Nothing has happened since the election to challenge the view that the Coalition’s Direct Action plan for carbon reduction is vastly inferior to carbon pricing, write Frank Jotzo and Paul Burke

DIRECT ACTION is often perceived as an exercise in keeping up appearances: a fig-leaf policy from a government that has expressed little enthusiasm for serious action on climate change. But with the possible neutering of the Renewable Energy Target, Direct Action subsidies are set to be the main pillar of Australia’s climate change mitigation effort as well as a new drain on our scarce fiscal resources.

The cornerstone of Direct Action is a system of subsidies for emissions-reducing projects, channelled through an Emissions Reduction Fund. In a nutshell, government will pay companies to implement specific projects that are thought to reduce emissions. It will “buy up the cost curve,” purchasing the lowest-cost emissions reductions first.

Not much more detail is available about the policy than was sketched before the election. The government’s December 2013 green paper leaves many of the most crucial questions open, including how baselines would be set, whether there would be a penalty for companies that exceed their baselines, and whether projects in all parts of the economy would compete directly or there would be separate pots of money for sectors such as agriculture, forestry and industrial energy efficiency.

The consultation process is under way and will no doubt reveal the competing interests of different groups. It is also no foregone conclusion that the Senate will vote in favour of the scheme.

When examined under a bright light, as we have done so in our submissions to the recent Senate inquiry on Direct Action, Direct Action doesn’t hold up at all well. Yes, it’s an attractive political phrase, the combination of two very positive-sounding words. Yes, the Coalition’s negative strategy surrounding carbon pricing has been politically successful. But as a piece of public policy for use in achieving either short- or long-term emissions reduction goals, Direct Action is fundamentally flawed.

From an economic point of view, the first weakness of Direct Action is that, unlike carbon pricing, it doesn’t offer the potential to pick all of the “lowest hanging” emissions reduction opportunities. Many of the best abatement options may be small in nature or not in line with scheme requirements, and potential participants might hesitate to take on the costs and uncertainties involved. Missing low-cost opportunities is expensive: the OECD estimates that subsidy approaches can involve an economic cost per unit of emissions reduction that is more than ten times higher than under carbon pricing.

A second problem is that the size of emissions reductions from projects registered under Direct Action will be impossible to verify. The reason is that each firm’s (or project’s) emissions without the subsidy are difficult to guess. Firms may well apply for subsidies for projects that they would have implemented anyway – and, indeed, this is the experience from emissions reductions projects in developing countries under the Kyoto Protocol’s Clean Development Mechanism. Equally disturbing is the possibility that firms would hold off on emissions reductions until they are able to secure a subsidy. In fact, the talk about Direct Action is probably delaying investment right now.

Trying to sort the wheat from the chaff will require our public service to have an elite unit of baseline guessers working into the night. Their guesses will always remain contestable, which means that contracts for the procurement of emissions reductions will have to be written in a fog of uncertainty. If baselines are set too generously, we’ll see windfall subsidies and very little abatement, a severely wasteful use of public money. Australia has had earlier experiences with grant-based schemes to reduce emissions, which the Grattan Institute concluded have done “very little to reduce greenhouse pollution.” In many instances, grants on offer were simply not taken up.

Another fundamental weakness of Direct Action is that it is short-term only. The promised payments would be for five years’ worth of claimed emissions reductions – much less than the payback periods for many projects across the energy, industry, building and transport sectors. The subsidy scheme is also only being touted as a stop-gap approach: no one is seriously saying that a growing share of Australia’s budget should be allocated to purchasing emissions reductions for decades to come.

The proposed Direct Action involves no cap on emissions, meaning that purchased emissions reductions may simply be offset by increases in emissions elsewhere in the economy. How we will reach our emissions target is also unclear: there is much work still to do to get Direct Action off the ground and for abatement to actually start happening, and those who have crunched the numbers (for example the Climate Institute) suggest the proposed funding is likely to be insufficient to achieve our 2020 emissions target. The government has indicated that the budget for Direct Action will not be increased, which implies that the 2020 national target is seen as a “maybe.”

The fiscal burden of Direct Action is another major shortcoming. An advantage of carbon pricing is that it helps the budget bottom line, making a handy $3.6 billion contribution to cash receipts in fiscal year 2012–13. Governments have to raise money somehow, and pricing carbon kills two birds with one stone.

Direct Action, on the other hand, is funded by revenue from existing taxes. To pretend that Direct Action has nothing to do with taxes is misleading. As the old saying goes, “to spend is to tax.” Direct Action taxes the broader community and gives the proceeds to carbon emitters. The carbon price, by contrast, takes money from emitters and recycles it to the broader economy, including via income tax cuts and higher welfare payments.

A further downside of Direct Action is the subsidy culture that it will encourage. Got an idea to reduce emissions? Look to Canberra, and hope the government will give the nod to your project. Not successful this time around? Go to Canberra and lobby the minister, hire a consultant to lobby the department and the regulator, then try again. It goes against the approach to business subsidies that the Abbott government has championed so far.

Direct Action–style subsidies may work to some extent for abatement opportunities in sectors such as agriculture and forestry, which are challenging to include in a broad emissions pricing scheme. The Carbon Farming Initiative, introduced in 2011 and working right now in tandem with the carbon pricing scheme, provides a suitable framework. But as a broad-based emissions reduction policy Direct Action appears to be an ill-considered clunker, like the hastily chosen gift you bring to your aunty’s fourth wedding – or, as Ross Garnaut put it, a Martian with a gnarled toe sticking out from under a veil.

CARBON pricing, on the other hand, automatically provides firms and others with an incentive to pursue the least-cost emissions reduction possibilities: by doing so, they can avoid paying the emissions price and so increase their profit. Whereas Direct Action is complex and bureaucratic, carbon pricing is the simple, free-market solution. There is a strong consensus among economists and international organisations (the World Bank, the OECD and the International Monetary Fund) that a broad pricing mechanism is the best policy approach to reducing greenhouse gas emissions. In the long run, a gradually increasing carbon price would see Australia transition to a low-carbon economy at low economic cost. Other taxes could be reduced in a revenue-neutral way if desired.

Politics aside, Australia’s carbon price is working well: electricity-sector emissions fell by 5.5 per cent over the year to September 2013, although various other factors also contributed. Overall emissions from companies covered by the carbon pricing mechanism fell 7 per cent in 2012–13. Inflation is safely within the Reserve Bank’s target range; and, as noted, the sale of emissions permits is providing welcome relief to our struggling budget bottom line.

The carbon price imposes a smaller burden on the economy than some other existing taxes (see Box 1.1 of the Henry Review for a list of some of the worst of these), and the carbon pricing package included reductions in income taxes to low- and middle-income earners to ensure that they have become no worse off. The government estimates that scrapping emissions pricing (instead of moving to a floating price, as the previous government planned) will reduce inflation by less than 0.25 of a percentage point in 2014–15, which will go almost unnoticed except for the effect on power prices.

To be sure, there was plenty of lobbying during the design of the carbon pricing mechanism, and many industries got sweet deals – especially the coal-fired power industry and some emissions-intensive trade-exposed industries. And the power of the carbon price to influence long-run investments has been diminished by the prospect of repeal that has hung around its neck since the collapse of the bipartisan agreement on carbon pricing at the end of 2009.

Outside Australia, the international reach of carbon pricing is spreading. Most significantly, China – the world’s largest greenhouse gas emitter – is launching seven emissions trading pilot schemes covering over 250 million people, with a view to a future national emissions trading scheme, potentially in parallel with a carbon tax. South Korea, South Africa and Mexico are preparing to introduce emissions trading or carbon taxes. Thailand, Vietnam and other countries are considering proposals. It is true that the short-term prospects for national carbon pricing in the United States are not looking good, but state-based approaches are being employed there, including a full-scale emissions trading scheme in California. The European Union’s emissions trading scheme is in its tenth year.

WHEN it comes to economic management, Australia holds a respected position in the international community. This reputation would be hurt by a move from pricing emissions to Direct Action subsidies. Ditching our carbon price would also be a setback for international efforts to advance emissions pricing as a sensible instrument of both environmental and fiscal policy.

Nevertheless, the reality is that the new government has been exceptionally clear in its intention to axe the carbon price, and the prime minister has turned it into a defining issue. It seems that no amount of well-reasoned argument from the academic or policy community will change the government’s intent.

Given this, it might be worth investigating what role Direct Action could play in smoothing the exit of old, inefficient coal-fired power stations from the Australian electricity grid. Power demand is falling, putting pressure on the profitability of electricity generators, and hampering investment in new, lower-emission plants. The fundamental problem is that the old, high-polluting plants can continue to run cheaply if there is no carbon price. The Hazelwood power station is probably the first candidate: built in the 1960s, it is one of the most polluting large power stations in the world, and the dirtiest in all OECD countries – even before fire broke out in its brown coal pits.

Shutting coal-fired electricity generators would cost serious money, probably much more than the government is willing to spend. The Gillard government, following the agreement reached in the Multi-Party Climate Change Committee on Climate Change in 2011, tried to buy out some of the most polluting power stations under its “contract for closure” scheme. We don’t know the price demanded by the owners of the plants, but the Australian public was told it was too high – presumably because even then the power industry expected that there was a good chance the carbon price would not last.

Another option is to follow the regulatory approach being pursued at the national level in the United States. While clearly inferior from an economic point of view, sizeable emissions reductions could be achieved by new standards for coal-fired power plants and vehicles. Regulations have a key advantage over Direct Action subsidies: they would come at little direct cost to the federal budget.

As economists we will always recommend a price-based instrument as the backbone of climate change mitigation policy. But if carbon pricing is politically impossible, we believe that well-targeted regulations are preferable to the hopeless alternative of an economy-wide system of Direct Action abatement subsidies.

From an economic point of view, it is a great shame that carbon pricing has become so politicised in Australia. If the parliament does revoke the carbon price – as appears likely – and Australia ends up not making a reasonable contribution to the global mitigation effort, we will set a terrible example internationally. •