This article by Dr Jane O’Sullivan provides a thorough critique of carbon reduction approaches based on production and argues instead for a straight-forward model that targets carbon consumption working along very similar lines to the GST/BAS processes with which we are familiar. Dr O’Sullivan’s intelligent well-informed arguments are impressive and hopeful.

Cap and Trade on a hiding to nowhere. – by Dr Jane O’Sullivan

Whose side are you on in the debate over carbon trading?  You could be forgiven for not buying into this one.  The arguments from both sides are confused and inconsistent and the media commentary has focused more on whose interests are being peddled than on the logic of their case.  But perhaps you should make an effort to understand it because it just could make the difference between a policy that may save the world and one that won’t work at all.

Internationally the one thing nations agree on is that we need a price on greenhouse gas emissions.  Britain’s Sir Nicholas Stern described climate change as ‘the greatest market failure in history’ because the costs of climate change are not borne by the people making decisions to emit greenhouse gases.  That’s you and me creating a demand for emissions-generating activity through just about everything we buy.  If the environmental cost were added to the price we pay we would be encouraged to find less polluting ways to meet our needs.  That’s referred to as a carbon price signal – carbon in this instance being a rather inaccurate but convenient shorthand for greenhouse gases.

The Rudd Government’s Carbon Pollution Reduction Scheme or CPRS is intended to do just that – to put a price on emissions.

The CPRS is what’s called a ‘cap-and-trade’ system.  It only directly affects our biggest polluters about a thousand companies who account for around 70% of Australia’s emissions.  That doesn’t mean they’re the bad guys – they’re just polluting on our behalf by making our electricity delivering our food and making the materials for our homes and possessions.  Each of these companies will have to submit permits to account for all the emissions they make.  The Government will release a limited number of permits annually (that’s the cap bit) and companies can buy them at Government auction or buy and sell to each other or buy additional permits on the international market.  International trade means that emissions here in Australia might go above our cap but in theory they would be off-set by reduced emissions elsewhere.  To give companies some certainty on the maximum cost to them Government will set a maximum price for permits at least for the first few years.  It’s called the price cap.  That’s a different cap to the quantity cap.  Are you confused yet?  Oh and another thing you’ve probably heard talked about: at least for an introductory period most of the biggest emitters will get most of their permits free by government handout to reduce the disadvantage they will suffer in international competitiveness.

The CPRS is not popular – both business and environmental lobbyists oppose it and it was recently rejected in the Senate.  But Government members have put up the shutters.  Anyone who’s against the CPRS is against action on climate change they insist.  Now the party politics of this don’t much interest me but the climate change impact does.  And I’m going to argue the CPRS is a mistake.

I think we risk loosing sight of the real goal by focusing on a carbon price.  What we really need is a reduction in greenhouse gas emissions.  That is we need behavioural change –  we need people to decide to do things differently or to do different things in ways that generate less greenhouse gas.  How will a price on carbon achieve this?  Market theory says that the higher the price the less people will use.  But it’s not as simple as that.  It is not the price that determines consumer behaviour.  It is the difference in price between viable alternatives.  Have you noticed many people using less housing since the prices doubled?  If there is no alternative we simply accept the going price and adjust our expectations.

So how would the CPRS affect consumer behaviour?  The carbon price component of any goods and services we buy would be completely invisible to us.  Even if we went to the trouble of finding out what emissions were involved in making a particular item or service we would not know how much we are paying for them.  Each company may be paying a different price for carbon depending on what they’ve negotiated in the emissions permit market.  So we consumers would only have an indirect price signal.  We might expect a high-emissions product to be more expensive than a lower-emissions alternative.  But in fact we might pay more for a relatively low-emissions alternative produced by a small company who is paying the cap price for their permits than for a high-emissions alternative produced by a large company who is getting their permits cheaply on the international market or imported from a country without a carbon price.  Looks like a pretty muddy price signal to me.

Nor is there any effort within the CPRS to provide viable alternatives to high-emissions activities.  None of the revenue from the sale of permits is earmarked for creating alternatives for example for expansion of the rail freight network or providing safe dedicated bikeways for city commuting or a smart grid to prevent electricity supply problems from increasing proportions of intermittent renewable power sources.  Without alternatives small shifts in price will not change behaviour much – in economist language the elasticity of demand for emissions will be low.

But it doesn’t matter what the little consumers do says our Government.  It only matters what our big emitters do.  The behavioural change the CPRS hopes to achieve is in the major emissions-generating businesses.

What can we expect from them?  They can respond in several ways to the price signal.  The scheme intends that they will reduce their emissions but they’ll only do this if it can be done cheaply and doesn’t challenge their core business.  Alternatively they can just pass on the extra cost to their customers.  But they don’t want to lose custom so they’ll avoid this unless consumers have no viable alternative.  That is they’re happy to raise prices just as long as it’s not likely to cause behavioural change.  Alternatively they can engage in the international trade of permits and pay developing countries a paltry sum for a promise not to cut down forests thereby reducing their carbon price.  Or they can rearrange their business so that the emissions-intensive activities are separated into smaller independent units that don’t qualify for obligations under the CPRS.

A further option for them which is the subject of much of the political debate is that they can pack up shop here and move their operations to another country that doesn’t charge for emissions.  Our national emissions would certainly drop as a result but global emissions wouldn’t and we’d lose a lot of jobs.  Businesses have a legitimate complaint here as a cap-and-trade system would disadvantage trade-exposed industries who are competing with others on an international market.  That applies not only to our exporters but also to our domestic producers who compete with imports.  The Government has acknowledged that complaint and has allowed trade exposed industries considerable exemptions and free permits but it’s a partial fix that would be wound back over time and in the mean time it puts even more pressure on other sectors to make up the required emissions reductions.

Businesses are complaining about the jobs leakage and unequal compensation and environmentalists are complaining about the emissions leakage as emissions move overseas with the jobs and with the international trade in permits.  Because both business and environmentalists are dissatisfied with the proposal the Government thinks they’ve got the balance about right.  But this assumes these two groups are pulling in opposite directions.  What if they are both complaining about the same fundamental problem with the CPRS?  What if an alternative system would eliminate that problem?

The problem comes from basing the system on emissions produced in Australia in contrast to emissions consumed in Australia.  A production based system counts domestic production and exports but not imports.  A consumption based system exempts exports but taxes imports.  It might seem like a petty distinction – globally imports equal exports so it wouldn’t matter if their emissions were accounted for where they are produced or where they are consumed.  It wouldn’t matter if everyone adopted the same system at the same time.  But they won’t.  A production based system strongly disadvantages early-adopters and rewards the laggards who get the jobs that move away from the adopters.  Those who produce a lot of stuff for other countries like China would be disadvantaged and those who import a lot of stuff and export mainly services like Singapore would get off lightly.  A consumption based system is fairer: it’s a user-pays system.

And a consumption-based system is trade-neutral.  No disadvantage to trade-exposed industries so no need for compensation or exemptions.  It doesn’t matter when others adopt a tax or what price they apply any more than it matters to us what GST or VAT other countries charge.  Nevertheless it makes it easier not harder for them to follow suit.

How did we come to have this CPRS proposal and not for instance a consumption-based carbon tax?

The answer to this is partly historic and partly ideological.  The historic part is that the Kyoto protocol is based on accounting of emissions produced in each country and hence reduction commitments have been focused on a production basis.  No accounting system exists to trace the emissions generated in delivering each product to a consumer so national consumption figures are not available.  But a consumption-based carbon tax would automatically generate that accounting as I’ll soon explain.  Instead of promising to reduce emissions by 25% compared with 1990 levels we could promise to reduce by for example at least 4 % per year.

The ideological part is the market ideology favouring cap-and-trade over direct tax.  In theory cap-and-trade offers more direct control on the total quantity of emissions allowing the price to adjust so that these emissions are rationed to those willing to pay enough for them.  A carbon tax in contrast sets the price and allows that price signal to adjust the quantity.

But while cap-and-trade sets the quantity of permits it doesn’t really limit the quantity of emissions.  An unlimited international trade in permits will expose the Australian system to the highly questionable emissions reductions claimed under the Clean Development Mechanism (CDM).  Purchasing these permits means no emissions reduction here in Australia in exchange for a probably temporary delay in emissions in a developing country.

Furthermore companies that hold fewer permits than their emissions at the end of the year will simply pay for the extra emissions at the price-cap rate.

The price cap is effectively a carbon tax.  It is just a production-based tax that applies only to big emitters and therefore as we’ve seen one with enormous potential for perverse behavioural change and little for effective behavioural change.  If seen in this light the entire emissions trading system is nothing more than an elaborate tax evasion mechanism.  It merely allows companies to secure their permits at less than the capped price.  As with all tax evasion mechanisms the biggest players benefit most.  They are the ones who can employ international carbon traders with enough clout to drive down prices.  The little guys will be stuck with the price they pay at Government auction.

There is another inherent problem with cap-and-trade.  You see the cap also becomes the floor.  It is not possible to draw down emissions faster than the trajectory set by Government targets.  If the Government targets are too weak to prevent dangerous climate change that is what we’re stuck with and personal action counts for nothing.  Voluntary actions by you or me will only benefit emitters – by bringing down the demand for permits and therefore their cost.  Penny Wong has attempted to accommodate this complaint under an add-on scheme allowing people with solar panels to retire their renewable energy certificates instead of selling them into the permits market.  This only slightly reduces the problem as it doesn’t do what really matters which is to reward people who simply consume less.  The CPRS might even cause an initial jump in emissions as people abandon their self-restraint in frustration.

A consumption-based carbon tax in contrast sets a uniform and visible price signal throughout the economy.  It is inherently equitable and therefore likely to gain public acceptance.  Although it doesn’t directly control the quantity of emissions it will allow the quantity reductions to be achieved at a lower price because the price signal is more effective and because we avoid all those traders siphoning off their cut.  (You may have heard people argue that trading permits will result in reductions for the lowest cost.  This is not true because a direct consumer price signal maximizes demand elasticity while a hidden producer price signal minimizes it.)  And the price will be predictable giving businesses certainty.  The value of the tax may go up over time but the total cost to the economy may not as the quantity of emissions being taxed will fall.

How painful would such a tax be to our economy?  If it were introduced at a starting level of $10 per tonne which is the proposed price cap for the first year of the CPRS and if it applied only to fossil fuel emissions in the first instance it would be the equivalent of a 1% increase in the GST.  If we replaced the GST with a carbon tax and set the rate in order to raise the same revenue we could charge over $100 per tonne straight away with no net cost to the economy overall.  That would make most renewable energy and low emissions technologies profitable in their own right without costly Government subsidies or rebates or feed-in tariffs.  At no extra cost to the economy overall.  Yes your power bill would go up and so would the cost of everything that takes a lot of energy to provide.  But that would be off-set by all the GST you wouldn’t be paying.  And you have the option of changing the way you consume in order to reduce the cost to you.  That’s the whole point.  Behavioural change.

I gave the example of swapping the GST for a carbon tax just to illustrate the scale of economic impact we’re talking about.  It’s not that scary after all.  But there are a number of options for the tax rate and timing and for what to do with the revenue that we don’t have time to explore right now.  Let’s just imagine for illustration that the tax is introduced at $15 per tonne and ramped up to $150 over 10 years with subsequent changes depending on the emissions reductions we’ve achieved.  Let’s propose that 20% of the revenue is used for clean development and climate change adaptation projects in developing countries 20% for creating low-emissions alternatives here in Australia and the rest returned to people either by equal payment per person or by reducing the GST or some other mechanism such as simultaneously adding an amount to all welfare payments and to the tax-free threshhold.  While the idea of replacing the GST with a carbon tax is attractive at face value it’s not so wise to replace a tax base that grows with the economy with a tax base that’s intended to shrink over time.

Contrary to popular belief a consumption tax would require less complex accounting than is proposed in the CPRS.  The accounting needed would be very similar to that currently undertaken for the GST – so similar that it could be reported on the same business activity statements.  The producers or importers of fossil fuels would pay a tax for their emissions at the point those fuels enter the market.  Other sources of emissions such as lime (for cement or agricultural use) or methane-producing activities may be included in the scheme when adequate monitoring is in place.  Producers would have to demonstrate that they have passed on the full tally of carbon units to all their clients and declare it on tax invoices to their clients in the same way that they demonstrate the collection of GST.

Each intermediate business would not need specific expertise on monitoring emissions from various sources as the CPRS requires of them.  They would only need to keep accounts of the units of carbon and the value of tax that they incur and charge.  They would be expected to demonstrate a balance on their business activity statement allowing for any change in inventory held and a limited amount of carry-over from one period to the next.  Carbon units incurred on purchase of capital items would be claimed in the period and proportion that a tax deduction is claimed that is for the amount depreciated or the deferred loss claimed in the reporting period.  Businesses would need to distribute all the emissions incurred to the products and services they provide.  They would have flexibility about how they do this such as a uniform amount per dollar charged or an overheads amount on top of the emissions attributable to each item when they received it or a separate charge for different activities based on their energy intensity.  It doesn’t matter as long as the total charged to clients equals the total incurred by the business.  Market forces will encourage them to attribute the emissions as accurately as practical to the items that incur them.

The beauty of this system is that each business’s decisions about their own energy efficiency energy sources choice of transport modes waste reduction et cetera impact on the carbon price they must attach to their products.  Behavioural change at all levels counts.

The value of the carbon tax may vary from time to time by government decision (somewhat like shifts in interest rates) and businesses will be holding inventory at the time of the price change.  So it’s important for the preservation of the embodied emissions record that it is the units of emissions that are passed on not the value of the tax paid.  This might be most easily managed by following the GST system of claiming the value of all carbon tax incurred and paying the value of all carbon tax charged.

The idea is that the tax is always passed on to the end users – that’s us as it’s our decisions not the producers’ decisions that control demand for emissions.  Not only would we have a price signal in the total price paid but our invoice would show how much of that price is due to carbon tax.  So whether you are motivated by economics or ethics you would have the information you need to make choices.

Exports would claim a rebate according to their tax invoice.  This invoice would provide a statement of embodied emissions that the recipient country can base their tax on.  Imports would be taxed on estimated embodied emissions including their transport.  Other countries with a carbon tax may be advantaged by being able to supply a more accurate emissions statement.  These border adjustments are just like the GST and are quite compatible with WTO rules.  So no compensation would be needed for the trade-exposed industries and the burden would be more equally shared across the economy.

But don’t we need a carbon trading system to get money to developing countries to help them curb their emissions?  Well actually internationally traded permits don’t achieve a net benefit by doing this.  Yes some potential emissions in developing countries may be avoided by paying them not to emit.  But these emissions will be replaced with extra emissions by us over and above our cap.  And the emissions reductions will not count towards their national targets because they already count towards ours.  We will get their easy reductions and leave them with the hard yards.  Yes we do need funding flowing from developed countries to developing countries.  But it must not transfer ownership of the reductions and it should be directed to those most in need of help not those most able to demonstrate carbon credits.  It would be better for a percentage of our carbon tax revenue to be tithed to international assistance for low-emissions development and for climate change adaptation measures.  These emissions reductions would then be additional to ours not off-set by them.

What will happen if we introduce the CPRS?

Treasury thinks that Australia would meet most of its obligations by buying international permits without having to reduce emissions here much at all.  The problem is Europe and north America have the same expectation and as George Monbiot demonstrated in a recent column in the Guardian there just aren’t enough avoidable emissions in developing countries to go around.  That is unless they are packaged into futures and derivatives that exchange hypothetical future potential sequestration for real present emissions and ensure that the system is impenetrable to scrutiny.  That charade can’t go on for ever.  Michael Porter director of research for the Committee for Economic Development of Australia warned ‘A carbon finance bubble could eventually dwarf the recent Global Financial Crisis problems’.

In the mean time any emissions reductions Australia achieves will probably be due to shifting production overseas with no net impact on global emissions.  Voluntary efforts will have dried up in disgust.  Our renewable energy industries and energy efficient technologies will continue to languish due to lack of profitability.  International progress on greenhouse commitments will have stalled because developing countries will refuse to pull their own weight as well as ours and will not introduce a system that hurts their export industries.  And with them accounting for more than half of current emissions climate change mitigation will be going nowhere.

Kevin Rudd argues that we need to pass the CPRS so that we go to Copenhagen with a strong position.  It is far more likely that passing the CPRS will impede international agreement at Copenhagen.

But most commentators believe that the political process is too far down the track and there is no going back.  Why bother to talk about alternatives to the CPRS at this stage?

I may be spitting in the wind but I’m in good company.  The world’s most renowned climate scientist NASA’s James Hansen doesn’t mince words calling carbon trading ‘worshipping in the Temple of Doom’.  He described the American proposal as ‘less than worthless because it will delay by at least a decade starting on a path that is fundamentally sound from the standpoints of both economics and climate preservation’.  Robert Shapiro Clinton’s former undersecretary of commerce said ‘Cap and trade has proved very vulnerable to vested interests and is therefore too weak to deliver the necessary emission reductions’.  The Committee for Economic Development of Australia has released a report with contributions from a range of eminent economists highlighting problems with the CPRS and advocating a carbon consumption tax.

To accept the inevitability of the CPRS is to accept that it’s too late for effective action on climate change.  The ACF and WWF (almost alone among environmental groups) defend the CPRS as an incremental step in the right direction.  I believe it’s a step on the wrong path.  We haven’t got time for detours.  We’re already too late to avoid dangerous climate change but strong action now is our best chance to minimize catastrophe.  If we accept the CPRS we will have blown it.