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 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.

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.