Saturday, February 12, 2011

A carbon price can't save the planet by itself

I have a love-hate relationship with economic rationalism. I have great respect for the power of market forces - individuals and firms do change their behaviour in response to changing prices - but I'm well aware of their limits.

To me the test of economic understanding is whether it's pragmatic and "evidence-based" or ideological and faith-based. Is the neo-classical model simply a tool of analysis, suited to some jobs better than others, or is it an infallible guide to the universe?

A good test for economists is their attitude to climate change. A few - particularly those associated with the Lavoisier Group and libertarian think tanks such as the Centre for Independent Studies and the Institute of Public Affairs - would prefer to deny the weight of scientific opinion rather than admit that global warming represents an instance of "market failure" needing to be corrected by government intervention.

I'm convinced the great majority of economists, however, accept the existence of global warming and the need for intervention. They argue the best way to tackle the problem is to use a carbon tax or emissions trading scheme to incorporate the cost of the damage done by greenhouse gas emissions into the prices faced by the producers and consumers of emissions-intensive goods and services, harnessing market forces in the service of the environment.

Agreed. But the next stage of the evidence-versus-faith test is whether an economist thinks "putting a price on carbon" is all we need to do the trick, or whether "complementary policies" are needed to bolster the pricing policy. Such complementary policies may involve government subsidies or tax concessions, or laws imposing certain requirements or prohibiting certain behaviour.

This issue arises because Julia Gillard is proposing to cover much of the cost of rebuilding Queensland's public infrastructure by ending or capping various government spending programs intended to reduce emissions. She's defended this by saying they'll no longer be needed once we get a price on carbon.

Actually, most of the programs she wants to chop would be no loss because they're far from cost-effective in reducing emissions. But should they be replaced by programs that are cost-effective or will the carbon price be sufficient, as Gillard implies?

The present secretary of the Department of Climate Change and soon-to-be secretary to the Treasury, Dr Martin Parkinson, is in no doubt that complementary measures are necessary.

He said in a speech last year that "the lack of a carbon price signal is fundamental, and no long-term policy solution is possible without the creation of [price] incentives to protect the integrity of our climate system and reduce the risks of dangerous climate change.

"But it needs to be complemented by other measures. These include support for the development of new low-emission energy technologies, integration of climate considerations into transport planning, provision of general energy efficiency information, and addressing split incentives in rental markets."

In a discussion paper issued this week by the Australia Institute, Dr Richard Denniss and Andrew Macintosh remind us that governments have a long history of using complementary policies to augment price-based measures in changing behaviours.

In their efforts to discourage smoking, for instance, governments used taxes to raise the price of cigarettes but also used subsidised access to quit treatment plus restrictions on advertising, sales to minors, who may sell cigarettes and where they may be smoked.

To encourage the use of unleaded fuel, governments cut the tax on unleaded but also required all cars sold after 1998 to run on unleaded petrol.

So when are complementary measures necessary and how should they be designed? Denniss and Macintosh set out six principles. First, measures should be cost-effective. The budgetary cost of measures to reduce emissions should be compared with the quantity of emissions likely to be prevented, thus expressing the cost as dollars per tonne of carbon dioxide. This can be compared with the price on carbon created by the tax or the trading scheme.

Second, measures must be in response to a clear case of market failure. It's because in practice markets sometimes fail to deliver the benefits the economists' model promises that putting a price on carbon isn't enough.

One example of market failure is "split incentives": if a tenant incurs the cost of installing insulation in a rental property, it's likely to be future tenants who capture most of the benefits. And if a landlord installs insulation it's the tenant who will benefit from better temperatures and lower electricity bills.

Another example is "public goods": sometimes people can't be excluded from benefiting from services they haven't helped to pay for, making it unprofitable for the market to provide these services in sufficient quantity. Research and development spending has this characteristic, meaning it should be subsidised by government in the public interest.

Third, complementary policies should work in conjunction with, not in opposition to, other policies aimed at reducing emissions.

For instance, the Rudd government's emissions trading scheme was designed in such a way that any reduction in emissions caused by its subsidies for households installing solar panels would simply reduce the effort required by other polluters, not add to the overall reduction.

Fourth, the complementary policies of the federal government should fit with the policies of state governments. Rudd's emissions trading scheme gave the feds all the responsibility for reducing emissions, while leaving with the states the responsibility for "adaptation" - coping with the effects of climate change - even though in some areas the states were better placed to reduce emissions.

Fifth, complementary policies should be equitable. While it's accepted that low-income earners should be compensated for the effects of a carbon price, much less attention is paid to the fairness of complementary policies.

For instance, only the well-off could afford to install photovoltaic solar panels but the cost of the generous feed-in tariffs they enjoy is borne by all electricity users, rich or poor.

Finally, complementary measures need to involve accountability. As we saw with the home insulation scheme, it's easy for such measures to be badly administered or for a lot of money to be spent without much effect, particularly where subsidies are involved.

So the objectives of complementary measures need to be spelt out clearly and the schemes need to be monitored regularly against those objectives.

It's no bad thing for Gillard to abandon those complementary measures that have proved wasteful. But the limitations of market forces mean doing no more than imposing a price on carbon emissions is unlikely to reduce emissions to the extent we need.