EXPLAINING EMISSION TRADING SCHEMES AND CARBON CREDITS

December 2009

APN Feature Article

Editors comments: With discussions surrounding an Emissions Trading Scheme for Australia likely to be re-ignited when Parliament resumes next year we thought we would go out this year with an article actually seeking to explain in relatively simple language what an ETS actually is and how it is likely to work. With most Australians expressing little understanding of what such a scheme involves we thought it may be helpful to many folk to give a simple explanation of the fundamentals behind what our leaders will be debating (and we may be asked to vote on) in due course.

We owe a debt of gratitude to Professor Kevin Parton, Head of Campus, Charles Sturt University in Orange NSW for the explanation, and to the National Alliance of Christian Leaders who facilitated its distribution to us.       

Strange as it may seem, the idea of an ETS is to establish a market for trading in greenhouse gases. This would put a price on such gases, increase the costs of those who produce them, thereby reduce the amount going into the atmosphere and hence limit further global warming. The eventual objective is to bring together in the marketplace those who produce greenhouse gases (principally carbon dioxide) with those who absorb them (in a process called "sequestration"). This is achieved through a system of trading permits-to-emit.

Firms with manufacturing processes that emit carbon dioxide into the atmosphere are the principal target of the ETS. This includes, as a significant example in Australia, the coal-fired generation of electricity. Without government intervention there can be no greenhouse gas market, because the polluters can simply put carbon dioxide into the atmosphere at no cost. Governments need to regulate to get the market off the ground. Under the Australian ETS, the government is proposing a cap-and-trade mechanism.

This involves the auctioning of permits by the government. For every tonne of carbon dioxide that they emit to the atmosphere, the firms that are major greenhouse gas emitters must purchase one of these permits. Let’s say that the price in the auction reaches $50 per tonne. However, if firms that emit carbon can buy a permit privately for less than $50 per tonne, they will. Also, permits can be created by private individuals who sequester (or absorb) carbon dioxide by growing forests or other means.

Let’s say it only costs $20 to sequester a tonne of carbon dioxide, and thus create a permit at a cost of $20 per tonne. If firms that sequester carbon can obtain more than $20 per tonne in payment for their activities there is an incentive for them to sequester. Therefore there is a financial incentive for emitting firms and sequestering firms to get together and trade permits for, say, $36 per tonne. For example, an electricity generating power station uses coal for fuel and emits, say, 10 000 tonnes of carbon dioxide. It needs to obtain 10 000 permits.

It can go to the government and buy them at a cost of $500 000 or it can go to a sequestering firm and buy them for $360 000. Indeed it can sequester the carbon underground itself if the cost of doing so is less than $36 per tonne Under the normal operation of a cap-and-trade policy, the government usually wants to get out of the permit trading system as soon as possible, and concentrate on setting the cap (or the total amount of greenhouse gases that will be allowed to be emitted).

Direct trading between those who sequester and those emitting, without government involvement, is more likely to lead to an efficient outcome, that will more rapidly lead to activities and innovations that reduce the emission of greenhouse gases. These activities will include carbon dioxide capture by polluters, improved methods of sequestration, and renewable energy generation. Greenhouse gas emissions are a by-product of producing goods. The idea of an ETS is to encourage firms to reduce emissions by charging them for the privilege of emitting.

To reduce emissions effectively, the Australian ETS is focussed on the operations that emit the most. Only firms with annual emissions greater than 25,000 tonnes are included. There are about 1000 firms included at the outset and they effectively are responsible for about 75 percent of Australia’s greenhouse gas emissions. Under the ETS, these firms will need to purchase permits in an auction system to allow them to continue to emit. The government will issue a fixed number of permits and the price will be determined by what firms are willing to pay for this fixed supply.

This means, that the costs of these firms will rise and so higher prices will be passed on to consumers. All things being equal, we would expect the steepest price rises in goods whose production processes give off the most greenhouse gases. Electricity is one of these because in Australia we rely significantly on coal-fired power generation. This means that we might expect noticeable price increases for electricity as a result of the ETS. On the positive side, such price rises will encourage the generation of electricity by non-emitting processes such as solar and wind generation.

Under the proposed ETS, an important class of firms will receive free permits to emit. These are emissions-intensive trade exposed businesses. The reason for providing this concession is to avoid the situation of increasing the costs of production of exporting firms and disadvantaging them relative to overseas competitors. However, a problem arises as soon as concessions like this are introduced. All firms will be encouraged to attempt to join the group receiving concessions and the ETS becomes subject to political and bureaucratic interference.

To summarise, the main impacts of the ETS will be price rises for consumers and firms as they purchase goods that have a high greenhouse gas content. The legislation introducing the ETS foreshadows redistribution back to households through reduced taxes, so that a close to neutral net effect results. The main objective of all these government policies is to encourage us to adopt more sustainable technology that produces no greenhouse gas emissions.

The ETS works is by increasing the costs in production processes that have greenhouse gases as a by-product ("the carbon content"). Firms engaged in such processes have to purchase permits or offsets for every tonne of greenhouse gases produced. Consequently, production processes that involve no greenhouse gases seem relatively cheaper. In electricity generation, Australia’s dominant form of production using coal power will be penalised by the ETS, and green power sources, such as wind turbines or solar photovoltaic panels, will, as a consequence, be favoured.

Of course, overall, the costs of generating electricity will initially rise, and so will the price per kilowatt hour that consumers must pay. A carbon tax, the second policy considered, has a similar disadvantageous effect on goods and services whose processes of production generate greenhouse gas by-products. However, the tax is placed on consumption, rather than production, much like the GST. The carbon tax overcomes three disadvantages of the ETS. It avoids the disadvantage to exporting firms that occurs if Australia applies an ETS while other countries do not.

There is much scope with an ETS for large firms to lobby to gain exemption status. There is no way to avoid a carbon tax. An ETS is a financial derivative and as such introduces scope for further financial turbulence. While a carbon tax overcomes these problems, it also has some problems. First, the carbon tax is a "tax". It would be politically unpopular. Even though the price impact for consumers could be similar to an ETS, an ETS is not thought of as a tax. 

The third policy to consider is a subsidy on new non-emitting technology. This has the effect of directly encouraging the type of technology that we need. Also, it does so at low carbon prices, without the need to force up prices of products like electricity. The main disadvantage is that the Australian taxpayer would have to fund the subsidies. Also, it presumes that the government either knows the technology to develop before it is proven or subsidises a large portfolio of potential new technologies and accepts some winners and some losers.

Source: National Alliance of Christian Leaders