Australia's carbon pricing mechanism

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Introduction & Overview

The Australian Government announced details of its climate change plan on 10 July 2011. The plan builds on the February 2011 announcement of the Multi‑Party Climate Change Committee (MPCCC) which set out the architecture for a permit-based scheme to apply a price to greenhouse gas emissions (the Carbon Pricing Mechanism). The July plan incorporates the Carbon Pricing Mechanism, broadly in the form outlined in the February announcement, and also covers industry assistance, governance arrangements and funding for related measures.

This note provides an overview of the July plan and includes a more detailed introduction to the Carbon Pricing Mechanism and how it is intended to work.

The Clean Energy Legislative Package, which comprises the exposure draft legislation to implement the plan and supporting materials, was released today (28 July 2011) and can be found at www.climatechange.gov.au.

Overview of the plan

Under the plan, emission of greenhouse gases will incur a cost, principally through the permit-based Carbon Pricing Mechanism. For transport fuels, an equivalent carbon price will be applied through the fuel excise and rebate arrangements.

Not all sectors are covered. Emissions from the agricultural sector are excluded, as are emissions from light vehicles and vehicles used for agriculture, fishery and forestry. For facilities in covered sectors, liability will in general only be incurred for emissions above a threshold.

Many households are to receive assistance to meet increased costs caused by pricing greenhouse gas emissions, principally through adjustments to personal tax thresholds and tax rates. Assistance for businesses will include free allocation of permits to emissions-intensive, trade-exposed industries. The July plan proposes other support measures - such as a $300m assistance package for the steel industry and a $2 billion assistance package for the coal sector - which the Government wishes to implement but which do not have MPCCC agreement.

CO2-e

CO2-e refers to carbon dioxide equivalent, a unit that allows emissions of different greenhouse gases to be scaled to a common measure according to their global warming potential. Carbon dioxide is the base unit and has a global warming potential of one. One tonne of methane (for example) has a global warming potential of 21.

Support will be provided to energy markets, responding to concerns that the scheme has the potential (without that support) to threaten energy security if financial stress on existing generators causes them to leave the market and investment in new generation capacity stalls. An energy security fund will provide an estimated $5.5 billion of assistance for generators with emissions above 1 tonne CO2-e per MWh. Assistance will take the form of free permits and cash, conditional on the publication of plans to reduce emissions.

The Government also proposes the closure of around 2,000 MW of emissions-intensive generating capacity by 2020 by inviting generators that emit more than 1.2 tonnes of CO2-eper MWh to bid for closure contracts. Loans will be made available to buy permits for future years and may also be made available to refinance debt. An Energy Security Council will advise the Government on risks to energy security and possible responses.

In addition to pricing greenhouse gas emissions and the associated industry and household assistance, the July plan allocates funding to a range of measures in the energy, industrial and agricultural sectors.

  • Support for renewable energy includes $10 billion to be invested by a new Clean Energy Finance Corporation. A new Australian Renewable Energy Agency will administer $3.2 billion in existing support measures. The MPCCC has also agreed changes to eligibility rules under the Renewable Energy Target.
  • Support for industry includes $800 million in grants for manufacturers with high energy consumption levels, $150 million for the food processing industry and $50 million for the metal forging and foundry industries.
  • Support for carbon abatement and biodiversity activities in the land sector includes $250 million for the Government to buy credits created under the Carbon Farming Initiative, $429 million to support participation in the Carbon Farming Initiative and $946 million to support biodiversity outcomes through planting and biodiversity management.

Carbon Farming Initiative or CFI

The Carbon Farming Initiative is the Commonwealth's proposed scheme for land-based projects to reduce or store greenhouse gas emissions. Participants will be able to earn tradeable emissions credits, some of which will be eligible under the Kyoto Protocol.

CFI projects will include those that reduce emissions from agricultural or other land-based activities, from landfill from legacy waste and projects that store carbon in trees, vegetation or soil. At the time of writing, the CFI legislation is still before the Senate.

The July plan provides for new bodies to be established, some incorporating existing bodies such as the Office of the Renewable Energy Regulator. These bodies will be given responsibility for governance, research and advice, regulation, administration and allocation of funding. The Productivity Commission will continue its work on emissions policies in other countries and will be responsible for reviewing industry support measures.

More information about the plan is at www.cleanenergyfuture.gov.au. That site also gives access to the MPCCC's Clean Energy Agreement which sets out the agreement reached by the MPCCC and forms the basis for the July plan. The Clean Energy Legislative Package is at www.climatechange.gov.au.

The Carbon Pricing Mechanism

The Carbon Pricing Mechanism will commence on 1 July 2012. The draft legislation is expected to be released for comment around the end of July 2011.

From carbon tax to emissions trading scheme

The Carbon Pricing Mechanism is to be implemented in two phases. During the first phase, an unlimited number of permits will be available and the price will be fixed at $23, escalating each year. An entity with compliance obligations under the scheme will need to buy and surrender enough permits to cover its emissions during each compliance year. A compliance year coincides with the Australian financial year. Two surrender dates apply, with 75% of permits to be surrendered by 15 June in the compliance year and the remainder by the following 1 February. For small emitters, all permits for a compliance year can be surrendered on 1 February in the following compliance year.

The first phase will last three years. The second, 'cap-and-trade' phase, will start on 1 July 2015. By fixing the date the MPCCC has removed much of the uncertainty in the announcement made in February 2011, under which the timing of the transition from the fixed price phase to the second phase was left open. In the second phase, an entity with compliance obligations will continue to have an obligation to surrender permits to cover its emissions, but only one surrender date applies (1 February).

If a liable entity fails to meet its obligations in either phase, a charge will be payable. During the fixed price period the charge is 1.3 times the fixed price for permits. During the flexible price period the charge will be double the average price of permits for that year.

Caps on emissions

During the second phase, the Government will set an emissions cap for each compliance year. The cap will set the number of permits that the Government will make available to the market. The permits will be issued to the market either through free allocation to emissions-intensive, trade-exposed industries (such as steel) or by auction. Auction revenues will be used to finance the support mechanisms and other measures announced as part of the plan. The level of the cap is important since it will affect the price for permits. The price will also be influenced by overall demand for permits, in turn affected by factors such as the weather, the availability and price of international permits, the cost and speed of the transition to less emissions-intensive technology, economic activity and the extent to which emissions move offshore.

The first five years of caps will be announced in the 2014 budget and implemented by regulation. To address the risk that the regulations will be disallowed, there will be a fallback mechanism in the legislation. The cap will be extended by one year every year, also by regulation, to maintain five years of caps at any given time and again with a fall-back if the regulations are disallowed.

A Climate Change Authority is to be established and one of its roles will be to make recommendations to Government about scheme caps. Ultimately the caps will be set by Government, having regard to the advice given by the Climate Change Authority and Australia's international climate change obligations. The cap-setting process is nonetheless one which entails political risk and the July announcement indicates that the Government will have regard to a range of factors such as medium and long term national emissions targets, economic and social implications of various caps and anything else the Minister considers relevant.

Voluntary action and GreenPower

Voluntary action will also be taken into account in setting caps.

One form of voluntary action will be cancellation of flexible price permits, units under the Carbon Farming Initiative and international units. For individuals who wish to take voluntary action, the Government will establish a Pledge Fund, contributions to which will be tax deductible. The Pledge Fund will voluntarily cancel units.

If permits are voluntarily cancelled, the cancellation will not be counted towards Australia's national emissions target and will reduce the number of units in the market.

Renewable Energy Target or RET

Since January 2011, the RET has been split into two schemes, the large-scale renewable energy target (LRET) and the small-scale renewable energy scheme (SRES). Each scheme requires retailers to buy a percentage of their electricity sales from renewable sources, with separate targets for large and small scale technology.

GreenPower

GreenPower refers to electricity produced from renewable generators accredited under the government-run GreenPower Accreditation Program. GreenPower electricity is additional to the renewable electricity used to meet a retailer's obligations under the RET. Electricity consumers generally pay a premium for the product, contributing to the development of renewable energy beyond the mandated targets.

The July plan indicates voluntary action also includes purchases of GreenPower. The Government will measure GreenPower purchases and take these into account in setting caps. GreenPower purchases will not count towards meeting Australia's national emissions reduction target. The intent would appear to be to protect the integrity of the GreenPower brand. The effect may also be to protect permit prices against a drop in demand caused by new renewable generating capacity entering the market at levels well above the target set under the RET.

Coverage - who is liable and for what?

The Carbon Pricing Mechanism will cover four of the six greenhouse gases under the Kyoto Protocol - carbon dioxide, methane, nitrous oxide and perfluorocarbons from aluminium. For the remaining Kyoto greenhouse gases (hydrofluorocarbons and sulphur hexafluoride) existing legislation will be applied.

The scheme will cover:

  • stationary energy, which refers to electricity generation and direct combustion of fuel in manufacturing, mining, construction and domestic heating and cooking;
  • fugitive emissions, referring to emissions from the production, processing, transport, storage, transmission and distribution of fossil fuels but (in the case of the Carbon Pricing Mechanism) excluding emissions from decommissioned underground coal mines;
  • industrial processes, covering emissions which are the by-products of cement, metal and chemical production; and
  • emissions from waste (except where the waste is deposited before 1 July 2012).

In the transport sector, a carbon price will be applied to domestic aviation, domestic shipping, rail transport, off-road transport use of liquid and gaseous fuels and non-transport use of liquid and gaseous fuels. The carbon price will be applied not through the Carbon Pricing Mechanism but through adjustments to existing arrangements such as business fuel tax credits, a reduced remission of excise, and, for aviation fuels, an increase in domestic aviation fuel excise. The July plan indicates that the Government wishes to apply the carbon price for heavy on-road transport from 1 July 2014, but that measure does not have MPCCC support.

No carbon price will be applied to fuel used for light commercial vehicles and households or to fuel used for off-road transport in the agricultural, forestry and fishery industries or gaseous fuels used for on-road transport. Other exclusions from the scheme are emissions from agricultural and land sector activities and emissions from the combustion of biofuels and biomass.

Scope 1 and scope 2 emissions

Facilities that emit greenhouse gases or use or produce energy above certain thresholds must report under the National Greenhouse and Energy Reporting Act 2007 (Cth). Both scope 1 and scope 2 emissions are reported.

  • Scope 1 emissions are the direct result of the activities of the facility (for examples, emissions resulting from the consumption of coal or gas to generate electricity).
  • Scope 2 emissions are the result of one or more activities that generate electricity, heating, cooling or steam that is consumed by the facility but that do not form part of the facility.

Point of liability

In its allocation of liability to the entity with operational control of a facility and among joint venturers, the July plan appears to have moved away from the arrangements for allocation of liability proposed in the Carbon Pollution Reduction Scheme. Those arrangements had attracted criticism. The new approach seems likely to lead to changes to the reporting arrangements under the National Greenhouse and Energy Reporting Act.

In general, a threshold of 25,000 tonnes of C02-e will apply for determining whether an emissions producing activity gives rise to compliance obligations under the scheme. Scope 1 (direct) emissions covered by the Carbon Pricing Mechanism, and legacy waste emissions, will count towards the threshold, with the exception of scope 1 emissions from excluded fuels or sources.

The liable entity will generally be the person with operational control of the activities covered by the scheme. Natural gas retailers will be responsible for emissions from the use of natural gas by their customers, however large consumers of natural gas will be able to take responsibility for their emissions under an obligation transfer mechanism. For unincorporated joint ventures where no one person has operational control, liability will be allocated among joint venture participants in proportion to their joint venture interests. An operator will also be able to apply to transfer liability in certain circumstances.

Free permits

One form of assistance for emissions-intensive trade-exposed activities will be the allocation of free permits. The number allocated will be based on actual production, so free permits issued but not required will not be available for sale. Assistance will cover:

  • scope 1 (direct) emissions;
  • the cost of indirect emissions from electricity and steam use; and
  • cost increases for upstream emissions from natural gas and its components used as feedstock and stored in the output of the activity.

The amount of assistance will either be 94.5% or 66%, depending on the industry and will reduce at a rate of 1.3% per year, labelled the 'carbon productivity contribution'. LNG projects will receive a supplementary allocation to ensure an effective assistance rate of 50% in relation to their LNG production each year.

The Productivity Commission is to be given responsibility for reviewing these industry assistance measures. It will, for example, consider whether the carbon productivity contribution should pause at 90%/60% in any sector and whether changes should be made to the framework for assessing the level of assistance provided. Some generators (with emissions of 1 tonne CO2-eper MWh or greater) will also receive free permits, but on condition that steps are taken to reduce emissions and capped at an emissions intensity of 1.3 tonnes CO2-e per MWh. If these generators exit the market, they will be able to keep the permits (and sell them) subject to replacement capacity being in place.

How will the Carbon Pricing Mechanism reduce greenhouse gas emissions?

The aim of the Carbon Pricing Mechanism is to reduce Australia's contribution to global greenhouse gas emissions, either by taking action to reduce emissions from activities in Australia or (subject to international frameworks) by paying for emissions to be reduced outside Australia and importing the credits earned. Liable entities facing a cost under the scheme have a number of choices. These include:

  • taking action to reduce emissions covered by the scheme, such as moving production offshore to a jurisdiction that does not price greenhouse gas emissions (a choice not open to all sectors covered by the scheme) or investing in energy efficiency or new technologies;
  • acquiring Australian permits at auction or on secondary markets;
  • investing in emissions abatement or sequestration projects under the Carbon Farming Initiative and earning credits eligible under the mechanism (but only for up to 5% of liability in the first phase); and
  • in the second phase, using international permits eligible under the mechanism, either by acquiring them in the market or investing in offshore projects which earn international units (but only for up to 50% of liability at least until 2020).

Depending on the price of permits, in general terms the mechanism should result in production processes that are less emissions-intensive having a price advantage over their more emissions-intensive competitors. In the power generation sector, less emissions-intensive generators should displace more emissions-intensive generation. Activities that are no longer competitive in an emissions-constrained economy, such as some conventional coal-fired generation, may simply exit the market.

Since permit prices are expected to increase over time as the cap reduces, the mechanism should also result in investment to reduce or abate emissions. Investment decisions will involve an understanding of forward prices for permits and of risks over the investment time frame. Political and regulatory risks are inherent in the market and will be a consideration for investors and lenders assessing projects that rely on a carbon price to be economic.

Managing risk under the Carbon Pricing Mechanism

The Carbon Pricing Mechanism includes design features intended to mitigate price and volume risks while also maintaining its environmental integrity.

In the first three years of the flexible price period, the price of permits will be subject to a cap and floor. The cap is intended to protect against very high prices and will be set at $20 per unit above expected international prices, rising by 5% (real) each year. The floor will provide some certainty for making investment decisions and protect auction revenues. The floor will initially be $15 per unit, rising at 4% (real) each year. Papers published by the MPCCC indicate that the floor price will extend to international units, possibly by applying a fee to international permits brought into the Australian market, to make up the difference between the international price and the domestic floor price. Implementing a floor price for international units seems likely to present a significant challenge.

Unlimited banking of permits will be allowed in the flexible price period. This will enable an entity which holds more permits than it needs for compliance, perhaps because its production was lower than forecast, to keep the excess for use in future years. There will be limited borrowing of permits, up to 5% of liability in the second phase. Borrowing allows a liable entity with a shortfall in its holding of permits to avoid the penalty charge.

What are permits?

A recurring question in carbon markets is: What is the legal nature of permits? The answer can have practical implications for matters such as security of title, financial services regulation, taxation and insolvency. The question is answered, up to a point, in the July plan. Permits are entries in an electronic register. Each permit corresponds to one tonne of C02-e. Permits will be personal property. It will be possible to create equitable interests in permits and to take security over them.

The July announcement indicates that permits will be regulated as financial products. If the approach adopted for credits under the Carbon Farming Initiative is followed, this will be achieved by amending the relevant legislation to define them as financial products. This approach treats permits as if they were securities, rather than commodities, which is at odds with market practice. The 10 July announcement also covers tax treatment of permits. The cost of a permit will be deductible. The purchase of permits will be GST free but the application of the normal GST rules will apply to transactions in financial derivatives of permits and payments of grants of assistance.

Links to other schemes

Market participants will be able to use some units from international emissions trading schemes and credits from the Carbon Farming Initiative to acquit their obligations under the Carbon Pricing Mechanism. Eligible international units will include units created under project mechanisms established by the Kyoto Protocol, subject to exclusions for some types of project. The Government may, by regulation, allow other types of international units to be used and will also retain the power to disallow the use of any type of international unit. Issues for purchasers of international units will therefore include current eligibility, the risk of future ineligibility and the impact of the floor price proposals.

The July plan indicates that links to other trading schemes, such as those of the European Union and New Zealand, may be created in the future. If so, changes under these schemes (such as excluding categories of international units) seem likely to have an influence on eligibility rules in the Carbon Pricing Mechanism.

Kyoto Protocol Credits

The Kyoto Protocol establishes arrangements under which projects that avoid, abate or store emissions of greenhouse gases can earn tradeable credits.

  • CDM: The clean development mechanism. Eligible projects earn certified emissions reductions or CERs.
  • JI: Joint implementation. Eligible projects earn emission reduction units or ERUs.
  • LULUCF: Land use, land use change and forestry activities, which earn removal units or RMUs.

National emissions trading schemes may exclude the use of some Kyoto credits, for example where there are concerns about environmental integrity or social impacts. The European Union's emissions trading scheme includes numerous restrictions on the type and location of projects from which it will accept Kyoto credits. The July plan for the Carbon Pricing Mechanism excludes CERs and ERUs from nuclear, from some large-scale hydro-electric projects, from the destruction of trifluoromethane and from the destruction of nitrous oxide from adipic acid plants.

Projects under the Carbon Farming Initiative will earn Australian carbon credit units or ACCUs, some of which will be compliant with the requirements of the Kyoto Protocol. Kyoto-compliant ACCUs and some other ACCUs will be eligible under the Carbon Pricing Mechanism. In the fixed price phase, liable entities will be able to surrender eligible ACCUs totalling not more 5% of their obligation. It will not be possible to use eligible international units. In the flexible price phase, there will be no limit on the surrender of eligible ACCUs and until 2020, liable parties will be able to meet up to 50% of their annual liability with international units. The 50% restriction will be reviewed by the Climate Change Authority in 2016. ACCUs can be exported. Fixed price units under the Carbon Pricing Mechanism cannot, nor can flexible price units while the price cap is in place.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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