Rationales for additional climate policy instruments under a carbon price.
Twomey, Paul
1. Introduction
With growing awareness of the huge costs of mitigating and adapting
to climate change (and the great dangers of getting climate strategy
wrong), the choice as to the most appropriate set of policy instruments
to address this issue has been receiving significant attention (OECD
2008). The primary approach, particularly during the 1960s, to address
environmental problems involved the use of command-and-control type
policy instruments such as technology or emissions performance
standards. The rise of environmental economics as an established
sub-discipline of economics has led policy-makers over the last two
decades to consider more market-based instruments, such as environmental
taxes or permit trading schemes, to be the preferred policy solutions to
environmental pollution problems (Stavins 2003).
For climate change policy making, this trend has seen the
dominance, at least among mainstream economists, of carbon pricing as
one of the preferred policy instruments of consideration for developed
countries seeking to adopt a climate policy that can deliver significant
cuts in greenhouse gas (GHG) emissions. The leading example of this
approach is the European Union Emission Trading Scheme (EU ETS), which
began operation in 2005. Other schemes that are currently operating
include the New Zealand Emission Trading Scheme (NZ ETS), the Regional
Greenhouse Gas Initiative (RGGI), which operates across 10 states in the
United States, and the NSW Greenhouse Gas Abatement Scheme (GGAS). In
November 2011, the Australian Federal Parliament passed legislation to
introduce the Clean Energy Future policy package, whose centrepiece is
an emissions trading scheme with an initial three year fixed price
period from July 2012 (Commonwealth of Australia 2011).
The appeal of carbon pricing, whether in the form of an emissions
trading scheme or a carbon tax, is quite apparent in the orthodox
neoclassical economics framework--it attempts to address most directly
what is deemed to be the underlying cause of the problem. As Nicholas
Stern has put it:
The science tells us that GHG emissions are an externality; in
other words, our emissions affect the lives of others. When people do
not pay for the consequences of their actions we have market failure.
This is the greatest market failure the world has seen. (Stern 2006: 1)
The standard neoclassical solution to the problem of a negative
externality has been well defined since at least Pigou (1920). A
tax--often described as a Pigovian tax--is levied on the production or
consumption activities that are generating the externality, with the
level of the tax being set equal to the previously unaccounted social
costs of the activity. With a proxy for the social cost brought into the
(self-interested) decision making of firms and households, the market
outcome should move to the socially efficient level. Economists
sometimes describe this as the 'first best' solution.
Part of the attraction of the Pigovian tax is that it does not
require the government or regulator to know the individual abatement
costs of firms or households, but only requires that actors know their
own abatement costs in making the decision of whether to internally
abate or pay the tax. Furthermore, a carbon price should permeate the
economic system, from production decisions on the use of raw materials
and production processes to the final consumption choices by households
on goods and services of varying carbon content. This should result in
the least cost abatement for the economy.
The same underlying mechanism is also the basis for using an
emissions trading scheme (ETS). This involves the creation of an
artificial market of 'permits to pollute'. Under ideal
conditions, the carbon tax under a tax scheme should equal the permit
price under an emissions trading scheme for a given emission target
(Montgomery 1972). As with a tax, the permit price of the ETS should
permeate the economic system and lead to least cost abatement.
It is within this context that the question arises of the necessity
and relevance of using other policy instruments to mitigate carbon
emissions once a carbon pricing scheme is in place. As reviewed in
section 2, these instruments range from production subsidies to
technology standards to R&D grants and information disclosure
policies. Is there any necessity for using such policy instruments once
a carbon pricing scheme has been implemented?
From the perspective of orthodox neoclassical economics, the first
pass in answering this question is simple--no. If we are facing a single
environmental issue that can be addressed directly, a 'first-best
optimum' can theoretically be reached through the use of a single
instrument (OECD 2007). A single Pigovian tax should correct the
externality in a Pareto efficient manner. To employ further instruments
only risks creating distortions that may, at minimum, result in
redundancy, and even threaten undermining the efficient solution itself.
A policy mix risks becoming a policy mess.
The inefficiency of additional climate policy instruments under a
carbon price (for example, renewable energy subsidies) is often
illustrated using a standard carbon abatement cost curve (e.g. McKinsey
2009), showing how such additional policies may only result in resources
being pushed toward more expensive abatement options and (under an
emission cap) displacing cheaper abatement options, thus raising the
overall cost of abatement for the economy (e.g. Fankhauser et al. 2011).
On a second pass, however, orthodox economic theory does provide
openings to justify the use of multiple policy instruments for
addressing environmental problems. The most important justification is
if we can no longer assume the ideal functioning of the relevant markets
surrounding the externality. In this case, 'second-best'
theory comes into play, where one or more deviations from the ideal
conditions of the general equilibrium system mean that attainment of
other Pareto optimal conditions is no longer necessarily
welfare-increasing (Lipsey and Lancaster 1956). The relevant implication
here is that addressing a single externality may not necessarily be best
achieved by a single policy instrument, if there are interactions
between the externality and the other market imperfections and
constraints. It may be possible that a mix of policy instruments will
achieve a better outcome.
From this perspective, a key determinant of whether one believes
that multiple policy instruments are likely to be necessary is whether
one believes that market failures and other imperfections are common and
pervasive phenomena or relatively rare and benign occurrences. As is
well known, many of the heterodox economic traditions take the former
view. Consider, for example, the post-Keynesian economist Joan Robinson
commenting on the problem of externalities:
The distinction that Pigou made between private costs and social
costs was presented by him as an exception to the benevolent rule of
laissezfaire. A moment's thought shows that the exception is the
rule and the rule is the exception. (Robinson 1972: 101)
By comparison, in the lengthy debate in Australia over whether to
adopt an emissions trading scheme, a number of important reports and
submissions seem to adopt the orthodox line of thinking in dealing with
this question, indicating that only a relatively small set of market
failures offers reasons for having complementary policies and that the
presumption should always be that the market is working effectively. The
Strategic Review of Australian Government Climate Change Programs
(Commonwealth of Australia 2008a) and reports and submissions by the
Productivity Commission (2008, 2011) appear to adopt a position that
once the 'prices are right' in an appropriate carbon pricing
scheme, then (with some small exceptions) there will be little need for
other mitigation polices, including those at other levels of government.
Even the flagship Renewable Energy Target (RET) program, which aims to
have 20 per cent of electricity generation come from renewable sources
by 2020 and is, to date, one of Australia's most successful
policies in terms of aggregate greenhouse gas emission reductions, is
questioned (Climate Spectator 2011).
These a priori arguments have been further reinforced by empirical
studies that appear to show comparatively high costs, on a per-tonne of
carbon abated basis, for many climate-related programs in operation in
Australia. For instance, the Productivity Commission (2011) estimated
that various clean energy programs and policies in Australia's
electricity sector cost between $44 and $99 per tonne of C[O.sub.2]
abated. Their modelling suggested that the same level of abatement could
be achieved with a carbon price of $9 per tonne. Daley and Edis (2011)
found similarly high costs for many of these programs.
These concerns have fed into the political debate. In August 2011,
Federal Climate Change Minister Greg Combet questioned the efficiency of
state-based solar feed-in tariffs, which pay owners a premium on
electricity from home solar PV systems (The Australian 2011). The
Western Australia Premier Colin Barnett and the Business Council of
Australia have also called for the removal of the national Renewable
Energy Target (Perth Now 2011).
In Europe, while there is still general support for renewable
energy targets and associated policy instruments such as feed-in tariffs
and green certificate schemes, there has also been increasing reflection
on the apparent high costs of such programs and the distortions that
they may be causing to the carbon price in the EU ETS (Fankhauser et al.
2010; Moore 2011; Moselle 2010a, b).
This article will not attempt to determine whether particular
schemes, such as solar feed-in tariffs, are an appropriate element of a
climate change strategy, particularly in the presence of a carbon
pricing scheme. Rather, the more modest aim is to challenge the use of
stylised models and reasoning to prematurely reject instrument
combinations under a carbon price. In particular, analysing instrument
selection through the use of simplified, static cost abatement curves,
surrounded by a small set of acknowledged market failures, omits from
the analysis a number of relevant issues that open up a relatively wide
set of possible reasons for using multiple climate policy instruments.
As we will see, the rationales draw upon both conventional and heterodox
economic traditions. They involve looking beyond market failures to
include system failures that are particularly related to responses to
the implications of fundamental uncertainty. Furthermore, it also needs
to be understood that implementing a carbon pricing policy, such as
contained in the Clean Energy Future package, involves a policy package
of monitoring, management mechanisms, and collection administration that
naturally opens up complementarities with other instruments.
Of course, providing potential rationales for the use of multiple
instruments is still a long step from justifying any particular set of
instrument combinations--the policy mix. Indeed, no combination of
reasons offered can justify a 'pay-whatever-it-takes' approach
to employing additional climate policy instruments such as feed-in
tariffs or renewable energy targets. Rather, the aim here is to show
that it may be mistaken to prematurely dismiss certain climate policy
mixes based on the narrow application of standard neoclassical economic
arguments and modelling.
This article takes the existence of a carbon pricing scheme as
given and questions whether there are weaknesses or other constraints
with carbon pricing that warrant the use of other climate policy
instruments (or 'complementary' policies). However, it can be
argued that the difficulties with carbon pricing may be so profound that
no amount of 'patching up' will sufficiently solve the
inherent problems (Paton and Bryant 2010; Rosewarne 2010; Spash 2009).
Certainly the evidence to date from the most significant experience with
carbon pricing--the EU ETS--has been mixed. Some studies, such as
Ellerman et. al. (2010), are generally positive, given that the first
phase of the EU ETS was meant to be a learning process. Others have been
much less complimentary (e.g. Helm 2009). This article does not attempt
to address this broader evaluative question of the suitability of
employing market logic to this environmental problem and the long run
viability of carbon pricing (see, for example, the article by Spash and
Lo (2012) in this symposium for a more detailed discussion of this
issue).
The outline of this article is as follows. Section 2 provides a
brief review of the range of possible climate policy instruments and
offers examples of their use in Australia at the Commonwealth (Federal)
and State levels. Section 3 provides a range of rationales for having
multiple climate policies, starting with the generally accepted market
failures acknowledged in the mainstream economics literature and moving
on to system failure arguments from the more heterodox traditions.
Section 4 briefly discusses some of the implications of such rationales
for policy instrument selection. Section 5 concludes the article.
2. Climate Mitigation Policy Instrument Options
Environmental economics offers a range of policy instruments to
tackle pollution problems such as greenhouse gas emissions (OECD 2008;
Sterner 2002). The aim of this section is to provide the reader who may
be unfamiliar with environmental economics with a quick overview of the
variety of instruments that are available. We also provide some examples
that are currently in operation in Australia. No attempt is made here to
evaluate these instruments.
One representative taxonomy of emission reduction policy
instruments, based on Productivity Commission (2011) and International
Energy Agency (2011), is shown in Table 1. It divides the instruments
into the following types: (i) explicit carbon prices; (ii) subsidies and
(other) taxes; (iii) direct government expenditure; (iv) regulatory
instruments; (v) support for research and development (R&D); and
(vi) information, education, and other instruments.
In the environmental economics literature, the focus of research
has been upon the efficiency and environmental effectiveness of single
instruments or comparison of two instruments (Goulder and Parry 2008).
Much less research has involved the evaluation of policy mixes or the
rationales of multiple policy instruments (Bennear and Stavins 2007;
Lehmann 2010).
In practice, however, the use of multiple policy instruments is the
norm rather than the exception in environmental policy (Bennear and
Stavins 2007). The Wilkins Review, conducted in 2008, found over 260
relevant programs at the national and state level in Australia
(Commonwealth of Australia 2008a). The Productivity Commission (2011),
similarly, found around 230 relevant programs in Australia, 300 in the
United States (federal and state) and 100 in the United Kingdom. The
taxonomy in Table 1 provides some examples of the various types of
policies used in Australia.
Unfortunately, as noted by the OECD (2008), such wide ranging
environmental policy instrument mixes are usually not implemented as a
result of an integrated and coherent policy design process, but are more
often than not the result of an ad hoc process of adapting to the
evolving challenges and political demands of the day. Only in a few
cases have policy mixes been fully designed and articulated in a
coherent manner.
For this reason, it is both understandable and important that we
clearly define the purpose of the policy instruments that are employed,
including an understanding of how they may interact with each other. In
the following section, we look at some of the challenges that may arise
in implementing climate policy that open up the possibility of policy
mixes. Although motivated by the question of whether other instruments
are necessary in the presence of a carbon price, many of the arguments
can be applied more generally to climate policy mixes, whether they
include a carbon pricing scheme or not. We will not go deeply, however,
into the question of how various specific policy instrument combinations
could address such issues.
3. Rationales for Multiple Policy Instruments
In this section, a number of rationales is offered for the use of
multiple policy instruments to achieve greenhouse gas emission
reductions. At the broadest level, one possible way of understanding the
following set of rationales is in terms of the concepts of 'market
failure' and 'systems failure', in which the former is
grounded in risk management and the latter in management of fundamental
uncertainty. In the former, the risk management approach enables an
optimisation of the policy toward what a single carbon price strategy
would have achieved if there had been no market failure. That is, in the
presence of a carbon externality, the existence of other mutually
reinforcing market failures may provide a reason for using more than
just a carbon pricing scheme in the climate policy mix. The systems
failure approach situates the analysis as one characterised by
institutions, evolution, and fundamental uncertainty and is not an
optimising approach. Rather it allows for a more flexible and iterative
approach to achieving the target of significantly reduced emissions of
greenhouse gases (e.g. Courvisanos 2009a). As we will see, some of the
categories below are characterised by both market and systems failure.
Along the way, we will explore some examples of how these
rationales may support the use of some of the specific types of
instruments mentioned in section 2. However, as discussed in section 4,
we will also see that some of the rationales provide less guidance as to
the most appropriate policy instrument response.
3.1 Knowledge Spillovers from Technological Innovation
Reducing GHG emissions while maintaining or increasing levels of
economic activity will require significant technological innovation. A
well known potential market failure that may affect innovation and
diffusion of technology generally is the limited ability of firms to
capture the returns from new ideas, owing to the multiple channels
through which diffusion of knowledge occurs. A phenomenon known as
'knowledge spillover', in which one firm's innovation
spills over and provides similar advantage to a neighbour (and possible
rival), is likely to induce firms to invest less in research and
development (R&D) than would be desirable for society.
In effect, this market failure is due to imperfect property rights
in the stock of knowledge, leading to the social return on investment in
R&D being greater than the private rate of return on investment in
R&D. While intellectual property rights can help address this issue,
they are often imperfect in practice, meaning that private investors are
not always able to capture the full social benefits from their
innovation (OECD 2007).
Various attempts have been made to estimate the magnitude of
R&D spillovers. It is generally agreed that such spillovers are
greater for fundamental research than later stage development (Nordhaus
2009). For climate mitigation policy, Grubb et al. (1995) have indicated
that technological spillover effects may dominate the effect of a carbon
pricing mitigation policy. They estimate that the benefits of
stimulating and adjusting innovation and diffusion directly may be up to
seven times larger than the emission reduction benefits derived from
direct Pigovian taxes. Grubb and Ulph (2002) have also shown that the
blunt use of a carbon price may also not be efficient if the long-run
potentials of low emission technologies are varied. Rather, a more
focused stimulation of innovation and diffusion, using other policy
instruments such as R&D grants or tax breaks, is needed. Thus, pure
pollution control policies using a Pigovian tax are not efficient from a
dynamic perspective (Lehmann 2010).
As well as knowledge spillovers occurring from R&D, similar
effects may occur with learning-by-doing (LBD). This captures the basic
idea that the cost of producing a good declines with cumulative
production as the firm learns how to produce the good more effectively
(Arrow 1962). While there is little work on the extent of LBD
spillovers, there is evidence of significant LBD present in a number of
renewable energy technologies (Jasmab 2007).
3.2 Information Problems
Households and firms who are poorly informed may act inefficiently
even if faced with adequate incentives such as an energy or carbon tax
(OECD 2008). For example, households may not be aware of the energy
efficiency of electrical appliances they buy or how to minimise the
energy consumption of such devices. Thus, a growing body of literature
advocates the provision of information as a policy device to support
carbon pricing policies (Jaffe et al. 2005). This may include public
information programs (media campaigns and websites) as well as labelling
standards on the energy efficiency of devices. It may also include
having better quality feedback on electricity consumption and usage
(e.g. from smart meter devices). For commercial purposes, government
agencies may be in a better position to collect information on future
energy conditions (e.g. demand) and make such information available to
the public.
Another information market failure that can arise is the classic
principal-agent or split incentive problem. In most rental properties,
landlords make the decision about whether to invest in energy efficiency
(by, for example, improving thermal insulation) or installing
distributed generation renewable energy devices (e.g. photovoltaic
cells), while tenants pay the energy bills. If the rental market does
not adequately reflect the value of such investments then landlords are
not compensated for their investment decisions with higher rents, and
they will tend to under-invest in such energy efficiency or renewable
energy installations (Levinson and Niemann 2004). Renters, in turn,
either lack the power to make investments or will not occupy the
premises long enough for the efficiency benefits to offset the upfront
costs. In such cases, it may be justified for the government to impose
energy efficiency or renewable energy standards, or offer incentive
schemes for landlords to implement such measures.
3.3 Imperfect Functioning of Financial Markets
Information problems may also contribute to imperfections in the
operation of capital markets, where information differences between the
firm and potential investors about the future returns from R&D
and/or adoption of existing technologies may hamper a firm's
ability to raise capital for such activities. Similarly, imperfect
financial markets may affect the ability of households and small firms
to finance investments in profitable energy-saving equipment that has
high upfront costs but low running costs (OECD 2008). Once again, the
incentive signals for innovations provided by a carbon price may be
greatly impeded and require other policies to ameliorate or compensate
for these problems.
In addition to such information or transaction-cost market
failures, it may also be argued that predatory behaviour in financial
markets may cause systems failure (see Galbraith 2008) that affects the
financing of innovation.
3.4 Market Power
The existence of market power can provide a number of possible
distortions and is a particularly pertinent concern in the electricity
generation sector (Gillingham and Sweeney 2010), which is a major source
of GHG emissions. For example, the exploitation of market power in
substitutes for clean energy (i.e. the fossil fuel market) may raise the
profitability of low carbon energy generation and artificially drive
over-investment. On the other hand, incumbent fossil fuel generators may
have an incentive to buy-out or use their market power to reduce
emerging competition from renewable energy sources, which may lead to
under-investment in renewable energy. Such strategies may include the
use of vertical market power, where vertically integrated utilities may
favour their own (fossil fuel) generation facilities over independent,
small scale (renewable energy) generators. The more systemic problems
that can arise have been discussed in the literature on the politics of
monopoly capitalism (see Courvisanos 2009b).
There is a range of potential policy responses, the most direct
being better policing of anti-competitive activities by the appropriate
energy regulator and/ or competition commission. However, to the extent
that such monitoring and enforcement is deficient, other measures that
are potentially justified include the use of feed-in tariffs for outside
suppliers (to compensate against favouring in-house generation) and
mandatory purchasing of energy from small scale or renewable energy
suppliers (Gillingham and Sweeney 2010). The latter can also be an
effective policy strategy to create critical mass in the formative
stages of a new technology.
3.5 Administration and Other Transaction Costs
Another potential rationale for a policy mix is the situation where
fully implementing a first-best policy involves prohibitively high
transaction costs, i.e. costs that exceed the value of internalising the
externality (Lehmann 2010; Tietenberg 1995). While it is not generally
the case that applying more instruments will reduce total administrative
costs, there can be some situations where this does occur (OECD 2007).
In such cases, it may be possible that a portfolio of policies results
in higher net value of internalisation benefits minus total transaction
costs than is possible from any single instrument.
For example, with large emission trading schemes such as the EU
ETS, the size of the transaction costs of administration of the system
and the compliance costs incurred by companies participating in the EU
ETS are not inconsiderable. For small and medium size enterprises, these
costs can outweigh the efficiency benefits of using a permit trading
system and it may be more cost effective to regulate these firms using
other instruments such as emission standards (Schleich et al. 2004).
This consideration was seen in the adjustments to the EU ETS in phase 2
of the scheme, which involved raising the C[O.sub.2] emissions threshold
for qualifying companies required to participate in the scheme.
3.6 Regulatory and Other Policy Distortions
A range of pre-existing regulatory and other government policy
distortions may also bias against low carbon technologies such that
introducing a carbon price does not necessarily 'level up the
playing field', as it is sometimes claimed. For example, in
Australia, there still exist various continuing subsidies to the fossil
fuel industries. Denniss and Macintosh (2011) estimate such subsidies to
be in the order of $9 billion per year.
Another source of distortions is in the various electricity market
rules and regulations that may bias against some aspects of renewable
energy generation (Gillingham and Sweeney 2010). For example, when
households face a fixed pricing structure that is not sensitive to a
fluctuating wholesale price, they may underestimate the value of solar
photovoltaic (PV) systems whose output often coincides with the peak
demand period (and highest wholesale prices). Borenstein (2008)
estimated that the fixed retail pricing structure in California had lead
to an undervaluation of solar PV systems by up to 20 per cent.
The most direct response to such distortions is to remove the
distortion rather than compensate for it in other ways. This would
involve the removal of fossil fuel subsidies and implementation of a
more flexible retail pricing structure (for example, time-of-use pricing
or real-time pricing) through the use of smart meter technologies.
However, as before, where direct solutions are not feasible or are
prevented by other political constraints, it may be appropriate to use
subsidy instruments such as feed-in tariffs to compensate for and
counteract such distortions or biases.
3.7 Multiple Modes of Behaviour
From the perspective of heterodox economics, an obvious criticism
of relying solely on a carbon pricing mechanism for climate policy is
that it is based on a concept of human behaviour as one that is
rational, narrowly self-interested, and purposefully aimed towards
subjectively defined ends.
The economic literature that critiques this so-called 'homo
economicus is vast, including contributions by Thorstein Veblen, Karl
Polanyi, John Maynard Keynes, Herbert Simon, Amos Tversky, and Amitai
Etzioni, to name just a few. It is not the aim here to examine the
various criticisms of rational economic man or the alternatives that
have been proposed. For our purposes, it will suffice to consider just
three aspects that may be relevant for climate policy.
Habit as a mode of human behaviour has been neglected for many
decades in mainstream economics but was once prominent in the
institutionalist thought of Thorstein Veblen and John Commons, as well
as sociologists such as Max Weber and Emile Durkheim (Hodgson 2004). For
our purpose, we can define habits as essentially submerged repertoires
of potential behaviour that can be triggered or reinforced by an
appropriate stimulus or context. The mechanisms of habit are largely
unconscious, but they may press on our awareness.
For climate policy, it is important to recognise that many of our
emission-related activities have a habit basis, and we should look to
appropriate policies to drive behavioural change. For many desirable
behavioural changes, such as turning off lights or changing travel
routines, the imposition of a small price increase from a carbon tax may
have minimal or no effect. It may not be so much due to a lack of
information of these price changes as a complete by-passing of any
deliberative cost-benefit decision making in such behaviours.
Educational policies that attempt to break habits through
consciousness-raising measures may be useful to support a carbon pricing
policy.
A second form of criticism of homo economicus points to the
excessive emphasis on extrinsic motivation (rewards and punishments from
the economic and social environment) as opposed to intrinsic motivation.
Veblen, for example, highlighted the inherent pleasure from
craftsmanship and drive for technological improvement (Veblen 2006).
Intrinsic motivation has been particularly studied by social and
educational psychologists since the early 1970s, and a number of
intrinsic motivators--such as curiosity, the need to direct our own
lives, to learn and create things, and to do better to ourselves and our
world--have been shown to be powerful motivators (Pink 2010).
Importantly, Bruno Frey and others have indicated that in some contexts,
too much emphasis on rewards and punishments (extrinsic motivators) can
'crowd out' (discourage) intrinsic motivation. For example,
paying someone for lowering their carbon footprint by recycling may
actually push them away from doing those tasks 'to help the
environment' and towards doing them simply for the extrinsic
reward, which may be a weaker motivator (Frey 1997).
One example of a direct interaction between these different
motivations of behaviour arises from the existence of a national cap on
carbon emissions in a standard emissions cap-and-trade scheme (such as
will occur with the Clean Energy Future proposed scheme after three
years). An inherent design feature of standard cap-and-trade schemes is
that, once the cap on emissions has been set, no actions by individuals,
organisations, communities, or governments within the scheme can provide
additional reductions beyond the level of the cap without further
specific provisions. Thus the emissions cap is also an emissions floor.
In Australia, a number of commentators raised the concern that this
design feature could have the undesirable implication of discouraging
ethically motivated mitigation action--'if my socially responsible
behaviour is not going to make a difference to total emissions, then why
bother?' (Fear and Denniss 2009). The need for supplementary
instruments or adding new design dimensions to the standard
cap-and-trade scheme to avoid muting this mode of behaviour has been
discussed by Twomey et al. (2010).
Another weakness of homo economicus that is particularly
highlighted by sociologists is that the model ignores or avoids the
question of the origins of preferences and the parameters of the
so-called utility function. The role of education, training, and social
influences from family, peers, and marketing is typically taken as being
outside the scope of traditional economic analysis. This exogeneity of
preferences contrasts with homo sociologicus, in which tastes are taken
as partially or even totally determined by the societal environment
(Hirsh et al. 1990).
One implication for climate policy is that the general level or
specific form of consumption (e.g. suburban use of enormous off-road
vehicles for school and shopping trips) is not an issue of analysis
(outside of the budget constraint), as these are driven by exogenous
preferences. Again, Thorstein Veblen provided an early analysis of the
nature of 'conspicuous consumption' and has provided a useful
insight into this important driver of excessive consumption (Veblen
2004). More recently, Fred Hirsch's (1977) identification of
'positional goods'-whose value is mostly a function of their
ranking of desirability by others--has provided a framework for
understanding the dynamic of 'keeping up with the Joneses'.
Robert Frank (2005) has described it as a 'positional good
externality' which creates a futile 'expenditure arms
race' for goods and services. This phenomenon is clearly wasteful,
but mainstream economic theory has little to say on it. It has been
argued by some that governments can improve social welfare by imposing
high consumption taxes on certain luxury goods to correct for this
externality and mitigate the social waste. On the other hand, as just
mentioned, a pricing mechanism may not necessarily be effective and
other moral suasion approaches could also be considered. In any case,
there may clearly be a role for policy measures beyond a simple carbon
price. Jackson (2009) provides a useful review of the 'iron
cage' of consumerism in the modern economy and suggests other ways
that this could be changed.
3.8 Institutional and Co-Evolutionary Aspects of Innovation
Institutional and evolutionary economics can also provide
perspectives on why a carbon price may be inadequate as a comprehensive
strategy for transitioning to a low carbon economy. In particular, it
can provide a systemic perspective on social and technological systems,
such as the energy system, whose transformation will be a vital part of
any transition. This contrasts with the simple 'black box'
perspective in neoclassical economics which sees technology as a mere
input-output relation, with relative prices on either side being the
sole driving factor. As described in de Laurentis and Cooke (2008) and
Foxon (2008), a co-evolutionary analysis offers a dynamic and
multi-level perspective on the interaction between technology,
institutions, and organisational strategies. This approach suggests that
the rationale for government intervention to support innovation goes
beyond simple 'market failures', where individuals in the
system face divergences between their private and social returns, to the
systemic context in which these actions take place. The concept of
'systems failure' is proposed as a rationale for policy
interventions and provides a more complex picture of a wider set of
drivers and barriers to successful innovation (Edquist 2001).
There are a number of different insights from this approach, of
which only a few can be mentioned here. One key idea that directly
follows from a co-evolutionary perspective is the possibility of path
dependency and 'lock-in' of the techno-institutional complex.
Of particular interest is how path dependency creates a technological
trajectory that sets up factors, such as supporting techno logical
infrastructure and institutional frameworks, that favour the incumbent
technology and bias against potential competing technologies.
Within this framework, one can argue that the electricity sector
has become locked into a centralised, fossil fuel-based system, in which
the co-evolution of both physical and social infrastructures has created
an environment that makes it difficult for new technologies to compete,
even if they have many superior intrinsic characteristics. Thus, even
where fossil fuel subsidies have been removed, transmission access is
freely available, and carbon emission externalities are being priced,
the history of the energy system is still embedded in the current
technological infrastructure, institutions, and even culture of
consumption (Unruh 2000). The idea that renewable energy technologies
are competing on a 'level playing field' is probably
misleading. Additional policies may be needed to specifically assist
change in infrastructure, supply chains, and social receptiveness to new
forms of power generation.
Looking forward, the problems of path dependency demonstrate the
value of maintaining flexibility in technological and institutional
structures, since there is no clear way of knowing which will be the
most successful and we do not want lock-in to the wrong technology (see
Nelson and Winter 2002). Thus, care needs to be taken to avoid locking
the system into a single new technology, such as gas-fired generation,
which may be the most favoured technology given the current
technological costs and carbon price, but which may not provide a
sustainable solution in the long run. The same, obviously, applies to
particular forms of renewable energy (wind, solar PV, solar thermal,
etc.)
Another insight that arises in the literature of institutional
economics is the importance of the creation of networks for sharing both
technological and institutional knowledge between innovators at the
early stages of technology development, both for the direct effects of
knowledge sharing and in terms of increasing shared confidence in future
technological and market potential. For example, the 2005 study by Foxon
et al. for the Department of Trade and Industry in the UK concluded,
'Knowledge flows are currently not adequate to provide the policy,
technology, finance and demand communities with understanding of, and
confidence in, the economic and environmental implications of biomass
energy systems' (Foxon et al. 2005: 2130).
Furthermore, the evolutionary approach emphasises the importance of
having diversity in technological options and the value of providing
temporary protection to emerging technologies through subsidies and
other means. Such protection may be required to give them a sufficient
chance to create the positive feedbacks in the various supporting
structures necessary for successful development. The idea of fostering a
transition in energy technologies by supporting variation within a broad
portfolio of technology platforms has been a central element of the
Dutch transition management policies (Nill and Kemp 2009).
3.9 Uncertainty, Robustness and Polycentric Action
There is general agreement that climate change is an issue that
involves various layers of uncertainty (Quiggin 2008). These include
uncertainties relating not only to the science of climate change and its
various impacts on the environment, economy, and society, but also
uncertainties as to the effectiveness of the various policy responses
that have been proposed to deal with climate change. However, factoring
uncertainty into the planning and development of climate policy has been
somewhat inconsistent and haphazard (Lempert et al. 2006). Here we
mention just two implications of uncertainty for the consideration of
the climate policy mix.
In the neoclassical treatment of uncertainty as risk (i.e.
identified outcomes characterised by a well defined probability
distribution), one of the more developed analyses on how uncertainty has
a direct influence on instrument selection is in regard to mitigation
cost uncertainty. In a seminal paper, Weitzman (1974) demonstrated that
the expected deadweight loss between choosing a quantity instrument
(e.g. permit trading scheme) and a price instrument (e.g. carbon tax)
would depend on the relative slopes of the marginal abatement cost
function and marginal damage function. An important implication of this
analysis for rationales of multiple policy instruments has been provided
in Robert and Spence (1976) who demonstrated that, under a range of
realistic conditions, a combination of quantity and price instruments
(or hybrid instruments) would provide a better outcome in terms of
social costs than either instrument individually.
Another perspective on the role of uncertainty in the policy mix is
to consider the fundamental uncertainty surrounding the performance of a
chosen policy instrument. The concept of fundamental or radical
uncertainty arises in a number of heterodox economic traditions,
particularly post-Keynesian economics (Dequech 2000). In this case, the
implication is that we are not just interested in 'known
unknowns', such as the future costs of mitigation, but in
unforeseen occurrences including the operation of the instrument itself.
As Phase 1 of the EU ETS demonstrated, a number of unanticipated
problems arose that ultimately impeded the environmental effectiveness
of the scheme. Following the portfolio theory maxim of 'not putting
all of one's eggs in one basket', the issue arises as to
whether a diverse portfolio of instruments may provide a more robust
overall climate strategy.
The idea of encouraging diversity in approaches for dealing with
fundamental or radical uncertainty is common in the natural world and to
modern risk management (Stirling 2003). The value of establishing a
portfolio of options comes from providing a buffer zone to possible
surprises and in providing greater flexibility to adapt quickly to new
circumstances as they emerge.
The first advantage is illustrated by the well known benefit of
having a diversified financial portfolio. On average, the negative
idiosyncratic shocks of some assets in the portfolio are counterbalanced
by the positive idiosyncratic shocks of others, with the net result
being that the total portfolio performance is buffered from
idiosyncratic risks and is exposed only to systemic risk.
The second advantage--of greater flexibility--is provided by having
a wider range of options to choose from, given new information and
opportunities. For example, a technologically diversified portfolio of
electricity generation not only provides greater resilience to shocks
such as gas or coal price hikes, but also provides greater know-how in a
wider range of technologies, with an option to expand capacity as the
circumstances dictate. Evidence of this can be seen in Germany, whose
investment in wind and solar power for the last decade has provided it
with the technological and institutional know-how to expand such
capacity in response to the decision to close its nuclear generation
fleet following the unexpected Fukushima nuclear plant disaster of early
2011.
Such diversity in options may be induced by a single policy
instrument, but there are analogous benefits from having a portfolio of
multiple policy instruments. Policy instruments can fail unexpectedly,
and having other mechanisms in operation can buffer against such
failure. Furthermore, having multiple policy instruments also provides
'parallel experiments' that promote learning as to what are
the most effective channels of achieving the policy objective.
This idea of developing more robust climate policy by addressing
the issue at multiple scales, levels, and instruments has recently been
articulated by Elinor Ostrom, the 2009 Nobel Prize winner in Economic
Sciences (Ostrom 2010). Drawing upon her knowledge of collective action
problems, she argues for a 'polycentric' approach to coping
with climate change. Ostrom argues that simply recommending a single
governmental unit using a limited set of policy instruments to solve
this public collective action problem is inherently weak. The
polycentric approach advocates working at various levels, including
local, regional, and national stakeholders. Ostrom notes:
Building a strong commitment to find ways of reducing individual
emissions is an important element for coping with this problem, and
having others also take responsibility can be more effectively
undertaken in small--to medium-scale governance units that are linked
together through information networks and monitoring at all levels.
(Ostrom 2010: ii)
Thus, as well as providing greater total action through the
summation of different sources of action, the different levels may also
mutually reinforce each other (for example, engaged households, as well
as providing reductions from their own actions, may be more active in
supporting government actions). Ostrom also highlights the policy
learning provided by experimenting with different approaches.
3.10 Political Acceptability
Another important constraint on climate policy is the political
acceptability of any climate policy mix, which will hinge on a number of
factors including the overall cost-effectiveness, the way costs and
benefits are spread across stakeholders, and the general perception of
the fairness and legitimacy of the particular instruments employed
(Baldwin 2008). For example, the 'right to pollute' under an
emissions trading scheme may be deemed objectionable to some parties.
In the political economy literature, Bartle (2009) has reasoned
that it may be essential to have a range of policies to appeal to a
wider range of rationalities. By rationalities, Bartle refers not so
much to modes of behaviour but rather world views. As Compston (2009)
argues:
The idea here is that market instruments appeal to just one type of
human rationality, namely that of an economic actor who responds only in
a self-interested way to price signals, whereas in fact there is
considerable evidence that individuals and organizations use other
rationalities as well. Egalitarians, for example, want greater equity
between humans and between humanity and nature, while hierarchicalists
want better governance and planning to ensure that the natural world and
its resources are better managed (Thompson et al. 1990). This suggests
that messages should be formulated to appeal to each of these different
rationalities, and that a combination of policy instruments needs to be
put in place in order to secure wide support. (Compston 2009: 15)
3.11 Other Social Policies
Finally, mention should be made of the fact that many low carbon
technologies or activities may be promoted for social objectives other
than emissions reduction (Gillingham and Sweeney 2010). For example,
support for renewable energy is sometimes justified as contributing to
the creation of 'green jobs' and to the export benefits from
international leadership in emerging technologies. Renewable energy may
also provide greater security against international oil and gas price
shocks. Of course, in all these cases, it is correct to say that we are
no longer talking about pure climate policies but rather combined
climate/ industrial/security/etc. policies. Pollitt (2011) for example
has critiqued recent UK renewable energy policy as being characterised
by a confusion of industrial and climate policies.
Furthermore, the distributional implications of climate policy may
also warrant further policies to address equity concerns. For example,
it has been generally recognised that a carbon tax has slightly
regressive consequences. The Clean Energy Future policy package was very
sensitive to this concern and included significant tax cuts to
compensate households for such effects (Commonwealth of Australia 2011).
4. Implications
The above set of market failures, system failures, and other
constraints provide potential justification for further policy
intervention beyond the imposition of a carbon pricing scheme. However,
it still may be the case that such policy interventions are more costly
than the problem they are trying to solve or result in other unintended
consequences--government failure may be as common as market and system
failure! Furthermore, I have not attempted to systematically go through
the policy instruments listed in section 2 to determine which are
appropriate in light of the policy intervention rationales. I will not
do so here. However, a few comments can be made on some principles that
can provide guidance. (1)
Firstly, it clearly makes sense to employ additional climate policy
instruments only when they evidently address an identified market
failure, system failure, or other concern (Denniss and MacIntosh 2011).
Some examples were provided in the previous section, such as energy
efficiency labelling schemes and smart metering to provide greater
information to electricity consumers, and research grants, tax breaks,
or other targeted subsidies for firms to address R&D knowledge
spillovers. While the precise form and level of such intervention may be
disputed, these types of policy instruments and the rationales for such
interventions (in particular, knowledge spillovers and information
problems) are generally acknowledged and have been accepted by the
mainstream policy literature including Garnaut (2008, 2011), Wilkins
Reviews (Commonwealth of Australia 2008) and the Productivity Commission
(2008, 2011).
Much more challenging is the question of how to respond to those
issues that are difficult to quantify (for example, the value of
promoting diversity, the value of robustness from multiple policies, the
significance of historical lock-in) or that cannot be addressed directly
due to other political constraints (such as fossil fuel subsidies). A
policy instrument such as the Renewable Energy Target may well be
justified as an attempt to take account of such rationales. That is, it
is necessary to 'make up' for all the residual market
failures, distortions, and other policy objectives that could not be
addressed more directly. However, determining what is the socially best
level of support, or whether these factors are significant at all, poses
questions that are difficult to answer. How does one determine whether
we should have 20 per cent of our energy from renewable sources as
compared to any other level? This is clearly a question for which
further research is required.
Secondly, the cost of complementary policies should also obviously
be examined. As mentioned in the introduction, the apparent high
per-tonne cost of carbon abated for many programs in Australia and
elsewhere has raised questions as to the appropriateness of such
policies. However, as a number of the rationales indicate, there are
both dynamic and systemic value propositions that are possibly being
promoted by such policies that are not necessarily being picked up by
these studies. Further research needs to be done in order to not
underestimate the learning curves, capacity building, and other
institutional feedback cycles that such policies are driving but which
are not necessarily being accounted for in such studies.
Thirdly, it is also important to take into account the temporal
structure of the market failure, system failure, or other concerns
(Gillingham and Sweeney 2010). Economic theory suggests that not only
should an intervention be matched to the failure or concern, but also
the temporal pattern of the intervention should be matched to the
temporal pattern of the failure or concern. For example, the diversity
value of an emerging technology or potential value of learning-by-doing
diminishes in magnitude over time and hence any policy support in these
areas should similarly taper off as well. Other policy instruments, such
as those encouraging fundamental R&D, are likely to be an ongoing
issue and require more sustained policy intervention.
Fourthly, care needs to be taken in understanding the potential
interaction among policy instruments, which may be both positive and
detrimental (Sorrell et al. 2003; Oikonomou 2007). An example has
already been given of the potentially muting consequences of an
emissions cap in a cap-and-trade scheme for voluntary or ethically
driven action. The same logic also applies to other forms of additional
climate policies under a cap, such as solar PV rebates, which do not
have an effect on overall emissions under a total emissions cap (Twomey
et al. 2010).
5. Conclusions
In response to the original question in the introduction--is there
any necessity for using other climate policy instruments once a carbon
pricing scheme has been implemented?--the answer is almost certainly
yes. This article has presented a broad set of reasons why the use of
multiple policy instruments as part of a climate change policy package
can be justified. While it may not be unreasonable to propose that the
core of an effective climate policy package should involve putting a
price on carbon, to argue that this should be the only instrument used
is much less tenable. No single policy instrument is likely to be
sufficient to effectively, efficiently, or equitably address the goal of
GHG emissions reduction.
The article has also highlighted that these rationales need to
include system failures and not just market failures as highlighted in
the orthodox neoclassical economic literature and as contained in
influential reports in the Australian climate debate such as the Wilkins
Review and Productivity Commission reports. In particular, we have
highlighted the importance of fundamental uncertainty, which is closely
connected to the wider knowledge, institutional, and social factors that
are crucial to responding to such uncertainties in the innovation
process. It argues the importance of recognising multiple modes of
behaviour and the value of diversity in dealing with the fundamental
uncertainties that permeate the climate change challenge.
It is also important to note that many of these rationales touch on
dynamic issues and often involve investments in expanding future options
and capabilities. They may be difficult to quantify but should give rise
to caution in uncritically accepting the results of studies that just
look at current costs of emerging low carbon technologies and that fail
to account for future savings and the value of flexibility options they
are creating.
Nevertheless, the concern of Wilkins and others that there are
probably many inappropriate and wasteful programs in operation cannot be
dismissed. Indeed, the lack of integration of climate policy design and
development among departments and at different levels of government
gives reason to believe that the current policy mix has been built up
through a series of ad hoc decisions. In such cases, it is entirely
believable that there is not only costly duplication of effort, but also
that instruments may be undermining each other. In a set of case studies
of environmental problems in Europe, the OECD (2007) found that in a
number of situations, the use of overlapping instruments reduced the
efficiency and effectiveness of the policy outcome.
The development of any climate change strategy (including the
selection of the policy instrument mix) will therefore require careful
analysis. It is dependent on many contextual factors, including the
source of emissions and the type of investment or behavioural change
that is being targeted, and an understanding of the dynamics of the
broader institutional changes that the set of policies are attempting to
guide. It is hoped that this article has made clear that there is a
danger of dismissing policy instruments, such as a Renewable Energy
Target, on the basis of simple text-book, idealised frameworks based
solely on static, technology-centric, least-cost thinking. A richer
framework, including ideas from the heterodox economic traditions, can
help provide a more systemic and nuanced perspective to evaluate such
policies. However, future work is clearly needed in order to provide a
better understanding of the significance of these wider sets of issues
and provide guidance on how to develop policy instrument mixes that best
address them.
Acknowledgements
The author wishes to thank Regina Betz, Iain MacGill, Martin Jones
and two anonymous referees for their helpful comments. Further gratitude
is also given to attendees of the Institute of Environmental Studies
(UNSW) 2011 lunchtime seminar series and the Society of Heterodox
Economists 2010 Annual Conference, in which early ideas on this topic
were first presented and on whose feedback and encouragement this
article has formed. The research was partly funded by the Australian
Research Council (DP1096268).
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Paul Twomey, The University of New South Wales
Notes
(1.) Also see Denniss (2012) in this symposium issue for a
discussion of principles for adopting complementary climate policies.
Dr Paul Twomey is a Research Fellow in the School of Economics in
the Australian School of Business, UNSW, and is located in the Centre
for Energy and Environmental Markets (CEEM). He has a PhD from the
University of Cambridge and was a Jean Monnet Fellow at the Florence
School of Regulation, European University Institute. His research
focuses on energy and climate policy, including analysis of market
power, the economics of renewable energy technologies, and climate and
energy policy interaction, coherence and robustness. He can be contacted
at p.twomey@unsw.edu.au.
Table 1: Taxonomy of emissions reduction policies and illustrative
Australian examples
Explicit carbon prices
Emissions trading scheme-cap-and-trade
* part of proposed Clean Energy Future policy
package after third year.
Emissions trading scheme-baseline and
credit
* NSW Greenhouse Gas Reduction Scheme
(GGAS).
Carbon tax
* First three years of the Clean Energy Future
policy is similar to a carbon tax (Comm.)
Subsidies and (other) taxes
Capital subsidy
* Renewable Energy Bonus Scheme (Comm.)
* Solar cities program (Comm)
Feed-in tariff
* Solar feed in tariffs (SA, Vic, NSW, Qld)
Tax rebate or credit
* Hybrid vehicle registration discounts (Vic)
Tax exemption
* Tax breaks for green buildings (Comm.)
Preferential, low-interest, or guaranteed loan
* Greens loans programs
Other subsidy or grant
* Biofuels Infrastructure Grants Program (Vic)
Fuel or resource tax
* Fuel excises (Comm.)
Other tax
* Green Vehicle Duty Scheme (ACT)
Direct government expenditure
Government procurement-general
* Cleaner NSW Government Fleet Program
Government procurement-carbon offsets
* Carbon Neutral NSW Government
Government investment--infrastructure
* Energy efficient government buildings (SA)
Government investment--environment
* Installation of Adelaide's first public 'smart'
electric vehicle recharging station
Regulatory instruments
Renewable energy target
* SA Renewable Energy Target
Renewable energy certificate scheme
* Large-scale and Small-scale Renewable
Energy Target/Scheme (LRET & SRES)
Electricity supply or pricing regulation
* GreenPower Accreditation Program
Technology standard
* C[O.sub.2] Emissions Standards for Light Vehicles
Fuel content mandate
* NSW Biofuels Mandate
Energy efficiency regulation
* NSW Energy Savings Scheme (ESS)
Mandatory assessment, audit or investment
* Mandatory greenhouse gas emissions and
energy use reporting
Synthetic greenhouse gas regulation
* Ozone Protection and Synthetic
Greenhouse Gas Management Act 1989
Urban or transport planning regulation
Other regulation
* Carbon Farming Initiative
Support for research and development (R&D)
R&D-general and demonstration
* National Low Emissions Coal Initiative
* Australian Solar Institute
R&D--deployment and difusion
* Carbon Capture and Storage Flagships
Program
Information, education and other
Information provision or benchmarking
* Carbon Management Information and Tools
(Victoria)
Labelling scheme
* Mandatory energy efficiency labeling for
appliances
Advertising or educational scheme
* Showcase renewable and energy efficient
technologies (ACT)
Broad target or intergovernmental framework
* National Waste Policy
Voluntary agreement
Source: Based on Productivity Commission 2011: xvii
