Date created: 28 November 1996

Last modified: 18 November 1997

Maintained by: John Quiggin

John Quiggin

Greenhouse gas sums don't add up

Australian Financial Review 17 December 1996.

For some time the Australian government has been seeking to break its commitments to the international community to cut emissions of greenhouse gases back to 1990 levels. This position has been backed up by a recent ABARE report claiming that keeping the commitment would impose losses equivalent to a reduction of $7600 in the savings of the typical Australian family. That sounds pretty scary. Even though the readers of the Financial Review are better off than the average Australian, there are few who could easily afford a loss of $7600.

ABARE got its estimate by calculating the present value of reductions in per capita GDP between now and 2020 projected to arise from implementing the commitment. Let's put the same numbers in some different ways. Assuming an average annual GDP growth rate of 3.5 per cent without the greenhouse commitment, ABARE's estimate is that implementation of the commitment would reduce the growth rate to around 3.48 per cent. Alternatively, we may say that, if Australia breaks its commitment our children can expect to enjoy double the 1990 level of per capita income around Jan 1, 2025. If we keep our word, that happy day will be deferred until about March 1 of the same year. Put this way, the loss from keeping the commitment appears trivial.

Neither of these ways of presenting the evidence is very helpful, but the ABARE calculation is particularly unhelpful. The most straightforward way of presenting the results of the study is to say that keeping the commitment will reduce per capita income by about 0.5 per cent by 2020. In converting this modest, but not insignificant sum, into a loss of of $7600 from the average household's savings, ABARE took at least two very dubious steps.

First, the present value calculation used a real discount rate of 5 per cent, which is reasonable in evaluating public projects and the like, but not in converting flows of household income into lump sums. A present value calculation of this kind is appropriate only if households can borrow or lend as much as they wish at the relevant discount rate. Very few Australian households face a real borrowing rate of 5 per cent. For sums of thousands of dollars at short notice, the scenario suggested by the ABARE estimate, most households would face real borrowing rates of 10 to 15 per cent, if they could raise the money at all.

Further problems are created by the use of the mythical average family. Calculations of changes in average income are misleading enough. Australia's per capita income is about $25000, so the 'average' family of four used in the ABARE calculation has a household income of $100 000. Because of the uneven distribution of income this mean value is much higher than the median. But by expressing results in terms of income rather than wealth, ABARE makes matters much worse. Wealth is distributed much more unequally than income. ABARE's mythical average family has net physical and financial wealth of about $400 000, but at least 90 per cent of families have less than this average. Taking natural resources and human capital into account the World Bank has estimated a per capita wealth of $1m, or $4m for the 'average' family of four. The World Bank number is an overestimate, but even so, with such values for average wealth, average loss of $7600 is hardly catastrophic. In fact, the basic principles of present value analysis show that a permanent reduction of 0.5 per cent in income is exactly equivalent to a reduction in wealth, including human and natural capital, of 0.5 per cent.

Despite the lofty ideals expressed in charters of Budget honesty, the use of this kind of presentational trick appears to be increasing. When governments want to make small expenditures, or small savings in expenditures, look big, they have taken to expressing them over three or five or seven years. The use of a present value calculation simply takes this process to its logical extreme.

The Howard government has already reached this extreme with the $1 billion environmental fund which is part of the political payoff from the proposed part-sale of Telstra. I leave aside the points that an asset sale generates no net increase in wealth, and therefore cannot be legitimately used to finance current expenditure, and that the proposed sale price will actually reduce the net present value of government income evaluated at the ABARE rate (correct for this purpose) of 5 per cent.

Even if the $1 billion were a genuine windfall, it would finance a permanent expenditure program of only $50 million per year. This would certainly be helpful, but it is far from being the biggest environmental initiative ever undertaken in Australia. The government proposes a higher level of expenditure but this leaves open the question of what will happen when the notional $1 billion runs out.

If we are to take the idea of transparency seriously, it might be helpful to add another clause to the charter of Budget honesty, as follows: governments should express all monetary sums in terms of annual flows, or else explain why they are not doing so.

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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