Making the best of Direct Action - Part 1

Despite the overwhelming support among academics, business leaders and economists for an emissions trading scheme type approach to global warming, it appears “Australia has chosen”, and the reality is that come the new senate on 1 July 2014, the carbon tax will be repealed and replaced with the Coalition’s Direct Action Plan (DAP).

The central policy designed to succeed the carbon tax, set out in the Government’s recently released Green Paper, is the Emissions Reductions Fund (ERF), a tender process that will request businesses to propose abatement (carbon reduction) projects.  Outlining the mechanism and identifying its shortcomings will be the focus of this article, Part 2 will attempt to address these problems and offer simple practical adaptions.

The goals of the ERF can be summarised as follows:

(1) economic efficiency: to ensure the most efficient, low cost emission reduction projects take place over less efficient, more costly projects, and

(2) cost minimisation: that the most abatement is achieved for a given budget constraint.

The proposed ERF aims to achieve these goals by running a reverse auction in which firms place bids on the quantity and cost of their abatement, whereby the cheapest projects will be selected until the funding cap is reached.

The auction design is characterised by the following properties:

• Sealed tender, or confidential bids and prices, and a hidden price ceiling
• Pay-as-you-bid, so that winning bidders receive the price of their bid
• Frequent auction rounds

The logic is that by keeping auctions silent, businesses will be incentivised to participate and make bids equal to their willingness-to-abate – the minimum cost of reducing emissions – otherwise face the risk of losing and hence forego funding.  Winners are only paid what they bid, which at their true cost of abatement will ensure low cost emission reductions and value-for-money for the Government.  Frequent rounds aim to reduce administrative delays and improve the timeliness of emission reductions.

Not so fast.

Although this appears to be an appealing auction and market-based approach, these three core features together ensure that both economic efficiency and cost minimisation will not be achieved.  The incentives required for participants to reveal their true willingness-to-abate are not robust, nor is the auction strategy-proof.

A pay-as-you-bid auction distorts incentives by encouraging participants to inflate their bids in order to receive a higher price.  This is known as ‘bid-shading’ and makes it difficult to accurately identify and rank low cost projects due to ‘noisy’ price signals.

Frequent rounds, along with sealed pricing, create a ‘sequential game’ where strategic bidding is promoted over truthful bids.  Participants have perverse incentives to withhold bids or over-bid in the belief that clearing prices will be higher in subsequent auctions.  This reduces the participation or ‘thickness’ of an auction, and lessens the competitive pressure required for any market-based solution.

Confidential bids and a hidden price ceiling can also result in wasted resources and efforts by firms whose abatement projects are priced beyond the upper benchmark.  Developing ineligible proposals can be costly and unproductive for firms, as well as increasing the administrative burden of auction regulators.

The likely result is a subversive auction that not only produces inefficient costly outcomes, but also policy with poor accountability, transparency and confidence.  These shortfalls are further compounded by more inherent features of the ERF’s auction process.

An important element of any abatement scheme is to ensure ‘additionality’; that the policy promotes emission reductions beyond that of regular business activity.  If not, then firms are rewarded with a community-paid government subsidy for otherwise routine investment decisions, or worse, a simple transfer of emission sources.

In order to set a yardstick to determine ‘additionality’, the ERF proposes to estimate baseline emissions at the ‘facility-level’ based on historical data.  Not only is this an administrative burden to calculate accurate and consistent parameters for the 7,250 facilities that fall under the National Greenhouse and Energy Reporting Scheme (NGERS), but emission levels are also known to vary substantially.

Businesses will surely be active in attempting to influence the determination of their baselines, as higher baselines will not only reduce the pressure for emission reductions, but also increase a firm’s ability to unfairly extract funding from the ERF.  How these baselines will change over time and the predictability of these changes are also crucial in ensuring ‘additionality’ and creating a positive investment environment for businesses.  Identifying worthwhile projects and calculating how much each project results in genuine emission reductions is a difficult and subjective process, one which exposes the Government to inefficient lobbying and rent-seeking, as well as favouritism and corruption.

One final shortcoming, albeit far from the last, involves safeguarding abatement. That is, ensuring that businesses comply with their purchased reductions as well as refrain from increasing their emissions beyond historical levels.  The ERF is yet to stipulate any punitive measures, so much as to say “a clear objective [is] not to raise revenue” (pp. 38); read: this is not a tax.  Feedback is being sought by the Government whilst they develop a safeguard mechanism together with business stakeholders, and one can only wonder at the soft-handedness of any resulting proposal.

There are considerable deficiencies with the ERF as it stands. Part 2 will look to address the shortcomings identified in this article and attempt to make the best of a subprime policy for tackling climate change.

For now, what are some other shortcomings of Direct Action and the ERF? What positive outcomes can be recovered from this policy, if any?