Since July 2012, Australia has had in place its carbon pricing scheme. It is commonly referred to as a “carbon tax”, but also as an “Emissions Trading Scheme (ETS) with a fixed price”. And the plan is to move to an ETS with a floating price.

So, which is it, and what are the differences between these different types of schemes?

How does an ETS work?

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 following description is current as of May 2013. The possibility of changes post-election later this year is not considered.

The Australian system is rolling out in two phases.

The first phase, which we are currently in, is sort of an amalgam of an ETS and a tax. Like an ETS, it is based around permits. However, unlike an ETS, the permits have a fixed price, have no cap on quantity, and cannot be traded.

Technically, it’s not a tax system, but its effect in practice is much more like a tax than like an ETS.

The second phase, starting in July 2015, is an ETS, as described above, with a floating price, a cap on local permits and trade in permits.

But again there is a twist. After the initial scheme was in place, the Government announced that in the ETS phase, it would be linked to the European ETS. Since that scheme is so much bigger than ours, it means that the local price of permits will be determined by the price in the European scheme.

This two-phased approach was presumably intended to have a smooth transition period after the scheme commences. However, as things have panned out, it looks likely that there will be a significant drop in price once we join the European scheme. The fixed price in Australia in 2014/15 will be $25.40, but the current (May 2013) price in Europe is only 3.40 Euros (about A$4.50).

Where does the money go?

When people pay a carbon tax, the revenue goes to the government. Government can use that revenue to reduce other taxes or costs, or to provide compensation to particular groups which are adversely affected.

An 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, provided that the cap is enforced. The Australian scheme does involve some permits being given to Emissions Intensive Trade Exposed (EITE) industries.

Revenue from subsequent transactions between emitters within an ETS would go to the seller of the permits, not to the government.

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 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 standard carbon tax instead of a fixed-price ETS, 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 occurring under the current scheme. 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”?

Given the traction opposition Leader Tony Abbott got from his line about a “great big new tax on everything” during the last election campaign, the government might have been tempted to avoid the “tax” word.

However, I haven’t seen them try to argue that their carbon pricing system is not a tax. In the circumstances, this is probably wise. Even though, technically it involves purchase and surrender of emission permits rather than a tax, in practice the effect is basically the same as a tax. For that reason, I think it’s good that they haven’t tried to fight a semantic battle about this.

* This story was updated on May 23, 2013.