A gift from the former colony: carbon trading in Europe?

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(re-worked from the conversation)

Linking Australia to the European Union carbon emissions trading scheme by 2015 will undoubtedly affect the revenue gained from carbon trading. The question is, how much? My best guess is that it will cost around 50% less revenue than originally thought in 2015 (some $3-5 billion a year) – but there are many variables that could blow even this figure completely off-course.

The main change for Australia is that our decision to join the EU under its current rules effectively means our revenue and foreign development aid will suddenly become the result of an internal EU struggle for control over the permit system.

To set the scene, consider what we will have in the run-up to 2015. Until then, we intend to charge about 300 Australian companies a fixed price per carbon emission, increasing from the current level of $23 per tonne to $25.40 per tonne in 2014, estimated to yield around $8 billion in 2014.

In 2015, the main change is that companies no longer face a fixed price, but can choose between buying permits at auction from the Australian government or from the EU trading scheme.

Three aspects of this change will affect revenue: there will be changes around who will have to buy carbon emission rights, the number of carbon emission rights sold by the Australian government, and the price.

The price of carbon emissions is the easiest to gauge: since we would then be in a fully integrated market with the EU, the Australian carbon price would align with that.

At present this price is around $8 per tonne, although it was as high as $30 per tonne in 2006. But the key thing to know is that in 2015 it will almost entirely depend on who controls the allocations of permits in the EU then.

At present, individual European countries effectively control this allocation and with a combination of over-allocations, cheating and corruption, these countries have flooded the EU with permits leading to the current low price.

If these countries still control the allocations by 2015 – and there are some good reasons to believe they will – the price will undoubtedly still be low, leading to the obvious assumption that Australian companies will want to acquire a substantial number at that price.

One could safely expect a price of around $10 per tonne, meaning total permit revenue from Australian firms would be no higher than $3 billion – of which up to half would go the EU countries and not Australian coffers.

If, on the other hand, the European Commission wins the political fight for control over permits, then one can be quite sure that permits will be much scarcer and better policed in the EU, and one should expect the price to be closer to $30 per tonne. In which case, the Australian government will get close to 100% of the $9 billion or so that would then be raised by the sale of domestic permits.

The EU Commission has long announced it would be in control by 2013, but the reality of the EU in these years of budget crises is that climate change is a secondary concern for most countries and they will resist further Commission control.

I thus personally expect some fudge compromise to be agreed so that only very slowly the EU Commission will get control over the permits, certainly not as early as 2015.

It’s handy to bear in mind that the EU and Australian scheme has a “development aid” component to it. This development aid has a ‘Kyoto’ aspect to it and a non-Kyoto aspects. Part of the deal with the EU is that Australia can `only’ buy 12.5% of our carbon rights from poor countries that are part of the Kyoto deal. In total however, we can meet 50% of our own targets via international permits. Those foreign carbon “Kyoto” emission rights are much cheaper ($3 per tonne at the moment) and are also almost entirely the result of politics. The question will be how many projects will be recognised by EU and UN bureaucrats, and how much money will again be paid to other countries.

Australian development aid will thus go up in 2015 to the probable tune of around $500 million, just on that score. In short, a nice Christmas present from Australia to the EU and other countries under the current plan.

What about the longer-term and further complicating factors? For one, by 2018 the plan to fully integrate the Australian carbon market with that of the EU mean EU internal politics will determine the rules in Australia. This includes the number of permits sold domestically, the sectors exempt from permits, and the rules on using international off-sets (via the Kyoto, EU, or UN international schemes).

The upshot would most likely be that Australia would get fewer domestic permits to sell – as we are relatively energy-intensive – and also that Australian companies would be allowed less leeway to buy international off-sets from places like India and be forced to buy the much more expensive ones from the EU. This would only get worse in the future.

Then of course there is the issue of uncertainty around exchange rates. It’s expected the Australian dollar will go down as the commodities boom comes to an end, but this may well coincide with internal EU turmoil leading to a weakening Euro.

As to the many pronouncements on revenue, risk, and planning: most are quite fallacious. For instance it is not true that Australian companies now have more certainty over the price they will pay: they have simply switched from the uncertainties in the Australian political system to those of the EU, which are at least as big.

By the same token, there is no great difficulty in pulling back from this deal at a later date for a future government, certainly not before 2018 when there are not yet any foreign companies buying off-sets from Australia (an unlikely event anyway). If a future government simply abolishes this deal, then companies having bought permits would simply sell them again in the EU.

Indeed, if companies fear abolition of Australian permits without compensation, then this would lead companies to buy EU permits, further reducing the Australian revenue.

Finally, the announcement that Treasury knows the price in the EU will be $29 in 2015 is completely fanciful: the internal politics of the EU are incredibly complex and unpredictable and Treasury is not really set up or suited to predict political events. As with almost any asset price, the best guess of the price of a permit in the EU in 2015 is roughly the price today, that is, around $10.

The silver lining is that we too can cheat and we almost undoubtedly will. In 2015 we can simply adjust the number of permits we sell domestically to whatever level needed, so our companies won’t have to buy in the EU. Given the alternative is for us to send money to the EU, the political pressure to do this would be enormous, so the EU shouldn’t bank on this sort of the Christmas present.

In all, the stars are aligning for a big drop in domestic revenue from carbon permits and an increase in development aid, some of it to the EU.

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