Blueprint in individual states

51. Conclusion
There are better ways to deal with climate change than the Kyoto Protocol
The costs of Kyoto to Australia are largely due to the actions of major trading partners.
Subsidies, even if appropriately targeted only address a small part of the climate issue (ignores the demand side and risk management by individuals).
Australia needs to lead the global debate on global cooperative alternatives to the Kyoto approach – just hitting the Kyoto targets and doing nothing else is not enough

52. Background Papers