Cracking Copenhagen’s curse

Emissions trading schemes (ETS) have two major flaws preventing a global deal on climate policy. Government-determined design features, not “market failure”, are the cause.

The government’s recent release of the Mid-Year Economic and Fiscal Outlook (MYEFO) hinted at the first design flaw.

It noted an increase in the value of the $A, and consequent greater Australian purchases of cheaper overseas permits, would lower the price of permits issued in Australia. Revenue from sales of Australian permits would fall. So would government capacity to finance “compensation” to various interest groups. This is simply the “market-based” ETS/CPRS at work.

This revelation is but the tip of the iceberg in terms of its global ETS implications.

International trading of emissions permits is a design feature of ETS (and the CPRS). Those buying permits will try to source them from countries with the lowest price, while sellers will try to sell in the highest priced countries.

Let’s call this international trade “permit arbitrage”.

Sources of “permit arbitrage” include: (i) initial permit allocations between countries that result in different initial permit prices across countries; and (ii) currency fluctuations that have the same effect (as noted in the recent MYEFO).

“Permit arbitrage” shifts any initial permit allocation under a global ETS deal away from low price countries to high price countries until any price difference disappears.

Isn’t this just sensible trade in permits?

Yes - for trade in permits. However, under a binding global ETS, international sales of permits reduce the selling country’s capacity for ETS-compliant economic growth.

“Permit arbitrage” shifts the initial global allocation of permits away from countries with low initial permit prices, and further constrains their capacity for growth. That growth capacity is added to the initial growth capacity of the countries buying the permits.

There’s the rub.