Offset credit trading

Australia’s successful RET emission trading scheme is an Offset Credit Trading Scheme (OCTS) that has been quietly driving investment in utility scale renewable energy since 2001.  Best of all, it has been doing this without causing any dramatic increase in power prices or political pain.  This quiet success  means that few Australian’s have heard of the RET scheme let alone understand what offset credit trading is.

The main aim of this post is to explain what offset credit trading is and how it can be used.  In addition, the post compares OCTS with cap and trade schemes, as well as systems based on long term contracts. (Ex: Feed in Tariff (FIT) based schemes.)
All of these schemes can be used to drive a variety of changes. For convenience, most of the examples used are government run schemes aimed at emission reduction.
A: Offset Credit Trading Schemes (OCTS)
OCTS can be used to drive investment in desirable alternatives (Ex: Renewable energy) or to drive changes in the mix of desirable and less desirable products.  (Ex: Reduce the average emissions per km of new cars )
OCTS use market forces to set a levy on an undesirable alternative(s).  The money from the levy is then used to subsidize desirable alternatives.  Market forces drive the levy/subsidy to the point where desirables can compete with undesirables.  Details of offset credit trading schemes may vary.  The key features of a basic offset credit trading scheme are:

  1. OCTS  controls averages.  To do this it needs working targets expressed as averages.  (Ex: “average emissions per kWh”).
  2. OCTS cannot be used directly to control things like “total power emissions” because this target is not an average.  However, it will often be possible to convert “primary targets” in an unacceptable form to “working targets” expressed as averages. (Ex: A “total power emissions” primary target could be converted to an “average emissions per kWh” working target by first working out what “average emissions per kWh” would have to be for the total emission target to be met.)
  3. Better than target performance is rewarded by the award of free credits by the government.  (Ex: One credit per mWh renewable power.)  These credits can be held for future use, sold to others directly or sold via a credit trading market.
  4. Worse than target performance has to be offset by the surrender of credits to the government by “liable parties”.  If necessary, credits will be purchased from others to meet this requirement.  (NOTE: Only credits that have been awarded for better than target performance are available for purchase.)
  5. The number of credits that have to be surrendered will depend on the target.  (Ex: If the target is 25% renewable power, one credit would have to be surrendered for very three units of dirty power.)
Key points to note here are:

  1. OCTS is not a tax.  The government does not get any money for the credits awarded for better than target performance. 
  2. As the target rises from zero to 100% desirable, the average price will ramp up slowly from the price of undesirable (without any levy) to the price of desirable (without subsidy) – When the target is low it only takes a small levy on undesirable to make the price of desirable competitive.
  3. The system ensures that the target will at least be met provided there is enough desirable product available.
  4. A single OCTS can be expanded by adding to the number of actions that generate credits or require the surrender of credits.  For example, the original RET scheme awarded credits for both renewable power and rooftop solar.  The risk here is that expansion can cause confusion and make the market for different types of action less predictable.  The RET scheme was split into separate large and small scale schemes because the growth in rooftop solar was disrupting the market for large scale renewables.

NOTE: The RET OCTS scheme:

“The  RET scheme was first introduced in Australia in 2001. It imposes legal liability to support electricity generated from renewable sources on retailers and large wholesale purchasers of electricity. These ‘liable parties’ are required to meet a share of the renewable energy target in proportion to their share of the national wholesale electricity market. Liable parties must prove that they have purchased the relevant proportion of renewable energy by surrendering renewable energy certificates (RECs) or paying the shortfall charge, which is a penalty for non-compliance…..”
The option of paying a shortfall charge protects the scheme from causing blackouts when there isn’t enough renewable power available to allow the renewable target to be met.

B: Cap and Trade Schemes (CATS):
Like the OCTS, CATS can be used to drive investment in desirable alternatives or changes in the mix of desirable and less desirable products.
CATS are schemes that use market forces to set a tax on an undesirable alternative(s).  It is up to the government to decide how the revenue they take from CATS schemes is used.  Details of CATS may vary.  The key features of a basic CATS are:
  1. CATS  controls totals  by using working targets such as “total emissions from power generation”.  In many cases primary targets not expressed as totals could be converted to totals.  (Ex:  A “total power emissions” working target could be calculated from a primary target of “emissions per kWh”.)
  2. The government sells permits to those who want to do something that is undesirable.  (Ex: One permit per tonne CO2 to be emitted in the future.)
  3. Permits are surrendered to the government once the undesirable act has taken place.
  4. Permits can be traded on a permit trading market or bought directly from permit holders.

Key points to note here are:

  1. CATS is a tax.  
  2. CATS works by increasing the price of undesirables to the point where desirables become competitive.  For this reason,  prices will jump to the full price of desirables as soon as a scheme is started. 
  3. The system ensures that the target will at least be met provided there is enough desirable product available.
  4. CATS can be expanded to cover a wide range of desirables.  Keep in mind that many of the problems with Rudd’s complex CPRS scheme arose because the scheme started off targeting all emissions.
C: Use of “Direct Contracts” (DC):
Contracts are a basic business tool with well established procedures and laws.  They will be part of the process of going from a decision to invest driven by OCTS or CATS to the actual building and operation of something like a new wind farm.
Contracts can also be used to directly drive investment in desirables.   However:
  1. Not all climate action can be efficiently driven by contracts.
  2. Governments decide what contracts are going to be signed when. The system will not run on automatic like some of the trading schemes.
The normal process for setting up large contracts may involve the following key steps:

  1. A tender document is prepared that specifies what is required.
  2. “Invitations to tender” are issued.
  3. Tenders are received and the preferred tender is selected.
  4. Contract details are negotiated with the preferred tenderer.
  5. The contract is signed and work commences.
Using this competitive tendering process has a number of attractions:
  1. It uses market forces to minimize the contract price.
  2. Long term contracts provide a high level of investor certainty.  This encourages investors to offer very competitive prices.
  3. DC can be made very targeted or very broad by changing specifications.  (Ex: “Wind farm at location X” Vs  “reduce emissions by any means”.)
  4. It would not be a tax unless the government sets the contract up to produce revenue.
The ACT Solar Auction is an example of the use of a competitive tendering process to set up long term contracts for the supply of utility scale solar PV.

Feed in Tariffs  (FIT) for rooftop solar are another example of the use of long term contracts to encourage investment.  However, problems have arisen because the price has been set by politicians, not a competitive tendering process.   As a result, the price has changed radically over time resulting in the solar installation industry going from boom to bust.  FIT would be better if the contract price was set by some form of competitive tendering.  Some form of online bidding for contracts using automatic bidding might be a good way of improving FIT.


Offset credit trading Vs cap and trade:

Both systems should be able to achieve much the same as long as primary targets can be converted into an appropriate form of working target.  Key points:

  1. Price rises will be much lower under OCTS, particularly at the start of the process.
  2. OCTS does not have the sudden, politically and economically disruptive price increases that occur when CATS is introduced.
For these reasons OCTS is a much better trading system than CATS.
Some politicians and economists like a comprehensive cap and trade because it can be presented as a grand scheme  that it will “control all emissions at one time.”  Problem is – the simple concept becomes very complicated once all the claims for special (and often reasonable) claims for exclusion are dealt with.
There is a logic that says it is appropriate to use a carbon tax to raise the money needed for climate action.  However, this tax should be evaluated against other methods for raising revenue. The Gillard experience with the carbon tax suggests that combining a tax and a scheme for reducing emissions can be politically toxic.
Trading systems Vs direct contracts:
Both trading systems will be better at controlling the mix of desirables and undesirables than direct contracts.
In terms of driving investment, using direct contracts:
  1. Gives much higher investor certainty because the price formulae is fixed for the length of the contract.  (By contrast, the future price of traded credits/permits may change with market conditions, changes in government, speculator activity and technical advances.)
  2. Gives much better control of what takes place when, and where.  In some cases, such as the transition to 100% renewables, getting the technical and geographical mix right will be important.  (By contrast, trading schemes will tend to encourage the most profitable technology to be located in the most profitable location – This is not always is best from the point of view of the overall system.)
  3. May make it easier for pork barreling politicians to influence where investment takes place.
Done properly, direct contracting combined with some form of competitive tendering is better than trading systems for driving large scale investment as well as some small scale investments such as rooftop solar.