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The Australian Senate Select Committee on Scrutiny of New Taxes has been looking at a number of proposals, including a possible carbon tax.

Frontier (Australia) made a submission to the inquiry into carbon tax pricing mechanisms. The submission evaluates the policy options for introducing emissions pricing in Australia.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

The Australia Energy Regulator (AER) has handed down its final determination in the Victorian electricity distribution price review for 2011-15. The determination sets the revenue that the five electricity distributors in Victoria are able to recover for the provision of electricity distribution services.

Frontier (Australia) advised two distributors, CitiPower and Powercor, on electricity consumption forecasting methodologies, and on the impacts of climate change and energy efficiency policies on energy consumption. Frontier's advice supported their regulatory proposals to the AER for the Price Review.

The Impact Of Delayed Investment In The Power Sector

Some studies and commentary have recently raised the issue of carbon certainty for the electricity sector. The uncertainty regarding whether a carbon price will be introduced in Australia means that investors in the power sector will delay decisions to invest in new baseload capacity. One study (Nelson et al, 2010) provided an estimate of the cost of this uncertainty to LRMC as a proxy for electricity prices. This note provides more detailed analysis of this cost using Frontier’s proprietary electricity market model: WHIRLYGIG. While the theory is correct, the cost involved depends largely on the requirement for new baseload investment, which is an empirical question. Alternative policies to encourage energy efficiency and renewable policies are significantly mitigating the cost of any uncertainty.

THE PROBLEM WITH CARBON UNCERTAINTY

As current policy stands, investors in the power sector are unsure when, or if, a carbon price will be introduced in Australia. This is critical to electricity investment: if a carbon price is introduced then investors will likely favour gas for new baseload capacity; if a carbon price is not introduced then coal will continue to be the most cost effective choice for baseload demand. Given that power sector investments are hugely capital intensive and long term, the potential cost of a wrong decision means that investors will delay investments in baseload capacity until there is policy certainty. Given the long lead time for making decisions about power sector investments (3-5 years) this means that uncertainty over policy will potentially affect the markets for several years: even when investors decide to build, capacity will not be available for several years.

ESTIMATING THE COST OF UNCERTAINTY

The cost of uncertainty is an empirical question and depends on the need for new baseload capacity. The sooner that new baseload capacity is required (and the larger the requirement), the greater the cost of policy delay. The implication of this is that any other policy that reduces the requirement for new baseload generation capacity will reduce the cost of carbon uncertainty.

Nelson et al provides a useful framework for estimating the cost of uncertainty by comparing estimates of long-run marginal cost (LRMC – as a proxy for price) for the following scenarios:

We assume that a carbon price is introduced from 2014 (when policy certainty is provided) and this is included in the LRMC estimates. Nelson does not include a carbon price. Nelson relies on a simple cost model that determines the optimal mix between three options: Coal, CCGT Gas and OCGT Gas according to capacity factors and the load duration curve.

One limitation of the approach in Nelson is that it does not take into account the current stock of capacity. It assumes that the actual investment mix is optimal and does not take into account the current excess in baseload capacity. This approach overstates the requirement for new baseload investment, which overstates the estimated cost of uncertainty.

A second limitation (identified in Nelson as an area for further research) is that it only considers coal, CCGT and OCGT investment options, hence it does not consider the impact of the extended renewable energy target (eRET). Any policy that reduces the requirement for new baseload capacity will reduce the cost of carbon uncertainty. This includes the eRET, since it will drive increased investment in wind and renewables (directly). The intermittent nature of wind will also indirectly shift other investment decisions in favour of complementary peaking gas plant. The renewable growth driven by the eRET will largely meet the growth in demand in the next few years, which will mitigate any cost of carbon uncertainty. Various energy efficiency schemes will have the same effect, as will the Victorian 5% solar target.

Finally, a comparison of LRMC at a point in time will only reflect the impact on consumers at that time. This does not reflect the average cost of the delay (the resource cost). This average cost will be less than the LRMC, which will be driven by the marginal plant. If LRMC increases by more than the average costs, this means that existing generators may benefit from higher prices even though their costs do not increase. Where this occurs, this represents a transfer from consumers to existing generators, which is a cost to consumers but not a deadweight loss.

MODELLING APPROACH

For this note, we replicate the general approach of Nelson but extend it by applying Frontier’s investment model: WHIRLYGIG. This model optimises total generation cost in the electricity market, calculating the least cost mix of existing plant and new plant options to meet load. This model is more complex than the model used in Nelson, as it considers all existing plant (including the current excess of baseload capacity), a broader mix of new investment options (beyond simply coal, CCGT and OCGT), and it includes all other regulatory constraints, including the effects of the eRET. It also allows the option of existing OCGT (peaking plant) temporarily operating at higher capacity factors to meet demand.

MODELLING RESULTS

Nelson estimated that the cost of delay would be an increase in LRMC of $8.60/MWh (13%), or $3.97/MWh (6%) where additional energy efficiency policies were in place.

The more detailed modelling conducted for this note using WHIRLYGIG suggests that the requirement for new baseload investment is much less than suggested in Nelson. In the “Certainty” scenario, New CCGT investment is required from 2015 in some regions. This means that the cost of delay (in terms of the increase in LRMC) is $3.40/MWh in NSW, or 4.1%. This is without taking into account the benefits of energy efficiency measures, which would further reduce this cost. This does not include the Victorian 5% large scale solar target, which would further reduce any cost of uncertainty.

As discussed, this is a point in time estimate, though the LRMC eventually reverts to the same level as the “Certainty” case. A chart of NSW prices is provided in Figure 1.

The actual increase in resource costs (as opposed to LRMC) is closer to 0.3% over the modelling period. This suggests that much of the increase in LRMC is actually a transfer to existing generators as opposed to a resource cost.

Figure 1: LRMC in NSWSource: Frontier Economics

CONCLUSIONS

The theory that carbon policy uncertainty will lead to higher electricity costs is sound, though the degree of cost increase is an empirical question. The modelling above only considers delay policy uncertainty until 2013. Further delays would increase the cost of uncertainty. On the other hand, any policy to reduce the requirement for new baseload – energy efficiency measures or technology specific policies such as the eRET – reduces the cost of uncertainty.

Firstly, there is currently an excess supply of baseload capacity in the NEM, which mitigates the cost of carbon uncertainty. Our detailed modelling reveals that this reduces (or delays) the cost of carbon policy uncertainty.

Secondly, policies to encourage new renewables (eRET), other technology specific policies (the Queensland Gas scheme, NSW GGAS, the Victorian large scale solar target) and various energy efficiency measures will further reduce any cost of carbon price uncertainty.

Finally, the LRMC (as a proxy for electricity price) will rise by more than the actual cost increase. While LRMC provides a measure of cost to consumers, this does not represent the cost of the policy uncertainty since some of the benefit of higher prices would be a transfer to existing generators.DOWNLOAD FULL PUBLICATION

Coordinated Effects In Mergers

The Australian Competition and Consumer Commission (ACCC) has been placing increased emphasis on the possibility of ‘coordinated effects’ as a reason for deciding to oppose mergers between firms. While concerns about mergers resulting in potentially harmful coordinated effects have a solid grounding in economic theory, quantifying them robustly can be difficult. For this reason, assessing coordinated effects will often rely on qualitative assessments. To be credible these assessments need to establish a realistic explanation of the degree of likelihood and damage to competition of the coordinated conduct following a merger.

Coordinated effects involve an increase in market power as a result of joint or accommodating actions of firms following a merger. They imply some anticipation, be it tacit or explicit, of complementary reactions by rival firms that give rise to increased profits for the merged and other firms. These effects can be contrasted to unilateral effects, under which the increase in market power from a merger arises from a firm acting alone without implicit or explicit collusion or cooperation with other firms.

Traditional competition analysis of mergers is directed at determining market definition, market shares and changes in price, quality and output. These analyses are relevant to assessing the potential for both unilateral effects and coordinated effects. However, in assessing coordinated effects, further assumptions and investigations need to be made about firm inter-dependence.

THE THEORY OF COORDINATED EFFECTS

The theoretical underpinnings of coordinated effects are traceable to the economics of tacit collusion (where collusion is based on each firm having expectations about the reactions of others to its behaviour, rather than formally discussed and agreed activities). A well-known paper by George Stigler suggests that tacit collusion is more likely to occur when:

These factors determine what the firm could get out of entering into, or breaking from, a collusive agreement with other firms. In deciding to break from a collusive arrangement, a firm will compare the extra profits it can make from cheating now, with the discounted value of profits given up in future when rivals react.

Under this framework, collusion (and coordinated effects) is more likely when there is:

Coordinated effects are less likely when:

ISSUES OF QUANTIFICATION

Quantification of the effects of a merger can be crucial to guide decision making. However, the traditional oligopoly simulation models of price and quantity competition often used in merger analysis only capture unilateral effects. This is because one of the underlying assumptions of these models is that each firm independently maximises its own profits, rather than the profits of a group of firms or industry as a whole.

In the United States, researchers have recently attempted to estimate the incentives of firms to engage in coordinated conduct by fitting data to a model of differentiated products price competition. This involved quantifying the increase in profits the firms could achieve from collusion, as well as determining the sustainability of collusion, by calculating the payoffs from unilateral deviations from the collusive outcome.§

However, we think there are three major shortcomings with this technique that mean it is likely to overstate the gains from coordinating post-merger. First, it assumes coordination takes the form of a further merger (i.e. perfect collusion) between the merging and selected non-merging firms, which seems unlikely. Second, the model can imply that major coordinated effects result from relatively small gains in market share of a firm simply as a result of unrelated assumptions made about post-merger coordination. Third, the assumption that there is no coordinated conduct pre-merger could mean that more gains from coordination are attributed to the merger than would be the case in practice.

Because of the problems in applying simulation methods, econometric estimation will often be a better way of indicating the extent to which a merger is likely to create problems because of co-ordinated effects. Econometric analysis can capture both unilateral and coordinated effects by estimating the effects on prices of previous mergers as well as the effects on prices of differences in market concentration across regions. Conventionally applied, this analysis will not isolate the separate contribution of coordinated effects. However, this objective might be achieved, at least in part, by isolating input parameters that are associated with coordinated effects, but not unilateral effects. As an example, using a measure of a firm’s level of communication with other firms, such as the number of pricing announcements or trade association meetings attended, it might be possible to isolate coordinated effects.

The difficulty of quantifying coordinated effects is one reason why the analysis of these effects often tends to be more qualitative in nature. This involves making professional judgements, with reference to the theoretical literature and case studies, about conditions that make coordination more or less likely. To be credible, these assessments need to be able to establish a realistic explanation of the degree of likelihood and damage to competition of the coordinated conduct following a merger. This requires being able to assess the relevance of the theory and other evidence to the particular economic conditions of the merger under consideration.

SOME RECENT ACCC DECISIONS

The ACCC’s 2008 Merger Guidelines outline concerns about potential coordinated effects from mergers, and increase the emphasis placed on these effects compared with the previous Guidelines issued in 1999. Further, concerns about coordinated effects have been more prominent in ACCC decisions to block acquisitions in the past 12 months. Two recent decisions were Caltex’s proposed acquisition of Mobil service stations, and Link Market Service’s (Link’s) proposed acquisition of the registry services company Newreg (Registries).

In the Caltex case, the ACCC relied on the greater potential for coordinated effects to reject the merger outright. It took the view that the proposed acquisition would increase the risk of more stable and effective coordinated pricing behaviour in metropolitan markets in the ‘restoration phase’ of the observed weekly retail petrol price cycles. The reasoning was that under counterfactual scenarios where the service station sales sites were to be bought by alternative retailers to Caltex, these retailers were more likely to lag price restorations. This, according to the ACCC, would lead to greater price uncertainty and less possibility of retail price coordination.

In the case of the proposed Link merger with Registries, the ACCC rejected the merger on the basis of concerns about the potential for both coordinated effects and unilateral effects. In relation to the former, it was concerned that the acquisition of Registries by Link would remove a ‘maverick’ firm from the market, which would make the possibility of coordinated conduct between the remaining two registry providers more likely. The ACCC was particularly concerned about increased likelihood of tacit market sharing with only two registry providers, leading to higher prices. In both cases, the ACCC relied entirely on a qualitative assessment of coordinated effects to reach its conclusions.

CONCLUSIONS

Consideration of coordinated effects is gaining importance in merger assessments in Australia. While the economic theory of coordinated effects is quite well developed, the use of robust quantitative techniques for determining the magnitude of these effects can be problematic. Given this, judgements about the importance of coordinated effects will often tend to be more qualitative in nature. These will require careful arguments being made by proponents of mergers and the ACCC using robust theory and other evidence applicable to the conditions of the merger.

Frontier (Australia) has advised a number of firms on coordinated effects in merger cases considered by the ACCC.DOWNLOAD FULL PUBLICATION

The Australian Government's Productivity Commission (PC) has today released its draft report on Rural Research and Development Corporations (RDCs). The report recognizes the strengths of the existing co-financing model for funding rural research and development (R&D). But it also suggests that a significant proportion of public funding has been diverted to support R&D that industry would have financed anyway. This has been to the detriment of R&D with a bigger public good component. Amongst other things, the report has proposed the creation of a government funded RDC focusing on R&D that is socially beneficial but for which private incentives to invest are particularly weak. It also proposed reducing the cap on government funding for industry sponsored RDCs to half its current amount over 10 years.

Frontier’s 2006 report into rural R&D funding and governance arrangements raised concerns as to the alignment of public funding and public benefits under existing arrangements. It has been widely cited by the PC in both the terms of reference for its inquiry and in its draft report.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

Mobile Termination Regulation In New Zealand

The Minister for Communications and Technology in New Zealand has finally accepted a recommendation from the New Zealand Commerce Commission (NZCC) to regulate mobile termination rates (MTRs). This follows two previous decisions to reject NZCC recommendations to regulate these rates.  In this note, we discuss some of the controversy around the latest NZCC inquiry into whether to regulate the service, and consider the likely next steps in New Zealand.  We conclude that the NZCC needs to improve greatly its current approach to benchmarking to estimate credibly the cost of mobile termination in New Zealand. We also consider the implications of the latest New Zealand decision for MTR regulation in Australia.

To all but hard-core mobile telecommunications regulatory enthusiasts, mobile termination is a largely unknown wholesale service that telecommunications companies provide to each other. Whenever someone calls (or texts) you on yourmobile phone in Australia, New Zealand and most countries in Europe, your mobile network operator (MNO) normally does not charge you to receive the call. In these countries, the convention is that the “calling party pays”.

To cover its costs of ensuring you can receive calls and texts on your mobile phone, your MNO usually levies a wholesale charge on the telecommunications carrier of the person who contacts you. This fee is called a termination fee – a fee for putting through (or completing) the call that someone else starts (or originates). While most consumers are unaware these wholesale transactions are occurring, they represent an important source of revenue for mobile operators. While MTRs have been decreasing in most jurisdictions over the last decade or so, they still represent around 10-15 per cent of revenues for MNOs in many jurisdictions.

Regulators throughout Europe and many other parts of the OECD have long been concerned about the impact MTRs have on retail prices paid by consumers for calls made to and from mobile networks. In particular, regulators have been concerned MNOs can have the incentive to raise the price of MTRs above cost, and that this can lead to efficiency concerns.

Many regulators have therefore regulated MTRs so the price of mobile termination more closely reflects their estimates of the cost of providing it. Given the importance of mobile termination revenue to the business models of MNOs, however, regulators have typically allowed MNOs to reduce the price of regulated MTRs over a staged “glide path” of rate reductions.

THE NEW ZEALAND CONTROVERSIES

MTRs have not previously been formally regulated in New Zealand. This is not without controversy, however, as the national regulator – the NZCC – has unsuccessfully twice previously recommended to Ministers of the New Zealand Crown that the service should be subject to regulation. In the first instance, the relevant Minister asked the NZCC to re-consider its decision. In the second instance, the relevant Minister rejected the NZCC’s recommendation and instead accepted voluntary undertakings from Vodafone and Telecom to lower their voice MTRs.

The genesis for the NZCC’s decision to commence a third investigation into whether to regulate MTRs appears to have been the impending entry of a new MNO (2Degrees) into the New Zealand mobile market. The NZCC was concerned that a new mobile entrant may not be able to compete with existing operators who combined above-cost MTRs with discounted prices for so-called “on-net” calls. On-net calls are those made between consumers on the same network (e.g. when a Telecom consumer calls another Telecom consumer).

During an investigation with enough twists and intrigue to match the da Vinci Code, the NZCC initially made a controversial 2:1 split majority recommendation in February 2010 that MTRs should not be formally regulated. Instead, it recommended that voluntary undertakings provided by two mobile operators –which had involved prices falling faster and more quickly than the existing undertakings – should be accepted. However, in a final twist, a decision by one of the operators to launch an on-net pricing proposition in April 2010 seems to have led the NZCC to change its mind, and recommend to the Minister that MTRs should be regulated in preference to the new undertakings. In July 2010, the Minister accepted this recommendation.

THE NZCC WILL NEED TO IMPROVE ITS COST ESTIMATES

Giving the NZCC the power to regulate MTRs is only the first stage in setting prices for this service. The NZCC will next conduct a “standard terms determination (STD)” process to set regulated rates for the service. Based on previous STD processes conducted for other services in New Zealand, this could take anywhere up to a year and will involve a number of rounds of submissions and public hearings.

Developing a reasonable estimate of the cost of providing mobile termination will not, however, be quick or easy. To date, the NZCC has used a “quick and dirty” approach to get a feel for the likely cost of mobile termination in New Zealand. In reaching its view that MTRs were substantially in excess of costs, the NZCC did not seek to estimate directly the cost of providing mobile termination in New Zealand. Instead, it chose to adopt a basic benchmarking technique that:

On the basis of this technique, it concluded in its final recommendation to the Minister that cost-based MTRs are likely to lie within a range of between 5.4 NZ cents per minute (cpm) and 8.3 NZcpm. This compared with the existing undertakings that set MTRs at 14.4 NZcpm.

Now the NZCC is actually going to set MTRs, it will need a more sophisticated approach to estimating the actual costs of providing the service in New Zealand. Experienced cost modellers recognise that the cost of providing mobile termination varies substantially from one country to the next, and depends on a range of factors including network scale and usage, population density and distribution, spectrum allocations etc. Unless the NZCC adjusts overseas estimates to take account of New Zealand specific values for such variables, there can be no confidence that a benchmarking approach will provide a robust estimate of the cost of providing the service.

AUSTRALIA WILL BE WATCHING

The outcomes of processes “across the ditch” are likely to influence the Australian Competition and Consumer Commission’s (ACCC’s) future considerations of appropriate MTRs in Australia. The decision has already been made in Australia to regulate MTRs, and the ACCC has issued pricing principles for voice MTRs that apply until the end of 2011. These set an MTR of 9 Australian cpm. We expect the ACCC will commence a process soon to determine appropriate MTRs for the period after 2011.

We do not believe debates in New Zealand regarding the interplay of termination rates and on-net mobile pricing will be as significant in Australia. This is because there is no suggestion that a new entrant is considering building a mobile network and entering the market in Australia.

We do believe, however, that debate in New Zealand about the actual cost of providing mobile termination will be of relevance to the regulatory discussion in Australia. Evidence collected as part of any detailed benchmarking and modelling conducted by the NZCC throughout the second half of 2010 and early part of 2011 is likely to be of particular interest to the ACCC in 2011 when it starts its deliberations on the future level of MTRs in Australia. Debate in New Zealand may also focus on whether estimates of cost should include a contribution toward the fixed and common costs of running mobile networks. This debate between so-called “TSLRIC” and “TSLRIC+” pricing has become a significant issue in Europe, where the European Commission has suggested pricing for MTRs should not include a contribution towards fixed and common costs. Removal of the fixed and common cost “+” from TSLRIC+ would have a significant impact on cost estimates in both New Zealand and Australia. For instance, the UK regulator (Ofcom) has recently issued a consultation document indicating that MTRs reflecting ‘pure LRIC’ could be significantly lower than MTRs set on the basis of LRIC+. If New Zealand decides to exclude the + from TSLRIC+, this may also lead the ACCC to consider this issue more closely.

CONCLUSION

While New Zealand has come late to regulating MTRs formally, the outcomes of its regulatory processes over the next year may, when combined with events in Europe, have a significant bearing on regulatory events in Australia during 2011. Given the importance of mobile termination payments made between telecommunications carriers in Australia, these debates will be well worth keeping an eye on.DOWNLOAD FULL PUBLICATION

The Minister for Communications and Technology in New Zealand has finally accepted a recommendation from the New Zealand Commerce Commission (NZCC) to regulate mobile termination rates (MTRs). This follows two previous decisions to reject NZCC recommendations to regulate these rates.

Frontier (Australia)’s latest bulletin discusses some of the controversy around the latest NZCC inquiry into whether to regulate the service, and consider the likely next steps in New Zealand.  It concludes that the NZCC needs to improve greatly its current approach to benchmarking to estimate credibly the cost of mobile termination in New Zealand. The bulletin also considers the implications of the latest New Zealand decision for MTR regulation in Australia.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

Using Economics To Adapt To Climate Change

Adaptation in climate policy is about reducing the harm, or seizing the opportunities, caused by climate change. Unlike mitigation, which focuses on the reduction of greenhouse emissions, economists have been much slower to focus on adaptation. But adaptation is critical. Economists can help by doing three things: focusing on policy reforms as well as projects; dealing with uncertainty; and preventing unintended consequences.

The “Sea Change” is a very Australian phenomenon. It reflects the desire to swap city living for the coast. But, as more people move towards the sea, the sea is also threatening to move in. Anthropogenic global warming is projected to raise sea levels anywhere between 0.18 and 0.59 metres by the end of the century. Managing the impact of these projected changes falls under the heading of climate change adaptation. Examples include ski resorts that rely more and more on artificial snow, and drawing more on irrigation for agriculture. Adaptation also includes the ability to take advantage of new opportunities resulting from climate change, such as altering crops.

Adaptation is the “other” plank of climate policy, along with mitigation (policies to actually reduce emissions). Adaptation is critical because many of the medium term impacts of climate change are already locked-in as a consequence of the existing stock of greenhouse gas emissions; and significant long-term climate change impacts are still predicted.

To date economists have been more interested in the economics of mitigation than adaptation. This is partly because mitigation has the glamour of international treaties and negotiations attached to it. But it is also because the core issues in mitigation – setting a price on something (emissions) and creating markets – is the sort of challenge economists relish. By contrast, adaptation is a much more diffuse subject, dependent on myriad sector-specific and local issues.

This relative neglect is a pity. Economics has much to contribute to adaptation policy. It helps to identify when government policies and leadership in investing in adaptation are needed to make society as a whole better off, and when governments should focus on facilitating adaptation activities undertaken by private economic actors (firm, and businesses). Are economists up to the challenge of climate change adaptation? That depends on their ability to handle three sets of problems.

POLICY BEFORE PROJECTS

When economists have thought about adaptation, they have tended to do so in the same way as they think when choosing between, say, alternative construction projects. This reliance on project appraisal paradigms has led to two biases.

One assumes a centralised decision maker – usually the state –has to decide between alternative projects, when in reality adaptation efforts are driven by many agents, private and public. Individuals and businesses have inherent incentives to adapt because their livelihoods and assets will be affected by climate change. Farmers have a long track record of adapting to variability in, and changes to, climatic trends. The key issue is to understand whether, left to their own devices, agents will adapt in a way that is not just of private benefit to them, but also in the interests of society at large and to develop pro-adaptation policies where this is not the case.

This leads to the second bias, which is a focus on “hard” infrastructure projects over policy reforms. This might reflect that much of the thinking about adaptation has been done by the development cooperation community where haggling over dollars is the norm. Physical projects are by nature easier to see, cost and measure outputs from than are reforms to markets, prices and property rights.

Yet precisely because agents adapt out of self interest, these “soft” aspects of reform can do much to deliver optimal levels of adaptation efforts. For example, irrigation offers a way for farmers to adapt to reduced rainfall. But if water resources are mispriced and over allocated to farmers relative to the needs of ecosystems, then increased irrigation can exacerbate the costs of environmental degradation due to a drier climate. If the true scarcity value of water resources is not reflected in the price of water, adaptation techniques based on irrigation might well constitute “mal-adaptation” from a the point of view of society as a whole.

Pricing water properly benefits society regardless of future rainfall levels, and is beneficial should water scarcity increase. Economists refer to these as “no-regrets” options. Trade policy provides another example of this. Climate change will affect the relative suitability of different regions for particular types of crops: cereal and rice yields are projected to increase in mid to high latitudes relative to lower ones. Freeing up trade can help to manage the food scarcity concerns in adversely affected regions, and send the right price signals to producers in areas that become more suited to particular types of cropping. Moreover, it should discourage the pursuit of inappropriate adaptation in regions which are no longer at a comparative advantage when it comes to these types of agriculture.

DEALING WITH KNOWN UNKNOWNS

Climate change policy operates in a context of pervasive uncertainty. The ranges of values for key variables (such as surface temperature, rainfall or sea-level rise) that drop out of climatic modelling are large and often open-ended. The same applies to projected damages that flow from changes to climatic variables as it is difficult to assign probabilities to future scenarios (as distinct from risk, which involves known variability around a mean). In short, policy must, to quote Donald Rumsfeld, deal with “known unknowns”.

Uncertainty complicates the economics of adaptation, but does not make it intractable. After all, many economic decisions involve some degree of uncertainty. When faced with uncertainty it is essential to understand the value of “real options” that are embedded in a policy or set of decisions. A real option is the flexibility to adapt strategy or policy as new information comes to light. In an uncertain environment a policy that allows for future flexibility is better than a policy that does not.

Consider the case of policy targeted at managing the threat of damage and loss due to sea level rises and storm surges. One solution has been to restrict coastal developments, while an alternative could be to acquire land and set foundations for levees, which can then be built upon as more information about possible damage to coastal development becomes available.

Using standard cost benefit analysis based on discounted rates of return, the first option may initially be less expensive, but can impose substantial costs in development opportunities foregone if the flooding risk turns out to be overstated. On the other hand, the more capital intensive approach, which might have been ruled out under standard approaches, could prove to be more valuable because of the flexibility embedded in it.

HAZARDS, HUMAN AND NATURAL

Climatic uncertainty is not the only sort of uncertainty policy makers have to worry about. The ways in which individuals and businesses respond to policies are also unpredictable – and they may respond in ways that can have unintended consequences.

Consider coastal management again. A policy based on constructing levees can lead people to believe that they will be insulated from flood risks. This can cause more intensive use of the flood prone land than would have otherwise been the case, in turn increasing the possible damage associated with a catastrophic flooding event in which the levees fail. Risk taking behaviour that defeats the intended purpose of policy is an example of “moral hazard”. This problem may be further exacerbated if governments cannot pre-commit against providing ex-post disaster compensation to those affected. This perverse outcome is reflected in the experience of flood policy in Australia in the 1970’s and 1980s, where there has arguably been less than optimal private investment in flood mitigation as flood victims have been generously dealt with by governments.

The example is also a further illustration of why it is dangerous to consider “hard” adaptation solutions in isolation from “soft” ones. Hard solutions are often only partial and can have unintended consequences; soft solutions can re-align behavioural responses to reduce impacts. In our coastal example, one solution would be a policy to recover the costs of levee construction from inhabitants of the affected area, for example in proportion to the value of their assets at risk. This can curtail reduce the amount of investment that takes place, and reduce the escalation in damages that goes with it. The main challenge for economists lies in modelling behavioural responses – intended and unintended – that flow from the pattern of incentives embedded in policy and in institutional expectations. This requires taking into account limits on the rationality of economic agents, as well as the role of unwritten expectations.

SINK OR SWIM

As with society at large, economists need to adapt to the consequences of climate change. Adaptation will become more politically important as climate change manifests. As it becomes more politicised there is a danger policy will run ahead unchecked by sound economic thinking. In particular, there will be incentives for certain constituencies to ensure that adaptation efforts are geared towards the status quo for them, even if this status quo is not in the general interest.

You might say that climate change throws an uncompromising spotlight on existing policy and market distortions. As we saw in our discussions on water pricing and trade policy, a refusal to address distortions becomes even more costly in the presence of climate change. By contrast, the rewards from addressing distortions are even greater when climate change occurs.

In engaging more deeply with adaptation issues, economists can draw on a particularly rich and varied toolkit to address decision making under uncertainty and incomplete information to cut to the core of the key challenges posed by climate change impacts.DOWNLOAD FULL PUBLICATION

The Australian Sports Commission (ASC) held its biennial conference, Our Sporting Futures, on 29 and 30 July 2010. At this event, Brian Parmenter, who leads the Economy-wide modelling team at Frontier (Australia), presented the results of a study into the economic contribution of sport to Australia. The study identified three main ways in which sport delivers benefits to the economy, above those gained directly by providers of sport services or by participants.

The study was commissioned by ASC and undertaken by Frontier.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

The Australian Competition Tribunal announced on 1 July 2010 that it would declare access to two privately-owned railway lines carrying iron ore from the Pilbara region in Western Australia to the coast for export.

Fortescue Metals Group Ltd (FMG) seeks access to railway lines operated by BHP Billiton (BHPB) and Rio Tinto Iron Ore (RTIO). The first step in seeking access is to have the lines declared. BHPB and RTIO vigorously opposed the applications for declaration. The Tribunal decided to declare the Goldsworthy Line (BHPB) and the Robe Line (RTIO); but it decided not to declare the Mt Newman Line (BHPB) and the Hamersley Line (RTIO). The tribunal decided that the risks of access were greater for the two lines not declared.

Frontier (Australia) advises RTIO.

For more information, please contact Marita O’Keeffe at m.okeeffe@frontier-economics.com.au or call on +61 (0)3 9620 4488.

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