The Australian government has just released a “Green Paper” on trading of carbon emissions. The media coverage has been dominated by discussions about compensation for high emitters, trade-exposed industries and low income groups.

There are a few things that have struck me when listening to the public conversation about compensation.

1. Some of the discussion on current affairs programs sounded like people thought that, if we compensated ourselves for the increased costs, we could somehow avoid those costs. In fact the costs will still have to be borne. Compensation just redistributes the costs within the community.

2. The redistribution of costs away from high emitters means that the costs will end up being borne more by low emitters, on average.

3. The prospect of compensation mobilises people to lobby for special deals through the political process. For far-reaching policies like this one, the transaction costs of such lobbying activities are likely to be substantial.

4. Some commentators seemed to think that paying compensation to emitters would reduce their incentive to abate emissions. However it depends on how compensation is provided. If it is paid as a lump sum, unrelated to future emission levels, then there is no diminution in the incentive to abate. Overall, the level of abatement required is determined by the cap that is set on emissions. All the other details of the program just determine the cost of achieving that cap, and its distribution, not the aggregate level of abatement achieved (although there can be leakage in various ways, of course). All emitters covered by the scheme will have an incentive to abate emissions, irrespective of whether they have to buy or are given emission permits, and irrespective of how many emission permits they are given. This is because the permits have a market value and can be sold, but to sell them, you have to limit your own emissions.

5. Commonly in cap-and-trade schemes, permits to emit are “grandfathered”, meaning that they are given for free to existing emitters, at a reduced proportion of their current emissions. The proposed emissions trading scheme in Australia is relatively unusual in not using grandfathering for the initial distribution of rights, although grandfathering has been proposed as one of the means of compensating some emitters. Grandfathering does not mean that firms in aggregate avoid abatement costs, because they still have to operate within the lower cap set by the system. Individual firms might avoid abatement costs by holding or purchasing sufficient permits, but to do so they have to forgo the revenue from selling those permits.

6. Given that Australia will be ahead of many other countries if it does implement the proposed emissions trading scheme, there is a risk of firms moving off shore to avoid the impost of having to purchase emission permits. Given this likelihood, it does make some environmental sense to compensate those industries that are likely to move off-shore in response to the policy (assuming that reducing their emissions is actually worthwhile).

7. Compensation is being justified as an interim measure. However, it is worth asking what would bring the interim measure to an end? If we are providing compensation to industries that are threatening to move overseas, presumably we would need to keep providing it until most other countries adopt similar policies. That could take some time. If we are paying compensation to heavy emitters because we want to allow them time to adjust to the new system (or some such rationale) we could be stuck with paying compensation for a very long time indeed. The expectation seems to be that the cap will slowly become more stringent, probably over the next 50 years or so. If we have to compensate heavy emitters for the scheme’s introduction, why wouldn’t we also compensate them each time it became more stringent? The same sort of question would apply to compensation to low income earners suffering from higher prices. Compensation starts to look more like a permanent feature than an interim measure.

Overall, is compensation worth the complexity and the transaction costs that it will introduce? If one supports the general thrust of the program, then I suppose the leakage of heavy emitters to countries without emissions policies does potentially justify some compensation. Other than that, the idea looks pretty questionable, and even for that case, I have concerns, particularly about who will qualify for compensation. The scope for special pleading will be enormous. The point where the line is drawn will be essentially arbitrary, and the temptation for politically motivated decisions will be irresistible. I suppose we might have to live with that as the price of getting the scheme established quickly.

David Pannell, The University of Western Australia