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Practical realities of carbon trading

By Des Moore - posted Friday, 27 April 2007


I begin with a disclaimer.

My disclaimer is the same as Nicholas Stern’s when last month he addressed the National Press Club in Canberra. Stern then declared he was not a scientist but then proceeded not only to accept the so-called consensus but to use it to call for urgent policy action globally to reduce CO2 emissions.

As (like Stern) a former senior Treasury officer, I also declare that I am not a scientist but, by contrast, I take a position similar to the Dual Critique of the Stern Review by 14 well-qualified scientists and economists. Their conclusion was that the Review is “flawed to a degree that makes it unsuitable … for use in setting policy”.

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I also agree with the not dissimilar conclusion on the IPCC’s February report by ten qualified economists and scientists, including Australian meteorologist, William Kininmouth, in a February 2007 publication by Canada’s Fraser Institute.

One reason for my view is related to that given in the CSIRO’s 2001 publication on Climate Change Projections for Australia (PDF 1.65MB). It was there correctly acknowledged that, as projections based on results from computer models “involve simplifications of real physical processes that are not fully understood”, no responsibility can be inferred for conclusions reliant on the results.

This gels with my experience of formulating policies in the world of economic modelling. That taught me that modelling of possible outcomes reflect assumptions that are not necessarily correct about the weightings given to possible influences, or about the simplifications of highly complex human relationships. My analyses of past scientific predictions also suggest to me that, when looking to the future, science faces modelling problems similar to economics and has made as many if not more erroneous predictions.

But what you may ask has this got to do with assessing the possible size of the global carbon market?

Quite a lot, I suggest.

If there is uncertainty about the underlying analysis behind the IPCC type predictions of increased temperatures, and the associated causes of recent global warmings and what action governments might take in response, that is likely to make sensible individual governments cautious about the severity of policies adopted to reduce emissions.

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Among those expressing uncertainty is our highly respected Productivity Commission. In the Commission’s key points of its recent submission on Emissions Trading it stated the following:

There is a growing consensus that the anthropogenic contribution to climate change could pose serious risks to future generations and that co-ordinated action is needed to manage these risks. However, uncertainty continues to pervade the science and geopolitics and, notwithstanding the Stern Review, the economics. This is leading to divergent views about when and how much abatement effort should be undertaken.

Another example comes from New Zealand where the Executive Director of the Business Roundtable made the following statement accompanying the BR’s submission in response to discussion documents issued by that country’s government:

New Zealand should move cautiously and in line with key trading partners … It should not proceed with ill-considered actions that could involve large costs for firms and households, seriously damage the New Zealand economy, and have no discernible impact on global warming.

These and other analyses raise a question as to whether the conclusion reached by the IPCC in its February presentation of The Physical Science Basis (PDF 1.25MB) does actually provide a satisfactory basis for major policy action to reduce emissions. For example, its conclusion that it is 90 per cent certain that most of the recent warming is due to increased human activity is the weakest acceptable level of confidence in a hypothesis test.

Caution about policy action is enhanced to the extent there is a wide range of possible temperature outcomes and/or of costs of mitigation or business as usual policies. For example, Stern claims a mitigation cost of only 1 per cent of GDP a year for reducing emissions by 60-90 per cent in industrial countries by 2050. That estimate is derived, however, as an average of “most” of the estimates stated to be “clustered in the range of -2 per cent of GDP to 5 per cent of GDP”. But it is also stated that estimates outside this cluster range from -4 per cent to +15 per cent of GDP.

Perhaps times have changed but when I was in Treasury an average derived from such a wide range of possibilities would have provided only limited confidence for recommending major policy action. There are similar reservations about Stern’s claim that business as usual would cost 5-20 per cent of GDP a year.

Individual governments will be additionally cautious if there is doubt about support by major emitting countries for policy reducing measures. At present there is no sign of developing countries joining the emission-reducers league in any substantive way. On a business-as-usual basis (BAU), emissions of CO2 by China and India alone are projected to increase from 18 per cent of the world total in 2003 to about 30 per cent by 2030 and, surprisingly in view of his advocacy of urgent global action, Stern himself appears readily to accept that those two countries are unlikely to adopt a national cap on emissions before 2020.

With emissions of CO2 by all non-OECD countries projected to increase from 48 per cent of the world total in 2003 to 60 per cent in 2030, individual governments have every reason to proceed cautiously unless a global agreement emerges.

CO2 produced in developing countries can, of course, still be part of a carbon trading market if businesses in developed countries invest either directly or indirectly in developing countries in ways that make them eligible for obtaining carbon credits. However, the scope for genuine trade-offs of such a nature seems relatively limited unless developing countries set emission limits themselves.

Media reports of increased carbon-trading with developing countries such as China and India suggest that a significant proportion of the credits currently being obtained may involve emission reductions that are either limited or that relate to more energy efficient investment that represents current state of the art technology.

Even so, the availability of such trading for Australian businesses - and of potential trading with businesses in countries that operate trading systems - does raise the question of whether Australia itself actually needs an officially organised trading market. The setting of official emission limits for certain Australian businesses would quickly lead financial institutions to develop the market without official involvement. Indeed, the adoption by some businesses of carbon neutral policies in Australia is already involving purchases of carbon credits overseas.

Doubts over the possible extent of policy action by the United States are also relevant to policy determinations by individual developed countries such as Australia. Although recent changes in the United States political and judicial situations foreshadow more politically serious attempts to reduce emissions in that country, it must remain doubtful that the US will move in the foreseeable future to an actual carbon-withdrawal position.

A major component of any emission reduction program for the US (and for countries such as Australia and Canada) would likely involve the replacement of coal burning electricity power stations with nuclear power that could double electricity costs and would presumably need to be spread over a considerable period of time.

Taking account of such possible adjustment processes, if the US about halved the current BAU projected rate of growth (1.1 per cent pa) of CO2 emissions over the period to 2030, it would then still be the second biggest emitter (after China) and emissions by non-OECD countries plus the US would have increased by 87 per cent since 2003.

One projection of the outlook for total world emissions to 2030 might arguably be to assume that OECD Europe would by then have cut its emissions of CO2 by 30 per cent (compared with 1990), that developing countries would continue on BAU, and that OECD North America and OECD Asia would have halved their current projected rates of growth. In that event the world total in 2030 would still be over 50 per cent higher than in 2003.

All this suggests that, for international competitiveness reasons alone, most individual countries which decide to adopt or further pursue policies to reduce their own emissions are likely to set any overall targets at relatively low levels and increase them slowly over a period.

The Productivity Commission has specified this and other reasons for adopting such an approach and the terms of reference of the joint government-business Task Group state specifically that, in assessing Australia’s further contribution to reducing greenhouse gas emissions, Australia’s “major competitive advantage through the possession of large reserves of fossil fuels and uranium … must be preserved”.

If this is the case it will be another reason for expecting the potential size of any carbon market to be limited. In this context, the announcement of targets set to be reached in say 2050, such as the 60 per cent reduction postulated by Stern and others, seem largely irrelevant. The issue that existing political leaders have to face is what targets might be set now and over the next few years because they will determine reactions from the electorate.

Possible adverse electorate reactions to higher electricity and petrol prices may also limit the overt use of carbon pricing through either trading or higher taxes. Notwithstanding advice from economists that market pricing of carbon is a more efficient method of reducing emissions, governments may well decide to obtain a significant proportion of such reductions by further increasing subsidies for renewables through government budgets. That would in turn also limit the size of any carbon trading market. However, if experience with wind power is any guide, the cost of such subsidies is likely to be substantial.

A further reason for expecting limited carbon trading, at least initially, is that if the reduction target is set too high, there will be nobody who would want to sell any credits, and lots of firms who would want to buy. That means that the permit price (effectively an indirect carbon tax) would settle at a very high level, and many firms would simply shut down.

The European Union realised this and the limits they initially set on emissions turned out to be higher than actual emissions, effectively creating a lot of carbon credits for businesses with emissions below the set limit. However, although this created a market, it caused the initial price to fall to such a low level that it would not have induced the affected businesses to adopt emission-reducing technology.

While tighter limits have now been set for next year, the consequent jump in the forward price has led to many complaints from adversely affected businesses. This illustrates the difficulty all governments face in trying to establish an artificial market that sets a carbon price that allows businesses time to adjust and at the same time encourages them to do so.

A further significant difficulty is the problem of determining what actually constitutes a genuine reduction in emissions and/or a carbon credit and what institutional process would exist for certifying claims in that regard. The obvious scope for cheating could itself limit the resort to an international trading scheme.

Overall, the various difficulties involved, not least being measurement and certification, make it unlikely that an international emissions trading scheme can be developed and that such trading as does develop is likely to play only a limited role in reducing emissions. The extent of other approaches taken will depend importantly on assessments of scientific uncertainty. There are many, viz:

  • temperature levels have been as high if not higher in periods in the past and this did not then have adverse effects on societies;
  • scientific records suggest the overall size of the ice sheets of Antarctica and Greenland is, if anything, stable;
  • although carbon dioxide emissions have grown strongly since the 1960s as industrialization and economic growth generally have spread around the globe, since the mid-nineteenth century there appears to be little or no direct connection between emission and temperature increases. For example, between 1940 and 1975, average temperatures fell slightly. Moreover, evidence has now emerged suggesting that any warming effect from carbon dioxide emissions diminishes progressively, while historical analyses of ice cores show that past temperature increases preceded increases in carbon dioxide by 800 years or so; and
  • some leading scientists have pointed out that variations in sunspot activity are closely co-related with variations in temperature.

Given the extent of dissent amongst scientists and others, there is no credibility in the claim that there is a “scientific consensus” on human activity being the principal cause of global warming.

The reality is that the certainty thesis has no substantive basis. Even if increases in temperature were to continue at about the same rate as in the past century, the normal operations of market economies and governments should be able to handle problems that might emerge.

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This is an edited version of a speech delivered to the Annual Conference of APEC Centres on Melbourne 18-20 April. The full text is available here.



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About the Author

Des Moore is Director, Institute for Private Enterprise and a former Deputy Secretary, Treasury. He authored Schooling Victorians, 1992, Institute of Public Affairs as part of the Project Victoria series which contributed to the educational and other reforms instituted by the Kennett Government. The views are his own.

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