ECONOMIC PAPERS, VOL. 32, NO. 4, DECEMBER 2013, 440–453 Emissions Pricing, “Complementary Policies” and “Direct Action” in the Australian Electricity Supply Sector: Some Conditions for Cost-Effectiveness* Barry Naughten1 For Labor, the core approach to mitigating climate change is the pricing of carbon emissions. The primary purpose of this article is to defend this approach, specifically in the electricity sector and under Australian condi- tions. In so doing, it rebuts recent arguments to the contrary put by the Liberal National Party Coalition (LNP). The article underscores the longer run impact of emission pricing, and price expectations, when the key mecha- nism is about switching investment toward less emissions-intensive technol- ogies. This core approach of emission pricing is also supported by so-called “complementary policies”. These can assist in the cost-effective reduction of emissions, for example by addressing certain “imperfect information”, “market failure” problems and institutional distortions, as well as uncertain expectations about future emission price trajectories. For the LNP, the core policy is presented as “direct action”. However, at least some “complemen- tary policies” can also be described as “direct action”. Properly applied, selected “direct action” policies (however labelled) can contribute to achieving emission targets at least cost, providing that distortions due to rent-seeking are avoided, notably through transparent, accountable and evidence-based policy-making. Keywords: emission pricing, climate change, electricity sector, direct action, complementary policies. 1. Introduction In Australia, debate on whether carbon emissions pricing should be the core policy response to dan- gerous climate change has been contentious and confusing. In the run-up to the Federal elections in September 2013, the Labor government recommitted to immediate implementation of a tradable emissions scheme. For its part, the Liberal National Party Coalition (LNP) has pledged to repeal that scheme, instead advocating a “direct action” approach, albeit one that paradoxically also incorporates a type of emissions pricing. *Discussions occurred with Professors Steve Hatfield-Dodds, Frank Jotzo, John E King, Andrew Macintosh, Hugh Saddler and Tony Wood, with Brian Dawson, Dr Onko Kingma and Dr Ian Maclaine-cross. Comments of an anonymous reviewer were useful. Glenda Naughten provided editorial advice. All are acknowledged with thanks and the usual disclaimers. The article builds on the ANU Crawford School Working Paper 1304 (Naughten 2013a). 1Departmental Visitor, Centre of Arab and Islamic Studies (CAIS) Australian National University (ANU) Canberra, ACT, Australia. JEL classifications: D62, D81, E27, H23, L71, L94, P46, Q41, Q42, Q54, Q58 Correspondence: Barry Naughten, 36 Wagga St, Farrer, ACT 2607, Australia. Emails: [email protected] 440 Ó 2013 The Economic Society of Australia doi: 10.1111/1759-3441.12053 2013 EMISSIONS PRICING AND DIRECT ACTION 441 The initial purpose of this article is to rebut some recent LNP challenges to the effectiveness of emis- sion pricing, notably in regard to the electricity sector under Australian conditions. In evaluating emission pricing as applied to the electricity sector, the article considers the problem of “locked-in” carbon-intensive generating capacity, as highlighted by the International Energy Agency (IEA, 2011). It focusses on emission pricing to reduce carbon intensity of electricity generation. Further- more, passed-on price increases can encourage cost-effective end-use savings of electricity, by encouraging more energy-efficient end-use. These two examples involving the electricity sector demonstrate the centrality of longer run impacts of the price mechanism and price expectations through relevant investment decisions. This “long run” emphasis is appropriate given the context of catastrophic climate change as an irreversible long-run phenomenon, albeit one also requiring urgent mitigating action. A second intent of the article is to clarify the related notions of “complementary policies” and “direct action” policies. In a “real world” of imperfect and asymmetric information together with vari- ous institutional distortions, valid applications of “market instruments” can and should be reinforced by well-designed “complementary policies”. These can be regarded as a sub-set of “direct action” pol- icy. In this particular sense, “direct action” and emission pricing need not be incompatible. 2. National Emissions Targets: Conditional and Unconditional As to reducing greenhouse gas emissions so as to meet given national targets, the LNP’s committed2 policy approach broadly resembles that proposed by the Labor Government.3 Both parties seek to meet a so-called “unconditional” national emissions target by 2020, that is, 5 per cent below 2000 levels by that year. This target can be compared with business-as-usual level emissions. These have been estimated at 20 per cent higher than in 2000 (DIICCR&TE, 2013) although more recent esti- mates suggest even lower figures (Edis, 2013d).The slackening in the consumption of electricity over the last half-decade (well before from emission pricing) is discussed later. Some differences remain about these unconditional targets. For the LNP, the reductions would all be from mechanisms operating within Australian territory. In contrast, Labor’s approach in an inter- national emissions trading scheme also relies (up to 50 per cent) on reducing overseas emissions through this mechanism. This difference has implications for the cost of meeting the target (being more constrained in this way, the LNP’s target will tend to cost the economy more) and for encourag- ing international engagement with the issue (underlined in Labor’s approach). Neither unconditional target comes close to an equitable Australian contribution to meeting the widely accepted global target of a two degree limit to global average temperature increase or (equiva- lently) an upper limit of 450 ppm CO2e in the atmosphere. The more stringent national requirement, known as the “conditional target” is a step toward this more stringent global target. Such an Austra- lian target would come into play given some level (as yet undefined) of international commitment. The Labor Government position on a “conditional target” has been 15 to 25 per cent below 2000 levels by 2020, with a reference also to and 80 per cent below 2000 levels by 2050 (DCC&EE, 2013). The LNP has not yet committed to a “conditional” target though in Government it has pledged to con- sider this more ambitious policy in a review4 scheduled for 2015. 3. Policy Differences as to Mechanisms There are some apparently more significant differences as to policy instruments, toward these not so dissimilar targets. For the LNP, the proposed core approach is one that relies on so-called “direct 2Some backers of the Coalition continue to reject mitigation of climate change. An example is the Melbourne- based Institute of Public Affairs (Kelly, 2013) which has proposed that a Coalition Government should repeal the carbon tax, and do not replace it. It will be one thing to remove the burden of the carbon tax from the Australian economy. But if it is just replaced by another costly scheme, most of the benefits will be undone. (emphasis added). 3For convenience, the minority Labor Government in concert with the Greens and a majority of House of Rep- resentative Independents over the period 2010–2013 will be referred to here as the Labor Government’s policy 4The author is drawing here on a personal communication from Andrew Macintosh of the ANU Law School and Tony Wood of the Grattan Institute (2013). See also Tristan Edis (2013a,b,c). Ó 2013 The Economic Society of Australia 442 ECONOMIC PAPERS DECEMBER action”. The LNP specifically rejects Labor’s core approach based on the pricing of greenhouse gas emissions as part of an emissions trading scheme. This rejection is despite various forms of emission pricing being widely accepted within the international economics community as the most cost-effec- tive and core approach to reducing emissions. On tradable emissions permits specifically, see Tieten- berg (2003), Adams et al. (2012) and Stern (2007). On carbon taxes as one example of application of a “pigovian tax” see, for example, Mankiw (2009), Frank (2013). A corollary, to be considered below, is that predominant reliance on ill-chosen “direct actions” could impose a much higher cost on the economy for a given set of targets. 4. Purposes of the Present Article A comprehensive comparison of the rival policy approaches of the two major parties is not attempted here.5 Rather, the primary purpose is to consider two arguments put forward by the LNP. These argu- ments were put by the Shadow Minister for climate change, in his speech of 18 April 2013 and in his associated written speech and paper (Hunt, 2010; Hunt 2013). These arguments specifically relate to the electricity supply sector. The LNP’s first argument is that emission pricing will be ineffective in changing the carbon intensity of electricity generation because the evidence is that such pricing will not significantly change the “merit order” of generation from existing power stations. This argument fails in two ways. On the one hand, it conflates decisions about operating a given electricity supply system with decisions about investing in new, less carbon-intensive generating plant such as gas turbines and renewables. On the other hand, it fails to distinguish the mechanism