Australia: The EU ETS (European Union Emissions Trading Scheme) - A primer for Australian companies

Introduction

On 28 August 2012, the Australian Government and European Commission announced that they would link their respective greenhouse gas emissions trading schemes. This unexpected revelation led to an international outpouring of excitement, ranging from "Far out!" and "Strewth" south of the Equator to "Mon Dieu" and "Goodness me" in the Northern hemisphere. Australian and Brussels-based bureaucrats have clearly been hard at work during the Olympic season.

What is linking and what effect would it have?

The idea of "full" or "direct" linking is that allowances or units representing tonnes of carbon dioxide equivalence used in one scheme can be "surrendered" to satisfy compliance obligations of emitters in another scheme. These are EU Allowances or EUAs in the case of the European Union Emissions Trading Scheme (EU ETS), and Australian carbon units or ACUs in the case of the Australian Carbon Pricing Mechanism (CPM). Linking increases liquidity in the emissions market for the linked schemes and broadens the range of opportunities for cost-effective emissions abatement. The practical effect is that if, by way of example, a power station in the EU did not have enough allowances to surrender in respect of its emissions, it could purchase allowances not just from other entities in the EU, but from a linked scheme such as the CPM.

What is proposed?

Full linking is proposed between the EU ETS and CPM. This will be a two-stage process. From 1 July 2015, a "one-way" link will be established, whereby liable entities in Australia will be able to surrender EUAs to fulfil up to 50 per cent of their compliance obligations under the CPM. From 1 July 2018 (subject to a bilateral agreement being completed) EU entities will be able surrender ACUs to fulfil their EU ETS liabilities. In essence, EUAs and ACUs will become fully "fungible", creating a single market for allowances. The Australian Government and the European Commission are aiming to have the bilateral agreement completed by mid-2015.

Implications

Many Australian companies will be seeking to understand the likely impact of design of the EU ETS on demand and price drivers in Australia. The EU ETS is the CPM's "big brother", with CPM-regulated emissions being roughly the size of those of Germany alone. We have set out below some of the key issues for consideration.

How do the schemes compare?

Compliance entities

"Liable entities" under the CPM are in general those that exceed a threshold of 25,000 tonnes of carbon dioxide equivalent for "covered emissions" per facility. The CPM applies to stationary energy, industrial processes, fugitive emissions (except from decommissioned coal mines) and emissions from non-legacy waste (i.e. waste deposited after 1 July 2012). Similarly to the EU ETS, agriculture and land sector emissions are excluded from the CPM (although these sectors have the potential to generate offset project credits (Australian Carbon Credit Units (ACCUs)) under the Carbon Farming Initiative which can be used for compliance under the CPM - see below). Transport fuel for households and light commercial vehicles and fuel used by agriculture, forestry and fisheries are also not covered. Other business transport emissions from liquid fuels will be subject to an equivalent carbon price, generally applied by reducing business fuel tax credits by an amount equivalent to placing a carbon price on liquid fuel emissions.

Installations under the EU ETS include a broad range of activities, subject to specified thresholds being reached. These sectors and activities include certain combustion installations, oil refineries, production of various metals, cement clinker, lime, glass, ceramic products, mineral wool, gypsum, pulp/paper, carbon black and certain chemicals. Carbon capture and storage facilities are also subject to the EU ETS. Emissions from aircraft operators in respect of flights into and out of the EU have been covered since the beginning of 2012.

The difference in scope between the schemes should not concern regulated entities, who will be more interested in what their allowance surrendering obligation is at the end of a compliance year.

Phases / Pricing

The EU ETS is implemented by way of Phases. The first Phase of the Scheme ran from 2005 to 2007. The second and current Phase began in 2008 and ends in 2012. Phase III of the EU ETS runs from 1 January 2013 to 31 December 2020. A fourth phase will be implemented from 2021. The EU ETS does not have a fixed price mechanism or any price collar.

Changes to the CPM pricing structure were announced in August 2012. There will continue to be a fixed price phase from 1 July 2012 to 30 June 2015. The fixed prices will be A$23 for 2012-2013, A$ 24.15 for 2013-2014 and A$25.40 for 2014-2015. A flexible pricing phase will start on 1 July 2013. A price ceiling will operate for the first three years of the flexible price phase. It will now be set at A$20 above the expected price of EUAs for 2015-2016 (rather than the previously proposed international price) and will rise by 5 per cent in real terms each year. The previously proposed price floor of A$15 per eligible emissions unit (rising by 4 per cent in real terms each year for the first three years of the flexible price period) will no longer be implemented.

Caps

The Australian government will announce the caps for the first five years in the 2014 Budget and will be required to table regulations setting five years of pollution caps in the Parliament by no later than 31 May 2014. The cap will be extended by one year every year from 2015-2016 to maintain five years of known caps at any given time.

Under the EU ETS, the cap has been determined to be 2,039,152,882 EUAs in 2013. This will decrease each year by 1.74 per cent of the average annual total quantity of allowances issued by the Member States in 2008-2012. In absolute terms this means the number of allowances will be reduced annually by 37,435,387. This annual reduction will continue beyond 2020 but may be subject to revision not later than 2025. This figure does not account for aviation, which has a separate cap.

Whether or not the EU's cap will be further tightened, driving up price (and Australia's price ceiling), is discussed below.

Allocation of carbon units / allowances

Under the CPM, free allocation of carbon units is based on historical industry average levels of emissions per unit of production. For the fixed price phase, there will be no auctioning of carbon units, but there will be some advance auctioning of flexible period carbon units. During the flexible price phase, carbon units will be allocated by auctioning, taking into account transitional assistance provisions for key sectors.

Under the EU ETS, free allocation will be 80 per cent of total EU emissions from 2005-2007 that installations emitted. The quantity of EUAs allocated freely will decrease in each subsequent year, so that there will only be 30 per cent free allocation in 2020. 100 per cent of emissions in the power sector will be auctioned in Phase III. Sectors that are identified as being in significant risk of carbon leakage will receive 100 per cent of their emission allocation for free. In Phase III, benchmarks for free allocation have been set based on the average performance of the 10 per cent most efficient installations in a sector or subsector in the EU in the years 2007-2008. It is expected that roughly half of the allowances under the EU ETS will be auctioned, i.e. some one billion allowances per year. 120 million allowances for Phase III are being auctioned in 2012, the year before Phase III starts. In addition, in the aviation sector, 15 per cent of the EU Aviation Allowances (EUAAs) will be auctioned from 2012. We set out more information on recent auctioning proposals below.

Banking and borrowing

Under the CPM's fixed price phase, carbon units bought for the fixed price phase will be automatically surrendered and are not bankable or tradable within the fixed price phase. Under the flexible price phase, carbon units are bankable for future use and liable entities can borrow up to 5 per cent of the carbon units they are obliged to surrender from the following vintage year.

Under Phase III of the EU ETS, there is no limit on banking of EUAs. Entities allocated with any free allocation will receive them more than a year in advance of the surrendering deadline for a year's emissions and can use them for compliance for the current year's emissions.

Penalties

Under the CPM, for a shortfall in a given compliance year, under the fixed price phase the penalty would be 1.3 x fixed price cost of a carbon unit. Under the flexible price phase the penalty would be double the average price of carbon units for that year. In the EU, a penalty of EUR 100 is paid for each tonne of carbon dioxide equivalent emitted for which the operator has not surrendered allowances, and the operator must in any event make up for the unsurrendered allowances.

Use of international units

The position in relation to the use of international units under the CPM and EU ETS is summarised below.

In addition, Australian carbon credit units (ACCUs) issued for voluntary offset projects under the Carbon Farming Initiative (CFI) can be used for compliance under the CPM. In the fixed price period, this is limited to 5 per cent of total compliance obligations (unless the majority of liability comes from landfill emissions, in which case it is unlimited). In the flexible price period, there will be no limit on the surrender of ACCUs.

Key Issues

Having reviewed some of the key similarities and differences between the CPM and EU ETS, it is important to assess some of the bigger picture issues.

Stringency

A particularly important issue will be an assessment of the overall stringency of the CPM and EU ETS and to what extent the effort required by entities regulated under the schemes is comparable. This has perhaps been the greatest design challenge faced by the EU ETS. Before considering the structural changes currently being discussed to enhance the EU ETS price signal, it is worthwhile considering how this has been tackled to date.

The objective of the EU ETS is not only to reduce absolute emissions but also to prompt investment in emission reductions within installations and the development of new low carbon installations. That objective is undermined where there is insufficient scarcity of allowances to underpin a strong price signal because a weak price makes it more difficult to justify these types of investments given the time scales involved for some of these projects. The EU ETS is based upon the allocation of emission allowances in respect of each Phase of the scheme which are less than a baseline of historically verified emissions, thus creating the required level of scarcity.

The impact of the financial crisis in 2008 and attendant recessions within a number of key Western economies, including in Europe, resurrected the question of whether an unfettered market-based scheme can generate a strong long-term carbon price signal. In essence, the decline of economic activity in Europe during Phase II (2008 - 2012) has resulted in significant falls in the price for allowances within the EU ETS (as market participants align the allocation of allowances for the Phase with the lower emissions profile such economic downturn implies). This has occurred despite the steps taken by the European Commission prior to the commencement of Phase II to address the drivers of the price collapse in Phase I. Those included: (i) issuing detailed guidance to Member States outlining the rigour with which it would assess proposed member state caps; and (ii) forcing further reductions on Member States that it considered had failed to comply with that guidance.

The core design elements of Phase III were settled by Europe in 2009 with the passage of the amendments to the EU ETS Directive. The key tools they sought to employ to prevent further incidences of reductions in the strength of the EU ETS price signal were the "linear reduction" structure of the Phase III cap, the ability to bank allowances and greater levels of auctioning, all of which have been discussed above.

Unfortunately, the depth of the financial crisis and its impact on European industrial activity has resulted in continuing depressed prices for allowances in the EU ETS. The European Commission has commenced a process of legislative reform to address this. These reforms can be separated into near term measures and long term measures.

Near Term Measures - Backloading auction volumes

In late July 2012 the Commission set out how it proposes to amend the timetable for auctioning of EUAs in Phase III. The Commission's proposals set out several options of adjustments that could be made to the amount of EUAs that will be auctioned at certain points during Phase III. The objective is to tackle the potential surplus of EUAs at the beginning of Phase III as the Commission has concluded that the EUA demand and supply balance at the beginning of Phase III is no longer aligned with what was envisaged when the auction profiles were originally decided. In essence, the Commission has decided that unforeseen economic and regulatory changes represent "exceptional changes" which justify it putting forward the adjustment measures.

Although the Commission initially considered pushing forward with delayed auction volumes without seeking amendments to the EU ETS Directive, the Commission has now decided to seek formal amendments to the EU ETS Directive and associated auction regulation. This is likely driven by the Commission's painful experience of losing in the European Court of Justice after European Member States such as Poland challenged the Commission over aggressive interpretations of its scope of authority. With evidence that certain European Member States were preparing to challenge the Commission if it pushed ahead, the Commission decided for legal certainty over speed of action.

The Commission proposals are that a given volume of EUAs would be removed from the current auction timetable for 2013, 2014 and 2015 and these EUAs would instead be auctioned in an amount to be divided between 2018, 2019 and 2020. No permanent set-aside of EUAs is currently envisaged in these proposals.

The earliest the backloading proposals are likely to be in place is 2013.

Longer Term Measures - Structural reform

European Commission representatives have acknowledged that backloading is only a temporary measure which may not do enough to prop up a strong carbon price in Europe. As such, they are due to release a report later this year on more permanent measures to address over-supply in Phase III. Little detail is available at this point but the likely options that will be consulted on are:

• Permanent removal of the auction volumes that are delayed under the near term actions discussed above;
• Revision of the linear reduction factor of 1.74 per cent that is currently specified in the EU ETS so as to reduce volumes to be allocated across the Phase (for instance, adjusting this to 2.2 to 2.4 per cent);
• Increase demand in the EU ETS by extending the scope to other parts of the economy such as residential or transport sectors (although there are existing measures that would need to be considered in these sectors that are already seeking to reduce emissions); or
• Agreement to increase the ambition of the EU from a 20 per cent target to a 30 per cent target (as has been offered by the EU under international climate change negotiations).

The timing of such fundamental changes is currently unclear and depends in large part on the political dynamics of a stressed Eurozone. In light of that, the period for discussion and implementation of such measures could occur in 2013 but could also be envisaged extending through until 2015.

Offsets

Another fundamental design characteristic is the extent to which schemes continue to allow cost containment by way of the use of "offsets" (being credits imported into the scheme from emissions reduction projects outside of the relevant cap). This issue relates both to the nature and type of offsets permitted for use and also to the extent to which they can be used. Australia appears broadly to have mirrored the EU's offset criteria. This is to be welcomed from the point of view of linking.

However, it will be interesting to see whether Australia eventually follows the EU in implementing requirements in respect of the use of the CERs coming only from Least Developed Countries for CDM projects registered from 2013. We also note that unless the current provisions are changed, Australia risks becoming a "dumping ground" for CDM projects registered after 2012 whose credits are not eligible under the EU ETS. The implications of this would need to be assessed in terms of linking the two schemes. It also remains to be seen whether the EU seeks to impose further restrictions on the use of different kinds of offsets.

Registries

Another technical aspect of emissions trading implementation relates to the registries architecture. For schemes to link there will inevitably need to be a certain degree of connectivity between different registries. Registries rules and practices may be different between jurisdictions. However, we do not believe that such regimes would necessarily have to be fully harmonised in order for two systems to link. We note though that the EU's system of registries is becoming ever more complicated. This is partly in response to relevant security breaches. Recent changes have included factors such as movement to a single registry, enhanced security measures and improved "know your client" requirements.

Regulation

Perhaps of paramount concern will be the extent to which respective regulators trust each other to guide schemes adequately through the inevitable turbulence of the carbon markets.

Faced with uncertainties about the ongoing international negotiations, the legal nature of domestic targets going forward and the offset pipeline, schemes will have to be managed robustly to ensure that they respond to surrounding policy uncertainty and attract investor confidence. Issues such as registry security and fraud which have dogged the EU ETS are likely to continue to niggle at the edges of emissions trading schemes. Each jurisdiction will have to ensure that it trusts the other to properly respond to such challenges. It may be difficult for the schemes to interact if there are greater levels of policy uncertainty and risk on one side.

Conclusion

How smoothly the EU - Australia link will be implemented and whether or not it will help lead to a significant rejuvenation of the carbon markets remains to be seen. Significant concern has focussed around the dangers of increasingly fragmented carbon markets, in light of the limited international progress with respect to negotiating a fully fledged post-2012 climate agreement. The linking of the EU ETS and the CPM is likely to serve as a useful blueprint for how linking can be done. Nonetheless, the idea of an integrated OECD-wide carbon trading system, which was mooted in 2009 to be possible by 2015, still seems a long way off.

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