AT THE END OF 1997 THE AUSTRALIAN government made a commitment at Kyoto to increasing greenhouse gas emissions by no more than 8% above 1990 levels by the year 2008. The Kyoto Protocol, which covers 39 industrialised countries (Annex B countries), allows for various mechanisms to meet agreed targets and the one that is being discussed most avidly in Australia is the use of emissions trading.

The philosophy behind emissions trading is that it is a way of achieving environmental goals, in this case Kyoto targets, at a minimum cost. This is based on the idea that it is cheaper for some firms to reduce their greenhouse gas emissions than others and therefore it is more cost effective to allow the market to decide where emission reductions will be made than for governments to require uniform reductions across an industry. Firms that find it expensive to reduce emissions could buy up emission rights instead.

There have been several conferences on emissions trading in Australia and the Australian Greenhouse Office (AGO) released the second of four discussion papers on National Emissions Trading at the end of June. Gwen Andrews, the CEO of the AGO gave the opening address at the "Emissions Trading" conference organised by International Communications for Management (ICM) held in Sydney in July.

Andrews said that current projections of greenhouse gas emissions, which incorporate previously announced measures to reduce emissions, show that Australia will emit an estimated 118% of 1990 levels in 2008. The government is hoping that various new measures including emissions trading and reductions in land clearance will help it achieve its Kyoto target.

There are various ways emissions trading can be done. Mike Young, senior principal research scientist, CSIRO outlined one system. Australia's allocation of greenhouse gases would be divided into shares that would be allotted to each emitter. Based on that share the emitter would get a permit to emit a certain volume of gas per time period. The share would be owned forever but the volume of gases it permitted could vary if Australia's allocation varied, for example because of new international agreements. The permits could be bought and sold.

There are various ways of allotting shares or permits. The two main ways are usually referred to as grandfathering and auctioning. Grandfathering involves allocating shares or permits to firms on the basis of their past emissions. Firms would then have to buy extra permits if they increased their emissions or would be able to sell those they don't need because they have reduced their emissions. Auctioning involves selling permits off to the highest bidder. (This is the method used by the US government to allocate SO2 permits to powerstations.)

The AGO discussion paper outlines the problems associated with each method. Auctioning would mean that each firm has to bear additional costs just to operate as they would have to buy permits to emit gases they had previously been emitting for nothing. This would be especially hard for firms that were competing with overseas firms not having to bear these costs.

Grandfathering, because it involves a free allocation to begin with, would not involve these costs. However, if the initial allocation is based on current emissions, firms might not have enough incentive to make the reductions necessary to meet Australia's Kyoto commitments. Also, such a system would advantage existing firms over newcomers "thereby impeding domestic competition and innovation" and so "delay abatement action".

Young, like several of the other conference speakers, favoured the grandfathering approach. He argued that auctioning would not be "politically acceptable". He suggested that shares could be allocated to new firms based on a mean figure for that industry, less a discount to account for the fact that new industries tend to have less emissions. The overall allocation could be reduced progressively over time till the 108% figure was reached in 2008.

A key question is whether Australia should introduce some form of emissions trading before the Kyoto treaty is ratified and before other countries do? Andrews pointed out that the early introduction of a trading scheme could disadvantage some sectors of Australian industry which are in competition with oveseas companies. However, several conference speakers spoke of the advantages to Australia of acting early. These include having a national system that has been trialled in place when international trading begins.

Young proposed a timetable that would only involve powerstations at first. In the second phase, 2002-4, transport sector organisations would begin emissions trading. The government would have to be careful in the early phases that people from overseas didn't come and buy up Australian permits, which would leave local industry short. In the third phase, 2005-7, other major Australian sources of emissions would become involved in trading and selected international companies would be able to buy permits. In the final phase there would be international trading of permits.

Warwick McKibbin, professor of international economics at ANU, offered an alternative system. McKibbon was concerned that a regular international emissions trading system would result in huge transfers of money between countries. His scheme would avoid this by keeping trading within a country. Emissions permits would be set at a fixed, internationally agreed price. "Existing emitters would be given permits and new emitters would be required to buy permits" at the fixed price. This price would be kept low, say $10 a ton of carbon. In this way the market would decide where emissions reductions would take place and how much reduction would occur. This compares with the normal system where a cap is set on the amount of emissions allowed and the market sets the price of permits.

McKibbon argued that permit trading would reduce the costs of meeting the Kyoto Protocol by up to 50%. However, 60% of these cost savings were "hot air" savings arising from the fact that the former Soviet Union would have excess permits because its emissions were decreasing as a result of economic decline. This was, McKibbon recognised, "a bit of a fudge", since the trading of these permits would not actually reduce emissions.

Stephen Brown, manager of the Global Change Section of ABARE, argued that international trading would save more money than individual countries acting alone. This was because trading would allow emission reductions to be done in countries where it could be done most cheaply, such as Russia and Eastern Europe. Australia, like the US, he said, was a middle-level country when it came to the costs of abatement, while Japan and the European Union were high cost countries.

Brown estimated that the cost to Australia of meeting its Kyoto commitment could be reduced by 20% with international trading. This figure was based on ABARE's Global Trade and Environment Model (GTEM) which assumes zero transaction costs, a perfectly competitive market (with no cartel's affecting the price), no restrictions on trading and perfect compliance.

A related issue of importance to Australia is the use of forest growth as carbon offsets. This is referred to as carbon sequestration. The Kyoto Protocol enables countries to take account of increasing carbon sinks in their calculations of emissions. Since trees absorb and hold carbon dioxide when they are growing and release it when they are cut down and destroyed, afforestation, reforestation and deforestation all have to be taken into account.

David Brand, executive general manager of State Forests of NSW explained to the conference that, of Annex B countries, "only Australia and New Zealand have created significant new forests on previous grazing land since 1990". While sequestration is likely to contribute only a small percentage to the overall global targets for greenhouse gas reduction, it could be significant in Australia. The idea is that companies could buy up carbon rights associated with growing forests to offset their gas emissions. Deals of this type have already taken place and the NSW government has passed legislation, "The Carbon Rights Legislation Amendment Act", which enables State Forests and powerstations to own and trade carbon rights associated with forests.

Examples of deals include those done by NSW State Forests with Pacific Power and Delta Electricity. Tokyo Electric Power is also investing in 10,000ha to 40,000ha of NSW State Forests between 2000 and 2010. BP Amoco is working with the Dept of Conservation and Land Management (CALM) in WA to reforest farmland to offset emissions from its Kwinana operation. It also hopes that this will mitigate the effects of salinisation in the area.

Currently, Brand points out, there is no standard for how much carbon an area of forest is worth. And so at the moment trading is limited to a few bilateral swaps between forestry organisations and electricity generators. But he foresees that once "the product being offered is standardised" the way will be open for auctions of carbon rights and maybe eventually continuous trading with the market setting price through supply and demand.

Because the carbon stored is lost when the forests are harvested, new planting must always exceed harvesting. It is the pool of growing forests (above 1990 levels) that is important for carbon accounting purposes. (Some carbon is retained in paper and wood while it is in use but for the purposes of the Kyoto protocol it is assumed lost at the time of harvest). The pool also needs to be big enough, says Brand, to ensure that occasional disasters like fire and insects, which wipe out sections of forest, do not significantly affect the total amount of carbon sequestered.

It is clear that emissions trading and carbon sequestration will not eliminate the need for engineering innovations and improvements to reduce greenhouse gas emissions. The aim of emissions trading is to make such innovations and improvements profitable as well as environmentally beneficial.