April 2009

The scientific journal Nature has released a special issue on climate change – The Coming Climate Crunch. It has a good editorial, and some important papers. According to the editorial:

Nations urgently need to cut their output of carbon dioxide. The difficulty of that task is manifest: emissions have continued to rise despite almost two decades of rhetoric, diplomacy and action on the matter. But that unhappy fact should not be taken as a licence for fatalism. Governments have a wide range of pollution-cutting tools at their command, most notably tradable permit regimes, taxes on fuels, regulations on power generation and energy efficiency, and subsidies for renewable energy and improved technologies. These tools can work if applied seriously — so citizens around the world must demand that seriousness from their leaders, both within their individual nations and in the international framework that will be discussed at the United Nations Climate Change Conference in Copenhagen this December.

There is also a good blog post at RealClimate about the issue, which states:

At the heart of it are the two papers which calculate the odds of exceeding a predefined threshold of 2°C as a function of CO2 emissions. Both find that the most directly relevant quantity is the total amount of CO2 ultimately released, rather than a target atmospheric CO2 concentration or emission rate.

My submission to the Senate Select Committee on Climate Policy is here. Here is the abstract:

This submission is on the Australian Government’s Exposure Draft Legislation for the implementation the Carbon Pollution Reduction Scheme (CPRS), and Australia’s climate policy in general.

This submission is primarily concerned with two issues. Firstly we shall look at the issue of achieving international cooperation to reduce greenhouse gas emissions. We shall examine how this relates to the targets in the CPRS, and the approach for choosing targets, based on “scheme caps and gateways”. This relates to items (1) (c) and (1) (d) of the terms of reference.

Secondly we examine the issue of what is the best instrument for a carbon price signal. We conclude that an emission trading scheme with a “price floor” is the most appropriate policy for Australia. This relates to items (1) (a) and (1) (d) of the terms of reference.

Summary of Recommendations

We have two key recommendations.

  1. To not set a lower bound for Australia’s emissions after 2015. We therefore recommend the removal of paragraphs 2(b) and 3(b) from Section 15 of the Exposure Draft Legislation.
  2. To introduce a floor in the carbon price. The price floor could be implemented by either altering Section 129 of the Exposure Draft Legislation, or by altering Section 103 of the Exposure Draft Legislation.

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: