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Procrastination and Carbon Pricing: the Real Option of a Carbon Price on the Economy

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Introduction

A couple of weeks ago, after I posted “Was it Worth It? The Benefit-Cost of Air Pollution in China“, I was asked by Ecoscore to think about the benefit-cost of Australia procrastinating on a carbon price.

 

So, using my understanding of Australia’s carbon policy and economics what do I think? Has it been good for Australia? What can the rest of the world learn from Australia?

Is Procratination a Bad Thing?

Not if procrastinating preserves a ‘real option‘. A real option is the ability to retain strategic flexibility in the face of uncertainty – e.g. should I build a factory now or wait for market conditions to improve? What is the benefits-cost of doing so?

We can apply similar reasoning to policy. What options does a government retain from procrastinating on a carbon price? It may be able to introduce a lower cost policy because new technology allows the economy to reduce carbon at a lower cost. Or it may allow the country to free ride on other countries’ efforts.

But procrastination can result in a real option lapsing and therefore missing a valuable opportunity. Like options in the financial sector, the value of a real option is dependent on time. The longer you wait the lower the value of the real option until the opportunity to act has lapsed. Or the value of the opportunity may not have been worth implementing a carbon policy in the first place so letting it lapse would not result in significant losses to the economy.

Economic Impacts of Carbon Pricing

Before I move on to analysing the example of Australia, I just want to make it clear what carbon pricing is meant to do. It is a ‘price signal’ that is designed to compel carbon emitters to internalise the cost of carbon. That is, emitting carbon is no longer free. By imposing a price on carbon, this is meant to change the incentives for carbon emitters to reduce pollution. It is meant to hurt financially, but also, the government wants you to actually avoid the tax.

Yes, it will hurt some industries, particularly those that are heavily carbon-intensive. But companies aren’t helpless, they can change their energy use to reduce carbon. This can be done through energy efficiency and/or using more clean energy. The resulting increase in demand for low carbon energy would stimulate growth in the renewables and energy efficiency industries. Like all economic transitions, there will be rise in new industries and decline in old industries.

Unfortunately, like all industries, the policy environment is critical to the future viability of the renewables and energy efficiency industries. How has procrastination affected them in Australia?

Procrastination and Carbon Pricing – the Australian Example

In some ways, the current Australian government is quite clear about its carbon pricing policy – ‘axe the tax‘ and anything that may introduce a ‘price signal’ on carbon such as the Renewable Energy Target (RET). The government will now act as a buyer of carbon abatement through it’s Direct Action Policy. So instead of acting as a regulator of the carbon market, the government will form the demand side.

Direct Action provides incentives to polluters to improve energy efficiency but little to creating renewable energy sources – hence the departure of many large scale renewable developers. The Direct Action Policy is one way of maintaining the status quo and dealing with climate change while avoiding the economic disruption of changing Australia’s energy mix from predominantly high carbon coal to low carbon renewables.

An obstructive Senate has saved some of Australia’s carbon pricing policy architecture, but this hasn’t eased uncertainty. In fact, it may have compounded it by leaving everyone unclear what the future direction of carbon policy is.

So has Direct Action Policy succeeded in retaining a real option to pursue a lower carbon path in the future? It would appear that Direct Action has done the opposite by subsidising major emitters’ transition at the expense of other ways to attain lower carbon-intensity of the economy. This would be true anyway if the RET was also abolished. Retaining the RET is estimated by the Clean Energy Council to attract $14.5 billion to 2020. So, the current policy confusion may actually a blessing in disguise in retaining a real option for Australia to transition towards a lower carbon path in the future.

Lessons from Australia

What the rest of the world can learn from Australia is that a government may accidentally retain a real option of value despite it’s best efforts. Policy chaos is hardly a strong recommendation to a government trying to introduce a sweeping policy reform. In the case of Australia, the real option has value because the architecture of a strong carbon price was retained despite the abolition of the Carbon Tax. Retaining the policy architecture could be seen as investing in a long-lived option to introduce a carbon price in the future.

But most other countries won’t be in this same situation where a government can accidentally retain the real option of a strong carbon price because of a previous government’s policy reform. A real option has value if it allows you to take advantage of a change in circumstances. For most countries, the governments will have to start from scratch when introducing a carbon price. In this case, procrastination will defer the cost of investing in the policy architecture require to effectively administer a carbon price. The price of creating the real option not be worth the cost for most governments concerned with short-term economic gains.

There are costs from the procrastination, such as the investment uncertainty in a new industry that could create new jobs for highly trained people and the environmental benefit from reducing carbon emissions. But all is not lost, at least the Australian government has retained the flexibility to change it’s mind in the future. As Keynes allegedly said, “When I’m wrong, I change my mind. What do you do?”