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An Easy Guide to the Economics of Climate Change

07 March 2011

Are you confused by the Emissions Trading Scheme? Well, according to recent opinion polls 80% of Australians are.

Let's see if my \"Easy Guide to the Economics of Climate Change\" helps reduce the confusion.

The starting point has to be the reports of the Intergovernmental Panel on Climate Change (IPCC) which is the United Nation's major advisory group on climate change. The IPCC maintains that global atmospheric concentrations of greenhouse gases have increased markedly as a result of human activities since 1750. Major components of greenhouse gases are carbon dioxide; increases in which are due primarily to fossil fuel use and land use change. Other gases are methane and nitrous oxide, increases in which are primarily due to agriculture.

The IPCC has concluded that \"continued greenhouse gas emissions at or above current rates would cause further warming and induce many changes in the global climate system during the 21st century that would very likely be larger than those observed during the 20th century.\"

These changes will have an economic cost- plausible estimates are about 5% of GDP a year roughly equivalent to the worst of the GFC. The cost of reducing emissions can be much less - about one per cent of GDP so there is an incentive to act sooner rather than later.

The Stern Review of Climate Change identified the major ways to reduce emissions; these are increased energy efficiency, changes in demand and the adoption of new technologies of clean renewable energy. Also needed are cuts in non-energy emissions i.e. those from deforestation and agricultural and industrial processes.

Climate change is a case of very large market failure because those emitting greenhouse gases do not have to pay the costs of climate change resulting from the emissions but impose costs on others. There are, broadly speaking, three ways the market failure can be rectified-

1) Regulation

2) A Carbon Tax

3) Emissions trading.

However, climate change is a global problem and the ultimate solution requires international co-ordinated action. The Copenhagen Conference to be held this month is the latest effort to get international agreement about binding targets and effective and comprehensive strategies.

Whatever system is used the use of fossil fuels will become more expensive and these costs will be passed on to final users ie consumers. There is no escaping it - moving against climate change will require some painful adaption and economic costs. The trick is to minimise these.

Regulation of emissions would require the government to ban certain emissions or place a ceiling on emissions and enforce this by inspection and monetary penalties.

The carbon tax, so much per ton of emissions, would increase the cost of goods and services produced with a carbon component. This may reduce output of those goods or increase their price to the consumer. The government would collect the tax and it could be used to subsidise alternative energy or new technologies (or just use it to reduce the deficit.)

A carbon trading scheme would set an overall limit to emissions in the economy and require emitters to buy a permit to pollute (permits would be auctioned and subsequent trading in them allowed).

Both the carbon tax and the carbon trading scheme would be market oriented policies in that they would use price signals to lower carbon emissions.

In Australia, we have seen the introduction of a Carbon Pollution Reduction Scheme (CPRS) which, as I write this, is currently being debated in the Senate and whose fate is highly uncertain. The CPRS aims to reduce our pollution by 60 per cent of 2000 levels by 2050 including an unconditional 5 per cent reduction in carbon pollution below 2000 levels by 2020. There is a further but conditional target of a reduction of 25 per cent below 2000 levels by 2020 if there is an international agreement to substantial cuts in emissions by 2050. The basis of the CPRS is a carbon trading scheme under which emitters of carbon will require a permit which will be priced at so much per ton and the permits auctioned for full market trading to start in 2012-13.

The initial proposal has been radically amended in the Senate; the major amendments are to give a high number of permits away free and to compensate industries and households for the changes.


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The changes have been of three major types:

1) To exclude some sectors of the economy from the Scheme e.g. agriculture and transport;

2) To give permits away rather than selling them; and

3) To compensate some industries and households for the increased costs of the scheme.

The overall effects of these amendments are to suggest that big changes can be made without any cost and to transform the CPRS into a regulation based scheme which eliminates many of the price incentives to adapt. Exclusion of some sectors from the scheme means, of course, that others have to make a bigger adjustment to achieve the same target reduction in emissions.

The CPRS is far from the last word on carbon reduction. There may be some international agreement out of Copenhagen or we may just muddle along for a while longer.