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Carbon Pricing: The Real Dirt on Tax Vs Permits

May 10, 2011

​​Australian Prime Minister Julia Gillard's proposed carbon tax has triggered a strong backlash from sections of the business community. They are concerned they will be disadvantaged by Australia imposing a carbon tax before other major economies, such as the US. But their biggest worry is uncertainty and volatility.

Gillard has sought to provide some certainty by saying Australia will introduce a carbon tax in the first few years, then move to an emissions trading scheme (ETS). The carbon tax – expected to be imposed from 2012 – gives businesses more certainty: they know exactly how much they will pay per tonne of carbon emitted.

The future emissions trading scheme would work as a cap-and-trade scheme where the total amount of emissions the economy can produce is capped and the price of permits would fluctuate freely as they trade. To ensure the price of permits does not go above a certain level, price caps would be necessary. However, it is uncertain whether price caps and price floors are planned for the permits in a future emissions trading scheme in Australia. Without them, the price of carbon could oscillate widely, which many economists and business people claim would hinder investment planning.

Cutting carbon price volatility seems to be the driver of policy development at the moment. But new research by Chung-Li Tseng, a professor of Information Systems at the Australian School of Business, and Yihsu Chen of the University of California at Merced, has found the volatility under an ETS is actually the key driver in power plant owners – one of the major carbon emitters – investing in new clean technology. That could mean that Gillard's plan to delay the introduction of an ETS in favour of a carbon tax could also delay environmental benefits from a carbon price.

"What is the purpose of having an emissions policy?" Tseng asks. "Whatever scheme or whatever tax, the ultimate purpose is to cause polluters to change and to adopt cleaner technology. Our paper looks at which one – an ETS or a carbon tax – gives the power plant owner more incentive to do that. (According to the paper), volatility is not necessarily bad. It's the key driver that gives producers incentive to adopt clean technology and incentive to reduce CO2 emissions. But policymakers are doing the obvious thing and trying to reduce volatility."

Chen and Tseng's research – outlined in their paper, Inducing Clean Technology in the Electricity Sector: Tradable Permits or Carbon Tax Policies?, to be published in The Energy Journal – highlights that the current carbon debate, which focuses on whether or not Australia should price carbon, is missing fundamental questions relating to the implementation of a carbon price: first, will a carbon tax or an ETS deliver a better environmental outcome?; and second, is much-feared volatility actually what's needed to drive change and generate investment in clean technology?

Australia's push to put a price on carbon and address climate change has already claimed several political scalps. Australia's foreign minister Kevin Rudd was dumped as prime minister in 2010, in part, because he scrapped plans to implement an ETS or Carbon Pollution Reduction Scheme (CPRS). Ironically, on the other side of the political fence, the Liberal/National parliamentary opposition leader Malcolm Turnbull was rolled because he supported the CPRS. He was replaced by climate-change sceptic Tony Abbott.

Julia Gillard, who governs with the support of independent MPs and members of the environmentally focused Greens party (who have applied pressure for a carbon price to be implemented), has pressed ahead with another attempt to price carbon. Along with a number of business groups, Abbott has launched a furious attack on the proposal, expressing concerns about the lack of detail.

Gillard plans to have a carbon tax for the first three years, then move to an ETS. Under an ETS, the government caps the total amount of greenhouse emissions in the economy. As a simplistic example, they may cap total emissions at 100 tonnes and issue 100 tradeable permits. In this circumstance, the economy can only emit 100 tonnes of carbon and the price paid is whatever the market will bear for those 100 permits.

Targeting Certainty

"Under an ETS the cost people have to pay to continue to emit is uncertain because it is determined by the market; but there is certainty around the volume of emissions," notes Jeff Lynn, a senior associate at law firm Blake Dawson who advises firms on carbon pricing and carbon cost management. "This certainty is helpful for policymakers signing up to emissions reduction targets."

Under a carbon tax, there is no ceiling on the amount of emissions in the economy. "The system of carbon tax doesn't allow you to control in a direct regulatory sense the number of tonnes of emissions in the economy," Lynn says. "However, a carbon tax provides price certainty so people do know what they have to pay to emit. Regardless of whether you are a company that emits 5,000,000 tonnes or 50,000 tonnes, you know that your direct carbon cost will be the number of tonnes of emissions multiplied by the price (say, A$20 or A$30 per tonne)."

Lynn says that because a carbon tax does not involve an absolute limit on the tonnes of emissions, if the government is set on an emissions reduction target – say in a five, 10 or even 20-year window – it cannot be sure that a carbon tax is going to deliver the desired results, because no one knows in advance how effective the carbon tax will be at driving emissions reductions. "An ETS involves legislation capping the number of tonnes of emissions. It provides you with a much better chance of hitting your reduction targets. If you look out to the medium and long terms, and assume everybody comes to grips with the new regulatory environment in the first few years, an ETS is probably a more effective policy."

But Lynn says the government's approach of introducing a carbon tax before moving to an ETS makes sense. "It allows both of those objectives to be achieved. It provides a predictable beginning, but ultimately over time allows achievement of the goal, which is reduction of emissions to pre-determined emission targets," he says. Lynn believes the government has gone for a fixed-price approach for three years to provide more certainty for industry. Industry is concerned about significant volatility in the price of permits, particularly at the beginning of a trading scheme – before everybody becomes familiar with the system and understands how costs would flow through the economy.

The introduction of an ETS without any form of price cap could create significant permit price volatility, as happened in Europe. "A lot of people in business would think that significant price volatility was a bad thing," Lynn points out. "It's hard to develop a carbon cost management strategy if the permit price bounces around. The government is concerned with managing that price volatility risk. That's one of the fundamental reasons for going for a carbon tax at a fixed price."

Tseng agrees that a carbon tax gives some sense of stability, relative to an ETS where the price of carbon fluctuates. "People prefer a tax. At a presentation, I asked the audience: which one do you intuitively prefer? They said `we like the tax because it's more stable and more fixed'."

But when looking at the overall aim of cutting carbon emissions, is volatility such a bad thing? In their paper, Chen and Tseng looked at how coal-fired plant owners would consider introducing clean technology under a carbon tax and under an ETS. What they found is that an ETS is superior in inducing plant owners to invest in clean technology. What's more, they found that with a carbon tax, policymakers have to punish power plant owners much more to get them to invest in clean technology: under an ETS, with carbon costing at just A$30 a tonne, the power plant owner is happy to add power plants and clean technology. But under a carbon tax, the price of carbon would have to be set much higher at A$80 to induce similar change.

This seems counter-intuitive. Wouldn't volatility hinder investment in clean technology? What they found is that volatility – the very thing that policymakers are trying to avoid – is the trigger for change under an ETS. "The difference between a tax and an emissions trading scheme is uncertainty," Tseng says. "Uncertainty is not necessarily bad. But policymakers try to set a cap to reduce uncertainly and volatility. People tend to get a bad impression about that (volatility)."

The Price of Volatility

​So how does greater ETS volatility cause a power plant owner to invest more in clean technology? It revolves around "real options", or flexibility. While there is considerable academic literature comparing carbon taxes and ETSs, Chen and Tseng say to date there has been no formal treatment based on real options comparing investment timing between the two instruments.

Chen and Tseng considered the example of a power producer who owns a coal power plant, like most producers in Australia. The producer is considering adding a cleaner natural gas plant, which requires capital investment. If the carbon cost is zero, doing nothing is the best option because coal is cheaper and no investment is needed. However, if a high carbon cost is imposed, generating power using coal may become more expensive than using natural gas. It should be noted that this also depends on the price of natural gas, which changes over time.

Chen and Tseng think after adding a new natural gas plant, the producer can lower its generating cost by "dynamically dispatching" both plants – that is, switching between the coal and natural gas plants depending on which is cheaper. The producer benefits from constantly exercising what the researchers call "dispatch options".

It is like a car owner who can buy a gadget that allows them to run a car using petrol and natural gas. The car owner can switch between petrol and natural gas depending on which is cheaper. In the case of the power plant, the producer gets the "dispatch options" – or gets flexibility between the two plants – only after they add a natural gas plant. The cost savings from exercising the dispatch options can be used to justify the investment in the natural gas plant.

But how does price volatility under an ETS encourage the plant owners to invest in a new clean technology plant? Theoretically, when the cost discrepancy between using coal and natural gas changes more rapidly over time (or is more volatile), the producer would have more chance to benefit from the dispatch options. "With an ETS, not only does the gas price change over time, the carbon price also changes over time," Tseng says. "The volatility of the permit price helps to increase the volatility of the cost discrepancy and the value of the dispatch options as well."

Again, looking at a car owner purchasing a gadget that enables the use of natural gas in addition to petrol: if prices are stable, there's no incentive to buy and add that gadget to their car because there will be no benefit from being able to switch between petrol and natural gas. However, if prices are volatile, there's more incentive to invest in the gadget.

In Chen and Tseng's case study, under an ETS where the average carbon price is about A$30 per tonne, the investment in the natural gas plant can be justified, but it takes a carbon tax of A$80 per tonne to justify the same investment. "The difference is the missing volatility in the carbon price under a tax," Tseng says. "We conclude it's the volatility of the carbon price that induces the adoption of the natural gas plant. That volatility of the carbon price is what most people fear – and it's the main reason they prefer a tax. With the right mechanism, one can convert the uncertainty of carbon pricing into profitable opportunities. In this case, we designed `dispatch options' to do this job."

Tseng notes that the prices of A$30 and A$80 per tonne under an ETS and carbon tax respectively are not an attempt to predict the price for carbon in Australia. "We have used existing data to illustrate the relative prices and the timing needed under an ETS and tax to induce clean technology. The importance is their `quantitative' comparison, not their absolute values."

But their research has significant policy implications. Under the Australian scenario, the message is that the delay in introducing an ETS could delay investment in clean technology. "Every time you try to dampen the volatility associated with permit prices you delay investment," Chen says. "The initial three years of the Australian program will not allow volatility in the tax system. So it may delay investment compared to a permit system."​
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