Misleading on an ETS 'free' market

Tim Wilson, director of climate change policy at the Institute of Public Affairs, argued in last Friday’s Climate Spectator that because an emissions trading scheme doesn't meet 100 per cent of his criteria for a "free" market, it should be discarded as the most effective and efficient central policy for addressing climate change. This is a classic straw man argument, as mischievous as it is misleading.

First, does Tim accept the existence of the climate change problem? Without that acceptance his rejection of an ETS or any policy instrument to reduce greenhouse gas emissions is perfectly logical.

Furthermore, his argument that technology innovation will replace fossil fuels at some point would also make sense. Recent successes in the development of unconventional oil and gas resources mean that replacing fossil fuels would be unlikely to occur for several hundred years. Yet once the problem of climate change with its environmental impacts is accepted, Tim’s central conclusions are neither logical nor sensible.

Climate change policy begins with the need to recognise the real economic cost of the environmental damage being wreaked by unmitigated emission of greenhouse gases. This requires intervention by governments. They could simply ban or strictly limit emissions, as they have done with other social or environmental externalities, and leave it to customers and suppliers to find alternative products and services.

Yet the weight of economic opinion is that a broadly-based price on emissions (a carbon price) that will rise in a secure and predictable fashion into the future is likely to be the most effective and efficient way to address climate change.

Once you accept that premise, the result is a market. People can argue over whether it is free, but it is a market just the same.

Introducing an ETS or another market-based policy is not the end of the story, however. There are valid criticisms of such policies that must be addressed.  

The first is that the carbon market and price will be subject to political changes, thereby seriously undermining investor confidence. Indeed continual changes have been a feature of climate change policies since they began to be introduced in various countries and regions over the last decade or so.

However, political risk is not unique to carbon markets. Indeed, it is common to physical and financial markets around the world. It will take some years of stable application before markets have the capacity to price and work within the specific risks associated with climate change policies and politics. 

The second major limitation that Tim sees in an ETS and other climate change policies is that while they are very efficient in deploying today's lowest cost technologies, they are unlikely to bring forward the low-emission technologies that have the potential to be lowest cost in the future.

Grattan Institute's 2012 report, No easy choices, described both of these limitations in some detail and identified how they could be addressed. First governments can reduce investor uncertainty about whether future emissions caps will be implemented by including ETS design features such as gateway mechanisms that set upper and lower bounds on longer-term emissions caps. The Garnaut Climate Change Review and the Prime Minister's Task Group on Emissions Trading report to the Howard Government (2007) advocated such mechanisms. Second, the lived experience of ETS schemes will provide its own level of predictability, as it does with fiscal and monetary policy instruments,

Governments can also enable investors in low-emission technologies to overcome carbon price and early mover technology risks by entering into long-term contracts with project developers. These contracts would provide electricity at a price that makes the most efficient technologies viable. Grattan Institute's 2012 report, Building the bridge, explained how the use of a series of reverse auctions could select the lowest cost technologies over time.

Governments should use a well-designed emissions trading market because it is the most efficient central policy to meet the challenge of climate change. To suggest that economies will magically and spontaneously price emissions without government intervention is to deliberately misrepresent both the problem and the solution.    

Tony Wood is Energy Program Director at Grattan Institute.