Two weeks ago, just days before the carbon pricing debate opened up again, I was posed this question by a very literate member of the public (he had two degrees) who had been trying to scrape together an understanding of this question for years.  If this gentleman hadn’t been able to develop an understanding from the mainstream press, then no doubt a significant portion of the population is in the same boat.  So Carbon Coach figured it was worth devoting some space to it here.

Cap and trade is a form of emissions trading scheme (ETS).  The Rudd government’s unsuccessful proposal for a Carbon Pollution Reduction Scheme (CPRS) was one such scheme.  Gillard’s Mulit-Party Committee on Climate Change envisage another such scheme, but expect to precede it for a few years with a carbon tax.

The way cap and trade works is that the government sells permits to industry, or might even issue some for free.  The permits allow the owners to emit a fixed amount of pollution, such as one tonne of carbon dioxide equivalent emissions (CO2-e).   For each tonne of emissions they create, they must surrender back to the government a permit for that pollution or face penalties.  Over time, the government reduces the number of permits available, thus capping the total amount of emissions allowed to be produced by industry.  The initial sale of permits by the government can either be at a fixed price, or more likely, through an auction so that they price is set by market demand.

Companies are also allowed to trade their permits between each other in accordance with their operational needs.  Consider two examples.  Company A buys 1,000,000 permits from the government because they expect to emit 1,000, 000 t of CO2-e in a year.  Near the end of the year they find they haven’t grown as much as they expected, or maybe their business became more efficient than they expected, and they have 50,000 permits left over.  They can sell those permits to someone else who needs them.   Company B expected to need 2,000,000 permits, which they bought from the government accordingly, but as they secured some major new contracts, they find they will actually need an additional 200,000.  They then need to buy 200,000 additional permits on the market.

Trading of permits between firms in this secondary market will be facilitated by a carbon exchange, just like the stock market.  The level of supply and demand in the market will determine the carbon price of these secondary trades.   If there aren’t enough permits to go around, the carbon price will go up.  If there are too many permits available, the carbon price will drop.

The advantage of an ETS or cap and trade scheme is that some sectors of the economy will find it cheaper to reduce emissions than others.  By having a market based carbon price the cheap reductions happen quickly (because they are cost justified at a low price for permits) and the expensive ones are delayed until the carbon price is higher.  The economists call this ‘efficient’ because the price for permits is set by the cheapest reduction methods available at the time.  Effectively, the government says how much pollution is allowed each year and then industry collectively finds the cheapest way to do it – some companies implement reduction activities and some just buy permits because the permits are still cheaper than the extra cost to that business of reducing emissions.

On the other hand a carbon-tax sets a fixed price for permits.  A key advantage of this is that it gives business certainty of what the price for a permit (carbon price) will be, whereas under an ETS it can vary.  However the economists call it ‘inefficient’ because carbon pricing is set by the government, not by the cost of the most efficient means of pollution reduction in the economy.

It is expected that only around 600 companies will have to buy and surrender permits under the scheme as the scheme will only apply to very large emitters, or at the most efficient point of collecting the permits within the economy.  This means electricity generators will buy their own permits and then incorporate this cost into the wholesale electricity price.  For fuel, the permits will need to be purchased for the fuel that leaves a refinery, rather than by each end customer who puts fuel in their vehicle at the bowser, even though it is the end user who is creating the pollution.

The other quandary my interrogator had was “what do the banks stand to gain from this?”  Under the CPRS, and likely under the legislation for any future cap and trade scheme, the permits are made ‘property rights’.  This gives them value and allows them to be traded.  It also means they can be used as collateral for loans and speculation can be made on future prices.  Thus a whole new category of futures trading and debt markets open up to support the permits, creating a host more transactions and new products for the banks to sell.

We hope that helps with understanding carbon pricing, cap and trade and carbon taxes.  If you have another question you’d like us to answer, please contact us or post a comment below.

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