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Explainer: The difference between a carbon tax and an ETS

Since July 2012, Australia has had in place its carbon pricing scheme. It is commonly referred to as a “carbon tax”, but also as an “Emissions Trading Scheme (ETS) with a fixed price”. And the plan is…

An emissions trading scheme and a carbon tax are not the same thing. AAP

Since July 2012, Australia has had in place its carbon pricing scheme. It is commonly referred to as a “carbon tax”, but also as an “Emissions Trading Scheme (ETS) with a fixed price”. And the plan is to move to an ETS with a floating price.

So, which is it, and what are the differences between these different types of schemes?

How does an ETS work?

An ETS works by setting a cap on emissions and requiring emitters to hold a permit for each tonne of CO₂ that they emit. The level of the cap determines the number of permits available.

If emitters don’t already hold a permit, they must either cut back on their emissions or buy a permit from another emitter, who must then cut back.

This means that a cost is imposed on emissions, equal to the price of buying or selling a permit.

But importantly it’s not actually the price that causes the overall cuts in emissions. The cap determines the level of emissions, and the required cuts in emissions cause the price.

That is, permits have a value because they allow you to avoid making cuts in emissions.

How does this differ from a carbon tax?

A carbon tax is sort of the opposite. A cost is added to all emissions, equal to the level of the tax, and this causes people to cut back.

There is no cap on emissions in a tax-based system. People are free to emit as much or as little as they like, but if they do emit, they must pay the tax.

Unlike an ETS, under a carbon tax it is the price that determines the level of emissions.

Where is Australia in all this?

The following description is current as of May 2013. The possibility of changes post-election later this year is not considered.

The Australian system is rolling out in two phases.

The first phase, which we are currently in, is sort of an amalgam of an ETS and a tax. Like an ETS, it is based around permits. However, unlike an ETS, the permits have a fixed price, have no cap on quantity, and cannot be traded.

Technically, it’s not a tax system, but its effect in practice is much more like a tax than like an ETS.

The second phase, starting in July 2015, is an ETS, as described above, with a floating price, a cap on local permits and trade in permits.

But again there is a twist. After the initial scheme was in place, the Government announced that in the ETS phase, it would be linked to the European ETS. Since that scheme is so much bigger than ours, it means that the local price of permits will be determined by the price in the European scheme.

This two-phased approach was presumably intended to have a smooth transition period after the scheme commences. However, as things have panned out, it looks likely that there will be a significant drop in price once we join the European scheme. The fixed price in Australia in 2014/15 will be $25.40, but the current (May 2013) price in Europe is only 3.40 Euros (about A$4.50).

Where does the money go?

When people pay a carbon tax, the revenue goes to the government. Government can use that revenue to reduce other taxes or costs, or to provide compensation to particular groups which are adversely affected.

An ETS could be set up so that the initial revenue goes to the government (i.e. all the permits are sold by government at full price).

But it could also work effectively even if some of the permits are given away, provided that the cap is enforced. The Australian scheme does involve some permits being given to Emissions Intensive Trade Exposed (EITE) industries.

Revenue from subsequent transactions between emitters within an ETS would go to the seller of the permits, not to the government.

Another difference between the two approaches would be in the level of transaction costs – the costs of administering the scheme and or of participating in it. Some have argued that a carbon tax is likely to have lower transaction costs, and that does seem plausible to me.

How will households be affected?

From the perspective of households, the scheme will be no different in its fixed-price phase than in its later floating-price phase, other than in the level of carbon prices and the initial absence of price volatility.

Households will not have to pay for emissions permits directly, but will do so indirectly as businesses pass on some or all of the higher costs they face.

If the government had opted for a standard carbon tax instead of a fixed-price ETS, the result at the household level would not have been noticeably different. Higher costs would have been passed onto them through higher prices in a similar way.

It would also have been possible to compensate low- and middle-income earners through reduced income tax or increased government payments, just as is occurring under the current scheme. In neither case would individuals have to put in any sort of tax return for their carbon emissions.

Can the government avoid the stigma of the word “tax”?

Given the traction opposition Leader Tony Abbott got from his line about a “great big new tax on everything” during the last election campaign, the government might have been tempted to avoid the “tax” word.

However, I haven’t seen them try to argue that their carbon pricing system is not a tax. In the circumstances, this is probably wise. Even though, technically it involves purchase and surrender of emission permits rather than a tax, in practice the effect is basically the same as a tax. For that reason, I think it’s good that they haven’t tried to fight a semantic battle about this.

* This story was updated on May 23, 2013.

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16 Comments sorted by

  1. David S

    IT Communications Professional

    The difference between an ETS and a carbon tax is, unfortunately, too nuanced for a large portion of Australians.

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    1. Greg North

      Retired Engineer

      In reply to David S

      Oh, I don't know David for it's a bit like the auto industry with people either buying new cars and the $$$ going to the manufacturer/dealer or if you're in the used car market and $$$ go to who you buy a car from, whether it be a dealer who has bought from a seller or to the seller direct as in a private sale.

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  2. Troy Barry

    Mechanical Engineer

    It's possible that, in the aftermath of the financial crisis, "trading scheme" tested worse on focus groups than "tax". At least people understand what a tax is, while to the untrained ear "trade in carbon dioxide emission permits" doesn't sound very different to "trade in collateralised debt obligations".

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  3. Ken Xie

    Policy Officer, DCCEE

    Without having insight into the deliberations of the Multi-Party Climate Change Committee, one can surmise that the reason why the Labor Government is calling the proposed scheme a "carbon tax" is because the fixed price of the permits means the result is more akin to that of a carbon tax than an ETS.

    A slight alternative to what is proposed above is an ETS with a price floor (and/or ceiling), which would provide stability and predictability in the price of permits without having the Government take over the role of markets in setting prices.

    But all this is conjecture since the devil, as always, is in the details, and we don't yet have the details.

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    1. Peter Poul Bjerregaard

      Sociologist

      In reply to Ken Xie

      An often-overlooked downside of Emissions Trading Schemes (ETS) is the progression, or the lack hereof, of the amount of total emissions-quotas.

      In a situation where the ETS has a fixed level of emissions, energy-efficient companies will create an unintended disincentive for other companies not to adopt more energy-efficient technologies or improve business models as the improvement of other companies will lower the price of emissions and thus create an unintended disincentive to move towards emissions abatement.

      This concern is partly also reflected in the EU’s recent efforts to move from 20% CO2-reductions in 2020 to 30% in 2020.

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    2. Greg North

      Retired Engineer

      In reply to Peter Poul Bjerregaard

      " In a situation where the ETS has a fixed level of emissions, energy-efficient companies will create an unintended disincentive for other companies not to adopt more energy-efficient technologies or improve business models as the improvement of other companies will lower the price of emissions and thus create an unintended disincentive to move towards emissions abatement. "

      I suppose Ken, it'll be a bit of discerning between other companies and other companies.

      For instance, first cab of the…

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  4. Mel Nicholls

    logged in via Facebook

    My understanding was that when the idea was first proposed, Labor did call it a carbon price, or something similar with less negative connotations, and the opposition jumped on it as a tax, which has stuck as a label.

    Either way, good to have the differences explained.

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  5. Douglas Cotton

    B.Sc.(Physics), B.A.(Econ), Dip.Bus.Admin

    Whatever you call it, it's totally useless ...

    If you care to visit http://earth-climate.com you'll learn why adding extra CO2 has no further effect on temperatures. You'll also learn that the IPCC completely disregarded the component of temperature contributed by gravitational energy. And you'll learn that temperatures have not risen since 2003 despite increasing CO2 levels. So why will they increase in the next 10 years? They won't until about 2027 or 2028. Then they will increase for 30 years (as in 1970 to 2000.) It's all in the stars.

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    1. Andrew Kirk

      logged in via LinkedIn

      In reply to Douglas Cotton

      Why did you choose 2003 Douglas? That's an eight-year period. Not five years, not ten years. Eight. Nobody ever quotes eight year periods unless there was some specific significance of the start and end dates. You wouldn't have happened to choose 2003 because it was a local maximum in the data series on which you base your observation would it? As you have a BSc in Physics I assume you realise that if that's the case, it makes your observation devoid of any significance.

      What happens if you instead use the shortest round period most people would use - a ten year period starting in 2001?

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  6. Richard Lester

    Teacher

    I am not an economist, but if:

    1) the carbon price is floating under an ETS

    2) the 2020 cap is a 5% reduction on 1990 levels under both a direct action model and an ETS

    3) direct action works, ie reduces the emissions to 5% below 1990 levels

    Won't the floating market clearing carbon price fall to zero? (If the permits are not bankable)

    If this is the case, the coalition won't even need to repeal the legislation, they will simply need to deliver on their promised cut and there will be no price on carbon.

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    1. David Pannell

      Director, Centre for Environmental Economics and Policy at University of Western Australia

      In reply to Richard Lester

      As long as the 5%s are the same (i.e. they relate to the same base level) then yes, you are more or less right. The coalition would need to issue permits for every ton of emissions reduced, and then yes, the price would be driven to zero for as long as the "direct action" cuts match (or exceed) the reductions implied by the cap.

      Whether this is a good idea is another matter entirely. There is a strong consensus amongst economists that The Coalition's approach will be a more expensive way of achieving a similar outcome.

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  7. Keith

    logged in via Twitter

    I realise this is an old article, and I guess it was written before the legislation was announced, but I just want to address something.

    In the governments fixed price period of the ETS (3-5 years) there is:

    -No cap on emissions
    -No trading of permits
    -No banking of permits

    I think there is a very fine line between this "fixed price ETS" and a "carbon tax". I think it is -fair- to call the fixed price period a "tax", it functions effectively as a tax. But I think that you should always…

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    1. Troydeboy

      logged in via Twitter

      In reply to Keith

      Great call here Keith, you are spot on. Of course we are looking at these comments and the article in hindsight, by a year actually. Abbott has a bit of a dodgy stench about him due to his flip floppiness. I think we'll be in for a turbulent time, if this guy gets in.
      A double minded man is unstable in all his ways. Not sure how true this proverb is, but makes sense to me!

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    2. David Pannell

      Director, Centre for Environmental Economics and Policy at University of Western Australia

      In reply to Keith

      Yes, things have changed since I wrote that article. It is now clear that the system, as actually implemented, is to all intents and purposes, a carbon tax in this initial phase. So my comments above about avoiding the use of the word "tax" are no longer relevant. It is still the intention to switch to an ETS with a floating price. Another new aspect is that the ETS will be linked to the European system, so that Australia will basically be price takers.

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  8. Greg North

    Retired Engineer

    The or a an ETS would seem to be something of a dogs breakfast approach unless there was some much finer tuning in set up and management and reports of rorting being rife would seem to indicate that was not the case.

    For starters, there is the accuracy of setting total carbon emissions and caps in the first place not to mention effective monitoring of the same as the author refers to.
    So what is the score for new industries?
    Is it that approvals for development are not granted unless they can…

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  9. Delphi Janmark

    logged in via Facebook

    David,

    Rudd's CPRS (or for that matter Howard's plans) always (in all iterations) involved a fixed-priced (or hybrid) ETS [1][2] which included a transitional fixed-price implementation phase as is the current scheme (with the implication on the tradeability of permits - only free permits are tradeable in the fixed-price phase and no permits cap [3]). Although your description of the current scheme in the original version of this article as a 'standard ETS' was clearly incorrect, you correctly…

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