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Economics Legislation Committee - 19/10/2012

FRIJTERS, Professor Paul, School of Economics, University of Queensland

MURRAY, Mr Cameron, School of Economics, University of Queensland

Committee met at 09:20

Evidence was taken via teleconference—

CHAIR ( Senator Mark Bishop ): I now declare open the public hearing of the Senate Economics Legislation Committee's inquiry into the Clean Energy Amendment (International Emissions Trading and Other Measures) Bill 2012 and related bills. The Clean Energy Amendment (International Emissions Trading and Other Measures) Bill 2012 and related bills were referred to the committee by the Senate on 20 September 2012 for report by 29 October 2012. The committee has received 19 submissions, which are available on its website.

These are public proceedings, although the committee may determine, or agree to a request, to have evidence heard in camera. I ask everyone to ensure they have switched off their mobile phones. I also ask photographers and cameramen to follow the instructions of the committee secretariat and ensure that senators' and witnesses' laptops and personal papers are not filmed.

I remind all witnesses that in giving evidence to the committee they are protected by parliamentary privilege. It is unlawful for anyone to threaten or disadvantage a witness on account of evidence given to a committee, and such action may be treated by the Senate as a contempt. It is also a contempt to give false or misleading evidence to a committee. If a witness objects to answering a question, the witness should state the ground upon which the objection is taken and the committee will determine whether it will insist on an answer having regard to the ground which is claimed. If the committee determines to insist on an answer, a witness may request that the answer be given in camera. Such a request may, of course, also be made at any other time.

I remind members of the committee that the Senate has resolved that departmental officers shall not be asked to give opinions on matters of policy and shall be given reasonable opportunity to refer questions to superior officers or to a minister. This resolution prohibits only asking for opinions on matters of policy and does not preclude questions asking for explanations of policies or factual questions about when and how policies were adopted.

I now welcome Professor Paul Frijters and Mr Cameron Murray of the School of Economics at the University of Queensland. Gentlemen, would either or both of you like to make an opening statement?

Prof. Frijters : Not necessarily, no.

CHAIR: I have a few brief questions, and then I will hand over to my colleagues. Professor Frijters and Mr Murray, in the past you have referred to political pressure to keep prices low in the EU, citing the fact that vested interests would stop the EU set-aside plan. In the light of those comments, are you aware that Europe's power companies issued a joint statement this week supporting the EU commission's plan to limit the supply of carbon permits and strengthen EU emissions trading?

Mr Murray : I was not aware of the letter, but I am familiar with the stage 3 policy on power generators.

CHAIR: Is the phase 3 policy on power generators about plans to limit the supply of carbon permits and strengthen the US emissions trading scheme?

Mr Murray : In phase 3, basically the member states of the EU have been able to give out as many permits for free as they like. In phase 3, starting next year, power generators are not to be given free permits except in the 10 new member states, so they are going to have to purchase them.

That is the main change, but there is still no limit on the quantity they can purchase. There are still plenty of permits in the system for them to satisfy their needs, and the price, as we have seen from recent auctions, is going to be pretty low compared to Australia's price at least.

CHAIR: Yes, but I think that we are talking at cross purposes. Are you not aware of the EU Commission's plan to limit the supply of carbon permits and strengthen the EU Emissions Trading Scheme, as outlined by the power companies late last week?

Mr Murray : Nothing apart from the EU—

CHAIR: Okay, I will move on. You have also advocated in the past that once we get an emissions trading scheme that Australian policy is designed to implement a higher carbon price than Europe. What do you consider the views of Australian businesses would be if that should come to pass?

Prof. Frijters : Can you repeat the question? The reception is a little bit poor.

CHAIR: In the past you have advocated that once we get to an emissions trading scheme that Australian policy is designed to implement a higher carbon price than Europe. What do you consider the views of Australian businesses would be if this should come to pass?

Prof. Frijters : My view would be that Australian businesses would welcome the move to go to European trading because they would anticipate a lower cost for their carbon permits, and I would anticipate businesses, furthermore, to even try to undercut that price by trying to use the Kyoto offsets, which are outside both the Australian and the EU system.

CHAIR: That is right. It would be a natural and logical reaction—

Prof. Frijters : Absolutely

CHAIR: for businesses to do that, would it not?

Prof. Frijters : Of course.

CHAIR: Could you see anything that would interfere with that natural inclination?

Prof. Frijters : No, I think that is all well and true and proper. They are trying to minimise their costs of having permits and for them the externalities on the long-term environment are something that is a collective worry, as it were, and hence something that the chosen representatives of the population should worry about.

CHAIR: That is right. That then becomes a necessary consequential debate. You will also be aware that it is policy of the opposition to repeal the carbon price. In your opinion, how would this impact entities in Australia that have bought Australian carbon permits? Does it represent a risk or uncertainty for business?

Prof. Frijters : It depends very much on the exact timing of repealing the carbon scheme. If they would repeal it the second they came into office, midcycle, as it were, then there is great uncertainty as to the worth of the permits that the businesses have bought and that would naturally lead them to either want to buy European permits or want to have a lower price that they had paid for Australian permits.

If, on the other hand, the Australian opposition would let it run its yearly cycle and then say that they were going to phase it out as soon as the year's batch had run its course, then there is no difference between the Australian and the European permits so there should not be a price difference nor a risk associated with it. So the details of the exact repeal matter in this case.

CHAIR: Why do you argue, Professor, that if there is a slight delay in the phasing in of that policy—if I have articulated it correctly—of 12 months that there is such a significant difference in outcomes?

Prof. Frijters : Imagine that you have bought permits which you had to hand over at the end of the year for carbon emissions that you have done in that year, that duty of handing in your emission permit is worth something as long as you think that you have got to hand in those permits. If, however, before the handing in of the permits someone says, 'Sorry, you do not actually have to hand in these permits, we are going to go back from these schemes,' it means that those permits at a stroke become valueless within Australia.

Then the question arises: can you sell them on somewhere else? If you buy permits within the European system, you can sell them on to European companies so they are still worth something. If however you are locked into the Australian system, then they are worthless because there is no-one left to sell these permits to, hence your asset starts to depreciate 100 per cent the moment that the system is repealed. But if you wait until they have to hand in these permits, which is at the end of the yearly cycle, then all you have to do is say, 'Don't buy any new permits. We are not going to enforce this next year.'

CHAIR: Professor, in your submission you suggest stricter limits on access by Australian liable entities to international permits, so stricter access. Your submission suggests that limiting the number of EU permits purchased by Australian liable entities might be achieved through a control system in which the government could float additional technical permits to ensure that Australian permits are preferred and revenues are captured locally, and I understand that approach. Could you expand on that concept and explain why one approach is to be preferred over simply lowering the limit on international permits?

Prof. Frijters : Yes, I can answer that. The issue of a flexible permit system is already well established in the European Union where they have several technical reasons for increasing the number of permits that they have there, and maybe Cameron can talk a little bit more about that later, about how that exactly is done. But the issue for Australia is that we cannot quite anticipate the demand that we will have for these permits every year, and one way to deal with the notion that Australia would have additional demand, by which we would not want to see funds flowing out to the European Union, is to then meet that demand locally by expanding the permit scheme. You would still have a price, so there would still be an incentive for Australian business to limit the carbon emissions, but unless you have a flexible system of adjusting the number of permits you sell locally then the funds are going to flow to the European Union. As we argue in our submission, that will not lead to a lowering of the carbon emissions in Europe because of all the reserve permits that they can sell without any change in their prices or volume.

CHAIR: Thank you for that. In your submission you suggest, in passing, that the clean development mechanism, the CDM, has almost collapsed. Could you elaborate on your understanding of trends impacting the value and integrity of certified emission reduction—CER—units and Kyoto units generally?

Prof. Frijters : Yes. What we are moving off is mainly UN utterances on these issues. One of the things that has happened with CDMs is that their price relative to those of the European permits has gone down and there have been barriers erected by the European Union and others as to a complete move towards CDMs. So various aspects of the CDMs have now been outlawed. As for CFG gases, as I think they were called, there were carbon offsets for those to be purchased in previous years, and all that was discontinued a few years ago because of issues with corruption in that scheme. So it is on the mind of the European Union and you can see it in the price but there is this differential, suggesting that the scheme, as it were, has credibility problems. The volume of the scheme, furthermore, is also quite low. It is very low compared to the total volume either in Australia or in the European Union. So if you look at a market where the price is very low, the volume is very low and there are credibility issues where parts of the market have been deemed outlawed in other instances, you are looking at a market in decline.

CHAIR: I have one question to ask on the issue of insurance components for Australian permits. On page 3 of your submission you suggest that, by definition, the fact EU permits will be fully tradeable and Australian permits will not be increases the associated risk of Australian permits. Does this concern about the unequal value of permits issued by the two schemes extend beyond the one-way link to the transition period? Do you envisage your insurance component being required once a two-way link is established?

Prof. Frijters : Once a two-way link would be established this insurance component would no longer be an issue, because Australian permits can then be sold to Europe whether or not they are bought here or whether or not they are bought in Europe and vice versa. So the insurance component would go away. We understand that there are a lot of negotiations between now and then to ascertain all the details of that two-way system. Hence we cannot really comment on a system which is as yet unknown.

CHAIR: What about the concern about the unequal value of permits issued by the two schemes? Does it extend beyond the one-way link of the transition period?

Prof. Frijters : No, not in the sense, if you believe what is being put out in the media, that by having a full two-way link and hence treating all the permits on a par the insurance component would fall away.

CHAIR: In that case that is a matter then for the results of the negotiations to be made public in due course?

Prof. Frijters : Exactly.

CHAIR: I will hand over now to Senator Birmingham.

Senator BIRMINGHAM: Thank you, gentlemen, for your time today. Can I start by asking about your concerns about the scope for fraud and manipulation and the integrity of the EU ETS. In your submission you talk in particular about scoping fudge factors and enforcement fudge factors. Can you give us a little bit of evidence as to why you see these as genuine concerns and not just concerns that should be viewed in a historical context when it comes to the EU ETS?

Prof. Frijters : I can comment a little bit on that. There are three pieces of evidence that one can see outright. One is that there have been years in which there are more freely allocated permits then there are actually carbon permits used and hence that means that the political systems within the countries in the EU have led to so much free stuff being given out that it has oversaturated the market. That tells you that there is a strong feedback between policy and internal demand.

The second aspect of enforcement is that there was a Europol report into the sloppy accounting mechanisms that were used to verify people's identities. There was an approximated—according to some estimates—five billion fraud in GST within the European Union. It was a little scheme of companies supposedly outside the scheme buying permits and then selling them within the permit scheme and there was a GST differential that they could then pick up. By disappearing off into the Caribbean or Spain these people were then, as it were, untraceable but they did leave with the GST revenues. That tells you that, historically speaking not so long ago, there was a very sloppy accounting as to who will actually did cross-border trading.

If we then look at the verification mechanisms, the crucial aspect of the scheme whereby you see how much a company has actually used, this is to a large extent self-reported. The verification scheme is that you have almost like a yearly account, you say on the books how much you have used, how much of the various fuels, what your efficiency factor is, and then you have a verifier come in to look at your reports. So all that the verifier in principle needs to do is just look at the documentation that you have provided. Nominally, they are supposed to do spot checks, but as yet there are is still no operational peer review mechanism for these verifiers and hence there is a strong possibility that people choose the verifiers who go easy on them. This is, of course, an unverifiable statement in itself precisely because there is no peer review mechanism as yet—it is a murky world of verifiers. But the European Commission itself is really worried about this and hence in just the last two years has put a lot of legislation in place to try to get a peer review system of verifiers. That does show that the commission is quite worried about it.

Those are the three things that are directly on the table in the public domain. If you then think about further worries about the enforcement mechanisms, you look at the actual verification documents. We went through some of the actual documents which verifiers have to send in and there was a lot of room for interpretation or manoeuvring in what we saw. So there is a lot of room to manoeuvre on what you actually count as the fuel that went into a company, as to the efficiency factors that you would allocate and the level of cross-border trades that had these carbon components in them. This then falls back to the local national legal system to enforce proper accounting mechanisms. Of course the incentives to, as it were, penalise your own companies are very limited within the European Union. So those were the main concerns we had. Cameron, do you want to expand on them?

Mr Murray : No, that pretty much covers it. There is a loss of self-reporting and not much incentive to monitor or audit these reports from the national governments.

Senator BIRMINGHAM: Thank you. Just picking up on that last issue of verification, in terms of how that compares with Australia where we have had the National Greenhouse and Energy Reporting Scheme in place for a number of years and there are centralised audits, undertaken nowadays by the Clean Energy Regulator through that process, how does Australia's legislative construct and set-up compare in terms of its reliability versus the seeming unreliability or concerns you have expressed regarding Europe?

Prof. Frijters : In our inquiries we were mainly concerned with analysing the internal politics of the European Union and hence we have not made a huge amount of effort to ascertain how credible the Australian verification system is. However, you can see from the movement in the European Union itself that there is a greater amount of veracity put on a centralised system, whereby you have people who are paid basically to catch cheats and hence you incentivise the inspectors to do a proper job and you then rely on the discipline of an actual regulator. We already have that in Australia. So although we have not looked specifically at whether the Australian regulators get it right, we would be astounded if they would be as bad as what is currently normal in the European Union.

Senator BIRMINGHAM: In terms of your reference to the local national legal systems that apply in each individual member state in the EU, how unified could you describe the commitment across the EU to actually rectify these problems? There may be a commitment out of Brussels at a central level and there may be a commitment in some countries, but is the problem that you are trying to herd a bunch of sheep who do not necessarily want to go in the one direction?

Prof. Frijters : It is definitely true that the central problem in the European process is the limited powers of the European Commission. The European Commission essentially does not have budgetary powers and hence it is up to the EU countries themselves to decide on permits and things that have to do with money. The European Commission is restricted to trying to legislate and regulate in markets on which other players are primarily involved in enforcement and in prices. Hence it is very difficult to see how the European Commission could actually incentivise all the countries in order to get a proper accounting system unless those countries themselves are fully committed to doing this.

There are many states involved here and it is very hard to generalise across all of the states, but if you look at the demise of various green parties in recent elections—in the Netherlands the green party has been decimated to less than half its former size—and see the reduction of the whole emissions and global warming issue on the national political scenes then it would be our judgement that as a whole this is no longer a major priority within the European Union and that would make it very hard to corral all of those countries into an equally strong enforcement system. A good example is the current situation in Greece. We hear a lot about the Troika enforcing reforms but no-one is saying that we should make the Greeks enforce the ETS permit system rigorously and without fault. It is basically seen as a secondary issue. The fact that that is not in the public domain already tells you that there is a lack of pressure. At least that is how we read it.

Senator BIRMINGHAM: How do you view the likely impact of the legislation before us, and the way the market would then operate between Australia and the EU, on revenue that the Australian government could expect to receive as a result of the ETS and the likely impact on domestic emissions in Australia?

Prof. Frijters : In our submission we were mainly interested in the likely revenue and price effect, so we looked at the various estimates. One was by the Treasury, which as far as we could ascertain was derived from what the European Commission said, and we looked at those of Deutsche Bank and Point Carbon. The key thing to say is that Deutsche Bank and Point Carbon have a long ancestry of trying to predict what the carbon prices would be in Europe and they have an incentive to get it right because these are commercial institutions which sell this on to businesses who are planning ahead. In contrast, the European Commission is not a budgetary institution and hence it has very little incentive to get the forecasted price right. These are more political utterances of prices they would like to see. The Australian Treasury is similarly not set up to predict political events in the European Union. Hence we found there are a much more believable set of assumptions that were made by Deutsche Bank and Point Carbon after the enormous importance of all these reserve permits that were still in the system, the reduced economic growth, meaning there was already a downward pressure on the demand. That led them in their forecast to predict prices of between €10 and €5 in 2015, which we saw as a much more realistic price level than the $29 that was forecast by the Australian Treasury and the commission. We think the revenue is going to be something like a third of what has been forecasted.

In relation to the secondary question of how much volume of this would be bought in the European Union, we expect that Australia too will find a way to, as it were, not let too many funds flow out of its own country. The form that will take will probably partially depend on this inquiry, but I would not myself expect too much volume to go to the European Union because I think it will be recognised by all players that that is an undesirable thing.

As to the impact on the carbon emissions, the internal incentives in Australia to reduce carbon emissions depend directly on the price and, since that will be fairly low, the local impacts on innovation will be fairly minor as well and there will be certainly almost no knock-on effect within the European Union because it is expected that they are just going to sell us reserve permits if we buy any of them at all and the reserve permits are so enormous they already have three times more than our total annual usage in reserve permits that there is no pressure on their internal system from the meagre demand that we might actually put on their system.

Senator BIRMINGHAM: With those applications of reserve permits and allocation of permits to different companies in the EU, have you done any comparison as to how that compares with the allocation of free permits to companies in Australia?

Prof. Frijters : No, we have not. We have tried to ascertain the precise mechanisms by which the free permits were distributed in the European Union. It is clear that this is up to national governments. It is also clear that this is basically due to historical levels of emissions. The European Commission has put up a target of wanting to reduce to 60 per cent the free allocations regarding the rest. However, this is merely a target, so we have not yet seen a credible proposal by the European Commission to actually make this happen.

As to what Australia's ability would be to hand out free permits, we shall be honest: we do not actually know what that would then be under this system, because this is an area of active negotiation between the European Union and all the member countries. So we have no idea as to what the legislation in Europe is really going to look like, because it is still to be negotiated locally there. I basically have no special insight on the Australian political system as to what would give rise to free permits here. Cameron?

Mr Murray : I have no idea how many or what mechanisms would allow free permits in Australia. At the moment 98 per cent of them are like that—being given away for free in Europe.

Senator BIRMINGHAM: That is a significant figure. This is the last question from me: in terms of the scale of the two systems, whose public policy determinations are going to basically determine where pricing goes and where control over these systems goes? Will it be largely determined by what happens in Europe and their public policy systems, or is there still scope for Australia, in your opinion, to influence the price and activities of its system?

Prof. Frijters : This is, of course, a judgement on political process within the European Union, but given the unequal treatment that Australia is already receiving in the current treaty, whereby we can buy their permits but they will not be buying our permits, it is clear that we are secondary partners and that hence our interests will count for very little in the internal deliberations of the European Union. I would anticipate that the only degree to which Australia will really matter is that there may be a jockeying for positions for countries to sell their reserve permits to us. So the precise way in which the permits are being traded in Europe is being changed quite radically—they are moving to a sort of common platform system—but you will still have national agencies selling mainly to national firms. I am sure the precise details of who would then be selling to the Australians will be a major bone of political contention within those negotiations.

CHAIR: Professor, I just have one question. I want to tidy up a matter arising out of Senator Birmingham's first question. You were critical of the European peer review system. You said there was too much emphasis on self-reporting. In terms of the proposed Australian verification regime, do you have any particular criticism that you draw to our attention at this stage, or is it too early to comment on the Australian proposed system?

Prof. Frijters : I must admit slight ignorance as to precisely how the Australians do the verification system, but I can say that the Australian system of having a National Audit Office with its own powers to independently go and check individuals would be a desirable thing for us to push amongst the European Union. However, I would predict to you that the odds of actually changing the verification system within the European Union are pretty slim and that at best we can hope that the European Commission is successful in putting forward a more regulated system of their internal verifiers. Cameron, maybe you know more about the Australian system.

Mr Murray : No, but the very fact that there is one body dealing with it improves the incentives a lot. There is no jockeying between member states to basically give their own better deals to their own companies.

Prof. Frijters : But we do not really know. It would be unfair to say that we have any special knowledge of the Australian system of verification.

CHAIR: Okay. Thank you very much, Professor Frijters and Mr Murray, for your assistance to the committee this morning.