Jul 5, 2008

Is Cap And Trade The Right Way To Go?

The climate change debate is really hotting up in Australia in advance of the Garnault and Government papers being released. This think piece by Warwick McGibbon caught our eye. We too have been skeptical of the adoption of the EU model. We quote some sections

What is needed is a global framework of agreed actions that take into account the environmental gains and the economic costs rather than a framework of national targets. It is not a large step to go from the current Kyoto approach into a more effective post-Kyoto approach.
The design of the Australian policy needs to be done in the national interest and not used as a short-term political football nor designed as a short-term revenue-raising device to pick winners in industry.

Is cap and trade the answer?

The standard approach of ''cap and trade'' permit markets based on the idea of ''target and timetables'' does not deal sufficiently with the uncertainty surrounding climate change. In this approach a target for emissions is picked and industry then needs to buy a permit from a limited pool if they emit carbon. The price will be whatever the demand in the market generates given a fixed number of permits.
However, this simple and seductive idea is not adequate to tackle the uncertainty that defines the climate question how much to cut or how quickly. Science does not tell us what concentrations of greenhouse gases should be sought globally in 2050. It does not tell us which of many paths of emissions reductions the world should follow.

Then what is?

Instead, what is needed are long-term markets within countries to enable the private sector and individuals to manage long-term climate risk and reduce emissions where possible at low cost. There should be clear and credible policy goals that long-term markets can value so policymakers are held accountable, innovators can innovate, and entrepreneurs can hedge their investment risk in existing and new technologies.
These are far more important than where the debate has hovered for the past year in Australia which has focused on short-term carbon prices and revenue-raising auctions of short-term emission permits. What is needed is a hybrid approach of long-term emissions trading with 100 years of future carbon prices along a carbon yield curve, but a short-term fixed price for carbon. This is how monetary policy works in Australia. The short-term interest rate (carbon price) is set by an independent authority within a framework based on an inflation goal (long-term concentration goal) set by the government but a long-term bond market (long-term carbon market) guiding long-term investment decisions given the goals of policy and the stance of the Reserve Bank of Australia (carbon bank).

Will this work?

Professor Ross Garnaut has publicly dismissed this approach for Australia while large parts of the rest of the world are considering it. Rather than following the European trading system designed in the 1990s, Australia should look forward to a framework that will encourage countries to reduce greenhouse gas emissions, knowing the maximum cost in the near term of any reduction commitment but with markets that enable risk management and clear long-term carbon-price signals.
The idea that countries should promise to hit a target no matter what it costs is what has prevented most countries from taking binding emission targets and what has caused many countries with binding targets to miss those targets.
Our empirical results show that the real story for Australia is not how we price carbon in Australia but how our major trading partners implement their climate policies and how this impacts on our fossil-fuel exports.
It is in Australia's national interest to have a global system that encourages comparative advantage through coordination of national carbon prices along the lines of the McKibbin-Wilcoxen hybrid rather than one of arbitrary targets with inefficient and potentially volatile ''cap and trade'' permit markets of the type usually advocated. Australia and the world have a lot at stake in the decisions to be made in coming months about climate change in this country. We have already waited far too long for sensible climate policy.