Gillard's vaccine for carbon market ills

The price on carbon under the European emissions trading scheme (ETS) dropped to a record low this week. A 2012 EU emissions allowance (EUA) fell almost 14 per cent to €6.14 (AU$7.87) during Monday trading and lost further ground overnight.

Carbon prices are now stuck so low, and the market so oversupplied with allowances, that they are increasingly irrelevant to investment decisions. This is according to a survey of 3000 carbon finance professionals by Point Carbon, which found that just 38 per cent of respondents said carbon pricing was a decisive factor when making investments. That is down 6 percentage points from the 2011 survey and 9 percentage points lower than 2010.

Deutsche Bank estimates that, even out to 2020, there will remain an accumulated surplus of 681 million emissions allowances (EUAs) as a hangover from the depressed economic conditions plaguing Europe today. To illustrate the huge size of the excess EUAs, this is 30 per cent more than Australia's entire annual emissions, and about a third of the entire annual demand for EUAs under the European ETS. This kind of oversupply will ensure the price on carbon in Europe (and therefore in Australia as well were it not for the price floor) will remain at feeble levels below €10 that will make little, if any, difference to transitioning toward low carbon investments and technologies.

Mark Lewis, Deutsche Bank's chief European carbon market analyst, was sufficiently moved by the depressed state of the carbon market to state, “EUA's are now financial options on political action [to remove the EUA surplus] rather than instruments with intrinsic economic value.”

Jason Anderson, head of climate and energy policy at the World Wildlife Fund said the ETS was at risk of “imminent malfunctioning”. Shell, in conjunction with several other companies, has even called for a billion EUAs to be set-aside to revive incentives for low carbon investments.

Because the European ETS is so large relative to other carbon markets, this malaise will overwhelm any other emissions trading scheme that trades in international carbon credits (CERs) linked to it. The price of the New Zealand ETS has been dragged down to $5.70, driven by a huge excess of international credits without any home. The New Zealand government's environment department was sufficiently concerned that last month they urged the government to curb use of CERs to restrict offshore cash flows and stimulate domestic emission cuts.

The UK has been forced to double the carbon price floor levy in an effort to correct for the failure of the European ETS to provide a reasonable incentive for investment in low carbon technology.

The European Parliament and interested stakeholders are currently engaged in a vigorous debate on how they might correct this failure of the scheme. Measures being debated include instituting a minimum floor on the carbon price and setting aside a large proportion of EUAs from future years to reduce the supply overhang. Climate Strategies, one of the leading think tanks globally on climate change issues, released a report last month recommending that a combination of measures would be required. This included a floor price, plus the withdrawal of large amounts of permits from future auctions, and setting a stringent target for the 2030 period.   

Thankfully, unlike Europe, the Australian government set a minimum floor price that companies have to pay for their carbon permits. This will act as a safeguard to ensure there is a reasonable level of incentive for domestic emission reductions and hopefully prevent misguided investments in high polluting plants that could be stranded at a later date. The floor is set at $15 increasing by 4 per cent per annum in real terms.

Yet while Europe is currently seriously considering copying our floor price mechanism, The Australian Financial Review and The Australian are dominated by reports that we should remove the price floor. Essentially this would mean we'd inherit Europe's problem. This would leave us with a carbon price that did almost nothing to transition Australia's economy from being the highest per capita emitter in the developed world. Instead we would just outsource our emissions abatement task to other countries, and be no better prepared for future carbon constraints.

Don't be fooled by the government's provision that companies cannot meet more than 50 per cent of their emissions liability through the use of international credits. This is purely a fig leaf. It means that in the year 2020 companies could emit up to the amount of Australian permits available – which would be set at our target of 5 per cent below emissions levels in the year 2000. Then these companies could emit exactly that same amount again through buying international credits. It acts to effectively double our emissions cap – which is not really any kind of cap.

Also don't be fooled by lobby groups trying to argue that this price floor is some kind of abomination inhibiting the efficient functioning of the market. Economic research literature stretching back to a famous 1974 paper by Harvard Economics Professor Martin Weitzman indicated that where there is uncertainty about the costs and benefits of pollution reduction, governments should employ a hybrid of an emissions permit cap with floors and ceilings on permit prices. A paper I wrote with John Daley in 2010 provided detailed real world experience across multiple emissions and clean energy trading schemes that supported Weitzman's theoretical analysis about the value of a floor on the carbon price.

Overall the argument boils down to simple common sense. If it turns out reducing pollution is much cheaper than what government and the community were initially prepared to pay, then why wouldn't government reduce pollution further than originally planned? This is the way every other natural market works – where something turns out to be really cheap you buy more of it. This applies to bananas and it shouldn't be any different with reducing pollution.

Mark Lewis of Deutsche Bank put it nicely when he said there was a structural problem inherent with emissions trading schemes: “the ETS is the only market in the world where demand varies but the supply is fixed for years in advance.”

Australia's floor price on carbon should be vigorously defended against vested interests whose only objective is to pay as little as possible for the pollution they emit.