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John Quiggin

Greener future is permitted

John Quiggin Australian Financial Review

6 December 2007

For the last decade, the struggle over ratification of the Kyoto protocol has been one of the central issues in Australian environmental policy. Even after the Howard government abandoned its long-standing rejectionism on climate change, entrenched positions on Kyoto continued to frame public debate.

On Monday, within hours of being sworn in, Kevin Rudd put that debate behind us. Suddenly the polemics of the past seem hopelessly dated, and attention has turned to the practical problems of implementing an economically and socially cost-effective way of reducing our emissions of greenhouse gases.

Having wasted the decade since Kyoto was signed, we are starting well behind. On the other hand, we have what has been referred to as the ‘advantage of backwardness’. We can learn from the mistakes and successes of the first movers, such as the European Union.

The biggest single problem with the first round of emissions trading in the EU was that too many permits were allocated, free of charge, to existing emitters. This is a prime example of what has been called a ‘grandfather clause’.

The term has an unsavoury history, going back to the disenfranchisement of blacks in the South of the United States after the Civil War. A variety of poll taxes and other restrictions were imposed on voters, but men who had been entitled to vote before the War (all white of course) were exempted, as were their children, grandchildren and so on.

The idea of changing the rules in a way that does not affect existing interest groups appeals to politicians in a wide variety of contexts. As a result, grandfather clauses continue to appear in all sorts of contexts, and the term has lost the pejorative associations of its origin.

Economists are less enamoured of grandfather clauses, and generally prefer a consistent set of rules, without historical exceptions. This view is supported by the experience of the US Clean Air Act. When emissions from coal-fired power plants were regulated for the first time in the 1970s, existing plants were exempted.

The expectation was that, over time, these plants would be decommissioned, and the new regulations would become universal. In reality, precisely because they were exempt, utilities kept the old plants in operation. Some even managed to build new, unregulated generation capacity under the guise of refurbishing old plants. The problem remains unresolved to the present day.

Unsurprisingly, then, the idea of issuing free permits to existing emitters is controversial. The economically purist position, put forward by Professor Ross Garnaut, is opposed to any free issue of permits. Garnaut’s policy recommendation is to sell all permits and use part of the proceeds to compensate those who are adversely affected.

Importantly, as Garnaut observes, energy-using businesses do not necessarily bear the burden of higher cost of carbon. Much of the cost of permits will be passed on to consumers, so adverse effects on low-income households is at least as important as those on energy-intensive businesses.

But the pressure to issue at least some free permits will be intense. If grandfathering does become public policy, the obvious question is how many free permits should be given out. It’s natural to think about this in terms of the ratio of free permits to existing emissions.

Obviously, since the aim is to reduce emissions the total volume of permits, free or auctioned, has to be less than the current volume of emissions. But in fact, there are very good reasons to restrict the volume of any free allocation to well below half of existing emissions.

As with any tax, explicit or implicit, the burden of a price on carbon will be shared between energy producers and consumers, typically about evenly. The requirement for a permit will raise the market price of energy services to consumers, and this will partially offset the increase in costs to producers of energy and other CO2-intensive goods and services. This means that if the volume of permits is large in relation to pre-existing emissions, producers may be overcompensated, as occurred in a number of cases in Europe.

An advantage of cash compensation is that the cost to government is obvious, so overcompensation is less likely. On the other hand, compensating energy -intensive businesses with permits rather than cash reduces their exposure to the risk associated with uncertainty about the price of permits.

On this and many other issues, the Rudd government faces difficult decisions. But at least we are finally facing the problems head-on, instead of cloaking them in obfuscation and denial.

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

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