The discussion paper on the emissions trading scheme (ETS) also supports the auctioning of all permits rather than free allocation.
The ETS discussion paper suggests fixed limits on emissions by establishing defined emissions ‘trajectories', which would map the pathway to emissions reduction targets over time.
Permits would be regularly released in line with the trajectory. For increased flexibility, Garnaut suggests the banking and borrowing of these permits should be allowed.
Banking allows unused permits to be saved for future use while borrowing allows organisations to use permits from the future to meet current obligations, on the condition that the loan will be later repaid.
"Binding annual targets for actual emissions may be extremely costly, as fluctuations in supply and demand for emissions-intensive products would force large short-term structural change," says the paper.
"Allowing flexibility in using permits by allowing hoarding and official lending would mean that actual emissions were above or below targets at particular points in time, while staying within the emissions budget."
An independent carbon bank set up to monitor and enforce compliance with the ETS would administer the lending of permits to the private sector. To ensure compliance and credibility, Garnaut suggests lending may be subject to limits in terms of quantity and time.
The concept of borrowing has received mixed support, with ABN AMRO's director of environmental markets Craig McBurnie telling PNN's sister publication Environmental Management News earlier this month it could play a vital role in emissions trading through increased flexibility.
But Jeff Angel from the Total Environment Centre said borrowing is a "recipe for laziness" that allows companies to defer action on climate change.
Policy makers will have to choose whether permits should be auctioned or issued free to emitters.
The discussion paper says the most important point in determining the method of allocation is that the impact of an ETS on the price of goods and services is independent of the approach adopted by governments.
Garnaut has disputed the suggestion that providing free permits to electricity generators will limit the impacts of higher energy prices.
In the first two phases of the EU ETS, generators received free permits but they still passed on higher energy costs to consumers, the paper says.
Auctioning is therefore the preferred method because transaction costs will be lower under this system of allocation. "Any free allocation of permits will involve elaborate assessment and political processes," the paper states.
Other design features put forward in the paper include:
* Stationary energy, industrial processes, fugitives, transport and waste should be included from the beginning in 2010. Agriculture and forestry should be included as soon as practicable;
* Permit revenue should be spent on subsidies or transitional assistance to trade-exposed emissions intensive firms and households adjusting to the higher price of goods and services, R&D funding for low-emissions technology development and public infrastructure;
* The ETS should be designed on the basis that it will ultimately be part of a global agreement on greenhouse gas mitigation.
Submissions are invited on the discussion paper by April 18.
