Thursday, July 31, 2014

Direct Action vs. Carbon Pricing

There was an op-ed in yesterday's Australian Financial Review by Danny Price criticising the 59 economists including me who agreed to sign a statement in favour of carbon pricing and praising direct action. First, a clarification. By signing that statement we were not endorsing the previous Labor government's Emissions Trading Scheme. We were simply endorsing some pricing mechanism on carbon. Price criticises carbon pricing because of the "cost to the broader economy of any tax". Here he seems to be referring to the tax interaction effect. Where there are existing distorting taxes,  a new tax interacts with these and increases the costs of the new tax beyond the amount of the direct costs involved with abating pollution. The advantage of a carbon tax is that the revenue from the tax can allow the government to cut existing distorting taxes and reduce of offset this effect. This is known as a "green tax reform" and was much discussed in the so-called "double dividend debate". But imposing a regulatory cap on emissions (and issuing free tradeable permits) results in the same increased costs in the presence of existing distortionary taxes. So, this is why economists generally recommend auctioning emissions trading permits rather than giving them away.* This raises revenue allowing other distortionary taxes to be cut. Direct action is effectively a cap on emissions where the government subsidizes firms reducing emissions through a reverse auction. But this uses government revenue and doesn't allow the cutting of other taxes unless the government budget is cut drastically, which doesn't look like happening. If other spending isn't cut at all then the government will have to increase the existing distortionary taxes. So, direct action is worse than a carbon tax or traded permits on this basis. However, Price says that under direct action the government only imposes one dollar of costs on the economy for every dollar spent. This seems to be incorrect.

On top of that are the problems of the incentives for firms to inflate the baseline from which they claim they will reduce emissions.

So, I'm still in favor of carbon pricing of some sort though I think there are also important problems with emissions trading schemes that only provide a very volatile short-term price signal. The article by Ottmar Edenhofer in the latest issue of Nature Climate Change discusses some of these issues.

* I've argued that the Australian scheme failed because due to objections by the Greens, not enough free permits were given away allowing the scheme to be characterised as a "huge tax". The Australian scheme was less generous than the European scheme. But any such giveaway should be a transitory policy that would be replaced by more auctioning of permits over time.


  1. David, a good post.

    A footnote on your footnote though. I don't think the "great big tax" problem relates much to the amount of free permits. It was the politics: in the larger sense, Rudd failing to seal a deal with Turnbull and Abbott taking over. In a narrow sense, the fact that the price was fixed which in turn gave rise to Gillard's famous comment "I’m happy to say yes it works effectively like a tax". I also don't think the Greens are to "blame" for a low share of free permits. The Greens pushed for it, and so did Garnaut and almost all of the economics community; and this was a good thing. Labor in government were keen to have revenue to pay for income tax cuts and climate related expenditure measures.

    I completely agree with your statement that free permits should be transitory and give way to auctioning. Australia's scheme was a good model in that regard I think.

  2. I agree that it wasn't just the amount of free permits but if there had been more maybe it would have been harder for the "great big tax" meme to get traction.