Monthly Archives: October 2008

140 – Renewable energy in a carbon market

Some time back I had a discussion with a scientist who was a lead author on the latest report of the Intergovernmental Panel on Climate Change. Given his senior position in the IPCC I was amazed to find that he had a remarkably inaccurate view of how renewable energy (specifically bio-energy) would work in a carbon emissions market.

The problem was that he believed that an energy supplier who relies on fossil fuels would (and should) pay an amount (based on carbon emission savings per unit of energy produced) to an energy supplier who uses renewable fuels, such as bioenergy from agroforestry.

That is not the way that markets for emission permits actually work, and it is not the way they should work either.

If the market is working well, net emitters of carbon should pay an amount equal to the marginal environmental cost of that carbon times the amount emitted. Let’s assume that the cap on carbon emissions has been set at the “right” level, meaning that the market price of carbon emission permits would equal the marginal environmental cost of carbon emissions.

Now here is a stylised example to show how an emissions permit market would work. Suppose the price of carbon emission permits is $50 per tonne. There are two emitters, named Fossil and Forest.

At time = T0 Forest grows some trees and instantly sequesters a tonne of carbon.

At time = T1 (one year later), Forest chops down the trees, burns them to generate energy, and emits a tonne of carbon.

Also at time = T1, Fossil generates some energy using fossil fuels and emits a tonne of carbon.

In an ideal market for carbon emission permits:

  • Forest sells a permit at T0, and gains $50.
  • Forest has to buy a permit at T1, at a cost of $50.
  • At T1, Forest would receive interest from its bank on the $50 that has been sitting there since T0. If interest rate is 5%, Forest gets $2.50.
  • At T1, Fossil has to buy a permit, at a cost of $50.

The net outcome of all this is that at T1, Forest has gained $2.50, and Fossil has lost $50 (not counting any other costs or income). Thus, Fossil has been appropriately penalised for the carbon it has emitted, and Forest has been appropriately rewarded for the carbon that it briefly sequestered. Any other cross payments will mess this up. If one tonne of emissions was moved from the non-renewable to the renewable energy producer, the net gain would be $52.50.

(Note that the annual benefits to Forest equal the interest rate times the carbon price times the amount that remains sequestered during that year. If the carbon is sequestered for longer, the annual benefit remains the same. This relates to another misconception I’ve encountered among some people who promote sequestration, that the annual benefit per tonne of sequestration is the carbon price.)

Now consider what would happen if there was a cross payment (of $50 per tonne of carbon emitted) from the non-renewable energy producer to the renewable energy producer.

(a) If the cross payment occurs in addition to the above system, then we would end up with Fossil paying $100 for a tonne of emissions and Forest receiving $52.50. This is much too large a penalty to Fossil and too large a benefit to Forest. If one tonne of emissions is moved from the non-renewable to the renewable energy producer, the disparity is $152.50, which is about three times too big. It favours renewable energy relative to fossil fuel energy by too much. We would end up paying more than it was worth to cut carbon emissions.

(b) Maybe a cross payment could happen instead of the above. The result would be Fossil paying $50 and Forest receiving $50. This time the difference in net receipts is $100, which is almost double the correct amount for one tonne of carbon.

My scientist protagonist thought that the cross payment should be calculated on the basis of emissions per unit of energy produced. Notice, however, that in my explanation above, I did not talk about the quantities of energy produced by either Fossil or Forest, as they are completely irrelevant to the carbon market. Of course the amounts of energy generated per tonne of carbon are important to Fossil and Forest, but they are not relevant to the market for carbon emission. The overall relative attractiveness of fossil fuel energy versus renewable energy is a combination of the energy economics and the carbon economics.

All the above discussion is based on an ideal market for emission permits. In reality, the rules and regulations that are put into place may make it difficult, impossible or expensive for it to actually work this way. For example, the system may exclude sequestered carbon, or require it to be sequestered permanently, rather than temporarily as in the above example. In principle there is nothing wrong with allowing and rewarding temporary sequestration using the approach described above, but some people seem to think that if it’s not permanent, it’s not real. This is bad logic. On the other hand I suppose there may be better arguments around the transaction costs of rapidly turning over permits from brief sequestration. In any case, it doesn’t alter the conclusion that cross payments in the example above would be illogical and inefficient.

Unfortunately, despite a long discussion, I wasn’t able to convince the scientist that his view was in error, and when I followed up with a detailed explanation by email, he didn’t reply! Oh well. One can only try.

David Pannell, The University of Western Australia

139 – Free-rider problems: milk in the office fridge

Free-rider problems can be serious impediments to good management of environmental or natural resource assets. The example of milk in the office fridge illustrates many of the issues.

Economists recognise free-rider problems as one of the most important fundamental causes of environmental degradation or resource over-exploitation. Free-rider problems are closely tied to one type of public good: non-excludable goods, and to the issue of weak property rights.

Suppose there is an unregulated fishery where one of the fishers is worried that the level of fishing effort is excessive. This fisher thinks about cutting back on fishing effort in order to allow fish numbers to grow, so that fish catches will be higher in future. The problem is that this fisher cannot stop other fishers from stepping in and increasing their own effort in the area where the first fisher was previously working. The incentive for any individual fisher is to free ride on the benefits from conservative fishing behaviour by others. The result is that no individual has any incentive to fish conservatively, and so most commercial fisheries in most countries are badly over-exploited.

Closer to home (for many of us), consider the issue of milk being provided for tea and coffee in the workplace. If there is no coordination of milk provision, then any individual who buys a carton of milk for themselves and leaves it in the office fridge faces the risk that others in the workplace will free-ride, using up milk without contributing fairly themselves. What’s to stop others from putting your milk in their coffee, or even drinking a whole glass of milk when they feel like it? You can’t stand guard over the fridge, and it isn’t worth buying a fridge of your own to keep in your office just for your milk. The risk is that nobody will provide any milk, so that everybody will be worse off.

Free-rider problems, if they are serious enough, may be worth managing by some authority taking control and closely directing the behaviour of the people involved. In a fishery, a government may institute a quota system, and exclude people who don’t hold quotas from fishing. In the office, the boss may decide to be generous and provide milk for all workers, or (less generously) to levy people and use the funds to buy milk. Alternatively the boss may organise a rotation system where people take turns to buy milk. I have seen each of these in operation in practice, but they don’t necessarily happen (just as fisheries are not always regulated).

I work amongst resource economists. You’d think that, as a group, we’d know a thing or two about managing free-rider problems, but I started to have doubts when I learned about the milk situation in our School. I don’t drink milk at all myself, but in a coffee-break discussion the other day, I learned that our office milk is completely unregulated. It appeared that this lack of regulation is causing a free-rider problem. It came out in the discussion that there are two or three people in the School who are regularly purchasing milk, and finding that some of their colleagues in the School are helping themselves to it. The situation seemed to cry out for a regulatory solution of some sort.

However, on closer inspection, it emerged that the situation was not so simple. People had responded in a variety of ways, such that the additional (marginal) benefits of a regulatory solution would probably be small – possibly not large enough to outweigh the costs.

It was interesting to see how different people had adopted different strategies. Within our small group, individuals reported a remarkable diversity of strategies:

  • Switching to drinking their tea or coffee without milk. This was quite a common strategy. Having made the switch and become used to it, the cost to these people was minimal.
  • Buying soy milk, on the basis that people are less likely to free ride, given that many people don’t like soy milk. The person who did this was quite happy with soy milk.
  • Buying UHT (long-life) milk, using the same logic as for soy milk.
  • Only bringing in enough milk for one day.
  • Bringing in milk in a distinctive container, such as a sturdy plastic container.
  • Writing the owner’s name on the milk carton. This was reported to be only partially successful.
  • Purchasing normal milk but putting the carton inside a plastic bag and placing it low down and at the back of the fridge. For some reason, this seemed to be more successful than the name-labeling strategy.
  • Forming a cooperative, where a group of people agreed to take turns at buying milk. This doesn’t completely solve the problem as there are still milk drinkers (potential free riders) outside the cooperative. However it does somewhat reduce the risks, the more so the larger the cooperative. Unfortunately the cooperative in our School was actually very small – just two members.

These two members and one other person purchased most of the School’s milk. All three were well aware that they were bearing a cost due to free riders. Two of the three even named one other person (the same person in each case) as a particularly bad free rider.

However, I was interested to note that they took no steps to attempt to reduce free riding. They did not approach the worst offender. They did not petition the Head of School or School Manager to institute some sort of regulatory system, and they did not organise some peer-pressure-based system themselves. They also did not use any of the strategies employed by other members of the School, such as using a distinctive container. There were several reasons for this:

  • If they took steps to reduce free-riding, the cost to them in awkward feelings or in time would not be trivial.
  • The benefits to them from resolving the problem did appear to be trivial, or nearly so. The cost of the free riding was said to be low and not worth getting bothered about. Milk, after all, is not all that expensive, and the level of free riding was tolerable. The marginal value of the second half of a carton would be close to zero. If only one person was drinking it, it may go off before it has been completed. With this in mind, it was easy to tolerate free riding.

Overall, after discussing the issue with most people in the School, I concluded that the free-rider problem was not that serious in this case. Those who were bothered by it had adopted effective strategies to avoid it, and those who were not bothered by it just bought the milk. These strategies were clearly superior (in the minds of these people) to the option of any one of them attempting to negotiate and enforce a strong common-property solution. And the current head of School (in common with the previous three) clearly did not consider it to be an issue of sufficient importance for it to be worth the costs of him intervening. (This was in contrast to the situation with the fridge itself, which was provided by the School for all to use, as happens in most offices. I suppose that, since a fridge is relatively expensive, the need for a coordinated solution is greater.)

I was struck by the parallels with the writings of economist Ronald Coase. Coase argued that market failure problems such as free riding are often not as serious as we tend to think, and that if we look closely, we may see that they actually have been addressed to some extent. If you factor in the transaction costs of making changes, the case for a more interventionist approach may not be strong. For example, when lighthouses were put forward as the archetype public good, with high risks of free riding to be faced by any shipping company that builds them, Coase (1974) investigated and found that prior to the mid 19th century in England, lighthouses were privately owned, operated and funded (see here). This showed that, in some circumstances at least, people can work out ways to get around free riding.

Any attempt to alter such a system runs the risk of making it worse, at least for a time. For example, as a result of my interviews, and a frank discussion I had with the School’s worst free rider, we ended up with an excess supply of milk in the fridge. No doubt, this will work itself out in time, but until then we may see an increase in milk wastage.

I’m not saying that a coordinated solution is a bad idea. If some community-minded person in the School did organise and operate a coordinated system, it probably would be better than the current arrangement. Just not as much better, overall, as you might have expected.

David Pannell, The University of Western Australia

Further Reading

Coase, Ronald H. (1960). “The Problem of Social Cost”. Journal of Law and Economics 3: 1–44.

Coase, Ronald H. (1974). “The Lighthouse in Economics”. Journal of Law and Economics 17: 357–376.

138 – Practice change by farmers: National symposium

There will be a national symposium in Melbourne on 14 November 2008 on the topic “Understanding Practice Change by Farmers”.

Back in PD#125 I mentioned that a group of us was contemplating running a national workshop to celebrate the success of our paper on adoption of conservation practices by rural landholders (Pannell et al., 2006), which had just become the most downloaded paper of the Australian Journal of Experimental Agriculture. This idea now will become a reality, with a national symposium in Melbourne on 14 November.

Already the interest in the symposium has been remarkable. We were hoping to get 200 delegates, but with minimal publicity we had 200 registrations within five days of announcing the event. We’ve now changed the venue to accommodate an audience of up to 400, but even that looks likely to be booked out. So if you wish to register, don’t take your time about it or you may miss out.

The general plan for the day is to bring together a group of Australia’s leading researchers on the subject of rural practice change to:

(a) present an overview of what the existing research literature says about adoption of new practices by rural landholders,

(b) present new research results, cutting edge ideas and responses to current topical issues, and

(c) highlight implications of all this for organisations and individuals who engage with rural landholders.

The event will encompass rural landholders generally, not just farmers, which is important given the changes occurring in some regions.

The speakers will be:

Dr Neil Barr (Department of Primary Industries Victoria). Neil is a social psychologist by training with a longstanding research interest in the adoption of farm innovations and the demographic, psychological and social aspects of adoption.

Professor Allan Curtis (Charles Sturt University). Allan researches watershed organisations, the policy and institutional arrangements supporting catchment management, and the evaluation of NRM programs.

Dr Geoff Kaine (Department of Primary Industries Victoria). Geoff has expertise in adoption of new technologies and practices by primary producers and market based instruments in natural resource policy. Current projects include policy choices for climate change.

Dr Rick Llewellyn (CSIRO Sustainable Ecosystems). Rick’s research focuses on adoption of various farming practices, the role of farmer-led groups in the research and extension network, and a variety of farming systems issues.

Dr Graham Marshall (University of New England). Graham’s current work focuses on the economics of community-based environmental programs reliant on farmer’s voluntary adoption of conservation practices.

Professor David Pannell (University of Western Australia). David is a Professor in Agricultural and Resource Economics, ARC Federation Fellow, and Director of the Centre for Environmental Economics and Policy. He has researched rural practice change from a number of perspectives.

Professor Frank Vanclay (University of Tasmania). Frank is a Professor of rural sociology and leader of the Rural Social Research Group in the Tasmanian Institute of Agricultural Research, with a long track record of research on rural practice change and related issues.

Roger Wilkinson (Department of Primary Industries Victoria). Roger has worked as a rural sociologist and extension researcher in Australia and New Zealand and is currently senior social researcher in the Victorian Department of Primary Industries.

The event will be facilitated by Andrew Campbell (Triple Helix Consulting Managing Director).

For those who cannot make it to the event or miss out on a place, we will be using a number of strategies to capture the day and make it available to a broader audience:

(a) All talks will be recorded and made available as podcasts on the event web site, together with copies of PowerPoint presentations.

(b) Briefer video interviews with speakers will be recorded and placed on YouTube, with links from the event web site.

(c) Written papers for each talk will be published as a book.

See the event web site at http://www.futurefarmcrc.com.au/workshops.html for a flier, a program, and details of how to register.

David Pannell, The University of Western Australia

Further Reading

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.