Carbon markets update May 2011

This update gives an overview of two major developments in Australian carbon markets. The Carbon Price Mechanism, or carbon tax, is expected to be the foundation for emissions trading in three to five years' time. The Carbon Farming Initiative is a project based mechanism which will allow emissions credits to be earned through sequestration and offset projects. Watch the video here.

Carbon Price Mechanism

The Multi-Party Climate Change Committee (MPCCC) called its 25 February proposal a "Carbon Price Mechanism". It has become known as a carbon tax. In fact the mechanism is a hybrid model which will take the form of an emissions trading scheme, but with unlimited availability of emissions units at a fixed price in the first phase. In the second phase it will convert to a cap and trade model with the price for emissions units set by the market.

The Government aims to commence the mechanism from as early as 1 July 2012.

Architecture

The MPCCC's February announcement set out the broad architecture for the Carbon Price Mechanism. Six weeks of press releases and commentary has followed but there is very little reliable new information about the detailed design.

The 'Key Features' list below sets out the proposed framework. In many respects it is similar to the Carbon Pollution Reduction Scheme (CPRS). One key difference is the much longer fixed price period, which is expected to run for three to five years but could be extended, since the proposal includes an option to defer the decision to move to the second phase. The longer initial phase also raises questions about the price path in that transition, which will in turn depend on the emissions cap. Questions for investors and market participants will include how those decisions about timing and the cap are made, and what political and regulatory risks they entail.

Measures designed to manage some of the transition risk may be incorporated into the design. Professor Garnaut, for example, has proposed an auction of undated permits in the first phase up to around 5 to 10 per cent of the current year's volume. Immediate payment would be required. The undated permits could be banked for use after the first phase. The objective is to encourage the development of a forward price curve and forward physical market.

Carbon Price Mechanism: Key Features

• Coverage: It is likely that all six greenhouse gases under the Kyoto Protocol will be included. Sector coverage has not been decided but the announcement suggests it will be very similar to the coverage of the CPRS. Agricultural, forestry and legacy waste emissions are to be excluded.
• Pricing: Decisions have yet to be made about the price for units in the initial phase and the fixed annual escalation rates. Some insight may be provided by Professor Ross Garnaut's paper, Carbon Pricing and Reducing Australia's Emissions, which was discussed at the MPCCC meeting on 19 March 2011. The paper recommends that the starting price should be between $20 and $30 per tonne, rising at 4 per cent (real) per annum. In the transition to the second phase, the price would float, without any cap or floor.
• Start of the second phase: The fixed price phase is expected to run for three to five years but could be longer, since the proposal includes an option to defer the transition.
• Industry assistance: The MPCCC's proposal indicates that industry assistance is still to be determined. The final three papers from Professor Garnaut consider various forms of assistance including support for emissions-intensive, trade exposed industries and the electricity sector. Whether those proposals are likely to be adopted is unclear. If adopted, they represent a move away from the approach under the CPRS.
• Use of proceeds: At least part of the proceeds will be used to provide assistance to households and communities most needing help to adjust to a carbon price. The mechanism remains unclear, with the Garnaut proposal for assistance to be delivered through the income tax system now seeming unlikely to be adopted.
• Links to other schemes: The MPCCC's 25 February proposal indicated that, during the fixed price phase, international emissions units (such as emissions units under the clean development mechanism) could not be used for compliance. The pricing mechanism may be linked to the Carbon Farming Initiative by allowing credits under that scheme to be used for compliance.

What next?

A number of Consultative Working Groups and Forums have been established, among them the Industry Transitional Assistance Working Group and the Energy Sector Working Group jointly chaired by Ministers Combet and Ferguson. Between them these groups will provide industry feedback to Government on scheme architecture, transitional assistance for energy-intensive trade exposed industries and issues for LNG, coal and the energy sector.

At the technical working group level, three will be established initially, dealing with the point of liability for facilities (of particular relevance to corporate groups and joint ventures) and issues for the natural gas sector and refinery fuels.

Draft legislation is expected in late August or early September this year. Many businesses will be well prepared for the introduction of a carbon price given their obligations under the National Greenhouse Energy and Reporting scheme and their preparations for the CPRS. The Consultative Working Groups and Forums and eventually the exposure draft legislation will provide an opportunity to assess how much of that work remains valid and what else needs to be done.

Carbon Farming Initiative

The Carbon Farming Initiative (CFI) is a project-based emissions reduction mechanism. Participants will be able to earn tradeable emissions credits known as Australian Carbon Credit Units (ACCUs). The CFI targets projects 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.

The CFI is intended to start in July 2011. Demand for ACCUs is expected from international carbon markets (for ACCUs that are Kyoto-compliant), the domestic voluntary carbon offsets market and, depending on its final design, from the Carbon Price Mechanism.

Eligible projects

The CFI is for projects that reduce emissions from agricultural or other landbased activities and from legacy landfill (emissions avoidance offset projects) and projects that store carbon (sequestration offset projects).

Emissions avoidance offset projects include:

• managing emissions associated with livestock and introduced animals, including avoiding emissions from digestive tracts and from the decomposition of urine or dung (manure management);
• avoiding emissions from rice fields or rice plants, from the burning of savannah, grassland, crop stubble, crop residue and sugar cane and from soil; and
• avoiding emissions from landfill facilities (for waste accepted before the start of the Carbon Price Mechanism).

Sequestration offset projects such as reforestation remove carbon dioxide from the atmosphere by storing carbon in trees and other living biomass, in dead organic matter and in soil. Projects involving clearing or harvesting native forests are excluded.

The CFI will include a "negative list" to preclude projects that have a significant adverse impact on the availability of water, biodiversity conservation, employment or the local community. Other exclusions will include cessation of harvesting in plantations established for harvest and sequestration projects on illegally cleared land.

Scheme design

The CFI is intended to satisfy internationally recognised standards. These include additionality (which in the CFI refers to activities not required by law and not common practice) and the delivery of measurable and verifiable results. Leakage - meaning any increase in emissions as a result of undertaking the project - must be accounted for. Project methodologies must be consistent with internationally agreed methodologies and supported by peer-reviewed science.

Offset projects must therefore be declared eligible before they can earn credits. To be eligible, the project must be located in Australia and must be covered by a declared methodology covering that type of project. Methodologies must take into account the "offsets integrity standard" and must be endorsed by the committee of independent experts established for the CFI known as the Domestic Offsets Integrity Committee or DOIC.

The crediting period for a project is the time over which it can earn credits. In general a seven year crediting period will apply, with 20 years for native forest protection projects. At the end of each crediting period, the project proponent will need to demonstrate that the project continues to meet the applicable methodology and the additionality test in order for the project to continue to earn credits.

ACCUs are issued at the end of each reporting period within a crediting period. The reporting period for a project may be between 1 and 5 years.

Sequestration offsets projects pose particular challenges since the carbon store can be released deliberately or through natural disturbance such as flood, bushfire and drought. The scheme includes mechanisms to manage these risks. These include a "risk of reversal" buffer which banks 5% of credits to cover release of carbon due to natural disturbance. The manager of the land will need to take steps to re-establish the lost carbon stocks.

Sequestration projects have long term implications for the value of the land on which they are located. The obligation to maintain carbon stocks will apply to future owners of the property. This will affect, for example, those who inherit land and lessors after termination of a lease. While a new owner can buy and relinquish credits in order to release the land from the long term obligation, that may be costly outcome if the market price for ACCUs is high.

Participation

Anyone wishing to participate in the CFI should consider the appropriate participation structure for their project. As presently drafted, the Bill imposes potentially onerous obligations on participants and as noted above, can attach long-term liability to land.

Any participant will need to become a recognised "offsets entity" by applying to the Carbon Credits Administrator. The Administrator must apply a "fit and proper person" test which in broad terms considers whether the applicant, or an executive officer of the applicant in the case of a corporate entity, has been convicted of various offences, breached the CFI legislation or related legislation such as the NGER Act or is insolvent. The regulations can specify other tests.

Recognition can be cancelled by the Administrator if the entity ceases to pass the fit and proper person test. While there is no obligation to re-apply if, for example, the officers of a corporation change, the current proposals do include ongoing obligations to report information such as a conviction relevant to the fit and proper person test.

The fit and proper person test and notification obligations seem likely to prove onerous, both for individuals and for corporate entities. It also appears to expose participants to the risk of additional sanctions under the CFI (cancellation of recognition and potential loss of rights to be issued with ACCUs) where there is an unrelated breach or offence.

The Explanatory Memorandum indicates that the test is intended to reduce the risk of fraud, deceptive or unfair conduct and non-compliance. That suggests a lack of confidence in the sanctions elsewhere in the CFI legislation. It would seem preferable to target the specific areas of concern.

What next?

The Carbon Farming Initiative is intended to commence in July 2011. The Australian National Registry of Emissions Units is already established and much of the institutional framework is now in place. The Domestic Offsets Integrity Committee was appointed in late 2010 and from 12 March 2011 has been accepting methodologies for assessment. Interim guidelines for the submission of methodologies have been published and the relevant Commonwealth Departments are working with industry to develop offset methodologies.

The Carbon Credits (Carbon Farming Initiative) Bill 2011 was introduced into the House of Representatives on 24 March 2011. It is one of a package of three related bills, the other two being the Australian National Registry of Emissions Units Bill 2011 and the Carbon Credits (Consequential Amendments) Bill 2011.

The Bills have been referred to a Senate enquiry which is due to report on 20 May 2011.