Inside Story

An exotic answer to a real world problem

There are more straightforward ways of moving towards a low-carbon future, argues Brian Toohey

Brian Toohey 2 December 2009 2260 words

Climate change minister Penny Wong leaves the chamber after the carbon pollution reduction scheme bill was voted down in the Senate. AAP Image/Alan Porritt

FOR YEARS, some environmentalists have been campaigning to tackle global warming by establishing a market for carbon. It sounded much more respectable to opt for a “pro-market” solution than for heavy-handed government regulation. And relying on real world markets to optimise the supply of goods and services certainly has lot going for it. But this is not what the environmentalists got in Europe, and are in danger of getting in the United States and Australia. Instead, they have to confront a market for a new financial product – a right to emit greenhouse gases such as carbon dioxide – and any cuts to emissions that accompany the operation of these artificial markets will be due solely to the old fashioned government regulation that they claimed to eschew.

The distinction between markets for real goods and services and markets for synthetic financial products is not trivial. The non-metallic element, carbon, has been traded in traditional markets for thousands of years. Markets for trading artificial financial products, such as a right to emit a harmful gas, are a more recent invention. Replete with derivatives, these tradable property rights are similar to the products that helped trigger the global financial crisis. Investment banks are now busy bundling up and selling carbon credits and offsets – often with dubious links to emissions cuts – in much the same way as they sold the collateralised debt obligations and other exotic products that have done tremendous damage.

Despite the repeated claims of the climate change minister, Penny Wong, that an emissions trading scheme will give business certainty, it will do will do no such thing. Since the European trading scheme began in 2005, the price for an emissions permit has swung wildly from a few euro cents to over 30 euros. The outgoing chair of BHP Billiton, Don Argus, has noted that this type of financial product suffers from an inherent price instability that only makes it harder to make decisions to invest in new production facilities. Argus argues that a simple emissions tax would provide price certainty for many years ahead and be much less administratively complex. Brad Orgill, the former head of the Australian branch of the Swiss investment bank UBS, made similar points in recent article he wrote for the Australian Financial Review, in which he also advocated that more emphasis be placed on encouraging new engineering solutions.

Supporters of emissions trading claim that the extreme volatility exhibited by the European scheme is an aberration and won’t be repeated in future. This would only be true if the efficient markets hypothesis were valid. But the EMH was always nonsensical. It assumes that all market players are endowed with perfect foresight about price movements far into the future. A slightly more sophisticated version makes the equally implausible assumption that any errors will always neatly cancel each other out along either side of a bell-shaped probability distribution curve. Oddly, Kevin Rudd wrote an essay earlier this year in which he was highly critical of the “neo-liberal” philosophy that underpins the creation of these destructive financial instruments. But he proceeded to create a similar neo-liberal market of his own to conduct emissions trading in Australia, provided parliament ultimately concurs.

Price volatility is already besetting another exotic financial product that Rudd is relying on to meet his target for 20 per cent of Australia’s electricity to come from renewable sources by 2020. The price of this instrument – a renewable energy certificate – has fallen so low recently that it is delaying the deployment of wind and other renewable sources of power. Political expediency has left the scheme so badly designed that tradable certificates are given to technologies that either don’t produce any electricity or produce it in nothing like the quantity claimed. It would have been much simpler, and effective, to leave electricity wholesalers to buy the required renewable output in the normal marketplace.

A key feature of Rudd’s proposed ETS will add to price uncertainty by allowing local polluters to buy emissions permits and credits from overseas to meet their obligations. If overseas permits are cheaper, as is widely expected, this will put downward pressure on the price of an Australian emissions permit. One consequence will be that the local price is likely to be well below what’s needed to give big polluters an incentive to switch to the low or zero emissions technologies essential for an efficient transition to a less emissions-intensive economy.

Although you would never guess it to listen to those environmentalists who have gone into the emissions trading business themselves, “putting a price on carbon” will do nothing to cut emissions in Australia’s proposed ETS. The cuts are totally dependent on government regulation to impose an emissions cap that reduces each year. Apart from a recent minor change to accommodate voluntary cuts, the cap acts as both a ceiling and a floor on emissions. No matter how high the price rises for a permit, emissions can’t fall below the floor set by the cap.

The emissions trading market was supposed to complement the cap by making the process of cutting emissions more efficient by sending a “price signal” that encourages a move to low emissions products and processes. But massive government intervention will distort the market so badly that the “price signals” can’t work as intended.

The government will give every cent raised by the ETS to big polluters and households to compensate them for the price impact of the scheme. In the most extreme example, the compensation will more than fully offset the price impact on petrol and diesel, thus removing any incentive to cut emissions from fuels that account for about 16 per cent of the Australian total. The rest of the estimated $116 billion in compensation due to be paid between 2011 and 2020 will severely muffle the much-trumpeted signal supposedly sent by putting a “price on carbon.” Why would a “trade exposed” industry that has 95 per cent of its increased costs covered by compensation bother to take any action to cut its emissions? It won’t, until the compensation is much lower.

Much of this compensation is based in the false premise that these trade exposed industries are competing against companies that move to “dirty” third world countries to take advantage of their supposedly lax emissions standards. In fact, global companies normally use the latest technology wherever they locate, because it is more efficient than earlier versions and thus has lower emissions. BHP Billiton, for example, established aluminum smelters in southern Africa a few years ago that use the latest equipment. The smelters built thirty years ago in Australia are much dirtier; their emissions of particularly potent greenhouse gases (perfluorocarbons) are almost 75 per cent higher than the new smelters in southern Africa.

Amazingly, the Rudd government plans to give $7.3 billion to the worst polluters – the electricity generators that burn brown coal. The only condition is that they must not close down. The opposite condition – that they agree to a phased shut down – would make much more sense. Nor is there any requirement that the money be used to invest in low emissions technologies. Instead, in an unprecedented twist to Australian public policy, it is meant to compensate for a loss in capital value. All the generators have to do is keep pumping out huge quantities of CO2 – about 11 per cent of the nation’s total emissions.

SOME commentators argue that it doesn’t really matter if the government wastes $7.3 billion that could otherwise be spent on helping to deploy clean generating capacity, because the cap can still deliver any nominated target for cuts to emissions. But this is a highly inefficient way to deliver the cuts. Relatively clean industries will be squeezed to make up for the cuts avoided by the dirtiest generators. If cap is really the driving force behind the cuts, why go to all the trouble and expense of setting up an artificial market to generate an impotent price signal? After all, nothing is gained by establishing an artificial market to enrich bankers, brokers and traders, including the new breed of environmental entrepreneurs who confuse a high turnover for new financial product with a serious response to global warming.

Even if the government did not distort its ETS by paying polluters to keep polluting, not much faith should be placed in price signals to cut emissions. Small consumers of electricity, for example, will not bother to change their behaviour in response to relatively low price rises. As should be clear by now, politicians will never let prices rise to the level where they hurt enough to induce a change in the desired direction. This is one reason why International Energy Agency officials suggest that mandatory improvement in energy efficiency for household appliances would produce a better result. Similar arguments have convinced several leaders to apply mandatory emissions standards for cars. Rudd refuses to do so, even though his ETS does nothing to reduce vehicle emissions.

It is a different story for the handful of industrial plants that consume large amounts of electricity generated by coal. The size of their electricity bills has long made most of them pay a lot of attention to energy efficiency. The best policy in these circumstances is to encourage the deployment of much cleaner generating technology.

Another problem with emissions trading is that it assumes – in line with neoclassical economic theory – that a wide range of competing technologies are sitting on the showroom floor waiting to be put to use once the dirtier versions become a little dearer. If suitable clean technologies don’t exist, a price signal from the ETS is assumed to call them into existence. Apart from the way the price signals are muffled, or full negated, by the huge offsetting payments, the ETS ignores the private sector’s reluctance to invest large amounts in the necessary R&D because of the risk that they won’t obtain a big enough return.

This is one of the reasons the Garnaut report recommended that at least $3 billion should be allocated from the ETS each year for this purpose. Rudd has decided, however, that not a cent of that revenue will go to helping commercialise the clean technology crucial to efficient cuts in emissions. Instead, all money has to come from the general budget. But spending clamps mean there will be almost no increase in existing funding, which averages about one-tenth of the amount Garnaut recommended should be spent over the next few years.

This is one reason for replacing the heavily compromised ETS with a simple, low-priced tax or levy. The key to success is to avoid relying on the price of the levy do all the work of cutting emissions. Some ETS supporters accept that a levy would deliver price stability but say that it couldn’t meet targets for emissions cuts. Just as with the ETS, however, any target can be met by covering a shortfall with carbon credits from overseas. Because the government would do the buying, the difference is that there would be a better chance that the credits are based on genuine abatement measures.

One suggestion is for a levy to start at around $10 a tonne of CO2 – instead of the estimated $26 for a pollution permit under the earlier ETS auction. The price could increase annually by $2 until 2020. The low initial price would remove the justification for compensation, with pensioners automatically covered by indexation to average earnings. Even at $10, a levy would raise about $5 billion, enough to fund the $3 billion a year Garnaut recommended for developing low emissions technologies. The rest could be used to promote energy efficiency, fund adjustment assistance for displaced workers and buy abatement credits that include those generated from storing emissions in soil and vegetation.

After initial research grants have been allocated in the standard fashion, governments should give potential operators a bigger role in determining what type of demonstration plants get subsidised. Although it has only budgeted a total of $1.3 billion over the next four years for its Clean Energy Initiative, the government has allocated the bulk of the money to carbon capture and storage projects for coal-fired generators. Solar energy also gets a disproportionate amount of the available funding, leaving almost nothing to be split between promising alternative sources of power such as geothermal and wave, let alone carbon capture and storage options involving biochar and algae.

At present, secretive governments panels decide which projects are funded. It would be better to rely on a more market-oriented approach by pooling this money and dividing it up in proportion to how much capital the applicants raise in the private sector. A similar process could still apply to the $7.3 billion announced for the generators, by splitting it between all firms with a financial commitment to deploying low or zero emissions technologies. The Australia Institute’s Richard Denniss has suggested another option: the government could call for bids to share $10 billion and allocate it to those who show they can produce the biggest cuts to emissions per dollar.

Environmentalists who focus on exotic financial products to cut emissions should shoulder some of the responsibly when the ETS proves a severe disappointment. There is no need for financial engineers to get a look in when so much work has to be done by real engineers to address the problem. •