Linking the Australian and EU Carbon Markets - an overview of how, when and what this means for business - Clean Air / Pollution

The Government has passed legislation that implements a one-way link between Australia's carbon pricing mechanism and the European Union's emissions trading scheme. The proposal to link the schemes was announced in August 2012 and the extra flexibility it will provide is good news for business. In this article, we provide an overview of how and when the schemes will be linked and explore the implications for business.

On 26 November 2012, the Government passed legislation that implements an interim link between Australia's carbon pricing mechanism (CPM) and the European Union Emissions Trading Scheme (EU ETS) and facilitates linkages to other international carbon trading schemes in the future. In addition, as expected, the $15 price floor for Australian carbon units was removed.

The proposal to link the CPM to the EU ETS was announced on 28 August 2012 by the Australian Government and the European Commission. Initially the link will only be one-way, allowing European Unit Allowances (EUAs)ⁱ to be used to meet obligations under the CPM in Australia from the commencement of the flexible price period (1 July 2015). However, the parties are intending to conclude a formal agreement on a full link by mid-2015, which is to commence no later than 1 July 2018.

In this article we provide an overview of how the interim link will work and comment on the opportunities and challenges for business. If you are not familiar with the CPM, you may like to read our general summary first.

OVERVIEW OF THE LINK

Implementing the Link

The Link has been implemented by bringing EUAs and Australian Issued International Units (AIIUs) (a new kind of unit) within the definition of "eligible international emissions unit" in the Clean Energy Act 2011 (Cth).

Although EUAs are now eligible international emissions units, it is not currently possible to transfer EUAs directly into the Australian National Registry of Emissions Units (the Australian Registry). In these circumstances, there are two ways to enable the transfer of EUAs to Australia – either the Clean Energy Regulator could issue AIIUs to "shadow" EUAs in the EU ETS Registry (AIIUs can be held in the Australian Registry) or the EU ETS Registry could be prescribed as a "foreign registry" in the Australian National Registry of Emissions Units Regulations 2011.

The Australian Government has issued draft regulations which adopt the first of these options up until the commencement of the full link. This would mean that a liable entity would be able to transfer EUAs to Australia (as AIIUs) from the beginning of the flexible price period on 1 July 2015 and surrender them to partially satisfy its obligations under the CPM. These regulations are expected to be introduced by 1 June 2013.

When the full link commences, the Government intends make the necessary regulatory changes to enable EUAs to be directly held in the Australian Registry. At this time, it is intended that all AIIUs will be automatically cancelled and equivalent EUAs held in the Australian Registry will be provided in their place.

Draft Registry Linking Arrangements

In March 2013, the EU Commission and the Australian Government issued a joint consultation paper on Registry options to facilitate linking of emission trading systems, and the Australian Government issued draft regulations.

Under the proposed arrangements, the holder of the EU ETS Registry account where the relevant EUAs are being held will start the transfer of those EUAs by issuing the appropriate instructions to the EU ETS Registry, including nominating an Australian Registry Account to which the equivalent AIIUs will be issued. Behind the scenes the transfer will be validated by both registries and the relevant EUAs will then be transferred into the Australian Government Account in the EU ETS Registry. When this process is complete, the Clean Energy Regulator will issue equivalent AIIUs to the nominated Australian Registry Account.

It will be possible to "swap back" AIIUs held in Australia for the underlying EUAs in the EU ETS Registry via a similar process operating in reverse.

The cancellation or surrender of AIIUs in Australia will require the Australian Government to arrange for equivalent EUAs to be deleted in the EU ETS Registry.

Limits on the use of international units

A liable entity is only entitled to surrender "eligible international emissions units" to satisfy up to 50% of its obligation under the CPM and this limit will still apply until 30 June 2020.

However, the Government may now introduce (by regulation) sub-limits for classes of eligible international emissions units. The first sub-limit to be introduced is a 12.5% limit on the number of Kyoto unitsⁱⁱ that can be surrendered.

The purpose of sub-limits is to protect the price of Australian carbon units (ACUs) from an influx of cheap international units and to ensure that the demand for EUAs in Australia is not undercut by the availability of cheaper units under the Kyoto Protocol.

To give business certainty, the sub-limit on Kyoto units cannot be modified until at least 1 July 2020. The Government must also provide at least two years' prior notice of the introduction of a new sub-limit. Less notice (one year) may be given if a sub-limit is required by an international agreement.

In addition, the Government is proposing to restrict the type of Kyoto units that may be surrendered under the CPM, as set out in recently released draft Regulations that restrict the use of Kyoto units arising from the destruction of trifluoromethane, destruction of nitrous oxide from adipic acid plants, nuclear projects and large scale hydroelectric projects that are inconsistent with EU criteria.

Scrapping the $15 price floor

Previously, auctions of ACUs were subject to a $15 reserve and the surrender of international units in Australia was subject to a surcharge to bring their effective cost up to the reserve.

Although both of these provisions have now been repealed, the Minister still has the power to set a reserve price for each auction of ACUs and to decide how the reserve price will be determined. A determination of the reserve price will be a legislative instrument and can be disallowed by Parliament.

The explanatory memorandum accompanying the recent legislative amendments indicates that the purpose of this power is to enhance price discovery and to ensure that the auction price of ACUs does not significantly diverge from the secondary market price. It may also be used to set a starting price in auctions of ACUs to increase their speed and efficiency.

Changes to the calculation of the equivalent carbon price

The availability of cheaper international units and removal of the price floor means that the effective compliance cost for businesses under the CPM may be less than the average auction price of ACUs.

To ensure that the equivalent carbon price on liquid fuels and synthetic greenhouse gases reflects a lower effective compliance cost, the legislative amendments provide for a "per–tonne carbon price equivalent" to be calculated which takes into account the availability of cheaper international units. This is used in determining the equivalent carbon price imposed on liquid fuels and synthetic greenhouse gases.

IMPLICATIONS FOR BUSINESS

The introduction of the link provides new lower cost compliance opportunities for liable entities, which is undoubtedly good news for business. These new compliance opportunities and the likely impact on the price of ACUs are the key implications of the link for business.

Other significant benefits of the link for business are the possibility that those receiving support under the Jobs and Competitiveness program will receive a higher effective rate of assistance and the potential to use the "per-tonne carbon price equivalent" in commercial agreements.

On the other hand, the key potential downside of the link is the impact of price uncertainty on investment in domestic abatement projects.

We explore these implications in more detail below.

New lower cost compliance opportunities

As both the EU ETS and the CPM allow banking of units, it is possible to purchase EUAs in Europe now with the intention of using them to meet obligations under the CPM in the future. With the prices of EUAs currently at record lows, this is potentially a significant opportunity for business particularly if its commercial preference is to manage carbon price exposure a number of years ahead of liability under the CPM actually accruing.

Further, the EU ETS is a more established market with a well developed long-term pricing structure (including a futures market) which could help businesses manage long-term price risk and, if the CPM is repealed in the future, EUAs purchased now could be on-sold in the EU if they cannot be used in Australia.

However, this strategy is not without risk. Some of the matters to consider when deciding whether to purchase EUAs now are:

the future price of EUAs (which is likely to remain volatile due to continued uncertainty regarding whether and when the European Commission's proposal to "backload" the auction of surplus EUAs to 2019-20 will be implemented) and future exchange rates;
whether to transfer EUAs to Australia as AIIUs as soon as the link is established or wait until just before units must be surrendered. This is a consideration because the transfer and issue of AIIUs is implemented through regulations, which could be disallowed by Parliament following a change of government, potentially stranding AIIUs in Australia. ;
the risk that a sub-limit may be introduced on EUAs or AIIUs; and
the likelihood and price impact on ACUs if the CPM is linked to another foreign emissions trading scheme before the flexible price period commences.

Impact on the price of ACUs

Under the previous arrangements, some predicted that the availability of very low cost Kyoto units would cause the price of ACUs in the flexible price period to immediately fall to the $15 price floor. Although the price floor has been removed, the introduction of the 12.5% sub-limit on Kyoto units will lessen the impact of low cost Kyoto units on the price of ACUs.

Under the new arrangements, the supply of and demand for units in both Europe and Australia will be the primary factors influencing the price of ACUs. This will be influenced by both economic and political factors, including:

the nature of any medium term measures taken by the European Commission to prop up the price of EUAs (e.g. "backloading" proposals), and if any further measures are taken to permanently reduce the number of EUAs (noting that structural changes would require amendment to the EU ETS Directive, which is currently unlikely to occur due to the opposition of countries, such as Poland, that would be significantly affected by an increase in the price of EUAs);
economic growth rates in both the EU and Australia; and
the emissions reductions required by the carbon pollution caps under both the EU ETS and CPM, which will be heavily influenced by the success or failure of negotiations for the second commitment period of the Kyoto Protocol (note that the Climate Change Authority's review of emissions caps under the CPM is due in draft in the 4th quarter of 2013 and must be completed before 28 February 2014).

The Department of Climate Change and Energy Efficiency has acknowledged that the larger size of the EU ETS market means that:
... decisions about the parameters of the European emissions trading scheme will have more influence on the overall price than decisions about the parameters of the Australian emissions trading scheme.ⁱⁱⁱ

The Department also expects that the carbon price that will apply in Australia will be consistent with the carbon price applying in the EU ETS^iv. This means that it is important for businesses participating in the CPM to keep abreast of political and economic events in Europe which affect the EU ETS and the price of EUAs.

A higher effective rate of assistance under the Jobs and Competitiveness Program

If the price of ACUs is higher than the price of EUAs and other eligible international units, Emissions Intensive Trade Exposed businesses could receive a higher effective rate of assistance under the Jobs and Competitiveness Program.

This could be achieved by purchasing and surrendering cheaper eligible international units (Kyoto units and EUAs) and then on-selling free ACUs allocated under the Jobs and Competitiveness Program at the market price.

Use of "per-tonne carbon price equivalent" as an estimate of carbon compliance costs in commercial agreements

In commercial supply agreements between a liable entity and its customers, a liable entity may seek to pass through its CPM compliance costs before those costs have actually been incurred. In these situations, it is likely to be important to the parties that the costs are calculated as accurately as possible. The variety of different units which can be used to discharge CPM liability, and their differences in price, make these calculations challenging.

An advantage of the new arrangements is that there is now a formula for calculating a "per-tonne carbon price equivalent" which takes into account the availability of cheaper international units. The Clean Energy Regulator will use this formula to calculate the "per-tonne carbon price equivalent" every 6 months and this figure could potentially be used as a reference for CPM compliance costs in commercial agreements.

Less certainty for investment in domestic abatement

The $15 price floor on ACUs during the flexible price period provided a clear "bottom-line" return on investment in domestic carbon abatement measures (e.g. under the Carbon Farming Initiative).

The scrapping of the price floor will mean that the price of ACUs (and hence the return on investment in domestic abatement) will be strongly influenced by the price of EUAs, which is currently lower than $15. This exposes investments in domestic abatement to the uncertainties surrounding the future price of EUAs set out above. However, the limits on the use of eligible international units and the likelihood that the price of EUAs will rise in the future will mitigate this risk for domestic abatement investors.

WHAT NEXT?

It is likely that there will be further linkages between the CPM and foreign carbon trading schemes in the future. Potential candidates include New Zealand, where a carbon trading scheme was introduced in 2008; and California, whose scheme is to commence at the beginning of 2013 following the initial auctions of permits this year.

Other potential candidates include Japan's regional carbon trading schemes, such as the Tokyo ETS which started in April 2010; South Korea, where legislation was recently passed to establish a carbon trading scheme starting in January 2015; and China, where pilot schemes are currently being established in a number of provinces and cities (some of which are starting next year) and a nationwide carbon market is to be established by 2015.

Australia's decision to link the CPM first with the EU ETS, the longest running, largest and most established emissions trading scheme in the world, was a good move. The experience will provide valuable lessons that will inform the consideration, negotiation and implementation of links to other trading schemes in the future.

Now that the link with the EU ETS is in place, the most important consequence for business is that Australia's carbon market will be impacted by events in Europe and changes in the European carbon market. Successful management of carbon liabilities under the CPM will now require a comprehensive understanding of what is happening in Europe.

Footnotes

ⁱ EUAs issued for aviation activities are excluded and will not be able to be used to acquit liability under the CPM.

ⁱⁱ Kyoto Protocol units which can be used in Australia include Certified Emissions Reductions (CERs), Emission Reduction Units (ERUs), Assigned Amount Units (AAUs), and Removal Units (RUs).

ⁱⁱⁱ Commonwealth Senate Economics Legislation Committee, Report on the Clean Energy Amendment (International Emissions Trading and Other Measures) Bill 2012 [Provisions] and related bills, October 2012, paragraph 3.44.

^iv Commonwealth Department of Climate Change and Energy Efficiency, Regulatory Impact Statement on Interim Partial (One-Way) Link Between the Australian Emissions Trading Scheme (ETS) And The European Union Emissions Trading System (EU ETS), 3 September 2012, page 6.

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.


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