Key Point
- The Discussion Paper recommends broader coverage of sectors in the Australian economy, with a consequential reduced role for offsets.
As foreshadowed in its Interim Report released in February 2008, the Garnaut Climate Change Review has released a discussion paper on the recommended design elements of an Australian Emissions Trading Scheme ("AETS"), which is the centrepiece of Australia's climate change policy.
The significance of the introduction of an AETS should not be underestimated - it signals profound and long term structural change for Australia. As with the establishment of any artificial market and the creation of new tradable rights, there will be winners and losers from the creation of a carbon market. There is also the potential for significant redistribution of wealth within the Australian economy and the wider community. This creates significant tension in ensuring that the new market operates efficiently so as to achieve its fundamental objective: to reduce the emission of greenhouse gases by limiting the right to emit those gases, while at the same time mitigating the potential adverse impacts from the scheme on those who are least able to absorb the cost associated with its introduction.
At the outset, the Discussion Paper makes clear that the environmental objective of reducing greenhouse gas emissions is best achieved by ensuring that an effective market is established for carbon permits. The Discussion Paper identifies a number of guiding principles which it considers should underpin the market:
- scarcity - that is a scarcity in the number of permits available in the market which is aligned with Australia's emissions target. Without that scarcity, a market will not exist and permits will have no value;
- tradability of permits - this requires a permit to have clearly defined characteristics and a mechanism through which trading of those permits can take place;
- credibility - the rules and institutions that define the market must be credible. Since an AETS exists entirely at the behest of Government, the Government must ensure that the operating rules of the market are clear and consistent and that any changes occur through an equally transparent process;
- simplicity - special rules, concessions and exemptions are to be avoided as much as possible since compromises will inevitably result in increased uncertainty and transaction costs to market participants; and
- integration with other markets - an AETS must be able to co-exist and integrate with international emissions markets as well as other financial, commodity and product markets in the domestic and international economies. This is essential to avoid distortions in the market and the price for emission permits.
Intrinsic And Extrinsic Design Features, And Exogenous Factors
The Discussion Paper categorises the design features of an emissions trading scheme into those which are intrinsic and those which are extrinsic.
Intrinsic features are those which are essential to the operational efficiency of the scheme to create an efficient transactional space that enables the ready trading of permits. Extrinsic features by contrast are those which are found outside of the scheme's operation, but still have considerable influence on the scheme's economic and environmental impact.
The Discussion Paper also has regard to what it describes as exogenous factors which are matters beyond the influence of policy decisions on AETS design but which nevertheless effect the operation of the scheme. Exogenous factors include evolving scientific and technological knowledge in respect to climate change as well as evolving international agreements to address climate change.
Intrinsic Features
Coverage
This concerns the scope of an AETS in terms of the sectors of the Australian economy and the types of greenhouse gases covered by the trading scheme. Firms in covered sectors will be obliged to hold and acquit permits equal to their emissions, depending on the type and quantity of greenhouse gas emissions captured by the scheme.
Uncontroversially, the Discussion Paper recommends that the six main greenhouse gases be covered by the scheme which are currently subject to the Kyoto Protocol. This is consistent with the approach adopted both by the Prime Minister's Task Group on Emissions Trading and the National Emissions Trading Taskforce Final Report. In relation to sectoral coverage, the Discussion Paper restates the position set out in the Interim Report which recommends broad coverage of the Australian economy to include stationary energy, industrial processes, fugitive emissions, transport (including civil aviation and sea transport) and waste. It also strongly recommends that agriculture and forestry be included in the scheme as soon as practicable.
Offsets
A reduction or removal of emissions from activities in one area of the economy can be used to offset emissions in other sectors of the economy. Offset credits can be created by sectors not covered by the AETS and, consequently, the coverage of the scheme has direct implications for the availability of offsets. As broad sectoral coverage is recommended, domestic offsets will have a small role to play. Nevertheless, the Discussion Paper recommends that domestic offset credits should be accepted within the scheme without limits.
Point Of Obligation
This is the point of the supply chain where the liability to hold and acquit permits in respect of the release of greenhouse gas emissions occurs.
The Discussion Paper acknowledges that while liability should generally occur at the point of emission, transaction costs and administrative convenience may dictate that the point of obligation may need to be moved either "upstream", or "downstream" to improve robustness of reporting and scheme efficiency. A good example is emissions from fuel use where imposing the permit liability on upstream fuel suppliers rather than end users would capture 100 percent emissions from fuel use and impose the least regulatory burden on small end users.
Permit Design
A permit will enable the holder to emit a certain quantity of greenhouse gases, and are generally worth 1 tonne of CO2 equivalent (or CO2-e). Options available in relation to the design of permits include making them available for single use at any time throughout the life of the AETS (such that a holder of the permit has no time limit within which permits may be acquitted). Alternatively, permits can be date-stamped which restrict their use to particular years or periods.
Permit Issuance
How permits are allocated and the basis upon which that allocation occurs will have a large effect on the distribution of income within the Australian economy. Permits can be allocated to a range of potential recipients, either free of charge or by selling them, such as through auctioning. In this respect, the Discussion Paper continues the argument advanced in the Interim Report that there should be no or very limited free issuance of permits under the AETS. It contends that the design principles of credibility, simplicity and integration argue for auctioning of all or the vast majority of permits.
Whether permits are freely allocated or auctioned does not influence the price of goods or services in the economy once an emissions trading scheme is implemented. In any event, the Discussion Paper concludes that it would be impractical for Australia to administer a free allocation scheme prior to the proposed introduction of the AETS in 2010.
International Trade And Linkages
The Discussion Paper devotes a considerable part to considering the implications for Australia in linking internationally with other schemes. The Discussion Paper acknowledges the inherent advantages in international trade which would develop through the integration of emissions trading schemes; that it would create greater efficiencies in abatement opportunities, broaden the market and therefore dilute the risk of price volatility, and provide financial incentives for developing countries to take on commitments. The Discussion Paper however also acknowledges the risks that linkages present since its implies loss of control over some aspects of mitigation policy.
The fact that Australia will be a relatively small player in any emissions trading market will mean that it is a "price taker" if fully linked with other, larger markets such as the EU ETS or emerging US carbon markets. Consequently, the Discussion Paper recommends a cautious approach to international linkages and the necessity to ensure that any potential trading partner has a mitigation system with sound design features and which are governed effectively and with probity.
Price Controls
These act as qualifications to the market by either providing a price ceiling on permits or a floor price.
The Discussion Paper comes out strongly against any price controls being included in the design of the AETS on numerous grounds. Apart from the inherent arbitrariness in setting price controls, the AETS becomes a defacto carbon tax once any ceiling price is reached. Further, price controls dampen the incentive for development of secondary markets which are critical in helping shape the forward price curves for permits so as to enable the market to manage future risk. By imposing price controls, the government effectively assumes those risks. The existence of price controls will also more than likely present a barrier to any international linkages.
Banking And Borrowing
Hoarding permits by the private sector ("banking") and lending of permits by government authorities ("borrowing") provide flexibility during times when there can be fluctuations in the demand for permits. This flexibility provides an incentive for private sector participants to reduce emissions in the early years of the scheme, and the capacity to bank/borrow allows market participants to use permits at the time when they are the greatest value.
The Discussion Paper supports unlimited banking by private sector participants of permits and recommends that the independent authority established to govern the AETS be able to lend permits to the private sector, subject to limits in terms of quantity and time to be determined by that authority. In this way, the authority can manage the carbon budget and maintain stability in the market.
Governance
Governance structures are necessary to facilitate the issue of permits, to ensure that permits are acquitted in line with emissions liabilities and that Australia meets its own emissions targets.
The Discussion Paper advocates that the administration of the AETS be the responsibility of an independent authority with a high degree of executive independence in the exercise of its powers. It identifies the closest analogous institution as being the Reserve Bank of Australia.
In no small part, the Discussion Paper makes this recommendation because of the significant financial implications that the establishment of an AETS will have with consequential political pressure being brought to bear by vested interest groups. No better example of the types of demands likely to be made of the Government is needed than that which occurred on the same day that the Discussion Paper was released: the Australian Industry Group called for the Government to introduce a phased reduction in the company tax rate from 30 percent to 25 percent by 2010 to help industry cope with its participation in the AETS.
Compliance And Penalty
A compliance regime needs to preserve the environmental integrity of the scheme and to do so, the Discussion Paper recommends that where a party fails to surrender permits equal to their emissions during a given compliance period, in addition to any penalty, make good provisions should apply. This will require the party with emissions in excess of its permit holding to acquire and surrender any additional permits to cover those excess emissions.
Alternatively, the Discussion Paper recommends that revenue from financial penalties should be used to purchase abatement in respect of those excess emissions.
Extrinsic Features
While outside the scheme's operation, setting the emissions limit and defining the circumstances in which it may be changed, as well as dealing with the adverse consequences of the establishment of a carbon market, will have a considerable influence on the scheme's success. These extrinsic features are given considerable analysis in the Discussion Paper.
Emissions Limits
The Discussion Paper argues that merely setting an end year objective limit (such as a 60 percent reduction by 2050) is impractical when the objective is to stabilise emissions at a specific concentration (such as 450 parts per million of CO2-e). This is achieved by limiting the world to a quantum of cumulative emissions. Consequently, the Discussion Paper recommends that end year targets should be augmented by a series of interim targets which together total the cumulative emissions, so that the end year target is the date at which stabilisation of emissions is achieved. Trajectories can then be used to define paths for release of emissions permits within that budget.
What Australia's emissions limit should be is not addressed by either the Discussion Paper or Interim Report. Any recommendation will be left to the final reports of the Review due in September 2008. In the Discussion Paper, however, it is recommended that Australia consider having multiple budgets and trajectories:
- Trajectory A which covers a period from the commencement of the AETS to the end of the Kyoto period in 2012. Trajectory A is derived from Australia's existing Kyoto commitment;
- Trajectory B could reflect Australia's commitments in the 2013-2020 period and could reflect the broad commitments made by other developed countries for the same period;
- Trajectory C would represent Australia's commitment to a 60 percent reduction in greenhouse gas emissions by 2050 from 2000 levels.
As made clear in the Interim Report, however, reductions to the levels prescribed in these first three trajectories will be totally ineffective in limiting global cumulative emissions to the level required to avoid the risk of dangerous climate change. Consequently, the Discussion Paper recommends a fourth trajectory:
- Trajectory D, which might reflect a comprehensive global agreement to stabilise atmospheric emissions at a level to avoid the risk of dangerous climate change.
The Discussion Paper also recommends that the government announce a number of trajectories and budgets at the time of the announcement of its AETS policy. The Government would then make clear the budget and trajectory for a five-year schedule for the release of permits under the AETS. The Government would also announce conditions under which it would move from one trajectory to a more constrained trajectory with the relevant shift occurring five years after that announcement. Essentially, the Discussion Paper recommends that more onerous budgets and trajectories should only be assumed if global agreement can be reached on comparable carbon constraints.
The proposed five year "gateways" are likely to attract criticism in that these time frames do not reflect the investment cycle for major infrastructure which can be up to 25-30 years, if not longer. In some way, the Discussion Paper seeks to anticipate this criticism through the announcement of alternative budgets/trajectories, and the circumstances in which transition to more constrained budget/trajectories will occur, so that the market can inform itself as to the risk of such a transition occurring in those longer term investment cycles.
The Discussion Paper claims that the virtues of this approach are that it would help build support for effective global action, provide clear guidance to business about the size of the potential changes and the conditions under which they would occur, and provide incentives as to early action to reduce emissions. To the extent that the five year delay may mean that the trajectory underpinning the AETS is not in line with Australia's international commitment to reduce emissions, it would be necessary for the independent carbon bank to acquire permits internationally.
Compensation
The Discussion Paper argues that until Australia's major competitors have broadly similar emissions constraints, some form of compensation to trade exposed emission intensive industries are justified for reasons of both environmental and economic efficiency. The Discussion Paper however recommends that an exemption for trade-exposed emission intensive industries not constitute a designed feature of the AETS since this would only distort the market. In the interests of simplicity and credibility, the Discussion Paper recommends payments to firms either in the forms of cash or permits as a transitional measure. In this respect, the Discussion Paper recommends that the independent carbon bank adopt a rigorous approach to assessment of payments to trade exposed emission intensive firms.
In contrast, the Discussion Paper continues the argument detailed in the Interim Report that compensation payment should not be made to non-traded sectors such as the stationary energy sector. The Discussion Paper relevantly states:
While the Discussion Paper acknowledges that decisions whether to compensate emitters are for Government to make, it argues that there is a stronger case to support structural adjustment systems for communities facing the risk of stagnation and decline rather than provide payments to affected industries. Similarly, equity grounds would strongly suggest that low income households will have claims for compensation. Claims to compensation by shareholders in sectors such as in the stationary energy sector would need to be assessed alongside the equity claims of other groups.
Indeed, the Discussion Paper identifies many claims that will be made on the Government's revenue stream from the auctioning of permits. Importantly, the Discussion Paper contends that the Government will need to use this substantial source of revenue to correct market failures, particularly in relation to funding research and development into low emissions technology, to provide public infrastructure and provide cash reserves to enable international permits and offsets to be purchased to reconcile Australia's emissions with international commitments.
Conclusion
If a carbon price is needed to address the market failure of unpriced greenhouse gas emissions, then the most efficient means to realise that price is through the creation of an emissions trading scheme which has broad coverage and with minimum exemptions.
Like many other world economies, the problem for Australia presented by the global challenge of climate change is the uncertainty of an international commitment to reduce emissions to an appropriate level to avoid dangerous climate change. The Discussion Paper has provided a useful map to navigate and accommodate this uncertainty. In particular, the recommendation that Australia adopt multiple targets and trajectories with five year gateways permits greater emissions constraints to be adopted if stronger effective international mitigation commitments are made, enabling the market to factor in more onerous constraints in its pricing of permits.
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