With last week’s federal budget slashing the forecast revenue from Australia’s carbon pricing scheme for the second half of this decade, it’s a good time to have a closer look at the Gillard government’s decision to link the scheme with its embattled European counterpart from July 1, 2015.

It may seem moot to be analysing the medium-term prospects of a scheme that seems likely to be repealed if an Abbott government comes to power later this year. But it is important to understand that, even if the scheme stayed in place, the EU linkage is likely to weaken its effect so drastically that its retention would be scarcely better than its demise. My purpose is not to advocate that demise or support the Coalition’s alternative, “direct action” plan (which I think would be a shameful regression). Rather, in the hope of improving the design of future climate policy, my intent is to expose the linkage decision, and the ideology on which it is based, as mistaken.

One of the putative benefits of putting a price on climate-warming greenhouse gas emissions is that the government generates revenue from the sale of carbon permits. Up until last week’s budget, Treasury had been forecasting future revenue from the carbon scheme based on the assumption of an Australian carbon price of $29/tonne. The latest budget, however, slashed the forecast scheme revenues for 2015-16 and beyond, basing its forecast on a new carbon price assumption of $12.10 in 2015-16, 60% less than the previously assumed $29 figure.

Why the sudden change? Well, the $29 figure was always optimistic; over the past couple of years, as the handful of existing overseas carbon markets have stumbled and the prospects for global collective climate action have dimmed, it has looked fantastical. Most importantly, though, the downward revision is a recognition of the structural imbalance between demand and supply for European carbon permits that is keeping the EU carbon price extremely low.

Understanding the dynamics of the European scheme is vital, because the price in Europe will effectively set the Australian price from 2015. The third phase of the European scheme, which operates across its 27 member states and covers sectors responsible for about 45% of Europe’s emissions, began at the start of this year and will continue until 2020. The annual “cap” on European emissions is driven by Europe’s emissions reduction target (20% below 1990 levels by 2020). Permits are allocated freely to some emitters and auctioned by member states according to figures determined by the European Commission (the EU’s executive arm). The supply of permits is obviously affected by these allocations and auctions, but also by the supply of international credits from the Kyoto Protocol’s emissions trading mechanisms (which are mostly from emission abatement projects carried out in developing countries, and are eligible for compliance purposes in Europe) and the number of permits “banked” by scheme participants from Phase II.

Due to a flood of cheap international credits, banking from Phase II and the early auctioning of Phase III permits, the number of permits in the European market has been extremely high at a time when demand for permits has been depressed by the economic downturn in Europe. The result has been a large surplus of permits — that is, an excess of permits above the emissions cap — in each year since 2009 and a correspondingly low carbon price (currently around 3.50 euro, or A$4.65). The Commission projects the surplus will reach a cumulative total of around 2 billion permits — about the equivalent of Europe’s entire annual emissions cap in 2013 — and that this surplus will persist for the rest of the decade, meaning prices will stay at their farcically low levels.

In a bid to avoid this spectacle, the Commission has initiated a two-stage reform process that seeks to redress the supply side of the surplus problem. The first stage involves a proposal to postpone the auctioning of 900 million permits from the years 2013-15 until 2019-20. This proposal, known as “backloading”, would not alone change the number of permits in the system released in total over the course of Phase III, but it would serve two important functions.

First, on the assumption (which the Commission makes) that demand for permits will have grown by the end of the decade, backloading some of the permits would “smooth” the price somewhat over the course of Phase III, raising it now (while demand is low) and depressing it later (when demand is expected to be higher). Secondly, it would buy some breathing space within which more fundamental structural reforms could occur, such as removing the surplus permits altogether, or some other measure to push the price higher. (The Commission released a paper late last year canvassing six such options, about which it is currently consulting with stakeholders.) Jonathan Grant, director of sustainability and climate change at the consultancy PwC, says some such deeper structural reform and an increase in permit demand driven by a return to growth in Europe would be necessary to send the price into the 15-20 euro range.

*Read the rest of this article at Inside Story