To Trade or not to Trade? The ETS Question.

Without doubt the Governments ETS is one complex piece of legislation. Market based carbon price, up stream fuel suppliers, emission permit auction procedures, fugitive emissions or C02-e caps and gateways don't make for light reading before bed. Indeed the shear scale of the detail in the CPRS can lead many to not even bother to try and understand how an ETS fundamentally works or what the difference is between that an a Carbon Tax. Thus the daunting complexity of the subject leads many to give up on their own understanding, leading to the inevitable question "which pundit or politician should I listen too"? Alas that is not a recipe for informed debate, as often people listen to those who yells the loudest or speaks to their pre conceived ideas or fears. So I thought I would try to explain fundamentally what an ETS is, how it works, why it is efficient and the other options we have for abatement. The legislation may indeed be massively complex, but the ideas behind these mechanisms are neither new nor rocket science. Fundamentally it all comes down to giving carbon a price.

Let's assume for arguments sake that we both understand the mechanisms behind CO2's role in the atmosphere and believe the scientific consensus that observed climate change is driven by human CO2-e emissions. We can get on to the merits of that debate later.

Due to the pervasive dependence on fossil fuel based energy CO2-e is emitted from every nook and cranny of our society. From Agriculture to Electricity Generation to Forestry to Heavy Industry to Households CO2-e is everywhere, and it is this incidence that makes CO2-e different from other forms of atmospheric pollution. Due to the small locations of CFC or SO2 pollution (point sources) legislating for their control was a relatively simple affair. Heavy Industry was banned from using CFC's in aerosols and other products, and coal fired power plants were required to have sulphur dioxide scrubbers on every smoke stack. Voila, problem solved. Unfortunately the fact that CO2-e pollution comes from point (factories) and non-point (land use/households) sources means that simple regulation of CO2-e can not be an effective way to dramatically reduce emissions. In order for that to work the government would have to effectively require all industries and households to introduce specific measures to cut emissions, such as requiring all cars to be hybrids or making deforestation of any kind illegal. As you can imagine the complexity of determining every exact abatement procedure for every single industry would be massively complex and costly, not to mention the massive financial, economic and social cost of government intervention on such a scale. Clearly direct regulation is not a viable option in this instance.

Another abatement opportunity, one apparently championed by the current opposition leader, is to simply change the electricity generation method in Australia. Simply build nuclear power plants and we will be able to make significant CO2-e reductions without really changing anything! Even if Nuclear was an economically viable option (which I personally doubt) unfortunately the nature of our economy means that the majority of CO2-e emissions come from outside the electricity sector. Cars would still be burning fossil fuels, heavy industry would still be producing massive amounts of carbon directly and planes would still be flying around burning kerosene. Basically in order for there to be long term sustainable reductions in CO2-e emissions the whole economy needs to change the way it functions, Nuclear Power alone will not achieve that.

So how do we change the way the whole economy functions and do it with the least cost?

You use the Market. The whole economy is one great, big, trillion dollar market place, with producers and consumers of labour, produce, products, services and everything in between trading one for the other. Employer's trade money for labour, consumer's trade money for products, the government the promise of money in a few years for money now (bonds), and yes people and corporations buy products and services that create CO2-e emissions like petrol and cars. The market is the economy and every economic decision occurs in a market environment. Therefore you can achieve an economy wide change be manipulating the market or, as economists would say, addressing the market failure.

So why give carbon a price?

The simple reason is if you make carbon intensive services or products more expensive less people will buy them resulting in lower emissions. The complex reason is a concept called allocative efficiency. One of the major benefits of a free market is that under perfect circumstances market forces will lead to a price level that means the total costs society suffers in producing a good (cost of labour, inputs of production, pollution, use of land ect) exactly equal the total benefits society receives from consuming that product. Just by allowing consumers and producers to barter the total costs will equal the total benefits, leading to an efficient outcome. A pretty cool trick. Unfortunately no market operates in perfect conditions and many limitations lead to market failure (i.e. a market not achieving an efficient outcome), the largest of which being imperfect information. The damage caused by CO2-e emissions (valued at $80 a ton by the Stern Report) is not included in the market for aluminium, and thus the price is too low. There is a cost to society caused by the production of that product that is not included in marked decisions. The carbon price raises the price level and brings the market back to equilibrium and efficiency. That leads to less production and less pollution.
So what's the difference between an ETS and a carbon tax?

Well both are ways of addressing a market failure by including that additional cost in market interactions. Both will effect almost every economic interaction that directly or indirectly causes CO2-e pollution and both will reduce pollution levels by making carbon intensive products and services less competitive. The major difference is how they affect different industries, how they effect individual firms, what level of abatement is actually achieved and how they set the price level. But before I explain the primary differences I guess I should explain how both work.

A Carbon tax is, surprisingly, a direct tax on carbon emissions. Every company that falls within the desired size level must pay a tax for every ton of CO2-e it emits every year. The tax level is set by government and has to be raised and lowered in order to reach an efficient price level. That cost is then past on to consumers making carbon intensive products or services more expensive. The only complicated element to this system is the need for robust reporting and audits of carbon emissions for all liable companies or individuals.

An ETS is in effect a permit trading system. Instead of just levying a flat tax on all emitters an ETS requires every company that emits over a pre determined level to present a pollution permit to the government for every ton of CO2-e emitted for the reporting period. These permits are fully transferable and can be owned by any legal person allowing proper market interactions to occur. In order to meet a certain abatement level an emissions cap is set every year of x number of tons determining the number of permits to be released into the market. The permits are auctioned several times a year allowing the market to set the carbon price. Every year the cap is reduced in order to meet a certain emissions reduction target, which in turn raises the carbon price.

So which one is better?

Both approaches have their strong and weak points, in short a Carbon tax is simpler to introduce and administer and an ETS is more economically efficient and environmentally effective. The bureaucracy needed to implement a carbon tax is for the most part already in place through the normal tax system. No new markets need to be established and regulated, no new regulatory bodies need to be created. Additionally the government has direct control over the price leading to certainty for business. An ETS however is far more efficient. By allowing market forces to set the carbon price the price level will automatically move toward an efficient outcome as the firms who can reduce emissions easily buy less permits. Additionally by allowing permits to be traded, industries that can move to low emissions technologies cheaply can sell their permits to those industries which can not, allowing the burden of abatement to shift to those sectors and firms who can reduce their emissions at the least cost. This flexibility significantly reduces the national cost of abatement. A Carbon Tax on the other hand hits every single firm and industry with the same flat tax meaning all sectors and firms have to abate equally, regardless of the individual cost. This mechanism alone means an ETS is far less costly and more efficient than a Carbon tax. From an environmental perspective there is no way that a carbon tax will guarantee to hit a target level of reduction, there will be abatement but it is almost impossible to set binding targets. That tax level may reach the target, it may not, and you may not be able to raise the carbon price to the desired level due to political constraints thus the environmental integrity of a carbon tax is significantly less than an ETS with concrete caps on emissions.

In short all though more complex, an ETS is less costly, more efficient and guarantees emissions reductions. It is by far the best mechanism for reducing carbon emissions on such a scale and is the basis for the EU's and U.S.'s climate change policies. Now there are some significant deficiencies in the governments CPRS, primarily the level of free permits given to polluters. One of an ETS's benefits is it spreads the abatement costs over the whole economy making the individual cost small. However as large industry lobbies for free permits through threats of job losses and moving off shore, the total number of firms covered by the scheme decreases raising the individual cost to the rest of us. This phenomenon is called rent seeking and it is a major flaw in the current CPRS.

Hopefully that cleared up a mew misconceptions for you. In a later piece I will examine the government's proposal in detail. If you have any questions or comments don't hesitate to leave them below, thanks.