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 American Clean Energy and Security Act, also known as the Waxman-Markey bill, has a reserve price for permits that are auctioned. This functions as a type of price floor. It is not a strict price floor, because there is nothing preventing the market price for permits from getting lower than than the auction reserve price. Also, only something like 15% of permits will initially be auctioned [Actually significantly more than 15% of permits are likely to be auctioned, because entities that are allocated permits for free have the option of having them auctioned by the Administrator. However, firms may buy international permits from other qualifying cap and trade schemes, which could drive the US market price to less than the reserve price.]

This is what the bill has to say:

Section 791 (d) RESERVE AUCTION PRICE.—The minimum reserve auction price shall be $10 for auctions occurring in 2012. The minimum reserve price for auctions occurring in years after 2012 shall be the minimum reserve auction price for the previous year increased by 5 percent plus the rate of inflation (as measured by the Consumer Price Index for all urban consumers).

The fact that the reserve price increases by 5% above the CPI is very important. This sends a strong long term signal to investors. People will think twice about investing in new coal plants when they know that the carbon price will be at least $39 in 2040, $63 in 2050, and $100 in 2060. If the initial price was higher (say $20 or $50), there would be an even stronger signal. A higher floor price would also send a stronger signal to developing countries that the US is prepared to play its fair share in reducing global emissions.

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.

Australia’s Prime Minister, Kevin Rudd, has announced some changes to the proposed carbon pollution reduction scheme legislation. In short, this is what is being proposed:

  1. The scheme will be delayed until July 2011;
  2. In 2011-2012 the carbon price will be set at $10/tonne and there will be an unlimited amount of permits;
  3. Emissions trading will be begin proper in July 2012 — I don’t know if there will be any price caps or floors after July 2012.
  4. There will be “recession buffer” where industries eligible for assistance at the 60% rate “would receive a 10% buffer for a finite period”, while those eligible at the 90% rate “will receive a 5% buffer for finite period”.
  5. The 5%-15% target reduction range will be kept unless an agreement consistent with 450ppm CO2-e is agreed to, in which case Australia will agree with a 25% reduction on 2000 levels.
  6. Some token measures that enable households to buy and cancel permits — something that they probably would be able to do anyway.

Some of the fine print on how the targets will work is here.

I’ll reserve my final opinion until I see whet the new legislation looks like next week, but it does seem like overall it is a slight improvement. There is stuff in the scheme that is unfortunate, such as the delay, the $10 carbon price in 2011-12, and the extra 5-10% free permits to emissions intensive industries. But the targets for 2010-11 and 2011-12 in the White Paper were so weak that I wouldn’t have been surprised if the carbon price was less that $10 in those years anyway. The 5-10% extra free permits to emissions intensive industries won’t affect the overall target, but is an equity issue and a waste of taxpayers money.

In my opinion the conditional target is more important than the unconditional target, because that is what makes the most of a difference for international cooperation. The willingness to go beyond 15% emission reductions is very good news, the government has partially fixed what was the worst problem with the CPRS. Unfortunately a 25% reduction for Australia would only consistent with 450 ppm CO2-e that was very generous to Australia, and unlikely to be acceptable to developing countries, low per-capita emitters, and countries responsible for low amounts of historical emissions — in other words Australia would be getting a “special deal”, which is similar to free-riding. What Australia should be doing is be willing to accept a reduction of at least 25% by 2020 as part of an agreement consistent with a stabilisation target of 450 ppm CO2-e or less.

One way to respond to this development would be to put on the table proposals that have not been on the agenda so far. A steadily increasing price floor should be at the top of the list, as should be overhauling the scheme caps and gateways approach for setting the target (too inflexible), and the ability of firms to buy an unlimited amount of CDM credits (which have additionality problems). Only a steadily increasing price floor will drive the investment in renewable technologies that we need.

On whether the legislation should be passed, I would be very reluctant to pass it unless something was done about the scheme caps and gateways approach to setting the trajectory. The problem with the gateway approach is that the minister can set lower (and upper) bounds on Australia’s emissions forever. It is not appropriate for the minister to set any lower bound for emissions, let alone forever.

In Phase I of the European Union Emissions Trading Scheme (the EU ETS), between 2005 and 2007, the carbon price collapsed. In April-May 2006, the price for a permit to emit one tonne of carbon dioxide collapsed from over 30 euro to less than 10 euro. The carbon price then eventually declined to less than 0.10 euro by September 2007. The primary reason for this was that too many permits were allocated — the size of the cap was higher than the total amount of emissions. Has Australia learned from what happened? Is the carbon price likely to collapse during the initial phases of the Carbon Pollution Reduction Scheme (CPRS)?

This question is pertinent because the Australian House of Representatives economics committee has been instructed conduct an inquiry into the choice of emissions trading as the central policy to reduce Australia’s carbon pollution. A low carbon price is inefficient because there is a lost opportunity to make deeper reductions in greenhouse gas pollution. This means that deeper reductions will need to be made later (which will cost more), or impacts from climate change will be greater (which will cost significantly more). This issue applies, in a much worse way, when there is no carbon pricing at all (as is happening now).

Phase I of the EU ETS has not been the only time that cap and trade schemes have experienced low carbon prices. In the north-eastern states of the United States, an emissions trading scheme called the Regional Greenhouse Gas Initiative (RGGI) has commenced. The RGGI covers emissions from electricity generation, and allows for the purchase of offsets. It aims to stabilise emissions at 2002-2004 levels by 2015, and then reduce emissions by 10% by 2020. Permits are auctioned, and there have been two auctions so far, the emission permit prices were US$3.07 and US$3.38 per tonne of carbon dioxide.

One “design feature” of the CPRS is that Australia’s emissions trajectory is set 5 years in advance (see Chapter 4 of the White Paper). There is also a target range for emissions reductions to be achieved by 2020 to be 5-15% below 2000 levels (Policy position 4.2). The target range is perhaps the worst aspect of the CPRS White Paper, because an unwillingness by Australia to reduce emissions beyond 15% undermines a good comprehensive international agreement to reduce greenhouse gas emissions. The initial trajectory is given in Policy position 4.5 of the CPRS White Paper. I have converted these figures from percentages to megatonnes of greenhouse gases (carbon dioxide equivalent).

The first indicative national emissions trajectory will be:
• in 2010–11, 109 per cent of 2000 levels (602.5 Mt)
• in 2011–12, 108 per cent of 2000 levels (597 Mt)
• in 2012–13, 107 per cent of 2000 levels.(591.5 Mt)

How does this trajectory compare with what Australia’s emissions will be in the absence of of the CPRS? If the trajectory is higher, then the carbon price is likely to be very low (although this is affected by intertemporal flexibility measures, such as banking).

Projections for Australia’s emissions in the absence of of the CPRS are supplied have been estimated by the Department of Climate Change here. They project Australia’s emissions during the 2008-2012 Kyoto commitment period to be 599 Mt CO2-e. Note that this is below the CPRS trajectory for 2010-2011, about the same as for 2011-2012, and slightly higher than for 2012-2013. The projections include uncertainties in emissions for each sector, they range from 3% to 10%. They do not include uncertainties in emissions from land use change or from forestry. Aggregating these uncertainties is difficult, because emissions in different sectors are not independent. There can be covariance between different sectors. If we assumed the sectors were independent and ignore uncertainties in land use change and forestry, then the uncertainty in the projected emissions is 12-13 Mt CO2-e (about 2.2% of projected emissions). If the emissions in each sector are highly dependent, and we take into account the uncertainty from land use emissions, then the amount of uncertainty could be several times higher.

The Treasury modeling predicts that a 5% 2020 reduction scenario would be consistent with an initial nominal carbon price of $23 in 2010. Since the modeling was released, the global financial crisis has gotten worse and the global carbon prices have dropped significantly. The boom in Australia’s emissions intensive resource industries has also ended. The government has also unveiled a stimulus package that includes $3.9 billion in ceiling insulation for households and incentives for solar hot water.

There have been some very serious declines in the price of carbon as the global financial crisis has been unfolding. In the EU ETS, the carbon price has declined from around 30 euro in mid-2008 to 8-9 euro in February 2009. Credits for clean development mechanism projects (known as certified emission reductions, or CERs) have also declined in price, and are trading at less that 8 euro (around A$15). The price of CERs functions as a cap on the carbon price in the CPRS, because firms will be able to purchase an unlimited amount of CERs to account for their emissions (Policy position 11.5).

One thing that will provide stability for carbon prices is the banking of permits. The CPRS White Paper proposes that “Unlimited banking of permits will be allowed under the Scheme (except those accessed under the price cap arrangements)” (Policy position 8.2). Firms with extra permits can always hold them until a later year, and exercise them then. This means that even if there is an overallocation of emissions, there still will be some demand for permits if there is the expectation that there won’t be an overallocation of emissions in subsequent years. In Phase I of the EU ETS, there was banking of permits allowed, but not between phases. At the end of Phase I the permit price declined to less than 0.10 euro. When there is overallocation, banking spreads the impact in carbon prices across several years, instead of confining it to one or two years.

Because of unlimited banking of permits, the carbon price in the early years of the CPRS will also be affected by the medium term trajectory. The target range of 5-15% that has been set for Australia is not very steep, and is not consistent with what science and equity arguments suggest would be appropriate for Australia. Business as usual projections for 2020 emissions are available, but are even more uncertain than for 2010. Australia’s unconditional target is likely to be easier to meet than the EU’s unconditional target, because Australia’s high per capita emissions imply more opportunities for abatement.

At this stage it is too early to know for certain whether there will be an overallocation of emissions in the initial years of the CPRS, but is is very likely. In this sense, Australia appears not to have learned the lesson of Phase I of the EU ETS. International developments alone suggest that the carbon price is likely to be significantly lower than the price suggested by Treasury modeling. Banking of permits means that the carbon price probably will not be as low as the end of Phase I of the EU ETS. The US RGGI also has unlimited banking of permits, and that has not prevented the carbon price from being very low. It is therefore very likely that unless significant changes are made to the CPRS, it will start with very low carbon prices.

What changes need to be made to the CPRS to make it more effective and efficient? What changes need to be made to put in place long-term incentives for investment in clean energy and low-emission technology? Clearly the targets need to be tightened, the unconditional target could be significantly stronger. The conditional target only serves to undermine climate negotiations by ruling out Australia playing its part in a global effort to reduce greenhouse gas emissions. It is not appropriate for the government to rule out any level of emissions reductions.

There are also structural changes that should be made to the CPRS. The best way to rule out downward price volatility is by introducing a price floor. This could be implemented by having firms pay an extra fee when they surrender their permits, or could be implemented by having a reserve auction price. By having a price floor (and making it sufficiently high) we get many of the advantages that we get from a carbon tax. The CPRS also should not allow firms to purchase unlimited amounts of CERs, this is also because of credibility and additionality problems with the CDM, as well as the effect on prices. If the CPRS allows banking of permits, then for each permit banked, the regulator could reduce the cap by that amount of permits in the following year.

The overallocation issue suggests that permits should not be treated as property rights. This has lead to problems elsewhere, such as with the overallocation of the water in the Murray River. It is also inappropriate to create and allocate property rights that potentially infringe on the rights of future generations to a clean atmosphere. Emissions permits should instead be treated as limited compliance instruments. This suggests that Policy position 8.1 of the White Paper needs to be changed.

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)..