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Good, Bad and Ugly in Australia’s Carbon Pollution Reduction Scheme

January 26, 2010

Below is an article I had published back in November in French Policy Magazine La Courriere de la Planete. In a nutshell it explains what is best and worst about Australia’s proposed ETS.

“There is a chance, just a chance, that humanity will deal with this issue in a manner which future generations judge to be satisfactory.” These words were not those of someone given to hyperbole. Rather they were written by an orthodox professor of economics, Prof. Ross Garnaut, upon submitting his final review of Australian climate change policies to Australia’s Prime Minister last year.

Prof. Garnaut’s Review painted a bleak picture of Australia’s future in a warming climate. Take Australia’s Great Barrier Reef off of the north-east coast, for example. As a UNESCO world heritage site, it is the largest coral reef ecosystem in the world. The Review found that with a rise of just 1°C in average global temperatures, the reef’s coral and ecosystem would disappear within 30-50 years. In fact, it cited evidence that 5-10% of the reef is already suffering severe coral bleaching.

If the severe impacts of global warming envisioned by climate scientists are correct, then Australia is likely to be among the first to know. Sydney, Melbourne, Adelaide, Perth, and Brisbane have all started building sea-water desalination plants, and imposed mandatory water restrictions, because of historically low dam-water levels during the past 10 years – something Australian scientists say is a consequence of a warming climate. And there is an eerie connection between scientific predictions of warming effects and the increasing frequency and severity of Australian bushfires.

The upshot is that Australians have become engaged in the issue of climate change. At the last national election in 2007, Australia’s incumbent Prime Minister of 12 years was defeated partly because his refusal to ratify the Kyoto Protocol led voters to believe that his Government could not be trusted to deal with this issue.

Since then, there has been rapid change in terms of national policies. Australia has taken the symbolic step of signing the Kyoto Protocol in 2007, and will meet its target to limit average annual emissions to 108% of 1990 levels during 2008–2012.

The Australian Parliament also recently passed a national renewable energy target (RET), which will begin the tough work of transforming Australia’s heavily emitting energy sector. Due to large coal reserves, carbon intensive coal is the preferred energy fuel in Australia: 84% of Australian stationary energy came from coal-fired generation in 2008. But the RET will force electricity producers to supply 20% of their energy from renewable sources by 2020.

The biggest policy change, however, is Australia’s plan for a carbon emissions trading scheme (ETS). The ETS, which would commence in July 2011, forms the largest part of a legislative package called the Carbon Pollution Reduction Scheme (CPRS) and is currently awaiting a final vote in late November in the Australian Senate.

The CPRS will set a target of reducing emissions by between 5-15% below 2000 levels by 2020 (4-14% below 1990 levels). It will require polluters who emit more than 25 000 tCO2e each year to purchase emissions rights equivalent to their yearly emissions. These would include around 1000 installations in the stationary energy, transport and aviation, mining, industrial processes, and waste sectors.

The Australian ETS would be a standard cap-and-trade market for carbon like the EU ETS. The Government would set a cap on domestic emissions each year that is consistent with its reduction target and then allocate that number of emissions allowances to emitters. Because the government will be reducing emissions by limiting this allocation, the scarcity of allowances relative to the demand by firms to emit carbon – to produce goods and services – creates a commercial value, and thus a market price, for them.

Observing the emissions allowance price for each tonne of CO2e, firms will then compare it to their cheapest abatement options and decide whether it is cheaper to reduce emissions (e.g. by investing in cleaner technologies), or to continue to emit and purchase allowances at the prevailing price.

Since the government enforces the supply of allowances, the price of carbon in the market will rise and fall with demand by firms to ensure that emitters do not emit more on aggregate than the overall emissions budget or cap. The process of de-carbonising economic activity thus begins as economic actors respond, through the carbon price, to the need to live within a carbon budget. So the first positive point about the CPRS Bill is that it will introduce a cost on carbon for firms responsible for a massive 75% of Australia’s emissions.

The second positive point about it is that the CPRS Bill would auction the majority of the allowances. This is good policy because free allocation can have perverse effects. For instance, firms will tend to pass on some of the market price of allowances to consumers even if they get them for free. Free allocation thus delivers them windfall profits. This is what occurred in the trial phase of the EU ETS when more than 95% of allowances were allocated for free. Australia has learned this lesson.

Auctioning allowances also helps strengthen the incentive to abate – managers tend to really focus their attention on their firm’s abatement options when they have to pay for allowances! The other major advantage of auctioning allowances is that, just like a carbon tax, it creates revenue with other spin-off benefits. For example, in Australia AU$4.5 billion of the CPRS auction revenue will be spent subsidising solar and carbon capture and storage trial projects in the first 5 years of the scheme alone.

The CPRS is not perfect, however. For instance, there is a risk of excessive free allocation to certain firms in competition with other firms in countries where there is no carbon price. Some allocation is sensible to avoid firms shifting production offshore, but the CPRS’s proposals are somewhat overgenerous. Moreover, the Government’s desire to provide business investment certainty may make it hard to fix mistakes, e.g. the bill requires the Government to give firms at least 5 years advance notice before removing free allocation. Negotiations in the Senate in November are more likely to exacerbate this problem than to improve it, since the Government will need the support of parties more closely aligned to business to secure passage of the bill.

A second issue is that even the Australian Treasury (who helped designed the CPRS) does not believe that it will do much to transform Australia’s carbon-intensive stationary energy sector much before 2030. In short, there is a risk of an insufficiently strong price signal because of certain provisions allowing unlimited use of international offsets by covered firms. This is a problem, since stationary energy represents around half of Australia’s emissions. Given Australia’s abundance of sun, wind, tide, geothermal potential, gas and uranium, significant possible abatement at reasonable carbon prices could easily be delayed.

Globally speaking, Australia has made rapid and positive strides to address its emissions and establish a target and a carbon price to reach it. And well it should. For the Great Barrier Reef, “delay” seemed like a policy that future generations might not find satisfactory.

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