Category Archives: Politics

192 – Transaction costs

If I buy something, I have to pay the asking price, but I may also incur a range of extra costs. These might include things like time, stress and travel costs involved in making the purchase. Economists call these extra costs ‘transaction costs’. There are also transaction costs involved in establishing, running or participating in a government program. I’ve become very interested in how transaction costs affect environmental programs.

I’m visiting China in October, so this week I applied for a visa. When I pick it up next week, it will cost me $30. However, that’s not the only cost I will have borne to get it. They have a new rule that you can’t apply by mail; you have to make a personal visit to the consulate. So far I have had to:

  • complete the application form, which was not straightforward, requiring me to make two queries to the people who are organising the visit;
  • look up the location of the Chinese consulate in Perth;
  • drive about 10 km to where I thought (mistakenly) it was, involving costs of fuel, vehicle wear and tear, and time;
  • pay for parking;
  • spend time walking around the area looking for it, unsuccessfully;
  • look at the street directory again and realise I was about a kilometre from the right place;
  • drive to the right place;
  • pay for parking again;
  • walk to the consulate;
  • wait in a slow-moving queue for about half an hour; and
  • drive home (more petrol, depreciation and time).

When I go to pick it up, I’ll need to invest more time, fuel and vehicle wear and tear. By the time I get the visa, the $30 cash cost will be pretty minor compared to the rest of the costs.

Economists call these other costs ‘transaction costs’. They are costs, using the term broadly, involved in undertaking a transaction, other than the direct financial cost of the transaction itself. They may include costs associated with thinking, analysing, negotiating, monitoring, enforcing, administering, learning, and so on.

In simple text-book economics, transaction costs aren’t accounted for, but in recent decades, economists have paid more attention to them. There have even been a couple of Nobel prizes awarded to people whose work included an emphasis on transaction costs.

I’m interested in transaction costs in environmental policy. I’ve been amazed at how big they can be. For example, under the National Action Plan for Salinity and Water Quality (Pannell and Roberts, 2010), the approximate allocation of Australian government funds to projects was as follows:

Category Budget ($ million)
On-ground works 220
Capacity building 260
R&D 44
Administration, planning, monitoring and evaluation 120

The last category is clearly solely transaction costs involved in getting the program delivered. They are large, but this number greatly understates the total transaction costs of the program. For one thing, the Australian Government took a large slice off the top for its own administration costs (to get the program established and run it), and that’s not included in the above figures. Also, the numbers in the first three categories include significant transaction costs involved in running those individual projects. As a rough guess, I estimate that the share of the Australian Government’s money in the program that was spent on transaction costs could have been about 40 per cent. That’s a lot of money not being spent on managing salinity.

Elsewhere in government, there were four reviews of the program during its life: two by the Australian National Audit Office, one by a committee of the House of Representatives and one by a Senate committee. Each of these involved substantial costs. And there were transaction costs prior to the program being established, as governments around Australia negotiated, discussed, and argued about the shape, the size and the rules of the program.

On top of that were the transaction costs borne by farmers and other organisations who were engaged with the program. They had to incur transaction costs in the course of negotiating with their partners and collaborators about involvement in projects, completing project application forms, completing reports to satisfy accountability requirements, meetings of various sorts, phone calls, and so on. Some of them would have incurred transaction costs from lobbying the government during the period when the program was being developed, or attempting to change aspects of the program once it was up and running.

These are even more invisible than the transaction costs incurred by government, and they are probably even more likely to be overlooked when a program is being designed or implemented.

For example, the first full round of competitive funding for the Caring for our Country program in Australia received about 1300 project applications, of which less than 10% were actually funded. These applications can be quite time consuming and difficult to prepare, but more than 1200 applicants must have felt like they had borne those transaction costs for no benefit. If this had been considered, I think the process would have been designed differently.

Focusing on the transaction costs in environmental programs could be beneficial for various purposes, including:

  • identifying cases where they seem excessive, guiding efforts to reduce transaction costs;
  • designing programs in a way that limits transaction costs to participants;
  • guiding better choices about policy mechanisms;
  • understanding why some policies achieve less than intended; and
  • understanding why people are unwilling to participate in programs in some cases.

Well-conducted studies of transaction costs in environmental programs should ultimately contribute to greater achievement of environmental outcomes from those programs, by encouraging greater participation and leaving more money to be spent on the problem.

David Pannell, The University of Western Australia

Further reading

Pannell, D.J. and Roberts, A.M. (2010). The National Action Plan for Salinity and Water Quality: A retrospective assessment, Australian Journal of Agricultural and Resource Economics, 54, 437-456. Journal web site here

188 – When is a carbon tax not a carbon tax?

The proposed carbon pricing policy in Australia is now routinely referred to as a carbon tax by both government and opposition. This is odd, because the proposed scheme is not actually a tax.   

It seems reasonably likely that Australia will, sooner or later, end up with an emissions trading scheme (ETS) for CO2.  An ETS works by setting a cap on emissions and requiring emitters to hold a permit for each tonne of CO2 that they emit. The level of the cap determines the number of permits available.

If emitters don’t already hold a permit, they must either cut back on their emissions or buy a permit from another emitter, who must then cut back. This means that a cost is imposed on emissions, equal to the price of buying or selling a permit. But, importantly, it’s not actually the price that causes the overall cuts in emissions. Rather, it’s the required cuts in emissions that cause the price. That is, permits have a value, because they allow you to avoid making cuts in emissions.

A carbon tax is sort of the opposite. A cost is added to all emissions, equal to the level of the tax, and this causes people to cut back their emissions. There is no cap on emissions in a tax-based system. People are free to emit as much or as little as they like, but if they do emit, they must pay the tax.

The system that the Australian Government is currently proposing to move to in the medium term is a standard ETS, not a carbon tax. But in the short term, there is a twist. The proposal is to fix the price of permits for the first few years, presumably to reduce uncertainty during the transition period after the scheme commences. It would still be an ETS, with a cap on emissions, and permits that can be traded, but the price of permits would be fixed by the Government.

Depending on how high the price is fixed during the early years of the scheme, it might be either the price or the cap that determines the level of emissions. If the fixed price of emissions is low, it would not create much incentive to reduce emissions, so the level of emissions would be determined by the cap on emissions. On the other hand, if the price is high enough, people might actually emit less than the maximum level set by the cap. In this case, the price of permits would be the main driver, not the cap, and there would be some unused permits.

You can see that there is a similarity between the fixed-price ETS approach and a carbon tax, in that it can be the price that determines output, although only when the price is set at a relatively high level. There still are important differences, however. In the Government’s proposed scheme, permits could still be traded among emitters and potential emitters, even in the period when there is a fixed price. That does not occur under a carbon-tax regime. When people pay a carbon tax, the revenue goes to the government. A fixed price ETS could be set up so that the initial revenue goes to the government (i.e. all the permits are sold by government at full price), but it could also work effectively even if some of the permits are given away (which the government is likely to do) provided that subsequent sales were only allowed at the fixed price or the cap is enforced. Revenue from subsequent transactions between emitters would go to the seller, not to the government.

As far as I can tell, from the perspective of households, the scheme will be no different in its fixed-price phase than in its later floating-price phase, other than in the level of carbon prices (which will rise over time) and the presence of price volatility. Households will not have to pay for emissions permits directly, but will do so indirectly as businesses pass on some or all of the higher costs they face. If the government had opted for a carbon tax, the result at the household level would not have been noticeably different. Higher costs would have been passed onto them through higher prices in a similar way. It would also have been possible to compensate low and middle income earners through reduced income tax or increased government payments, just as is planned under the ETS. In neither case would individuals have to put in any sort of tax return for their carbon emissions.

Despite the similarities described above, it is factually incorrect to call the proposed system a carbon tax. I can understand why the Opposition wants to call it a tax. It plays to people’s dislike of any sort of tax. But to me it seems odd that the Government has adopted the same language. Given the traction that Opposition Leader Tony Abbott got from his line about a “great big new tax on everything” during the last election campaign, you’d think that the government would avoid the “tax” word if they could. And they can. Their proposed initial approach is, in fact, not a carbon tax, but an ETS with a fixed price.

David Pannell, The University of Western Australia

p.s. 8 June 2011. I received several interesting responses to this PD.

Rob Fraser pointed out that, if the price of permits is fixed at a level below the market-clearing price, this would inhibit trade between emitters. My judgment is that, if all the permits were sold by government at the fixed price, this would not be a major problem. But if a lot of permits are given away (as is likely), they could easily end up in the hands of businesses that don’t have the highest marginal benefit from using them. In this case, the low fixed price would introduce significant inefficiencies to the market. This would not occur under a carbon tax. I don’t think this is a problem if the fixed price is above the market-clearing price.

Jerry Vanclay pointed out another likely important difference between a tax and an ETS: the transaction costs of the two systems. These are the costs of administering and participating in the market. “… one difference you didn’t canvass is the transaction costs for ETS and tax. My view is that there will be considerable costs associated with estimating and monitoring emissions and ETS trading – plus there will be volatility that [imposes] additional costs and uncertainty on industry. In contrast, a fossil carbon tax levied on those who dig up fossils, would be cheap and easy to implement – and may even save bureaucracy if it is made revenue-neutral by reducing income tax …”

David Alonso Love commented: “I agree the Federal Government is doing itself no favours by calling this a carbon tax, but I’m not sure “an ETS with a fixed price” quite cuts through. It would sound like goobledy-goo political speak to the punters.” I’m sure he’s right. Perhaps this is part of the reason for the government’s acquiescence.

p.p.s. 5 August 2011

I wrote the above prior to the government releasing details of the scheme. It turns out that trading amongst permit holders will not be possible during the fixed-price period. Permits can only be obtained from government. Emitters will have to buy permits (or be given them) in order to be permitted to make emissions. This means that the scheme is actually a bit more like a tax than it might have been during the fixed-price phase. However, it may still be like an ETS if it is the level of the cap, rather than the price, that determines the level of emissions. At this stage, it isn’t clear to me whether the price will be high enough for it really to behave like a tax.

 

187 – Public attitudes to climate policy

There was a poll on climate change and climate policy conducted by Newspoll for The Australian newspaper over 29 April to 1 May 2011. I discuss the results and the various factors that might be driving them.

Two or three years ago, Australian popular opinion was broadly in favour of the government intervening in a fairly strong way to contribute to climate change mitigation. Indeed, former Prime Minister Kevin Rudd’s failure to follow through on climate policy has been put forward by some commentators as one of the reasons for his ousting. Things have changed, according to this poll.

One thing that hasn’t changed much is the number of non-believers. According to the poll, 16 per cent of people don’t believe that any climate change at all is currently occurring, for any reason. This is broadly similar to the poll numbers in most other developed countries. If this belief in no climate change applies generally, not just to the current time, then it is inconsistent with the evidence. No doubt, some of the 16 per cent are staunch conspiracy theorists, and don’t trust the clear evidence of temperature rises over the past century.

On the other hand, perhaps some of them believe that there was change last century, but there is no change occurring right now (which is what the question asked about). They might think there is a temporary stasis in the climate, or that the changes we observed last century were natural and have come to an end. The poll doesn’t help us unpack the 16 per cent, so we can’t tell how many of them think this.

Six per cent of respondents were “uncommitted” on the question of “current” climate change. Perhaps this is not an unreasonable position given the way the question was phrased. One might believe that there was change last century but be unsure about the present. Questions about “current” climate change are actually fairly tricky if you want to rely on statistical evidence. It would be pretty hard to prove one way or the other, unless “current” is defined as a reasonably long time – some number of decades. Perhaps that explains the thinking of some of the uncommitted group.

The poll did further unpack the beliefs of the 78 per cent who believe that there is climate change currently occurring. We learn that 5 per cent out of this group think that climate change is not caused by human activity at all (and 1 per cent are uncommitted).

The remaining 72 per cent who believe in some human influence on climate change were asked whether they’d be prepared to pay “more” (no indication of how much more) for energy, if that would “help slow the climate change caused by human activity”. Surprisingly (to me), 30 of the 72 per cent say “no” (and 3 per cent are uncommitted). That’s pretty striking. Thirty per cent of people believe that climate change is occurring, and that humans are partly or fully responsible for it, but say they aren’t prepared to pay “more” to curtail it.

We can’t tell from the survey what’s behind this. Perhaps they believe in climate change but they don’t think it’s very serious. Perhaps they think humans are partly responsible, but only for a small part of it. Perhaps they are rejecting the premise of the question that paying more would actually slow climate change. Perhaps they are unhappy about just slowing it because they would rather stop it completely. Perhaps they are worried about the vagueness of “more” – after all, “more” could be a lot. Perhaps they are just feeling confused or are answering randomly. Whatever the reasons, it leaves just 39 per cent saying they are prepared to pay “more” for climate change mitigation.

Finally, all respondents were asked about their support for the “Federal Government’s current proposal to put a price on carbon”. There were 30 per cent in favour, 60 per cent against and 10 per cent uncommitted. What’s intriguing about this is that there is so little information available about what the “current proposal” actually is. Few of the details have been released. People must be responding on the basis of their general feeling about the broad policy direction, rather than specific knowledge of the policy. But not even all of the 39 per cent who are prepared to pay are on board! Where has 9 per cent gone? It’s not as if the Government is proposing something whacky. Their signaled broad direction is consistent with what most economists with expertise in the area would recommend (subject to inevitable disagreement about details).

My guess is that they’ve been scared off or confused by the Opposition’s shameless scaremongering. If that’s true, it’s somewhat ironic that the Opposition’s policy is not at all consistent with what most economists with expertise in the area would recommend. Its “direct action” approach would likely cost the country much more to achieve any given level of emissions reduction than an approach built around a price on carbon.

I’d guess that the Opposition’s political strategy is also contributing to the fall in support for paying for climate policy generally. They are probably not the only factor contributing to this, though. Other factors probably include the controversies about climate science in the past couple of years (ClimateGate, the IPCC’s error about glaciers in the Himalayas), the continuing efforts of skeptical blogs, the relatively skeptical positions adopted by parts of the media, the tendency for some advocates to oversell their case, and the difficulty of actually discerning slow climate change within a background of high climate variability.

Where does that leave the Government’s current policy? Not in a good place, clearly. It is not inconceivable that it could pass through the parliament with support from The Greens and the rural independents, but the Government is going to be looking for every opportunity to make it look more appealing and less scary. Polls like this one mean that, if the policy does get up, it’s likely to end up being fairly tokenistic, with a low price and low targets. Maybe if it gets in, people will see that the sky hasn’t fallen in, and that most of them are no worse off after compensation, making tougher targets more feasible.

Either way, I still think that lack of political acceptability is going to mean that relying primarily on a carbon price is not going to work at the global level, making an approach centred on technology development more likely to make a real difference. However, that alternative has no backers at the political level, so it probably won’t happen either.

David Pannell, The University of Western Australia

p.s. 5 June 2011. I discovered that that last sentence is not totally true. Ross Garnaut, in the update of his report for the Australian Government, is apparently recommending that spending on “innovation” should build up to $2.5 billion per year. He said in a talk in Perth this week that there is support from some backbenchers for this idea, and I’ve heard separately that one of the rural independents in the House of Representatives is supportive, and so is the semi-independent National Party member. Maybe there is some chance for a version of this approach after all.

186 – Submissions to government

There are many opportunities for Australians to attempt to influence government through making submissions to government inquiries and reviews. Relatively few people go to the bother of writing submissions, but I often have a go, especially when it relates to environmental policy. What have I learnt about the process?

As well as being a regular submitter, I have a little bit of experience of being on the other side of the process. I was a member of a four-person Ministerial Taskforce reviewing salinity policy in Western Australia in 2001 (Frost et al., 2001). We took written submissions and held public hearings.

I’ve learnt not to have high expectations that one’s carefully crafted submission will have a noticeable impact on policy.

If what you say is similar to many other submissions, then the fact that you put in a submission will probably not make much difference. Its value is in reinforcing points that others are also making.

On the other hand, if your submission is different to or in opposition to most other submissions, you have more chance of it standing out, but also more chance of it being dismissed as being out of line with popular opinion. It’s not necessarily the case that sound logic and evidence can outweigh the majority view.

Another reason why it might not have much impact is information overload. Whoever has to read the submissions has to get through a huge amount of information very quickly. Any ideas that are a bit challenging risk getting put aside because there isn’t time to give them the thought they would need. There are no rules saying that every submission has to be fairly dealt with and responded to in detail. I suspect that many get only a cursory look.

My feeling is that some inquiries adopt a fairly cynical attitude to submissions, using them selectively to bolster a more-or-less pre-determined position.

Those comments probably seem more negative than is warranted. Many inquiries do make sincere efforts to get to the bottom of things, especially those with a panel that is relatively independent of the thing being inquired into.

The real challenge comes later. Even if your submission does make a substantial difference to the content and recommendations of the inquiry’s report, there is no guarantee that policy makers will respond accordingly. For example, in 2006 the Australian Government’s Senate Committee inquiring into salinity got very enthusiastic about our Salinity Investment Framework III (SIF3). Their report, “Living with salinity – a report on progress” includes a three-page section on SIF3, plus

“Recommendation 22: The Committee recommends that the Australian Government in cooperation with the states and territories keep a watching brief on the development of the Salinity Investment Framework 3 (SIF3), with a view to potentially implementing it (or a modified version of it) across the country. It is recommended that the framework be applied within the context of the new (post-2008) program(s).”

Of course, it didn’t happen. For one thing, salinity was completely dropped from the political agenda in 2008. But even the more general successor to SIF3, the Investment Framework for Environmental Resources (INFFER) has not been applied by the new program, Caring for our Country.

I was initially surprised to learn how easy it is for government to ignore the recommendations of inquiries, even its own inquiries! For example, I am on record as being a strong critic of the National Action Plan for Salinity and Water Quality (Pannell and Roberts, 2010). In my judgment, it was a very poorly conceived program that spent a lot of public money and achieved very little (PD174). There were four government reviews of the program conducted during its life (two by the Australian National Audit Office, one by a Senate committee and one by a House of Representatives committee), and many of my concerns about the program were raised in one or more of the inquiry reports. But the program continued on with no fundamental changes. The responsible departments were not held to account. They could get away with glib assurances that they would take the recommendations into account, but then continue on as before.

So why bother? There are several reasons why I persist in putting in submissions to almost every inquiry that is related to my research.

The main reason is that, even though change to an existing program seems to be almost impossible (unless there is some sort of public scandal), change can occur on a longer time scale. One can detect that many of the new features of Caring for our Country were attempts to address concerns about previous programs raised by the Australian National Audit Office. Not all concerns were addressed, and some of the new features introduced new concerns, but at least there was some attempt.

Another thing is that it provides another channel for communication. I accept that any particular act of communication is likely to have limited impacts, but over the long term I’m hopeful that lots of communication can add up to something that has an influence.

Finally, it doesn’t cost much time to put in a submission. They have to be pretty brief if you want them to be read, and given the other issues I’ve raised here, it isn’t worth labouring over them too much. So I usually do one, but do it quickly.

These thoughts are on my mind because last Thursday I put in a submission to the current review of the Caring for our Country program.

David Pannell, The University of Western Australia

Further Reading

Frost, F.M., Hamilton, B., Lloyd, M. and Pannell, D.J. (2001). Salinity: A New Balance, The report of the Salinity Taskforce established to review salinity management in Western Australia, Salinity Taskforce, Perth, 78 pp. Full report (732K pdf)

Pannell, D.J. and Roberts, A.M. (2010). The National Action Plan for Salinity and Water Quality: A retrospective assessment, Australian Journal of Agricultural and Resource Economics, 54, 437-456. Journal web site here

176 – The Murray-Darling Basin Plan

A couple of weeks back I attended a very good workshop in Brisbane on the Murray-Darling Basin Plan, which is causing so much political controversy at the moment. Here I’ll summarise a few key points from the workshop.

The workshop, organised by John Quiggin’s group at the University of Queensland, pulled together a who’s who of Australian water economists, including Mike Young, Jeff Connor, Lin Crase, Quentin Grafton, Jeff Bennett, Peter Gooday and Alistair Watson. In addition there were presentations from other social sciences, from ecology, and from the Murray-Darling Basin Authority.

The workshop came only a few weeks after the release of the “Guide” to the draft Plan, and in the wake of big public protests against the Plan by communities throughout the Basin.

The key point of the plan is that there needs to be a reduction in the amount of water taken from the rivers for irrigated agriculture. This has been obvious for a long time, and has been, on its own, a point of relatively little controversy. The recommended reduction is 3000 to 4000 GL, which amounts to 27 to 37% of current diversions. This size of reduction has clearly been a concern to many people.

Part of the controversy seems to be that farmers object to the government taking away their water. Given the media coverage that has occurred, most people who aren’t close to the issue assume that Government is going to forcibly acquire water rights from farmers, maybe even without compensation. This is completely wrong. To the extent that the protests are meant to protect agriculture per se, they reflect a total misunderstanding of the proposals in the Plan.

The proposal is for Government to buy back water from willing sellers only. This means that those farmers who end up with less water will be, by their own judgment, better off than they would have been without the plan. If they don’t think they’ll be better off, they won’t sell, and nobody will make them sell. Thus, farmers are protesting against a program that would make the farmers who sell better off.

Increasing Government purchases of water amounts to increased demand, which will result in a higher market price of water. This will obviously affect farmers who wish to buy water. I don’t think they are protesting about this, but even if they were, the protests would have little merit. The higher price would simply reflect that there are competing uses for the water, some of which are more valuable than some of the agricultural uses. It is just a better reflection of the true scarcity of water. The problem is not that water prices will be too high, but rather that they have been too low.

The other cause of consternation has been the predicted loss of non-agricultural jobs that depend on agriculture. Predicting the level of such job losses is extremely difficult, but the several different economic modeling teams who presented results at the workshop had a strong consensus that it would be small. The total loss of jobs attributable to the Plan over 20 years would probably be less than the daily turnover of jobs in Australia. John Quiggin notes that “For most towns and cities in the region, the ‘job loss’ estimates will be similarly notional. Total population in the Basin is growing, and so is employment.”

There are some communities in the basin where job losses are likely to be more significant locally. It would not be sensible to walk away from the whole Plan as a whole on their account. Rather, strong Government support for social and employment programs would be well justified.

Under the Howard government, billions of dollars were assigned to upgrading irrigation infrastructure in the Basin, as a way of saving water and limiting the need to purchase of water from irrigators. Given the controversy, this strategy probably looks tempting to the current government. Another point of strong consensus among the water economists was that this strategy is a bad idea, costing 2 to 4 times as much as purchasing water from willing sellers. Back-of-the-envelope calculations show that investing in infrastructure as a way to limit job losses would cost millions of dollars per job saved.

We heard about one very reasonable sentiment that is coming from people in the Basin community: if the Government is going to do this, they had better fix it! One could not blame people for being very unhappy if there are large, expensive, disruptive changes but they don’t achieve the hoped-for environmental results. There is a big risk for the Government here. If they aren’t very careful, they could easily find that they spend the money without getting worthwhile environmental benefits. The risks include:

1. Program failure. Past experience with large natural resource management programs does not give one much confidence about the likelihood of success. The Natural Heritage Trust and especially the National Action Plan for Salinity and Water Quality spent billions for very disappointing outcomes (see PD174). The Government will need (a) a real determination to pursue outcomes, not just activity, (b) to take the science and economics seriously, and (c) allow the time and resources to undertake good quality analysis to support decisions about how the money is spent on environmental assets.

2. Uncertainty about cause and effect. There is always a lot we don’t know about the relationship between particular changes in resource use and the resulting impacts on the environment. Even with the best will, and with very good analysis, there is still a risk that our poor understanding of the system will lead to poor results.

3. Ambiguity about the objectives. At the workshop, Hugh Possingham highlighted that, when we invest in the environment, we typically don’t know what we are trying to achieve or why. My experience strongly reinforces this point. This ambiguity makes it impossible to evaluate and compare different investment options.

Unusually for a long-term policy problem, it appears that we actually do have enough money on the table to achieve worthwhile outcomes. Whether we do actually achieve them will be a huge test.

David Pannell, The University of Western Australia

Note: the article has been edited to delete a comment about the effect of the past decade of drought on non-agricultural jobs. I accept a comment that was sent to me that this is complicated. Drought is not the same as permanent reduction in water — some business activities that are maintained at a loss during a drought would be shut down if there was less water permanently.