Economic responses

The use of fossil fuels—coal, oil, and natural gas—is the main contributor to carbon dioxide emissions. Economic responses to climate change will need to occur on both a demand and supply level to curb these emissions. Reducing dependence on fossil fuels and increasing the supply of alternative forms of energy will restrain the growth in greenhouse gas emissions and lessen the damaging effects of climate change.

Demand

On the demand side, there are three broad approaches to reducing greenhouse gas emissions at a global level. They are a global emissions trading and emission taxes and the regulatory approach. The two major options are emissions trading or emissions taxes. Both operate by increasing the relative prices of carbon-intensive goods and services. Global emissions trading would be a system of  national caps, or limits, on the amount of emissions produced in a country or region. Each country would have a national cap on the quantity of its emissions, allocate permits to its emitters, and establish a market to allow the trading of permits. Over time, each country would lower the quantity of emissions permitted until the national cap is reached. This would push up the price of permits and encourage measures to reduce emissions. Under an emissions trading scheme, the market would establish the prices of goods and services, and the level and composition of output would change until the target is reached. The European Union's Emission Trading Scheme is one operational example.

The emission tax approach—also called the carbon tax approach is a system of taxes on greenhouse gas emissions, particularly carbon dioxide. Emission taxes affect the prices of goods and services directly, and the quantity of emissions would fall as consumers and business respond to the tax.

Various hybrid schemes have also been proposed. A key issue in such proposals is the cost of adjusting to a lower emission economy. McKibbin, for example, is critical of what he sees as the approach of the Kyoto Protocol of aiming for fixed emission-reduction targets in specified timetables no matter what the adjustment costs. Rather, McKibbin advocates a policy of:

Source: Warwick J. McKibbin, 'The Prime Ministerial Task Group on Emissions Trading—an assessment', Agenda, vol. 14, no. 3, 2007, p. 14.

Other responses (on a national, state and corporate level) include a Renewable Energy Target (MRET), feed-in tariffs, and promoting energy efficiency.

The third approach is that of regulation. Under this approach each country would specify an emissions outcome and regulate emitters to achieve this outcome. This is often known as the ‘command and control’ approach.

No one approach is effective in all circumstances. Rather it is likely that a combination of approaches will be the most effective in dealing with greenhouse gas emissions.

To be most effective, measures to reduce greenhouse gas emissions would have to be global. As the Productivity Commission observed in its March 2007 submission to the Prime Ministerial Task Group on Emissions Trading:

Source: Productivity Commission, 'Productivity Commission submission to the Prime Ministerial Task Group on Emissions Trading', Productivity Commission Submission, March 2007, p. viii.

A system that involves as many countries as possible would minimise scope for 'free riding' whereby countries that are not members would place the burden of adjustment on participating members. But there are many—perhaps insuperable—barriers to a global emissions trading system, especially one with fixed targets and timetables. First, developing countries understandably do not wish to forgo growth to placate rich country concerns over global warming and so are reluctant to join an emissions trading system that might curb their growth. Second, some countries have reservations about the rigidity of a system with fixed targets and timetables given the uncertainty over the economic consequences of global warming. In particular, governments are concerned that strict adherence to targets could damage their economies.

As noted, in addition to reducing demand for fossil fuels, it will be necessary to increase the supply of alternative forms of energy. While there are alternatives to fossil fuels—nuclear, geothermal, wind power, solar, biofuels, hydrogen fuel cells etc.—they currently provide only a portion of present energy needs. Although there are advocates for each of these different forms of energy, we do not know what the precise combination of alternatives that eventuates will be.

Markets will play an important role in determining this. That's because markets create incentives to change behaviour on the demand and supply side. On the demand side, as the relative prices of energy-intensive goods rise, users will reduce demand for goods that are energy-intensive and increase demand for goods that are less energy-intensive. This process will also create incentives for suppliers of goods to produce less energy-intensive goods and to find the least-cost way of doing so.

It is tempting for governments to get involved in this process by favouring particular technologies or 'picking winners'. The risk is that governments may end up supporting industries which will not be viable over the long-term. Rather, the best strategy for government may be to resist making premature choices and instead focus on eliminating barriers to the development of new technologies—for example, by addressing market failures—and providing incentives for the development of the most cost-effective ways of reducing emissions.

Further reading:

L. Nielson, Emissions Control: your policy choices, Background note, Parliamentary Library, 10 May 2010.