Human induced climate change is a global problem and an effective solution requires large mitigation contributions from all major developed and developing countries, and from the rest of the world too.

The search for effective climate change policy is partly a search for effective cooperation amongst countries of a kind and dimension that has never previously been known on a global scale.

To be truly effective, global agreement on mitigation needs to:

• Define the total amount of carbon dioxide equivalent that can be emitted into the atmosphere over time.  In effect this establishes an emissions budget and provides a foundation for each country’s emissions entitlement from within the overall carbon budget. It also provides a firm basis for international trade in entitlements, which would substantially reduce the costs of global mitigation and improve prospects for strong mitigation.
• Recognise it will be impossible to achieve strong mitigation objectives whatever developed countries might do, unless there is an almost immediate slowing of emissions growth in China, followed before too long by slowing in other large developing countries. However, it will be necessary to provide a differentiated set of incentives to encourage widespread participation by developing countries. Otherwise developing countries may weigh the present cost of mitigation more highly than the future gains of avoiding dangerous climate change.  These incentives would need to include funding from developed countries to assist the technological transition and increased minimum levels of expenditure on research, development and commercialisation of low-emissions technologies.

The foundations upon which the United Nations Framework Convention began building an international agreement after Kyoto in 1997 were made all the more complex by the deep flaws that became embedded over time.

First, the artificial segregation of countries into two groups based arbitrarily on levels of economic development in 1992 led to the anomaly that only a small group of ‘developed countries’ were obliged to specify emissions reductions.

Second, these arbitrary classifications became increasingly irrelevant, as rapid industrialisation in major developing countries shifted emissions trends toward the developing world. The shift in emissions was accelerated by the Great Crash of 2008 which pushed geopolitical and economic weight away from the established industrialised economies of the ‘West’ toward China and the large developing countries.

With the long-term consequences of the Great Crash not yet understood and with the formalities of international relations still defined by a long-gone past, the Copenhagen climate change meeting in December 2009 was a critical test of multilateral cooperation within the new global power structure.

With the benefit of hindsight it is clear the much maligned Copenhagen meeting delivered a new framework for international cooperation on mitigation that took account of the new global power realities and strengthened constraints on global emissions. It has also kept alive the possibility of effective mitigation to achieve strong emissions reduction objectives.  This is a much under-rated achievement of Copenhagen to which Australia contributed significantly—particularly through its proposal for a transparent mechanism to capture voluntary contributions by all participating countries.

The Cancun Agreements reinforced the achievements of Copenhagen and marked a new beginning for international climate change efforts and provided building blocks toward comprehensive international agreement that brought together mitigation commitments and actions by developed and developing countries alike. Success at Cancun owed much to deft Mexican diplomacy as well as the hard-won gains struck in Copenhagen.

The main outcomes from Cancun are:

• To anchor under the United Nations Framework Convention the pledges made by developed and developing countries to the Copenhagen Accord, providing an agreed pathway to achieve major emissions cuts;
• The establishment of the new Green Climate Fund to support developing countries’ climate change responses, adaptation and technology needs;
• A REDD+ mechanism to deliver economic opportunities for developing countries to reduce emissions that result from deforestation;
• New measurement, verification and reporting and international consultation and analysis rules to ensure all countries can see what others are doing to tackle climate change;
• Agreement to provide strong and practical support for vulnerable developing countries to manage unavoidable climate impacts; and
• The establishment of a technology mechanism to help diffuse clean energy technologies around the world.

It will take some time for the full implications of the change in the international regime to emerge, but the shift to a bottom-up approach to mitigation has been decisive.

To date, 85 developed and developing countries representing over 80 per cent of global emissions and about 90 per cent of the global economy have pledged targets and actions under the now-anchored Copenhagen Accord.

With strong commitments from China and other large developing countries, the sum of commitments by developing countries to the end of 2012 is more satisfactory than those of developed countries alone.  But overall these commitments continue to fall short of what is required to meet an objective of holding temperature increases to around 2°C.

Another important factor is that both China and the United States accepted commitments under the new arrangements that would have been impossible under a binding regime, such as the Kyoto Protocol.  In both cases, higher ambition was achieved where binding commitments may have led to greater caution.

Perhaps most importantly, new arrangements for measuring, reporting and verifying emissions are a major step forward and, in the absence of treaty-like obligations, will provide improved certainty and over time, a foundation to better understand the comparability of different countries’ actions.

The current framework does contain gaps.  It is not clear how the shift toward the kinds of binding commitments that provide the basis for deep international trade in emissions entitlements will emerge.  However, groups of states, most likely neighbours in a region, could replicate many of the advantages of deep multilateral trade within regional trading systems.  This would reduce costs of mitigation and encourage greater ambition in participating countries.

The international agreement on climate change achieved at Cancun and Copenhagen is capable of supporting an historic change in trends on global emissions over the next few years.  There is a possibility that under the new measurement, verification and review framework, and as confidence builds, mitigation consistent with continued prosperity and strong economic growth will be offered by many more countries.

Nevertheless, it is unlikely that the world will achieve 2°C unless there is comprehensive and binding agreement on entitlements to emissions that adds up to the emissions constraints implied by that objective.  Many developing countries continue to value the Kyoto structure with its clear demarcation of binding commitments.  There will need to be deft diplomatic footwork around the next United Nations Framework Convention meeting in Durban in December 2011, to allow some formal retention of Kyoto language alongside substantive departure from its binary content.  And this in large part will depend upon the behaviour of many countries over the coming months.

Ross Garnaut is a Distinguished Professor at the ANU, a Vice Chancellor’s Fellow at the University of Melbourne and Adviser on climate change to the Australian Government. In November 2010 the Australian Minister for Climate Change and Energy Efficiency, Greg Combet, commissioned Professor Garnaut to update his 2008 Garnaut Climate Change Review. The Garnaut Climate Change Review – Update 2011 will be presented to the Australian Government by 31 May 2011.

1. Regional movement on the global problem of climate change
2. Finding a way forward to a post-Kyoto global agreement on climate change
3. Comparing key proposals for climate change mitigation

What are the implications of the turning period for China’s continuing economic development, for China’s interaction with the global economy and for economic policy? Here I focus on four of the most important consequences, mention a consequence that is widely anticipated and feared, but which need not eventuate, and briefly discuss one way in which perceptions of China’s growth will be affected by its having entered the turning period.

As China enters deeply into the turning period (when unlimited supplies of labour become more difficult to mobilise for industrial development), there will be large and continuing increases in real wages and in the wage share of income. The powerful tendency since the 1980s towards increased inequality in income distribution is likely to be reversed. The rise in the wage share of income is likely to be reflected in an increase in the consumption share of expenditure. There will be a reduction in the national savings rate.

It is possible that the investment rate will in fact rise. Whether or not this is the case, it is likely that China’s savings rate will fall more than its investment rate. This will reduce the external surplus in trade and current payments. It will therefore ease current international pressures over payments imbalances and exchange rates. It would be wise for China to ensure that total domestic demand expands enough to ensure that this is the case.

The reduction in Chinese current external payments surpluses is therefore a second important consequence of moving through the turning period. This could ease tensions with other countries — especially the United States — which have identified Chinese surpluses as a principal cause of their own economic problems. Regrettably, a large fall in Chinese savings relative to investment would put upward pressure on global long-term interest rates and increase the requirement to reduce domestic expenditure on goods and services in the countries facing large challenges in the management of external and public debt, including the United States.

The third important consequence of China moving through and beyond the turning period is that the centre of China’s comparative advantage in international trade will shift rapidly from a fairly narrow range of labour-intensive products to a wider range of more capital-intensive and technologically sophisticated products. This will ease some dimensions of China’s trade problems with the rest of the world (perceptions of competitive pressure on other developing countries and heavily concentrated pressures for adjustment on particular sectors in industrialised countries) and complicate others (competitive pressures will be felt across a much wider range of industries in industrialised countries). The diversification of China’s comparative advantage will probably halt the decline in Chinese export prices that was associated with the heavy concentration of export expansion in a small number of products.

The fourth important consequence of entering the turning period involves a policy risk to economic stability and growth in the period ahead. Rising real wages and the pressure of strong increases in demand for non-traded goods and services will be inflationary unless accompanied by a combination of firm monetary policy and an appreciating renminbi. Nevertheless, the Chinese authorities might be tempted to maintain the fixed exchange rate against the US dollar to avoid adjustment pressures on export-oriented labour-intensive industries, which have played such an important part in Chinese economic growth since the mid 1980s.

To seek to maintain a fixed exchange rate against the US dollar through and beyond the turning period would only postpone and not avoid the structural adjustments that are a necessary accompaniment of the current stage of Chinese economic growth. Payments surpluses would eventually overwhelm the efforts to sterilise their monetary effects. The adjustments would occur through inflation.

It is likely that the authorities would respond to higher inflation by tightening fiscal and monetary policies. This would unnecessarily reduce the rate of economic growth below sustainable levels and postpone the increase in Chinese living standards that can come through and beyond the turning period. The inflation and the delays in inequality reductions could be destabilising to domestic political stability. The delays in reduction in the external payments surplus would certainly be destabilising for China’s productive interaction with the international economy and society.

There is one consequence of moving through and beyond the turning period that is often feared but which is unlikely to be important unless there are mistakes in economic policy, and one important implication for perceptions of the growth of the Chinese economy. There is no basis for the expectation that China’s rate of growth in output per worker must necessarily fall as it moves through and beyond the turning period. The rise in real wages as China moves through the turning period is likely to lead to an increase in the rate of total factor productivity growth. In the nature of things, this will be concentrated in industries producing relatively sophisticated and capital-intensive products, the competitiveness of which is less sensitive to increases in real wages. It is possible that the increase in Chinese domestic demand that is necessary to reduce external current payments surpluses will require an increase in the investment rate for a while. Together with the expected acceleration of productivity growth, this would support an increase in the growth rate in total output per worker, above the high rates of the early twenty-first century. That could surprise the world and also the Chinese authorities, but it may well be necessary to maintain internal and external balance in the period ahead.

How successful China is economically in this period of rapidly rising real wages will depend on the flexibility of the economy, its openness to foreign trade and investment and the world’s most productive ideas about managing enterprises, the quality of the human resources created by the rapid expansion of the education system in the past couple of decades and the quality of the regulatory systems applied to the more complex economy that is emerging. It is possible that the rate of growth in total output can be maintained at something like the average rates of the decades of reform, until the approach of the industrialised countries’ frontiers of productivity and living standards reduces the scope of rapid productivity growth through ‘catching up’ with the industrialised countries.

Whether or not China succeeds in maintaining such high aggregate rates of growth until it reaches the frontiers of the world economy, most observers will be surprised by how quickly China catches up now that it has entered the turning period. China’s real exchange rate will rise rapidly — whether that occurs through inflation, nominal exchange rate appreciation or a combination of the two. The value of China’s output when measured in the national accounts and converted into international currency at current exchange rates will converge towards the much higher ‘purchasing power’ estimates of GDP. People in China and abroad who focus on conventional measures of national output will find that China catches up with the world’s most productive economies in output per person — and with the United States in total output — much more quickly than they had been expecting from extrapolation of differentials in national growth rates.

Ross Garnaut  is Vice-Chancellor’s Fellow and Professorial Fellow in Economics at the University of Melbourne. He is also Distinguished Professor of Economics at the Australian National University. This essay is an excerpt from Chapter 2 in ‘China: The Next 20 Years of Reform and Development,’ Ross Garnaut, Jane Golley and Ligang Song (eds). For Professor Garnaut’s background notes and recent papers see www.rossgarnaut.com.au.

Ross Garnaut’s full chapter from this year’s China Update, China: The Next Twenty Years of Reform and Development, can be downloaded from here.

1. Chinese wages and the turning point in the Chinese economy
2. Is China entering a period of ‘marginal stagflation’?
3. A new paradigm for thinking about China’s economy – Weekly editorial

One year has passed since I released the final draft of the Climate Change Review. In the lead-up to Copenhagen, this is a timely opportunity to reflect on developments in the consideration of this diabolical policy problem and where it is all going now.

It’s relevant that my final report was presented to the Australian Prime Minister on the morning of the biggest ever points fall on the New York Stock Exchange. The discussion of the review has been against the back drop of the Great Crash of 2008 and the recession which followed.

The Great Crash had three sorts of effects on the climate change challenge.

Firstly, it temporarily and briefly stopped the growth in global emissions, but by an amount that is not material in the sweep of history.

Secondly, the unemployed resources, the unemployed capital and labour which were a consequence of the great recession, lowered the cost of investment in structural change. It made this a relatively cheap time to invest in the new technologies. Many countries including the United States and China made a major place for investment in emissions reducing structural change in their stimulus packages and the total effect of this on the world scale was considerable.

Thirdly, the political economy of mitigation became more difficult. Because it is a time of rising unemployment globally, demands by established industries for support for resistance to structural change are on the rise.

Overall, the elections of new governments committed to stronger mitigation in the USA and Japan, the strengthening of old governments in India and Indonesia, and strong community support for action has prevented a general international retreat on mitigation in the year since the Great Crash.

The approaches of the Review to the science, and the uncertainty surrounding it, have been influential. The Review accepted the views of mainstream science ‘on a balance of probabilities’. There is a chance that it is wrong. But it is just a chance. To heed instead the views of the small minority of genuine sceptics in the relevant scientific communities would be to hide from reality. It would be imprudent beyond the normal limits of human irrationality.

Substantial support has been generated for the idea put forward in the Review, that Australia’s national interest is in a strong global agreement, with Australia’s part being to reduce emissions entitlements by 25 per cent from 2000 levels by 2020 and 90 per cent by 2050. The Government and Opposition have accepted the Review’s approach to conditional and unconditional targets for 2020. A year ago the 60 per cent reduction target from 2000 levels by 2050 was seen as a stretch target, but now mainstream discussion is about how far beyond that we have to go. The Prime Minister has indicated willingness to seek a mandate at the next election to tighten old 2050 targets from 60 per cent to larger reduction.

Some environmental groups have wanted stronger mitigation with more ambitious goals than 450 parts per million, but I’m not sure those views come to grips with the awful reality that any path to anything more ambitious than 450 must first secure 450 parts per million with some overshooting and then go lower. There is a danger that the best has become the enemy of the good, and the friend of the bad.

The Review’s approach to compensation for low-income households has been widely accepted by the government and has not been controversial, but compensation to businesses has followed different lines.

The absence of principle in payments to trade-exposed industries for the temporary period in transition to effective global mitigation has led to arbitrary distribution, probably to over-allocation on average, to the absence of an expectation of, or process for, early phasing out as others move to stronger mitigation and to the ugliest ‘money politics’ we have seen for a generation.

It’s a pity that there’s been so much focus on what are essentially transitional arrangements. We would have a more fruitful discussion if we focused on how the mitigation system would work once an effective global agreement was in place with all major economies taking part.

There has been relatively little fiscal allocation for innovation in low-emissions technologies; the pre-emption of permit revenue for other uses is one of the reasons why.

The ambits of the government’s response have focused on carbon capture and storage technologies.

The initiative that the Australian government took in global leadership on carbon capture and storage (CCS) is a valuable one. There’s been criticism of the support for CCS technologies, mainly from green groups because it’s seen as supporting an old industry, the coal industry. CCS research investments are thoroughly justified. The problem is not the support for CCS, but the absence of support for innovation in other technologies in which Australia has comparative advantage in research, a large economic interest, and which are potentially transformative for the global mitigation effort. Bio-sequestration is the most obvious of these.

Much of the debate has not been about the targets, the objectives or the need for mitigation, but has been about the instrument that Australia should use in reducing greenhouse gas emissions. There’s been a tendency to compare an ideal carbon tax with a flawed emissions trading scheme (ETS). In truth, the political economy of implementing a clean carbon tax would be as difficult as a clean ETS. One senior business figure who favours a carbon tax has said to me that there is much controversy about giving free permits to favoured businesses, and it would be much more straightforward to give special support for a favoured industry under a carbon tax: under the traditions of the Australian tax system, he said, if you want to favour some industry you just exempt it from the tax and people don’t notice it very much.

The international regime proposed by the Review has held up well to the international discussion. There’s been a fair bit of discussion of it in India, China and Indonesia, and this is to a considerable extent focused on the date at which convergence to equal per capita entitlements should occur. It’s also focused on the parameters of support of developed countries support for new technologies and adaptation.

Further, there’s growing acceptance in China that the Review’s formula for Chinese participation in a global regime is consistent with attainable Chinese policy objectives.

While the ETS as proposed by the government has many weaknesses, it’s likely that changes to facilitate support in the Australian Senate would exacerbate rather than ameliorate weaknesses. One main exception to what I’ve just said would be if stronger measures were introduced to support innovation related to bio-sequestration. Another would be if it were possible to introduce explicit arrangements to phase out assistance to trade exposed industries as other countries strengthen their mitigation efforts.

But such good changes are much less likely than exacerbation of distortions in response from business interests. From that perspective I hope that the ETS can be passed into law quickly and with no further distortion, if necessary through a Joint Sitting of the House of Representatives and the Senate.

This essay is adapted from a Public Lecture given at the ANU on 14 September. Listen to the full speech podcast here. For Professor Garnaut’s background notes and recent papers see www.rossgarnaut.com.au, Climate Change.

1. Garnaut on climate change; Japanese agriculture – Weekly editorial
2. Garnaut and keeping up with the science of climate change
3. Tiddlywinks on climate change

Australia and China share a great vulnerability to climate change. Australia is already hot and dry, and agriculture is conducted with precipitation levels.

With unmitigated climate change, Australia would dry and warm further, endangering agriculture and other human activity. China would likely see decreased flows in the Yangtze and Yellow Rivers. Rising sea levels associated with climate change would also place China’s vital coastal provinces at serious risk.

Yet against this backdrop, there is considerable room for strategic initiative to be taken. For the full address, please see the videos below.

Ross Garnaut, speaking to the Australia – China Climate Change Forum at the Australian National University:

Part 1

Part 2

1. Garnaut on climate change; Japanese agriculture – Weekly editorial
2. One year after the Garnaut Climate Change Review
3. Climate change policy resurrected in Australia

In the course of the work on climate change, members of the Garnaut climate change review team would sometimes ask how we would judge whether our efforts had been successful. Would the main indicator be the extent to which the Australian Government accepted the recommendations of our final report?

‘No,’ I would respond.

‘Policy decisions will reflect a range of pressures and constraints which we are not in a position now to assess and about which the Government is elected to form judgments. We will have done our job if the Australian community and Australian governments understand the implications of decisions that are taken.’

Whatever pressures and constraints shaped the Government’s white paper this week, it has implications for the environment and the economy. Should its policy proposals become law, they will be historic.

They would mark the beginning of comprehensive action in Australia to mitigate the growth in Australian greenhouse gas emissions. Australia would have taken a step where several countries have stumbled and in times that are difficult for the domestic and international economies. It would have taken this step in the context of the most pervasive vested-interest pressure on the policy process since the Scullin Government and of the most expensive, elaborate and sophisticated lobbying pressure on the policy process ever. It will have taken this step in the face of resistance from Her Majesty’s Opposition.

The white paper has been greatly criticised by environmental groups for its “soft targets”. The Garnaut Review recommended an unconditional commitment to reduce 2000 greenhouse gas emission levels by 5 per cent by 2020. I stand by my recommendation.

It costs much more to reduce emissions in isolation of global action and action in isolation does almost nothing in itself to solve the environmental problem. The purpose of acting at all in the absence of comprehensive global agreement is to keep alive the hopes of an eventual effective global agreement. Australian emissions are significantly above 1990 levels and 2020 is not far off. Our population grows strongly because, for good reasons, we choose to keep our doors open to people from many lands. Our new citizens need transport, a home with Australian accompaniments and access to employment income – all of which generate greenhouse gas emissions. The white paper’s 5 per cent unconditional target is challenging in the absence of an international agreement. To go further would risk a negative influence on others.

The white paper’s proposed conditional targets are more problematic.

The Garnaut Review proposes a formula for assessing comparability of effort of various countries towards effective global efforts embodying degrees of ambition. To hold concentrations at 450ppm, Australia’s proportionate share of a global effort would reduce emissions entitlements to 25 per cent of 2000 emissions by 2020 and 90 per cent by 2050. At 550 ppm, Australia’s proportionate share of a global effort would be to reduce entitlements for 2020 by 10 per cent from 2000 levels and entitlements for 2050 by 80 per cent.

The review analyses the economic and environmental costs of global action to mitigate climate change, with Australia playing its full, proportionate part. It concludes that it is in Australia’s interests to seek the strongest possible global mitigation outcome. Australia should indicate its willingness to play its part in a global agreement to bring greenhouse gas concentrations back to 450ppm or eventually to lower levels. Should this not be possible, Australia should play its proportionate part in the best possible outcome. The best possible outcome may turn out to be an effective agreement on 550ppm in the first instance. International success at this level of ambition would strengthen confidence in, and support for, stronger outcomes in subsequent negotiations.

The white paper proposes a variation on this theme. It suggests emissions reductions for Australia up to 15 per cent from 2000 levels, “in the context of global agreement under which all major economies commit to substantially restrain emissions and advanced economies take on reductions comparable to Australia”. It proposes that, “in the event that a comprehensive global agreement were to emerge over time, involving emissions commitments by both developed and developing countries that are consistent with long-term stabilisation of atmospheric concentrations of greenhouse gases at 450ppm or lower, Australia is prepared to establish its post-2020 targets so as to ensure it plays its full role in achieving the agreed goal”. The Prime Minister’s Monday speech to the National Press Club notes Australia would have to reduce its emissions by more than 60 per cent by 2050 within a 450ppm global agreement and that he would seek a mandate at a general election to amend current policy as required.

The white paper refers extensively to the Garnaut Review on these matters. Its Policy Position 1.1 says the “Government accepts the key findings of the Garnaut Climate Change Review”; that “effective global agreement delivering deep cuts in emissions consistent with stabilising concentrations of greenhouse gases at around 450 parts per million or lower would be in Australia’s interests”; that “achieving global commitment to emissions reductions of this order appears unlikely in the next commitment period”; and that “the most prospective pathway to this goal is to embark on global action” that “builds confidence”. These sentences are repeated elsewhere.

I did not actually use all of these words. However, pursuit of the approach proposed in the Garnaut Review may lead to the same end point as the white paper: Australia playing its full part in a global agreement to hold concentrations at 550ppm or, say, 520ppm, following Copenhagen and its full part in a more ambitious agreement as that becomes possible after 2020.

The white paper rules out Australia contributing to a global effort to achieve ambitious mitigation targets before 2020. That is a pity. There is a chance, just a chance, that with Barack Obama as American president, high ambition at Copenhagen will turn out to be feasible. Meanwhile, Australia cannot play a strongly positive role in encouraging the global community towards the best possible outcomes if it has ruled out in advance its own participation in strong outcomes. The Government should keep the 25 per cent option on the table.

This weakness of the white paper could be corrected without substantial unpicking of the policy package. The Garnaut Review argued that an effective global agreement including developing countries would need to allocate emissions entitlements on a per capita basis, converging to equal per capita entitlements at some time around the middle of next century. This in itself would be favourable to Australia in comparison with the developed and transitional countries with low immigration and slow or negative population growth.

But we cannot expect our advocacy of a new and superior approach to allocating emissions entitlements across countries to be internationally effective if we accept only implications that favour us (taking population growth into account), but not other implications (converging towards equal per capita entitlements).

Three elements of the white paper proposals lead towards large transfers from the general community to particular interests and to fiscal and environmental risks.

There is no public policy justification for $3.9 billion in unconditional payments to generators in relation to hypothetical future “loss of asset value”. Never in the history of Australian public finance has so much been given without public policy purpose, by so many, to so few. The best that can be said is that these are once-for-all payments – unless the spectacular success of investment in lobbying inspires repetition and emulation.

There is large risk to the public finances in the five-year price cap for emissions permits. The cap is to be set at an Australian-dollar price that is likely to be exceeded by international prices at some point in the first five years of the scheme. When that point is reached, the Australian taxpayer will have to fund the purchase permits from other countries at international prices and to underwrite the difference between the cap and international prices. At that point, there will be powerful commercial incentives for market participants to buy at capped prices and to hoard standard permits for future use or sale. This increases the risk to the national budget.

The proposed issue of free permits to trade-exposed, emissions-intensive industries raises different issues. Like free permits to generators and the price cap, it carries risks to the public finances. In this case, the risks are much bigger. Unlike the other instruments of transfer from the general community to particular interests, it is based on a sound public policy objective.

The problems arise from the fact that the white paper contains no sound conceptual basis for payments. Section 14.5 of the Garnaut Review’s Final Report sets out the principle upon which payments should be made to trade-exposed industries: compensating firms for the disadvantage they suffer from the absence of comparable carbon constraints in other countries. The Government’s white paper acknowledges that this is the correct principle but does not seek to apply it.

The consequences of not having a principled basis for the issue of payments are profound.

Wherever the partial application of a carbon constraint in other countries is having an effect on international prices, there can be over-compensation of Australian producers. Carbon constraints are being applied in many developed countries, including most states in America and in developing countries including South Africa and China. They will increase in importance.

Sound principles would lead to the automatic withdrawal of payments as carbon constraints emerge in other countries. With political bargaining determining payments, as in the white paper, there is no obvious point at which payments would be partially or completely withdrawn. Further, even if there were a comprehensive international agreement that completely removed the case for payments, five years’ notice would need to be given for withdrawal.

The July green paper proposed placing a cap of 20 per cent on value of permits issued to trade-exposed enterprises outside agriculture, or 30 per cent including agriculture. As indicated in the Final Report, these are reasonable upper limits to principled initial claims.

A principled approach to payments to trade-exposed industries would generate an early and continuing decline in the proportion of payments to trade-exposed industries as carbon constraints were extended elsewhere. In contrast, the white paper’s approach would see, on conservative assumptions, the proportion of permit value given free to trade-exposed industries rising to 45 per cent in 2020.

The ratio would rise well beyond 45 per cent if trade-exposed sectors grew more rapidly than the rest of the economy or if reductions in emissions were greater than 5 per cent.

The ratio could rise to 65 per cent with an emissions reduction target of 15 per cent and with trade-exposed industries growing twice as rapidly as the rest of the world. With similar relative growth rates and an emissions reductions target of 25 per cent, three-quarters of permit value would be transferred to trade-exposed industries.

And yet the revenue pool from sale of permits is exhausted at 45 per cent, by the household compensation arrangements proposed in the white paper. Already there is nothing left for increases in payments to households as the carbon price rises over time. Little is left for incentives to research, develop and commercialise low-emissions technologies, which are essential components of the domestic and international mitigation efforts.

Nothing is left for systematic support for overcoming information and contractual market failures inhibiting energy-saving in low-income households.

What happens as the claims of trade-exposed industries rise above 45 per cent? This is a big risk to future budgets. To the extent payments to trade-exposed industries exceed those necessary to compensate for the absence of carbon constraints in other countries, they introduce distortions in international trade.

One justification for unexpectedly high payments to trade-exposed industries in both Europe and Australia – and presumably other countries – is the global recession.

The Smoot-Hawley tariff in the United States in the 1930s, and the competitive increases it inspired in protection in other countries, made the Great Depression much deeper than it would otherwise have been. Will the treatment of trade-exposed industries become the Smoot Hawley tariff following the Great Crash of 2008?

The introduction of a sound basis in principle for trade-exposed industries is an urgent matter for the restoration of global prosperity, as well as for Australian fiscal integrity, and for the avoidance of high risks of dangerous climate change.

—

This article first appeared in the Sydney Morning Herald here
See related article by Peter Hartcher: Carbon plan fuels meltdown

1. One year after the Garnaut Climate Change Review
2. Garnaut’s conditional emission reduction targets
3. What China really delivered at Copenhagen

China is in a better position to sustain growth through large-scale fiscal expansion during the current crisis than it was at an equivalent stage of the Asian financial crisis. Its current account surplus and foreign exchange reserves are incomparably larger. And the successful Keynesian response of the Asian financial crisis gives all participants in the process confidence that it can be done again. Extensive discussion of the need to expand expenditure on rural development over the past three years has established a foundation for fiscal expansion without wasting resources.

But China will need all these advantages if it is to maintain strong growth through the current crisis.

This external recession is going to be large by any standards. It may push China’s export growth near or below the zero rate of the worst period of the Asian financial crisis. Slow export growth may last for longer. Exports now represent a much larger share of the Chinese economy and so have greater leverage over the growth process. And China now has a much more important market economy, in which the normal business cycle of a market economy can exaggerate the initial impact of external shocks.

Growth will be significantly weaker than the average of the reform period over the next 18 months.

But with good policy, China can avoid a major slump, as it did a decade ago.

These are the concluding points in a paper delivered at the inauguration of the National School of Development at Peking University, a digest of which was published in the Australian Financial Review on 27 October 2008 [link paywalled].

Update: Full paper presented is Thirty years of Chinese reform and economic growth: Challenges and how it has changed world development [pdf]

1. China not immune from the US financial crisis
2. China’s response to the global financial crisis
3. The global financial crisis and short-run prospects for India