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Taking care of the next generation

This is How the Carbon Tax will Work

Archived News, Posted on 24 Mar 2011

All about: Carbon trading

* Published 9:40 AM, 24 Mar 2011
* Updated 10:26 AM, 24 Mar 2011
Australian Science Media Centre

With the Gillard government proposing to introduce a carbon price – fixed for a period with the aim of transitioning to a emissions trading scheme – the  has gathered a selection of key questions about carbon trading and posed them to experts in the field. Answering the questions are Professor John Foster, leader of the UQ Energy Economics and Management Group at the University of Queensland; Professor Kevin Parton, Institute for Land Water and Society at Charles Sturt University; and Professor David Pannell, an ARC Federation Fellow at the Centre for Environmental Economics and Policy, University of Western Australia.

Q: Which countries have, or are planning, a carbon price and is Australia leading the way or just catching up?

Prof John Foster: The EU (which is a lot of countries) is well ahead and about to enter Phase 2 of their cap-and-trade scheme in 2012.

Prof Kevin Parton: Our trading partners (including the European Union, China, Korea and Japan, and a number of states of the US) are pricing or are moving to price carbon. They are doing this by various policy measures including regulation, subsidies on consumption of non-carbon polluting technologies such as solar PV panels, subsidies on the production of non-carbon polluting technologies, subsidies on research and development related to green technologies, and pricing schemes such as a cap-and-trade emissions trading scheme (ETS).

For Australian industry to remain competitive, we also need to be pricing carbon. The real question is: what type of policy will move the carbon price in Australia as quickly as possible to international carbon price levels? This is a critical question because Australia risks getting left behind in the international market place unless our carbon price quickly moves to international price levels.

Many countries have used a combination of the above policies. For example, in Germany there is an emissions trading scheme, together with subsidies on consumption and production of non-carbon polluting technologies. One outcome has been that Germany now produces a significant number of solar PV panels, while Australia produces none.

The real question for each country, including Australia, is what is the appropriate policy to move the country into a world of new, non-carbon polluting technologies, and keep the country competitive in an environment in which all of our major trading partners are pricing carbon.

Economic analysis has not completely answered this question. Nevertheless the research that has been completed gives a strong indication that the best policy is a cap-and-trade emissions trading scheme. As long as it can be introduced with few administrative inefficiencies, and few exemptions for polluters, it is theoretically the most economically efficient form of policy. Moreover it can be designed to focus directly on the pollution problem by most taxing those producers who generate the most pollution. Furthermore, if you examine the alternative forms of policy to achieve the objective of putting a price on carbon, they are either more costly or there are more imponderables about them. For example, in the more costly basket is subsidising the use of non-carbon polluting technology in the form of solar PV panels.

The demise of the New South Wales subsidy policy on solar panels occurred because the technology has not developed to the extent necessary to generate electricity at low cost. In the imponderable basket is subsidising research and development (R&D) related to non-carbon polluting technology. A significant problem with this type of policy is that we don't know, before we've done the research, which type of R&D is going to be successful. This suggests that we should invest in a range of R&D activities related to various forms of new technology. For a small country like Australia, the size of the investment needed for such a portfolio of R&D activities would be prohibitive. Another form of policy, regulation to prevent pollution, has been successful in the past in overcoming other industrial pollution problems. It has not seriously been considered for overcoming greenhouse gas pollution. It is also considered administratively inefficient.”

Q: How will carbon pricing actually work and, given the experience in other countries, what is the price likely to be?

JF: Currently the EU price is about $A22 per tonne. $20 would be a good choice for the initial fixed price but I fear that politics will drive it down to $10.

Prof David Pannell: This will vary over time. In the short term, price will be fixed. Later it will be determined by the market. For a simple explanation of how it will work at that stage, see here. Experience in other countries is irrelevant. It will depend on how tightly the government sets the limit on emissions.

KP: The government in Australia has announced that from July 2012 it wishes to introduce a fixed price carbon policy, with a movement to an ETS three to five years later.

Under the fixed price carbon policy, each firm that generates greenhouse gases in its production processes must purchase one permit for every CO2 equivalent emitted. It will be able to purchase these permits from the government at a fixed price. This is similar to an emissions trading scheme, except the price is fixed by the government and not determined in the market place.

Although the initial incidence of the fixed price will be felt by polluting producers, these producers will attempt to pass their cost increases on to consumers. Hence the impact of the fixed price carbon policy will be broadly felt across the economy because many goods contain inputs that have some carbon content, so many goods will have price increases.

The effect of the fixed price carbon policy (and an ETS) is to change the price relativities that face consumers. This effect is rather like the introduction of a variable rate Goods and Services Tax (GST), with higher rates of tax on goods that have a larger carbon content. The objective is to have consumers shift their preferences away from these goods. So ‘green’ power, in future with zero carbon tax, should become relatively less expensive compared with electricity generated by coal.

The current traded price of carbon in Europe is around $A22/tonne. It seems probable that the initial fixed carbon price in Australia will be considerably less than this in order to make the policy more politically acceptable. The fact that international offsets will not be permitted under the current Australian government proposal also supports the notion that the carbon price will be considerably below international levels.

In terms of economic efficiency, moving more quickly to an ETS, with prices free to adjust to international levels, is preferred to the current proposal of the government, which has a fixed price initially with an ETS three to five years later. Immediate movement to international carbon price levels has the advantage of providing the incentive for Australian industry to be more competitive in the international economy.”

Q: From the experience of other countries, how much of an impact does carbon pricing have on reducing emissions – and should we expect the same in Australia?

JF: The EU's Phase 1 was experimental and not intended to reduce carbon emissions much. Phase 2 is but it hasn't started yet. The best example in the past was the cap and trade scheme for sulphur dioxide in the US and it was very successful.

DP: In an emissions trading scheme, price has no impact on reducing emissions. It’s the other way around. The level of emissions is set by government up front, and this determines what the price ends up being. “

KP: This is a difficult question to answer, because it is difficult as yet to disentangle the effects of the policy from other influences on carbon emissions. One major exacerbating factor has been the global financial crisis that has restricted growth in some advanced economies and hence reduced their greenhouse gas emissions below what they would otherwise have been. Thus in Europe there has been a slowing in greenhouse gas emissions at the time that an ETS has been introduced, but this can’t be attributed to the ETS.

Q: Can we learn anything from New Zealand, which is apparently ahead of Australia in terms of carbon trading?

JF: We can't learn too much from NZ because it is a country with a lot of hydro and not much power generated by fossil fuels. Australia is the opposite, thus, the very strong opposition of the coal lobby echoed by the Coalition.

KP: We may not learn much from New Zealand, because its policy introduction is phased-in by sector of the economy, involves many free permits, and has an initial fixed price of only about $A10/tonne.”

Q: What alternatives to carbon pricing are in place in other countries and how successful are they in reducing carbon emissions?

JF: An alternative is sustained subsidies for investments in renewables. Examples of success are Germany and Denmark. But this has to be paid out of general taxation, unlike a cap and trading scheme which reditributes from polluters to non-polluters. Another alternative is a carbon tax. Being an explicit tax, most governments have shied away from it despite its simplicity and the certainty that it offers businesses. a problem with it is that it is hard to know what the emission reduction effect will be. With cap and trade this is known and it is the price that is uncertain.

KP: This was covered in answer to the first question. There are alternatives and their successfulness depends on the characteristics of the country concerned. In the European Union, the principal policy is an ETS on grounds of political expediency among the member states. In Australia, an ETS is probably the best policy on grounds of both economic efficiency and because other policies make little sense for a small economy.

Q: How robust is the global carbon trading market?

JF: It won't be robust until the US gets involved because of their size. the US plus the EU would be enough to fully establish a global market because others such as China would fear that they would have to face carbon tariffs in both of these regions.

DP: The carbon trading prices will not be stable. Prices in an ETS are likely to be quite volatile. For example, see this graph of prices in the European market (see below).”

KP: After some difficulties at the start, the European market now is trading effectively.”

Q: How will a carbon price impact on household energy prices and are there examples from other countries of how government could compensate any costs?

JF: Up until now, the impact on electricity prices in the EU, compared with other costs, have been minimal. The impact has not been high enough yet for there to be specific compensation schemes. However, all governments seem to accept that, if this cost component gets large that the lowest income group should be compensated.

KP: If the European experience is reproduced in Australia, the price impact due to climate change policy will be unnoticeable relative to general price movements. At current international carbon price levels, the average electricity bill for households in Australia would rise by about $3 per week, assuming that households make no response to the price change.

As mentioned above, the effect of the fixed price carbon policy (and an ETS) is to change the price relativities that face consumers. This effect is rather like the introduction of a variable rate Goods and Services Tax (GST), with higher rates of tax on goods that have a larger carbon content. The objective is to have consumers shift their preferences away from these goods. So ‘green’ power, in future with zero carbon tax, should become relatively less expensive compared with electricity generated by coal.

However, this relative price effect will occur within a system of many prices moving higher. In Australia, the government proposes to link the fixed price policy to “assist families with household bills”. The obvious form of such compensation is a cut in income tax, probably with larger cuts to the poor to compensate for the regressive impact of the fixed price carbon policy. Another form, considered in the US, is a per capita refund.

Whatever the compensation mechanism, an objective is to make consumers no worse off overall while still having to face the full set of new prices.

Microeconomic analysis suggests that coupling carbon price policy to compensation to consumers can be inefficient. However, on equity grounds, it may be defensible.

Q: What vested interests are there in carbon pricing and who stands to benefit from it?

JF: Aside from generators of renewable energy, such as wind, the biggest beneficiary in the short term will be gas generators who will gain a clear competitive advantage over black coal generators.

KP: As a market-based policy, a properly organised ETS gives good prospects of avoiding the influence of vested interests. However, if an ETS or the proposed fixed price policy is to be effective and at the same time avoid the influence of vested interests, the government must not liberally distribute free permits. For their part, we would expect firms in the energy intensive industries to be lobbying heavily to receive free or discounted permits.”

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