Date created: 12/4/07
Last modified:12/4/07
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John Quiggin

Don't hide behind economy

Australian Financial Review

13 October 2005

Back in July the Howard government announced, with some fanfare, the formation of the Asia-Pacific Energy Partnership, a six-country agreement presented variously as an alternative or a complement to the Kyoto Protocol on Climate Change. The agreement involved no commitment targets for reductions in emissions of carbon dioxide and other greenhouse gases or market-based incentives for more efficient use of energy, preferring instead to focus on technological solutions.

No concrete proposals were announced, and observers of the climate change issue have been waiting with interest for the first meeting of the group which, it was announced, would be held in Adelaide in November. Now, however, it appears that the meeting has been postponed or abandoned, and the government is saying there was never a formal commitment to hold such a meeting.

The cynical interpretation is obvious enough. The purpose of the pact, in this interpretation, was to prevent action on Kyoto by raising the prospect of alternative initiatives. Holding a meeting would require some actual commitments, and therefore has to be deferred as long as possible. A more charitable interpretation is that, while the major parties were agreed on what they did not want to do (impose effective targets for reducing emissions) they have found it more difficult to reach an agreement on what they do want to do.

While we wait to see what, if anything comes out of the Asia-Pacific Partnership, it’s worth re-examining the premise on which it is based, namely that, with current technology, it would be prohibitively costly to achieve the kinds of reductions in emissions needed to stabilise atmospheric concentrations of carbon dioxide and therefore, ultimately, global climate. The economy, it is assumed, cannot function without ample supplies of cheap energy.

It is not surprising to see the Chinese government, still nominally Communist, taking this line. The representation of technology in terms of recipes with fixed proportions of each input being essential is a central feature of old-fashioned Marxist economics, as is disregard for and distrust of price mechanisms. Lenin’s dictum that ‘Communism is Soviet power plus electrification’ is still influential, even if, in practice, capitalism is the goal nowadays.

But for anyone who takes mainstream economics seriously, the idea that a physical resource like oil or coal is essential to prosperity must be regarded as fallacious. Economic theory teaches, and economic history has repeatedly shown, that, when one resource becomes scarce, others are substituted to take its place.

Some of these effects are immediate, but others take place over much longer periods of time. For example, an increase in petrol prices may cause some drivers to take fewer trips or switch to public transport. But the full effects will only be felt over a span of decades. Assuming higher prices are sustained, car buyers will switch to more fuel-efficient models (which manufacturers will have an incentive to develop), and homebuyers will seek locations closer to work. The car fleet turns over in about twenty years, and the housing stock takes even longer.

Economists measure such responses in terms of the price elasticity of demand. Econometric studies of energy demand tend to show a low elasticity, which explains some of the pessimism discussed above. But the ‘long run’ in such studies is typically only five years. The important responses to changes in energy prices are slower than this, suggesting that if the long run is measured over decades, energy demand will prove to be elastic.

A standard calculation suggests that if carbon-based fuels account for about 8 per cent of GDP at current prices, and the price elasticity of demand is greater than 1 in the very long term, a doubling of the effective price of carbon will eventually produce a reduction in emissions of 60 per cent, at a welfare cost of around 3 per cent of GDP or one year’s economic growth.

We don’t need to rely on theoretical exercises like this, however, to demonstrate the capacity of the economy to handle price shocks. The world price of oil has tripled over the past few years, and the economic impact has been marginal. Admittedly, this increase arose from demand pressures rather than from a gradual policy-imposed increase in prices, but the example is still relevant.

When the Asia-Pacific Energy Partnership finally meets, its members will no doubt have much to say about technological solutions to climate change. They should not, however, ignore the power of market-based instruments.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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