There’s a proposal doing the rounds in Canberra for a floor price on the price of CO2 permits, to apply once the emissions trading scheme moves from its fixed price period into a floating price period. The UK has just implemented such a scheme as a “top up” on the price of permits under the EU ETS. The main rationale being put forward is the underpinning of investment of new entry power generation plant. Here’s four reasons why I don’t think it’s a good idea:
IT WON’T WORK
The long term returns of new entry generation plant is impacted by many factors, of which the carbon price is just one. Exchange rate (which determines up front capital cost), supply/demand balance of electricity (which moves in and out of constraint), the coal price and the gas price all have a powerful impact on returns. There’s a useful chart in the Fin Rev today (p14) that shows the dependency. The carbon price is important to set the direction for decisions about new entry but it can’t single handedly secure a minimum return for new plant.
NO MARKET FAILURE
To implement a floor price before the carbon price is even in existence is to assume that there’s a market failure before there’s a market. A floor price is effectively saying that the market got it wrong, that abatement is too cheap and needs to be priced up. It institutionalises a government intervention in the market. It would be much better to leave the market to be priced on fundamentals.
The floor price idea came up when the EU ETS went through a brief dip during the GFC. Obviously as economic activity declines, so do emissions, so the EUA price dropped to reflect this. The drop was probably made more severe due to the lack of readily available credit, which would have otherwise seen many utility buyers purchasing to store permits for later use. As it turned out, the market found its own floor at €8/t, but has since recovered to trade at a consistent mid-teen level, with some recent support due to the implications of Fukushima.
In much the same way as our floating exchange rate saved us from the worst impacts of the Asian financial crisis in the 1990’s, so to can a floating carbon price lift the brake on the economy when an economic restriction is doing the abatement task.
NOT COMPATIBLE WITH GLOBAL ABATEMENT
The price of an Australian Emission Unit (AEU) reflects the supply/demand of permits, including the ability to import offshore credits/permits. The whole idea of global abatement is to build towards a global price. But a floor price is effectively saying that if the international price for whatever reason is “too low” then we should continue to apply a restriction to our own economy regardless of its effects. It is effectively elevating the importance of domestic abatement over the availability of more cost effective abatement offshore, to the detriment of our local economic performance.
POOR USE OF GOVERNMENT FUNDS (ie our taxes)
A floor price, in practice, is the government re-entering the market to purchase abatement, sort of like a reserve bid at a real estate auction. Ironically, this shares some features of the “direct action” policy which sees taxpayers funds used to purchase abatement according to a market-based merit order. But we need to ask why this is a good use of taxpayer funds, especially when the market is quite happy to purchase abatement from cheaper sources elsewhere. A risk for government will be that a floor price reduces the amount of revenue from auctioning the permits (which it would do in a floating price regime), and this is the revenue it would be using to compensate households. There are many better uses for government revenue than this.
In my view, the challenge of implementing a carbon price is already great enough without adding complications, such as a floor price, along the way.