The great carbon debate: part 2

In 2007, the authors presented the International Climate Change conference in Sydney with a paper, Climate Change: Getting it right, published by the conference host, the Committee for Economic Development of Australia. The article below is an edited extract of their paper, and was first published on November 17, 2007.

Why a hybrid policy is better for Australia
by Warwick J McKibbin and Peter J Wilcoxen

Many people believe that the best way to reduce greenhouse gas emissions is to specify a target for emissions and a timetable for reducing those emissions.

This "targets and timetables” approach seems like common sense and, until recently, has been the basis of most of the climate policy debate in Australia and internationally. Unfortunately, many aspects of the targets and timetables approach that look so attractive in theory do not work well in an uncertain world.

As a climate policy, however, a targets and timetables strategy is flawed because climate change involves vast uncertainties, especially in the cost of reducing emissions.

The initial step in a targets and timetables program is to establish a sequence of emissions targets and set a timetable over which the former will be achieved.

Once the targets have been adopted there are a number of policies that could be used to achieve them: subsidies for emissions-control devices; direct intervention such as mandating the use of particular devices or technologies for controlling emissions; an appropriate emissions tax; or creating markets in emissions rights based on the target.

Economists generally agree that a market-based approach is the lowest cost way to implement an emissions target. In recent years much attention has been focused on so-called cap-and-trade mechanisms, under which total emissions are capped but firms are permitted to buy and sell emissions allowances among themselves.

The cap-and-trade approach has many attractive features for conventional pollutants, but it has important liabilities for climate policy. In particular, it does not work well in a world of uncertainty.

There is a much better approach to climate policy, one that addresses the inherent uncertainties and provides credible, long-lasting incentives for reducing emissions. It is a hybrid approach that combines the best features of two market-based mechanisms used for controlling other kinds of pollution – emissions taxes and tradable permits.



Carbon Trading

The idea behind a cap-and-trade permit system is relatively straightforward. A target for emissions is chosen for a given year. Emission permits are then printed and distributed for that year. Legislation is also enacted that requires an emitter of carbon to have permits equal in number to its emissions, and to specify rules for monitoring polluters and punishing violators (for example, the penalty for non-compliance is often a very high fee).

The strength of the system is that the emissions outcome is known and specified explicitly in the policy. However, the price of an emissions permit (often called the price of carbon) will not be known until after the market clears. Moreover, it will move around with shifts in the demand for permits, and can be highly variable.

Moreover, what matters for the climate is the concentration of emissions in the atmosphere. It is not the flow of emissions each year but rather the accumulation of these emissions over time that is important.

As a result, it is important to achieve any given amount of abatement as cheaply as possible over time. Reaching a precise target at high cost in one year and then achieving the same target at low cost in another year would be inefficient because it is the sum of emissions in the two years that matters.

A conventional carbon-trading market performs poorly in this context because it targets the annual flow of emissions rather than the stock.

A better policy would be to have a flow of emissions each year that is determined in a manner allowing for cost-smoothing over time. The hybrid approach allows exactly that.



The hybrid blueprint

In a hybrid policy framework a country wishing to control its carbon emissions would issue a limited number of tradable long-term emissions permits, each of which would entitle the owner to emit one ton of carbon per year. A polluter emitting more than its permit holdings in any given year would be required to pay an emissions fee per ton of carbon in excess.

In essence, the policy would present polluters with two mechanisms for compliance: buying permits or paying an emissions tax (or any combination of the two).

The emissions fee is often referred to as a "safety value” because it would ensure that the costs of complying with the policy were not excessive. The idea of a safety valve has been adopted in the domestic debate in the United States.

This approach can be extended to allow for differentiation between developed economies by imposing a tight and tightening constraint on developed economies over time but a loose and tightening constraint on developing countries, and adapted to provide stronger incentives for technological innovation.

All versions of the approach would provide a foundation for a global system of emissions control, but the emphasis would be on coordination of national policies rather than on imposition of an overarching international regime.

Coordination would focus on achieving a common world price for carbon rather than implementing a rigid system of targets and timetables.

An advantage of this approach is that it would build the global system by starting at national level in a few countries and adding greater coordination and additional countries over time.

Moreover, it would not require global consensus and would allow individual countries scope to tailor the policy to meet their own national interests.

Most importantly, establishing clear, credible policies at the national level will be essential for encouraging the private sector investments in key energy infrastructure that will be needed to address climate change.

In summary, a hybrid policy combining a fixed supply of tradable long-term emissions permits with an elastic supply of annual permits would be a viable and efficient long-term climate policy at the national level.

It would be more credible than many alternatives, especially a carbon tax, because it builds a political constituency with a large financial stake in preventing backsliding by future governments. It thus addresses the inherent difficulty that a democratic government faces in binding future governments to continue carrying out the policy.

At the same time, the provision for annual permits allows the hybrid to avoid the inefficiencies and political hurdles that would arise with a conventional system of permits that imposed a rigid cap on emissions.

It would provide a strong foundation for investment decisions by the private sector because it would create credible, long-term returns for reducing greenhouse gas emissions.

Warwick J McKibbin is professor and director of the Centre for Applied Macroeconomic Analysis in the ANU College of Business and Economics. Peter J Wilcoxen is an associate professor of economics and public administration at the Maxwell School of Syracuse University.