There is a widespread misperception that the Emissions Reduction Fund (ERF) cannot, in principle, work to effectively reduce carbon emissions. An example is in today’s article in The Saturday. Basic environmental economics on the equivalence between taxes and pollution subsidy policies shows that this is wrong. It is also wrong to dismiss the ERF scheme as a “non-market” based scheme. It is just as much a market-based scheme as the carbon tax provided that subsidies are allocated to the low cost pollution abaters.
Economists look at carbon polluters and focus on the costs that these polluters face in cutting their last tonne of carbon emissions. To use jargon this is the marginal cost of cutting emissions (the marginal abatement cost or MAC). If a tax per tone of emissions t is imposed on emissions from a firm with a certain MAC then, if t > MAC, the firm will abate since it is cheaper to do so for these marginal emissions than to pay the tax. In fact firms will abate up to the point where t= MAC. If instead the government provides a subsidy on emissions reduction s and offers to pay this subsidy to those who offer to cut their emissions at a cost to the government of less than s then firms will offer to cut their emissions and receive the subsidy provided s > MAC. They make money by doing this because they pay less for abating than they receive from the subsidy. Again they will cut their emissions up to the point where s=MAC.
Comparing the tax and subsidy schemes it is clear that both are market based and that both yield the same level of emissions reduction for t=s. A tax of $25/tonne on carbon emissions will yield the same level of emissions reduction as a subsidy paid to polluters of up to $25/tonne.
That the carbon tax was fixed in amount where the pollution subsidy under the ERF is determined implicitly by the budget to be spent reducing emissions changes nothing in principle provided that, as is the case, those who seek subsidies are those facing the lowest MACs.
Why then the popular opposition among economists to the ERF in favour of the carbon tax? There are several reasons:
1. Fiscal. The emissions tax potentially yields large amounts of revenue to the government whereas the ERF scheme costs the government revenue. There are two responses to this claim. First the carbon tax scheme as introduced by the Labor Government was designed to be revenue neutral so consumers and many producers were offered benefits that compensated for the tax. Thus, as introduced, the carbon tax would not have yielded any revenue. One could counter argue that times have changed and that these offsets should not now be paid because of looming public sector deficits. That presumably was what Ross Garnaut had in mind when he claimed the other day that restoring the carbon tax and abolishing the ERF could deal with the Government’s fiscal woes if the Senate rejects its program of social welfare cuts and charge increases. Even doing this it is easy to show (joint work I have done with Rob Waschik and Iain Fraser does this) that the revenues paid under the ERF to firms are much smaller than the revenues transferred to government by a carbon tax for all but very high (exceeding 90%) levels of abatement. It doesn’t seem to me that the fiscal arguments against the ERF are compelling. Another possible source of non-equivalence could stem from double dividend benefits from a carbon tax.
Another claimed fiscal disadvantage of an ERF could stem from the fact that it does not yield the double dividend benefits of a carbon tax. The claim is that carbon taxes punish a bad activity and yield an additional benefit by permitting the reduction of more distorting taxes such as income taxes on labour. UI think now the consensus is that such double dividend benefits are either negligible or small. The difficulty is that extra costs imposed by a carbon tax in any event reduce real incomes which obliterates any benefit from improved tax efficiency. That said the ERF is funded by taxes on income so, even if the absolute scale of the ERF is not great, its “excess burden” (or deadweight loss) costs on the tax-payer should be accounted for.
2. Implementation. There are difficulties of implementing an ERF. Both tax and ERF schemes require monitoring of current emission levels to check that carbon emission laws are being met. But the ERF requires also that an emissions baseline be determined which determines the size of the subsidy payments to be paid. These will depend on the difference between baseline emissions and current emissions. The difficulty here is to make sure that polluters are not “gaming” the ERF scheme by exaggerating initial emissions in order to get higher subsidy payments. Even without gaming issues the issue is to determine the genuine level of emissions reduction that occurs as a result of the ERF. Emissions by coal-fired electricity generators have fallen in recent years not because of carbon charges but because of falling electricity demands. In addition generators switched to using less polluting gas even before carbon pricing was introduced. It would be unattractive if payments to carbon polluters were made for emissions reductions that would have occurred anyway. Such issues do not arise with a carbon tax since a firm’s tax liability depends only on its actual emissions – there is no benefit to a firm in fudging a baseline or gaining an unwarranted advantage from a switch to gas. While touch unwarranted payments to firms are unattractive I do not think that, again, they provide an overwhelming case against the ERF scheme given the comparatively small scale of aggregate subsidy payments.
Other issues of implementing the ERF concern selecting the least cost emitters too subsidise. This is proposed to be done by a reverse auction where those who can abate emissions at low cost will get the subsidies. Potentially it seems to me this can work provided firms do not collude and provided they bid a price for abatement that is close to their MAC. Again it seems to me a detail rather than an overwhelming criticism of the ERF.
3. Time frame. There are considerable difficulties in understanding the issue of whether firms will sustain emissions reductions. The current ERF is scheduled to run for 5 years and presumably the Government assumes emissions reductions made during this 5 year period will be sustained into the future. There are real issues here of the credibility of the ERF scheme. Will firms cut emissions now in response to an emissions subsidy which compensates them for the extra costs they will occur over such a short-term time horizon? At least the longer-term future for the ERF needs to be spelt out.
4. Non-equivalence arguments. Environmental economics texts such as the well-known work of Baumol and Oates (BO) point out that the model outlined above suggesting that tax and subsidy policies are equivalent (in the sense that if s=t the same emissions are produced) are wrong. BO point out that under a subsidy scheme there are reduced incentives for high polluting firms that would exit an industry under a carbon tax to in fact exit under a subsidy policy. The reason is that their value is boosted by payments for emissions reductions. BO also point out that firms may in fact enter an industry to secure ERF type benefits. Neither of these outcomes seems realistic in Australia where firms engaging in such behaviour would certainly expect a prompt regulatory response. I don’t regard this as a real problem.
5. Political. Many citizens distrust the Government on climate change. There are many climate change “skeptics” (more accurately, “delusionists”) in the Government and among its group of major advisors. This is probably the major reason for disbelieving in the ERF’s efficacy and it is reasonable given the Government’s track record.
In my view the problem with the current Abbott Government policy is not its use of an ERF rather than a carbon tax to reduce emissions to 5% below those of year 200 by 2020 but the fact that this target is so miserly. We are shamed by the intended actions of the Obama administration and by the intended actions in countries such as China and Indonesia. But to dismiss the ERF wrongly when it could potentially address climate issues is foolish.
Caution: I am working on this material. Subject to revision.