The EU’s announcement that it would link emissions markets with Australia beginning in 2015 brings a breath of fresh air to the prospect of a global price on carbon. In July, Australia introduced a tax that will transition into a cap and trade program in 2015. Currently the policy is under intense political attack. The prospect of linking to the EU’s existing carbon market should bolster the program because it makes the contribution of Australia more relevant: rather than bearing, by themselves, the cost of a policy that will make only a small dent in global emissions, it becomes clear that theirs is part of a global effort. Because the Australian price projections are higher than for the EU, there are potential savings for Australia as well.

The EU’s program has had its own doldrums lately, with allowance prices falling below €8 ($10) per ton. The link to Australia will broaden the current market and renew the enthusiasm for the long-run prospects of a global market. Further, both programs have contingency provisions that allow for strengthening their targets in the case of broader international action.

However, linking requires compromise to make program designs consistent across jurisdictions.

For the EU and Australia, prices are managed inconsistently. The Australians take a rule-based approach by applying a price floor to their cap and trade program, intended to bound risk for investors in clean technology. In contrast, the EU asserts that it does not manage prices or make program adjustments. If this were strictly true, it would enable a level of price volatility that would undermine support for emissions trading in the US. In practice, the evidence is that the EU practices administrative discretion. Most recently, low prices in the EU precipitated a delay of auctions to constrain the supply of allowances. Although the European Commission insists this is not a market intervention… it sure walks like a duck. These alternative approaches to price management (or, equivalently, the EU’s assertion that it does not manage prices at all) were incompatible, so something had to give. Consequently, to link with the EU, the Australian program will surrender the idea of a price floor.

Lack of price controls makes possible future links with North American carbon markets more difficult. These markets have often featured not only price floors, but price ceilings too, employing a rule-based rather than discretionary approach. Floors provide greater certainty for investors and are popular with environmentalists, while ceilings are popular with industry. Beginning in 2009, the cap and trade program in the northeast Regional Greenhouse Gas Initiative included a price floor in their quarterly auctions. As it turned out, the program created too many allowances and the price would have fallen to zero without the floor (as it did during the trial period in Phase 1 of the EU’s program). Instead, the supply of allowances was automatically constrained. The moderate program survives and is currently under review, and meanwhile has netted nearly a billion dollars in revenue from the auction. The 2010 Waxman-Markey national cap-and-trade bill borrowed the idea of a price floor, and the California and Quebec trading programs will include a price floor beginning at $10 per ton when trading begins in 2013. To guard against the possibility of an unanticipated price spike, the California program also has a complementary allowance reserve that becomes available starting $40 per ton.

The linking of the EU and Australian programs is a huge event in the evolution of global climate policy. But, the program architecture should be as robust as possible to provide a stable market design that can withstand unanticipated market volatility. To North American sensibilities, a rule-based approach to managing costs would appear preferable. One day this issue may be at the center of a negotiation that involves North American trading programs in an even broader linking of price-based carbon policies.

About Clayton Munnings

Clayton Munnings is a research associate at Resources for the Future.

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About Dallas Burtraw

Dallas Burtraw is one of the nation’s foremost experts on environmental regulation in the electricity sector. For two decades, he has worked on creating a more efficient and politically rational method for controlling air pollution. He also studies electricity restructuring, competition, and economic deregulation. He is particularly interested in incentive-based approaches for environmental regulation, the most notable of which is a tradable permit system, and recently has studied ways to introduce greater cost-effectiveness into regulation under the Clean Air Act.

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