This is an edited extract of Frank Jotzo's submission to the Senate inquiry on Direct Action. The following nine points are a comprehensive and succinct summary of the weaknesses of Direct Action.
A subsidy approach draws on the budget, and requires taxes to be levied in order to pay for it. In public discourse, Direct Action is sometimes presented as superior to carbon pricing on the grounds that it does not impose a taxation burden. This is untrue as any payments from an Emissions Reductions Fund need to be financed from the federal budget, and paid for by taxpayers.
Available analysis (for example by The Climate Institute) suggests the proposed budgetary allocations for the Emissions Reduction Fund are likely to be insufficient to achieve even the 5 per cent emissions reduction target at 2020. Increasing the budgetary allocations would no doubt be difficult, especially in the context of tighter overall fiscal settings. It is therefore questionable that the policy can achieve Australia’s current 2020 emissions target. An emissions trading scheme by contrast can automatically achieve a given national target, through access to overseas emissions units.
Overstated emissions savings at the project level
As in offset mechanisms connected to emissions trading schemes, payments under an Emissions Reductions Fund would be made for the difference between actual emissions and a (higher) counterfactual baseline of emissions. Any approach that allows flexibility in defining baselines provides project owners with an incentive to overstate the baseline. There may even be projects that receive payments for activities that would have occurred anyway (no ‘additionality’).
These problems with inflated baselines and additionality have plagued the Clean Development Mechanism, the international offset scheme under the Kyoto Protocol. At the project level, their effect is inflated payments to project owners. In the aggregate, the effect is that overall emissions savings are smaller than the sum of claimed emissions reductions under each project, reducing the cost-effectiveness of the mechanism.
Perverse incentives to withhold investment
By the same token, a subsidy approach can also create incentives to hold back investments that reduce energy use or emissions unless they are subsidised under the mechanism. This in turn has economic costs through suboptimal investment and skewed investment patterns.
Short time horizons
The proposed payment period for the Emissions Reductions Fund is five years. Project proponents will have no realistic expectations that further payments would be made beyond the initial five-year period. Therefore, only investments with payback periods of less than five years at a given payment per tonne of claimed emissions reductions will be commercially viable. This will exclude many abatement options that involve long-lived equipment, as is usually the case in energy and industrial investments.
Confined to specific eligible activities
By its very nature, an Emissions Reductions Fund can only provide incentives for activities that can be defined within a project boundary, and that have an identifiable project owner. This excludes many abatement options in broader changes in production practices, and any abatement options through changed consumption patterns such as end-use energy efficiency. This limitation has been borne out in experiences with the Clean Development Mechanism.
Large administrative burden
A project-by-project approach involves a comparatively large administrative burden on the part of government as well as participating businesses. A large share of the costs will be fixed and independent of project size, thereby putting smaller projects at a severe disadvantage. At the international level, experiences with the Clean Development Mechanism have shown that the transaction costs tend to make smaller projects unviable, and procedural costs account for a not insignificant share of overall payments.
Any subsidy approach encourages continued lobbying by potential beneficiaries. The experience with the setting up of the Carbon Pricing Mechanism has shown that Australian industries are prepared to mount a large and sustained lobbying effort in order to influence the design of climate change mitigation measures. This is unsurprising. In the case of an Emissions Reductions Fund, there is a danger that the lobbying effort will extend beyond the phase of mechanism design to the entire period of operation, with the aim of getting additional project categories included.
More broadly, any discretionary subsidy approach is in danger of fostering a culture of rent seeking with its adverse impacts on the overall economic policymaking framework.
Frank Jotzo is associate professor and director of the Centre for Climate Economics and Policy Crawford School of Public Policy at the Australian National University.