Decision making under uncertainty

Last night I attended the Minerals Council of Australia Annual Dinner. 

Prime Minister Gillard spoke – and she said something I agreed with.  The business leaders in the room, she observed, spent much of their time dealing with risk and uncertainty.  So too must national leaders.  The problem of climate change is a classic example of leaders needing to deal with risk and uncertainty.

The fact is that there is plenty of uncertainty facing policy makers in Australia – and around the world – about climate change and how to respond.  Let’s consider some of those uncertainties – and their cumulative impact.

The first link in the chain of logic is uncontroversial: the relationship between the concentration of greenhouse gases in the atmosphere and the average temperature.  If we did not have an atmosphere containing greenhouse gases such as carbon dioxide and methane, the earth’s temperature would be many degrees lower than it actually is.  This is because the sun’s rays would hit the earth – but there would be nothing to stop the thermal energy radiating back out to space.

The next link is well established too: the concentration of greenhouse gases is rising.  In the nineteenth century it stood at around 270 parts per million; most recently it is in the high three hundreds.

Less certain, though, is the linkage between the rising concentration and rising average temperature.  Some people question whether there is any linkage at all. This is a scientific question, the answer to which is best determined by recourse to rigorous analysis of the data.  Policymakers must seek expert advice on this question.  The scientific consensus is that there is a linkage, and in my view this is the best and most sensible conclusion for policymakers to draw.  But I do not think it is right to say that it is certain that global average temperatures will rise as a result of rising greenhouse gas concentrations; it is better described as a high to very high likelihood. 

The existence of a causal relationship (with a high degree of likelihood) is one thing; the exact quantitative relationship between these two parameters is a different thing.  That is, assuming a given increase in the concentration of greenhouse gases, what is the specific increase in the earth’s average temperature which will follow?  There is no agreed point figure: the best advice is that there is a range of possible outcomes. According to the most recent report of the Intergovernmental Panel on Climate Change, the range of expected temperature increases from 1990 to 2100 is 1.4 degrees Celsius to 5.8 degrees Celsius.

This is a challenge for policy makers, because the extent of policy action that might be justified to head off an almost 6 degree increase in average temperature is very different to the extent that would be justified to head off a 1.4 degree increase. 

There is another area of uncertainty which is even more important for policymakers in a small, resource dependent economy like Australia.  As is widely acknowledged by all participants in the policy debate, a policy objective of reducing greenhouse gas emissions with a view to stabilising the concentration of greenhouse gases in the atmosphere can only be achieved through co-ordinated global action.  If Australia reduces its emissions, and the rest of the world does not, Australia’s efforts will be in vain.  Conversely, if any given country decides to take no action, and the rest of the world does take action, the country which does nothing will enjoy the benefits (but none of the costs) of the reduction in greenhouse gases. (This is what economists call being a ‘free rider.’)

This I believe is the most profound and serious uncertainty of all facing Australian policy makers.  The wrong policy settings could gravely damage Australia’s economic fortunes – and do so to a much greater extent than similar settings in other nations, given that our economy is much more dependent on the high-carbon emitting activities of our resources industry than are many other economies.  So the costs could be higher for us than other nations; at the same time we know that the benefits of action are uncertain because action by Australia is only of benefit if all (or at least most) other nations similarly take action to restrict emissions of greenhouse gases.

Both major parties have put forward detailed policies seeking to deal with this problem of how to respond to a risk of uncertain magnitude, and using a policy instrument which is also uncertain in both its effectiveness and in its undesirable side effects.  I can’t help noting in passing that the difference between us is that the Liberal Party took its Direct Action Plan to the 2010 election, whereas Labor took no detailed policy on climate change to the 2010 election. 

But putting aside that brief partisan political observation, it is worth pointing out that both parties are committed to achieving a reduction in Australian greenhouse gas emissions, such that by 2020 our total emissions are 5 per cent  lower than they were in 2000.  To put some numbers around that, in 2000 Australia emitted approximately 550 million tonnes of greenhouse gases, meaning that by 2020 we need to reduce our emissions to around 530 million tonnes.  To appreciate how demanding a target this is, in the absence of any changes in policy it is anticipated that by 2020 total Australian emissions would be 690 million tonnes: in other words, the 2020 target is a 23% reduction on the levels we would otherwise expect to reach. 

The Liberal Party’s Direct Action Plan uses a different tool than Labor to reach this goal: abatement purchasing, under which there are on-budget expenditures made to secure reductions in emissions from major emitters.  Some have criticised this as likely to expose the public purse to ever growing expenditures as the years go on.  In my view, that is an ill-judged criticism, which overlooks the fundamental point that our policy seeks to maximise Australia’s flexibility in dealing with this risk which is of uncertain magnitude.  We have specifically not committed ourselves as to our approach post 2020 – because in dealing with a challenge of uncertain dimension it is critical to preserve flexibility.  But it is also critical to have a credible policy to meet the 2020 target – so that if the threat proves by that point to be larger and more certain than it presently appears, we are positioned to take further action.  Conversely, if the threat proves to be less menacing by that point than today’s worst case scenarios suggest, we will again retain flexibility to respond accordingly.

There is disagreement between the two major parties about the right policy tool to use in response to the uncertain threat of global warming.  But there is agreement on the target; and agreement on the fact that the nature and extent of the risk is not known with precision. That, I believe, is an important basis for the specific policy design we in the Coalition have put forward to deal with this challenge.