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.

The Greens have proposed an interim carbon tax for Australia. The basic idea is that there would be a carbon tax of $20 for two years, and in that time, policy decisions on an ETS would be made. The details are here. Professor Garnaut made a similar proposal in the Garnaut Review.

This is a very sensible idea. A big issue with carbon pricing policy is that before a carbon price is introduced, there is a very strong incentive for polluters to act like the sky will fall in. This is because they know that would lead to weaker policy, or more compensation, or both. This creates a very bad environment for a government to make decisions about targets, especially about targets for the next ten years or longer. Introducing a carbon price first is a much wiser way to go about things.

This would probably be a good idea in the US as well. Getting climate legislation through the US Senate is very difficult, and will become more difficult now that the Republicans have an extra senator. It may be easier to introduce a low carbon tax now (possibly equal to the price floor in the proposed US legislation), and then introduce a cap on emissions later. Australian policy could show the way forward for US policy.

Good climate policy provides certainty for investors in low emission technology. When a cap is introduced, it could be possible to maintain the current price as a floor in carbon price.

Update: This architecture has been adopted for Australia’s proposed carbon price mechanism.

A joint working paper that I have written with Dr Frank Jotzo on Price Floors for Emissions Trading is on the Environmental Economics Research Hub website.

See also:

In a New York Times column, Nobel prize winning economist Paul Krugman has written some commentary on the Waxman-Markey legislation that proposes to introduce an emissions trading scheme in the United States. It is well worth reading. In his column, when Krugman discusses some of the objections to the scheme, he states:

One objection — the claim that carbon taxes are better than cap and trade — is, in my view, just wrong. In principle, emission taxes and tradable emission permits are equally effective at limiting pollution. In practice, cap and trade has some major advantages, especially for achieving effective international cooperation.

Not to put too fine a point on it, think about how hard it would be to verify whether China was really implementing a promise to tax carbon emissions, as opposed to letting factory owners with the right connections off the hook. By contrast, it would be fairly easy to determine whether China was holding its total emissions below agreed-upon levels.

I agree with Krugman that cap and trade has major advantages in terms of achieving international cooperation. This is the main reason why I support cap and trade. However, because carbon dioxide is more or less a stock pollutant, it has been argued that setting a price by introducing a carbon tax will be more likely to reduce emissions by an appropriate amount. I therefore disagree with Krugman that setting a tax is equivalent in principle to having tradable permits, because of uncertainty.

A cap and trade system with a price floor has the same advantages to emissions trading when it comes to international cooperation; it also has the same advantages of carbon taxation (and is probably superior to carbon taxation) when it comes to managing uncertainty. Unfortunately,it is very to find a serious discussion about price floors in the peer-reviewed economic literature since 1976 (but Roberts, M. J., Spence, M., 1976, ‘Effluent Charges and Licenses under Uncertainty’ is well worth reading). Most of the discussion on hybrids between cap-and-trade and carbon taxes has been about schemes with price ceilings.

See also:

Update: The Waxman-Markey bill does in fact have a price floor.

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:

The Carbon Pollution Reduction Scheme White Paper has been released. Australia’s Prime Minister Kevin Rudd has announced an emissions reduction target of 5-15% in 2020 compared to 2000 levels.

The target of 5-15% by 2020 sends a signal to the rest of the world that Australia is not willing to play its part in an international agreement that stabilises at 450 ppm or less. It does not even signal that Australia is willing to stabilise at 500 ppm or less. It obstructs a good agreement on climate change. This means that it says that we don’t care about the Great Barrier Reef, we will not make a serious attempt to stop it from being destroyed or seriously degraded. Curiously, Kevin Rudd states that 450 ppm should remain a core part of international negotiations.

Rudd and the White Paper have argued that a 5% reduction would imply greater per-capita reductions than the EU’s 20% reduction by 2020 because of Australia’s greater projected population growth. This argument is irrelevant because Australia’s per-capita emissions are much higher than the EU’s. Any international agreement that does not have high per-capita emitters reducing emissions more than low per-capita emitters would never be accepted by the developing countries in the world. Rudd’s approach makes promising per-capita approaches to climate change, such as contraction and convergence, more difficult to achieve.

In short, there are four problems with the targets that Rudd has chosen:

  1. They are too weak to correspond to the stabilisation targets that we need to avoid dangerous climate change. They effectively rule out Australian cooperation with global stabilisation targets that add up to 500 ppm or less.
  2. They are based on a model where low per-capita emitters and developing countries bear a disproportionate amount of the burden of emissions reductions. They do not take into account Australia’s high per-capita emissions and are therefore inequitable.
  3. This means that developing countries have less incentive to participate in a global agreement, making the mitigation task harder.
  4. There is considerable evidence that Australia can afford much more mitigation — the expected cost of climate change will be greater than the expected cost of mitigation.

Now for some comments on specific aspects of the White Paper.

Assistance measures: Much money is being squandered on assistance to emissions intensive industries. The coverage of assistance to “emissions intensive trade exposed” industries has been expanded to include industries that made the most noise, such as liquefied natural gas. Rentseekers have been rewarded. There will also be $3.9 billion dollars (assuming a $25 carbon price) in free permits handed out to coal-fired electricity generators. This is money that could have been invested in low emission technologies, reducing emissions from deforestation or forest degradation, or assistance to low income households. Instead it does nothing more than line the pockets of shareholders.

The large amounts of assistance to polluting industries have meant that there much less funding available for compensating households. The distribution of assistance to households is strange, households with incomes of less than $20,000 are given less assistance than households with incomes between $20,000 and $120,000. Newstart recipients will recieve $14.20 more per fortnight; people on the minimum wage will recieve $14.95 more per fortnight. No money has yet been allocated to help households increase their energy efficiency.

Low price cap on permits: There will be a price cap on permits, so the emissions cap can be exceeded by firms buying more permits at a price of the level of the cap. According to the White Paper:

  • The scheme will have a transitional price cap for the period 2010–11 to 2014–15.
  • The level of the price cap will be set at $40 commencing in 2010-11.
  • The level of the price cap will rise in real terms by 5% per year.

This price cap is less than recent estimates of the social cost of carbon from economists such as Richard Tol [Richard Tol disagrees, see comments]. It is much less than what Nicholas Stern has suggested is likely to be the social cost of carbon. Having a price cap does not make sense if it is less than the social cost of carbon.

No price floor: I have discussed why an emissions trading scheme needs a price floor here. Dr Richard Denniss, from the Australia Institute has recently pointed out a problem with purely cap-and-trade schemes, that in my opinion could be addressed by a price floor, if it was high enough. With cap-and-trade schemes, if a household decided that due to concerns about global warming, it wanted to reduce its electricity consumption, that will not necessarily reduce global warming. What it will mean is that the electricity generator would not sell as much electricity, would not need to buy as many permits, and another firm could buy the permits more cheaply. The total amount of permits will be the same. This is more of a problem when the cap is too weak.

A price floor, it it was high enough, would mean that the scheme would function more like a carbon tax, but still with an absolute cap on emissions. A price floor could be introduced by there being a reserve price when permits are auctioned, or by firms paying an extra fee when they exercise their permits.

Forestry: The White Paper proposes to cover reforestation, on a voluntary basis, and not cover deforestation. Forest entities will not be required to surrender more permits than have been issued for an individual forest stand. Only activities that are covered by the Kyoto Protocol will be included. Judith Ajani and I have shown that at carbon prices of significantly less than $20 per tonne, there will be more revenue from using plantation forests as carbon sinks that as sources of wood. Because native forest logging does not attract a carbon price, and is not properly regulated, there will be an increase in native forest logging. This is likely to lead to carbon leakage from the plantation forest sector to the native forests logging sector, and a net increase in emissions. We made some submissions to the Carbon Pollution Reduction Scheme green paper here and here.

Update: The Australian Governments’ climate change advisor, Ross Garnaut, has written an article criticising the White Paper for its conditional targets not being higher enough, the inclusion of a price cap, and the transfer of wealth to emissions intensive rent-seeking industries. This article was published in the Fairfax press, and at East Asia Forum (under the title oiling the squeaks)..