First the price, then the market: The transition to the Emissions Trading Scheme

Key Points:

Liable entities and other participants in the market will need to prepare now for the Emissions Trading Scheme in 2015.

The current plan under the Clean Energy Future package is for the carbon price mechanism to transition to an emissions trading scheme on 1 July 2015.

What's the cap?

Although during the transitional period there will be no limit on the number of permits the Government can issue, in order for the scheme to move to a free(-ish) market in 2015, the annual emissions cap will need to be set, thus quantifying the number of permits likely to be available.

The Government intends to announce the first five years' worth of caps in 2014. Each year thereafter, the cap for the fifth year will be announced to maintain five years of known caps at any given time.

When setting the caps, the Government must consider, among other things, the recommendations of the Climate Change Authority (CCA). The CCA will also make recommendations on indicative national trajectories and long-term emissions budgets, and provide advice on whether national targets are being met. Voluntary action by individuals, such as voluntary cancellation of permits or greenpower purchases, will be considered in setting scheme caps.

The scheme proposes default caps in the event that regulations setting Australia's caps are disallowed by Parliament. These default caps are intended to ensure that covered emissions are reduced in absolute terms each year at least consistent with meeting Australia's unconditional 5% 2020 target.

What's the price?

After the transitional period, the price will be determined by the market, however, to provide price stability, certainty and to appease some interests groups, the Government has agreed to both a "price floor" and a "price ceiling" for the first three years of the scheme.

The floor price will be set at $15 and increase each year by 4% in real terms. The price ceiling will be set at $20 above the expected international permit price for 2015-16, rising 5% pa in real terms.

The floor and ceiling prices will be reviewed by the Climate Change Authority in 2017, who will advise the Government on whether price controls at these settings remain appropriate. This suggests that there is a possibility that price controls may continue beyond the first three years of the flexible price mechanism.

How do I get permits?

During the transitional period, permits will be purchased directly from the Government. Any permits purchased at the fixed price will be automatically surrendered at the end of each compliance year.

A liable entity may also meet part of its obligation by using Australian Carbon Credit Units under the Carbon Farming Initiative. This is limited to 5%. There is a prohibition on the use of any other permits or credits (such as Kyoto credits) during the three year transitional period.

When the scheme moves to emissions trading, entities can meet scheme obligations by surrendering:

• permits under the mechanism (Australian Emission Units or AEUs for convenience), allocated for free as part of any industry assistance or EITE compensation;
• AEUs purchased at auctions conducted by the Government (similar to the regime proposed under the CPRS), or on the secondary market. The Government also proposes to advance auction future vintage permits;
• ACCUs which have been generated under the CFI, or purchased on a secondary market;
• eligible international emission units – these are units recognised by the Government. At this time, they are limited to most Kyoto compliant units such as CERs and ERUs, although the expectation is that through linking with other schemes (such as the NZ ETS), other units can be accredited.

During the first five years of the trading scheme (that is, until 2020), there will be a limit on the number of non-domestic credits that can be used to meet scheme obligations. Liable parties must meet at least 50% of their annual liability from domestic permits or credits.

Banking and borrowing

No banking or borrowing of fixed price permits will be allowed, with such permits on issue automatically being surrendered at the end of each compliance year.

During the flexible price period, unlimited banking of permits will be allowed.

Limited borrowing of permits will be allowed. A liable entity can surrender permits from the following vintage year to discharge up to 5% of their liability. This is similar to the CPRS model. Unlike the CPRS, however, there will be no deferred payment mechanism.

International linkages

During both the fixed price period, and initial period of the flexible price trading scheme, there will be limits on international linkages. In summary:

• international units cannot be used to meet scheme obligations during the fixed price period;
• no export of domestic permits (except Kyoto ACCUs) will be permitted during the fixed price period;
• international units can be used to meet scheme obligations during the flexible price period, subject to qualitative and quantitative restrictions. As note above, only eligible international emission units can be used, and during the first five years of the flexible price less than 50% can be used to meet scheme obligations;
• export of domestic permits (except Kyoto ACCUs) will be prohibited while domestic price controls are in place (ie. price floor and ceiling), except as part of a bilateral arrangement;
• unrestricted export of permits will be permitted only when there is no longer a price ceiling in place.

The Government may disallow the use of particular international units with notice, with liable parties holding such units in their registry accounts permitted to use those units for compliance in the compliance year in which the units are disallowed. The CCA will advise on the integrity of international units, and recommend which units should be accepted and which should be prohibited.

The Government has identified linking with the EU ETS and NZ ETS as being in Australia's national interests.

How do I discharge my obligation?

Fixed price period

During the transitional period, liable entities will generally be required to discharge their emissions liability in two parts:

• a progressive surrender obligation of 75% of their emissions obligation by 15 June of the relevant compliance year; and
• a "true up" for the remainder of the obligation by 1 February following the relevant compliance year.

Some exemptions from the progressive surrender obligation apply for small emitting facilities.

Flexible price period

During the flexible price period, emissions obligations for each compliance year must be met by 1 February following the compliance year.

Failure to meet obligations under the scheme will result in the imposition of an emissions charge. During the fixed price period, the charge will be 1.3 times the fixed price of a permit. In the flexible price period, the charge will be twice the average price of permits for that year.

Financial products

The Clean Energy Future package indicates that carbon permits issued under the scheme will be regulated as financial products, as was proposed as part of the CPRS.

A Bill currently before the Senate, the Carbon Credits (Consequential Amendments) Bill, designates ACCUs and eligible international emission units as financial products. It is to be expected that equivalent amendments will be made to regulate permits under the carbon price mechanism as financial products.

This has a number of implications for those looking to trade in, or advise on, such permits or credits. In particular, service provides may be required to be covered by an Australian Financial Services Licence (AFSL) issued by the Australian Securities and Investments Commission.

Companies which are liable entities under the carbon price scheme will not be required to be licensed to trade in permits or credits to meet their own compliance obligation (subject to some limited exceptions which we will explore further in subsequent Insights articles). However, if a person or entity:

• provides advice;
• deals;
• makes a market;
• operates a registered scheme; or
• provides a custodial or depository service,

in relation to the regulated permits or credits, they may need to be covered by an AFSL (or otherwise able to rely upon an available exemption). In addition, if a person or entity operates a financial market or a clearing and settlement facility in relation to the regulated permits or credits they may need to be covered by an Australian Markets Licence or an Australian CS Facility Licence respectively.

However, the Bill has a number of other important implications as it will trigger the application of provisions relating to financial services and markets, and disclosure in the Corporations Act 2001, reporting under the Anti-Money Laundering and Counter-Terrorism Financing Act 2006, and the general consumer protection provisions in Australian Securities and Investments Commission Act 2001. Accordingly, the Anti-Money Laundering rules will apply to those regulated permits and credits, and the inside information and market manipulation rules of the Corporations Act will apply.

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.