Friday, July 25, 2008

Economy in climate of changes

WHAT will be the greatest micro- economic reform of the Rudd Government's time in power?

Sorry, that was a test question. If you don't know the answer, go to the bottom of the class.

As the Minister for Climate Change and Water, Senator Penny Wong, was at pains to emphasise in her speech to the Australian Business Economists this week, the centrepiece of the Rudd Government's economic reform agenda is its carbon pollution reduction scheme.

(This is the new and more descriptive name for the emissions trading scheme.)

Wong said the scheme would "reform and transform the Australian economy". "In its ability to change the economy over time, the carbon pollution reduction scheme is likely to be on par with past economic reforms such as trade liberalisation, opening up the economy, and floating the dollar," she said.

"Those tough economic reforms of the 1980s and 1990s … mean that Australia now has a resilient and flexible economy which is well placed to undertake this new reform."

As Wong acknowledged, implementation of the scheme will be a test of the Government's economic leadership.

If you're in any doubt that tackling climate change is an economic issue, let me explain. Putting "the environment" and "the economy" in separate boxes makes no sense because the economy exists within the natural environment.

Economic activity has many adverse effects on the environment and, when that activity has done sufficient damage to the environment, the environment has adverse feedback effects on the economy.

That's the point we've reached with climate change.

The potential damage to the economy from climate change and a rising sea level is well known. The cost of this damage is likely to far exceed the cost of reorienting the global economy to largely eliminate the emission of greenhouse gases.

The broader point, however, is that if humankind is to survive and prosper, we'll have to pay a lot more attention to ensuring our economic activity stays within the physical constraints imposed by the natural environment.

The threat to the environment from economic activity is something humans have begun realising only relatively recently, say in the past 30 or 40 years.

In the case of greenhouse gas emissions, that's because we can't see them. Likewise, it takes a long time to realise that the extinction of species upsets the balance of the ecosystem.

But the main reason damage to the environment went unnoticed for so long is that it largely affects aspects of our surroundings that aren't privately owned — rivers, the sea, native forests, the air and the atmosphere.

And because environmental assets aren't privately owned, there isn't an owner objecting to the damage being done and demanding protection or compensation.

The trouble is that market exchange is built on private ownership, so it's only private interests that are reflected in the prices produced by the interaction of supply and demand. So, the market system can't cope with the wider damage to the environment such as from pollution or emissions done by private transactions.

Such "social costs" are simply outside the market system, which is why economists refer to them as "externalities". But here's the trick: just because something's outside the market system doesn't mean it's unimportant.

This is why economists acknowledge that environmental externalities are an instance of "market failure" problems we can't rely on the market to fix. So governments have to intervene in markets to fix those problems.

They could do this just by passing laws prohibiting people and businesses from doing certain things or forcing them to do other things, or they could do it by "internalising the externality". That is, by taking steps to ensure social costs (the costs of damage done to people who aren't parties to the relevant economic transactions) are incorporated into private costs (the costs faced by buyers and sellers).

And this, of course, is exactly what the carbon pollution reduction scheme seeks to do.

It seeks to incorporate the social cost of the emission of carbon dioxide and other gases into the private costs (prices) of the goods and services whose production or consumption has involved such emissions.

How will we know the social cost of those emissions? We're setting up a market for buying and selling permits to emit, say, one tonne of carbon dioxide. The social cost of emissions will be the price the market sets.

But in this newly created, artificial market, the Government will, on the one hand, require relevant businesses to hold permits to cover all their emissions while, on the other, control the supply of permits.

It will gradually reduce the supply of permits available as it reduces the "cap" (limit) on permitted emissions, in line with emissions targets. As it does so, the social cost will rise.

So that's another reason fighting climate change is just a new dimension of micro-economic reform: the device we'll use to reduce emissions is an "economic instrument", one aimed at harnessing market forces to reduce environmental damage and doing so at minimum cost in terms of lost growth in the economy.

I have a feeling that tackling climate change will just be the first of many reforms we will need to make to reduce the destructive conflict between the global economy and the natural environment that sustains it. So get used to it.

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