Why Drop the Price Floor? Taking a Gamble on the EU

I couldn’t make much at first of today’s announcement by Greg Combet, Minister for Climate Change and Energy Efficiency, that Australia was going to link its ETS with the EU ETS – and oh, by the way, we’re dropping the price floor.

That Australia and the EU will link their schemes good news, but it’s an expected development. Dropping the price floor, on the hand, had been speculated about (notably by the AFR; well done, Marcus Priest), but wasn’t part of the original plan.

As I wrote back in May, a price floor has some good things going for it, despite being technically challenging; and as it’s only regulation the government has the numbers to pass it even against Rob Oakeshott’s opposition. So my initial reaction was that the floor price had been put in the “too hard” basket and the ETS linkage was just used to disguise that announcement somewhat.

I’ve since heard, however, that dropping the price floor was a condition of the EU agreeing to link the schemes, and Australia replaced it with the restriction of foreign units. This makes more sense.

The EU currently has an oversupply of permits (European Union Allowances; EUAs), and will have for a quite a few years yet, so it would welcome a new source of demand: Australia. (Even if our purchase volumes aren’t that great in the scheme of things.) An Australian price floor would not only lessen demand for EUAs, it would also make integrating the schemes more complex.

The price floor, though, was there to stop the Australian market being flooded by cheap foreign permits; to give domestic sources of investment into potential abatement (or offsets) the certainty that they would be able to get at least $15 for their product. What fulfils that role?

Well, we’ve moved from a price restriction to a (sort-of) quantity restriction. Previously, entities could meet up to 50% of their AU ETS liabilities with foreign units, but the only foreign units decided upon were those from the Kyoto Protocol: CERs, ERUs, and RMUs. The CDM market is currently even more oversupplied than the EUA market, and prices are down, down, down;⁽¹⁾ well below the $15 price floor.

Now, the 50% limit on international units is still there, but only 12.5% (of total liabilities) can be met by Kyoto units. Once that limit is reached, the relevant price domestic permits (ACUs) and offsets (ACCUs) have to compete against is that of EUAs. (Remember that the large amount of free permits – I don’t have exact figures, but it’s around 30-40% of our cap, I think; leave a comment if you’ve better info – lowers the effective size of the domestic market, so the 50% international unit cap isn’t as strict as it sounds.)

That 12.5% limit suits not only the EU, since the EUAs don’t have to compete against the Kyoto units for the other 37.5%, but also suits those like The Greens who want the carbon price to rise over time: they expect the EUA price to rise over time, pulling ACU/ACCU prices with it. It’s not a bad gamble – certainly, I think the chance of EUA prices rising above $15 is higher than that of CDM prices doing so. (Exchange rates play a role in all this as well, but I’m buggered if I know which way they’re going.)

Limiting Kyoto units also does a little bit to allay concerns about the additionality of some of those units, though it’s a fairly blunt instrument; a quantity control is not a quality control.

That’s the policy side of things. On the politics side, the EU ETS integration/no price floor does some interesting things. The lack of an auction price floor and international surrender charge (which together constitute the ‘price floor’ we’ve been discussing) could well reduce government revenue from the carbon price; it depends on what the EUA price does.

More interestingly, though, I think the EU integration and lack of a price floor will make the AU ETS appeal more to free market types, especially since at first glance it looks like providing opportunities for cheaper abatement. (You fine readers, of course, know better.) And unless the Liberals want to start slagging off Europeans, they might reign back calling foreign abaters cowboys, scammers, frauds, and criminals.

Yeah, okay, I don’t buy that last one, either. But at least the government now have a better response to that.

Finally, integrating more fully with the EU ETS effectively places more responsibility for domestic prices in their hands: if EUA prices go up, so will Australia’s prices – sorry, guys, it’s out of our hands! (Though we keep the price ceiling, I understand it will be set with reference to the EUA price; so no great limit, there.)

A lot depends on how well the EU can reform its ETS to drive prices back up into its preferred (by almost everyone but Poland) range – but then, that’s always been the case.

⁽¹⁾ Come at me, Coles.

Update on Wednesday, August 29, 2012 at 14:28 by MCJ

I had a chat with the ABC’s Naomi Woodley about the floor price/EU ETS linking issue this morning. You can hear grabs from the interview in her piece on The World Today, or you can just read the transcript and imagine my voice to be that of your choice. I won’t judge.

Update on Thursday, August 30, 2012 at 16:27 by MCJ

The proportion of Australia’s ETS liabilities covered by free permits (under the “Jobs and Competitiveness Program”) amounts to 27% for 2012-13 to 2014-15, by my calculation. That’s based on figures from the Clean Energy Future plan Appendix C: Fiscal Tables

Free permits * price = revenue foregone
Total expected permits * price = revenue foregone + expected revenue from sales
Free permits / Total expected permits = 27%

So slightly less than I had in memory.