The proposed Australian Carbon Pollution Reduction Scheme is a policy that seeks to reduce greenhouse gas emissions by introducing a price on carbon. Possible policies for carbon pricing include cap and trade schemes, carbon taxes, and hybrid approaches. Cap and trade schemes involve setting the quantity of emissions, with this quantity and the market determining the carbon price; carbon taxes involve setting the carbon price directly, with the market determining the amount of emissions. Hybrid approaches can usually be thought of as cap and trade schemes but where there is either a minimum price – a price floor, a maximum price – a price ceiling, or both.

The CPRS is a cap and trade scheme, but there is a transitional ceiling on the carbon price (Section 89 of the Exposure Draft Legislation). This ceiling will be phased out by 2015. While this ceiling exists, the emissions cap can always be exceeded by firms buying permits that are at the value of the price ceiling. To this extent the CPRS has similarities to a carbon tax.

One of the main arguments in favour of cap-and-trade is that international negotiations are based on a “target-and-timetables” approach. Emissions trading (on a national scale) has the advantage that there is much more certainty that a given target will be reached. This increases the credibility of targets under international negotiations, more so than a carbon tax.

There are other advantages to a carbon tax. If the cost of mitigation is lower than expected, then there will be more mitigation with a carbon tax. There will be no limit to the amount of low cost mitigation that occurs. Under a carbon tax, voluntary measures that reduce emissions will add to Australia’s total emissions reductions.

A emissions trading scheme with a price floor has many of the advantages of a carbon tax and many of the advantages of a cap and trade scheme.

There are two ways that the CPRS legislation could be modified so that a price floor is introduced:

  1. The price floor can be maintained by having firms pay an extra fee when they surrender their permits, based on the amount of their emissions. The carbon price then becomes equal to the sum of the permit price and the extra fee. This could be achieved by altering Section 129 of the Exposure Draft Legislation.
  2. The price floor could be maintained by having a reserve price when permits are auctioned. This could be achieved by altering Section 103 of the Exposure Draft Legislation.

The approaches to introducing a price floor above are different to what was discussed in the Garnaut Review. The Garnaut Review considered and rejected a mechanism for introducing a price floor by having the government buy back permits. The Garnaut Review did not consider the approaches examined above.

If a price floor was introduced, changes may also be needed to be made to the legislation with regard to international trading of permits. If a price floor was introduced, what price should it be set at? There are two possible approaches to this:

  1. One approach would be to set it so that it is relatively low, but is high enough to mean that the amount of low cost emissions reductions is not limited, and high enough to provide some certainty to investors in low emission technologies. Under this approach, the emissions cap would be expected to be the main policy that drives emissions reductions.
  2. Another approach would be to have a significantly higher price floor, that is close to the social cost of carbon. Under this approach, the price floor is likely to be what drives emissions reductions. Under this approach the main role of the emissions cap is to provide certainty that a given target will be achieved, and add credibility to international negotiations.

If the role of the floor price was merely to provide insurance against the carbon price being exceptionally low (as was the case in the EU ETS during 2006 and 2007), it would not be necessary – there are better mechanisms from preventing this, such as banking, and making sure that there is scarcity when setting the cap. The idea of setting the floor price to be equal to the social cost of carbon is that the floor price has just as important a role as the permit price in driving emission reductions. There is a good chance that the slope of the marginal cost function of mitigation is higher than the slope of the marginal benefit function over short time scales, which suggests that the floor price will be a better driver of emission reductions.

Another issue with carbon pricing is how much should the price floor increase each year? An appropriate choice may be to have the price indexed by a discount rate of 4%, which is the discount rate used in Treasury modeling.

For more on why we need a price floor, see also:

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