Carbon Price Signals


The multi-party climate change committee has announced more details about carbon pricing in Australia. The approach is to have an initial fixed-price, and then to later transition to an emissions trading scheme. This is more-or-less the approach that I described in January 2010 here. A big advantage of the fixed-price approach is that there will be information about the effect of a carbon price on the economy and Australia’s emissions before Australia’s target is set.

Recent government projections suggest that Australia would need to reduce greenhouse gas emissions by  160 million tonnes of greenhouse gases per year by 2020 to reduce emissions to 5 percent less than 1990 levels, and by 270 million tonnes of greenhouse gases per year to reduce emissions to 25 percent less than 1990 levels. There is no politically feasible way to do this without a price on greenhouse gas emissions.

A carbon price works because if emission reductions are cheaper, there is an opportunity to make money from reducing emissions. It becomes like picking up a $100 bill from the ground. Now markets don’t work perfectly, and I might not pick up some of those bills (for example, due to an informational failure, I might not see some of them) but I’ll try hard to pick up as many as I can. Without a carbon price, this incentive is not there.

One argument used against carbon pricing is that it will increase the price of petrol or electricity, which is unpopular. But money raised from a carbon price can go back to households, and this is exactly what is planned. Petrol and electricity from fossil fuels will cost more, which will provide an incentive to use less, but we will get more than that back through paying less taxes, or through cheques in the mail. And we will get these cheques in the mail regardless of how much petrol or electricity we use, so the incentive to reduce emissions will remain.

Polluting industries will argue for assistance, and will have an incentive to exaggerate costs from a carbon price in order to bolster their case for assistance. But every dollar spent on assistance to industries will be one less dollar available for assistance to households. This is something that voters need to consider when greenhouse gas emitters make the case for assistance.

There is a string case for not all carbon price revenue to go to industry and households. Greenhouse gas emissions are an international problem, and carbon price revenue could be used to fund cost-effective emission reductions overseas and adaptation to the impacts of climate change. Technology advances could lower the cost of emission reductions, so there is a case for some carbon price revenue to be used for funding research and development. And the carbon price does not address emissions from agriculture, and probably not from land use, so there is a case for some of the money raised to provide incentives to sequester carbon in ecosystems.

Some key details:

  • The scheme would commence with a fixed-price in July 2012, this fixed price would increase by a fixed percentage each year.
  • After three to five years, the scheme would transition to a flexible price emissions trading scheme. The agreement does not specify any details about whether the emissions trading scheme would have measures such as price floors, price ceilings, or allowance reserves.
  • At least 12 months before the end of the fixed price phase, there would either be a decision on a 2020 target, or a decision to extend the fixed price phase. Issues that could be considered when deciding whether to extend the fixed price phase include: the state of the international carbon market; international developments in carbon pricing; Australia’s internationally agreed targets and progress towards meeting them, including whether they have been incorporated into a binding legal agreement; the fiscal implications of any on-budget purchases of internationally allowances that may be required to comply with any international emissions target; potential impacts on the Australian economy; and implications for investment certainty.
  • The scheme would cover emissions from energy, transport, industrial processes, fugitive emissions (methane leaking from things such as coal mines), and emissions from non-legacy waste (methane leaking from landfills). Agriculture would not be covered and sources covered under the proposed Carbon Farming Initiative would also not be covered.
  • The communiqué notes that “Options to provide economic value to activities which store or reduce carbon in the land sector could potentially include the use of Kyoto-compliant credits in the carbon price mechanism or alternative funding arrangements for the land sector.”
  • During the fixed price phase, international offsets will not be able to be used for compliance (although international allowances could potentially be purchased by the Australian government). During the flexible-price phase offsets could be used, with criteria concern quality and any other restrictions yet to be determined.
  • Many other matters, such as what to do with carbon price revenue, are still to be determined.
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The details are below. The proposal is for an initial fixed price transitioning to an emissions trading scheme. I’ll write some analysis on this later.

Carbon price agmt release 240211

MPCCC Carbon Price Mechanism Final

Update: More analysis here.

The journal Energy Policy has recently published a paper by my colleague Frank Jotzo and myself:

Wood, P.J., Jotzo, F., Price floors for emissions trading. Energy Policy (2011), doi:10.1016/j.enpol.2011.01.004

The paper (as well as this blog) proposes that one way that a price floor could be implemented is for emitters to pay an additional fee or tax per tonne of emissions. The carbon price is then equal to the sum of the ETS permit price and the extra fee. The UK government has proposed to introduce a carbon price floor via this approach, and has been engaging in consultations. The proposal is the reform the Climate Change Levy so that it functions like a carbon tax. Because the UK is part of the EU ETS, firms would also pay for EU permits, and so the effective UK carbon price will be equal to the sum of the Climate Change Levy and the EU ETS permit price.

The discussion paper includes three different “illustrative carbon price scenarios” of £20/tCO2, £30/tCO2 and £40/tCO2 which is somewhat more ambitious than likely to be proposed for the carbon price in Australia, or the price floor that was proposed in the Waxman-Markey Bill.

Because most EU emissions are determined by the EU ETS, the direct effect on global emissions is likely to be minimal. Emissions in the EU are determined by the cap. If the whole EU ETS had a price floor, and the floor price was met, then that would reduce total EU emissions; but when a single country has a price floor, overall emissions are unchanged. For this reason Climate Strategies has made the important point that the UK should embed its policy in a strategy to strengthen EU emission reduction targets.

What the UK proposal does do is provide ‘learning-by-doing’ on carbon pricing, which provides valuable information to other jurisdictions that may consider a carbon price. A UK price floor proposal is consistent with a polycentric approach to climate change. It also provides much more certainty about the carbon price for investors in emission reductions. By eliminating the risk that the carbon price will go below a particular level, the cost of investing in emission reductions is significantly less.

The UK proposal has attracted a storm of controversy. It will mean that polluters will have to pay more, and steel-makers have already started to complain. This is to be expected – if firms can shape government policy to reduce their costs, then their investment in shaping policy could have a huge payoff. This is why rent-seeking is such a big issue in climate policy.

What was less expected was the opposition from two environment groups: the WWF and Greenpeace (presumably the UK branches of these organisations). They have claimed in a media release that because a price floor will raise electricity prices, and nuclear generators do not have significant emissions, their profits will increase, which will make a “mockery of the Coalition government’s stated opposition to any form of public subsidy for nuclear” and “this is yet another taxpayer handout to a failing nuclear industry.”

Any carbon price will increase the profitability of nuclear energy, just like it will increase the profitability of renewable energy or energy-efficiency. A carbon price is technology neutral and the claim that it is a subsidy or taxpayer handout for the nuclear industry in completely ridiculous. This proposal is good policy and the WWF and Greenpeace should be supporting it rather than attacking it.

For more on price floors, see http://climatedilemma.com/2008/07/19/making-the-polluter-pay-prices-quantities-or-both/

Much of the debate on carbon pricing mechanisms is on whether to go with a carbon tax (a price based approach), or with cap-and-trade (a quantity based approach). It should not be forgotten than any carbon pricing instrument is far better than having no carbon price at all. Often debates on carbon pricing instruments ignore various hybrid approaches that incorporate mechanisms such as price ceilings (a maximum carbon price), price floors (a minimum carbon price), and allowance reserves – which we will discuss here in more detail. It is disappointing that hybrid approaches sometimes get ignored, because the economics of uncertainty suggests that these approaches are superior in the sense of having the lowest expected costs. But governments may have other policy objectives than minimising costs in the presence of uncertainty, and hybrid approaches can be useful for these as well. Because of this, hybrid approaches to carbon pricing could lead to the consensus required to introduce a carbon price into Australia.

An allowance reserve is a little bit like a price ceiling. When an emissions trading scheme has a price ceiling, the government makes a commitment to sell an unlimited amount of extra permits at the ceiling price. With an allowance reserve, there are two differences: the amount of extra permits is limited; instead of selling them at a fixed ‘ceiling’ price, they are auctioned at a reserve price. An allowance reserve provides some price stability, but unlike a price ceiling, the total amount of emissions is also capped.

In Australia, a proposed emissions trading scheme (the Carbon Pollution Reduction Scheme or CPRS) failed to pass through parliament because the Liberal Party got taken over by deniers of climate change; but also failed to get the support of the Greens because the targets were too weak, and there were concerns that it risks ‘locking in’ weak targets. An issue with the CPRS is that it would have risked locking in a weak target range for too long – maybe 5-10 years but possibly longer. But there was some sort of administrative review mechanism in around 2013 or 2014, and including some sort of review mechanism is a useful part of any solution. But the main way to get a carbon price to work effectively is through having it send a strong long term price signal to investors in long-lived assets such as buildings and power plants. This is why there is resistance to setting targets for a shorter period of time.Since the August 2010 election, the support of the Greens will be required to introduce a carbon price. The two most difficult issues are the targets themselves, and what to do about the process for setting targets.

In January 2010, the Greens proposed an interim carbon tax for Australia. The idea being to introduce a carbon tax (or fixed-price ETS) and transition to an ETS with targets decided at a later date. But when the interim target is in place, how do you provide a long-term carbon price signal? This is important because assets such as power stations and buildings are very long-lived, so the future carbon price is what drives investment decisions. A solution is that after transitioning to an ETS with a cap on emissions, it should maintain a price floor. If the price floor is the same as the level of the carbon tax, and it steadily increases by some percentage above the rate of inflation, there will still be a strong long term price signal.

Introducing a fixed price beforehand will help, but there is no doubt that the issue of targets will be difficult even if a interim fixed price is introduced. One approach that could make this less difficult is to use an allowance reserve.  Consider the following approach: the amount of ‘normal’ permits (which are auctioned with a reserve price that is the same as the floor price, e.g. $20) adds up to enough emissions for a 25 percent reduction by 2020. But there is an allowance reserve auctioned at a reserve price of $40, and if all of them are auctioned that adds up to a 5 percent reduction by 2020. The Greens are happy, because if the carbon price is $40 or less, emissions will be less that the weak 5 percent target; and if the carbon price is less than $20, emissions will be less than 25 percent below 2020. The Government is happy, because they get to keep their targets, but gain some environmental credibility. Investors are happy, because they have long-term information about the carbon price.

If you wanted, you could have more than one allowance reserve. For example, you could have normal permits that add up to a 40 percent reduction; Allowance Reserve 1, that is priced higher than the normal permits and goes up to a 25 percent reduction; and Allowance Reserve 2, that has an even higher reserve price, and takes you up to a 5 percent reduction.

By going beyond the “carbon tax vs ETS” paradigm and thinking creatively, it may be possible to forge enough of a consensus to introduce a carbon price to Australia. Hybrid approaches to carbon pricing not only are advantageous in terms of the economics of uncertainty; they also provide us with new approaches for dealing with political realities.

An earlier version of this post appeared as a comment responding to Tim Hollo’s blog post ‘Is an ETS automatically more ambitious than a tax?’ at Crikey’s Rooted blog.

The absence of a comprehensive legally binding global deal has sometimes been used as an excuse for lack of policy action. Australia’s conservative opposition leader Tony Abbott claimed that the outcome at Copenhagen “vindicated his party’s decision not to support the Federal Government’s emissions trading scheme legislation”; the absence of an international deal was also an excuse when Australia’s former Prime Minister Kevin Rudd abandoned a proposed emissions trading scheme. But how much does slow international progress really matter?

In a report for the World Bank and a journal article, political scientist and Nobel Economics Prize winner Elinor Ostrom has argued that we should not wait for a ‘global solution’ to emerge from international negotiations before acting on climate change. Instead, action on climate change should occur at all scales. These include individual, community, municipal, regional, and national scales as well as the international scale.

Ostrom argues for a polycentric approach for several reasons:

  1. There is evidence that people are more likely to be cooperative than predicted by conventional game theory. People are in particular more likely to be cooperative when they trust each other to be reciprocators. For this reason, it is possible to have cooperative action without negotiating a ‘global solution’.
  2. Action on climate change can also lead to positive externalities such as clean air. Clean air is particularly relevant to China, where air pollution is a major problem.
  3. At any scale, policies may encounter errors, but without trial and error, learning cannot occur. A polycentric approach facilitates learning at multiple scales.

What implications does this have for critical areas of climate policy, such as technology and carbon pricing? Policies such as research and development, as well as investment in renewable energy, all help to drive down mitigation costs. Like clean air, this is a positive externality that we need more of.

Two major issues when trying to negotiate an international climate agreement are participation and compliance. This is one reason why legally binding agreements are desirable, but designing a treaty to maximize participation and compliance is difficult. When a country makes a commitment to reduce its emissions, how do we know it will meet this commitment? Action at multiple scales means that meeting such a commitment is much more likely. If a country introduces an emissions trading scheme, it will then be highly likely that it meets the target specified by the scheme. But in the United States, the national government did not successfully pass legislation. Fortunately there are regional measures in the United States that are reducing emissions: the Regional Greenhouse Gas Initiative is an emissions trading scheme that operates in ten states; eleven states and provinces in the US and Canada are developing the Western Climate Initiative; and seven states and provinces in the US and Canada are developing the Midwestern Greenhouse Gas Accord. These approaches make it easier for the United States to argue that it will reduce emissions by 17 percent by 2020.

Because domestic policies and measures add credibility to countries’ targets, a climate agreement with a mechanism for countries to list their policies and measures as well as targets is more likely to be successful. The Copenhagen Accord had annexes for developed countries to specify their targets and developing countries to specify policies and measures. It would make sense for climate agreements to have developed countries specify policies and measures as well.

The good news is that action on climate change is occurring at multiple scales. If Ostrom is right, there are reasons to be optimistic about the prospects for long-term cooperation. But there still are advantages to more agreement at an international level, including less excuses for inaction from politicians.

Some sections of Australia’s business community (as well as the Abbott opposition) are concerned that we should not go ahead of the rest of the world on a carbon price. This ignores the fact that much of the rest of the world is already moving ahead of Australia on both carbon pricing in particular, and climate change mitigation more generally.

The Australian Financial Review (unfortunately paywalled) reported on Thursday September 16 that a number of CEOs have made the above argument. These include QBE Insurance CEO Frank O’Halloran who said “we ought to be patient and go with the other major developed countries around the world and not try to be the first cab off the rank”; Coca-Cola Amatil CEO Terry Davis who said “I don’t think we should lead the world”. The Australian Chamber of Commerce and Industry has claimed that “unilaterally imposing an emissions trading scheme has low business support”. Tony Abbott, who once said that climate change was “crap”, recently said that “a go-it-alone carbon tax in Australia would be an act of economic self-harm”.

One CEO who does not share this opinion is BHP CEO Marius Kloppers who has called for a carbon price to be introduced in Australia. The speech where Kloppers said this can be downloaded here (pdf). We will know whether Kloppers is serious when we find out whether Minerals Council CEO Mitch Hooke continues his scaremongering about a carbon price or not.

I will list below some of the climate action around the world that makes it impossible for Australia to “go-it-alone” on carbon pricing. The most comprehensive carbon pricing is in the EU ETS, where a carbon price partially contributed to emissions covered by the EU ETS falling by 11 percent in 2009.

Japan is presently drafting plans for an emissions trading scheme to come into effect from 2013. It will cover emissions from large emitters, include provisions for domestic and international offsets, and compensation for trade exposed industries. Japan already has a voluntary ETS in operation, and a mandatory ETS covering Tokyo.

South Korea, which does have commitments under the Kyoto Protocol, is also planning on introducing an ETS. Korea has already passed a ‘Basic Law on Low-carbon and Green Growth’, which mandates a cap on emissions. It is planning to pass further legislation to make this cap operational.

Although the United States has not yet passed national legislation, state-based approaches to carbon pricing are expanding. The Regional Greenhouse Gas Initiative is operating in ten states; eleven states in the US and Canada are developing the Western Climate Initiative and seven states in the US and Canada are developing the Midwestern Greenhouse Gas Accord. New Zealand now also has an emissions trading scheme. China has been dramatically reducing steel production in order to meet energy efficiency targets and has been driving down the costs of solar and wind power with its clean energy industries.

As was pointed out by Paul Gilding in Climate Spectator, “we are in as much danger of leading in action on climate change as we are of leading on indigenous health”. The risk for Australian Business is not that we will go ahead of the rest of the world on climate policy – it is already too late for that. The risk is that lack of climate policy and high Australian per-capita emissions will lead to our industries being frozen out of markets in the future.

This post was published in Crikey on Friday, 14 May 2010.

When defending putting off the Carbon Pollution Reduction Scheme (CPRS) until “the end of the Kyoto commitment period”, Kevin Rudd stated that “progress on global action has been slower than any of us would like”. The Copenhagen Accord may not have resulted in a legally binding agreement, but countries are now working out policies to implement their Copenhagen commitments. The Australian policy to not reintroduce legislation until 2013 leaves Australia in danger of being left behind.

In particular, it is becoming increasingly likely that China will introduce a price on greenhouse gas emissions before Australia does. China Daily is reporting that China is likely to be levied between 2011 and 2015. Business Green has reported that the Chinese language Economic Information Daily quoted the Chinese Ministry of Finance saying that the tax will be introduced in 2012 or 2013, will start at 20 yuan per tonne of carbon dioxide, and rise to 50 yuan (about $A8) by 2020. Professor Ross Garnaut has since announced that China is better than Australia on climate action. Ironically, Business Green is reporting that China will also introduce resource tax reform, probably not welcome news to the mining companies that have been complaining about the CPRS and an Australian resource rent tax.

The US Senate is now considering a Bill — the American Power Act — that will place a cap on emissions from 2013. It would reduce carbon pollution by 17% by 2020, and more than 80% by 2050. Australia is committed to a 60% reduction by 2050. The US legislation may not get past the Senate, but the Obama Administration is supporting it and not planning to postpone things until 2013.

In 2009, emissions covered by the European Union emissions trading scheme dropped by 11%. Part of this drop in emissions would have been due to the global recession, but the EU ETS has been in operation since 2005. Tony Abbott has advocated a “wait for the rest of the world” strategy on climate change, and Kevin Rudd now appears to be advocating the same thing. If Australia’s policy is to wait for the rest of the world, then the time to act is now.

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