The proposed carbon pricing policy in Australia is now routinely referred to as a carbon tax by both government and opposition. This is odd, because the proposed scheme is not actually a tax.   

It seems reasonably likely that Australia will, sooner or later, end up with an emissions trading scheme (ETS) for CO₂.  An ETS works by setting a cap on emissions and requiring emitters to hold a permit for each tonne of CO₂ that they emit. The level of the cap determines the number of permits available.

If emitters don’t already hold a permit, they must either cut back on their emissions or buy a permit from another emitter, who must then cut back. This means that a cost is imposed on emissions, equal to the price of buying or selling a permit. But, importantly, it’s not actually the price that causes the overall cuts in emissions. Rather, it’s the required cuts in emissions that cause the price. That is, permits have a value, because they allow you to avoid making cuts in emissions.

A carbon tax is sort of the opposite. A cost is added to all emissions, equal to the level of the tax, and this causes people to cut back their emissions. There is no cap on emissions in a tax-based system. People are free to emit as much or as little as they like, but if they do emit, they must pay the tax.

The system that the Australian Government is currently proposing to move to in the medium term is a standard ETS, not a carbon tax. But in the short term, there is a twist. The proposal is to fix the price of permits for the first few years, presumably to reduce uncertainty during the transition period after the scheme commences. It would still be an ETS, with a cap on emissions, and permits that can be traded, but the price of permits would be fixed by the Government.

Depending on how high the price is fixed during the early years of the scheme, it might be either the price or the cap that determines the level of emissions. If the fixed price of emissions is low, it would not create much incentive to reduce emissions, so the level of emissions would be determined by the cap on emissions. On the other hand, if the price is high enough, people might actually emit less than the maximum level set by the cap. In this case, the price of permits would be the main driver, not the cap, and there would be some unused permits.

You can see that there is a similarity between the fixed-price ETS approach and a carbon tax, in that it can be the price that determines output, although only when the price is set at a relatively high level. There still are important differences, however. In the Government’s proposed scheme, permits could still be traded among emitters and potential emitters, even in the period when there is a fixed price. That does not occur under a carbon-tax regime. When people pay a carbon tax, the revenue goes to the government. A fixed price ETS could be set up so that the initial revenue goes to the government (i.e. all the permits are sold by government at full price), but it could also work effectively even if some of the permits are given away (which the government is likely to do) provided that subsequent sales were only allowed at the fixed price or the cap is enforced. Revenue from subsequent transactions between emitters would go to the seller, not to the government.

As far as I can tell, from the perspective of households, the scheme will be no different in its fixed-price phase than in its later floating-price phase, other than in the level of carbon prices (which will rise over time) and the presence of price volatility. Households will not have to pay for emissions permits directly, but will do so indirectly as businesses pass on some or all of the higher costs they face. If the government had opted for a carbon tax, the result at the household level would not have been noticeably different. Higher costs would have been passed onto them through higher prices in a similar way. It would also have been possible to compensate low and middle income earners through reduced income tax or increased government payments, just as is planned under the ETS. In neither case would individuals have to put in any sort of tax return for their carbon emissions.

Despite the similarities described above, it is factually incorrect to call the proposed system a carbon tax. I can understand why the Opposition wants to call it a tax. It plays to people’s dislike of any sort of tax. But to me it seems odd that the Government has adopted the same language. Given the traction that Opposition Leader Tony Abbott got from his line about a “great big new tax on everything” during the last election campaign, you’d think that the government would avoid the “tax” word if they could. And they can. Their proposed initial approach is, in fact, not a carbon tax, but an ETS with a fixed price.

David Pannell, The University of Western Australia

p.s. 8 June 2011. I received several interesting responses to this PD.

Rob Fraser pointed out that, if the price of permits is fixed at a level below the market-clearing price, this would inhibit trade between emitters. My judgment is that, if all the permits were sold by government at the fixed price, this would not be a major problem. But if a lot of permits are given away (as is likely), they could easily end up in the hands of businesses that don’t have the highest marginal benefit from using them. In this case, the low fixed price would introduce significant inefficiencies to the market. This would not occur under a carbon tax. I don’t think this is a problem if the fixed price is above the market-clearing price.

Jerry Vanclay pointed out another likely important difference between a tax and an ETS: the transaction costs of the two systems. These are the costs of administering and participating in the market. “… one difference you didn’t canvass is the transaction costs for ETS and tax. My view is that there will be considerable costs associated with estimating and monitoring emissions and ETS trading – plus there will be volatility that [imposes] additional costs and uncertainty on industry. In contrast, a fossil carbon tax levied on those who dig up fossils, would be cheap and easy to implement – and may even save bureaucracy if it is made revenue-neutral by reducing income tax …”

David Alonso Love commented: “I agree the Federal Government is doing itself no favours by calling this a carbon tax, but I’m not sure “an ETS with a fixed price” quite cuts through. It would sound like goobledy-goo political speak to the punters.” I’m sure he’s right. Perhaps this is part of the reason for the government’s acquiescence.

p.p.s. 5 August 2011

I wrote the above prior to the government releasing details of the scheme. It turns out that trading amongst permit holders will not be possible during the fixed-price period. Permits can only be obtained from government. Emitters will have to buy permits (or be given them) in order to be permitted to make emissions. This means that the scheme is actually a bit more like a tax than it might have been during the fixed-price phase. However, it may still be like an ETS if it is the level of the cap, rather than the price, that determines the level of emissions. At this stage, it isn’t clear to me whether the price will be high enough for it really to behave like a tax.