What is an Emissions Trading Scheme (ETS)?
With the draft Garnaut report getting plenty of attention, it’s become clear that while the majority of Australians are in favour of the Government taking action to reduce our carbon emissions, only a minority understand what an Emissions Trading Scheme is.
Basically, there are generally two strategies that people talk about whereby the Government encourages industry and the public to reduce their emissions of carbon dioxide and other greenhouse gasses. They are:
- A Carbon Tax. With a carbon tax system, the Government sets a price on a tonne of carbon dioxide (CO2). So, if your company causes 1000 tonnes of CO2 to be emitted in a year, and the carbon tax is $20 a tonne, you have to pay $20,000 in “carbon taxes”.
- An Emissions Trading Scheme. With an emissions or carbon trading scheme, rather than set a price on carbon, the Government sets a limit on the amount of carbon that can be emitted. They then put “permits” for that much CO2 onto the market. Companies can then bid to buy these permits which entitle them to release carbon dioxide. If a lot of companies want to buy these permits, they will bid against each other and drive the price up, just like an auction for a house.
So, the tax sets a price on carbon, and the trading scheme sets a limit on carbon. Both systems result in industries having to pay in order to emit climate changing gasses. Garnaut (and many governments) have come out in favour of the trading scheme.
A carbon tax is comparatively simple to implement. The Government picks a price per tonne of CO2 – high if they want to greatly discourage emissions, and low if they want to gradually discourage emissions. In general, this will provide an incentive for companies to pollute less. But a carbon tax doesn’t allow Government to predict how much carbon will eventually be emitted. For instance if your company makes steel, and your customers are desperate to buy steel, you don’t care about the amount of the carbon tax. You simply pass it on to your customers, who will pay anything to get your steel! The Government makes more revenue, but there is no reduction in carbon dioxide.
By contrast, a trading scheme makes it hard to predict what the price of carbon will be, but allows the Government to be more confident about how much global warming gasses will be emitted. In the example above, your steel company may want to make more steel, but there are no more permits for the pollution that you will produce available on the market!
There are a lot of details in an Emissions Trading Scheme. This is a good thing – it allows countries to tune their scheme to suit their own economy. Some of the variations and options include:
- Giving out some permits free to specific industries. This means that certain industries are guaranteed the ability to emit some carbon dioxide and that their prices won’t have to rise as much. On the other hand, this means that there are now less permits to go round. Companies who miss out will then be bidding against each other for a smaller pool of permits which will drive the price up. The more free permits that are given out, the higher the price will be for the remaining companies.
- Setting a “safety valve” in the form of the no-permit penalty in case prices get too high. If there are very few permits left, and a lot of companies who want to buy them, the price of those permits might go through the roof! To make sure that companies don’t grind to a halt, the Government can set the “fine” for polluting without a permit quite low. So, if permits run low, and prices go up, it becomes cheaper for the company to just pay the fine. Effectively, the amount of the fine sets the “maximum ceiling” for the permit price.
- Allowing people to generate new permits by undertaking carbon abatement projects. So, if you plant enough trees to soak up 1 tonne of carbon dioxide, you may be given a brand new permit for that 1 tonne that you can then sell on the market.
- Providing free “extra” permits to exporting companies – basically not “counting” some emissions, so that companies who are competing with other companies overseas not involved in emissions trading are not disadvantaged. This levels the playing field for those companies, but means our emissions could rise above the “limit” set by the government.
It should be noted that none of the above will necessarily be a part of Australia’s eventual ETS, but it shows the way in which an ETS can be tuned, and shaped.
Garnaut suggests in his review that the revenue from this scheme be invested to assist in the transition to a “low-carbon economy”. Inevitably, companies will pass on some or all of their increased costs onto the consumer, so a portion of the revenue can be used to compensate households. Revenue can also be used to assist companies that compete overseas, as well as researching renewable or low-emission energy sources.
An ETS is a fantastic way to leverage the power of the market and people’s ingenuity to do something about mitigating against climate change. In the past, industry hasn’t had to pay for the environmental damage caused by their carbon emissions – even with the best intentions in the world, the main benefit to “being green” is the publicity benefit as far as the bottom line is concerned
But with a limited number of polluting permits available, if your company can find a way to reduce your need for emitting CO2, you will have an advantage over your competitor. In fact, the quicker you respond, the greater reward. When everyone else in your industry needs to pollute, there will be a lot of competition for the permits, and thus higher prices!
I’m not too rosy-eyed – inevitably there will be pain as the economy adjusts but there will also be opportunity. In fact an ETS could actually spur the economy on, at least in places. With profit at stake, companies may well be motivated to research new technologies, or rearchitect their processes to be more efficient. In turn, this will generate jobs, and new supporting industries.
All that, and a lower impact on the environment! 
To my mind, an Emissions Trading Scheme should start as soon as possible. Waiting until “everybody else does it first” reminds me of schoolyard days at the pool where everybody waited for someone else to jump in first. Sooner or later, someone has to make the first move. By being one of the early leaders, Australia could earn its badge as “The Clever Country” in developing new sustainable technologies and processes. And having implemented such a scheme, Australia will be in a much stronger position to encourage other countries to do the same.
Categories: current affairs, environment, green, reduce
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July 8th, 2008 at 1:49 pm
I am sceptical of the usefulness of the ETS. Remember the point of our schemes is to stop carbon emissions. We did not abolish slavery by setting up a slave market. That encouraged it.
The first thing is that in any scheme, you want to cover as much of the emissions as possible – especially if we’re talking about an 85% reduction by 2050 (to avoid more than 2C warming), obviously we have to deal with more than 85% of the emissions.
This is harder to do with an ETS than with a tax, because of arguments about how much this or that emits, and because of the temptation to exclude certain favoured industries or products (like petrol).
If you look at a graphical representation of the different contributors to global emissions here [source: IPCC 2007], then you see that, rounded to the nearest percent, the contributors are,
Burning fossil fuels, 57%
Deforestation, 17%
Livestock & rice-growing (methane), 14%
Excess fertiliser (nitrous oxide), 8%
Cement-making and chemicals (“other CO2″), 3%
Fluorine gases, 1%
The ETS aims only at the fossil fuel burning. The auction system also gives the government a financial incentive to NOT lower emissions in total. We’ve already seen how with the gambling and commodities taxes gains governments have been able to reduce income and company taxes, and are thus reluctant to reduce gambling or the extraction of mineral resources. There’s a danger of that with an ETS. They may be unwilling to reduce the total permits traded, and indeed will have an incentive to increase the traded permits to increase revenue.
Further, since they’re auctioned in a free market even if willing the governmments may be unable to reduce them. They’d have to buy them back, and in a buyback the price of each would rise; this limits financially how much the government can buy back, thus preventing a great decline in emissions.
And of course, the ETS covers only fossil fuels, thus only 57% of the problem – and may not even cover petrol, so less than half the problem.
If we had a carbon tax, it could cover a larger part of the problem. We could simply tax all fossil fuels or fossil fuel derviatives (artificial fertilisers, etc) the moment they come into contact with the economy (are dug up, imported, etc).
This would hit the 57% from burning fossil fuels, hit the 1% fluorine gases (they use hydrocarbon inputs), and about 4% or half of the nitrous oxide emissions (since they come from artificial fertiliser), bringing us up to 62%.
This would have flow-on effects to the methane from livestock, since holding so much livestock is only possible with fertiliser-boosted grain, pasture and oilseed crops; pessimistically the 7% from livestock might halve to 4%. Thus, 66%.
By having a carbon tax on timber and wood products, we could also hit the 17% deforestation, bringing us to 83% of the problem dealt with.
That would leave us with 3% from cement-making and other industrial chemical processes, and 14% from land use issues. Nonetheless it would take us much closer to addressing 85% of the emissions problem than an ETS.
If emissions declined, the government could simply raise the carbon tax on the remaining emissions to get the same revenue; thus avoids the incentive to encourage emissions inherent in the ETS. If emissions rose despite the tax, again the government could increase the tax, and in any case it could spend the extra revenue on renewables, afforestation and so on.
My prediction: if an ETS comes into place, over the next decade our emissions will at best stay static, they won’t reduce a bit.
Garnaut favoured ETS because he is an economist, and the prevailing ideology is “let the market do it.”
July 8th, 2008 at 5:53 pm
Appreciate the informative comment Kiashu – great to hear from readers!
I understand your point, but I think your concerns are more to do with how Australia’s ETS is likely to be implemented, rather than the general concept of ETS’s themselves?
As I understand it, there is nothing preventing an ETS from covering more than fossil fuels, just like there is nothing preventing a carbon tax only being applied to a specific industry rather than the whole economy. It comes down to economic thinking and, inevitably, political considerations.
I also think that Government won’t necessarily be discouraged from reducing permits _because_ its an auction system. The less permits the Government releases, the more valuable they will be because industry will be so keen to bid for them. This should have the effect of a) keeping revenue for the government fairly equal, regardless of permits offered (within reason, obviously!) and b) providing greater and greater incentive for companies to reduce their emissions as the permits become more valuable.
I have to admit, I haven’t seen any modelling on this. The one thing that is painfully clear is that the devil will be in the eventual detail. Roll on the release of the Green Paper!
Your point on the carbon tax encouraging government to raise carbon prices is a good one which I hadn’t thought of – market forces combined with Government’s natural urge to maintain its tax base could work together to drive down emissions! I like it!
Of course, the same could be said for the GST (a tax on consumption) – because of the low rate of the GST, I don’t believe it has had too much effect on lowering consumption and it would probably be a political nightmare to try and raise it. Again, I suspect the devil is in the detail of the implementation.
July 8th, 2008 at 6:36 pm
I know, it’s the comments that keep me going, too. Sometimes you see so many hundred views on your articles and then with no comments, you wonder if anyone got to the end!
I did mix up Australia’s particular ETS and the general concepts, which was sloppy of me. In general ETS are a bad idea, for reasons I wrote here and then more neatly in a recent blog entry (basically just what I said here fleshed out a bit). But the Aussie implementation is particularly bad. It’s looking like it’ll have so many exceptions and waivers that nothing useful will come of it. But really we have to see it to judge it.
Speaking generally of ETS: it’s true that if they make the permits scarce then they’ll get a high price for them. But in this it’s like a product of a business, you can go high volume, low price, and low volume, high price. The fact that Porsche exists in the same world as Lada shows that there is no single best solution for maximising profit. The difference is that a business will be influenced by production cost – they need to have the price at least one cent per unit more than the cost of making it – but government permits have zero production cost. So they can sell them at any price above $0 each and still turn a profit. They don’t really have an incentive to limit production when production cost is zilch.
The ideal in maximising profit in such a case will probably be to initially produce just short of demand, and then each year issue some more, again just short of demand. So if they assess that our total permit-affected emissions are (say) 300Mt and likely to increase at 10Mt annually, then they should issue 270Mt today and then another 7Mt annually.
You didn’t address the issue of the buyback. If we’re to reduce emissions, then over the years the government will have to buy the permits back. This will increase demand and price, so that the government will have to acquire money from elsewhere, raising other taxes. If they’re unwilling to do that (as they usually are in the first and third years of any particular three year term of government) then we see the total permits issued unchanged.
In this I’m reminded of the big sell-off of state-owned enterprises we had in the 1990s. Yes, we got a lot of money from it, but after that what? That’s why they brought in all that legalised gambling, and started subsidising mining even more – to bring in revenue to replace the revenue they used to get from the state-owned enterprises. So after the big cash burst of the initial permit-issuing runs out, what then?
What changes consumption/emission is a change in taxes. When you lower taxes/prices, people raise prices of goods to suck up the spare cash, and a new balance is found. When you raise taxes/prices, people drop the prices of goods, or people change their spending (eg with the real estate boom, people move to cheaper outer suburbs, thus spending less on housing, more on transport). That’s why when theyy brought in the GST spending dropped for several months and then went up again – people adjusted. So with a carbon tax, you’d want to start small and then raise it every year or two.
It’s like going to the gym, you have to be constantly under a little bit of strain to build your muscles. If you keep people’s carbon spending constantly under a little bit of strain, then they’ll build their carbon efficiency.
Incidentally, it’s with this sort of thing in mind that I developed my carbon accounting system.
July 8th, 2008 at 7:28 pm
Hi Kiashu,
So I think there is one misunderstanding here with regards to an ETS. An ETS permit does _not_ give the right to emit, or be responsible for, one tonne of CO2 for ever and ever. Rather, the permit is “one use”. If you need to emit 1 tonne of CO2, you buy the permit, you emit the tonne, and the permit is used up. If you want to emit a tonne of CO2 next year, you have to buy another permit.
What this means is that the government gets to issue permits “fresh” each year. So they have an ongoing revenue stream, just like with a carbon tax. To use your example of 300 Mt being the “normal” amount, In year one, they might release 270 Mt worth of permits. Due to demand, they sell for $10 a permit, so thats $2.7 billion dollars. Next year, they might only make available 260 Mt of permits. With less permits on the market, competition will be fiercer, so they might end up selling for $11 a permit. Thats $2.86 billion dollars – less carbon has been emitted, and the government’s revenue has increased!
(Of course, thats purely a hypothetical to show that the Government doesn’t have a disincentive to reduce the number of permits – the actual value of the permits won’t be clear until some models are released).
This also means that buyback is not a problem. As permits get “used up” as they are activated, all the Government needs to do is issue less and less each year. (I should mention that a “tuning” possibility with an ETS is the lifetime of a permit. That is, if you don’t “use it up”, how long does it last? There are some effects of this that are interesting to think through, positive and negative – I won’t get into it for now.)
If I’ve read your comment right, I think this point might answer a few of your concerns with an ETS. I still have a few concerns of my own, but they mostly rest with the detail of what is eventually implemented, rather than the general concept.
July 8th, 2008 at 8:38 pm
Well, we have to see how it goes in practice. As you note, the question of what happens to your permit if you buy it and don’t use it hasn’t been answered. Nor do we know what happens if people buy X permits and then do X+n emissions – do they just get sold more permits? Pay a fine of twice the permit cost? Or what? Will some companies be exempted, such as petrol companies, or coal-fired power stations? We don’t know.
Again, the number of permits x market price point where profit is maximised can’t be predicted ahead of time. As I said, we live in a world where George’s at $50 a plate and McD’s at $5 a meal can happily co-exist, each feeding us a single meal. But McD’s is high volume, low price, and George’s low volume, high price. So exactly what number the government will have an incentive to sell we can’t know. If the price rises companies may start screaming and demand more permits be sold next year, and if the price is high, the government will be tempted to sell more.
That’s basic economic theory – high demand makes high price which stimulates higher supply. With actual physical products there are limits to how much you can produce; but there are no limits to virtual products like mp3s and carbon permits.
Of course, they could reduce permits and increase prices, but this is contrary to the experience of everyone who ever produced anything. If you own a restaurant and get 120 customers willing to pay $50 a plate, and another 50 customers who want to come but there are no tables for them, do you (a) keep 120 seats and raise it to $60 a plate, or (b) add 50 seats and keep it at $50 a plate? The answer is almost always (b). Increase volume in response to higher demand. The only reason not to is if you can’t. Absent some international treaty, nothing prevents making more permits.
And again, what’s not being addressed is emissions other than fossil fuel burning.
A carbon tax would be more equitable and effective, and wouldn’t contain an incentive to increase emissions.
July 8th, 2008 at 9:09 pm
I don’t want to build the world’s longest page
, but a few extra points to close off.
As Kiashu says, a lot depends on the details. But this of course holds for both a carbon tax and an ETS. By limiting the breadth, making arbitrary exclusions of various industry, or enacting complex regulation, both carbon tax schemes and emissions trading schemes can be weakened.
The point has also been made as to whether the government would be able to resist turning any scheme (tax or ETS) into a simple money-making enterprise. Personally, while I can be as cynical as the best of them, I tend to hold onto the hope that politicians are looking for a good outcome, just like the rest of us. (I could be in the minority in this view!)
Failing that, of course, is the concept of a global treaty. Kyoto, for instance, did put binding commitments on its signatories. Assuming its successor does the same, this will help ensure that Government does the right thing and continue to bring down emissions – using the scheme that has been put in place, be that taxes or an ETS.
The two advantages that an ETS will bring where global obligations are concerned are:
– The ability of an ETS to set a firm ceiling on the _amount_ of emissions (as required by a treaty), and
– The ability of an ETS to allow trading between countries. This will both allow the global community to focus their effort where it can have the most impact as well as encouraging countries to do beat their targets – in a global scheme, if you have permits left over, you could conceivably sell them to other countries that weren’t so well prepared.
The debate between carbon taxes and ETS is a complex one, and I’m not even going to pretend that I’m that well qualified to get into it. Rather than keep stretching this page out, with a discussion on the details, we might leave it there. I think its fair to say that both have their plusses and minuses – maybe the discussion above will get readers thinking.
July 31st, 2008 at 12:32 pm
Hey just wanted to say thanks for the info on the debate between carbon tax and ETS’s. I didn’t know much about it and googled your page. It does seem to be a complex debate and the regulations that enforce either policy would probably determine how environmentally positive each one is. Sigh, i sigh because we live in a capitalist society and money is the only thing that will cause any actions in response to the problem.
Thanks again
August 5th, 2008 at 5:13 pm
Hey could anyone here please comment more on Nitrous oxide (N20) – trading globally, which countries allow it and specially in the coal fired boilers business.
Thanks
February 28th, 2009 at 6:01 pm
The debate on carbon tax and ETS is interesting and I can see merit in both. My concern is 1) how is the emission measured and 2) what size “army” will be required to police it or will it be self-regulated
Also, it’s been mentioned that the carbon tax will inevitably be added to the consumer costs. I can’t honestly see any company not passing the costs of permits on to the consumer, can you?
Cheers
November 24th, 2009 at 12:12 pm
This will just affect the lower to middle class people because me coming froma middle class family i see how my parents struggled to get byy.I just see this as a government tax grab and the rich getting richer and the poor getting poorer!!!.
December 9th, 2009 at 11:47 am
Australia is about to join the 3rd phase of the failed phase 1 and phase 2 EU ETS scheme. The third phase of the EU ETS is in significant trouble before it has even begun. The ability to bank permits left unused in phase 2 without limits means that phase 3 could start with a significant surplus over allocated permits due to the economic downturn. This reserve now offers a significant surplus of permits that can simply be rolled forward. There is up to 700 million surplus permits by the end of phase 2. If companies decide to purchase off set credits and ‘bank’ the surplus of credits for a later phase of the scheme as well – which would currently be the cheapest option for compliance – this permit surplus could be supplemented by over 900 million more surplus off set credits. This means that nearly 40% of Phase 3 could be met by carry-over from Phase 2’. This would mean that ‘the ETS will not require domestic emissions reductions for the next seven years.’ Also it is effected by inflationary and recessionary movements. An ETS just doesnt work. A flat based carbon tax is independent of economic movements and will have a direct effect.