Judging by comments on the net and the press and in general public discourse, it appears that there’s still confusion between the role of the carbon price signal and the role of the distribution of proceeds from revenue raised. The latter has derisorily been referred to as a great big merry-go-round. Here’s an example of one such comment…
A carbon tax would be a useful mechanism if it will generate a price signal that will lead to lower carbon emissions.
If this were the government’s proposal there would be very little that could be said against it. But instead of returning the revenue to the payers, it plans to create a bucket of money that then needs to be distributed.
If the carbon tax were returned to the payers, electricity prices would not dramatically increase, coal producers would be subjected to a levy, but would get a rebate if their coal mines were no worse than the average, and so on.
Instead, the government has set out to do a major redistribution of income, under the guise of doing something about greenhouse gases, but not actually doing anything. The Greens are frustrated, but they are also wedded to a gigantic money-go-around
The key to understanding the distinction here is to remember that it is the carbon price that drives decision making, including capital allocation. It does this by changing the economics of energy supply, incentivising lower emission sources and penalising higher emission sources. The distribution of equity from the government’s sale of permits is merely an allocation of wealth, which doesn’t affect decision-making. You would make the same decision in each case whether you were freely allocated or had to buy all your permits; the only thing that would change is your shareholder wealth, that is the equity on your balance sheet.
That’s where the quote above gets it wrong, and where we can learn from the European experience. The early scheme designers thought, in error, that if you distribute revenue to emitters that they will not pass through the costs and electricity prices will remain low. But any economist will tell you that it ignores opportunity cost. Regardless of whether they have a cash cost or not, emitters will value the permits at the value they could achieve if they sold them at market price. So what happened? The emitters pocketed the permits and passed through the costs anyway, hence the windfall gain.
Philosophically, auctioning vs free allocation comes down to who you think initially “owns” the right to emit CO2. The emitters in the early schemes effectively argued that they had previously enjoyed that right and that therefore an initial allocation to them was logical. Governments are arguing, on behalf of taxpayers, that the right to emit is “owned” by the community, and that it had previously been conferred on industry at zero cost. If it’s owned by taxpayers, then taxpayers have a right to decide how best to distribute this equity through the economy.
Historically, cap-and-trade systems have been based on a very small amount of permits being auctioned; normally less than 5%. This is the basis upon which the US SOx and NOx trading schemes were initiated back in the 1990’s, and is also where the EU ETS is at the moment.
When you hear carbon price detractors say that the EU ETS only raised $2.5b over its history relative to the $11.5b proposed from the Australian carbon price in one year, this is because a very small proportion of the carbon value was auctioned. The actual size of the EU ETS in Phase II is over $100b per year, ten times the size of the Australian scheme. Note that Phase III of the EU ETS envisages a move towards greater use of auctioning rather than free allocation, starting with 100% auctioning to the power sector in 2013. However, you measure the effectiveness of the scheme by the impact of the carbon price and the reduction in emissions relative to what would otherwise be the case, not how much revenue is raised.
So where does the value go if only 5% is auctioned? In these early schemes, most of the permits were freely allocated to the emitters. In some cases this led to “windfall gains” because not only did shareholders of these companies enjoy the value of the permits, but they could also pass on the carbon costs and receive a profit uplift anyway.
Imagine a scenario where there is no revenue collected by government, that the permits are 100% allocated to emitter for free. The emitters would be better off, in aggregate, to the tune of $11.5b. Compare this with the other extreme, where the government sold all the permits (ie under a fixed price ETS or 100% auctioning under a cap-and-trade floating price ETS). There would still be a carbon price (eg $20/tCO2e) but the government would be better off by $11.5bn, and could effectively choose to hang on to this as general revenue. In between these two extremes, you then have the “merry-go-round” to decide where to place this value; it’s effectively a distribution of equity and policy designers around the world have gravitated towards distributing it to those sectors of the community most affected …. lower income households and trade exposed industry. The alternative is to have these sectors face higher costs without any compensation, which would make it extremely politically difficult to implement the scheme.
But regardless of the distribution scenario, there would still be a carbon price and therefore an incentive to reduce emissions. If the merry-go-round or the “bucket of money” is the offending part of this, it’s easy not to have one. But I doubt that such a scheme would be politically achievable.