If not an Emissions Trading Scheme, then what?

The news that the Australia government is going to hold back from trying again to get its emission trading scheme (ETS) into legislation is something that should be welcomed so long as it leads Kevin Rudd and his colleagues to start considering and promoting other means for reducing greenhouse gas emissions. There are plenty of other ways of going about reducing these emissions that seem, from the standpoint of behavioural, evolutionary and Post Keynesian economics, to make much more sense than what was being proposed.

While carbon-trading schemes such as the one proposed for Australia may look logically coherent from the standpoint of mainstream economics, they are in practice riddled with difficulties, which Clive Spash has catalogued in his paper ‘The Brave New World of Carbon Trading’ and in recent public presentations. Cap and trade systems theoretically provide a way to reach particular targets and provide incentives to reduce emissions but they presume that financial markets work efficiently, much as standard optimal depletion models presume that markets will find ideal price trajectories for oil, etc. However, from the standpoint of Post Keynesian macroeconomics (particularly the work of Hyman Minsky), we should have doubts about financial markets being good at providing reliable price signals to those who need to work out the implications of strategies with different emissions implications.

The crucial thing that firms (and consumers need to know) under ETS systems is how the price trajectory for emission permits is going to unfold, as this will shape the relative prices of new output and durable assets. Uncertainty about this trajectory will add to the planning nightmare that they face, just as flexible exchange rates have made business calculations so much harder. Insuring against such uncertainties will require derivatives that work over long time horizons, so it is no wonder the financial community likes the ETS idea. If the derivatives designers and dealers get it wrong (as per the GFC) and if major emitters procrastinate over reducing emissions in the belief that they will be able to buy permits to carry on as they have been, then we could run into a situation where there are major business failures because the permits turn out to be way more expensive than big emitters and derivatives expected. It is a recipe for a Minsky-style mess at a time when a lesson of the GFC us that we should be trying to reduce scope for that in the financial system rather than be adding to it.

An alternative approach is to do what the EC and California have been doing with vehicle emissions and set a timetable of progressively tightening targets that firms have to meet. If these targets apply to the weighted average of a car firm’s sales, there is of course a back door route for something akin to trading to occur, via mergers: low emission Fiats can be weighed against profligate Ferraris if they are all coming from one company. Setting a timetable of targets may cause the firms to squeal but at least they know what they have to do over the next five to ten years. By setting particular standards for particular kinds of products, a jurisdiction such as the EU can have an impact that stretches to other countries whose products compete with those made in Europe.

Because of the complexity of the interaction between the economy and the ecosystem, policy makers need to be focusing on sector- or activity-specific targets rather than trying to reduce every act of emission to a common numeraire and saying that all emitters of greenhouse gases need to match their emissions to the number of permits they have. It is doubtful that we can yet pronounce reliably on the emissions consequences of many economic activities. This is particularly the case with agriculture and forestry activities. But there are some major polluting sectors, such as transport and electricity where emissions can be measured and policed pretty reliably.

In a world of bounded rationality, we need to apply rules to those sectors where measurement and monitoring are possible, where we may be able to make a big impact on emissions soon. This is an arbitrary but pragmatic way of operating. It is also a way of giving business clear signals of what they have to do. The risk is that governments will end up doing nothing pending the discovery of reliable ways of bringing everyone into a scheme designed to ensure each gram of emissions is charged for in the same way regardless of its source.

Consumers likewise can be given clear signals and required to comply with them: many countries do this with vehicle emissions, using increasingly tight emissions standards in roadworthiness tests to get the bad cases off the roads. The same can be done with building regulations. Even without regulations for actual standards there is much scope to change what people do by requiring the labelling products (including used houses) in relation to their environmental impact. The ‘new’ approach to behavioural economics may miss many of the insights of evolutionary approaches to choice that stress the importance of habits and rules in shaping behaviour but there is great scope in relation to environmental matters for applying the ‘Nudge’ philosophy advocated by Thaler and Sunstein. For example, during the recent drought, Brisbane residents learnt to economize on water when the Brisbane City Council suggested targets per household, introduced certain restrictions on outdoors water use and facilitated the installation of water-saving devices. A crisis of falling dam levels was averted despite the council not following the conventional wisdom that would have involved sharply increasing water prices.

Much of what we do that contributes to environmental damage is the result of habits and beliefs that have no particular strong foundation. Australians have got used to expecting a lazier driving experience than Europeans, probably as a result of kidding themselves they need effortless vehicles to cope with huge distances, despite living in one of the most highly urbanized countries on the planet. A consequence of this is that, Ford doesn’t supply 1.6-litre Focus cars to the Australian market, whereas few Europeans bother with the 2.0-litre model that Australians drive and which have vastly inferior fuel consumption. It is easy to reduce emissions if the options are available and one is nudged into trying them out and being surprised that little is lost by adopting the greener solution. If Europeans find smaller engines perfectly OK because they are used to them, Australians surely can get used to them too if nudged into experiencing them. That is where EC-style policies for vehicle registration can play a role.

One other area with major scope for using regulatory approaches to reduce emissions is that of the length of the working week for full-time employees. If we go to work less and consume less because we are paid less, we will pollute less. The length of the working week should be falling in affluent economies as productivity rises. The fact that this has not happened on a large scale probably owes much to the mortgage treadmill that many people have ended up on as a consequence of financial liberalisation and the failure of governments to regulate housing sizes and urban density so as to contain city sizes and reduce environmental impacts. People have come to expect to own their own McMansions and the banks have facilitated their attempts to do so by increasing the ratio of mortgage size to income; some have ended up in bigger homes but many have simply ended up with very expensive homes.

In short, policies need to be applied on many fronts to change preferences and technologies. The market-based view of tradeable pollution has nothing to say about changing ‘given’ preferences and technologies’, whereas evolutionary economics points to the potential of policies that focus on changing habits and knowledge. Approaches that use non-market strategies will involve bureaucrats, whom the financial sector and mainstream economists seem to presume are inherently less efficient than competitive markets. Such views seem oblivious to the gross failures of market processes that led to the GFC and are an insult to the professionalism that most of us in the public sector bring to our work. The ‘markets are best’ ideology also ignores the internal competition that provides incentives for bureaucrats even if the departments in which they work are not subject to the ‘discipline of the market’.

One final, general point is important here: many people need to get out of the habit of assuming that there are going to be significant costs for reducing emissions. Such thinking comes from economists who assume that firms and consumers have given technologies and preference orderings and take optimal decisions. From the standpoint of ‘old’ behavioural economics we should view with scepticism the wailing of industry about the cost of dealing with emissions requirements. If firms are put into a position where they find it harder to meet their profit goals, the behavioural theory of the firm predicts that they will search for new ways of doing so. It is thus possibly that there will be no reduction in profits as the price of meeting tighter emissions standards, since new technological solutions may be worked out, X-inefficiency may be reduced, or the burden, if there is one, may be shifted to other stakeholders (i.e., organizational slack may be taken up), encouraging the latter to find more efficient ways of operating. Indeed, being forced to rethink rather than being able to carry on down the easy road may actually result in gains for firms that initially squeal in protest. We can draw lessons here from some of the unexpected impacts of legislation in Europe requiring that manufacturers receive back their products and recycle them when they cease being serviceable: these requirements led firms to design products that were easier to disassemble but in doing this some discovered ways of making them easier to assemble in the first place.


One response

  1. Fabulously and eloquently put. You should see http://www.icr.org/research/ for similar arguments to yours.

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