Criticisms of the CPRS and calls for a carbon tax

The following editorial is a guest post from regular blogocrat Dave55

There has been some reporting over the past few days and much political to-ing and fro-ing over the relative merits of the Government’s proposed Carbon Pollution Reduction Scheme.

A group of 10 economists including John Quiggan spoke out yesterday criticising the CPRS. The Statement called for three main improvements to the CPRS and, unless these improvements are introduced, then the Government should consider a carbon tax as a matter of urgency.

The improvements demanded were:
*Lifting the targets to 25-40% by 2020 based on the latest scientific evidence
* Abolishing the free permits granted to the biggest polluters
* Ensuring that individual action results in lower emissions, not lower carbon prices

This Statement has led to much media and political debate over the relative merits of an ETS v a carbon tax. I’ll deal with the politics of this in a subsequent post but firstly lets look at the criticisms made by these economists and what they are actually calling for.

The first 4 of the criticisms in the statement (follow the link above) relate to the compensation packages under the CPRS which are largely in the form of free allocation of permits to large emitters. They argue that the free allocation of these permits will create perverse incentives for these emitters to emit more GHGs, reduce the economic drivers for new green technologies at a time when greater certainty regarding investment options will be rewarded by the markets, and benefit the existing emissions intensive industries when compared to cleaner technologies by compensating them for their emissions.

In short, they are arguing that the CPRS will result in the emission reductions of 5% or whatever the mandated cap is but the scheme itself will do little to drive investment in the cleaner technologies which will be necessary to achieve the cuts that the science indicates are necessary to avoid damaging climate change.

These criticisms I believe are valid. Garnaut has been very vocal in his criticism of free credits being given to emitters under the scheme for similar reasons.

The 5th and 6th criticisms are the criticisms that have led people to take this Statement as advocating a carbon tax over a cap and trade scheme. Because of this, these criticisms require a closer analysis to work out what is actually being criticised here and whether or not a carbon tax would actually be a credible answer to these criticisms.

The 6th criticism is that the Government has failed “to cost the complex administrative arrangements that will be required in order to effect the auctioning, the free allocations and the redistribution of permit revenues across the economy “ There is no doubt that the auctioning process will be complex and the process of tracking the flow of permits and sequestration credits administratively onerous for government and possibly industry.

The real administratively difficult process will be working out which emitters receive how many free credits and the formula for making this determination. It is hard to argue with this criticism but whether it in turn advocates a carbon tax or simply a variation to the cap and trade scheme based on the first 4 criticisms in the Statement warrants closer analysis.

The 5th criticism is a little more complicated; it is essentially a moral argument that actions by individuals to reduce emissions through, for example installing solar panels, are not rewarded and instead it is the emitters that are rewarded through lower permit prices resulting from the reduced demand for permits in the stationary energy sector.

This criticism is couched in terms of a moral argument, or at best an assertion that people are being duped into thinking that installing a solar panel will actually result in lower emissions and that this is somehow immoral.

This is the criticism of why people have taken this Statement to be a promotion of a carbon tax as opposed to an ETS. Because of this, this criticism requires a deeper analysis.

To understand the 5th and 6th criticisms it is important to know how a cap and trade scheme operates. The cap is the level of net emissions that can lawfully be emitted by those entities covered by the scheme. The cap will be set in terms of tonnes of CO2 equivalents or tCO2-e equally to the % reduction target set by the Government. A permit obtained from the Government must be acquitted by each entity covered by the scheme for each tCO2-e emitted by that entity.

Credits can also be obtained through carbon sequestration and these, like permits obtained from the Government, can be acquitted to cover actual emissions. The result is that the cap represents the actual level of net emissions that will be emitted by the sectors contained within the scheme. Because these permits can be traded, emitters will ascertain whether or not it is cheaper to reduce emissions or to buy permits or credits.

The price that an emitter will pay for a credit won’t exceed the marginal cost of abatement, which is the cost to the industry of implementing measures to reduce emissions by 1 CO2-e. So while an entity may reduce emissions, what they are doing through this process is reducing demand until the cost of permits through demand = the marginal cost of abatement. But while abatement reduces the emissions from that entity, it doesn’t reduce the number of permits in the system meaning these permits can be used by other, or new emitters.

The beauty of the cap and trade scheme is that you know exactly how much CO2-e will be emitted in a given period so targets can be set and achieved with a high degree of accuracy.

Because I will be comparing cap and trade to a carbon tax it is also useful to explain the basic elements of a carbon tax and it is simple, at least in theory. Essentially, a carbon tax is a tax on each tCO2-e emitted by persons covered by the tax. The level of the tax is fixed by the Government.

A carbon tax does not cap emissions, instead it relies on the level of the tax affecting the demand for products that result in emissions to such an extent that the target level of emissions is achieved. Carbon credits from forestry sequestration can offset a tax liability but the level of the tax is what will determine the marginal cost of abatement and not demand.

There is no guarantee that a carbon tax will achieve the desired target; if the tax is too low, the target will not be met and if it is too high, the target will be exceeded but at the cost to the economy.
First I’ll deal with the 5th criticism because, while I understand the argument, I don’t support it, or at least I don’t believe that the reasons given for this being a criticism are really criticisms of the cap and trade design but are in reality a criticism of the cap itself.

The crux of the 5th criticism is that home owners installing solar panels are not part of the scheme but do reduce emissions by participants in the sector and therefore free up credits making them cheaper for the entities covered by the scheme. However this criticism fails to acknowledge three things:

1. that the electricity retailers/ generators do not obtain income from the electricity forgone so the benefit to industry is shared among all scheme participants (not just the electricity retailers) in the form of reduced permit price through lower (albeit miniscule) demand.

2. that the reduced price of permits will flow through to the consumers meaning that the actual cost of the ETS on the economy as a whole is reduced by these actions so the installer of the solar panels will receive the benefit; and

3. that direct benefits are received by the person installing the solar panels as is the lower energy costs through the solar electricity generated by the installed panels.

It might be fair to argue that the Government hasn’t effectively explained that under a cap and trade scheme Australia’s emissions will only reduce by the cap and that unilateral efforts to reduce emissions (short of buying permits and ensuring they are never acquitted against emissions) wont result in us having lower GHG emissions; but it is hardly a strong economic argument to assert that people are being duped into thinking they are making an actual difference to the amount of GHG being emitted and that this is somehow an inequity worth of economic intervention.

The economic reality is that by installing solar panels they are helping to make the cost of reducing emissions less for Australia generally and this has its own social benefit that may make a person feel like they are contributing. IMO, this criticism of the CPRS is weak and is really a criticism of the targets themselves being dressed up as an equity issue. Consider this, if the cap was at levels which are consistent with scientific opinion (say 20-40% reductions by 2020) would these same economists be criticising the CPRS on this ground?

Would a person installing solar panels really feel ripped off if they knew that the Governments scheme was delivering what the science said was necessary? I think not.

Given that the cap has been mooted at only 5%, this moral argument is a good way to point out a characteristic of a cap and trade scheme that people may not have realised and may think unfair; but without pointing out the corresponding benefits under a cap and trade scheme of such unilateral action I believe that these economists are being intellectually cute in the framing of this arguments.

But would a carbon tax provide greater fairness in relation to criticism 5? The answer is yes -ish; but under a cap and trade scheme there is nothing to say that the reduction in electricity emissions will not be offset by a different entity emitting more and paying the corresponding tax or the neighbour turning on their air conditioner and using coal generated electricity and resulting in more tax being paid.

So while the person may feel good that they do not result in more emissions through their actions, there is no guarantee that Australia ’s overall emissions will be closer to what is environmentally necessary under a carbon tax.

And what about the 6th criticism, does it actually advocate a carbon tax in preference to a cap and trade scheme or does it simply suggest that the CPRS should be amended? IMO, it is the latter. The problem with a carbon tax is that it is administratively difficult to work out the level at which the tax should be set to achieve a desired reduction.

There is very little information regarding the marginal cost of abatement in most industries and most organisations have guarded, or overstated their level of emissions and cost of emissions reductions in order to support their arguments for greater Government assistance once a scheme is introduced.

Do not underestimate the administrative problems associated with working this out and then fixing it if it is too high or too low. This administrative burden does not exist in relation to a cap and trade scheme and the costs of this are probably comparable to the costs of a permit auction (although I have nothing to support this guess).

The costs of actually processing the tax returns and dealing with sequestration credits under a carbon tax are likely to be similar to the administration of permit and credit acquittals under a cap and trade scheme. The difference between the two in terms of administrative costs is therefore the costs of determining how permits should be freely allocated to participants of a cap and trade scheme. Given that criticisms 1-4 call for the removal of free permits, if the recommendation is adopted, there is very little to distinguish a carbon tax from a cap and trade scheme in terms of net costs of administration.

I don’t want the above discussion regarding the administration costs issue to sound like a cap and trade scheme and a carbon tax are equal in their costs because to do so would fail to take into account the risks associated with getting the level of the carbon tax wrong.

These risks are significant if there is insufficient data accurate data held by the Government on the actual level of emissions from industry and the likely costs of abatement.

Nothing I have seen or read leads me to believe that the Government has anywhere near the level of information necessary to complete this task to enable an effective carbon tax to be introduced by 2010 and definitely not if it is to be set at a level to achieve significant emission reductions.

For all the criticisms that free markets are copping at the moment, a well designed cap and trade scheme (ie one without too too many free permits) is one area where the market is actually the best tool to ensure that the costs of achieving actual emission reductions at the least cost to the economy.

The risks of failure are low and when this is compared to the risks of failure from a carbon tax (particularly in the absence of detailed emissions data), the choice between the two is easy. It is for this reason that most economists have advocated a cap and trade scheme over a carbon tax and why the Howard Government similarly advocated such a scheme.

So, are these economists actually advocating a carbon tax or are they recommending changes to the CPRS. IMO it is the latter.

The primary criticism on economic grounds is the second of the two demanded improvement, that is, the abolition of free permits. This is consistent with the recommendations of Garnaut and the advice provided to the Australian Government in 2001 by the Allen Consulting Group.

I support this demand wholeheartedly. Export entities affected by the CPRS should be compensated by targeted use of the revenue from the permit auctions, not by the gifting of free permits. Revenue recycling can also reduce the impost of the CPRS on disadvantaged groups like pensioners and the unemployed.

Each of the first 4 criticisms in the Statement are spot on and the Government should take note of these.
The environmental demand (ie, the lifting of the targets to 25-40% is warranted on the basis of the science but we don’t need economists saying this unless thay are doing a cost-benefit analysis of early action similar to that done by Stern and Garnaut.

I won’t debate the merits of the science in this forum.

The third demand comes from the 5th criticism. As discussed above, I believe that this criticism is unwarranted, particularly if the targets are set at the higher level. I cannot see any economic justification for this criticism or the corresponding demand.

Furthermore, the authors of the Statement have provided no advice on how this demand could be achieved within a cap and trade scheme. Short of the Government purchasing credits equal to the abatement provided by individual action would be one way of doing this but given that there are private benefits associated with doing it (ie reduced electricity costs), it would be difficult to justify, on economic grounds, any rationale for doing this.

I honestly don’t believe that the third demand withstands serious scrutiny and it lets down the Statement as a whole. This is a shame because the criticisms regarding the free credits and the targets are valid and well made.

The fact that it is this final demand that has been picked up by the media rather than the points about the free credits is disappointing to say the least.

Over to you…

Dave55

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22 Responses

  1. Sorry for the length guys but i needed to spell this out fully in order to develop the political analysis which (hopefully) I will do over the W/E.

    I would have linked to the Allen Consulting Group Report – Emissions Trading: Allocation of Permits (2000) but I can no longer find it online. It used to be on the Greehouse. gov.au site but it has not made the transition to the new climate change site. I will leave any consopiracy theories regarding this up to others but I will note that it is very critical of free allocation of permits.

  2. …but, but, if all the steel mills are closing and factories don’t need as much electricity, and we don’t need to transport as much “stuff’, won’t that reduce the greenhouse gases naturally?

    BTW, Dave55, is JMc your mentor?

  3. TB

    LOL re my mentor – I did try to avoid block quotes though.

    As for the comment – sure, this will make the targets in the short term earier to acheive but I think most people expect the economy to recover eventually and emissions intensity to increase.

    There are a number of people suggesting that the current economic crisis is a good opportunity to readjust the economy to be more environmentally (and socially) sustainable. This article in the age by Stephen McGrail is worth reading and even if you are a climate change skeptic (which I think you are from memory and I don’t mean any disrespect by that), these ideas should still appeal to you.

  4. Excellent post dave55, hefty & well fleshed out; the only way to attempt to broadly understand this whole scenario.

    I think that much of the apprehension around the CPRS, & “climate change” in general, is built around the fact that very few members of the population are capable of digesting the complexities of the issues & making informed, considered conclusions.
    I don’t begin to know how to change this, simply put there are only a minority with the requisite education or expertise in the field & we (the less informed) are left to choose sides based on the faith we attach to those presenting the answers.
    Unfortunately the debate appears to be radically polarised along political lines & therefore one must be especially careful in sifting the information from the agendas.

    This is all of particular interest to me (apart from the obvious influence of not wanting to bequeath a dying planet to my daughter) because my job is certain to be impacted by the CPRS, or other measures, as the company I work for is one of the larger industrial consumers of energy in SA. They’ve already begun (carefully) maneuvring & planting seeds of doubt in the workforce through official & unofficial statements.

    Great work dave55, you have your head around this much better than most based on your above contribution. Thanks for the insight.
    It’s gonna take me a lot more digestion to reach any sort of solid position on this.

  5. Ok, as much as I hate doing it, I will leave aside the point that I think that the concept of Anthropogenic Global Warming is perhaps the greatest fraud perpetrated on the citizens of the world in history. If we must head down this path, I am entirely against an Emissions Trading Scheme. The reason is that, whilst I consider myself an unusually intelligent type of chap, I cannot make head nor tail of the ins and outs of how the scheme would work. Much the same thing occurred over the last decade when I, as a qualified financial adviser, could not make head nor tail out of the concept of collateralised debt obligations becoming secure investment vehicles. Turns out with those that they couldn’t, and a bunch of traders made a stack of money out of pretending that they could and a bunch of people have lost a whole lot of money in realising that they couldn’t.

    If we go down the path of an Emissions Trading Scheme, exactly the same thing WILL happen. “Emissions Credits” will be traded until it is realised that they have no inherent value, the bottom will fall out of the market, and the losers will be (again) the poor punters who invested in them, because they were “secure” and “ethical” investments. Far better for the Government to collect the money and build a hospital, or a school, or a road, or a water redistribution system or something so some good can come out of this crazy bloody religion.

  6. not going to bite james

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  8. James

    If we must head down this path, I am entirely against an Emissions Trading Scheme. The reason is that, whilst I consider myself an unusually intelligent type of chap, I cannot make head nor tail of the ins and outs of how the scheme would work.

    And yet you are more than willing to say that the design of the scheme is flawed. Discussion about the ETS is interesting though because even though people openly admitting they don’t understand the scheme, they are more than willing to criticise it for reasons that relate to how it operates. If you don’t understand, then criticise it for it’s complexity by all means but dont say it is flawed when you have nothing to back up that argument.

    As Toiletboss and you point out, not many people do understand how it will work, but unless you are directly covered by the scheme, does that matter? The majority of people do not need to know how an ETS operates to go about their business, just the same as most consumers don’t understand how input tax credits operate under the GST but still manage to shop and pay for services quite effectively. The ETS will be much the same.

  9. Dave55, my criticism was entirely its complexity. Because its complexity will inevitably lead to its use as a rip off vehicle for the less able to understand, just as collateralised debt obligations were.

  10. James

    Possibly, but I think (or at least hope) that derivaties traders have learnt their lesson from the whole securatised mortgages disasters. Besides, we are only dealing with one commodity here which is identical regardless of the industry involved. Futures (ie future permit prices) are really the only derivate likely to have a big uptake and there is already a futures market in the price of carbon. Futures markets are well understood and operate pretty transparently; only a fool speculates on the futures market of a commodity he or she doesn’t understand. For example, future traders in gold would rarelly also speculate on wheat or wool futures for example because they don’t understand the market.

  11. My concern isn’t for futures traders, or any other speculators, they can take their punts and live or die by them. My concern is for when these credits get packaged up and sold in managed funds etc where they are called some fancy name, given top ratings, marketed to advisers by institutions, and on-marketed by advisers (who actually don’t by and large understand the ins and outs of many of the investments that they recommend, simply because they cannot possibly manage to, but rely on the ratings agencies and fund summaries) to their clients.

  12. Just noticed that I referred to Joshua Gans as being one of the Authors of the Statement. This is incorrect and I meant to reference John Quiggan.

    Joshua Gans has actually picked up on the same point that I have regarding the 5th criticism here. John Quiggan has actually debated the point in the commernts and you will not John Quiggan’s acknowledgement that the moral argument that forms the basis of the critism wouldn’t apply if the targets were more meaningful.

    I honestly hadn’t read that before writing my post either.

  13. James

    Why would you buy credits for use in a hedge fund? Yes this would increase demand and artificially raise the price but ultimately you have to sell them to an emitter to realise any return and when you start doing this, this supply counters the previous demand spike. In other words, the value of the permits is higher while the fund holds them but they are not generating any income for the fund while this occurs and when they are sold, the artificual demand is removed and the price crashes meaning the fund would never make any money from the trade. At most, a hedge fund doing this would simply be acting as a bank or retailer for the permits. If you understood how a cap and trade system worked you wouldn’t be making dumb specualtive comments like this.

  14. Not sure that I ever said “hedge” fund. Please don’t refer to my speculative input as dumb. I think someone did that when I stood up at a conference and pointed out that I couldn’t recommend an “Alpha” type managed fund because I couldn’t understand how they were any different from a straight bad loan. Got told that if I didn’t understand how they worked, I shouldn’t be in the industry. Same thing when I asked how it was you could accurately value a tech stock when it doesn’t derive an income…..”it’s the new economy” I was told. Now if these carbon credits are not going to “grow” in value, then what is the point of a business dropping their emissions?

  15. James

    Apologies, I meant managed funds and not hedge funds although the same comments apply to both.

    Now if these carbon credits are not going to “grow” in value, then what is the point of a business dropping their emissions?

    Because for every tonne of CO2 emitted, the entity will need to hold and acquit a permit. A permit is essentially just a licence to emit a certain amount of GHG. If they don’t have the licence, they will be fined (probably heaviliy) In this way the need to hold a permit is equivalent to a carbon tax. The company will reduce emissions to reduce the number of permits it needs to buy. If the cost of reducing emissions is less than the cost of a permit, the company will reduce emissions until the marginal cost of abatement equals the cost of the permit.

    Your comment just illustrates what I was saying about criticising the scheme without understanding how it works. If you had understood the scheme, you wouldn’t have speculated that managed funds etc would delve into the permit market.

  16. Someone has to blindly criticise otherwise no explanation will be forthcoming. I’d like to revisit this in 5 years, because it reeks of a con to me.

  17. James,

    Cap and trade ETS schemes have been advocated and discussed for over 10 years now. It has with stood pretty solid criticism over that period. The EU scheme has been operating for about 5 years. The EU scheme (initially) failed because the Government was conned by the emitters to an extent by the emitters overestimating their emissions, resulting in a surplus of credits. Up until this surplus became apparent, it worked quite well, as did the derivative futures market. I doubt that the CPRS will be revealed as a con but I do think the free allocation of permits to industry demonstrates that the Government is being conned by industry as to their financial exposure (but I don’t think that’s what you were asserting).

    As you say though, if you hadn’t made the comments, I wouldn’t have explained why it was wrong. Hopefully my comments have helped to inform you, at least a little.

  18. They’re helping to inform me, if that’s any consolation.

    People really need to take the time to wade through this stuff; otherwise it’s all gonna come down to an eventual shitfight between the Bolts of the world & the confused & disinterested billions of others.

  19. I keep getting surprised how unconcerned people can be about the fact that that the government tells people to ‘do their bit’ and that ‘they can make a difference’ when the simple fact is that if the CPRS comes in emissions would be exactly the same regardless of whether well meaning familes spent $15k on a solar system or paid $10k over the odds to buy a Prius.

    The argument that because it lowers the permit price and reduces the margianl abatement cost of a polluter we should be happy about it all the same is bizarre. Its like saying that if you donated money to a charity only to learn that for every dollar you donated a company would donate a dollar less you shouldnt be worried because it helps increase the comapnies profit.

    Why should individuals donate cheaper permits to companies? and why does the government continue to suggest individuals can make a differnce?

    Thats the moral case for fixing the scheme or scrapping it, but lets consider the economci case. If altruistic individuals are willing to make an extra effort why would we want to discourage them by making their efforts pointless? More formally, if someone is wiling to pay for a public good, why not encourage rather than prevent them?

    Finally, its much simpler to fix this problem than most people seem to fix. For example, when the Rudd Government announced it was spending $4billion on insualtion it said that would save 49 million tonnes of emissions. Of course, waht they meant to say was that it wouldnt reduce emissions by a single kilogram as thats the CPRS works.

    But, it would be easy to reduce the 2020 target in the white paper by the amount of emissions saved as a result of theinsualtion package. simple and efficient, and fair as well.

  20. But Richard, the companies just pass the cost of permits through to their customers, so it isn’t the companies that are being subsidised but the consumers. This is why the free permits given to the emitters is such a bad idea because these permits actually have a value (whatever the price stabilises at) and can be sold. Therefore the companies, if they reduce emissions, actually profit from selling the excess permits relative to emitters that use them. Whether they pass on these savings/profits is debatable.

    The success of an ETS depends on a transparent market and the ability to pass through the costs to consumers. By doing this, the more GHG efficient industries become more cost competitive and consumer demand for cheaper products will drive investment in the lower GHG intensive industries. Free permits to big emitters stuffs up this. This is the crux of the first criticism by the economists and one I fully agree with. The problem therefore isn’t with a cap and trade system, but rather the design of this one. A well designed cap and trade scheme will provide the same price signals for investment that a carbon tax will.

  21. […] Davee55 over at Blogocrats has an interesting thread up…better pack a lunch, concerning a cap and trade oppos… […]

  22. The Scheme 😯

    You’ve got “bugs” on the .org connection.

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