Treasury modelling of a carbon tax

I teach my post-graduate students of international trade that the value of economic modelling lies not in the projections —which are unreliable at best—but in the insight that building models provides into how a trading economy works.

The exchanges between Ms Gillard and Mr Abbott in the past day or so about modelling “compensation” for the proposed carbon tax suggest that the Prime Minister believes modelling is sufficiently accurate to guide the fine-tuning of her tax and “compensation”. But if the Treasury’s 2008 modelling of the proposed ETS are an indicationof the sort of advice she is getting about the impact of her tax then I can’t agree.

I’ve revisited the summary conclusions of the 2008 Treasury report on the impact of Ross Garnaut’s suggested $30 per tonne impost on CO2 emissions. These brief “talking points” are jam-packed with panglossian assurances and incredible assumptions that allow Treasury to pretend that all will be well. But if you pay attention to what the model tells us about the structure of our economy—stripped of the glowing gloss—the outcome is horrible, especially considering the utter futility of the emissions-cut gesture. The tax will mean our economy will be smaller, slower-growing, with fewer prospects and much less attraction for foreign investors…

The italicised text is from the Treasury’s summary of their report:

  • Large reductions in emissions do not require reductions in economic activity because the economy restructures in response to emission pricing.
    • Facts: The modellers project that with a $30/tonne CO2 price our economy would grow more slowly—despite some madly optimistic assumptions built into the model—so that instead of being 11% richer by 2020 we’ll be only 9% richer. That’s a difference of about $20 billion dollars (or half of an NBN) in today’s money or about $1000 for every Australian.

      Just how mad are the assumptions about adjustment built-into this model? Here are the incredible assumptions that Treasury has used to pad its estimates of electricity supply:
      By 2050, the share of electricity generated by carbon capture and storage ranges from 28 per cent in the CPRS -15 scenario to 39 per cent in the Garnaut -15 scenario. The share of renewables continues to rise strongly through the 2020s and 2030s. By 2050, the share of renewables is 40-51 per cent in the policy scenarios, compared with just over 5 per cent in the reference scenario (Chart 6.25).
      Memo: The majority of CCS pilot plants around the world have yet to be commissioned or are “on hold”, usually pending government funding. Australia has one, tiny, pilot plant due to come into operation in 2011 with substantial government research subsidies. As for renewables, according to the industry lobby group, the “Clean Energy Council”, renewable energy accounted for 5.2% of (electric) energy consumption in 2009 despite subsidies that the Productivity Commission estimates as equivalent to a current tax of $44-99 per tonne of CO2 saved by these industries! On what basis then, does Treasury project a ten-fold increase in the proportion of renewable supply following the introduction of a $30 CO2 price? Fantasy, pure fantasy.
  • Real household incomes continue to grow, although households face higher prices for emission-intensive products, such as electricity and gas.
    • Translation: The tax is not, in fact, fatal. The economy stumbles on although, given the unreality of the assumptions, the gas and electricity price impacts will be larger than the results indicate. The tax makes us poorer and life harder, especially for those doing it hard now.
  • Some costs are unavoidable and would arise regardless of whether Australia chooses to participate in the global mitigation effort. These costs arise from other economies’ actions, particularly through trade in energy- and emission-intensive commodities.
    • Translation: This can be taken two ways; both bad. Either other economies raise carbon prices so we pay more for imports of everything OR other countries do not raise carbon prices, we go it alone, and we don’t export as much as we used to. But the first is not happening and the second, if it happens, will be our own stupid choice (not ‘unavoidable’ at all).
  • Australia’s mitigation costs are higher than most developed economies due to its large share of emission intensive industries.
    • Facts: No question that this is right. We’ll cut our own growth and damage our comparative advantage in trade for a reduction in global CO2 emissions that is unnecessary and useless (less than one hundredth of one percent).
  • International trade in permits reduces the cost of Australia’s contribution to the global mitigation effort. Australia’s emissions fall significantly once new low-emission electricity generation technologies become cost-effective.
    • Facts: It’s hard to see a permits-allowance being coupled with the proposed carbon tax: it would create too much leakage (purchases from NZ) to allow the government to fund its “compensation” package. But it won’t happen even if we move to an ETS. The “permits” exchanges in the USA and Europe are collapsing because the market has apparently worked out that the carbon panic has peaked and the permits are are worth much less than their face value.
  • Allocation of some free permits to emission-intensive trade-exposed sectors, as the Government proposes, eases their transition to a low-emission economy in the initial years. Shielding redistributes costs from shielded to unshielded sectors, and could redistribute costs amongst shielded sectors.
    • Facts: This device make the modelling outputs look better. But free permits won’t happen under a carbon tax.
  • Australia’s comparative advantage will change in a low-emission world. Impacts on Australian producers will depend largely on their emission-intensity relative to other producers.
    • Facts: Again, no question our comparative advantage will change. As the Productivity Commission notes; for the worse.
  • Lower demand for Australia’s emission-intensive commodity exports could generate benefits for other export-oriented and import-competing industries through its impact on Australia’s exchange rate.
    • Facts: This is the silliest of all the talking points. What it means is that non-resource industries will breathe a sigh of relief because the minerals-led boom could be killed dead by emissions controls. The value of the dollar (not to mention the level of inward investment flows) will plummet and we’ll all be worse off. But, hay! Wool will again be a leading Australian export!

      Here’s how the Treasury, with exemplary sangfroid, describes our descent into to this miserable “pollution free” economy:
      “Australia’s trade balance improves as imports fall by more than exports. Imports fall as consumption and investment fall. Australian exports fall, but are partially held up by demand from China and other economies initially not in the trading scheme. The trade balance reduces the current account deficit, reducing Australia’s foreign debt and foreign interest payments, leading to a higher GNP.”
      Translation? We’re still not dead (yet) and we have less debt; but that’s because our economy is smaller and poorer than it could have been. Duh!

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