In 2007, the newly-minted Prime Minister Kevin Rudd made the famous claim “climate change is the great moral challenge of our generation.” In more recent times, to much fanfare, Pope Francis released his Encyclical on the Environment, further pulling one of the most powerful, socially-conservative organisations in line with the progressive push for action. Indeed, as influential leaders from all reaches of the globe and perspectives join the chorus, are we destined to sing our way off the environmental cliff or will we face the music and change our tone to one of action?
In December 2015, the latest iteration of an international agreement to reduce emissions was agreed upon by 195 countries – the Paris Climate Agreement. This has the headline aim of ensuring global warming does not exceed 2 degrees centigrade, with a target of only 1.5 degrees warming. The agreement will enter into effect in 2020. To date, 180 countries have signed the agreement, including large emitters like the United States, China and Russia – this includes Australia.
This all seems very promising. However, questions abound as to the legitimacy or effectiveness of an international agreement with what some would call limited enforce-ability (the United Nations’ Achilles Heal). At this time, none of the large emitters have ratified or acceded to the treaty domestically, meaning it does not have legal power in their home countries. There are 24 parties to their treaty currently, who have either ratified or approved the treaty domestically, however these are overwhelmingly small island nations who represent insignificant portions of our global emissions. Tuvalu, the Bahamas, Cook Islands, Fiji and Samoa – all of these nations stand to lose the most from climate change, as the rising tide of global inaction threatens to erase them.
As a result of this agreement-in-form but not substance from the major emitters, the treaty has not been put in to force as it does not yet reach the agreed thresholds – 55 countries whom have ratified the treaty and together represent 55% of global emissions or more.
As previously mentioned, those who have ratified or approved the treaty have the most to lose. Their interests are aligned with the treaty and thus it is no surprise they take action. No longer is it a discussion of the marginal cost of mitigation or adaptation for these countries – they are left with no option. For the others, they bear limited, less tangible or certain consequences. No climate model, to my knowledge, predicts the Russian landmass will be entirely engulfed by the rising tide. Classic moral hazard is at play here – the cost of our inaction is borne not by us, but these smaller island nations. Concurrently, if one nation acts, the benefits will not wholly accrue to this nation. Benefits of action spread, and thus less tangible and certain. Effectively, this means our problem is one of a public goods nature.
The monumental issues of uncertainty, moral hazard and international coordination have been identified by several economists working in this field. Warwick McKibbin of the Australian National University and formerly the Reserve Bank of Australia, has written several articles discussing the economic implications of imposing either of the two most popular market mechanisms to drive down emissions: a ‘carbon tax’ and a emissions trading scheme. Australia has some history with the tax system, after the Gillard Labor government introduced it in 2011 and the Abbott Liberal government repealed it in 2014. The alternative, now supported by the Federal opposition, an Emissions Trading Scheme (ETS), has been adopted elsewhere, most notably the European Union. The effectiveness of these schemes is hotly debated. McKibbin argues that a carbon tax, though economically preferable and the most efficient, is too politically unpopular and too against the interests of powerful economic agents to be viable as a long-term solution. McKibbin identifies the longevity of the system put in place as a key consideration, as a way to mitigate the uncertainty and ensure that firms do not simply discount the potential upside of mitigation or adaptation with the belief that any system put in place would soon be revoked or repealed.
A carbon tax applies a set cost to each unit of carbon emission, effectively correcting for the negative externality and hopefully bringing the quantity emitted back to the ‘socially-optimal level’ by increasing the cost of production. An ETS establishes a set number of permits that are then released and auctioned off. The number of permits is set at some previous level of emission rate, creating a market for the permits and giving them value as firms are incentivized to purchase and/or sell these permits between each other to reduce costs or derive profit from emission reductions they make.
McKibbin and Wilcoxen (2002) outlined their recommendation – a hybrid solution. They argue it combines the best parts of both systems. To decrease moral hazard and create a group of interested parties who would effectively self-monitor the policy’s success and continuation, McKibbin and Wilcoxen suggest giving long-term, perpetual permits to those designated as deserving of compensation (unlike a tax which is indiscriminate in its cost implications). These permits would again be limited to some pre-specified amount set by the government. Secondly, short-term, potentially annual permits would be issued to firms at a cost to allow firms to exceed their permit levels, but still bearing a cost for doing so. These second-class permits would make perpetual permits valuable, and entice firms to adopt mitigation or adaptation processes so they could sell these permits. Similarly, excessive emissions have an explicit cost due to the annual permit costings. The cost of an annual permit could be increased if more abatement is desired. Furthermore, perpetual permits can be re-purchased by governments or environmental groups to again reduce the allowable emission rate.
Crucially, McKibbin argues that this system should maintain allowable trading within national borders, this way giving government more control and eliminating the potential impact of international changes on the value of permits. This also means that international agreements are not required to begin, whilst also allowing quick adoption for other countries.
By creating a market which allows firms and individuals to create wealth through emission abatement, a strong moral hazard problem is mitigated. The negatives of both a carbon tax and an ETS are largely overcome and domestic implementation absent universal global agreement is possible. A clear path for an increase in reduction levels is also possible. However, this system potentially opens up another area in which financial speculators can establish futures, forwards and swaps markets – a growing area of concern for economic stability and policymakers.
The map above displays the current state of play on climate policy. Europe continues to lead the way, with Scandinavia setting aggressive targets and putting in place strong reforms. Some US states have introduced very progressive agendas on climate action, with California recently strengthening their reduction targets, whilst on track to reduce their rates to 1990 levels by 2020. The following graph highlights the greenhouse gas (GHG in the graph) reduction progress:
Despite this progress, the following graph is startling in its reminder of the situation faced:
The question originally asked definitely remains unanswered. This whole post may well have left the reader more confused than when they started. Even still, it is worth noting that underneath all of the politicized plans and unenforceable international calls to action, there are pragmatic, realistic alternatives available to policymakers with sound economic foundations. In our current capitalist, democratic society, the only option is creating a market for carbon emission reductions and endowing individuals with permits in this market as a source of wealth. This will align the interests of the CEOs of our large mining companies with the citizens of our small island nations. This is the only realistic method in which to do this. Waiting for universal goodwill to generate the desired outcome may prove too late.
- The World Bank – State and Trends of Carbon Pricing 2015 Report
- A Guide to the Economics of Greenhouse Gas Emissions Policies – A. Stegman and T. Stegman (2007)
- The Role of Economics in Climate Change Policy – W.J. McKibbin and P. Wilcoxen (2002)
- Climate Policy and Uncertainty: the roles of adaptation versus mitigation – W.J. McKibbin and P. Wilcoxen (2003)
- T.A., Marland, G., and Andres R.J. (2015). Global, Regional and National Fossil-Fuel CO2 Emissions.