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By Fergus Green on 23 May 2013 With last week’s federal budget slashing the forecast revenue from Australia’s carbon pricing scheme for the second half of this decade, it’s a good time to have a closer look at the Gillard government’s decision to link the scheme with its embattled European counterpart from 1 July 2015. It may seem moot to be analysing the medium-term prospects of a scheme that seems likely to be repealed if an Abbott government comes to power later this year. But it is important to understand that, even if the scheme stayed in place, the EU linkage is likely to weaken its effect so drastically that its retention would be scarcely better than its demise. My purpose is not to advocate that demise or support the Coalition’s alternative, “direct action” plan (which I think would be a shameful regression). Rather, in the hope of improving the design of future climate policy, my intent is to expose the linkage decision, and the ideology on which it is based, as mistaken. One of the putative benefits of putting a price on climate-warming greenhouse gas emissions is that the government generates revenue from the sale of carbon permits. Up until last week’s budget, Treasury had been forecasting future revenue from the carbon scheme based on the assumption of an Australian carbon price of $29/tonne. The latest budget, however, slashed the forecast scheme revenues for 2015–16 and beyond, basing its forecast on a new carbon price assumption of $12.10 in 2015–16, 60 per cent less than the previously assumed $29 figure. Why the sudden change? Well, the $29 figure was always optimistic; over the past couple of years, as the handful of existing overseas carbon markets have stumbled and the prospects for global collective climate action have dimmed, it has looked fantastical. Most importantly, though, the downward revision is a recognition of the structural imbalance between demand and supply for European carbon permits that is keeping the EU carbon price extremely low. Understanding the dynamics of the European scheme is vital, because the price in Europe will effectively set the Australian price from 2015. The third phase of the European scheme, which operates across its twenty-seven member states and covers sectors responsible for about 45 per cent of Europe’s emissions, began at the start of this year and will continue until 2020. The annual “cap” on European emissions is driven by Europe’s emissions reduction target (20 per cent below 1990 levels by 2020). Permits are allocated freely to some emitters and auctioned by member states according to figures determined by the European Commission (the EU’s executive arm). The supply of permits is obviously affected by these allocations and auctions, but also by the supply of international credits from the Kyoto Protocol’s emissions trading mechanisms (which are mostly from emission abatement projects carried out in developing countries, and are eligible for compliance purposes in Europe) and the number of permits “banked” by scheme participants from Phase II. Due to a flood of cheap international credits, banking from Phase II and the early auctioning of Phase III permits, the number of permits in the European market has been extremely high at a time when demand for permits has been depressed by the economic downturn in Europe. The result has been a large surplus of permits — that is, an excess of permits above the emissions cap — in each year since 2009 and a correspondingly low carbon price (currently around €3.50, or A$4.65). The Commission projects that the surplus will reach a cumulative total of around two billion permits — about the equivalent of Europe’s entire annual emissions cap in 2013 — and that this surplus will persist for the rest of the decade, meaning prices will stay at their farcically low levels. In a bid to avoid this spectacle, the Commission has initiated a two-stage reform process that seeks to redress the supply side of the surplus problem. The first stage involves a proposal to postpone the auctioning of 900 million permits from the years 2013–15 until 2019–20. This proposal, known as “backloading,” would not alone change the number of permits in the system released in total over the course of Phase III, but it would serve two important functions. First, on the assumption (which the Commission makes) that demand for permits will have grown by the end of the decade, backloading some of the permits would “smooth” the price somewhat over the course of Phase III, raising it now (while demand is low) and depressing it later (when demand is expected to be higher). Secondly, it would buy some breathing space within which more fundamental structural reforms could occur, such as removing the surplus permits altogether, or some other measure to push the price higher. (The Commission released a paper late last year canvassing six such options, about which it is currently consulting with stakeholders.) Jonathan Grant, director of sustainability and climate change at the consultancy PwC, said that some such deeper structural reform and an increase in permit demand driven by a return to growth in Europe would be necessary to send the price into the €15 to €20 range. Before the Commission can execute the backloading measure (let alone the deeper reforms), however, the European Parliament and Council must both pass a proposed amendment to Europe’s emissions trading law that confirms the Commission’s legal power to alter the timing of auctions in circumstances such as these. But in April this year, the European Parliament failed to pass the proposed amendment, dealing a major blow to the reform effort. The head of EU carbon analysis at Thomson Reuters Point Carbon, Stig Schjølset, said the vote makes it “very unlikely that any political intervention in the scheme will be agreed during the third phase from 2013 to 2020” and that the scheme would therefore be “irrelevant as an emissions reduction tool for many years to come”— sentiments echoed by other carbon market experts. The Commission hasn’t given up on the backloading proposal and is currently consulting about its next move, so reform is still theoretically possible. But the Parliament’s failure to endorse backloading — which is, remember, just a stop-gap measure — strongly suggests it is not willing to entertain the deeper structural reforms the Commission has in mind. Moreover, EU member governments, which must also assent to any proposed reforms in the European Council (which operates by qualified majority ), appear ambivalent. Some governments, including Britain’s, favour reform. Others are wavering, or more focused on other matters (like preventing the disintegration of the European economy). The German government, whose support for reform will be critical, is divided on the matter: its economy minister is against reform, while its environment minister favours it. Chancellor Merkel recently indicated that she favoured some kind of reform, but will not provide a clear position until after German elections in September this year. Others still, including coal-dependent Poland, are strongly opposed to any strengthening of the carbon market. The more likely outcome thus appears to be stagnation of the reform effort and the continuation of bargain basement EU permit prices for the remainder of the decade. Schjølset, from Point Carbon, predicted that the price would not rise much above the €3 mark and could fall again before 2020. IN THE light of this analysis, even the Australian government’s downwardly revised price projection for 2015–16 of $12.10 looks optimistic. Assuming a €3 European price in 2015, at the current exchange rate (around €0.75 to the Aussie dollar) the Australian carbon price would be a mere $4 — less than a third of Treasury’s revised projection for 2015–16. But let’s be generous about the EU carbon price and assume that, despite the absence of backloading or deeper reform, it rises to €5 by 2015, and let’s be exceedingly pessimistic about the exchange rate and assume it falls to €0.50 (over the last decade the average rate was €0.65 and the lowest point was €0.49). Even that would only bring the Australian price to $10. More disturbingly, on any of these assumptions Treasury’s revised projections for the Australian price even later in the decade — $18.60 in 2016–17 rising to $38 in 2019–20 — look utterly fanciful. It is not at all clear whence these implausible Treasury figures were plucked. The government’s Budget “Fact Sheet” on the revised projections states that “the carbon price estimates in the Budget projection years of 2015–16 and 2016–17 do not constitute forecasts. Projection year parameters generally rely on longer-term factors, such as the modelled prices in 2019–20 from the Strong Growth, Low Pollution report.” The “ Strong Growth, Low Pollution report ” is the Treasury’s original modelling, which contained the $29 figure. As such, the quoted statement is confusing: it seems to be saying that all figures from 2015–16 are not forecasts but are based on the original modelling; yet the new figures used in last week’s budget (and highlighted in that very fact sheet) depart strongly from those original figures in 2015–16 and then increase rapidly, as I have noted. How can the revised projections be based on the old projections that the revised ones are replacing? We can perhaps surmise from the following statement that, at least in case of the later years, the projections are based on Treasury’s views about what the price ought to be at that time: [Treasury’s original] modelling remains the best estimate of the price level required over time to meet long-term global environmental goals and international commitment pledges for 2020. Since that modelling, at the Durban UN climate change conference in 2011, countries committed to negotiate a new international agreement by 2015 that would be applicable to all and which would include binding emissions reduction commitments from 2020. But this is bunkum. Even assuming that Treasury’s price projections reflect what international prices would need to be in order to meet these supposed goals (a brave and questionable assumption), there is every reason to assume these 2020 goals, such as they are, will not be achieved. The only “international commitment pledges for 2020” are the vague, conditional and voluntary emissions reduction pledges made by major countries in the context of international climate negotiations, most of which are domestically non-binding and highly sensitive to favourable accounting assumptions . The Durban commitment is even less relevant. It is merely an “agreement to agree”: a commitment to negotiate a new treaty by 2015 that would (if actually agreed — a huge “if”) enter into force by 2020. It is not an agreement that some targets will be met by 2020 . The targets, if there are any, will be tied to some later deadline. My point is that the carbon price level supposedly “required” to meet these vague commitments has very little to do with what the Australian carbon price is likely to be in the second half of this decade. The spectacularly unsuccessful international climate negotiations are not and will not likely be the main driver of carbon prices in Australia. Rather, the main driver will be Europe’s carbon price and, in turn, the multifarious political machinations affecting the rules of the EU carbon market. Based on the recent developments I have outlined, an optimistic carbon price projection might be around $5 to $10. Not $12.10, not $18.60, not $29, and certainly not $38. THE woes afflicting the EU carbon market call into question not merely the federal government’s decision to link Australia’s scheme, and not merely Treasury’s carbon price projections. They also cast serious doubt on the prevailing wisdom of using emissions trading as the primary instrument for tackling climate change, and on the ideological commitment to “lowest cost abatement” that underpins that prescription. The point of emissions trading is to reduce a specified quantity of emissions at the lowest possible cost. But a key problem is that the specified quantities — the targets — on which Europe’s and Australia’s schemes have been based are far too low to constitute a fair share of the global mitigation effort to restrain climate change to within even broadly plausible limits. Because of these low targets and the myriad complexities , loopholes and carve-outs that greatly distort the functioning of these politically-constructed market schemes, carbon prices end up being extremely low, as we have seen. While the arbitrarily low targets will technically be met, the low prices ensure there is almost no incentive for the kinds of deep structural change — such as shifting away from high-carbon to near-zero-carbon energy sources for electricity and transport — that will be necessary over the medium-long term to achieve sufficiently ambitious reductions in global emissions. (I have explored each of these issues in detail, and offered my own proposals, elsewhere .) When Minister Combet announced the Australia–EU linkage in late 2012, he heralded it as the first link in an expanding network of transnational carbon markets. In doing so, he was attempting to locate the new arrangements squarely within a broader, utopian vision , long-shared by many climate economists and policymakers, of a single global carbon market that could carry the world efficiently to climatic stabilisation. But, as the European market shambles attests, every emissions trading scheme is a unique, gargantuan, techno-legal aggregation of political compromises. When one is joined to another, the fused whole merely becomes as strong as the weakest compromise embodied in either of the parts. Australia, it seems, is destined to learn this lesson the hard way. Fergus Green is an Australian researcher specialising in climate change law and policy. He is currently undertaking graduate study at the London School of Economics. This story was first published at Inside Story. Reproduced with permission. Continue reading →