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Apr 14, 2011

Carbon price compo for business v households: not the same thing

Labor would like us to think businesses will act just like households when it comes to carbon price compensation. Experience suggests otherwise.

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Another speech, another step closer to the policy that will not die: Greg Combet yesterday gave a couple of further clues as to why Labor’s preferred carbon price scheme will be the CPRS under another name.

Remember, Labor did its best to kill the CPRS. First they never sold it properly. Then they dumped it … sorry, delayed it. Then, just to make sure, they dumped the prime minister who oversaw it. Then, as if that wasn’t enough, they swore black and blue there wouldn’t be a tax on carbon after the election.

But that was 2010. This is now. In a Press Club speech primarily designed to provide a justification for injecting the unlikely phrase “millions will be better off under a carbon price” into public debate, Combet dropped more hints that the carbon price is just Mark V of the CPRS.

First, Combet said compensation will be more than 50% of revenue, and it will be permanent. That it will apply “for the first year and over a period of years”.

The 50% threshold is, I suspect, considered psychologically important in selling the carbon price scheme, in a way it wasn’t in 2009 when no one ever mentioned household compensation. It enables the government to say most of the revenue raised will go to households.

And strangely enough, Combet’s statements match the second-last iteration of the CPRS from the 2009-10 MYEFO documents in which, once the scheme was up and running, just over half the revenue went on compensating low and middle-income households. However, revenue grew faster than compensation over the out-years, so household compensation dropped to 45% of revenue by 2020.

Combet also used as his example for the steel and aluminium industries the 94.5% free permit compensation levels from the CPRS. It will look very odd, then, if the government’s carbon price model doesn’t include exactly that compensation level.

Combet did so as part of an argument that compensation to polluters doesn’t reduce their incentive to reduce carbon emissions.

“I should also make the point that by providing this assistance the government does not reduce the signal for these industries to reduce their carbon pollution. If the assistance is in the form of free permits, these permits are an asset. These businesses have an opportunity to reduce their carbon emissions and sell surplus permits. If they cannot there is a very substantial level of shielding against carbon leakage.”

Wrong, minister.

It’s not just Combet, of course — he was merely articulating the approach favoured by Labor and the Liberal moderates who backed Malcolm Turnbull’s ETS amendments, which was even more generous to polluters than the CPRS.

Combet is making the implicit comparison of households to business: we’re compensating households through tax cuts and transfer payments, but economics says (correctly) that they’ll still change their behaviour in response to changed prices. So too, he wants us to think, will business change its behaviour.

The first problem with that is that under any of the models advanced for a carbon price by Labor, businesses would be compensated differently to households. They wouldn’t get a tax cut or a grant, they’d get free permits. That is, they would see virtually no price signal, whereas consumers would see the full signal. It’s like giving householders a “no carbon tax” card they could wave every time they had to make a purchase.

If the carbon price revenue was being directed into a corporate tax cut, it might make more sense to argue businesses would respond to carbon price signals, but not when the price signal is almost entirely neutered.

But experience also suggests Combet is wrong on his principal point, that business will be motivated to reduce emissions by the prospect of selling surplus permits.

You’d never know it from the shock jocks and people like Greg Hunt, but a European emissions trading scheme has been in operation for five years. So there’s plenty of what the consultants call “learnings” to be had from it. The biggest “learning” of all of course is that the impact of a carbon price is far, far less than that alleged by business before its introduction, but we knew that already. Another relates to how businesses react when they’re given free permits, which was also the basis of the European scheme. A US economist, Daniel Matisoff, has looked at how business is supposed to respond in theory, and how they have in reality.

Matisoff identified a number of problems, and found that “companies exhibit a strong preference for business-as-usual operations, especially under conditions of high uncertainty”. Some are problems that turned up were relatively minor and would be addressed as businesses adjust to a scheme. For example, some smaller European businesses initially couldn’t find buyers and sellers of the small number of permits they needed, or wanted to sell — a problem that would presumably be addressed by brokering services.

Businesses can also attempt to pass on what carbon price cost they do face to consumers. At the beginning of the European ETS, power companies notoriously passed on the cost of their permits — despite the fact they had got them for free. The overallocation of permits that led to that has since been fixed.

But Matisoff found more fundamental problems. It’s big utilities that are most likely to operate as economic theory would suggest, and trade their permits after cutting energy use. But they adopted a short-term approach because of regulatory uncertainty around issues like the future regulation of coal-fired power, and put off long-term investment decisions because of uncertainty about the long-term carbon price.

However, those issues are endemic to a trading system, and can’t be fixed no matter what compensation model you use.

Large non-utility companies, however, are much more likely to opt for “business as usual” — as one quote used by Matisoff shows: “Many large industrial firms … have no desire to change behavior, regardless of possible profits from selling carbon permits.” Part of this is because they want to stick to their core business. As one says in the paper: “I’m a brick producer, I want to produce bricks.” The study also found internal issues about which areas of a business are charged with selling permits, which are charged with managing sustainability issues, and “shopfloor”, where the most practical energy efficiency measures are likely to be identified.

And small and medium firms simply don’t have the resources to invest in properly understanding the operation of the carbon permit market. For those business, the ETS is simply a compliance issue, not an opportunity to make money from selling permits. That, at least, is a problem obviated by targeting the carbon pricing scheme at the biggest polluters, something both the CPRS and the new carbon price scheme will do.

The problem of long-term certainty recurs in Matisoff’s findings. Such a problem is likely to be even greater in Australia if the Coalition remains in the grip of climate denialists and opportunists, who may be able to cruel the effectiveness of a carbon price simply by keeping businesses uncertain about whether there’ll still be a carbon pricing scheme of any kind in, say, 2020.

But it’s also an issue for Labor. The final version of its CPRS extended free permits well into the 2020s, meaning businesses could safely put off the need to plan for the full impact of a carbon price for several years. That’s why Ross Garnaut’s proposal to limit CPRS-style compensation to just three years until the PC develops a new set of compensation guidelines makes more sense than the original CPRS model — businesses will still be uncertain, but they’ll know that whatever the PC comes up with, it won’t be as generous as the CPRS compensation model.

Better still to abandon compensation altogether, and concentrate on providing transitional assistance that business will know expires after a limited period, say three or five years. And if provided via grants or tax cuts, it’s likely to maximise the chances of business acting in accord with how economic theory says they will.

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