How broken is the Government's Carbon pricing mechanism?

In a recent speech at a combined Melbourne Energy Institute-Grattan Institute seminar at the University of Melbourne, Shadow Minister for Climate Action, Environment and Heritage Greg Hunt, MP, outlined details of the Coalition’s Direct Action plan.

In a speech delivered with passion, good humour and a deft handling of a somewhat skeptical audience, Greg was at pains to emphasise that the Coalition agrees with the Government on three essential points (see here for video recording). Namely, there is agreement on the science of climate change, on the targets to reduce emissions, and on using markets as the best mechanism.

What the Coalition disagrees with is the Carbon Tax and the appropriate market mechanism to tackle climate change. To quote Greg Hunt’s background paper, “in short, it is a choice between a tax on electricity or market-based incentives for positive action.”

I was intrigued that he explicitly invoked “a tax on electricity”. Presumably, Greg is trying to highlight the narrow focus of the Government’s measures. Whereas the Carbon Tax most aggressively targets emissions in the electricity sector, Direct Action proposes a much broader range of measures for achieving least-cost, “source neutral” Carbon abatement using a reverse auction mechanism. The message is that the Coalition doesn’t want to be in the business of explicitly determining which emissions are abated.

According to Greg Hunt, the Coalition’s main beef is that the Government’s Carbon pricing mechanism is broken. To quote from the background paper “Apart from the current massive $9 billion a year cost of the tax, the central flaw is that it doesn’t do its job. Australia’s domestic emissions are set to go up not down.”

The claim domestic emissions are set to go up is founded on Treasury modelling. The modelling predicts domestic emissions will rise from 560 million tonnes to 637 million tonnes between 2010 and 2020. In the Treasury modelling, the bipartisan goal of a 5% reduction below 2000 levels by 2020 is obtained with an additional 100 million tonnes of internationally sourced carbon abatement.

So it seems the Treasury modelling is being used to justify Coalition’s proposition that “The election will be a referendum on the Carbon Tax”.

But does it?

We might ask if it is strictly appropriate to evaluate a policy measure such as the “electricity tax” targeting a specific sector, with a modelling exercise that covers all domestic emissions. After all the Treasury modelling includes emissions from right across the energy sector (including electricity generation, heating, cooking, transport and fugitive emissions), as well those from industrial activity and land use (including agricultural, deforestation forestry, and land-fill waste emissions).

But more importantly, if we are using it to justify policy, shouldn’t we now be asking how well the modelling is stacking up against reality? This is especially relevant since the Treasury modelling was conducted in 2012 prior to the implementation of the Carbon Tax. With a year of experience of the Carbon Tax, we can now “ground-truth” the initial model predictions.

To address the questions I will take up the theme I explored in a recent post related to emissions trends in the electricity sector reported by the National Electricity Market operator AEMO.

The key point is that electricity sector emissions are declining at an astonishing rate.

Since 2008-09, CO2 emissions have fallen 13%, from 188 million tonnes to 163 million tonnes, at an average rate of 3.4% per year. To the year ending June 30th 2013 corresponding to the first year of the Carbon Tax, electricity sector CO2 emissions fell 13 million tonnes, or 7%.

The fall has been so rapid that our electricity sector emissions are now below to 2001 levels. Not withstanding the caveats discussed here, and AEMO’s own disclaimers, the electricity sector trend is on target to meet the sectoral 2020 bipartisan target (5% below 2000 levels) by mid 2015 - some five years early.

Compare that to the Treasury modelling that predicted a reduction of about 1 million tonnes for the same period, or 0.5%, under a Carbon pricing regime. In fact Treasury modelling doesn’t obtain a net reduction of 13 million tonnes on 2012 levels until 2029.

I think we can safely assume the Treasury modelling has missed something.

Could this be an affirmation of the Government’s Carbon Tax?

Before we get too carried away, we should explore the contributors to this decline, and the extent to which policy as opposed to other factors have contributed.

In response to a question I asked about this very point, Greg Hunt responded that the reductions reflect the dramatic and largely unanticipated downturn in electricity demand following the GFC. And this isn’t necessarily a great thing.

Greg reported conversations with AEMO CEO Matt Zema that indicate the demand reduction splits in about equal measures attributable to shifts in our economy away from energy intensive industry, and shifts in our domestic sector related to uptake of PV, energy efficiency measures (‘pink batts’), and pricing elasticity.

I would concur with that.

However, even though demand for electricity is falling fast, at about 1.7% each year, it is falling at only half the rate of emissions. So independently of the demand reduction, something else is going on. And, in any case, emissions are being reduced at a rate far higher than predicted by the Treasury modelling.

While we can attribute some of this additional emission abatement to the various clean energy measures, including the Carbon Tax, some of it is also due to the fortuitous breaking of the Millennium drought that has seen hydro electric power contributions rise over the last few years.

The welcome news is that our emission intensity is falling much more rapidly than anticipated. The CO2 produced for each megawatt hour electricity has fallen from 0.95 tonnes to 0.88 tonnes in just 4 years. And there is some suggestion this decarbonisation is occurring at an accelerating rate.

As shown below, when measured against GDP growth, the electrical sector emission intensity has fallen 25% over the last decade, while energy intensity has fallen 17%. They are quite staggering figures. In effect, we are doing much more in economic terms with much lower input, and doing all of it in a much cleaner way.

That is good news for our economy and for our environment. And, as noted here, given that we have maintained significant GDP growth throughout, it is a story that should help motivate the rest of the world to meet the challenge of decarbonisation.

The trends established over the last few years give strong hope that the electricity sector will be well beyond the bipartisan targets by 2020. Now the challenge is to accelerate progress towards more significant emission reductions. Policy discussion should move on from whether the Government’s Carbon pricing mechanism is broken - it clearly isn’t - to a more sophisticated analysis. What are the mechanisms that will best serve attainment of bipartisan emissions targets appropriate to obtaining more significant environmental and economic outcomes?