No climate policy is perfect: here's how to choose the best one

The Australian government has pledged to the global community to reduce our greenhouse gas emissions by 26-28% below 2005 levels by 2030. The Paris Agreement suggests that this and other countries’ pledges will need to be strengthened if average global temperature increases are to be kept below 2℃.

In 2016, likely an election year, attention must and will turn to how these pledges will be kept.

Recent projections from the Australian government indicate that we are on track to meet the 2020 target - a reduction of 5% below 2000 levels. The current government’s climate change policies are contributing to this outcome.

But they will need to be re-engineered to meet the 2030 target. The Labor Party is consulting on a 2030 target of 45% reductions and will need to develop a policy that reflects its commitment to emissions trading and an aspiration of 50% renewable electricity.

Bipartisan support is essential for whatever mechanisms are adopted. Companies will not make long-term investments to reduce their emissions unless they are confident that policies are stable. To date, they have been anything but.

Choosing a good climate policy

The challenge for policymakers across the political spectrum is to construct a credible emissions reduction policy framework that satisfies multiple, sometimes conflicting, criteria.

A policy that may be ideal from a theoretical economic perspective may be too complex to secure political or community support. The criteria are:

• credibility: ability to meet current and future targets

• political viability: capacity to evolve from current policy settings and achieve bipartisan support

• flexibility: ability to adjust for changes in targets, political and technological developments

• adaptability: potential to move towards an economy-wide market-based scheme

• public acceptability: ability to be understood and accepted by the community

• low cost.

In a Grattan Institute working paper published this week we assess six policy alternatives that could do the job. These are cap and trade emissions trading, carbon taxation, intensity baseline emissions trading, emissions purchasing, regulation, and tradeable green certificates. None of the plausible policies fulfils all of the criteria.

The who’s who of climate policy

A cap and trade scheme meets many of the criteria. In a cap and trade scheme, the government releases a “capped” number of permits which carbon emitters must purchase. Demand for the permits drives the price of carbon. It is relatively easy to link a cap with an emissions reduction target and then expand in the future. Economists generally favour this approach to deliver lowest cost reductions.

However, it is complex to design and this creates challenges in terms of political support and public acceptance, as happened in the US in 2009 and in Australia with Kevin Rudd’s Carbon Pollution Reduction Scheme in 2008-9.

A carbon tax has the advantage of simplicity with a clear, explicit price on emissions, and is likely to drive low cost emissions reduction.

However, it can be difficult to set the tax level to meet a particular emissions target, and to establish a way of reviewing the price. And carbon taxes, like cap and trade schemes, impose costs on businesses that are passed on to consumers through higher prices.

The likely fatal flaw with a carbon tax is simply its name. This was illustrated starkly in 2013 when the Labor government’s fixed price on carbon provided a winning strategy for opposition leader Tony Abbott. He successfully labelled it as a carbon tax thereby severely damaging Prime Minister Julia Gillard’s credibility.

Intensity baseline and credit schemes, like cap and trade and carbon taxes, have the advantage of delivering low cost emissions reduction through a market mechanism but with less impact on prices. Intensity baseline and credit schemes set a limit (the “baseline”) on the carbon emissions per unit of output, such as tonnes per megawatt hour of electricity. Carbon emitters must pay for carbon produced above the baseline.

This type of policy was successfully applied in New South Wales from 2003 to 2012. It could be effective in the electricity sector, but is harder to extend into sectors with more uniform emissions intensity.

The Federal Government has successfully applied an emissions purchasing scheme, the Emissions Reduction Fund, to deliver cut emissions by 100 million tonnes at a cost of around A$13 per tonne. Funding from the government’s budget avoids direct price effects, but more stringent targets would require much bigger budget allocations, and this would likely become problematic.

Governments can directly regulate emissions reductions, an approach that the US has taken. Regulation can be effective in specific sectors such as applying emissions standards to vehicles, but becomes onerous if used as an economy-wide policy. The cost of reducing emissions through regulation is also likely to be higher than under market mechanisms.

Finally, tradeable green certificate schemes have been applied to the electricity sector in the UK and many US states. In Australia, the Renewable Energy Target has delivered emissions reductions in, the absence of a carbon price, at a moderate cost of around A$40 per tonne. However it doesn’t work as a broader policy.

The challenge to policy makers is significant and will be highly politicised. The task is to find solutions to the limitations of an individual policy, or to combine policies that collectively satisfy the criteria.

Our report in 2016 will contribute to this search. For example, it may be possible to build an emissions trading scheme on the core of the current government’s policies to meet the central principles of both the government and the Labor Party. There is much at stake.