Yearly Archives: 2007

104 – How would a carbon market work?

I recently did a radio interview in which the journalist asked a lot of really basic questions about how a market for carbon might operate. It made me realise that many people have little idea about this extremely topical question, so here is a brief primer.

There are many details that could vary, but this description provides an outline of a standard cap and trade system, which seems to be what policy makers are thinking about.

To start with, “carbon market” is a misnomer. Assuming that a market is created, it will not actually be a market for carbon dioxide. It will be a market for permits that allow the holder to emit carbon dioxide. That might sound backwards, but it does make sense.

This sort of market has several components:

1. The government sets a quantitative limit on emissions (e.g. of carbon dioxide equivalents), at some reduced level.

2. The government creates permits that allow people to emit no more than that level of carbon dioxide, and distributes them somehow (e.g. by giving or selling them to current emitters).

3. The government enforces compliance. If anyone emits more carbon dioxide than the amount for which they have permits, then they are penalised. The level of penalty, and the probability of detection, have to be high enough to encourage high levels of compliance.

4. The government sets up and manages a system that allows people to buy and sell permits from each other.

The first three components are the elements that control the degree of reduction in carbon dioxide emissions. Without the fourth element, the system would be similar to a simple regulatory approach that required people to cut back their emissions.

The fourth component means that the cost of reducing emissions is substantially reduced. It means that reductions in emissions are redistributed such that we achieve the reductions at least overall cost. People or businesses who have the least to lose by reducing emissions are the ones who actually make the reductions.

An example

Suppose ABC Electricity Company does not own any permits, but wishes to emit 10,000 tonnes of carbon dioxide in the process of generating and selling electricity. Suppose that, if it was prevented from making these emissions (i.e. if it was prevented from producing and selling electricity), it would miss out on profits of $2,000,000.

XYZ Mining Company owns 10,000 tonnes worth of emission permits. It could either use the permits and continue mining, with a profit of $500,000, or it could sell the permits to someone else.

If ABC Electricity bought the emission permits from XYZ Mining for, say, $1,000,000, both businesses would be better off than the status quo. The profit for ABC would rise from zero (with no permits) to $1,000,000 ($2,000,000 minus $1,000,000 to buy the permits). The profit for XYZ would increase from $500,000 (if the permits are used to continue mining) to $1,000,000 (if the permits are sold).

As a result of the trade, the total cost of reducing emissions would fall from $2,000,000 (from preventing the operation of ABC) to $500,000 (from curtailing mining by XYZ).

In reality there would be lots of buyers and sellers in the market, and the actual price would depend on the overall balance of supply and demand among them all, but the example illustrates the basic logic of the approach.

The permits have value in this system (i.e. buyers are willing to pay good money for them) because they allow the holder to avoid an even greater cost involved in reducing their carbon emissions. Not everyone can avoid this cost, only those people who value the permits highly enough to be willing to buy them (or, if they already own them, to be willing to forego the income from selling them).

A fifth component is the possibility for people to sequester carbon dioxide, such as in a tree plantation. These people would be issued with new emissions permits to match the level of sequestration, and they could sell these permits on the market. The existence of the market would encourage this option if the cost of sequestration is lower than the cost of just cutting back on emissions. This is, therefore, another way of reducing the overall cost of reducing emissions.

Yet another pathway to reduced costs is through innovation. If an existing emitter is able to use a new technology or management system that reduces emissions for a given level of production, they don’t need so many emissions permits any more, and can sell some. In this way a market creates ongoing incentives for innovative ways to cut emissions. There would be no such incentive in a simple regulatory approach.

On another issue, I’ve heard someone say that the price of carbon permits would reflect the benefits of avoiding climate change. This is unlikely to be correct. It would actually reflect the marginal cost of reducing carbon emissions. The price would be higher if the permits were scarcer, requiring more expensive abatement measures to be implemented. If the number of permits was just right, then the price would match the resulting climate-change benefits, but given the massive imponderables and uncertainties in the system, this could only occur by luck.

David Pannell, The University of Western Australia

103 – Influences on technology adoption in different phases

In a recent review of adoption of conservation practices by rural landholder, my co-authors and I broke down the factors that influence adoption into three groups: (a) social, cultural and personal factors; (b) features of a practice that influence its relative advantage; and (c) features of a practice that influence its trialability. These different groups of factors tend to come into play at different times in the adoption and learning process.

In the enormous literature on adoption of technologies, researchers have identified a huge list of factors that influence potential adopters, at least sometimes. In reviews and discussions of this literature, one often sees fairly unstructured lists of key factors. However, in my view it really helps to organise these factors into three groups:

(a) social, cultural and personal factors (e.g. peer pressure, government awareness-raising programs, attitude of the potential adopter towards risk);

(b) features of a practice that influence its relative advantage (i.e. its contribution to achievement of the adopter’s goals, such as profitability or environmental benefits); and

(c) features of a practice that influence its trialability (e.g. the ease of observing its performance in a trial).

In Pannell et al. (2006) we provide many examples of factors under each of these three headings.

Recognising these three groups of factors helps us think about the adoption process in a more systematic way. For example, in my judgment, the three factor groups tend to vary in their influence at different phases of the adoption and learning process.

What do I mean by “phases”? The adoption process can be broken down into phases as follows.

(i) Awareness of the problem or opportunity: In this context, ‘awareness’ means not just awareness that an innovation exists, but that it is potentially of practical relevance to the landholder.

(ii) Non-trial evaluation: Reaching stage (i), the point of awareness, is a trigger that prompts the landholder to begin noting and collecting information about the innovation in order to inform the decision about whether or not to go to the next step of trialing the innovation.

(iii) Trial evaluation: Trials contribute substantially to both the decision making and skill development aspects of the learning process.

(iv) Adoption: Depending on the trial results, use of the innovation may be scaled up.

(v) Review and modification.

(vi) Non-adoption or dis-adoption:

There is little firm evidence of how the above three groups of factors, (a), (b) and (c), vary in importance in the various phases, (i) to (vi), but in my judgment, the table below provides a reasonable indication. Three crosses indicates that a factor group is the decisive one during that phase.

Social, cultural, personal factorsRelative advantage of the practiceTrialability of the practice
Awarenessxxx
Non-trial evaluationxxxxxx
Trial evaluationxxxxxxx
Adoptionxxxxx
Review and modificationxxxxx
Non- or dis-adoptionüxxxx

In general, social factors are most important in the early phases, but as the landholder gains personal experience through trialing the practice, its perceived relative advantage becomes more important. Put simply, before they have experience, landholders have to rely on what others tell them, but after experience is gained, this experience becomes more important than outside advice.

This schema suggests that the trial-evaluation phase is the most complex, in that all three groups of factors are strongly involved.

It also has implications about the potential contribution of government in the adoption process. Early in the process, the key role would be provision of information, education and other facets of “extension” in order to raise awareness and assist in evaluation. Demonstrations of field trials may be part of that, and would be most effective if the practice is highly trialable.

Later in the process, when relative advantage is decisive, extension probably plays little role. However, governments may still have an influence at this stage by virtue of its activities years earlier, when the practice or technology was being developed. In agriculture, most of the research is publicly funded and undertaken in public organisations, so the choices that these funders and research providers make about which technologies and practices to develop (and their specific characteristics that affect relative advantage) eventually become the crucial drivers of adoption. It highlights the need for research funders and research providers to pay close attention to the adoptability of their technologies during the research process.

Participatory research, bringing together researchers and potential adopters, can be an effective way of injecting “adoptability” thinking into the research process at a certain point. Ideally, though, adoptability should also be considered right at the start of the research process, before there is yet a technology available to trial, which is normally when participatory approaches start to be used.

Perhaps there is scope to involve practitioners more in discussions at those very early stages of the research, although in my experience this has not worked particularly well. What has worked well is the use of detailed economic modelling to consider alternative research directions, providing information about the economic aspects of relative advantage (e.g., Pannell, 1999).

David Pannell, The University of Western Australia

Further Reading

Pannell, D.J. (1999). On the estimation of on-farm benefits of agricultural research, Agricultural Systems 61(2): 123-134. Full paper (61 K)

Pannell, D.J., Marshall, G.R., Barr, N., Curtis, A., Vanclay, F. and Wilkinson, R. (2006). Understanding and promoting adoption of conservation practices by rural landholders. Australian Journal of Experimental Agriculture 46(11): 1407-1424.

If you or your organisation subscribes to the Australian Journal of Experimental Agriculture you can access the paper at: http://www.publish.csiro.au/nid/72/paper/EA05037.htm (or non-subscribers can buy a copy on-line for A$25). Otherwise, email David.Pannell@uwa.edu.au to ask for a copy.

102 – A national market for biodiversity?

Someone asked me recently, “How close are we to having a national market for biodiversity? My answer is, “probably not very close”.

In part, the answer depends on whether you consider conservation tenders to be a form of market. Tenders were the most successful approach in the first round of the Market-Based Instruments Pilot Program, and it seems likely that they do have a viable future in Australian biodiversity policy. They have been described as “market like”, but really they lack a number of desirable features of markets. Certainly they are not like the market for, say, cars, which has many well-informed buyers and sellers competing and communicating. Conservation auctions have only one buyer: the environmental management agency, who has to dominate and drive the process. Because of the public good nature of biodiversity, with the resulting temptation for free riding, I think it is unrealistic to expect multiple buyers to emerge in a competitive market.

There are a couple of other ways to artificially create a kind of market. For some environmental issues, we are likely to see the development of markets for tradable permits (in a “cap and trade” system). The much-discussed carbon market is the obvious first candidate. This type of market works by creating scarcity in something valuable (e.g. the right to emit carbon) so that there are incentives for buyers and sellers to trade. I don’t think this approach is very relevant to biodiversity in Australia. It might have been if there was still a lot of clearing going on, but there isn’t. It’s been stopped by other policy measures.

Another approach is to allow trade in offsets. Someone is allowed to do something with an environmental cost, provided they fund some positive environmental works elsewhere to compensate. Farmers could potentially provide the positive works to become suppliers in this market. This has been explored a bit in Australia, but I don’t see it making a big impact on biodiversity broadly.

Overall, I think that conservation tenders will be the main economic instrument used to advance biodiversity (and of course economic instruments will continue to not be the only type of instruments used).

Now what about the “national” part of the question? Perhaps we could envisage conservation tenders operating nationally. While that may be technically feasible, I think there is little to gain, and plenty to lose in the form of transaction costs, relative to running a number of more localised tender schemes. These could be targeted to regions and for issues where the likely benefits are higher, rather than being offered indiscriminately across the whole nation. The challenges of comparing bids from different regions with radically different problems and opportunities would also tell against the feasibility of a unified national scheme.

Another challenge is that markets operate on a common currency, whereas biodiversity-related interventions are highly heterogeneous and hard to compare. We do have some tools intended for this purpose (non-market valuation, or “habitat hectares” as an index of the value of native vegetation in Victoria) but they do not seem sufficient (or, in the former case, not sufficiently cheap) to underpin a national scheme.

Even more fundamentally, it is difficult just to predict the biodiversity consequences of different interventions, let alone their values. If tenders are really to achieve their potential, we will need to greatly improve knowledge about cause-and-effect relationships for interventions and their consequences for biodiversity. I suspect that this may be the biggest single factor inhibiting improved purchase of environmental services, whether we use tenders or other approaches.

Then there is the issue of human capacity to roll out either a tender or market scheme nationally. It is not a game for amateurs. We are slowly building the number of people with the expertise, but we are still well short of being able to implement the approach at a national scale.

To reinforce these points it may be helpful to ask, what are the characteristics of the national car market that allow it to work but which are lacking for a biodiversity market?

  1. A clear measure of the value of the goods being purchased. In the car market, this value is revealed by consumers’ willingness to pay for the cars they buy, whereas the true values are obscured for biodiversity, and may be clouded by ignorance in any case.
  2. A capacity for buyers and sellers to communicate with each other cheaply. New communication systems would need to be developed for a biodiversity market.
  3. Confidence in the market. As a car purchaser, if you pay the money, you do get the product, and there is probably a warrantee on its quality. In the case of biodiversity, you may pay the money and have little idea about what product or service will be generated. This relates to uncertainty about cause and effect, but also to the reliability of suppliers.
  4. The absence of a free-rider problem. If you want a car, you’ll have to pay for it. If you value biodiversity, you could just wait for someone else to pay for its preservation, without making any contribution, or at least not a full contribution reflecting your benefits.
  5. A capacity to compare the values of different products easily. Easy among cars, hard for biodiversity.
  6. Essential market infrastructure exists. It does for cars (car yards, distributors, part suppliers, etc.) but there is nothing comparable for biodiversity.
  7. Relevant institutions have been developed. They have for the car industry (e.g. regulation of car dealers) but they are still being developed for biodiversity.
  8. Experts in the operations of the market. There are many people who are expert in the operation of the car market, but few experts in biodiversity markets or related approaches.

That is why my answer is “probably not very close”.

David Pannell, The University of Western Australia

101 – Outsourcing farm management?

In some parts of Australia, economic and social changes in agriculture are resulting in extreme time pressures on farmers. Perhaps it would help to re-think the farm-management paradigm in these areas.

Looking at demographic changes in Australian agriculture, Neil Barr has identified a split. Some regions, relatively close to population centres and with attractive environments, have growing rural populations and decreasing average property size, due to the growth in numbers of “lifestyle” landholders. Other regions, further from cities and green or wet places, continue down what has been the traditional trajectory of increasing farm sizes and falling rural populations.

Farmers in the latter areas face increasing farm management challenges. These include the difficulty of managing a larger property, staying on top of the growing complexity and technical sophistication of agriculture, and issues with labour.

Traditionally, most farms employed additional farm labour, but over time new farm machinery has tended to substitute for labour. However, farms in some areas (especially Western Australia) are now getting so big that the availability of good quality farm labour has become a key constraint. The current high demand for labour in the mining industry in Western Australia has created an acute problem for some farmers, but even without that, there would still be a chronic problem.

Since livestock production tends to be more labour-intensive than cropping, many farmers have made the obvious switch in emphasis. From a simple financial point of view, this is a sensible response. However, there may be hidden costs for long-term resource management or the environment. For example, some of the key management responses to dryland salinity involve livestock: grazing of perennial pastures planted to contain saline areas, or grazing of salt-tolerant species on areas that are already salt affected. Livestock can also play a valuable role in systems used to manage herbicide-resistant weeds, both by the grazing itself, and because a broader range of weed control options can be used on pastures than is possible on crops.

My colleague Ross Kingwell is interested in whether there is another way to tackle the livestock management problem to get around the shortage of on-farm labour. He is commencing research to examine the feasibility of groups of farms combining to outsource their livestock management requirements to specialised services. He is asking whether outsourcing arrangements can generate commercially and socially worthwhile opportunities for farm families with large broadacre farm businesses. Is it a practical idea? Could there be environmental benefits? Would it be worthwhile governments supporting such an approach, and if so how? It will be very interesting to see what comes of the research.

You might be so interested that you’d like to work with Ross on the project. He has two years of funding for a research officer, and he has his own labour shortage to contend with. If you know of anyone who may be interested, please advise them to contact Ross ASAP (rkingwell at agric.wa.gov.au). The appointee could also enrol in a masters degree on the subject, if they wished.

David Pannell, The University of Western Australia

100 – A jolly good Fellow

I have been awarded a Federation Fellowship. What does it all mean?

I had a very enjoyable visit to Canberra last week. Finally, eight months after applications closed, the Minister for Science announced this year’s crop of 20 Federation Fellowships, and I was lucky enough to make the grade.

The Fellowships are provided by the Australian Research Council, the Australian Government’s main funding body for University research. They are well rewarded for five years, and are across all research disciplines, so it’s very competitive to win one.

Of the new Fellows, three quarters are from from high-tech science fields, with topics like quantum nanoscience, astrophotonics, quantum computers, polymer nanomaterials, photonic integrated circuits, nanophotonics, and so on. (“Nano” is obviously the big buzz word.) By comparison, my research field felt rather homely. There were a few other Fellows who also deal with the human dimension, notably my colleague in economics, John Quiggin, whose stellar research performance was justly rewarded with his second Federation Fellowship. Congratulations John.

On the personal front, it means that we’ll be moving back to the Perth campus of the University of Western Australia at the end of 2007. It really is a wrench to leave beautiful Albany, especially for my family, but there is plenty of bright side to look on.

On the work front, I will be establishing a Centre for Environmental Economics and Policy in the Faculty of Natural and Agricultural Sciences at UWA, with the aim of improving environmental policy programs for land, water and biodiversity conservation. Using the resources of the Fellowship, and hopefully other proposals we have in the pipeline, we’ll tackle a range of issues that should contribute to this end, including:

  • consolidating the work on SIF3 the Salinity Investment Framework III.
  • analysing the balance of investment between on-ground works that produce changes in the short term, versus technology development that takes longer to pay off but does so on a larger scale.
  • analysing the relative importance of (a) choosing which environmental assets to protect, (b) choosing which policy mechanisms to use to protect them, and (c) the detailed operation of the policy mechanism that is used. In practice, (b) gets little attention, but I have a hunch that it’s as important as the others.
  • understand more about the way that policies influence landholder behaviour.
  • understand more about the ways that policy program design influences the behaviour of environmental management organisations.
  • adapting the SIF3 approach beyond salinity to address new environment issues.
  • new bioeconomic models for those issues.

We’ll also bring other environmental economics research in the School of Agricultural and Resource Economics at UWA (e.g. experimental economics, non-market valuation) under the umbrella of the new Centre, linking strongly to policy processes, and providing new opportunities for post-graduate students.

With this new Centre, together with John Quiggin’s team at the University of Queensland, and the newly announced CERF “Hub” in environmental economics at the Australian National University, environmental economics in Australian universities looks to be in robust good health.

David Pannell, The University of Western Australia