Policy commentary

A Carbon Price for Australia: From Tax to Trading

Apr 4, 2011 | Frank Jotzo

In the vigorous climate policy debate in Australia, an interesting possibility has emerged: an interim emissions tax that gives way to a cap-and-trade program. What promise does this option hold? And what challenges and questions does it present for climate policy in Australia?

Australia’s government is in the midst of another attempt to put a price on greenhouse gas emissions. It is likely to choose a novel hybrid scheme, in a bid to achieve a broad and lasting national consensus, but design and key parameters are still contested.

The Challenge

Climate policy is particularly poignant down under—Australia has the highest per-capita emissions among the major countries, and has built its recent prosperity in part on coal and energy-intensive industries. At the same time, it faces the worst risks from climate change impacts among all developed countries (Garnaut 2008). The national government set a target to cut emissions by 5 percent, relative to the year 2000, by 2020 and may strengthen the reduction commitment to 15 or even 25 percent depending on international action. Reversing the emissions trajectory is a considerable task, however, especially in an economy that has among the highest population and GDP growth rates in the developed world, and where resource-based industries are large and growing fast. Putting a price on carbon emissions is considered by the current government and the vast majority of analysts to be the principal instrument to achieve cost-effective mitigation in Australia.

Attitudes among the public and businesses, however, remain mixed. Many citizens place high importance on environmental issues, and addressing climate change is essential for a large proportion of progressive voters. At the same time, there are widespread concerns over the economic impact of reducing Australia’s emissions, and about the impacts of carbon pricing on the cost of living in particular.

The broader business community supports Australia “doing its bit,” in a scheme that offers assistance to strongly affected businesses and is fiscally prudent. Emissions-intensive industries (such as electricity generation, mining, and fossil fuel extraction, for example) seek a low and predictable carbon price, and are attempting to maximize financial assistance from the government.

Although previous attempts to pass emissions trading legislation have failed, an unusual constellation in the Australian Parliament may make it possible this year for the government to put in place a carbon pricing scheme. The current Labor minority government under Prime Minister Julia Gillard governs with the support of Independent and Greens party members of Parliament, who effectively made the introduction of carbon pricing a precondition for their support. Government has committed to start carbon pricing in mid-2012, which means a steep timeline for achieving political agreement and developing and passing legislation.

The Proposed Solution

The architecture proposed by the parliamentary Committee is a novel form of hybrid, which might be termed “phased” carbon pricing. The scheme would start out as a permit system with a fixed, government-determined price, increasing every year—similar, for example, to the short-run price promoted by economists McKibbin and Wilcoxen. It will act like a carbon tax, except that it uses the institutional architecture of a cap-and-trade scheme. Emitters are under a permit liability, and government sells an unlimited amount of permits at a predetermined price. After a number of years, there would be a transition to emissions trading. Implementation of the shift is simple: government limits the number of permits issued, and sells them at the market price, principally via auction.

This model was proposed by economist Ross Garnaut in his 2008 Climate Change Review, undertaken for the Australian government. In the aftermath of the 2009 Copenhagen climate conference, it became increasingly clear that the phased pricing approach was a promising avenue for Australia, as I have argued elsewhere (see Further Reading). The main virtue of such a system is that it offers the best chance for the broad-based and durable societal consensus on carbon pricing necessary for political sustainability.

Additionally, a phased carbon pricing scheme can provide confidence that the short-run economic and business impacts will be manageable, given that the price is relatively low and fully predictable. At the same time, the medium- to longer-term parameters can be set so to create confidence that emissions will begin trending downward. Combining a soft start with a ramp up over the medium term allows government to balance the interests of different groups in society.

Once the emissions-reduction target is established and sufficient trading opportunities in international carbon markets exist, emissions trading linked to international markets will be the most efficient option for Australia. It will allow the country to meet a given national target at least cost and businesses to use international trading opportunities and financial market instruments. It also places most of the cost risk of meeting the overall national target on polluters. And, importantly for a relatively small economy like Australia’s, linking the domestic scheme to international markets cuts the link between the domestic target and the carbon price. As a result, a more ambitious target does not mean an escalating carbon price. It only means that Australia will be financing extra climate action overseas by way of buying more permits internationally.

What Price?

This high-level architecture has effectively been decided. Ahead, some battles loom over design and parameters. The timeline and conditions for shifting from a government-determined price to a market price are still in question. Government has proposed to shift after three to five years, subject to review. Others call for a shorter transition period, or conversely for the transition not to be time-bound but based on conditions for the national target and international emissions markets.

Difficult decisions also need to be made about the level and rate of increase of the fixed price. A starting price of $25 per ton of carbon dioxide (note that one Australian dollar is worth approximately one U.S. dollar), rising at around 4 percent per year plus inflation, has been frequently mentioned.

This would provide confidence that short-term economic impacts are manageable. However, higher price levels are needed to trigger large-scale abatement options such as substitution from black coal to gas for electricity generation, and to start reducing Australia’s greenhouse gas emissions. A real price rising to $50 per ton by 2020 would see Australia’s emissions fall from around 2015, according to the modelling. Therefore if the fixed price were to remain in place for some time, it would have to rise faster or start higher.

Tax Reform

The stickiest issue of all is how to allocate the revenue from the carbon price. At $25 per ton, annual revenue would amount to over $10 billion per year, on the order of one percent of Australia’s GDP. The government has committed to the scheme being revenue neutral, returning the revenue to households, industry, and to climate change programs.

Predictably, interest groups are lining up to maximize their returns. Emissions-intensive, trade-exposed industries (such as aluminium, steel, and concrete) are likely to get free permits, on the basis of activity-specific benchmarks of emissions intensity of production. This structuring would preserve incentives to reduce emissions, but a significant share of permits—perhaps around one quarter—would be given for free to export-oriented industries. Although this is much less than in the European Union emissions trading scheme, the ad-hoc manner in which free permits are likely to be distributed has attracted criticism, including by Garnaut.

Every dollar given to shareholders is, of course, a dollar that cannot be returned to taxpayers. In Australia, the fact that introducing a carbon tax allows cutting other taxes is only now hitting the public and political debate in a big way. The prospect of income tax cuts appears to have lifted public support for carbon pricing.

If Australia succeeds in putting a price on carbon, it will provide valuable lessons for the world. American policymakers should be watching with interest—not only will a new model be tested, but it will be done in a growing rich economy that is heavily dependent on cheap fossil fuels.

Frank Jotzo is Director of the Centre for Climate Economics and Policy at the Australian National University’s Crawford School of Economics and Government.


Further Readings:

Garnaut, R. 2008. The Garnaut Climate Change Review. Melbourne: Cambridge University Press.

Jotzo, F. 2011. Carbon pricing that builds consensus and reduces Australia's emissions: Managing uncertainties using a rising fixed price evolving to emissions trading. Centre for Climate Economics and Policy working paper 11.4. Canberra: Crawford School, Australian National University.

Jotzo, F. 2010. Copenhagen targets and Australia's climate commitment.Centre for Climate Economics and Policy, policy brief. Canberra: Crawford School, Australian National University.

Hatfield-Dodds, S. and M. Morrison. 2010. Confusing opportunity costs, losses and forgone gains: Assessing the effect of communication bias on support for climate change policy in the United States and Australia. Centre for Climate Economics and Policy working paper 9.10. Canberra: Crawford School, Australian National University.