1. 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

2. 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

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

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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

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

30. 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

31. 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

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