Rudd’s scheme unfair but effective

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But let’s start at the beginning. An emissions trading scheme seeks to reduce emissions of carbon dioxide and other greenhouse gases by imposing a limit (or cap) on the amount of gas that may be emitted each year, then gradually lowering the cap every year.

In the ideal, businesses engaged in activities that involve significant emissions – such as power stations, transport and agriculture – would be required to hold permits to cover the emissions they make. Again in the ideal, the government would auction these permits to the highest bidders and use the revenue to compensate people on low incomes or to subsidise research on sources of renewable energy or advance the cause in some other way.

The way that most people think the scheme works is that the power stations and other big emitters that have to pay a fortune for their emission permits pass this extra cost on to their customers, including households.

The higher price of power encourages firms and households to be less wasteful in their use of electricity. It also makes it more economic for firms and households to switch to renewable energy sources such as solar and wind power.

Meanwhile, the power stations have an incentive to switch from coal-fired generators to less-polluting gas-fired generators or some renewable energy source, because this would mean they would have to buy fewer expensive permits.

If that’s the way you think it works, you get very worried when you hear that the Government is giving the big emitters a lot of their permits rather than making those emitters buy them.

Surely that means they don’t raise their prices as much, so there’s less incentive for people to change their behaviour and less incentive for emitters switch to less-polluting energy sources?

Fortunately, that’s not the way it works. Even if the Government gives the permits away, they’re still valuable. They have ”scarcity value” because you can’t emit gases unless you’ve got one and the Government has reduced the supply of permits available.

This means that even if a power station has been given all the permits it needs, those permits have an ”opportunity cost” because they could be sold to some other firm that needs them, at the market price for permits.

This leaves the power station with an incentive to switch to gas-fired generation, for instance, and sell the permits it no longer needs. And since its free permits are valuable, it will still raise its prices to customers, requiring them to compensate it for its opportunity cost in not selling its permits.

This means the prices of power and other emissions-intensive products will still rise as much as they would have had all the permits been auctioned, so that the incentive remains for behaviour change on the part of households, businesses and producers using fossil fuels.

In which case, what’s the effect of the decision to give away rather than sell so many permits (about half of them)? The effect is to transfer income to the big polluters from the people this money would otherwise have gone to – in the case of this week’s deal, middle-income households, who’ll now be getting less compensation for the (unchanged) increase in their power bills.

Is this fair? No. Was it necessary to make the scheme work or to avoid big job losses, as the industry lobbyists and their Liberal champions claimed? No. Was it necessary to get the scheme through Parliament? Possibly – if you lacked the stomach for a double dissolution.

This decision says a lot about the Rudd Government’s lack of courage to stand up to powerful business interests and its willingness to foster a culture of rent-seeking. Forced to choose between middle-income households and big polluters, it went with its big business mates.

But no matter how disapproving you are about the decision to fatten the profits of the big polluters, don’t imagine it reduces the scheme’s effectiveness in lowering emissions, because it doesn’t.

Let’s look at it another way. Had the Government decided to auction all the permits, but then used all the revenue to further some completely separate worthy cause rather than returning it to households in compensation, the scheme would have had two effects: an ”income effect” and a ”substitution effect”.

The income effect on households is that the higher price of power is like a tax increase, which leaves them with less money to spend. Their reduced disposable income may have prompted them to reduce their consumption of power to some tiny extent.

The substitution effect on households is that the price of power, and the prices of goods and services whose production requires a lot of emissions, are now higher relative to the prices of everything else they buy. This shift in relative prices will lead people to spend less on power and emissions-intensive goods and spend more on low-emissions goods and services.

Now let’s say all the permits had been given freely to power stations and other big polluters. The income effect is that they’re now more profitable (and households are out of pocket). This will have little effect on the power station’s choices about the energy sources they use to produce power. Nor will it have much effect on households’ decisions about how much power to use.

But the substitution effect is unchanged: power stations still face an incentive to switch to lower-emissions energy sources (so they can sell their valuable permits), while households face the same incentive to use electricity less wastefully or switch to lower-emissions energy sources because they’re now more economic.

The point is, the effectiveness of emissions trading schemes in changing behaviour and moving us to a low-emissions economy is not greatly affected by the decisions governments make about who gains or loses income.

It’s the substitution effect – the change in relative prices – that’s intended to do all the work.

Ross Gittins is the Herald’s Economics Editor.