Climate Change And Economic Policy

Climate change is defined as “Change of climate which is attributed directly or indirectly to human activity that alters the composition of the global atmosphere and which is in addition to natural climate variability observed over comparable time periods”(Bruno and Mehmet 2010). Modern methods of production create greenhouse gasses as a negative externality via the market failure and government intervention is needed to rectify the situation.

Climate change is an issue for the Australian government as it needs to intervene to correct the market failure caused by the free markets inability to provide property rights to mitigate damages caused by the negative externality. (Calhoun 2010) The greenhouse gas externality is a by-product of the production of goods and services via the over-production of emissions. Dr Peter John Wood argues that” climate change is an indisputable threat” and on that basis, as well as the world stage Australia has taken the reins in acting upon climate change.

An externality is defined as” are the unintended consequence of one economic agent’s economic activity that affect another agent’s economic activity, but which are not adequately priced through the market (Sonia and Jeff 2011)”. This is also known as market failure and requires government intervention to be able to rectify the problem due to a lack of property rights and correct mitigation for parties involved with the transaction. In this case, one form of the market failure is because the cost of CO2 is not factored into the transaction price.

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The Gillard government continued a legacy that was started with the Howard government back in 2007 that saw a Carbon Emissions Trading scheme take part in the Australian government to tackle Australia’s greenhouse gas emissions (Chris 2011). The Carbon tax was implemented on June 1st 2012 and has been controversial amongst politicians and economists alike according to Clive’s article “Australia's Carbon Tax: A Sheep in Wolf's Clothing”.

The steps taken to implement a policy should be understood first before critiquing from different viewpoints.

The four major points of policymaking are:

1. Specify the goals of policy

2. Identify the targets

3. Specify the policy instruments

4. Model the economy linking the instruments to the targets

Using this framework, the goal’s of the policy are to mitigate damages caused by the production of greenhouse gasses on the (global) environment on a national scale and decrease the amount of pollution via increasing the price of polluting. The targets of the policy are the agents involved (Firms producing pollution, environment and households) with the transactions. Firms are the largest creators of the pollution and the households are directly affected by price increases, therefore their welfare post-tax needs to be considered in a socially acceptable policy. The policy instruments include subsidies to the households most affected by the increases in prices of amenities as well as the Pigovian Tax on polluting (Energy 2012). Lastly, the model that directly links the economy to the instruments proposed can be shown below.

Tax brings the externality into equilibrium with the social cost. The amount of gain to the social benefit is the darker area and is also the taxation revenue collected on behalf of the government. This also decreases output by the difference in Original output-New output. This can also be shown on a Supply and Demand graph. The graph to the right illustrates the effectiveness of the tax on the existing market price and therefore reducing the quantity of pollution emitted. This tax is directly placed on the top 500 polluting firms in Australia which account for the majority of the pollution via production.

The Department for Climate Change and Efficient Energy published their “Forth Assessment Report” outlining that “There is clear evidence that our climate is changing, largely due to human activities”. One can infer that the government is acting morally and taking partial responsibility for these human activities, hence action for change and mitigation.

Market failure is defined as the inability of the market being able to deliver an efficient level of goods and or services (Calhoun 2010). This is an important aspect when determining what aspects of a policy are vital in addressing the issue at hand, because the situation of pollution is a non-Pareto optimal situation due to the negative externalities created in the transaction between agents.

The government’s intervention due to the market failing is justified by its role in the G8, Kyoto Protocol and its response to the public on the matter ("Australia to have leading role in carbon mitigation" 2007). Another reason is that property rights are not defined clearly with the environment, therefore the government intervention to make the Marginal Social Cost equal the Marginal Social Cost via a Pigovian tax, decreasing the amount of negative externality produced (greenhouse gasses).(Bruno and Mehmet 2010)

Macro-economically speaking, this issue impacts both Australia’s macroeconomic goal of efficient resource allocation and sustainable economic growth. Due to high public opinion on green alternatives and clean production, changes in consumer preferences will mean that some goods and services provided using traditional fossil fuels or unsustainable methods may be boy-cotted or fall second preference to ‘green goods’(Kathleen 2012)

The Efficient resource allocation goal of Australia addresses “...where resources are allocated in the most efficient manner”(Weng 2008). The environment is a common resource and traditionally has not been defined to any specific owner. Firms may utilise the environment (clean air, sunshine and or clean water) as a factor of production, examples may include Personal Trainers or tour guides. With a market failure existing, it renders the goal incomplete as there is an excess of pollution and undersupply of environment as it is a rival good. Either the polluters must reduce their output of pollution or they must mitigate the affected agents. This causes a problem in the regard, whom is affected by the pollution and by how much does the affected agents need to be mitigated for.

Sustainable economic growth in the long term is impacted by climate change. Not only will Australia be affected by the hypothesised changes to temperature for standards of living, but the changes may affect agricultural output and goods demanded by countries importing (supporting) clean production methods. Australia, by implementing policy change enables the economy to be in a better position to respond to act with funds allocated via the policy impact ("Australia: Australia Prepares for Carbon Tax" 2012).

Comparing the current Carbon Tax (Clean Energy Bill) to alternatives that have been proposed such as Carbon Trading Schemes and Subsidies for Clean Investment have both advantages and disadvantages (Calhoun 2010). Australia’s Carbon Tax initially is a fixed price of $23 per Metric Tonne of Carbon Dioxide emitted from the top 500 polluting companies in Australia(Harris 2012). This in its simplicity is a Pigovian Tax, which is used to deter consumption/production of a good or service that causes the negative externality. Simultaneously the Indirect tax signals the taxed firms that they should spend investment capital on ways to lower their output of CO2 emissions (Carrie 2011).

Pigovian taxes are designed to increase the price of the good that causes the negative externality by the amount that best reflects the cost to society in the production of the good which will internalise the effects of the externality (Carrie 2011). Examples of these in Australian society include the Alco-Pop tax and tobacco tax. In the case of the Carbon Tax, the good being taxed is pollution and the parties being mitigated are the Australian government on behalf of the environment in which it is representing, in effect the environment is gaining property rights in this explanation.

The Pigovian tax, when applied will cause a reduction in the level of pollution due to the cost added. This will vary from firm to firm due to the elasticity of the cost to pollute. It is safe to assume that all firms are elastic with pollution expenses; therefore the economics of the tax are sound.

Pigovian taxes have been praised for their simplistic approach to combating both losses of competitiveness due to inefficient methods of production and on goods themselves which are non-essential for consumption when viable substitutes are available according to Harris’s economic survey in 2012. Examples include using solar power on mine sites instead of Gas or Coal power.

Pigovian Taxes however are not ideal in the case of Carbon Leakage, whereby firms choose to produce their goods offshore in countries that are not yet or not participating in Carbon Reduction. It reduces Australia’s carbon footprint, however the loss of production in Australia mean relative to before the tax, there is a reduction in output. (Dellaware 2011).

By contrasting these to alternative methods to combat climate change such as an Emissions Trading Scheme (Cap and Trade) or the Carbon Offset system. All theoretically are able to reduce the level of the negative externality, however they all have different dynamics to each other and need to be applied using the framework aforementioned in the essay.

The Cap and Trade system allows for the Coasian Bargaining of the right to emit greenhouse gasses as part of production of a firm. These permits would be of a set supply, and would limit firms to a ‘cap’ of pollution. These would be traded in the open market meaning that the market subject to demand and elasticity by a firm, determines the price of the permit. This would encourage firms to innovate and reduce the number of permits needed to produce, or be more efficient with the given quota of pollution per year.(Kathleen 2012)

Advantages of the Cap and Trade system mean that the total level of greenhouse gases are controlled, IE a set amount per year meaning that it is easier to attain goals from the Kyoto Protocol. International trading markets are also proposed and feasible meaning that there is greater competition for permits which leads to more efficiency domestically. Firms that are unable to compete or innovate into cleaner greener methods are either absorbed by larger more efficient and environmentally viable companies or liquidate, meaning less pollution output.

Another advantage is that there is little regulation and or further government attention required to maintain the Cap and Trade system. Because the market forces determine prices between firms, the need for a middle man is removed. Comparing this to a Carbon Tax, where constant auditing, monitoring and enforcement is both time consuming and expensive from a tax payers perspective.

Comparing the two graphically below show the changes in price and quantity in the strict control of either supply of increase of price.

The Carbon tax is indirect, it controls the price movements, which affect the quantity, and the Cap and Trade system controls the supply, which then determines the price. The biggest disadvantage to not controlling the price of pollution as oppose to the quantity is that it does not promote efficient investment on clean alternatives to production and instead causes prices to rise of the permits, allowing larger companies to purchase the right to continue polluting and drive out smaller less profitable companies, provided they can’t sustain operation by selling excess permits to excessive polluters. Graphically, they yield the same result however; Clive argues that the amount of red tape needed to maintain the Cap and Trade System is not viable.

Introducing the Carbon Offset scheme, means that carbon offsets are purchased which in turn mitigates the marginal private cost of the firm to equilibrium level. Firms can only pollute according to their offset amount and has been successful in Europe with 5.5 Billion dollars of offsets traded according to Bruno and Mehmet’s paper on Governance and the Carbon impact.

Advantages exist in the offset scheme whereby it guarantee’s firms to take positive action/investment due to money spent on offsets directly in the form of buying credits from firms specific for reducing pollution and or investment on re-forestation and cleaner methods of production. Other arguments exist stating that having a Cap of pollution will force in-efficient firms to find the lowest cost method to reduce their pollution. Again, like any alternative to the Carbon Tax, much more bureaucratic procedures, monitoring costs and governing bodies are required to manage such a proposal (Oh 2007).

1. Similarities exist between the two policy options in that both require a base measured level of pollution to which caps and prices can be compared

1. Both systems will generate revenue via the increase of the Marginal Private cost which can be distributed via the governing body.

1. Both systems will require a governing body to standardise and monitor activities to be equitable (International-Emissions-Trading-Association 2011)

Using this information, the policies will affect different groups of individuals differently. The Carbon Tax will have some impact on households, but greater on the top 500 firms. Understanding how it will affect each party will enable a better understanding of the Pareto Efficiency concept.

Households under the Carbon Tax will be charged more for amenities and certain activities such as air travel. Using the graph below it is clear that electricity is the largest producer of greenhouse gases and will have the largest impact via the tax.

increase of costs of using electricity, any household that earns less than 80,000 dollars a year will benefit from subsidies and household assistance packages from the Liberal Government (Energy 2012).Households will also gain in subsidies and other cleaner initiatives from the government via the revenue collected from the tax which will increase their standard of living, proposed by the new energy reforms(Energy 2012). Linking back to Figure 1, the gains in Social Benefit are the largest gains that the households have, which economically speaking should be a new Pareto optimum specific to householders.

Firms on the other hand, if subjected to the tax will have an increase in costs relative to the $23 per metric tonne of CO2 emitted. There is also the added cost of administration fees and loss of investment due to higher costs. Other costs that may be included are changes in capital. Pigovian taxes are aimed to have a distortion effect, decreasing the amount of CO2 emitted, changing what firms use to produce and furthermore where future capital investment may be directed (Bruno and Mehmet 2010).

Firms from the impact of a Cap and Trade system will be partaking in Coasian Bargaining. This system has been used in the European Union and has shown dramatic decreases in the levels of CO2 by firms (International-Emissions-Trading-Association 2011). Due to the nature of the market, firms will bid and enter a price war against each other that will drive firms to have the lowest operating cost to save on purchasing permits. Firms that do not use the entire permit’s quota are able to bid off their remaining excess to firms whom can afford to pollute, or can’t afford to innovate into cleaner methods of production.

Production, if the firm is pollutant dependant will be affected due to a rise in fixed and variable costs and may decrease output (Gilbert 2007). If the firm is not heavily reliant on pollution, it will see increases in its profits due to the revenue gained from trading the permits. The Cap and Trade system promotes production efficiency according to Gilbert Metcalfe’s proposal for a US Cap Swap in those methods that reduce CO2 output cost less via the tariffs placed.

The Cap and Trade system from a household’s perspective will be similar to that of the carbon tax, however a time lag may be present due to firms having a time period in which they can allocate their pollution as opposed to an indirect tax.

Each policy suggestion from an economic perspective has its own merits and weaknesses and need to be considered when creating a policy that affects both households and firms. The policy must be fair, equitable and efficient to all parties involved. By comparing the implemented Carbon Tax with the feasible alternative, the Cap and Trade system, the different viewpoints of firms and households are understood.

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