A Submission To The House Of Representatives Standing Committee On Environment, Recreation And The Arts
INTRODUCTION AND EXECUTIVE SUMMARY
Much of this submission addresses the impact of the Kyoto Agreement and the Prime Minister's statement of 20 November 1997 on the environment and on industry. The thrust is that the Kyoto agreement itself will have little effect on the environment and any measures taken by Australia correspondingly less effect.
For Australian industry and consumers, the Australian measures, though far less onerous than some would have wished, will mean increases in electricity costs and an inevitable increase in administrative intrusion.
In terms of industry, abatement measures will have the most marked effect on those firms supplying electricity based on Victoria's brown coal. Should Australia decide to introduce abatement measures for greenhouse gases, either a tax or a tradeable right is preferable to traditional command-and-control regulation. Both measure make use of market incentives rather than relying on case by case bureaucratic decisions. Although they raise costs, economic instruments therefore achieve the same goals more cost-effectively than traditional command-and-control measures.
As the energy source with the highest levels of CO2 per energy output, any measure, be it a tax or a tradeable right, would have its greatest impact on brown coal. As such, any abatement measures would markedly lower the value of the assets of the four major brown coal generating businesses in Victoria.
For consumers and user industries, abatement measures will mean a price increase for electricity. Some user industries will find it more profitable to relocate to countries where no such tax effect is imposed. The most far-reaching of the Prime Minister's proposal is a requirement for an additional 2 per cent of electricity to come from "renewable or specified waste energy" sources by 2010. This quantity of additional energy approaches the size of the Snowy hydro facility. Even on very conservative estimates, a forced substitution of 2 per cent of fossil for renewable electricity (other than hydro and nuclear) would entail an annual cost of $200 million. If cogeneration is included in the definition of waste-product energy, little cost may be incurred.
Trading arrangements for greenhouse gases can be readily arranged. The key is the definition and allocation of property rights either through an auction system or by grandfathering existing users' emission levels. Beyond this there is little role for government bodies.
ENERGY PRICES AND EFFECTS ON INCOME
In 1973/4 when the first energy crisis was underway, there were many risks perceived to result from the quadrupling of oil prices that OPEC engineered. One of these stemmed from a long standing relationship between energy and GDP. At that time each percentage point increase in GDP was considered to require a 1.5% increase in energy.
Hence, aside from the fears over how petro-dollars were to be recycled, there was real concern that the reduced energy demand from higher energy prices would mean a sharp contraction in growth rates.
Among OECD countries such a contraction did take place. But it was not as a result of any automatic relationship between energy prices and GDP growth. Were that the case, we would not have witnessed the growth of many developing countries from then onwards, growth rates that remains astonishing even though events last year have taken the froth off them.
The energy crises of the 1970s did have one permanent effect. They brought a marked increase in effort on behalf of business to reduce energy inputs. We saw such phenomenon as steel making being converted to ensure that the coking coal it used was employed for heat as well as a carbon input. Motor car design placed a new accent on fuel economy. These economies broke the 1.5:1 relationship between energy and overall GDP. At present the ratio stands at a little over 0.8:1 for Australia.
Economies in energy use are continuing. This is not a matter that should cause much surprise since half the driving force of the profit motive is based on the benefits that accrue from saving inputs. Firms out to preserve their market positions and to gain increased margins are constantly seeking to reduce inputs. We can see the outcome of this in outputs as diverse as the thickness of cans and other containers, to the layout of supermarkets. In the latter case, over the past two years, Coles has managed to operate its stores without increasing its energy usage, in spite of having increased the floorspace of the main user of energy -- frozen and cooled areas -- from 15% to 35%.
A major recent catalyst for change has been the deregulation of the electricity market, the prominence this has received and the increased gains to be made from focussing on energy savings. Production therefore has a great deal of fungibility. Adding cost to one factor of production will bring substitutes for it and economies in its usage. This accounts for the fact that government regulation of production and high and distortionary taxes will rarely have the massive economy-wide adverse impacts that a static analysis of the effects of the measures would indicate. And this is reflected in the economy-wide estimates of the effects of emission restrictions undertaken by respected bodies like ABARE. ABARE's scenario based on a emissions 10% below 1990 levels by the year 2020 brought an output decline in Australia of only 1.5%. The corollary is that an 8% increase in emissions allowed by 2012 would have an even smaller overall effect. Even so, some sectors may incur particularly onerous costs and the measures may entail considerable restructuring.
GENERAL CONSEQUENCES OF KYOTO
For the vast number of countries in the world, the consequences of these agreements will be trivial. Developing countries are mainly exempted from abatement measures and, to the extent that they face lower costs, will attract energy intensive industries. Some countries, including Australia, face adverse outcomes as a result of costs involved in transferring resources to uses involving lower energy inputs or different forms of energy input.
Most countries used the Kyoto meeting to promote themselves as caring and sharing. In the main they sought to do so without incurring any costs.
For the European Union, achieving its targeted 8% reduction in emissions by 2010 is painless. Europe is shifting its electricity fuel source from coal to gas. It is doing so for perfectly sound reasons unrelated to greenhouse. But, as a by-product, the shift reduces carbon dioxide emissions by one third. Closing down East Germany's massively inefficient power industry adds a further bonus. This also allowed Europe to adopt differentiation whereby Greece and Spain were allocated very large increases in emissions. European enthusiasm for lower emission levels also contains a self-serving element -- saddling others with a real burden confers a competitive advantage to their own energy-intensive industries.
The US is a different matter. Much of its administration's support for environmental action stems from the views of Vice President Al Gore. But the US is one country where the Government's actions require ratification in the legislature. Congress has voted 95-0 against an agreement that does not include the developing nations. And China and India are adamantly opposed to any sort of greenhouse gas reduction strategy that impacts upon them. Congressional ratification is made all the more unlikely by forecasts that implementing the agreement would double energy prices and bring annual costs of $2,000 per household. In this respect it is worth recalling that the US Administration failed to obtain Congressional approval even to a relatively modest increase in the rate of petroleum taxes.
SPECIFIC AUSTRALIAN CONSEQUENCES OF KYOTO
Australia has been allocated an 8% increase in emissions. It remains to be seen whether this will be enough for a nation with a far more resource intensive profile than others. But the result could have been a lot worse.
The PM's statements of 20 November encapsulated the latest estimates of where Australia stands. It also points to various market interventions.
The measures announced are designed to reduce emission growth, excluding land clearance, to 18 per cent by 2010. This leaves a gap of 10 per cent to be filled on the 2010 business-as-usual estimates. By 2012 this is equivalent to a 12 per cent shortfall on the Pledge.
There are therefore three elements of the Australian approach:
- Land clearance measures.
- Regulatory and tax based measures designed to redirect output or energy inputs so that 10 per cent of the estimated net 31 per cent emissions growth is stanched.
- Any residual measures that would ensure the target is met.
One rather pernicious measure is the specialist renewable energy innovation investment fund. As well as a well resourced Internet site, this entails loans and grants totalling some $64 million for the subsidy of greenhouse gas free electricity generation. Conspicuously absent from mention were the two most greenhouse free sources of energy production: nuclear and hydro.
Not costed was a requirement that 2% additional energy from electricity is to come from renewable or specified waste-product energy sources by 2010. It may be that such magnitudes of renewable supplies will be forthcoming as a result of improvements in technology by then. But such dividends from technology have long been promised and have failed to materialise. Moreover, it would appear that the PM does not expect them to materialise without some industry planning sticks and carrots, since he says that the proposal will stimulate a new industry that will export its technology to the world. The prospects from such capital seeding has rarely lived up to potential in the past.
At present costs, requiring exotic renewable energy sources would more than double the price of the electricity supplied. At two percent of electricity, it would require these doubled costs to be incurred for some 4,000 GWhs of electricity. Four thousand GWhs is about four fifths the size of the Snowy hydro output. If the premium on this output is only 5 cents per KWh, this entails additional costs of some $200 million per annum. However, if the notion of waste-product energy is extended to co-generation, the cost premium may well be less than 5 cents (may even be zero).
Other costs will emerge from the increased use of regulatory Codes for housing and commercial building insulation including the minimum energy performance for new houses and minimum energy performance for a range of appliances. In addition we have an assured bureaucratic presence with the Commonwealth Greenhouse Office and an extension of the Greenhouse Challenge program.
These measures are not entirely new. In NSW, a retail electricity licensee to prepare annual reports on:
- the implementation of its demand management strategies;
- carbon dioxide emissions arising from electricity supplied by it as measured by a methodology approved by the Environment Protection Authority;
- the proportions supplied by each of its sources of electricity;
- strategies to achieve reduced greenhouse emissions "from electricity supplied to customers in NSW" and developed in negotiation with the Minister and independently verified.
The penalty for non-compliance is a fine of up to $100,000 and/or cancellation of the licence. To reinforce these provisions, the Government has established a watchdog four member Licence Compliance Advisory Board comprising two members appointed by the Minister of Energy, and the Nature Conservation Council and the Australian Consumers Association. Clearly the latter two members will be strongly agenda driven and will seek to pressure retailers into sourcing their contracts from suppliers which they consider most appropriate. Brown coal, with its intrinsically higher greenhouse gas emissions would be especially targeted.
TACKLING FURTHER REDUCTIONS (1)
Further reductions can be forced by use of subsidies, taxes, allocating tradeable rights to emissions or by command-and-control. Any such actions should avoid a focus on particular sources like thermal electricity. There are likely to be many circumstances where increased use of thermal electricity may actually reduce emissions. For example, where electricity replaces household coal or wood burning or where increased Australian electricity usage for transforming Australian raw materials means reduced energy used in transport and in transforming those same materials overseas. While Kyoto may be said to have settled the issue on the latter point, focussing only on electricity is likely to mean some lower costs options are foregone.
Normally, the best way to estimate what will be the outcome of a regulatory action is to measure its effects as a tax. With some minor reservations, discussed below, a tax and conferring tradeable rights have the same economic impact. Where a specific level of reduction is to be put in place, the tax is set at a rate to encourage consumers and businesses to find ways to meet this. The tax chokes off the least economical inputs and encourages substitution of other inputs.
Economic instruments, taxes and permits, are designed to bring about cost effective pollution control. This involves sheeting home to the emitters of pollutants the costs they impose on others, and providing incentives for emitters to reduce those costs. Both measures are preferable to command-and-control, because they encourage greater those individuals and firms who can provide the abatement at lowest cost to do so.
Economic instruments generate and harness the information about costs from a vast number of users and producers. They are, therefore, almost certain to bring about a more efficient outcome than if the control decisions were mandated by particular standards. This is due to market instruments making use of the same cost paring and profit searching incentives that have provided the higher living standards evident in market based economies.
The alternative of using command-and-control regulation is inferior to market solutions for two principle reasons. First, it requires that regulators have intimate knowledge of millions of productive processes and their alternatives so that an optimum regulatory structure can be set. Secondly, it relies on decisions not being clouded by political exigencies.
Pollution taxes and marketable pollution permits are two economic instruments designed to provide polluting firms and households with the necessary signals and incentives. Taxes set the price of pollutant emissions; the total amount of permits determine aggregate quantities of emissions, with individual permits being allocated initially on some basis such as current emission levels. Both taxes and permits signal the costs of pollution by putting a price on emissions. Taxes do so directly, by government decision, and permits indirectly, by forcing existing and would-be emitters to compete in the market for a limited supply of permits.
TAXES AND PERMITS COMPARED
Effectiveness in achieving a target: A marketable permits approach has an apparent advantage in that the quantity target is built into the instrument being employed. To attain the target using taxes, the authority may have to alter the tax several times before emitters adjust to the target level of emissions. However, the advantage of permits is illusory in this respect, because in setting a quantity, the price at which permits trade must be allowed to feed back on their total authorised levels. Without this, a higher than expected permit price will mean that too few permits have been issued, and vice versa.
Costs under uncertainty: With uncertainty about the costs and benefits of lowering pollution, the abatement target is unlikely to be the most appropriate target. Errors are likely whether a tax or permits approach is used. Compared with permits, tax based systems bring reduced costs from errors where abatement costs to emitters rise faster than damage costs to recipients. A tradeable rights system is preferable where abatement costs to emitters rise more slowly than damage costs to recipients.
Distributional issues: Depending on how they are distributed, taxes and permits have different effects on the distribution of income and welfare between emitters and recipients of pollution. In the case of taxes, a charge is normally levied where none previously existed. The initial impact of the tax is on the users, but its final incidence will depend on whether they are able to pass it on. Different allocations of the right to pollute can be achieved by combining different emissions standards with a tax on emissions in excess of the standard and a subsidy on reductions below the standard. In the case of marketable permits, different allocations of rights can be achieved by combinations of free distribution and auctioning of permits.
Effects of economic instruments on industry size: In the longer term, both taxes and permits will increase costs in polluting industries. The result will be some firms leaving the industry and others finding ways of adjusting so that normal levels of profitability are restored for the production that remains.
Risks of political interference: The main advantages of permits are that, as rights, they are less susceptible to governmental modification than taxes. Once vested, governments would be uneasy in seeking to raise further revenues from them, since to do so would be to impose a highly selective tax on a property right. If a tax is chosen, there is likely to be continuing conflict as to the appropriate rate. Permits therefore have the advantage of providing a more secure basis for planning and investment by firms and households.
Flexibility: Tradeable rights have an advantage over a tax in so far as the rights can be used and additional rights efficiently created through other market means. In this respect, abatement and sinks have an equivalence and a rights instrument may offer greater flexibility and administrative simplicity than a dual tax and credit approach.
Estimating the effects of tax or equivalent changes on price and then output is difficult enough one year hence and it is well nigh impossible a dozen years into the future. The effects of a tax at $10 and $100 per tonne of carbon on sources of power for electricity is indicated in the following table. Broadly speaking, the more carbon per unit of energy a fuel source contains, the higher the tax and price. Based on present estimates of costs of different fuel sources, even a $10 carbon tax tilts the competitive advantage away from brown coal. A $100 tax makes gas a cheaper option than black or brown coal providing the increased demand does not result in a scarcity driven price increase for gas. For renewables to be competitive, a carbon tax of at least $215 would be required. This would apply to a solar based system and even with such a tax advantage, the value of the renewable energy is likely to be discounted because of its dependence on weather conditions.
The table offers some estimates of different power source competitiveness under different carbon tax regimes.
A change in demand allows most naturally occurring materials and capital goods to be shifted to other uses. However, when brown coal is priced out of competitiveness, it cannot be diverted to other uses. Nor is there scope to concentrate only on the lowest cost mines. All areas are mined and supplied to generators at comparable cost. Beyond a point, imposing a cost penalty on brown coal supplied stations means they cease to be viable and the power source becomes redefined as dirt. There is therefore a wealth effect with brown coal.
It will doubtless be said that the knock on effect to electricity users of a tax even if it were $100 per tonne would be minor. After all, some will say, a 3 cents increase in price would translate into less than a 25% increase in fuel bills once transmission and distribution costs are included. And a tax increase on electricity is more neutral than some of the other taxes which it could replace. Those of this view, who include many highly respected economists, would also point out that electricity is relatively cheap in Australia.
Such views miss the point. We have a comparative advantage in low power costs just as California has a comparative advantage in the IT industries. We have just emerged from a period when State ownership of electricity had allowed the assets to fall way behind those overseas in terms of their productivity. Australia's future development is critically dependent on low cost power. Power intensive industries focus heavily on the price of electricity in their location decisions. This is readily seen post the 1974 oil crisis with the shift of Japan's aluminium production to lower cost energy locations like Australia.
Victoria is especially vulnerable to measures that force reduced greenhouse gas emissions. Brown coal, on which the State's low cost electricity is based, emits more carbon dioxide per unit of energy than other fuel sources.
Tough greenhouse emission targets would have been the death knell of Latrobe Valley. We would have been forced to write off both the Valley's national asset of limitless supply of coal, and the power stations themselves. Recent privatisations place a worth of over $11 billion on Victoria's five coal-fuelled power stations. Funds would have had to be found to replace these assets. And even then, households and industry would have faced skyrocketing electricity bills. Many industries would simply re-locate, further adding to costs and reducing jobs in the State.
A tight target would also mean the eventual closure of coal-based power stations in other States. This would mean increased quantities of Australian black coal would be diverted to exports and burned in those developing countries that were sensible enough to reject a target. The net effect on greenhouse would have been trivial.
The Australian Government took a firmer line against reducing our level of emissions than did other governments. It did so precisely because our costs from reduced emissions would have been far greater than those of other nations. And those costs would have been borne most harshly in Victoria.
PARTICULAR MEASURES THE COMMITTEE IS TO ADDRESS
Mechanisms for Measuring, Verifying and Monitoring Emissions and Compliance with Contracted Agreements
There are no technical difficulties in measuring emissions from production facilities. However, the P.M.'s statement links greenhouse gas abatement to the requirement of "retailers and other large users" to source an extra 2% of their energy from renewables by the year 2010. This gives rise to several difficulties:
- How are we to determine what constitutes an extra 2%? Such a measure assumes a stability of usage and of users. New firms or those on a fast growth trajectory cannot be treated in the same way as stable firms, while those that are downsizing or otherwise reducing their energy usage would arguably be advantaged.
- The measure would require users to conduct annual energy audits. This might be very difficult for larger firms and would certainly add to the paperburden of smaller firms, something the Government committed itself to reduce in its response to the Bell Inquiry.
- Electricity is a homogenous good. There is no difference between electricity generated from renewable or other sources. The market for electricity is based on spot sales. At any one time no user could determine the source from which his energy was derived. And while most users are likely to cover the bulk of their sales by contracts, some will operate purely on the spot market at least for some of their requirements. Moreover, it is likely to require arbitrary allocations to newly established retailers. The onus could, instead, be placed on generators to supply an extra 2% of their energy from the preferred sources, though this would give rise to other sets of difficulties, especially for generators that did not have a portfolio of different plant types and for newly established generators.
- New measures which call for a reduction in the existing usage of a commodity tend to proffer benefits to those who have not undertaken such activity in the past. Often these will be the less efficient participants. Typically, it becomes increasingly more expensive to substitute less efficient inputs into a production process. Accordingly, those businesses which have previously introduced such inputs may be expected to incur greater costs and will be unfairly disadvantaged.
- The notion of renewables may need to be tightened. Thus, many would see lead-acid battery to be a renewable technology but the materials actually need to be replaced. By the same token, brown coal in Victoria, with proven reserves available to meet the needs of the next 1,000 years is to all intents and purposes infinitely available and the equivalent of renewable.
Mechanisms to Integrate Emissions Trading with Carbon Sinks
Once property rights are defined and made tradeable, they are easily monitored. Some difficulties may arise over the treatment of plantations and the harvesting of the wood. Other refinements may be necessary to value certain types of wood at premium rates, e.g. that which goes into long lived products like structures and furniture compared to that being used for paper manufacture.
A further issue with respect to sinks is analogous to that discussed above in the context of countries that are newly involved in forestation. Australia has gradually been increasing its area under forest for over forty years. Many countries, especially in the developing world are still reducing their forested areas. Depending on the stage of deforestation/reforestation that a country finds itself, it will receive a bonus/penalty from the provision since reforestation is easier and cheaper the more of the previously present forest that has been cut down.
Allocation of Emission Rights
Allocation of rights is essentially a political matter. It makes no difference to efficiency once the rights are allocated. Those with the rights will either use them in their own businesses or, if they can obtain a greater gain, sell them to other parties who can use them to greater profit.
Of course, there are likely to be wealth effects resulting from and allocation of rights. An allocation based on existing usages may give rise to windfall gains by incumbents, while auctioning the rights may penalise an incumbent who has sunk capital into a greenhouse intensive facility versus a new party that has all options open in establishing such a facility.
Regulatory Mechanisms to Support a National Market and International Aspects
Regulatory measures should be confined to defining the property right and establishing general means of verification. There is no need to establish a market since this will occur automatically and more economically through the Sydney Futures Exchange or one of the banks.
Some greater difficulties may arise if emission rights are to be internationally tradeable (as they should be if lowest cost usage is to be assured) with countries that have a less than robust verification regime. In spite of the gains from international trading in emission rights, it would be regrettable if this led to the creation of a new UN verification agency.
These difficulties would be compounded if tradeable rights are conferred on the avoidance of a supposedly intended facility overseas, especially in a country which is not bound by the emission limitation regime. In such cases there is likely to be trades in phantom emissions which would amount to a business claiming to have installed more energy efficient plant in a particular country than had previously said to have been intended.
Possible Emission Traders, Administration and Transaction Costs
There should be no limitation on who may trade save for the prudential and other requirements specified by the market agency. Transaction costs through this approach will be minimal.
Role of Government
The Commonwealth needs to establish targets and allocate rights by auction and/or some other means like "grandfathering" existing users' emission levels and will have little subsequent role. Although governments would be pre-disposed in favour of an auction of rights or a tax, conferring free rights to existing users may be the preferable approach. If existing users had undertaken investments on the basis that no tax would be imposed (and Australian Governments have actually given such assurances) it may be a form of expropriation to impose a tax or require rights to emit are bought by those owners. Conferring rights on existing owners does not lock out new participants if the rights are widely held. Holders of those rights would sell them if it was more profitable than continuing to use them within their own businesses.
1. The following section is drawn from Moran A, Chishom A and Wills I, "Use of Economic Instruments in Pollution Control: The Respective Merits of Taxes and Tradeable Permits", Occasional Paper B12, Tasman Institute, 1992.
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