By Lyn Drummond

20 April 2011 – Market mechanisms reduces emissions most effectively and cheaply, a report by the policy think tank, The Grattan Institute has found. Three market-based schemes have produced 40 per cent of Australia’s emissions reductions since Australia signed the Kyoto Protocol in 1997 – once the one-off ban on land clearing is excluded.

The report, Learning the hard way: Australian policies to reduce carbon emissions names the three schemes as the Renewable Energy Target, the NSW and ACT Governments’ Greenhouse Gas Abatement Scheme and the Queensland Government’s Gas Electricity Target.

The three set mandatory targets for emissions reduction, or use of particular energy sources that electricity retailers must meet through purchasing tradeable certificates or permits.

Together, they will have delivered more than 40 per cent of Australia’s emissions reductions in 14 years –the greatest amount of reductions among policies introduced by Federal and State governments to cut carbon emissions.

The schemes have reached their emissions targets with little difficulty and ahead of time, showing that the cost of reducing carbon emissions is lower than experts forecast, the report says.

Analysts have been able to assess the evidence of what works and what doesn’t in reducing carbon emissions because Australia has introduced more than 300 programs since 1997.

By contrast, $7 billion of grant-tendering schemes – upfront grants to companies for proposals to reduce emissions – have done very little to reduce greenhouse pollution. Governments have also spent $5 billion on rebate programs to encourage the purchase of low-emission products. Again, the impact on emissions growth has been minimal.

A fourth kind of program – energy efficiency standards – can reduce emissions cheaply and effectively, but is limited in scope. Based on experience, only a market-based model can meet Australia’s 2020 target of reducing annual emissions by five per cent below 2000 levels, the report says.

Market mechanisms work because they minimise the need for government to predict the future, providing businesses and individuals with certainty and flexibility, according to the report.  Certainty because once the carbon price and the rules of the market are established business can invest for the long term with greater confidence. Flexibility because decision making is devolved to firms and individuals, allowing them freedom to choose how to reduce emissions in the most cost-effective way, without government involvement in assessing whether they will work or what the costs will be.

Trading schemes create a price signal that automatically moderates supply and demand for emissions reduction. For example, if an electricity retailer needs to purchase more certificates in order to meet its obligation under the Renewable Energy Target, it might contract with a wind farm producer to generate more of the tradeable renewable energy certificates that the retailer needs.

The report concedes that the present market mechanisms are by no means perfect and says the larger the size of the market, and the broader the scope of emissions reduction measures recognised within it, the better.

It also suggests that the scheme should avoid or minimise the use of imputed emissions baselines that provide benefits or concessions to firms on the basis of a measure of what they might have done in the absence of an incentive to reduce emissions.

Imputed emissions baselines enable firms to plead special circumstances – such as an unusually busy period of production – that they contend make it harder to reduce their emissions from their current amount. These baselines can allow businesses to game the system.

The report also advocates a trading scheme complemented with price floors and ceilings that make demand for abatement responsive to its cost. For example, if the price falls to the floor, it indicates that it is cheaper than expected to reduce pollution. In these circumstances it would be rational to seek to reduce pollution
more quickly.

The price floor effectively means that pollution will be reduced more than the original target of the scheme. These lessons suggest that a hybrid of an emissions cap and trade scheme and tax (which acts as a price floor), with very broad coverage of the economy, would be the best model to deliver Australia’s 2020 emissions reduction target.

Importantly, this scheme could be implemented quickly as the infrastructure to
support it is already largely in place with the National Greenhouse and Energy Reporting System.

The report concedes that a carbon trading scheme or tax will not be costless, but it is highly unlikely that the government can achieve 2020 emission reduction targets at a lower cost through alternative measures. They will either fall short of the target or cost a lot more.

Between now and 2020 a number of sectors in the economy that consume fossil fuels are expected to grow substantially. For Australia to both accommodate this growth and meet a 5 per cent emissions reduction target requires government policies (beyond those already committed to) that by 2020 will reduce emissions by 160 million tonnes of CO2-e a year

To give a sense of scale, it requires measures equal to:

  • Eliminating emissions from all of Australia’s planes, trains and
  • cars
  • replacing the current use of gas for heating and industrial production with a zero emission energy source;
  • Expanding from 10 per cent to 75 per cent the amount of electricity that is sourced from renewable energy;
  • Reforesting an area of land at least half the size of the state of
  • Victoria.

The report says the beauty of a broad-based carbon pricing scheme is that if abatement from green carbon turns out to be plentiful at low cost  and can be reliably measured, then the scheme will result in a lot of green carbon initiatives.

After all, it asks, why would businesses pay more than they must in order to comply with government obligations? If green carbon works at a large scale then it will lead to a lower carbon price which will reduce the impact on electricity prices.
But if green carbon turns out not to be cheap and plentiful, or its abatement can’t be reliably measured, then the market mechanism will lead Australia to reduce emissions in other ways, and will not waste money on green carbon.

Governments could instead make grants to green carbon projects, or provide rebates for green carbon activities. But as a scheme that provided grants to farmers proposing to adopt green carbon practices could encounter many of the problems experienced by the Greenhouse Gas Abatement Program and the NSW Energy Savings Fund, it would need to identify in advance land improvement projects within a narrow range of commercial outcomes.

On the one hand, it would want to avoid projects that are commercially viable anyway. On the other hand, it would want to avoid projects that are ultimately high cost per tonne of abatement. Based on the history of previous programs, government will struggle to make this assessment, the report says.

See the full report