For the first three years, the carbon pricing mechanism is set at a fixed price. Then on 1 July 2015 it automatically moves to a flexible approach where the carbon price is set by the market.
In the flexible price period, there will be an overall limit—or pollution cap—on annual greenhouse gas emissions from all covered sources of carbon pollution. There will be no limits on individual sectors, firms or facilities.
The Government will auction and issue Australian carbon units up to the quantity of the pollution cap.
The price of carbon units will then be determined by the market. Liable entities will compete to buy the number of carbon units they need to meet their obligations. Entities that value carbon units most highly will be willing to pay most for them. For some entities, it will be cheaper to reduce pollution than buy carbon units.
A price ceiling will be built into the system for the first three years of the flexible-price period to avoid price spikes. It will reduce risks for businesses as they gain experience with the market setting the carbon price.
The price ceiling will be set at $20 above the expected international price in 2015—16 and will rise in real terms at five per cent each year.
Banking and limited borrowing of carbon units is allowed in the flexible price period to enhance the efficiency of the carbon market.
Unit banking allows units to be surrendered in later years instead of their vintage year. For example, a 2015—16 vintage year unit could be surrendered against a liability in 2019—20.
Unlimited banking of carbon units is allowed in the flexible price period.
From the start of the flexible price, liable entities will be able to acquit their obligations with eligible international units. Eligible international units can be used for up to 50 per cent of an entity's annual liability, and eligible Kyoto units can be used for up to 12.5 per cent of an entity's overall liability. See eligible emissions units.
Limited borrowing of carbon units enables liable entities to surrender carbon units from the upcoming vintage year to discharge up to five per cent of their current year's liability.
Borrowing can increase flexibility, reduce the cost and provide a buffer against price spikes and any economic disruption around the final surrender date.
Limiting borrowing to five per cent reduces any risks to the environmental integrity of the mechanism.