Surrendering to the Idea of a Price Floor

From July 2015, the Australian federal government will set the price of the permits in its emissions trading scheme free – within limits. The government intends to introduce a price floor and price ceiling until at least 2017/18, in order to provide certainty and reduce risks for market participants and investors.

This is good news for emission reduction activities whose viability depends on prices several years hence, such as larger, more complex projects. Further, the goal of abatement at least-cost should be balanced against the goal of abating as rapidly as possible; should reaching current targets be cheaper than expected, a floor price can ensure a minimum level of spending on abatement. Several EU countries already have or are considering similar measures, in recognition that adjusting the targets of an ETS in response to price movements often isn’t possible rapidly.

Last December, the government released a discussion paper and called for submission on the price floor, which combines a reserve price for Australian carbon units at auction with an ‘international unit surrender charge’ that ensures international carbon credits cost at least as much as domestic units.

Four options are being considered for the international unit surrender charge, with two main approaches: Options 1 and 2 calculate the charge based on the difference between the price floor and the price of the international unit when it was purchased; Options 3 and 4 calculate the charge based on the difference between the price floor and the price when the unit surrendered.

While calculating the surrender charge based on the difference between the buying price and the price floor is intuitively appealing, it has implementation issues ranging from administrative complexity, through estimating firms’ time value of money (to adjust the prices of credits purchased earlier rather than later), to the possibility of firms gaming the system by artificially inflating the price of purchased credits. The government paper also notes that Options 1 and 2 would create a preference for foreign units as “if the international price goes up, [firms] could sell the unit at a profit, purchase another unit at a similar (or the same) price, and pay a lower surrender charge.” (Source)

Option 3 appears the most likely: when firms surrender their international units, a charge is applied based on the difference between the prevailing spot price and the price floor. This is the “purest” option, with minimal government involvement and low administration costs. The risk that the price of units changes between purchasing and surrendering them is borne by the liable firms, though financial markets are expected (e.g. by Westpac (PDF)) to provide hedging products or forward contracts.

The costs of hedging, in addition to the surrender charge, could promote the purchase of domestic units over foreign credits. However, it’s worth noting that, since markets for foreign units will likely exist further forward than domestic units (which will only be auctioned three years in advance, based on current plans), there will be a strong bias toward international credits from firms looking to hedge long-term.

Option 4 is similar to Option 3, though with an option for firms to lock in a surrender charge ahead of time based on a regulator-calculated forward curve. This interesting idea would assist firms who, for reasons of cost, access, or complexity are unlikely to use financial markets’ hedging products. Though adding complexity, it would avoid any bias Option 3 has toward domestic units. However, is it the government’s role to insure traders from carbon price risk?

While an MP who supported the ETS, Rob Oakeshott, has recently spoken out against the price floor, the government has an advantage: the relevant legislation has already been passed, and the remaining details (e.g. the choice of option) can be passed by regulation. Regulation passes automatically unless blocked, so the opposition would need to find a 75-seat majority in the House of Representatives to do so. (Under convention established by Speaker Denison, the Speaker votes against motions in case of a tie.)

Even in the government’s current precarious position, this seems unlikely – the defection of Oakeshott alone would not suffice –, so that, if the government survives long enough to introduce a price floor, it will likely pass.

This post was first published by Reuters Point Carbon.