Labor's global carbon delusion

Overnight the EU carbon price plummeted by 40 per cent to €2.81 ($A3.60) before recovering to above €4. 

One should be careful not to read too much into this specific freefall event, but it is yet another symptom of the politically volatile nature of carbon markets, and shows that the Gillard government's anxiousness to link our carbon market to others overseas is premature and misguided.

Before going on, it's important to put this freefall into perspective.

The bad news that apparently spurred selling was that the European Parliament's Energy and Industry Committee had voted against the proposal to reflate the carbon price by setting-aside the sale of 900 million emission allowances until later this decade. However this committee has no power over this proposal and its vote was purely symbolic.

It is the Parliament's Environment Committee that will make decisions on how the proposal proceeds before it is actually passed or rejected in the full European Parliament.

Furthermore, according to Reuters, the drop may be as much due to a freak loss of liquidity in the market at the time of the vote by Energy and Industry Committee (hence the rapid recovery in price).

Nonetheless it's clear the European carbon market and the aligned UN CER carbon credit market have ceased to effectively function in providing any kind of meaningful long-term signal to investors. Prices have fallen rapidly over the past 12 months and now sit at a level that can in no way be reconciled with the economic value to society from reducing emissions. 

The carbon market's importance to carbon related investments completely hangs on impossible to predict political processes between European national leaders and the EU Parliament.  Forward trading in carbon is more akin to laying bets on an election rather than something driven by a long-term evaluation of the economics of carbon abatement.

Carbon allowances are effectively at a rung below junk bond status.  

Even if Australia's carbon market were to survive Abbott's axe, because Australia's carbon market will recognise European allowances as equivalent to Australian permits, it is also hostage to European politics. In addition now there is talk of linking Australia's carbon market to the state of California, where they are seeking to cap emissions while importing large amounts of electricity from neighbouring states, which fall outside the scheme.

The Australian government and the public service that advises them appear to be under a grand delusion that we can create a seamless global carbon market. Yes, theoretically, full international trading of emission permits would be by far the most efficient way to stabilise carbon emissions and reduce the risks of climate change.

Yet carbon markets are inherently a product of national politics at this stage, and these politics are still in a state of flux. Each carbon market that is emerging chooses different rules as to what sectors it includes, and how the supply of carbon permits and credits is determined. What's more these rules could be and are likely to be regularly and suddenly changed by the stroke of a pen. When we recognise one-for-one their carbon permits or credits as equivalent to our own, we to a large degree inherit all the political uncertainty surrounding their markets.

To put this in perspective, imagine if Australia decided that we would recognise the Venezuelan or Russian currency as equivalent to an Australian dollar (or at least pegged at a fixed and unchanging ratio). While this might seem an extreme comparison, the politics surrounding European, UN and Californian carbon markets are probably as volatile and uncertain as the economic and currency policies of Russia and Venezuela.

Reducing greenhouse gas emissions is fundamentally an economic challenge around smoothly transitioning long-lived, highly capital intensive equipment from high carbon to low carbon technology.  This is all about long-term investments, not a month-to-month optimisation exercise. 

International linking will achieve short-run cost optimisation, but it also creates such significant uncertainty that it will undermine the ability to make long-term investments in low carbon assets and technology.

Australia should be heavily constraining linkages between our carbon market and those overseas until these markets achieve some kind of stability.