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How low can you go? A model for setting and increasing a carbon price

To achieve actual reductions in Australia’s emissions, the carbon price will need to rise from its likely starting point in the $20s. A price floor in the trading phase could help bring about efficient…

A carbon price won’t help much unless it keeps going up. AAP

To achieve actual reductions in Australia’s emissions, the carbon price will need to rise from its likely starting point in the $20s. A price floor in the trading phase could help bring about efficient low-carbon investments, by keeping policy related uncertainty in check.

It is no surprise the bookies have the range of $20-25 per tonne of carbon dioxide as the odds-on favourite for the starting price of Australia’s carbon pricing scheme. Ross Garnaut recommended $20-30 and singled out $26 for special mention; the Business Council’s call for a $10 price is counterbalanced by the Greens’ stated preference for something like $40; and Climate Change Minister Combet said it would be “well south of $40”.

What goes up – might keep going up

Will this price get us a reduction of 5% or more in Australia’s domestic emissions, in line with the national target?

First of all, it is important to understand that investment decisions that will shape the emissions trajectory depend on price expectations over the medium term, not on the starting price.

As I argued in this paper, the beauty of the fixed price approach is that it allows us to start with a low price that keeps the economic transition manageable, and ramp up thereafter to levels needed for investments that actually cut emissions.

Treasury modelling done for the CPRS scheme indicates that a 2020 carbon price in the range of $50 to $60 (in today’s prices) would be needed to achieve a reduction in emissions, relative to year 2000 levels.

A scenario with a price in the $40s had emissions stabilising rather than falling.

The modelling is being updated, and other analyses give different results. But the best guess is that prices in the $20s or 30s would see emissions keep going up.

This is because the underlying emissions growth trend is so strong. The government’s projection of business-as-usual emissions has our domestic emissions rising by 24% from 2000 to 2020 without further policies. This was revised up from the previous estimate because of faster resources and mining industry growth.

What to do?

We could hope that the response to the carbon price will be stronger than thought, as has been the case in many other market-based schemes to cut pollution. But there are of course no guarantees of that, and it could go the other way.

We could rely on carbon offsets from land-based sequestration. But as government analysis shows, the amounts of emissions reductions actually achievable might be small. The Climate Commission argues that carbon sequestration is no long-term substitute for avoiding fossil fuel emissions.

We could buy additional emissions reductions from overseas.

This is almost certainly going to be necessary for more ambitious targets than the 5% reduction, and it would be a useful contribution to the global effort by supporting investments and emissions reductions in developing countries. But it would be quite unpalatable to for many groups to see actual domestic emissions levels continue to rise, and it would raise questions about the extent of change at home.

Stepping it up

Two options could help square the circle.

Firstly, the fixed price could be legislated to rise at sizeable increments from the start – say, rising by $4-5 each year.

There is no economic or administrative hurdle to a steady scheduled increase. The money available for assisting households and industry increases in line with the carbon price. And a fast rising fixed price would create an incentive for business to support the transition to an emissions trading scheme.

The practical hurdle here is a potential political reluctance to embark on a trajectory that will result in substantial change in the way things are done, particularly in the energy sector.

Installing a price floor

Secondly, government would do well to firm up price expectations for the trading phase, slated to follow the fixed price scheme after a few years. As I have argued in a recent briefing for the Multi-Party Climate Change Committee, and in a research paper with Steve Hatfield-Dodds of CSIRO, a price floor (or minimum price) could encourage cost-effective investments in low-carbon assets, by reducing policy-generated price risk.

Providing a price floor would be the best way to deal with the possibility that international emissions markets might be fragmented, while they mature. For example, the European Union excludes certain types of international emissions offsets from the EU emissions trading scheme, and may shun offsets from anywhere but least developed countries. This could leave large amounts of credits from developing countries going cheap.

Where the emissions reductions are real, it is fine to use them towards our national target. But letting them set a low domestic price could delay investments that are efficient in the long run.

A price floor solves the problem: it allows the use of low-cost international emissions units, while maintaining a minimum price in the Australian market.

A price floor in operation could increase the short run cost of Australia achieving a given 2020 emissions target, but it could reduce economic costs over the medium to long term. Making provisions for a price floor would lower investment risk whether or not it is ever triggered.

Implementation could be through a reserve price on domestically auctioned permits, coupled with a fee on the conversion of international permits for use in the domestic ETS. It is administrative simple, and avoids arbitrary interventions in carbon markets.

A price floor is also provides a more direct and effective way to ensure that Australia’s domestic emissions fall than the alternative of putting a potentially arbitrary additional cap on the use of international permits. And , and it does this in a way that reduces rather than increases business risks.

The right start

Pulling together a compromise for a carbon price is no mean feat for a minority government and in a political climate where reasoned argument finds little room.

A fixed price on carbon is a good start toward sensible and effective climate policy. But ambition needs to rise, and it can.

Australia is riding an unprecedented resources boom. To think that we could not afford to modernise our economy to be more carbon efficient would be a narrow perspective indeed.

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