Let’s tax carbon: Why the time is right for a second shot at carbon pricing

Australia now has a government and parliament wanting timely transition to net zero. We have a government and parliament wanting to build Australia as the renewable energy superpower of the zero-carbon world economy. For the time being, we have favourable international settings for using our opportunity.

The government of Australia has embraced this superpower narrative, taken some big steps towards supporting its emergence, and articulated sound principles for guiding further policy development.

But Australians in business and the community wanting to make large efforts to turn opportunity into reality find themselves in a tangle of policy uncertainty and contradiction.

The source of the problem is the abolition of carbon pricing in 2014. Since then, the Commonwealth government has worked within constraints that rule out success.

We can make a start towards net zero and becoming a renewable energy superpower without moving the constraints, but we can’t get far. This is a problem for any government of Australia, and not only for the current Labor government. We will not rise sustainably out of the post-pandemic dog days until we get energy policy right.

Striking the right balance

Striking the right balance between state intervention and market exchange is always essential for successful economic development, in all places.

The market generally delivers goods and services more cost-effectively than the state where there is genuine competition among suppliers and purchasers of goods and services.

The difference is especially large and important at a time of structural change and uncertainty. State decisions inevitably tend towards continuation on established paths and slow response to new opportunities.

Australia will not make use of more than a small fraction of the superpower opportunities available to it without immense contributions from an innovative, competitive private business sector.

So we have to design energy and related markets that provide the widest possible scope for competition among enterprises within clear rules understood in advance of investment decisions by all market participants.

The state has to do well the things that only the state can do. Because government capacity is a finite resource, it is much more likely that it will do the essential things well if it doesn’t try to do the things that markets do well.

The state must define the boundaries between the services that it delivers and those to be delivered by the market.

In the electricity sector, government must take responsibility for design of the market rules and compliance with them. It must provide the natural monopoly services of electricity transmission and hydrogen transportation and storage. It must take ultimate responsibility for system security and reliability.

For any market to work, individual market participants must be blocked by regulation from damaging others through their business decisions, or subject to a tax equal to the costs they impose on others. And they must be rewarded for large benefits that they confer on others.

This is essential economics. Its understatement in Productivity Commission and financial media commentary on energy and climate policy discussion over the past decade reveals the debasement of Australian political culture that gave us the dog days.

It has been politically incorrect to tell the truth out loud.

It’s time for carbon pricing

A crucial element of post-2030 market design is introduction of a green premium for zero-carbon energy.

It is obviously necessary for low-cost decarbonisation and expansion of the electricity sector and building Australia as a renewable energy superpower. The green premium is crucial for securing international market access for the zero-carbon export industries.

One of the dog days constraints on policy is that there should be no mandatory demands on private investors. Those constraints must be broken for the green premium to reflect the social cost of carbon, as it must if we are to achieve net zero by 2050 and build Australia as the renewable energy superpower.

The economically efficient way of achieving the premium is carbon pricing. It would be most efficient within an economy-wide system, although it could be introduced initially for the electricity sector and extended to other industries later.

Investors now need to know soon that there will be a premium reasonably related to the social cost of carbon after the Renewable Energy Target ends in 2030.

What matters for the superpower industries is the green premiums for which they are eligible in other countries. Pending the emergence of appropriate premiums, the Commonwealth is proposing payments from the budget.

That is appropriate. It can get the early movers started. It would be expensive if it continued for long. The superpower industries will grow rapidly if they have access to premiums corresponding to the social cost of carbon. Over time, payments from the Australian budget will be replaced by market premiums in destination countries.

There are several possible forms of carbon pricing. The system operating in Australia from 2012 to 2014 was economically and environmentally efficient.

It would have been linked to the EU Emissions Trading System from July 1 2014 if it had not been abolished the day before. The Australian carbon price would be equal to the European price. We would be introducing a European-type Carbon Border Adjustment Mechanism to ensure that Australian producers were not disadvantaged by competition in the domestic market from suppliers who were not subject to similar carbon constraints. The ETS (emissions trading scheme) would be contributing around 2% of GDP to public revenues – going a substantial part of the way to answering the daunting budget challenge to restoration of Australian prosperity.

Part of that increased revenue could support payments to power users to ensure there was no increase in power prices to users until expansion of renewable generation and storage had brought costs down – along the lines of the A$300 per household introduced in the 2024 budget, but larger.

The arrangements would provide automatic access for zero-carbon Australian goods to the high-priced European market. There would be no need to provide for a green premium for sales to Europe from the Australian market. The green premiums in other markets would at first need to be covered, as they are now, from the Australian public revenue.

A carbon solutions levy

Rod Sims (former chair of the Australian Competition and Consumer Commission) and I have suggested a carbon solutions levy. It is administratively simpler than the ETS. It would initially raise much more revenue.

We propose exemption for coal and gas exports to countries in which Australian zero-carbon exports attract a premium comparable to the EU carbon price, even if it is not generated through an ETS.

We would hope that if the carbon solutions levy were to be introduced from 2030, our major trading partners would by that time have introduced green premiums that justify exemption from the levy for coal and gas exports to those countries.

The European Union would be exempt from the beginning. The Northeast Asian economies are moving towards eventual justification of exemption. China now has a country-wide emissions trading system.

The carbon price in July 2024 is about A$21 per tonne, having increased by 50% since early in the year. The price is expected to continue rising until it is playing a major role in transformation of Chinese industry.

Incidentally, China undertook to the United Nations Framework Convention on Climate Change that its emissions would peak by 2030, but its rapid expansion of renewable energy generation, electric vehicles and zero-carbon industrial technologies suggest that the peak may have come in 2023.

Japan is working on direct budgetary support for importers of zero-carbon products which could pass through into a premium for zero-carbon exports from Australia.

During a visit in April 2024, I was advised that the Japanese government is working towards issue of “green bonds” to pay for the premium. A carbon tax from 2035 would meet the cost of servicing and retiring the bonds.

Korea and Taiwan are introducing their own mechanisms for supporting premiums for zero-carbon imports.

One initial criticism of the carbon solutions levy is that it would cause leakage of Australian exports to competing suppliers of gas and coal. There would be some leakage, alongside substantial transfers from rents to the public revenues, and for metallurgical coal in particular, some increase in export prices.

The price increase would introduce an element of green premium for Australian green iron exports. The Superpower Institute (a non-profit research organisation founded by Sims and I) has commissioned the Centre of Policy Studies at Victoria University to quantify the extent of leakage, transfers from rent and higher export prices. The results will be available for public discussion early in 2025. The study will also calculate the effect of the levy on Australian public finances, real incomes and real consumption.

Regional considerations

Australia’s main competitor in regional coal markets is Indonesia. Its main competitors in gas markets are Papua New Guinea, East Timor, Indonesia, Brunei and the Middle East petroleum producers.

No informed person would suggest that there could be an economic problem with leakage to the Middle East: Saudi Arabia and the small Gulf states extract revenue from petroleum exports at much higher rates per dollar than Australia would after imposition of the levy.

There is a case in the Australian national interest for not seeing expansion of export sales from Papua New Guinea and East Timor as being entirely a waste.

But in their national interest and ours, I suggest that we seek to negotiate a four-way agreement on climate and energy with Indonesia, East Timor and Papua New Guinea.

We would all impose carbon solutions levy-type levies at similar rates. This would be a major source of revenue for all of us.

Participation of Indonesia removes leakage of coal exports. Indonesia already has an emissions trading scheme, although it generates a carbon price of only a few dollars per tonne.

It may choose to remove other imposts on fossil carbon exports at the time of introduction of new carbon-related measures – such as the requirement to make 35% of coal exports available at prices well below international prices for domestic power generation.

Participation of the four countries removes the leakage issue for gas. The four neighbours would cooperate in major development programs based on expansion of zero-carbon energy supply and goods production.

There is active discussion in Indonesia of archipelago-wide electricity transmission infrastructure to allow the superior renewable energy resources of the outer islands – Papua, Nusa Tenggara, Sulawesi, Kalimantan, Sumatra – to contribute to decarbonisation and growth of zero-carbon industry everywhere, including in the Java heartland.

The Indonesian grid would run close to neighbouring Australia, Papua New Guinea, East Timor, East and West Malaysia and the Philippines. It would be the geopolitically practical means of linking Australia and Singapore, as envisaged in the SunCable project in the Northern Territory.

The Indonesian national grid could link to the Australian Sungrid discussed in my book The Superpower Transformation in Darwin and the Pilbara.

The alternatives to carbon pricing are weak

The alternatives to economy-wide carbon pricing are likely to turn out to be short-lived expedients that lead sooner rather than later to the return of today’s incoherence and underperformance in energy and climate policy and performance.

The state must provide reliability of power supply to the general population.

The Commonwealth government can do this without distorting competitive electricity markets by establishing an energy reserve I have proposed in my book The Superpower Transformation.

The superpower industries depend on electricity and hydrogen markets operating efficiently and embodying carbon prices. Otherwise the market design issues relevant to their development are similar to those for electricity.

Negative carbon externalities need to be corrected by taxation or alternative carbon pricing mechanisms. Positive externalities from innovation should be rewarded.

Positive innovation externalities are important in the introduction of new industries, technologies and business models for the zero-carbon economy.

Economy-wide carbon pricing at the social cost of carbon is essential to getting the balance right between state intervention and market exchange.

Once it is in place with fiscal rewards for innovation, the government can let businesses decide which new industries and technologies warrant investment.

Once carbon pricing is known to be coming into place reasonably soon, there is no further need for government underwriting of investment in power generation.

There is no need to include a climate trigger in assessment of a project of any kind: if it emits carbon, it will pay for the climate damage it does.

There is no need for government to take a view on climate grounds about the merits of nuclear power generation. It is zero-emissions generation and, like renewable energy, not subject to the carbon price. If it can compete with other forms of generation, it will find a place in private investment decisions on the energy mix.

There is no need for government investment in nuclear power generation. Private investors will have the same incentives to invest in nuclear as in other zero-carbon generation technologies.

There will be no need for the government to take a view on incentives for carbon capture and storage. If it is effective and emissions are actually reduced, carbon payments will be correspondingly reduced.

The carbon price will allow private investors to get on with the job of expanding renewable energy supply at a rapid pace and decarbonising the economy more generally.