Carbon markets – you’ll never walk alone…

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Removal of the floor price will reveal the true colours of our free marketeers, who will have no camouflage left behind which to conceal their self-interest.

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The changes to the design of the Australian carbon price represent smart politics.  They also look to be good environmental and economic policy.  They will underpin support in the medium term for CFI projects and they will make it harder for anyone who wants to repeal the whole Clean Energy Futures legislative package.  (Blood oath, they will.)

In fact, the only genuine loser from today’s announced changes by Minister Combet and Commissioner Hedegaard is the poor old CDM market, which receives another stun gun blow to the head while it already lies gasping on the ground.

Politically, we can comfortably anticipate a cacophony of coalition claims about backflips and broken promises, about disaster and design flaws, about chaos and confusion.  The reality is that, following the 3 year fixed price period, Australia’s carbon price will be linked to and largely set by the European price.  We will be part of an international carbon market of over 500 million people, the largest in the world, refuting the complete furphy that somehow Australia is acting ahead of the rest of the planet.

Removal of the floor price avoids complicated, confusing and potentially costly mechanisms for top-up charges. It sensibly placates business concerns about market structures, neutralises extreme vocal opposition and will reveal the true colours of our free marketeers, who will have no camouflage left behind which to conceal their self-interest.  What else will they find to complain about?

Economically, the transition from a small standalone carbon market to a much larger international market will greatly increase market efficiency, providing Australian businesses with improved liquidity, reduced volatility, lower marginal costs of abatement and lower transaction costs.

While superior market efficiency is important, the absolute level of carbon pricing is the key metric.  Once Australia decided to allow international units into its carbon market, it was always going to end up as a price taker. The key question was which price?

The significant reduction in the amount of international offsets that liable entities can use (from 50% to 12.5%) means that Australian carbon prices will no longer be driven by CER prices.  Given that CER prices are currently at environmentally impotent levels of around A$3.60 per tonne, this is unequivocally good news.  At those prices, there is no incentive to invest in low carbon solutions of any sort.

Instead, by allowing European Allowances (EUAs) to be used for up to 50%, the changes mean that the Australian price will be driven by the EUA price, currently around A$10.  What’s more, with the European Commission looking at a range of measures to curtail supply and increase prices, the EUA price is arguably at the bottom of its market.

Indeed it is quite possible that, by the end of the fixed price period in 2015, the EUA price will be above the now-abandoned $15 floor price.  People really should be careful what they wish for.

 

All of which leads to a whole new set of risk management decisions and choices for liable entities.  They can now buy EUAs as well as CERs for surrender against future liabilities.  They will have to evaluate internal emission reduction options in light of very different carbon price curves driven by very different market dynamics. They will have to reassess the reality of the political risk and the likelihood of repeal in view of the new links that are being forged to the world’s largest carbon market (and Australia’s second largest trading partner.

On the supply side, the outlook for CFI projects has certainly improved.  Market prices above $15, uncapped demand from liable entities and limited supply make the medium term outlook very rosy.  Indeed, the whole question of land-based domestic offsets and their role in a fully linked European-Australian international carbon market will now be under review, with potentially significant impacts on future demand.

The downside in all of this is borne almost exclusively by the CDM market.  Already labouring under massive over-supply and increasingly curtailed appetite, the impact of reduced Australian demand could prove to be painful.

Still.  Swings and roundabouts, risk and return.  That’s how markets are supposed to work.  And the new, improved Australian version should work very well.

Freddy Sharpe is CEO of Climate Friendly.

 

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