A rationale for government policy intervention The material presented so far provides a rationale for government intervention on climate change. This relates to: The scientific evidence that human actions are contributing to climate change – with significant impacts to the environment and society Economic theory shows that GHG pollution is an externality BCA indicates the socio economic costs of potential climate change into the future The significant ‘fat-tail’ risks and uncertainty indicate that mitigation investments are a good insurance policy 1

Mitigation & Adaptation Mitigation – actions to reduce GHG emissions Adaptation – actions taken in anticipation of, or in response to, the climate change impacts that cannot be avoided by mitigation policy [Garnaut, 2008] Next slide compares Mitigation and Adaptation policies Thus 2 core policy types: Mitigation policies Adaptation policies (separate PPT) 2

Attributes of mitigation and adaptation shocks Source: Adapted from Garnaut (2008), p.303 3

Mitigation policy options Two broad responses: Regulatory approaches (command-and-control) including direct action Market-based approaches 4

1. Regulatory (CAC) Approaches A policy that directly regulates polluters through the use of rules or standards Mandating, licensing or banning particular technologies or production techniques 3 types of standards: Ambient standards, technology-based standards and performance-based standards OR it could be government choosing to support certain mitigation technologies (involve ‘picking winners’) 5

2. Market-Based Instruments (MBIs) An incentive-based policy that encourages pollution reduction strategies Commonly referred to as ‘putting a price on carbon’ Two common instruments: C tax (emission tax or GHG tax) ETS (emission trading schemes) 6

Putting a price on Carbon Behavioural change Market-based policy instruments (Tax and/or ETS) Allow flexibility in how, where and when emission reductions are made Provide opportunities and incentives to reduce the cost of mitigation In theory, both tools can provide an efficient outcome 7

Putting a price on Carbon Here are some similarities of a C tax and an ETS: Both ETS and C tax use the power of market price signals to encourage GHG reductions Both will correct the underlying market failure Both will achieve GHG reductions at a lower cost than command- and-control and direct action approaches Both will have the potential to raise public revenues However, there are differences in practice 8

Putting a price on carbon (C tax and ETS) Marginal Cost - Social Marginal Cost - Private Permit price C tax/ Marginal Benefit – Social and Private Socially optimal 9

The Social Cost of Carbon (SCC) The difference between the marginal private cost and the marginal social cost – is the external cost of carbon or social cost of carbon. It represents the cost of an additional unit of GHG pollution in a given year The quantitative estimates of the SCC come from IAM’s reviewed in week 5. It is an important estimate as the price of carbon should be equal to the SCC (the marginal damage cost) 10

The Social Cost of Carbon (SCC) Tol (2010) in a meta analysis of the SCC concludes: A conservative estimate of the SCC is $US23 per tonne of carbon in 1995 dollars There is a 1% probability it is $US78 However the range of estimates is wide up to $2,400 The Garnaut review update suggests: A price in the range of $20 - $30 per tonne of carbon Rising by 4 per cent per annum 11

Efficient Allocation of Pollution Theory behind an efficient allocation The Damage Costs: Increases with the level of pollution – as you increase the quantity of pollution (see Figure on next slide) the marginal damage costs increase (this may not be linear as illustrated) The Control Costs: The marginal control costs increase with the amount that is abated. So moving from right to left – increasing abatement costs more (again this is more likely to be non-linear) 12

Efficient Allocation of a Fund Pollutant Derived from Tietenberg and Lewis, Figure 14.2 p.304 Marginal Control Cost Marginal Cost $ per unit Marginal Damage Cost P Total Damage Costs Total Control costs Q* Quantity Page 13

Efficient Allocation of Pollution The efficient allocation is Q* where the marginal damage costs are equal to the marginal control costs. Why? To the left of Q* control costs exceed damage costs – so total costs rise To the right of Q* damage costs exceed control costs – so total costs rise The optimal level in this case in not zero – as the cost is too high 14

Efficient Allocation of Pollution Cost effective policies Emissions standards may only achieve the optimal allocation only by chance Emission charges (taxes) would have to be set equal to P achieve the efficient allocation Below P, firms choose to abate (control) pollution as its cheaper – after P the control costs are higher so firms pay the tax. This minimizes the costs of pollution abatement 15

Efficient Allocation of Pollution An ETS (cap and trade) the total allocation of pollution permits is set at Q* The permits are freely transferable, that is, can be bought and sold (see Figure 14.6 p.314 for the 2 firm case) Firms emitting more than their allocation buy permits a the price P – at a cost less than P they continue to abate Firms emitting less than the allocation sell permits at price P and continue to abate and sell permits until the marginal cost is equal to P This flexibility of trading establishes the price P – minimising the total costs of abatement. 16

Efficient Allocation of Pollution The choice of instrument is complicated by uncertainty In particular uncertainty about information, such as the true SCC Two cases: If the marginal damage function is steep and the marginal-control cost curve is rather flat, certainty about emission reductions is more important than control costs and an ETS is better If the marginal control cost curve is steep and the marginal- damage function is flat, than a tax is more appropriate as it is better to be more certain about the cost of cutting emissions. 17

What will work? Is a C tax the answer? Or an ETS? if yes, what type of ETS is best suited for us? Tax/subsidies, Direct Action, etc. – Tinkering at the edges? More importantly how do we decide which policy is the best? 18

Policy Evaluation Criteria Environmental integrity Does it achieve what it claims? Design and cost effectiveness Is it an efficient allocation? Distributional equity How the benefits and costs of a policy are distributed among the society? 19

Carbon Tax: How does it work? Carbon Tax = GHG Tax = Emissions Tax Economic (dis)incentives because they cost the firm money Per-unit fee, collected by the government The tax should reflect the Marginal Damage caused by emissions (SCC) 17

Environmental integrity A tax fixes the price of C and allows total C emissions to vary Does not provide the same level of emission reduction certainty as ETS 18

Design and Effectiveness Consistent price signals across sectors comparative stability of C price Firms will reduce their emissions up to the point where it is cheaper to pay the tax than to reduce emissions (in- house) further BUT, can the govt. set the ‘right’ carbon tax? Depends on the quality of information. Information asymmetry (Does the regulator have adequate information on private abatement costs?; Trial-and-error approach, initially) 22

An emission tax stimulates new technologies Incentive to invest in energy-efficient technologies As new technologies are discovered by the control authority, taxes are tightened 23

Distributional Equity Double dividend as it helps to reduce ‘public bads’ (emissions) as well as generates revenue for the government Often used to lessen the burden on low-income households and trade- exposed industries 24

How does an ETS (Emissions Trading Schemes ) work? Large emitters need to acquire a permit per every tonne of emissions The number of permits is limited (the “Cap”) and should be set to generate a market price consistent with marginal damage caused by emissions Permits can be traded Emissions are monitored and audited Surrender permits at the end of the compliance year 25

Environmental integrity An ETS fixes the total emissions and allows C price to vary Provides a high level of emission reduction certainty (the ‘cap’) Relative volatility in C price 26

Design and effectiveness Permit allocation: The most politically controversial part May dampen the incentive to adjust quickly Available approaches: Free allocation (e.g. Grandfathering) Auctioning Sold at a fixed price or A combination of above Has distributional impacts 27

Design and effectiveness Grandfathering: One-off allocation based on past emissions Emit more now to get more free permits later Create barriers to new entrants New entrant buying permits inefficient Permits allocated based on expected emissions inefficient May reward higher-C technologies Disincentives to exit from the market “Use it lose it” closure rules Under auctioning firms will face upfront costs May lead to efficient decisions that fully account for C costs 28

Design and effectiveness Additional flexibility can be built in: Banking and borrowing International credit offsets A common price across countries 29

Distributional equity Offset reduction of other forms of taxing (“revenue recycling”) Rebates to selected sources to help defray compliance costs Fund programmes that could reduce transition costs, technology development, etc. 30

Emission tax vs. ETS - Summary Relative stability of C price Total amount of emissions cannot be controlled Stimulates technological advances in emission reduction Substantial information requirements in setting an optimal tax Can raise public revenues ETS Relative instability of C price High level of emission reduction certainty through the “Cap” Flexibility through C permit trade Substantial information requirements in MRV Can potentially raise public revenues 31

How will an C price flow through the economy? Source: Garnaut (2008) Source: Adapted from Garnaut (2008), p.387 32