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15 July 2024 ⏲ 13 Minutes Policy
Australia’s Safeguard Mechanism was implemented to correct climate change externality, by targeting the top 215 carbon emission facilities (facilities producing more than 100,000 tonnes of CO2 equivalent) and curbing emissions to 43% emission reduction targets by 2030 and 2050 net zero emissions (DCCEEW, 2023). However, from an economic lens, the Safeguard Mechanism (SGM) presents multiple inefficiencies in its mechanisms. This article explores why this may be the case and analyses the merit of an alternative Cap-and-trade policy.
What is the Safeguard Mechanism?
SGM sets a capped emissions baseline – the point at which firms can legally emit emissions. This baseline decreases annually by 4.9% onwards to the 2030 and 2050 targets. Australian Carbon Credit Units (ACCUs) are issued and can be traded by firms below their cap to offset excessive emissions of other firms. The supply of tradeable ACCUs is unrestricted in the market, and thus its quantity is uncertain. In figure 1, firms will employ emission abatement strategies until the point Qf, where the cost of ACCUs is less the than marginal cost of abating. All safeguard facilities will continue purchasing credits along the $75 ceiling beyond Qf, increasing quantity until equal to their total emissions. The marginal abatement cost (MAC) for all entities is equal, establishing cost-effectiveness (under the equimarginal principle).
Figure 1: Firms Purchase ACCUs where MAC = $75 price ceiling until equal to their Actual Emissions
Figure 2: Emissions abated is not at Efficient Point (set at Q* not Qe)
Efficiency is established where the aggregate marginal cost of abatement is equal to the marginal benefit of polluting. In figure 2, if this $75 price ceiling is introduced above this equilibrium, inefficiency (in the form of Dead Weight Loss) is established.
Does the Safeguard Mechanism Economically Work?
For each firm, annual 4.9% baseline reductions are administered to meet 2030 emission targets. In the long-run, a higher MAC and stringent target trajectories drive demand for ACCUs towards the $75 price ceiling. Consequently, the equilibrium in figure 2 will shift from E1 (where the marginal social benefit (MSB) equals the MAC) to E2, where MSB equals $75. Total emissions abated will decrease from Qe to Q* and a deadweight social welfare loss is produced, rendering the policy inefficient.
Firms continue stockpiling ACCUs that exceed MAC until equal to their total emissions. Actual emissions are not falling and would require readjustments of 8.9% annual reductions to meet 2030 climate targets (Climate Council, 2023). Firms can also continue to commission new projects and offset them with credits. Despite targets, 116 new fossil fuels projects are currently in development and estimated to contribute 4.8 billion tonnes of pollution before 2030 (Campbell et al., 2023).
Baselines are output intensive; as firm output increases, scalability of emissions is accounted for (Syme et al. 2023). The listed flexible conditions are stressing 2030 targets as there is no hard cap on emissions. The pace of Australia’s reductions require “40% increases to meet 2030 targets” (energy minister Chris Bowen) (Vorrath, 2022).
What is the Cap-and-Trade Policy?
The Cap-and-trade mechanism, as the name suggests, sets an enforced emissions quantity, representing the perfectly-inelastic supply curve (SE) in figure 3 below. A set number of permits are issued matching the emissions target. As the market trades permits amongst themselves, demand and supply conventions enforce price. The ‘free market’ policy is efficient as firms only purchase permits until the market price exceeds their marginal cost of abatement. Furthermore, sellers, under a profit-incentive, trade excess permits until the marginal benefit of each additional permit exceeds the marginal cost of abating. Thus, all entities trade until the efficient equimarginal principle holds, where all firms’ Marginal Cost of abatement is equal (MACa = MACb) (figure 3).
Figure 3: Market Graph where emissions abated is not at Efficient Point (set at Q* not Qe)
The emissions cap is not set at the efficient quantity (MSB=MAC) hence DWL is created when firms produce where MAC is equal to the price. Both Safeguard and Cap-and-Trade are cost-effective. However, within Cap-and-Trade, the issuance of permits is equal and not equitable– the cap is not dependant on output intensity. Companies must either trade for permits or are incentivised to invest into long-run abatement strategies if price of permits peaks. For example, the EU’s implementation of cap-and-trade Emissions Trading System is driving innovation into renewable power sources, establishing long-term efficiency that secures future emission reductions (LSE, 2018).
The Difference between Price and Quantity Based Mechanisms
In practice, MAC of firms cannot be accurately predicted. Regarding climate change, the MSB of abating one additional unit of pollution is expensive: MSB is generally flat. As seem in figure 4, an inaccurately estimated MAC, seen as a shift from MACa to MACr, will cause higher DWL within a Cap-and-Trade mechanism over a carbon tax price mechanism.
Figure 4: DWL captured by Quantity vs Price Based Mechanim Models
Despite inefficiency limiting the model, Cap-and-Trade is still implemented by more countries as their primary reduction method, since supply-caps promote certainty of emission reduction over price-mechanisms (Ritchie & Rosado, 2022). As supply of permits is fixed, there is less flexibility for firms to avoid abating. Implementation is government-regulated, with significant fines for violations. From implementation to 2021, EU’s ETS has recorded 35% emission cuts, representing their largest historical decrease (European Commission, N.A.). This suggests potential effectiveness in meeting Australia’s 2050 targets.
Close
The current trajectory of the Safeguard Mechanism will not meet 2030 and 2050 emission targets. The inefficiency of the model suggests that a Cap-and-Trade mechanism, which permits less flexibility, is sustained to enforce corrective goals. However, Cap-and-Trade still presents its own risks, particularly if the marginal abatement cost of firms is not accurately estimated, or if external forces drive a sudden increase. Hence, more discussion and research is required to understand what is the best way to meet Australia’s emission goals, and maximise efficiency in the process.
Thank you for reading this article. I am always open to feedback on articles to improve. Please feel free to connect with me on LinkedIn or reach out directly via: shashikubsad48@gmail.com.
References
Campbell, R., Ogge, M., & Verstegan, P. (2023, March). New fossil fuel projects in Australia 2023. Retrieved from The Australia Institute: https://australiainstitute.org.au/wp-content/uploads/2023/03/P1359-New-fossil-fuel-projects-on-major-projects-list-and-emissions-WEB.pdf
Climate Council. (2023). Success of Failure: New Safeguard Mechanism Modelling Reveals Risk of Emissions Blowout. Retrieved from Climate Council: https://www.climatecouncil.org.au/resources/new-safeguard-mechanism-modelling-reveals-risk-emissions-blowout/#:~:text=The%20modelling%20shows%20baseline%20decline,if%20fossil%20fuel%20production%20increases
DCCEEW. (2023). Safeguard Mechanism Reforms. Retrieved from Australian Government Department of Climate Change, Energy, the Environment and Water: https://www.dcceew.gov.au/sites/default/files/documents/safeguard-mechanism-reforms-factsheet-2023.pdf
European Commission. (N.A.). EU Emissions Trading System (EU ETS) . Retrieved from European Commission Climate Action: https://climate.ec.europa.eu/eu-action/eu-emissions-trading-system-eu-ets_en
Kehoe, J. (2023). Chubb report clears the way for a carbon price . Retrieved from Australian Financial Review: https://www.afr.com/policy/energy-and-climate/carbon-credit-scheme-fraud-claims-overstated-chubb-review-20230109-p5cb7c#:~:text=The%20Chubb%20review%20followed%20claims,that%20would%20never%20have%20happened.
LSE. (2018). How do emissions trading systems work? . Retrieved from London School of Economics: https://www.lse.ac.uk/granthaminstitute/explainers/how-do-emissions-trading-systems-work/
Ritchie, H., & Rosado, P. (2022). Which countries have put a price on carbon? . Retrieved from Our World in Data: https://ourworldindata.org/carbon-pricing
Syme, R., White, A., Blackburn, M., & Page, L. (2023). Explainer: recently announced reforms to the Safeguard Mechanism and implications for industry. Retrieved from Corrs Chambers Westgarth: https://www.corrs.com.au/insights/explainer-recently-announced-reforms-to-the-safeguard-mechanism-and-implications-for-industry
Vorrath, S. (2022). Bowen says Australia poised to beat 2030 climate target, as emissions plateau. Retrieved from Renew Economy: https://reneweconomy.com.au/bowen-says-australia-poised-to-beat-2030-climate-target-despite-rise-in-emissions/
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