Labor's carbon price pragmatism

The price floor in Australia's permit trading scheme will be replaced with a binding limit on CDM emissions credits, coupled with early linking to the EU emissions trading scheme, the Australian government announced today. It means a common carbon price in Australia and the EU, from 2015.

In an ideal world, maintaining the price floor and linking later would have been the preferable. But with political pressure on the price floor and the carbon pricing scheme overall, the arrangement announced today is a good alternative.

The change carries risks, yet it will give much better prospects for investments in low-carbon options than if the only change had been to discard the price floor.

Along with other economists and carbon market analysts, I have argued that Australia's carbon price needs to be prevented from falling to the rock-bottom levels now seen in oversupplied markets for international emissions offset (CDM) credits, and that the best way to do so is a price floor (see here, here, and here.) CDM credits today trade at about $3.60 – far too low to provide any meaningful investment incentives if that was the price in Australia, and ripping a hole in the budget because of shortfalls in carbon revenue.

A price floor is one way to achieve the objective. A price floor for the period 2015-18 was agreed by the Multi-Party Climate Change Committee and legislated in the Clean Energy Act. But it required implementing regulations, and that is where the model became unstuck.

Some large industry players lobbied hard against the price floor, citing implementation difficulties and arguing that market pricing should reign. Rob Oakeshott withdrew his support for the price floor model with reference to industry concerns and the prospects for international linking of Australia's carbon market. The government did not table price floor regulations in Parliament.

The alternative way of keeping the domestic price above the CDM price level is to put a binding quantitative limit on the use of CDM credits, so that they do not determine the price in the domestic market. It is the approach the EU has chosen. EU emitters will exhaust their quota of CDM credits, and EU permits are already trading at well more than double the CDM price.

This is what will now be done in Australia: cheap CDM credits can be used to cover a socket amount of emissions at a low cost, but it will not determine the price and thereby the incentives for investments in Australia.

The proposed limit on CDM of 12.5 per cent of total emissions is tight enough to make sure the Australian price will not be set in CDM markets. Given the massive expansion of emissions-intensive resource projects, and small supply of CFI credits, there is no plausible scenario for the CDM price to end up setting the Australian price (unless the amount of permits issued under the national cap were to be increased above the legislated default cap).

By contrast, the limit on international units of up to 50 per cent under the old model would have allowed far more CDM credits than needed after permits issued by the Australian government are exhausted.

Crucially, the tighter CDM limit is coupled with linking the Australian and EU carbon markets. Australian emitters will have full access to the EU market from the start of trading in 2015, with EU permits valid for acquittal in Australia, and full linking expected from 2018. Making Australian and EU permits exchangeable will create one combined market, with a common price. That price will be higher than the CDM price.

What is lost and what is gained from this policy change?

The price floor would have provided a predictable price for three years from 2015. That predictability is being swapped for an uncertain EU price. On today's forward prices and exchange rates, that price is lower than the floor price would have been. But there is every chance prices will rise as EU governments are preparing to intervene to lift it to a ‘comfort zone' of perhaps around 15 euros (currently $18) per tonne.

More systematic price management – targeting a carbon price range – could and should be considered in favour of ad-hoc market interventions, and Australia should now have a voice in those decisions.

Our recent survey showed Australian experts' expectations of the EU carbon price in 2016 at $16 per tonne, about the same level as the price floor would have been. It also showed that the expert community considered EU-Australian linking only as a longer-term prospect. Many will be surprised that the EU is prepared to already agree to linking with Australia's scheme. No doubt a tight limit on CDM inflows to Australia – and hence the combined market – was a precondition for the EU to agree to link.

The bigger difference for Australia's carbon price is likely to be for the period from 2018 onwards. In the default policy, the price floor would had given way to unrestricted imports of CDM, likely resulting in a big drop in price levels from 2018. That risk no longer exists.

However, the EU link itself is also the biggest drawback of the policy change. Is not the EU creaking under the strains of Southern Europe's economic woes? Is it really a good idea to enter a market that is dominated by a larger partner, with a combined price that is much more influenced by policy decisions made in Brussels, Berlin and London than in Canberra?

The criticisms will come thick and fast, and in isolation they are justified. In my work on international linking of emissions trading, I have argued that it is in Australia's interest to link to the main emissions trading markets – but only once the time is ripe. 

Under ideal circumstances the Australian carbon pricing scheme would have been left to ripen, under the protective sheets of a domestic price floor and price ceiling. Australia would have waited to see how the EU scheme develops, and made the link when the time is right, and ideally involve other international trading partners.

But circumstances are not ideal. Ever since bipartisanship over Australian climate policy was lost, political pragmatism has been the name of the game. The precarious parliamentary situation complicates matters further. And it may well be that Australia's carbon pricing scheme has a better chance of survival under future governments, because repeal will now also mean severing the connection to the world's largest carbon market.

At the end of the day, what counts for the effectiveness of the carbon pricing mechanism is the forward price curve. There is now greater price uncertainty in the medium-term. But the expected Australian carbon price, averaged over the next decade and taking into account the risks, is probably higher as a result of today's policy change. And it is much higher than the CDM price curve.

The opponents of the floor price should welcome the earlier shift to full market pricing. If not, then that can be taken as an indication that the real argument over the price floor was about the level of the price, rather than the modalities. 

Frank Jotzo is director of the Centre for Climate Economics and Policy, Crawford School of Public Policy, Australian National University.

More commentary on the changes can be found here and here.