The economics of reducing greenhouse gas emissions are a complicated business. And this is especially true when you want to set up a domestic cap and trade system in a carbon-dependent economy, a process both the USA and Australia are in the process of beginning to work through.

At the outset there are the problems of setting a floor and ceiling price for carbon; this ensures that it remains scarce enough to be expensive but in supply enough to prevent a domestic economic squeeze from soaring prices.

Another issue is how the permits will be given out to emitters. This is the problem that the new EU climate deal has being grappling with. On one hand, auctioning permits increases the initial price of carbon and so further reduces willingness to pay; at the same time an a

uction also generates funds for other climate change policies, such as grants for clean technology. However, on the other hand, as the EU has found, auctions are politically rather unpalatable–so much so that the EU has agreed to only auction 30% of the second round of ETS permits. As well as economic prices, then, there are political prices to take into account.

Once the price and distribution has been set, there is still the question of coordinating the system. This is emerging as a particularly important variable in the Australian carbon trading scheme. While at the federal level the purchase price of carbon is capped at AUS$40 per tonne, a report released today shows that in New South Wales the state government has been buying permits up from companies at AUS$240 per tonne.

In effect the NSW government has been paying companies a vastly inflated price to force them to reduce emissions. These kind of actions heavily distort national markets, especially those still in their infancy; in this case, they give a competitive advantage to companies in NSW in a low-carbon economy compared to those who have not been injected with capital in this way.

Pricing, Politics, Coordination: three issues that the architects of domestic carbon markets need to tackle in order to get these systems working effectively. As yet the details of soon-to-be President Obama’s domestic cap-and-trade system have not been finalised or released. However, in a country that is traditionally market-driven, with powerful industrial political lobbies, and that is highly geographically diverse and decentralised, the Pricing, Politics, and Coordination questions are big ones to answer.

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