Explainer: The difference between a carbon tax and an ETS

The proposed carbon pricing policy in Australia is now routinely referred to as a “carbon tax” by
both government and opposition.
This is odd, because the proposed scheme is not actually a tax.

How does an ETS work?
It seems reasonably likely that Australia will, sooner or later, end up with an
emissions trading scheme (ETS) for CO₂.
An ETS works by setting a cap on emissions and requiring emitters to hold a permit for each tonne
of CO₂ that they emit. The level of the cap determines the number of permits available.
If emitters don’t already hold a permit, they must either cut back on their emissions or buy a permit
from another emitter, who must then cut back.
This means that a cost is imposed on emissions, equal to the price of buying or selling a permit.
But importantly it’s not actually the price that causes the overall cuts in emissions.
The cap determines the level of emissions, and the required cuts in emissions cause the price.
That is, permits have a value because they allow you to avoid making cuts in emissions.
How does this differ from a carbon tax?
A carbon tax is sort of the opposite. A cost is added to all emissions, equal to the level of the tax,
and this causes people to cut back.

There is no cap on emissions in a tax-based system. People are free to emit as much or
as little as they like, but if they do emit, they must pay the tax.
Unlike an ETS, under a carbon tax it is the price that determines the level of emissions.

Where is Australia in all this?
The system the Australian government is currently proposing to move to in the medium term is a
standard ETS, not a carbon tax.

But in the short term, there is a twist.

The proposal is to fix the price of permits for the first few years, presumably to reduce uncertainty
during the transition period after the scheme commences.

It would still be an ETS, with a cap on emissions and permits that can be traded, but the price of
permits would be fixed by the government.

There is a similarity between the fixed-price ETS approach and a carbon tax. If the fixed price is
set at a high enough level, then it would be that price, rather than the cap,
that determines the level of emissions.

At that high carbon price, people would actually emit less than the maximum level set by the cap.
In that case, the ETS would be behaving somewhat like a tax.

But there are still important differences.
In the government’s proposed scheme, permits could still be traded among emitters and
potential emitters, even in the period when there is a fixed price.
That does not occur under a carbon-tax regime.
Where does the money go?
When people pay a carbon tax, the revenue goes to the government.
A fixed price ETS could be set up so that the initial revenue goes to the government
(i.e. all the permits are sold by government at full price).
But it could also work effectively even if some of the permits are given away, which the government is
likely to do, provided that subsequent sales were only allowed at the fixed price or the cap is enforced.
Revenue from subsequent transactions between emitters would go to the seller, not to the government.
If the fixed price is set too low, it may actually inhibit trade, resulting in inefficient emitters who have
been given permits continuing to emit. That would not happen under a tax system.
Another difference between the two approaches would be in the level of transaction costs – the costs
of administering the scheme and or of participating in it. Some have argued that a carbon tax is likely
to have lower transaction costs, and that does seem plausible to me.

How will households be affected?
From the perspective of households, the scheme will be no different in its fixed-price phase than in its
later floating-price phase, other than in the level of carbon prices (which will rise over time) and the
initial absence of price volatility.
Households will not have to pay for emissions permits directly, but will do so indirectly as businesses
pass on some or all of the higher costs they face.
If the government had opted for a carbon tax, the result at the household level would not have been
noticeably different. Higher costs would have been passed onto them through higher prices
in a similar way.
It would also have been possible to compensate low- and middle-income earners through reduced
income tax or increased government payments, just as is planned under the ETS.
In neither case would individuals have to put in any sort of tax return for their carbon emissions.

Can the government avoid the stigma of the word “tax”?
Despite the similarities described above, it is factually incorrect to call the proposed system a
carbon tax.
I can understand why the opposition wants to call it a tax. It plays to people’s dislike of any sort of tax.
But to me it seems odd that the government has adopted the same language.
Given the traction opposition Leader Tony Abbott got from his line about
a “great big new tax on everything” during the last election campaign, you’d think that the
government would avoid the “tax” word if they could.
And they can. Their proposed initial approach is not a carbon tax, but an ETS with a fixed price.
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