Power plants in Victoria's Latrobe Valley: Brown and black coal generators will have to buy offset credits from combined-cycle gas, wind and solar generators. Credit:Paul Jones But this week the government's Climate Change Authority recommended that the fund be supplemented by imposing an "emissions intensity scheme" on the nation's generators of electricity, so we could be sure of achieving the commitments the Abbott government made at the Paris climate conference last year. Confused? Let me explain how an emissions intensity scheme would work and how it differs from its three predecessors. I think, given all the circumstances, it would be an improvement. All four approaches are "economic instruments" which seek to use prices - rather than simple government laws about what we may and may not do - to encourage people to change their behaviour in ways the government desires. Direct action just involves paying people to do things, whereas the other three are more sophisticated schemes, designed years ago by economists, to change market prices in ways that discourage some activities and encourage others.

Historically, economists have debated the relative merits of carbon taxes and emissions trading schemes, even though they are close relations. If you look closely, however, you find that Julia Gillard's "price on carbon" was actually a hybrid of the two. It started out as a carbon tax because the government fixed the initial price at $23 a tonne. Illustration: Glen LeLievre. But the plan was that after a couple of years, the price would be set free to be determined by the market, thus turning it into a trading scheme. An emissions trading scheme - also called a "cap and trade" scheme - involves the government setting a limit on the total quantity of carbon emissions it's prepared to let producers emit, then requiring individual producers to acquire a permit for each tonne of carbon they let loose.

Producers who discover they're holding more permits than they need are allowed to sell them to (trade them with) producers who discover they're not holding enough. The government would slowly reduce the number of permits it issued each year. This reduction in the supply of permits relative to the demand for them would force up their price. The higher cost would be reflected in the retail prices of emissions-intensive goods and services, but particularly the prices of electricity and natural gas. This, in turn, would encourage businesses and households to use energy less wastefully, as well as encouraging producers to find ways of reducing emissions during the production process. The third scheme economists have invented, the emissions intensity scheme (a class of "baseline and credit" schemes), has similarities with emissions trading schemes.

The government takes the total emissions of an industry - in this case, the electricity industry - during a year and divides it by the industry's total production of electricity during the year, measured in megawatt hours, to give the industry's average "emissions intensity" - C0₂ per MWh. Those producers within the industry whose emissions intensity exceeds this "baseline" must buy "credits" to offset their excess emissions, from those producers whose intensity is below the baseline, or face government penalties. In practice, this would mean brown and black coal generators having to buy offset credits from combined-cycle gas, wind and solar generators, benefiting the latter at the expense of the former. The Climate Change Authority recommends that the intensity baseline be reduced each year by a fixed percentage until it reaches zero "well before" 2050. If the scheme began in 2018 and was to reach zero by, say, 2040, the baseline would have to be reduced by 4.5 per cent a year (100 divided by 22).

So the absolute size of the reduction in emissions required would be high in the early years, but get smaller over time. A great political attraction is, whereas the other schemes raise the price of every unit of electricity, the intensity scheme just shifts costs between different parts of the industry, meaning the average price increase should be small. There would be some price rise, however, because the production costs of renewable generators are higher than those for fossil-fuel generators, and the scheme would increase the proportion of renewable energy in total production. Just how high the price had to go would depend to a big extent on the effects of further economies of scale and further advances in technology in reducing the average cost of producing renewable energy. An economic advantage of the intensity scheme is that it wouldn't be open to trading permits with other countries' emissions trading schemes (especially the European Union's, where the carbon price has collapsed) nor to dodgy emissions credits from developing countries.