A zero-sum carbon game

Published in Business Spectator (Melbourne), 1 March 2012

As Groucho Marx once put it, you have to learn from the mistakes of others because you can never live long enough to make them all yourself. If Australian policymakers heeded his warning they could save the $10 billion they are prepared to commit to the Clean Energy Finance Corporation.

In this case the mistakes of others were previously made by the Germans. For more than a decade, dating back to the election of the Social Democrat-Green coalition government under Chancellor Schröder in 1998, the Germans have pioneered the introduction of renewable energies. However, in designing policies to move closer to a clean energy future they made some basic mistakes of economic logic – mistakes that Australia is just about to repeat.

The Schröder government was keen to promote renewable energies like solar and wind power and passed the Renewable Energies Act (Erneuerbare-Energien-Gesetz, or EEG). The law, which came into force in 2000, guaranteed high feed-in tariffs for renewables. Without these guarantees, clean energies could have never competed with traditional energy sources such as coal, gas, oil and nuclear.

So far so good, if you support reducing carbon dioxide emissions and are not particularly worried by either granting subsidies or the resulting higher energy prices. Unfortunately, it soon turned out in Germany’s case that the interaction of the EEG with another climate change policy rendered it completely useless.

While Germany was trying to drive down greenhouse gas emissions by promoting alternative energies, the European Union started a different climate change policy by installing an emissions trading scheme. This scheme was based on the ‘cap-and-trade’ principle: Total emissions were capped, and carbon prices resulted from trading rights to pollute.

Two wrongs don’t make a right but in this case it was rather two rights that made one wrong: There is no point trying to subsidise reductions in carbon emissions if the total amount of emissions is capped anyway.

Economist Kristian Niemietz at London’s Institute of Economic Affairs recently offered an apt analogy to what is happening in German energy policy. “It is like imposing an overall annual cap on the amount of alcohol that can be consumed, and then subsidising the production of low-alcohol beers and wines: these subsidies would not reduce total consumption below the overall cap, but taxpayers’ money would be squandered, and consumers would end up with flabby drinks they would never have bought at market prices.” Precisely.

Replace ‘amount of alcohol’ with ‘carbon emissions’ and ‘low-alcohol beers’ with ‘renewable energies’ and you see why subsidising renewables and emissions trading do not work together. The physical effect of energy subsidies is precisely zero in an environment where the total emissions are predetermined by a trading system. Not a single gram of carbon dioxide is saved by pumping money into renewables. That is not due to any mismanagement within the system but simply follows the inherent logic of two incompatible environmental policies.

It’s not as if economists had not spotted this problem. As early as 2004, the academic advisory council to the German economics ministry issued a unanimous call for the abolition of the EEG. The German government’s experts concluded that this law, despite imposing enormous costs on businesses and consumers, would yield a zero effect on emissions because of the simultaneous presence of the European emissions trading scheme. Last year, the Monopoly Commission, the German equivalent of the Australian Productivity Commission, came to the same conclusion in a special inquiry on energy policy.

Despite such fierce criticism from two official and well-respected bodies, the subsidies provided under the EEG continue. Though the German government has now indicated that it wishes to reduce the feed-in tariffs by up to 30 per cent, particularly for solar power, this does not solve the fundamental dilemma. You can sponsor alternative energies, or you can have an emissions trading scheme. But you cannot sensibly have both.

If the Germans are silly enough to waste their economic resources on a policy that yields no gains, that would be bad enough. But it is even sillier that despite the German experience the Australian government is now bound to repeat their mistakes.

To be sure, the precise modus operandi of the planned Clean Energy Finance Corporation is different from the German EEG. The subsidies towards renewable energies are channelled in another way, namely by providing capital for investment rather than guaranteeing feed-in tariffs. However, the main problem remains.

As the Gillard government intends to move Australia towards an emissions trading scheme, scheduled to commence in 2015, we will end up in an environment where the total emissions for the economy will be capped once the ETS is fully implemented. As the German example makes clear, under such circumstances further support for renewable energies can only result in lower prices for the rights to pollute, not in a further emissions reduction.

If a policy does not make any sense from an economic perspective, why are politicians implementing it nevertheless? The answer is quite cynical: The emissions reductions resulting from a cap-and-trade scheme are not visible enough. They happen automatically without any direct involvement of politicians.

Politicians keen on photo opportunities would therefore rather funnel finance to concrete projects as that offers ample opportunities to appear at construction sites wearing hard hats and safety vests. Lobbying from the renewable energies sector aside, there is no better explanation for this waste of taxpayers’ money. From a rational, disinterested perspective, there are no justifications to pursue policies that have no benefits but only costs.

This is not an argument against alternative energies per se. But governments keen to promote them should at least have a policy that is inherently consistent. As it stands now it is only inherently wasteful.