Making the best of Direct Action - Part 3

I voted for Kodos.

To those of you who made it this far in my tirade against a poorly framed environmental policy, I congratulate you and hope that you now have a greater understanding of a $1.55 billion policy that is being rushed into parliament by an environment minister who wrote his thesis on A Tax to Make the Polluter Pay. At the very least, I hope it was more informative than this misguiding explanation by co-creator, supporter and lead advisor to the Commonwealth’s Direct Action Plan.

There are many more aspects of the auction process and the proposed policy design, which goes to show how the ERF is a complex policy with limitations, difficulties and considerations that go far beyond this series of articles. Unfortunately the series could continue with many more iterations about the numerous shortcomings and frailties surrounding the ERF, which suggests that the Commonwealth would benefit greatly from further discussion, consultation and experimentation.

To prevent this, firms could be required to purchase carbon offset credits for emissions beyond their baseline levels (not unlike in an ETS). This would satisfactorily safeguard purchased abatement, whilst minimally impeding on the finance of businesses.

A robust safeguard mechanism is required to ensure genuine abatement and a total reduction in national emissions. There is currently no mechanism in place for disincentivising firms who increase their carbon emissions, and so there is a risk that abatement paid for by the ERF may be neutralised by an increase in emissions elsewhere in the economy.

The competitive advantage of being a ‘best practice’ producer may further incentivise firms to participate in the ERF. Businesses will not only be bidding for funding to comply with their baselines, but they will also be seeking to increase their competitive advantage and/or reduce their cost of compliance.

Firms who are less efficient than the ‘top runner’ are required to improve their production processes within a given time frame, or else face harsh penalties. Reactive regulations like these can trigger a race to become the ‘top runner’ or ‘best practice’, as firms look to simultaneously improve and invest in their own processes whilst adding a cost of compliance on rival firms.

A better approach to incentivise competition and attract abatement would be to set all baselines at industry ‘best practice’, an option that is being considered for new entrants. Japan’s successful Top Runner program involves periodically resetting energy efficiency regulations at the standard of the most efficient producer, known as the ‘top runner’.

Only abatement efforts that are additional and would not have occurred under business-as-usual practices should receive funding. The ERF Green Paper is awfully evasive in describing how the additionality and credibility of emission reductions will be upheld. Ensuring reductions are additional is crucial to maximising abatement, but is also arguable the most difficult task for the Commonwealth. The current proposal advocates the use of historic emissions to create a benchmark or baseline, whereupon only reductions below a facility’s baseline will be accounted as additional and approved for the ERF.

Two elements of the ERF that may promote competition besides the auction mechanism are the concepts of ‘additionality’ and ‘safeguarding abatement’.

With over 7,000 facilities under the National Greenhouse and Energy Reporting (NGER) scheme, countless farms and landholders under the Carbon Farming Initiative (CFI), and the opportunity for other aggregated proposals, diversity of participation is well suggested. However, given the voluntary nature of the policy, sufficient competition is not yet satisfied.

Efforts to maximise competition will not only curb quantity bid-shading under a uniform price clock auction, but will also improve the outcomes of any auction design. Competitive conditions will reduce the magnitude that firms overbid in a pay-as-you-bid auction, and will lead to truthful bidding in uniform price auctions.

Fortunately, existing literature points to only large firms having the incentives to act in this way. Moreover, where markets display sufficient competition and heterogeneous bidders, the incidence of such strategic behaviour deteriorates and proves unprofitable.

It all comes back to economies of scale. Big firms with large scale, low cost emission reduction projects may underbid their quantity so as to allow smaller firms with more costly projects to enter the market and inflate the clearing price, resulting in higher prices for all participants.

Regretfully, what we find is that for multiple-unit, multiple-bid auctions like the ERF, a uniform price setting may induce untruthful bidding. This strategic behaviour is another form of bid-shading or bidding above ones willingness-to-abate. Instead of overbidding on price, firms may choose to submit proposals at their true minimum cost, but at a quantity that is lower than the project’s total potential.

Having previously identified that an open, ascending clock auction with uniform price is likely to cost less than a sealed tender with pay-as-you-bid pricing, due to overbidding and the desire to capture excess surpluses, it seems sensible to check whether the incentives for bidders to submit their true willingness-to-abate profiles holds under all conditions.

To address the question posed at the end of Part 2 regarding gaming the auction:

So far this series has examined the auction design of the Coalition’s Emissions Reduction Fund (ERF) and attempted to provide an alternative process to purchasing carbon abatement projects. Strategic behaviour has been highlighted as a primary risk to achieving low cost emission reductions through an auction process, whether it be a pay-as-you-bid sealed tender, or a uniform price ascending clock. Part 3 will cover how the clock auction described in Part 2 can sometimes provide perverse incentives for firms to act strategically, and also examine a few key components from outside the auction design. At this point a useful reminder: the aim is to achieve cost minimisation and economic efficiency, which will support low cost carbon emission reductions.

Read Part 1 and Part 2.