Australia: Carbon pricing mechanism snap shot: key features, certainty and flexibility

Introduction

The Australian Federal government announced today the long-awaited details of its proposed carbon pricing mechanism. We were fortunate to be part of the stakeholder lock-up which took place this morning prior to the Prime Minister's formal announcement at midday. This legal update outlines the key details of the carbon pricing mechanism (the Mechanism) and is provided to assist you in understanding the issues that may arise out of the Mechanism for your business or organisation.

This policy is perhaps the largest economic and environmental reform in a generation. It has far reaching implications for business, including those covered by the Mechanism and those indirectly affected, as well as those businesses operating in Australia and those investing in Australia.

Our analysis provides insight on the:

• Mechanism outline and key features
• Implications for business and investment certainty
• International linking, offsets use and hedging opportunities
• The treatment of transport fuels

We note the detail announced today builds upon the framework document released by the Multi-Party Climate Change Committee (MPCCC), 24 February, 2011.

Over the coming weeks we will be providing specific and detailed industry analysis of the Mechanism and its accompanying regulatory frameworks and implications, as well as more in depth analysis of the policy framework more broadly.

Mechanism outline and key features

The Mechanism will have the following key design elements:

• A legislated target to reduce Australia's emissions by 80 per cent below 2000 levels by 2050 (previously set at 60 per cent).
• A fixed price period of three years, commencing on 1 July 2012.
• A starting fixed price of $23 per tonne in 2012-13, rising in real terms by 2.5 per cent per year to AUD$24.15 in 2013-14 and to AUD$25.40 in 2014-15.
• A "hard wired" transition to a flexible price cap and trade emissions trading scheme on 1 July 2015, with pollution caps set for the first five years of the scheme in the 2014 budget, and a default position being a cap set out in the primary legislation that will ensure a five percent reduction in emissions below 2000 levels by 2020, and thereafter a reduction consistent with the annual reduction in emissions implied by the five per cent emissions reduction target.
• The Mechanism will not be based upon phases or periods as is the case with the schemes of other countries such as in the European Union (EU). Instead from 2016 caps will be set annually by regulations on a rolling five year basis with the result that there always be a five year horizon for forward price curves.
• A price collar will be in place for the first three years of the flexible price period with a price ceiling which is to be set out in regulations by 31 May 2014 at AUD$20 above the expected international price for 2015-16, rising by five per cent in real terms per year, and a price floor which will start at AUD$15 and rise by four per cent in real terms per year.
• Unlimited banking of permits at the end of the fixed price period, with limited borrowing allowed (up to five per cent). Permits will be auctioned (except for those permits to be freely allocated), and auctions will commence during the fixed price period.
• Export of domestic permits (except Kyoto based CFI credits) will not be permitted during the fixed price period or the flexible price period whilst there is a price ceiling in place, except where there is a bilateral link to another emissions trading scheme in place. However, once the price ceiling ends there will be unrestricted export of the units allowed. However, this does not mean that they will automatically be accepted for compliance in a foreign Emissions Trading Scheme (ETS) such as the European Union Emissions Trading Scheme (EU ETS).
• Broad coverage of emissions sources from commencement of the scheme, including stationary energy, industrial processes, fugitive emissions (other than from decommissioned coal mines), and emissions from non-legacy waste. Agriculture and land sector emissions will not be covered.
• Coverage of four of the six gases covered under the Kyoto Protocol, including carbon dioxide, methane, nitrous oxide and perfluorocarbons from aluminium smelting.
• A general compliance triggering threshold of 25,000 tonnes of CO2-e (including all Scope 1 emissions not expressly excluded from the Mechanism).
• Liable entities will be those with operational control (as previously proposed under the Carbon Pollution Reduction Scheme (CPRS), and in line with the National Energy and Greenhouse Reporting System (NGERS) definition). Liability for joint ventures will be shared by the participants according to their proportionate interests. Liability will be transferable through the obligation transfer number (OTN) mechanism, developed as part of the CPRS package.
• Light commercial vehicles (4.5 tonnes or less of gross vehicle mass) and households will be exempt from facing a carbon price under the scheme. Further, the agriculture, forestry and fishery industries will not pay a carbon price on their fuel use.
• The relevant units for compliance will be "carbon permits", which will each represent one tonne of CO2-e of greenhouse gas emissions. The units will be personal property; regulated as financial products and transferrable (excepting fixed price permits), and it will be permitted to take security over the permits and create equitable interests in them.
• The penalty for non-compliance will be 1.3 times the relevant permit price for the fixed price period, and double the average permit price for each vintage year in the flexible price period.
• Carbon credits produced under the Carbon Farming Initiative (ACCUs) will be eligible for compliance in the fixed price period, totalling no more than five per cent of each liable entities' compliance in the fixed price period, with no limit on surrender in the flexible price period.
• International emissions units will not be eligible for compliance in the fixed price period, but will be eligible for up to 50 per cent of an eligible parties' compliance until 2020, with a review to occur in 2016.
• The supply of carbon permits will be GST free. The cost of the permits will be deductible for income tax purposes, with the deduction to occur through the rolling balance method in the year that the permit is sold or surrendered.

The Mechanism utilises a number of new and existing bodies to govern the Mechanism, including:

• The creation of a Climate Change Authority (CCA) charged with advising the government in relation to providing recommendations to government on, inter alia, the future pollution caps having regard to a number of factors set out in legislation and setting long term indicative national trajectories.
• The creation of the Clean Energy Regulator (CER) charged with the administrative regulation of the Mechanism.
• Utilising the Productivity Commission to undertake, among other tasks, ongoing review of the effective carbon prices in sectors of major competitor economies and assistance to be provided under the Jobs and Competitiveness Program.

The scheme will provide assistance to both households and industry as follows:

• 90 per cent of households will receive assistance through the taxation system and through direct cash payments, and 70 per cent of households will be "fully compensated" under the scheme .
• Industry assistance will be delivered through the Jobs and Competitiveness Program, with free allocation of permits based on historic industry average levels of emissions per unit of production, which may be bought back by the government if not surrendered by the covered entity.
• Assistance will be based on an assessment of emissions intensity and trade exposure (EITE), consistent with the process, criteria and requirements currently used for Partial Exemption Certificate assistance under the Renewable Energy Target program.
• Any changes in assistance "that will have a negative effect on business" will not occur before the sixth year of the Mechanism, with three years' notice to be provided of modifications of EITE allocations that will have a negative effect on business.
• Liquefied natural gas (LNG) projects will receive a "supplementary allocation" ensuring an effective assistance rate of 50 per cent in relation to their LNG production each year.
• An energy security fund will provide transitional assistance to promote the transformation of the electricity generation sector, including:
  • scope for payments for the closure of around 2,000 MW of "very highly emissions-intensive coal-fired" generation capacity by 2020
  • a limited transitional administrative allocation of permits and cash estimated at AUD$5.5 billion over six years, to assist "highly emissions-intensive coal-fired" generators adjust to the introduction of the scheme.

A raft of support measures will accompany the Mechanism, with a particular focus on incentivising the development of renewable energy resources and clean technology innovation, including:

• The establishment of the Clean Energy Finance Corporation (CEFC) to invest in the commercialisation and deployment of renewable energy and enabling technologies, energy efficiency and low-emissions technologies. This program will receive AUD$10 billion of funding over five years from 2013-2014 which will be provided in the form of commercial loans, loan guarantees, and equity with capital reinvested in the CEFC.
• The establishment of a new statutory authority, the Australian Renewable Energy Agency, with a budget of AUD$3.2 billion to provide funding mainly through grants for renewable energy projects through competitive grants programs.
• A Clean Technology Investment Program to provide AUD$800 million over seven years to manufacturing businesses to invest in energy efficient capital equipment and low-emissions technologies.
• A Clean Technology Food and Foundries Investment Program to provide AUD$200 million over six years to manufacturers in the metal forging and foundry sector (AUD$50 million) and food processing sector (AUD$150 million) to invest in energy efficient capital equipment and low-emissions technologies, processes and products.
• A Clean Technology Innovation Program to provide AUD$200 million over five years to support business investment in low-emissions research and development in renewable energy, low emissions technologies and energy efficiency.
• The expedition of the development of a national energy savings initiative, such as the setting of a national energy efficiency target and the introduction of a national energy efficiency "white certificate" trading scheme as recommended by the Prime Minister's Task Group on Energy Efficiency.

Implications for business

The Mechanism has far reaching implications for business, including those businesses operating in Australia and those investing in Australia. With greater regulation and transition in the economy, those businesses that can more effectively and efficiently manage the cost of their emissions can use that advantage to either lower the cost of their product or service, gaining market share, or can maintain the cost of their product or service, increasing profit margins.

With this in mind, our analysis will focus on some of the key issues relevant to those sectors which will have a liability under the Mechanism, including:

• Implications for business and investment certainty
• International linking, offsets use and hedging opportunities
• The treatment of transport fuels

Implications for business and investment certainty

There is a clear transition from the fixed price period to the flexible price cap and trade period, which is to occur on 1 July 2015. Further, there is no process for the review or assessment of whether the transition should be deferred (as had been previously foreshadowed by the MPCCC in their initial outline for the Mechanism released in February). This will provide critical certainty as to when market participants can expect the transition to be made and when they can expect to begin managing their carbon liabilities in accordance with the rules set out for the flexible price period. The existence of the price collar, in the first three years of the flexible price period, in form of a price ceiling and price floor, although not providing long term price certainty, will provide short term certainty that the price will not fluctuate beyond those set price parameters if the market rules require adjustment. Whilst not ideal from a market efficiency perspective it would seem to be sensible interim measure to provide obligated businesses with some initial comfort prices will not spike and investors that prices will not collapse as happened in Phase I of the EU ETS. However, the access to domestic and international offsets also provides a "safety valve" against price spikes. The CCA will conduct its first full review of the Mechanism by 31 December 2016, and its second full review of the Mechanism by 31 December 2018. These two reviews will likely provide the flexibility required to respond to adjustments required in the market rules to maintain certainty and integrity in the Mechanism.

The Mechanism effectively provides two forward cost curves for the price of carbon; a cost curve based upon the permit caps set out in regulations, with a five year price horizon, and a default position cost curve in the event that Parliament rejects the regulations. The default position cost curve will be the marginal abatement cost of reducing emissions to five per cent below 2000 levels by 2020, and projected in a linear fashion beyond 2020. This provides a legislated bottom line for the setting of caps, providing business and industry with clarity and certainty in relation to the expected levels of scarcity of carbon permits in supply, allowing them to extrapolate a carbon price out well beyond 2020 and in line with the time-scales of investment in major infrastructure.

The creation of a number of independent bodies charged with key policy input functions for the market, including the setting of caps and the ongoing assessment of industry assistance measures, is likely to reduce the chance that those policy inputs will fluctuate based upon the position of the government of the day. The policy detail released today sets out clearly the criteria for assessment of these key issues, giving the market key and pre-emptive indicators of matters in the real world that will impact upon decision making in relation to the parameters of the market. It is important to note however that these independent bodies have advisory functions only. Government is required to publicly respond to the advice, but may ultimately make its own decision. However, the process allows for greater transparency of these review process, and therefore scrutiny (and in all likelihood consistency) of decision making.

International linking, offsets use and hedging opportunities

The ability to use Kyoto compliant carbon offsets created under the Carbon Farming Initiative (CFI) for five per cent of an entity's compliance in the initial fixed price phase, will create an immediate boost in investment to aspects of land sector that can produce those units, including reforestation and avoided deforestation investments and, from 1 January 2013, all other CFI project types. The key issue however will be the limited supply of those offsets. The CFI is an emerging project based offsetting market, still before Parliament in Bill form, with only limited development of the critical rules that govern the management of projects. The early identification and investment in such projects will be important for reducing, in part, the cost of compliance in the fixed price period, and critical for the reduction of greater proportions of the cost of compliance in the flexible price period. Supply will remain a critical issue into the flexible price period, where there will be unlimited use domestic offsets and a consequent high demand for them (with associated price implications).

The proposed rules surrounding quantitative limits on international offset usage within the market mandate that at least 50 per cent of a liable parties' compliance must be met from domestic permits or offsets, out to 2020, with no restrictions thereafter. The position after 2020 will be subject to a review to be conducted in 2016. The rationale would appear to envision the progressive exposure of the Mechanism to the international price on carbon, which is likely to develop into a global shadow price of emissions as markets develop. This, along with a number of other market design elements, point to an intention to ultimately link the Mechanism directly with existing and future markets such as the EU ETS, the NZ ETS and other emerging markets in the Asia Pacific region.

The proposed qualitative restrictions on international offsets usage accord largely with the restrictions currently in place in the EU ETS. The government however may disallow the use of a particular type of international unit at any time, to ensure the environmental integrity of the market. Units disallowed will only be available for compliance in the year that the disallowance occurred. This is a significant departure from the position in the EU ETS, where such units may be used for the balance of the current phase of the EU ETS, which may be up to eight years in length. For business investing in projects directly, or for emissions reducing project developers, this raises a key area of uncertainty which may affect the viability of an investment. That is, the uncertainty that given only one years notice their forward investments may be unable to produce offsets available for compliance under the Mechanism.

It will be important as the market develops and when making long term investments to keep abreast of trends and developments in both international rules regulating emissions markets, and of the development of emissions trading rules in existing and emerging domestic and regional markets. These trends will provide key insights into the future of regulation in this Mechanism, and identifying potential risks and opportunities early can lead to a more effective management of emissions costs.

The treatment of transport fuels

The Mechanism will extend to most emissions from business transport and non-transport use of liquid fuels. The only exclusions will be light vehicles, households and the agriculture, forestry and fishery industries.

Transport fuels will not be covered directly under the Mechanism. Rather, the carbon price will be applied by reducing business fuel tax credits by an amount equivalent to that of placing the carbon price on liquid fuel emissions. For domestic aviation, however, the domestic aviation fuel excise will be increased by an amount equivalent to the effect of placing the carbon price on aviation fuel, as fuel tax credits are not available for aviation fuels. Adjustments to credits and excise will be made annually during the fixed price period and then every six months (based on the average carbon price over the previous six months) during the flexible price phase.

Although this approach is perhaps necessary as a result of the carve-outs of household, primary industry and light commercial fuels use, it will significantly reduce the options available to the transport industry for managing their forward carbon liabilities through strategic hedging investments. Rather, the primary opportunities to reduce emissions liabilities will be through investment in efficiency measures (including both processes and fleet) and through the use of biofuels. Ethanol, biodiesel and renewable diesel will not incur fuel tax credit reductions or changes to excise as these fuels are zero rated under international accounting rules.

The Government has also signalled that it intends to pursue extending the Mechanism to heavy on-road transport from 1 July 2014 to ensure consistent treatment across the whole of the freight sector. This should effectively maintain competition neutrality between the various forms of transport. This measure was not, however, agreed to by the Multi-Party Climate Change Committee and has therefore been excluded from the Mechanism at this point in time.

Opportunities for investment in cost effective biofuels are likely to arise not only through the increased incentives for their use under these changes to excise and fuel tax credits for transportation fuels, but also through the significant funding provided to renewable energy investment under the package. This package will include the continuation of the Australian Biofuels Research Institute, and the creation of the AUD$10 billion CEFC which will provide significant opportunities for venture capital and innovative finance risk mitigation opportunities for biofuels and other private investors and product developers.

The Productivity Commission has been charged with undertaking a review of fuel excise arrangements, including an examination of the merits of a regime based explicitly and precisely on the carbon and energy content of fuels. No date has been given, however, for this review nor has it been identified what the consequences will be from the findings of the review. The required changes to the fuel tax credits and excise is to be based on the specific emissions intensities of the fuels. It would seem appropriate, therefore, that this be done and any issues resolved by Government before the commencement of the Mechanism to ensure certainty of its application to the transport sector.

Upcoming seminars

Our breakfast seminars on the Carbon pricing mechanism will take place in Sydney on 14 July 2011 and in Melbourne on 15 July 2011. To register, please contact Rana Kardan.

Related updates

A framework for pricing carbon in Australia

Carbon Farming Initiative legislation tabled

Further information

If you would like further information about any aspect of the policies underlying, or the proposed legislation implementing, the Government's Clean Energy Future package, please contact a member of our Climate Change team.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.