Monday, May 12, 2008

Climate change: how will the ETS work?

Over at Truth Seeker, Steve asks how does the proposed emissions trading scheme work? Reading further, he's familiar with the theory that "if you make people pay to pollute, they will pollute less", and this is not so much about the theory behind emissions trading than with questions of allocation:

I don't know how this has been proposed to work here in NZ. I'm aware of debate about who holds the credits, but not the outcome...

I want to find out so I can better distinguish between those who have legitimate issues with the proposed trading regime and those who may be seeking to shirk their responsibility to deal with their carbon emissions constructively.

The short answer to this question is "it's still up in the air". The Climate Change (Emissions Trading and Renewable Preference) Bill is currently before select committee and will be amended in various ways before it comes back to the House. But currently the plan is for the scheme to (eventually) include "all sources and all gases", and that is unlikely to change. What may change is the timing of various sectors' entry into the scheme. So we've already seen the government announce that the transport sector's entry into the scheme will be delayed from 2009 to 2011, and we may see further delays in response to sectoral lobbying or flow-on effects.

Exactly who is liable under the scheme - the "point of obligation" - is defined in schedules 3 and 4 of the bill. The points of obligation differ by sector and source, but all are chosen to be relatively high up in the economy to minimise the number of participants and hence compliance costs. So the average consumer or small business (or even large business in the case of transport) will not have to deal with the ETS at all; instead we will respond to the higher prices passed on by emitters. But energy and industrial emitters will be directly exposed to the scheme, and thus it will directly impact their investment decisions, hopefully driving them in a more sustainable direction. In the case of agriculture, the government will initially target fertiliser companies and meat and dairy processors, but can devolve the scheme to individual farmers at a later date (once they have a good way of measuring on-farm reductions).

The general effect of the scheme will be to impose the full international price of carbon across the entire economy. The primary effect of this will be through impacting the investment decisions of major emitters. For example, during the 90's most electricity generators built gas-fired plants because they were (artificially) cheap. But carbon pricing makes renewables cheaper than gas, and makes coal financially unsustainable. So we'll be getting cleaner electricity. We'll also be getting cleaner industry, as those industrial emitters which can make reductions and efficiency gains will have a direct financial incentive to make them. More generally, it will push us all towards greater efficiency and reduced emissions. The strength of price-based mechanisms such as emissions trading are that thy produce widespread distributed action as we each look for ways to reduce our costs, thousands of little things which all add up. In addition they also "find" reductions the government may not have thought of, and encourage people to exploit them by making it profitable for them to do so (this is one of the strengths of markets; weaknesses are left as an exercise for the reader).

All of this will affect the profitability of businesses. That's the point - to make it unprofitable to pollute. But those whose profitability is threatened have kicked up a fuss, and so there are free allocations for polluters (even a completely unnecessary $800 million a year environmental subsidy to our polluting dairy industry). None of this affects the overall effectiveness of the scheme - allocation only affects who pays who, not how much, and so the financial incentive to reduce emissions is the same. But the decision to delay the entry of various sectors will affect the supply and demand for permits, and hence the price. The cowardly decision to delay the entry of transport could leave us with a market consisting primarily of sellers, with a carbon price too low to produce any meaningful reductions. Alternatively, the government could compensate by auctioning fewer permits to the energy sector, forcing them to buy permits from the forestry sector or credits on the international market. So what you save on petrol, you may very well pay for in higher electricity prices. Unless of course the government delays the entry of the electricity sector as well. In which case, we might as well not bother to even have an ETS...