Puncturing the waterbed – climate policy needs more than the Emissions Trading Scheme

By Dr Jez Weston, Rohan MacMahon

The Emissions Trading Scheme sets the carbon price for New Zealand and the price has just gone nuts. September’s auction bashed through the Government’s $50 price cap to $53. December’s auction cleared at $68, nearly doubling the price from just a year ago.

This is how markets are supposed to work. Emissions reductions are in demand so prices rise, giving foresters more reason to plant trees to absorb carbon and giving dirty industries a stronger financial incentive to clean up. This price should filter through the economy to make cleaner products cheaper for the consumer, helping us all make choices that result in lower emissions.

But despite the high price, is the ETS alone going to solve our climate problem? Some economists are confidently promoting that this is the case. That’s a simplistic and dangerous position.

There is a strand in economics that comes up with theoretical objections for why government actions will not work and why it will be counter-productive for governments to even try. One example of this is “leakage”. If a government proposes that polluting industries should pay carbon costs, then those economists produce long and learned missives about how that will only cause pollution to leak to even dirtier industries overseas, increasing emissions overall.

In reality, the world does not respond so simply to theory. There is no empirical evidence of polluting industries leaking overseas due to carbon costs. There is, however, solid evidence of those polluting industries using the threat of leakage as a political tool, to delay government action and to keep dumping those carbon costs on the rest of us.

The latest theoretical objection to climate policies aside from the ETS is the “waterbed effect”. Like pushing down on a waterbed, the claim is that emissions savings in one part of the economy will result in increases in emissions from a different part. The ETS trades emissions within a cap, so a tonne saved from burning less coal means an extra tonne will be permitted and emitted from, say, burning more natural gas. Therefore the only thing that matters is the cap, all other climate policy cannot have any effect, and the Government shouldn’t even try.

In reality, does this theoretical objection hold water?

The emissions cap is set by the Minister of Climate Change, on advice from the Climate Change Commission, based on their judgment of what emissions reductions are feasible. Demonstrating emissions savings in any one part of the economy justifies a lower cap for the next emissions budget. Our wide mix of climate policies look to demonstrate such successes. We then lock in those successes by ratcheting the cap downwards, puncturing the waterbed.

For example, helping early adopters to buy electric vehicles should reduce the inertia in the vehicles market and convince importers to bring cleaner models to New Zealand. This may show that the transition to an electrified transport system will be easier and cheaper than we might fear, so we can reach those emissions savings faster than we would otherwise predict.

All economics is political and politics is a detailed game of compromise. Ivory-tower economists can ignore the details of what’s going on in the real world and talk about how they think the world should be. Politicians, business-people, and investors need to pay attention and deal with the world as is, details and all.

Every nation uses a mix of price and non-price tools for climate policy. We should continue this mixed approach. Rather than let theoretical objections hold us up, let’s be pragmatic and look for examples that demonstrably work. New Zealand’s emissions continue to be stubbornly high, with the exception of one sector – methane emissions from landfills. These have been dropping since 2005 despite record volumes of waste. This drop was not driven by price incentives. It was driven by black-letter law – the National Environmental Standards for Air Quality. Operators must cap landfills and capture that methane. And then there’s a positive knock-on – now the operators have that methane, they might as well do something useful with it so it gets burnt to make electricity, making power out of waste. That’s the kind of success we need.

Dr Jez Weston and Rohan are directors of the Climate Venture Capital Fund