The Grattan Institute has released a report that confirms that costs to reduce pollution, especially carbon pollution, are cheaper than governments anticipate.

The report examined six market-based pollution reduction schemes, including the NSW Greenhouse Gas Abatement Scheme, the EU carbon trading scheme and the US sulphur trading scheme.

In each case the outcomes diverged significantly from government and industry predictions. Environmental markets routinely led to lower emissions and achievement of targets at lower cost in practice than in  forecasts. Forecasts tended to underestimate commercial innovation once money was at stake. In some cases the targets and regulations required relatively less change to business as usual than governments expected. Because it was relatively easy to achieve targets, the market price of emissions was lower than forecast. The price crash in European carbon markets was not just a “one-off” result of peculiarities in its initial design. The same pattern recurred in a variety of environmental markets.

The experience from these cases suggests:

1. Market based carbon prices are the cheapest way to reduce emissions. Forecasts about costs were generally much higher than the actual costs. The Grattan Institute also reports that market-based systems also encourage innovation across the community that “converge on the cheapest reductions”.
2. There should be lower limit on carbon prices in a market scheme. A “reserve” price “effectively tightens the pollution target” and presumably would stop price crashes that occurred in the European Union.
3. Technological innovation is key. The Grattan Institute argues that market-based carbon reduction systems are “consistently effective at identifying lower cost opportunities, promoting innovation and responding flexibly to changes.”

This report is not earth shattering – I’ve read similar statements from climate change policy experts over the last few years that say the same thing. We already know that currency price fluctuations have a bigger impact on our economy than a carbon price. We also know that it is technically feasible for Australia to reach 100% of its power from renewable energy sources by 2020.

There are consequences to introducing a carbon price – one which many on the irrelevant left and loony right don’t understand.

The pattern repeated across each of these schemes is that forecast prices for pollution permits and clean energy certificates are much higher than actuals. Forecasts consistently assume a continuation of “known” technologies, and market forces routinely deliver surprising innovations within a few years, resulting in achievement of targets at substantially lower cost than expected. In some cases the targets and regulations required relatively less change to business as usual than governments expected.

When we see the same features repeated across eight phases of six different schemes, we are entitled to suspect there might be a pattern. We can probably predict that in future the forecasts for environmental schemes are likely to overestimate the costs of reducing pollution, and are likely to be wrong about which actions will deliver pollution reduction at the lowest cost. (p.20)

The take away message for the CPRS from this report is that rather than set a carbon permit limit, the Government should set a price floor.

Experience also suggests that in designing trading schemes, governments should set price floors. The market price of carbon is likely to be lower than government forecasts. When governments over-estimate the cost of reducing emissions, they tend to choose a weak cap, or target, and make it easy to generate offsets. Governments (at least in theory) set pollution caps so that the expected benefit of reducing pollution is the same as the expected cost of reducing pollution. If the cost of reducing pollution is less than expected, it would be rational to set a lower cap. A floor price automatically corrects this tendency. A floor price effectively reduces the number of permits issued if the price falls to the floor. (p.21)

The experience of pricing schemes also suggests that floor prices should be delivered by setting a minimum price at which permits will be issued. This is preferable to setting up a government agency such as a central bank of carbon that intervenes in the market whenever prices fall below the floor price. (p.22)

This report comes at at time when the Australian Government is looking anew at the Carbon Pollution Reduction Scheme. I wrote back in 2008 that the Federal Labor Government needs to “stand up to the self-interest of big business and the climate change skeptics in the Opposition.” I also wrote in 2008 that Labor looked as though it would squib on making the hard choices it needed when crafting the CPRS legislation.

I hope that the new Climate Change Minister, Greg Combet, and Prime Minister Julia Gillard, show more courageous leadership this time around.