Making Climate Policy from a Debate Driven by Extremes

The recent announcement by China and the United States of post-2020 carbon emission targets has been misrepresented by both sides of the debate. It was not a negotiation or an agreement.

Rather, it was a joint announcement of targets that both countries believe they can already achieve with current policies and their own forecasts of the future.

The view of climate sceptics that nothing is happening in the world on climate policy is clearly wrong. What is happening is very inefficient and potentially costly for the world and particularly Australia. Thus Australia’s self-interest is to drive the climate policy debate before we pay a higher price than necessary to address climate risk.

The basic problem is that the debate on climate policy is a battle between extremes. There are those who believe the world will end unless immediate and drastic action is taken to reduce human emissions of greenhouse gases.

In contrast, there are those who believe that climate change does not exist. The problem with a debate between extremes is that the policies which emerge are rarely the sensible policies that would address the central problem.

What’s more, information is misrepresented by both sides who believe that any distortion to the facts is acceptable if it achieves the outcome they desire.

Climate policy design is not about certainty and targets. Climate change policy is about managing risk given enormous uncertainty.

If climate change does turn out to be mostly driven by factors outside human control then draconian climate policy now may impose severe economic costs on top of a situation where economic resources will be needed to fund adaptation to natural climate change.

If human-induced climate change is the problem, then doing nothing when there are low-cost options available today to mitigate emissions may turn out to be very expensive. Doing nothing magnifies the economic uncertainty and this creates larger costs. A low-cost, flexible policy is clearly better than either extreme.

Cheap permits no incentive

How does this problem of extremes translate into policy? In Australia some people believed the former Labor government policy of introducing a carbon tax at a high level and then switching into a carbon trading system based on the European model was a good idea.

The problem is that the European scheme will likely have a low carbon price. This created a high carbon price in Australia that was expected to fall over time, which created high economic costs and very little investment in reducing emissions given cheap permits are likely to be available from Europe.

What the failed Australian system demonstrated was that emissions did fall in response to the carbon price but the costs were high due to bad policy design.

The Coalition government’s Direct Action plan is based on a reverse auction where firms announce emission reduction plans and the government pays for these up to a given target of reductions.

Given the targets and the expected trajectory between now and 2020, this is just as likely to reduce emissions as the alternative carbon tax or emissions trading schemes. To argue that this just doesn’t work to “pay polluters” reflects either the critics’ ignorance or dishonesty.

Direct Action is likely to work given the target to be achieved. However, the point is not whether the policy works or not; the point is how much of a reduction in emissions can be achieved at what cost and how flexible the policy is so as to adapt to new information over time.

Behavior must change by design

The most important question today is which type of policy is most likely to minimize the risk and costs for Australia in future years?

The Direct Action approach targets a small number of emitters to achieve a given reduction target. Because not all sources of emissions are given an incentive to change behavior, it must be that the cost of a unit of emissions reduction under the Direct Action policy will be higher than a policy that puts a long-term price on all carbon decisions in the economy.

A well-designed carbon price will change the price of carbon facing all firms and households today and in the future. Therefore, a small adjustment by everyone can achieve a given reduction in emissions over time.

By design, Direct Action doesn’t change the cost of carbon-intensive products such as electricity so a large number of households and firms do not change their behavior. It must therefore be more costly than a well-designed carbon price.

The second aspect of Direct Action is that the government pays for the reduction, whereas in a well-designed carbon pricing model the payments can be kept off the government budget and kept within a market of buyers and sellers.

This doesn’t matter much given the current trajectory of Australia’s emissions and Australia’s 2020 target. The differences are probably small. Environment Minister Greg Hunt is most likely right that Direct Action can deliver the 2020 target at a reasonable cost (but not at the lowest economic cost).

In the longer term, the question is how adaptable is the policy to changing global circumstances? What if the joint announcement by China and the US leads to a substantial shift in global policy in Paris in 2015? The costs of deeper cuts under a Direct Action style of policy will increase sharply because only a small share of emissions will be required to carry a rapidly rising burden.

In addition, the fiscal deficit will be put under strain because funding will need to pour into the Emissions Reduction Fund. There needs to be a clear path from Direct Action to something scalable.

Australia needs to lead the international climate policy debate. This requires a mature debate at home. It might be that the Coalition government has made the right call for the design of Australia’s climate policy given a particular future.

However, recent Australian governments have shown that poorly designed policies based on a future that doesn’t eventuate can ultimately end up costing the Australian economy dearly.