Summary
Australia continues to debate the best response to concerns about carbon emissions. Should we put a price on carbon emissions, or should government pay for specific actions? If we do price carbon emissions, should this be a tax, a trading scheme, or some kind of hybrid? Whatever the response, few doubt that this would be historic, fundamental, reform.
While pricing carbon emissions is a fundamental economic reform, it is not a new one. Over the last few years, governments in Australia and overseas have priced pollution to reduce emissions. In such a scheme government usually sets a pollution or clean energy target and leaves market participants to decide the actions to achieve the target. Grattan Institute investigated the experience of six schemes – including the NSW Greenhouse Gas Abatement Scheme, the European Union carbon trading scheme, and the US sulphur emissions trading scheme.
In each case the outcomes diverged significantly from government and industry predictions. Environmental markets routinely led to lower emissions and achievement of targets at lower cost in practice than in forecasts. Forecasts tended to underestimate commercial innovation once money was at stake. In some cases the targets and regulations required relatively less change to business as usual than governments expected.
Because it was relatively easy to achieve targets, the market price of emissions was lower than forecast. The price crash in European carbon markets was not just a “one-off” result of peculiarities in its initial design. The same pattern recurred in a variety of environmental markets.
This experience provides vital lessons for designing Australia’s response to reducing carbon emissions:
- Markets, enabled by pollution prices, deliver more emission reductions more cheaply than government selecting specific actions or projects to reduce emissions. In the schemes reviewed, governments and experts that advise them, were usually wrong in their forecasts about which specific measures would reduce emissions and achieve targets at lowest cost. Rather than governments picking winners, markets unlock ingenuity across the community to converge on the cheapest reductions.
- There should be a floor price for pollution – a little like the reserve price in a house auction – effectively reducing total pollution if it turns out to be cheap to reduce pollution. If governments think that reducing pollution will be expensive, they worry about the impact on the economy, and set relatively weak targets. If the economic cost of reducing emissions and achieving targets is less than expected – and this happened in all the schemes reviewed – then a floor price effectively tightens the pollution target.
Technology innovation is the key to reducing carbon emissions. Markets may not be perfect, but they are consistently effective at identifying lower cost opportunities, promoting innovation, and responding flexibly to changes. Markets are likely to deliver more innovation at lower cost than governments expect.