Without a safeguard, Australia will burn through our emissions target

Environment Minister Greg Hunt has reason to be pleased with the result of the first auction under the Emissions Reduction Fund (ERF). The auction delivered 47 million tonnes of emissions reductions at a moderate price of A$13.95 a tonne, and the auction process worked well. There’s no reason future auctions should not also be successful.

But more broadly the government is facing two significant problems in its Direct Action plan to reduce greenhouse gas emissions and combat climate change: there’s no limit on greenhouse gas emissions, and there’s no policy to reduce emissions beyond 2020.

The ERF is one branch of the government’s Direct Action plan. Another part that could play a significant role is a proposed Safeguard Mechanism, to come into effect in 2016.

However as it stands the safeguard will not prevent businesses increasing emissions.

The climate policy pitfalls

Under the ERF, the government contracts to pay for emissions reductions with proponents that participate on a voluntary basis, presumably because they will have commercially viable projects at the price they bid.

Yet with no mandatory constraints on emissions across the economy, there is a risk that the reductions for which the government has paid are more than offset by significant increases elsewhere.

To avoid this outcome, the government has proposed the Safeguard Mechanism in the Direct Action plan. The idea is to set levels of emissions – or baselines – for specific business facilities that cannot be exceeded without penalty. Not only would businesses be deterred by the threat of penalty, they could also have an incentive to develop actions to reduce emissions that could be bid into the ERF auctions.

The problem is that because the government has said it does not want to limit economic growth, the safeguard in its current form will allow a level of flexibility in setting and revising baselines that eliminates any constraint on emissions.

For example, a business that produces emissions is looking to expand its business. Inevitably, its emissions baseline will be exceeded. Provided its expansion is efficient, it will be able to increase its baseline to accommodate the expansion. This is not a safeguard.

The second problem is that the current combination of ERF and safeguard cannot meet whatever post-2020 target to which the government commits. And the government has a commitment to set such a target by around mid-2015 as its contribution to meet the agreed international objective of keeping the average global temperature increase to less than 2C.

To meet future targets, the ERF would have to be very substantially funded beyond the current level, and the safeguard changed to provide a real constraint. Can today’s pig’s ear be made into tomorrow’s silk purse?

The allure of emissions trading

Most economists and industry groups have long argued that the best policy is an effective market mechanism with the widest possible coverage. This means a well-designed emissions trading scheme (ETS) with firm caps on emissions, international linkages, and a mechanism to efficiently protect Australia’s emissions-intensive, trade-exposed industries.

The Labor government, with good intentions, failed to provide such a model. The most telling failure of its ETS was the setting of a fixed price based on compromise and forecasts of international carbon prices that were always going to be wrong.

The Labor opposition has said it would return to an ETS, hopefully better designed, by the time of the next federal election. This will almost certainly be rejected by the Coalition. Flip-flop is a bad place to be when credible, predictable policy is needed.

A second approach would be to introduce a broadly based carbon tax. Many informed stakeholders, including Ross Garnaut, argue that this would be better than a poorly designed ETS. Yet neither party is likely to support a new tax.

So if an ETS is off the table, can a path be found that has bipartisan support and takes Australia along a low-cost path to meet future targets?

Building a better policy

From 2003 to 2012, the New South Wales government implemented a form of emissions trading scheme known as “baseline and credit” to reduce emissions in its electricity sector. The policy worked reasonably well and delivered more than 140 million tonnes of emissions reductions at A$15-$40 per tonne.

The core idea is that a baseline level of emissions is set, and then progressively reduced. Companies can choose to reduce their emissions below the baseline or, if that is too expensive, buy credits from other companies that can reduce emissions more cheaply.

This sort of policy can work effectively and relatively efficiently when applied to a narrow sector. However, it is difficult to set baselines for many participants and with broader coverage the policy becomes very complex.

There has been speculation that the current federal government considered this approach as it designed its Direct Action Plan. But it would have been paid for through higher electricity prices, an outcome that was unacceptable to the government.

Yet the key design elements of such a scheme exist in the Safeguard Mechanism. Introducing firm, reducing baselines and allowing trading of emissions reduction credits would be the necessary changes. Initially, it could apply to a manageable number of businesses, most likely those covered by the current proposal, and then be progressively expanded until it became an acceptable ETS in the future.

There are two good reasons for taking this path.

First, it builds on the current policy framework without another bonfire.

Second, it quickly becomes a real market mechanism with future potential improvements. It may just have a chance of securing the bipartisan support that is so fundamental to achieving an effective Australian climate change policy

There are many hurdles at which things could stall. But with some cool heads, the Safeguard Mechanism could still become an example of political pragmatism winning over policy purity - not a bad result.

Tony Wood owns shares in a number of energy and resource companies through his superannuation fund..