Commentary 15th Dec 2014

Yes, we need an ETS, but which ETS?

The adage "Don't fight the last War" applies to all leaders – both victors and losers. Labor and the Government should not fight another election on carbon pricing as it will only prolong regulatory uncertainty and our sovereign risk. 

A joint policy that includes Direct Action and leads to a medium-term ETS is 'doable'.


Many have long advocated an Emissions Trading Scheme (ETS) linked to international markets. Bill Shorten and Labor also support an ETS and now the Palmer United Party has joined the chorus. The Coalition under Howard and Turnbull supported an ETS. Most businesses would also support a market-based mechanism such as an ETS. So, all is not lost

But what is an ETS? As Mr Tony Abbott pointed out, an ETS is another form of carbon impost on businesses with fluctuating prices determined by markets rather than the fixed price of a carbon tax. However, he has sensibly not ruled out an ETS explicitly which may provide the way out of our climate policy imbroglio.

Which type of an ETS? There are at least two types – the "cap and trade" ETS and "baseline and credit" ETS. Proponents of an ETS should specify which one they prefer as the difference between the two ETSs is stark, as shown below.

Under a "cap and trade ETS", the Government releases a number of permits into the market, based on national emissions reduction targets, eg five per cent less than 2000 levels by 2020. There is no limit on individual companies' emissions as long as they pay for all their emissions. Assume that a business emitted 30,000 Tonnes of GHG in a year and a market price for carbon permits of $10, then the business will be paying $300,000 under a "cap and trade ETS".

Contrastingly, in a "baseline and credit ETS" each company must keep its emissions below an agreed pre-determined level, for example, below the average of its previous three years' emissions. On that basis, assume that the company's "baseline emissions" had been set at 28,000 Tonnes. In a "baseline and credit ETS" it has to buy permits only for the excess emissions over the agreed baseline, in this case 30,000 – 28,000 = 2,000 Tonnes. Assuming a same carbon price of $10, the company's cash outflow will be a modest $20,000 only.

The two ETSs were debated in depth in the early 2000s before the EU favoured the "cap and trade ETS" design in 2005 and it became the blueprint for Labor's ETS design as well.

The case against the "baseline and credit ETS" in 2005 was that Governments had insufficient information to set "baseline emissions" for each company. It was seen as an intrusive regulation and impractical to implement. However, Australia has now detailed company-level GHG emissions data, thanks to the National Greenhouse and Energy Reporting (NGER) scheme introduced from 2008. Setting baseline emissions for each business need not be onerous, particularly if they are linked to individual companies past GHG emissions and their future plans.

The actual performance of the EU's "cap and trade ETS" over the last eight years shows its key weakness, namely Governments' inability to release the right number of carbon permits into the market, say for five years at a time, based on various forecasts. Random shocks such as the GFC in 2008 impacted EU's economic growth and GHG emissions. Demand for permits plummeted and the supply glut resulted in the permit price nose-diving from above 20 to around five Euros. So, the EU politicians panicked and tinkered with the supply of permits by postponing the release of new permits, a case of "moving the goalposts".

Linking an Australian "cap and trade ETS" to the much bigger EU market would make us a de facto member of the "Euro bubble" and we would lose complete control of the carbon price. Our investment decisions in low-emissions technologies will be tied to the whims of the European market price. And who can tell if the EU ETS price will not go back to 30 Euros in the future?

The "baseline and credit ETS" principle, on the other hand, has already been used in the NSW Greenhouse Gas Abatement (GGAS) program in the last decade delivering low permit prices. The now-defunct scheme has been reviewed and that experience can inform the design of an Australia-wide "baseline and credit ETS".

Linking an Australian "cap and trade ETS" to the much bigger EU market would make us a de facto member of the "Euro bubble" and we would lose complete control of the carbon price.

Mr Gujji Muthuswamy

Department of Banking and Finance

Interestingly, the kernel of a "baseline and credit ETS" can be introduced into the design of the Direct Action Plan/Emissions Reduction Fund (ERF).

Under the voluntary ERF, businesses can choose to apply for Government funding to implement GHG reductions projects. The Government will select only the low-cost projects using a tendering process. Those who get funding will reduce their emissions, but what about those who choose not to apply or do not get the funds? Will they continue to emit as before or more?

A yet-to-be developed "safeguards mechanism" in the ERF hopes to address the question "Should there be some commitments on GHG reductions from non-participating businesses to not exceed their baseline emissions?" Without a "safeguards mechanism" in the ERF design, we may not meet the national five per cent reduction target.

The ERF White Paper canvasses some options on how baselines can be set up for each business and there is sufficient room for reaching an agreed "safeguards mechanism" within the ERF that leads to the development of a small-scale "baseline and credit ETS".

Depending on how well it works within the ERF, the "baseline and credit ETS" can provide a glide path to a longer term ETS after 2017 when ERF funding ceases.

This compromise approach would mean the Government will get its Direct Action Policy while Labor, Greens and the PUP could eventually get an ETS in the medium term. Businesses can get much-needed regulatory certainty.

In parallel, the merits of the two types of ETS should be reviewed so as to answer the question "Which ETS?"

Gujji Muthuswamy is an Industry Fellow in the Department of Banking and Finance, Monash University and lectures on carbon pricing. He has been working in the Victorian electricity industry for more than 30 years.

By Mr Gujji Muthuswamy

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    Mr Gujji Muthuswamy

    Department of Banking and Finance, Industry Fellow Monash Business School

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