In 1991, Larry Summers (then at the World Bank) initiated a storm of controversy when he wrote the following in a memo:

Just between you and me, shouldn’t the World Bank be encouraging MORE migration of the dirty industries to the LDCs [Least Developed Countries]?

Back then it was an argument about pollution per se and not climate change. But it did give rise to a very interesting paper by Graciela Chichilnisky (American Economic Review, 1994) who demonstrated that differences in the definition and security of property rights between countries could give rise to apparent comparative advantage.

In other words, it may be precisely because some countries have ill-defined pollution rights that they appear to have a comparative advantage in some “dirty” production. In particular, asymmetries in property rights may exacerbate global pollution as the North (with well-defined property rights) overconsumes underpriced resource-intensive products imported from the South (without such property rights). One thing this analysis did is put “consumption” on a par with “production” over dirty goods.

This is of relevance when reading Chapter 14 of the Garnaut final report. This is the chapter that outlines the details of emissions trading and how to deal with the “truly dreadful problem” of trade-exposed industries.

Garnaut frames the problem of one where, if we price emissions properly in Australia, trade-exposed industries will face falls in production well beyond what would occur if international competitors faced similar emissions pricing. He worries that by the time this occurs, Australian producers may never be able to bounce back.

Garnaut’s solution is to pay producers in those industries a subsidy based on the difference between the world price that would arise if everyone dealt with climate change and that which it currently is. In theory, this will lead to our producer’s facing the external conditions that ought to arise as opposed to what they actually are.

This solution is dramatically superior to the one in the Government’s green paper. It proposes to allocate free permits. For instance, if you emit a large volume of greenhouses gases per unit of revenue earned, you will receive 90% of your permit requirements (based on historic output) for free. At least this is what will occur until 2020.

Free permits misread the economics of the situation entirely. Put simply, unless they are non-tradeable, which, let’s face it, would miss the point of emissions trading, those permits are just a handout to those industries. Otherwise, those firms will curtail emissions and over-shoot just as Garnaut forecasts. The end result will be a situation where emissions from Australia have been reduced but emissions globally are virtually unchanged. In other words, we are not helping mitigate climate change at all.

Nonetheless, even the Garnaut solution requires some delicacy. How do you forecast the future price of exports and imports under a global agreement when the whole point of emissions trading was to reveal those prices? In my opinion, it would be better to bite the bullet and, at least for imports, assess the carbon cost of those imports and tax them. This will get the price signals right and also put pressure on trading partners to put in their own emissions trading schemes so as to avoid that tax.