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STANDING COMMITTEE ON ECONOMICS
24/03/2009
Exposure drafts of the legislation to implement the Carbon Pollution Reduction Scheme

CHAIR —Welcome. Mr Price, do you have an opening statement you wish to make?

Mr Price —Yes. I also have some written material, if that assists.

CHAIR —Thank you. Do you have multiple copies of that?

Mr Price —Yes. I thought I would briefly go through this to give you a more structured view of our views. I am representing Frontier Economics today. I am not representing any clients’ interests. Our interest in emissions trading policy goes back more than 10 years to when we worked with the New South Wales government to create in New South Wales the world’s first mandatory emissions trading scheme, GGAS. The then premier, Bob Carr, was quite interested in demonstrating that emissions trading schemes could work. That is not to say that GGAS is the scheme that we would ideally put in place. It was an amendment to an existing voluntary scheme, so we were very constrained in what we could do. I am not indirectly representing any clients’ interests. We work for a broad range of clients, from governments and regulators to generators and retailers. We have done a lot of work for organisations such as the WWF Investor Group on Climate Change and Australia 21. We have a broad range of interests as far as greenhouse matters and energy are concerned.

I thought it would be worth while starting quickly on the policy objective. From our perspective, that should give you an indication of the way we think about this. It is pretty clear that the scientific community think a fast, effective response is required. This policy is like nothing else Australia or the world has had to confront before in that the policy objective can only be achieved by massive and ongoing investment. That indicates the sort of policy environment that you need to create—that is, to support investment. If you want private investment you have to give them a great deal of clarity and certainty around the arrangements to make sure they want to invest the billions of dollars that are required for long-lived assets. If you do not, taxpayers will become the investors of last resort. We have had a long history of that, and it does not work terribly well.

It is clear that under any scheme, irrespective of design, any meaningful target will involve considerable expense, but that should not deter governments from implementing emissions trading schemes. It is probably the case that the cost of not doing anything will overwhelm the cost of doing something. Being a very small and open economy, Australia has a great responsibility to ensure it has the most economically efficient scheme in place. Any scheme that unnecessarily raises prices could damage the Australian economy to the point that it undermines the incentive for people to implement emissions trading schemes worldwide. Particularly given Australia’s other policy objective of being a policy leader in this area, I think it is important for Australia, for the rest of the world and for the environment that we think very carefully about the nature of the scheme we put in place.

It is worth stating that almost all of the alternative schemes that have been proposed effectively do the same thing: they all try to shift the relative economics towards cleaner, lower-emission activity in production and consumption. They do so in different means. The real problem in terms of the difference in these schemes is that they produce absolutely different price effects, which make these schemes relatively more or less attractive. One of the reactions to schemes that produce very harsh and absolute economic outcomes is that policymakers tend to moderate the target that they put in place to try and achieve emissions reductions. If you can conceive a scheme that is effective in reducing emissions trading but has a less harsh economic impact, it stands to reason that you would be able to increase the target to get a more effective environmental outcome. That is something we have been thinking about for a good many years. We work around the world in very organised energy and emissions markets, so we have thought about this very carefully.

I will just run through the three key alternatives, the different types of schemes. I have tried to simplify this as much as I can. I apologise for the sacrifice of some technical and economic purity, but this is to communicate the basic features of these three alternatives. One alternative is the classic cap and trade scheme, which the CPRS is based upon. In terms of a carrot and stick approach, I classify that as a purely ‘stick’ approach. It changes people’s behaviour by charging for all emissions. From an environmental design point of view, it will achieve its objective. There is no doubt in my mind that a CPRS will work to reduce emissions outputs.

An alternative way of changing the relative economics of cleaner and higher-emission activity is by applying a carbon tax. A number of people prefer a carbon tax because they believe it will provide much more certainty for investors—and that is a laudable aim. The problem with taxes is that the tax would be constantly adjusted to meet an emissions outcome. So I think it is an illusion that this tax would lead to a more certain environment. The other problem with taxes is that you cannot trade a tax, so you cannot get the benefits of competition and trading. I guess a third problem with a tax is that it has the same absolute, harsh price effect that a cap and trade approach has—that is, it is all ‘stick’.

An alternative way to change behaviour is by using some inducements, some ‘carrots’—positive rewards for positive behaviour. I characterise that as a ‘carrot’ approach. There are two broad types for that approach. The mandatory renewable energy target scheme, which the government intends to rely on—and has relied on in the past—is a purely carrot approach in that it provides credit for positive action, for investment in renewable schemes. The clean development mechanism used extensively in Europe is a carrot approach as well. But it is a purely carrot approach in that it pushes all the impact on to the supply side, so it can lead to higher resource costs in meeting the target. And then there is the halfway house of the carrot and stick approach itself: you reward good behaviour but punish poor behaviour. In effect, you are meeting the needs of both parties. It is this scheme that we believe delivers the best balance of economic and environmental outcomes.

I would like to speak briefly about the benefits of this approach. In the slide pack I have given you there are three pictures which in a figurative way demonstrate the three key schemes that I have described. Slide 7 highlight the benefits of the carrot and stick approach. By far the key benefit is that the absolute price effect through the economy is much smaller for exactly the same emissions reduction and exactly the same resource cost. So it has the same economic efficiency characteristics but the price effect is much smaller. The reason why I think that is a positive outcome is that it mutes a lot of the harsh economic signals that people are concerned about and which cause governments and policymakers to adopt a less aggressive and less meaningful environmental target. Of course, the immediate response to that is that it must follow that less harsh price signals mean there is less demand side response—and we can talk about that a bit later. But that need not be the case, because you can change consumers’ behaviour by beating them up with a stick or by inducing them with a carrot. In this type of arrangement it turns out that inducing people positively to change their behaviour probably works more effectively for most consumers than simply raising prices, which they will not thank you for. This has been shown by experience in New South Wales.

The other major benefit of the scheme we are suggesting here—which is in fact a modification of the CPRS, not a wholesale change—is that it completely avoids the need to churn billions and billions of dollars of revenue. The value of the permits over time will be in the order of over $1 trillion of extra costs to Australian industry in terms of the cost of the permits to the economy. It is a huge number. That $1 trillion odd will get churned between government and industry. The logic of the CPRS is that it will offset the harsh price effects by handing money back to adversely affected consumers. But we all know that two things will happen: first, a large amount of money will be consumed in administering that arrangement; and, second, it will not be the case that those funds will be perfectly allocated for all time, efficiently allocated back to precisely the parties that are adversely affected. There will be leakage, there will be inefficiencies and there will be money that will go to people’s pet projects—which will create their own inefficiencies. This scheme completely avoids the need for that massive churn of revenue.

A third benefit which is really important and becoming more obvious to people—in fact, it was on the front page of the Age today and in the editorial, and I think it has been raised by the Australia Institute—is that the way the CPRS works is that if complementary measures are put in place by other state governments, or if voluntary actions are undertaken by consumers, all that does is leave additional emissions that are allowed to be produced by industry. It undermines the incentive for voluntary action and undermines the effectiveness of complementary measures that governments put in place at the federal, state and local levels because the way these schemes work is that it is a target that is consistent through time, irrespective of the economic conditions. It provides investors with a great deal of certainty. It maintains the task for producers and consumers to continue to reduce emissions through time. It does not give them a let-up if the economy goes back a little bit. It still keeps the pressure on reducing emissions through time and it does not undermine the incentive for voluntary action or complementary schemes.

I have said in the slides that the CPRS creates some perverse impacts in that it tends to reward higher emitters in the compensation arrangement than lower emitters and in fact discourages high emitters from reducing their emissions. The sort of scheme that we are promoting would not do that, would not let those higher emitters off the hook, if you like. Because the emissions task is constant through time under the scheme we are promoting, carbon prices will be far more stable through time. We spend a lot of time with investors in the energy sector in particular and the one thing they like is stable commodity prices or prices against which they can decide their investments. The last speaker I heard talked about the European emissions price rising and collapsing rapidly according to what happened in the regulatory arrangements. You will see the same thing with the CPRS through the course of re-establishing the so-called gateways. Prices will rise and collapse as you come close to those gateways. It will create lot of price instability. Price instability makes it very difficult for investors to make long-lived infrastructure investments. This type of arrangement provides much more stable prices.

It is often said that the scheme that we are promoting has limited coverage in terms of only being applied to, say, the electricity sector. That is not true. The arrangement we are promoting here can be applied to the exact same sectors as the CPRS. In fact, you could have the MRET, the demand side of abatement, any other form of abatement, agricultural abatement and all the other sectors that are currently covered under the umbrella of one scheme rather than having multiple schemes operating at great expense to investors.

I will skip to slide 9 because I think it is really illustrative of why this is such an important issue. If these were just administrative nuances I would not be sitting here in front of you. It makes a massive difference to economic outcomes. This is an example of some electricity modelling that we have done. We do a lot of this for all of the major electricity regulators and institutions in this country and around the world, so this is pretty robust stuff. Let us look at what I have called the base case, the Department of Climate Change reference case, which is the dark blue line. This shows what would happen to electricity prices if no emissions trading scheme were put in place in Australia. We did that modelling at the time of the green paper on ETS, which is the same target that is now being considered. The red line is the new electricity price and the dark blue line shows when there is no emissions trading. You can see there is a very severe jump in electricity prices. The reality will probably be more than that. Then we have modelled the scheme that we are proposing, which is the light blue line. This is modelled to produce the same greenhouse gas abatement as under the CPRS, under the red line. You can see the effect on electricity prices is far less severe for the exact same emissions outcome.

You can think about that either as softening people’s hardened opposition to introducing an emissions trading scheme or, alternatively, as extra headroom allowing you to increase the target to a more meaningful level. So there are different ways of thinking about the policy implications of that. But either way it is pretty clear that, if you have much less severe effects on such an important product as electricity, it will have less of an impact throughout the rest of the macroeconomy. So you will not have the requirement for compensation for industry, for the users. You will not have the adverse effect in terms of carbon leakage—industry leaving Australia for other countries where emissions may in fact rise. We can avoid all of that type of problem with this type of scheme. And our analysis, doing the same sort of general equilibrium analysis that the Commonwealth Treasury does, using the same type of model, shows us that, if we apply this type of scheme just to electricity, the economic costs are in the order of $300 billion to $400 billion cheaper than the CPRS. So it is not a case of just—sorry?

Senator ABETZ —Over what period?

Mr Price —Over that same time period, between now and 2050. So it is not a case of administrative nuances; this is a very meaningful difference in scheme design.

Senator CAMERON —You said ‘$300 billion to $400 billion cheaper’?

Mr Price —Yes.

CHAIR —Thank you, Mr Price. You were saying that the current scheme discourages voluntary action. I am not quite sure how voluntary action, particularly that of households or, say, small business, would fit into your scheme. How would that fit in, in terms of the permits? How would that work?

Mr Price —A working example of how this could work is already in existence in New South Wales as part of the GGAS scheme. There is something there called the demand-side abatement rule. I am not suggesting that for this, but it gives you an idea of how it works. The way that functions is that businesses—companies such as Easy Being Green—make money by going around to people’s houses and knocking on their doors, and retrofitting the entire house with energy-efficient light bulbs, low-flow shower heads et cetera, and they secure a credit. Then they use that credit to fund their business and to make money. What the consumer gets out of that is a lower electricity bill, because they are not heating as much hot water or using as much electricity. It is a positive inducement. The flipside to not producing such a harsh price by just charging people higher electricity bills—which, for most consumers, tends to do nothing, because it is such a small proportion of their total expenses—is that it is a positive inducement, and it generates a business where people go and look for these opportunities to reduce energy demand. That would be incorporated as part of this type of arrangement. So instead of ‘black permits’, these are the opposite—’white permits’. They are credits for positive behaviour.

CHAIR —But, under the CPRS, wouldn’t households have the same incentive to respond to people coming around, knocking on the door and offering to reduce their electricity usage? Your own graph shows prices going up quite steeply, so there would be the incentive there.

Mr Price —Electricity represents, for most householders, just a couple of per cent of their entire household budget, so even a very steep increase in electricity prices would have very little effect on the majority of consumers. So you have got, basically, two classes of consumers.

CHAIR —But why would the consumers do it under your scheme?

Mr Price —Because the business that actually makes money out of selling the credits gets a profit from that. The consumer, in that case, does not actually have to do anything. How, under a CPRS, would a company like Easy Being Green make money by reducing the consumer’s household consumption by a tiny per cent?

CHAIR —So you are not saying that the householder would benefit; you are saying that the intermediate company would benefit?

Mr Price —The householder benefits under this type of arrangement in two ways. Under both the CPRS and this type of arrangement, consumers benefit by getting a lower electricity price. What I am suggesting here, and what experience shows us, is that consumers are far more responsive to a positive inducement—or making it easy for consumers to switch to low-energy products like light bulbs and low-flow shower heads—if someone else does it. In this example, that someone else is a private sector company looking for profitable opportunities to make money, and where they make that money is by knocking on someone’s door and retrofitting their houses. That will not happen under a CPRS.

CHAIR —I do not see why not. The other thing you said that puzzled me a little was that the CPRS discourages high emitters from reducing their output. In what way does it discourage high emitters?

Mr Harris —It is more in the thresholds that are set for the compensation measures. So the fact that beyond 2,000 tonnes CO2 per million dollars you get a rate of compensation at 90 per cent for energy intensive trade-exposed industries whereas below 2,000, between 1,500 and 2,000, the level of compensation drops to 6,000. Below 1,500 there is a rate of zero per cent compensation. By these differences in the level of compensation you can create perverse incentives in terms of incentives for companies to reduce their emissions. That was highlighted by the Business Council of Australia in one of their submissions.

Mr Price —The logic is that there is a point at which a producer would have no incentive to reduce their emissions because they fall below a compensation threshold, so their profit will actually decline if they get cleaner, not increase. They have to bear the costs of getting cleaner plus their compensation then drops, so it creates a sort of crazy incentive to stay as a high emitter.

CHAIR —So the compensation levels are wrong.

Mr Price —I think wherever you set it you are going to get the same sort of boundary issues; that is always going to happen.

Senator ABETZ —On page 9 of your submission, the last page, there is an example of price affects electricity. On the left-hand side we have got a code LMRC dollars, per megawatt hour, I assume. Just reminded me what LMRC is.

Mr Price —These prices are in fact reflective of long-run marginal costs of the generation system, so it is the incremental cost of building another generator—or it could be renewable or whatever—to meet demand. It is a lower band of prices in the market.

Senator ABETZ —Reading that, starting at 2010, where does the scenario 1, the Green paper ETS, start us off at? Would that be at about 52 or something like that?

Mr Price —Yes. There is probably a good 25 per cent jump in prices, at least.

Senator ABETZ —What I am tracking is that in 2010 through to, if my eyesight is correct, about 2023 we see a significant jump of, in rough terms, $50, which is virtually a doubling of the cost. But if you project it out into the never-never, 2050, the total is in fact only about a $60 increase. If you average it out over those 40 years, the impact might not look as stark, but the reality is that there is a huge cliff to climb, if I can use that term, for the economy in about the first decade or first 1½ decades, and that is where the real economic impact is going to be, if I might say, very significant. What do you say to those people who are so anxious to spin it out and tell us about what the impact would be over the years to 2050 as opposed to telling us what the real impact is going to be in the first decade or first 1½ decades?

Mr Price —You are dead right, it is true that the price effects are more pronounced after the first 10 years. The reason is that that reflects when the absolute emissions have to come down, so the task at hand actually gets harder and harder. To slow the growth of emissions is one thing but to actually reverse it is another one altogether.

That corresponds pretty much with the rapid rise in prices, because it is actually trying to turn the absolute emissions over. The logic of this is that there will be more technology available in 15 to 20 years, and that will tend to flatten the price. But of course if technology gets much cheaper then the price in effect will be much less, or if the supply of that technology is more constrained—for example, we do not have carbon capture and storage or we cannot get the assumed level of forestry sequestration—then those prices will be much higher.

Senator ABETZ —Let me identify myself as being somewhat a sceptic when it comes to modelling in particular, especially the further out we get, because of all the variables that might come into the scene. For instance, somebody trying to model the economy even 20 years ago would not have taken into account the advent of computers, how they have just taken over and the impact they have had. The modelling that we have had put to us is usually based on the overall GDP impact, which up until the year 2050 will only be 0.1 per cent, 0.2 per cent or some other marginal percentage. That might be right if it is evened out over 40 years. Are you able to shed any light on the impact over that first decade or first 1½ decades? Will we have a similar ramp-up of the impact on GDP in that first decade which will then ease off?

Mr Price —Yes. First up, let me say I have the same scepticism about modelling. We do a lot of it, so I know how much caution you should apply to it—to everybody’s, including our own. Our interest here was first of all to demonstrate a relative effect between different schemes. Even if you did not believe the absolute numbers, I think what is really instructive here is the relative difference between these prices. That is one thing.

Electricity modelling is not for the fainthearted, but macroeconomic modelling is even more fraught, and we do a lot of it—and we have done lot of this for the CPRS. We use the same model as the Commonwealth Treasury, MMRF, and work with the Monash people, so is not a war of models. The way these models work is that, by and large, people concentrate on the long-term adjustment. So the way that the government report it is the way that all treasuries report these models: they look at long-term adjustment. But the reality is that the economy is nowhere near as flexible as modelled by the Commonwealth Treasury or by us. The economy responds relatively seamlessly and structurally adjusts without very much cost. So it is just not realistic.

Senator XENOPHON —The modelling, do you mean?

Mr Price  —Yes. I will give you a good example. In modelling the CPRS, one of the scenarios we modelled is the same, in fact, as what the Treasury modelled: that Australia adopts a CPRS and the rest of the world is assumed, also, to have adopted an emissions trading scheme. Clearly, that is not going to be the case. You would anticipate that a modelling scenario that had Australia adopting a CPRS and the rest of the world not doing anything would give you a much more severe outcome. That is what you would expect. But with these models you get almost exactly the same economic outcome, and the reason for that is that these macroeconomic models just assume that the economy adjusts seamlessly.

Senator ABETZ —That was a comment I made to a previous submitter—that it seems that all the modelling is based on the adoption of several assumptions and therefore it is not that surprising that the modelling comes out with similar impacts. But one of the aspects I am interested in is: are you aware of any modelling that has been done as to the impact on the Australian economy if other countries do not follow suit or the current world status quo—be it the discredited European system, the half-baked Canadian system or whatever they might have in New Zealand—were to limp on and remain in place and Australia were to go it alone? What would be the impacts then? Would they be significantly greater?

Mr Price —As I suggested before, we have actually done exactly that but using the standard macroeconomic modelling assumptions where the economy does adjust. We did it to try to understand more about how flexible the economies are assumed to be. So when we did a scenario where everybody does something together we got the same modelling outcome using the Centre of Policy Studies model and everybody else’s models. We got the same outcome when Australia just went it alone. That is illogical. The reason for the modelling outcome is that these models basically function as though the Australian economy is infinitely flexible, and it is not right. It is one of the things that you need to be very wary of when you look at these economic modelling results. We use these models, and we know how to use them, but I think there is a real danger that people will start to believe those modelling results. We did that modelling scenario just to demonstrate the care you need to take when you interpret the outcomes of those results.

When the government talks about one-tenth of one per cent, the absolute value of the economic cost on a cumulative basis over time is into the trillions of dollars, even on the basis of their own modelling. So the economic loss is trillions of dollars. If you keep dividing a number by a bigger number you come up with a smaller per cent, of course. But if you look at the underlying absolute cost, it is quite big. But as I said right at the beginning, it is my belief that it is still worth while pursuing an emissions trading scheme because it is probably right that the cost of not doing something will eclipse the cost of doing something. The challenge is really to find the best way to make use of your resources, to find a scheme that has less severe impacts. That is why we are so interested in scheme design. If we come up with a scheme design that mutes these trillions of dollars and can bring that down by half a trillion dollars or more, that would be fantastic.

Senator ABETZ —How can the cost of not implementing something be more than the cost of implementing? Is that in the context of Australia going it alone or the rest of the world coming on board as well?

Mr Price —I am not sure what you mean.

Senator ABETZ —I understood you to say that chances are there is a good argument for an emissions trading scheme because the cost of not doing anything would be greater than the cost of doing something, so we need to act. I am just wondering whether you put that in the context of the world acting in concert or of Australia just going it alone.

Mr Price —I understand what you are saying now. Let us say that in an emissions trading scheme the broader general equilibrium effects on the economy are $2 trillion or $3 trillion, which they are at least going to be. That means that you expect the damage from not doing something is going to at least exceed that. The corollary of that is that in undertaking that action you have actually done something positive in terms of reducing emissions around the world. If Australia were the only country to do something and expend that $2 trillion or $3 trillion and the rest of the world did nothing, it would be all for nothing. I agree with that. That is true.

Senator CAMERON —Mr Price, thanks for coming along and not asking for money, because that is mainly what we have had today! I have a whole range of questions. I may have to put some of them on notice if I do not get through them all. First of all, could you provide the committee with the data and assumptions that sit behind your slide 9?

Mr Price —Sure.

Senator CAMERON —From what I have seen, this is a baseline and credit scheme and an emissions intensity scheme. The Canadians have used this as what they are describing an interim measure. Why would the Canadians use it as only an interim measure if it delivers all of these benefits that you are proposing?

Mr Price —I think there is a confusion of terms here. What the Canadians have proposed is not a baseline in credit; it is an intensity based measure, so there is both a stick and carrot, whereas, with a baseline in credit, there is just a carrot. That is often misunderstood. So it is sticks and carrots.

Mr Harris —The difference between the two is: under a baseline-in-credit scheme, if your emissions are above the benchmark then you are not liable for those emissions, whereas under an intensity based or benchmark-type scheme you are liable for all emissions that are above that baseline target. That is where the source of funding comes from or the source of demand for purchases of the credits for those that are below that benchmark.

Mr Price —Under a baseline-in-credit scheme, the demand for those credits comes from consumers. If you think about the MRET scheme, for example, it is not producers that buy the credits; it is the retailers on behalf of the consumers, so the consumers are the demanders for those permits. That is the distinction. The Canadians have proposed an intensity based scheme which is in fact a cap and trade. You are capping emissions and you are allowing trade between producers of permits and buyers of permits. The key distinction between the CPRS and the Canadian scheme is that the baseline under the CPRS starts at zero, so you start buying emissions from any emissions that you produce, whereas under the Canadian scheme all they do is they move the starting point at which you buy emissions up higher and then they give credit for anyone that is below it and give a liability to buy permits for anyone above it. That is the only real distinction between the two, at a simple architectural level.

Senator CAMERON —I know these are complex issues, but I have to try to get through them as quickly as I can. How do you achieve broad coverage under your scheme? As I understand it, these schemes are more narrowly focused.

Mr Price —I think almost identically to the way that the CPRS is set. What ends up happening under the CPRS is that there is a coverage of a number of sectors, you know what they are and there is an overall cap. What the scheme does is that it then establishes a form of allocation of permits and they have a range of what they call allocative baselines to establish the permits that people receive. The Canadian scheme works almost identically to that, in that the allocative baselines that are incorporated in the CPRS are identical to the benchmarks that would be established for each sector under an intensity based scheme.

Senator CAMERON —Are you saying your scheme would be different, that you would have a broader base?

Mr Price —The base under an intensity scheme can be identical to that under the CPRS. You can have the same mechanical arrangement for any sector, and you can have permits traded. A permit that is created in, say, the cement industry is completely fungible, or tradeable, with a permit that is required to be purchased by an electricity producer and vice versa. These are completely homogenous permits that are created and bought by different sectors. In that respect, it works the same way as the CPRS but without the negative effects of the CPRS.

Senator CAMERON —How would you be confident that the variables you used to determine your baseline are 100 per cent?

Mr Price —That is a very good question. I think the first thing I would do is establish the benchmarks on the same basis that the government has already done for the allocative baselines in the CPRS. As I was suggesting before, the government has actually already solved this issue. It is often said that it is very difficult to establish the baselines in an intensity scheme or, for that matter, a baseline-in-credit scheme, but the government has already done that. It is actually a key design feature of the way in which it compensates industry. I know that the government has all already overcome that problem.

Senator CAMERON —Are you proposing that there should be baselines set for the myriad of companies, that companies should have different baselines, that residential consumers should have a baseline?

Mr Price —No.

Senator CAMERON —What are you suggesting?

Mr Price —I am just going to use the CPRS as an analogy, because they have a sort of clunky version of what we are suggesting. They already set sector targets and they call them allocative baselines. They set them according to different sectors. You would not have a baseline set for a particular generation type; that is not the way that the CPRS is set, so I would use the CPRS as an analogy.

Senator CAMERON —Regardless of the argument that other countries are not going to move to an international scheme, I am more optimistic than that and I think there eventually has to be an international scheme given the problems we are facing. It does seem that most companies are moving to a cap and trade—that seems to me to be an inevitability.

Mr Price —I have said before that I am a keen supporter of an emissions trading scheme and I think that wealthy countries generally need to establish some policy leadership, but being a very small economy we have a greater responsibility in that we have to establish a scheme that does not destroy the economy, which would destroy the reputation of emissions trading. That is why I am so interested in it. So I think we start from the same position in that regard. What was the rest of your question?

Senator CAMERON —Why aren’t other countries adopting it?

Mr Price —The point was that the dominant model—and you hear this a bit—is the cap and trade. It turns out that it is not. By far the most common model for emissions trading around the world is in fact some form of baseline and credit or intensity scheme. Major nations are actually moving towards an intensity based scheme. In fact global sectoral agreements, which are the emerging trend, are intensity based arrangements. They are becoming the more dominant model. China, for example, is moving towards an intensity scheme. As to the reason, I put up a slide the other day at the Parliamentary Library presentation that I did and it showed a very interesting relationship. Countries that have a greater exposure to global trade are tending towards these intensity schemes because they are very worried about the problem of carbon leakage. So they tend towards emissions intensity schemes because they have the properties that we have been suggesting. I do not think it is true that people are moving towards cap and trade. In any case, as I have suggested, the scheme that we are describing here is in fact a variant of a cap and trade. So I do not think there is a very useful distinction between intensity schemes and cap and trade. I have obviously been using that term to communicate the difference, but it is in fact a cap and trade. It is just that the baseline at which you start counting the cost of carbon is not zero; it is higher. That is the only key distinction between the two.

Mr Harris —And there is nothing to say you cannot trade between the two different schemes in the same manner that permits under the clean development mechanism are recognised in the European scheme even though the essential form of the schemes is different.

Senator CAMERON —I am still not clear on this because I thought your scheme went to individual companies to set the baseline.

Mr Price —No.

Mr Harris —They are sectoral.

Mr Price —That would not be workable; it would be an administrative nightmare.

Mr Harris —That is in the same way that the allocative baselines are set for the emissions-intensive trade-exposed industries under the CPRS.

Senator CAMERON —You criticised the government’s gateways.

Mr Price —I do not think criticism is the—

Senator CAMERON —I think you used the European analogy, but wasn’t that the reason why in the government’s scheme we have had very long lead times to the gateways and the gateways might never be reached. That is to make it so that you do not have a short gateway where the price could collapse, as in Europe. It is actually learning from the European model.

Mr Price —I do not think I was being critical of the gateways; what I was saying was that the gateways give rise to price volatility and price volatility is bad for investors—they find it difficult to hedge that sort of risk, particularly where that risk is not driven by economic fundamentals but by regulation. Maintaining some flexibility in targets is quite important to reflect the reality that science will develop, technology will develop and the relative costs of abating will change over time. Governments cannot give an ironclad guarantee to anybody—consumers, voters or investors—that they will stick with an emissions target for all time. That would be crazy. So a gateway is an explicit recognition that there is an opportunity for government at various waypoints to be able to adjust the target. That is one way of doing it. I think the reality is that under any scheme, whether it be tax, an intensity scheme, or classic cap and trade, it is naive to assume that the targets will be fixed through time. They will be driven by science, technology, economics and politics. They will change—all of them.

Senator CAMERON —Professor Garnaut gave evidence yesterday and spoke about the consultation that had taken place and that there was not a great deal of enthusiasm from business within Australia for an emissions intensive scheme. What is your comment on that?

Mr Price —My comment on that is that I think that is Professor Garnaut’s view. It is probably pretty fair to say that it received virtually no attention in the course of any analysis that Professor Garnaut undertook. His reports only referred to it in total over the telephone books of reports that he produced on a single page. It was a single page and yet this is a scheme design which is more dominant around the world and more prominent in Australia in terms of operations. It received a page of attention. Each state has in fact promoted the idea of a baseline and credit scheme in the form of their own stand-alone renewable schemes such as GGAS. Your own MRET scheme is in fact a baseline and credit scheme.

Senator CAMERON —Could you provide us information where this type of scheme is operating and why you believe it will become the dominant scheme?

Mr Price —Sure.

Senator JOYCE —Can you explain to the committee how we actually go about the process of administering exactly who is producing what and whether they are above the baseline or below the baseline? How do we do that?

Mr Harris —That is essentially a matter of tracking emissions, which would have to take place under any emissions trading scheme. It would be a process of monitoring and verifying actual emissions.

Mr Price —Under the CPRS, for example, you have to know who has produced what so you can penalise people if they do not have the required number of permits. You then match that against the permits that they have. They also then have to have a basis for comparing where they are compared to the allocated baselines. The administrative mechanics of this is precisely the same under the CPRS but avoids the need to establish a whole institutional structure for auctioning permits and recycling revenues back to consumers.

Senator PRATT —I note that President Obama has just announced a cap and trade type system. Irrespective of the number of countries that might have different models, would you concede that, when you are looking at an economy the size of the United States, that does create a fairly dominant paradigm?

Mr Price —When somebody talks about cap and trade, there are so many different versions of a cap and trade that you have to be absolutely clear what they are suggesting. All that has been suggested is that they develop a cap and trade scheme. The Canadian scheme is in fact a cap and trade scheme of a kind. So it depends on what they put in place. If they put something in place that is called a cap and trade of a certain kind that does not necessarily mean that we should follow that. Their interests may in fact be entirely different.

I was recently in California, for example, where the largest emitters are cars. So whether you put in place a cap and trade or a fuel tax it will not matter to that the economy, because it is not going to affect their trade flows. Whereas a scheme you put in place in Australia, because most of our emissions come from major industrial users and electricity generators, would could significantly affect trade flows. I would never expect that it was economically sensible to have the one scheme around the world. It is actually not necessary, because you can interchange, you can trade in between different schemes, as Europe has in fact shown.

Senator PRATT —I can accept that nations should adopt a scheme that suits them, but you did seem to argue that there were a large number of countries with it and that the intensity model was the dominant model. But America is clearly not pursuing an intensity model; it is a 100 per cent auction and cap and trade scheme. That might have a fairly dominant effect on what the market looks like.

One of my concerns about the intensity model as you have framed it—and I am sorry, you do not call it an intensity model, but it is an intensity based approach—is that you have purported that the benefit of it is the lack of churn in government revenues. But one of the concerns I have is in regard to the incapacity for government then to compensate those that may need protection from the most onerous price increases within the scheme—for example, low-income householders. How can we assist them easily without being able to raise that revenue that we can then commit to that?

Mr Price —I will take you to slide 9, but, first of all, compensation is not a permanent feature of the CPRS—it was not presented as such, unless you are suggesting that it will be; it is a transitional measure. I will take you to slide 9 in respect of electricity. You tell me what assistance low-income people will need—or industry, for that matter—in terms of compensation. They do not need it—that is the point. The only people that need compensation in this little world for electricity are in fact electricity generators. Generators are equally adversely affected under what we are suggesting here, as well as a CPRS, as well as a baseline and credit. It is only the money that goes towards compensating electricity generators. From that reason, of course, you will not hear the ESAA being very supportive of this type of scheme, because they want to be able to put their hands on some of the money you have created under the CPRS. So they will dislike an intensity based scheme for that reason.

Senator ABETZ —In relation to the sectoral areas that I think Mr Harris was referring to—possibly Mr Price, I cannot recall—how would you determine a sector in relation to the baseline system? One of the criticisms is: how do you determine what a sector is? Is the sector, say, the electricity generating sector; is it the coal sector; or is it the black coal sector as opposed to the brown coal sector—

Senator XENOPHON —Or gas.

Senator ABETZ —or gas, indeed, as Senator Xenophon quite rightly interposes? Your definition of ‘sector’ is going to be fundamental is it not to the efficacy of the scheme?

Mr Price —For practical simplicity, I would define it on the basis that the CPRS does. They have already defined these sectors. There is no real reason to change things just to complicate things. From an economics point of view, the way that you would define a sector—this is the way that economists think about it—is in reference to substitutions. So, for example, if gas generation is substitutable for coal generation, then you want to apply the target to both of those producers. You look at the product market so you do not create distortions on the product side of the market. That is a standard practice for economists in defining markets, in fact.

Senator ABETZ —Thank you.

CHAIR —Obviously there are a lot more questions that we would have liked to ask. Thank you for your time coming in today. Perhaps if we can give you questions for you to come back to us with. Likewise, if you have any other supplementary submission you would like to make, we would be happy to receive them. Thank you.

Mr Price —Sure. Thank you for the opportunity.

 [4.16 pm]