Building carbon markets with our nearest neighbours

A trading coalition would help Indonesia meet its emissions-reduction targets. World Resources

International carbon markets are on the nose in some quarters. From some on the left they are seen as a cheap way to absolve polluters’ sins without having a real impact on reducing emissions.

From some on the right, we hear that carbon markets are “un-Australian” and only provide an avenue for banks to profit from shady deals in developing countries.

Like them or not, carbon markets are at the forefront of domestic climate policy (and very much on the diplomatic front, too). The European Union (EU), New Zealand, Australia and California have legislation, with schemes either under way or about to kick off. Schemes are also under development in South Korea, Japan, China, Mexico and Chile.

How can international markets to do what they were originally intended to do? How can they provide low cost emission reductions and drive further ambition on addressing climate change?

We believe that Australia should be working towards regional emissions trading coalitions. Such coalitions would allow Australia to exceed its emissions reduction targets. It would do so at a lower cost and also magnify the positive climate impact by encouraging developing countries to reduce their emissions.

Building blocks

Australia has a choice about how it interacts with international carbon markets. It has a unique opportunity to provide international leadership and make the best of reducing emissions, domestically and internationally.

Australia should continue to explore links to schemes in New Zealand and the EU. But developed countries tend to have high emissions reduction costs ($/tonne) at the margin relative to many developing countries. This means that trading across developed countries such as Australia and the EU provides only limited potential for economic benefits from trade.

Those benefits would be significantly higher if developing countries were engaged. We need a stronger strategic focus on building markets in our region.

To illustrate, Australia and New Zealand already have national emission trading legislation that puts a limit and price on pollution. In Australia’s case, there is also a bipartisan-supported international pledge to reduce emissions by 5% below 2000 levels by 2020 on an unconditional basis, and between 5 and 15, or 25% depending on the actions of other countries.

Nearby Indonesia has also committed to reduce its emissions – by 26% below business-as-usual levels by 2020 and by more with international financial support. Indonesia is implementing policies to meet this target. But the extent to which it will meet its target remains to be seen and it doesn’t have any incentive to exceed it.

Under a trading coalition approach, Indonesia would be encouraged to meet its targets by rewarding it with access to an export market for emissions reductions beyond its target. Currently Indonesia has focused on curbing emissions by reducing deforestation. Given the governance issues associated with forestry, this sector does not lend itself to transparent trading yet.

But Indonesia could open up a key sector of its economy, such as energy, to international investment, creating a win-win situation for emission reductions. This sort of regional coalition would allow Australian companies, if Indonesia meets its own targets, to finance additional cost-effective emissions reductions. Meanwhile, Indonesia can further clean up its energy sector.

With access to low cost but credible emission units, Australia could increase its emission targets along or even beyond its pledged range of 5 to 25%. Indeed, emissions reductions imported as part of coalition arrangements could be used to give systematic meaning to the conditionality of Australia’s conditional pledges. This could be done by automatically tightening the target by (at least part of) one tonne for each tonne imported and would add to the global credibility of trading coalitions. It would also improve price stability in the scheme and make being part of such coalitions very potent politically for exporting countries.

More incentives, fewer emissions

Emissions trading coalitions can be useful in other ways, too. They can complement the United Nations based multilateral system and offer road-tested solutions to difficult policy design and implementation issues in areas like measurement, governance and price discovery. Greater confidence in these and other areas could speed up the multilateral negotiation process seeking to have a legally binding agreement covering all countries in force by 2020.

Another merit of regional trading coalitions is that they would reward developing countries that are acting on climate and offer incentives for others to follow suit. This contrasts with current arrangements like the Clean Development Mechanism (CDM). This is a flexibility mechanism under the Kyoto Protocol where emissions reductions from approved projects in developing countries are sold into developed countries.

Under this mechanism, developing countries are given a disincentive to agree to binding targets. This is because agreeing to their own target weakens their ability to sell emissions “offsets” through the CDM as they may be needed to achieve their own target.

Further, regional trading coalitions could make a greater range of emissions reduction initiatives from developing countries eligible for sale to developed countries. Basing credits on sectoral emissions rather than CDM type project mechanisms improves developing countries’ ability to use efficient mitigation policy tools such as emissions pricing. Project-based mechanisms, which require independent approval of each project, suffer from not being able to harness emissions reductions from large categories of actions (such as carbon taxes or broad-based regulations).

This provides a strong case for creating trading coalitions in the lead up to a comprehensive agreement. Also, trading coalitions can contribute to economic reforms that can reduce emissions and enhance economic development at the same time. This is because these coalitions provide opportunities for export revenues and thereby give additional incentives for reforms to inefficient sectors. They also provide additional revenue that may be used to manage the transition.

The heart of the matter

The possibilities go much broader than Indonesia when considering all the emissions trading schemes in place or under development.

We know that carbon markets are not perfect, so the left and right are not entirely off in their complaints.

But the heart of the matter is this: if they are well designed, carbon markets can very effectively encourage greater levels of global emissions reductions. Trading coalitions are a concrete example of where Australia could show initiative to economic and diplomatic gains.

As an advanced economy very vulnerable to the impacts of climate change, it is in Australia’s national interest to act. It is in its further interest to lead on initiatives such as emissions trading coalitions.

This article was co-authored by Erwin Jackson, Deputy CEO, The Climate Institute.