INTRODUCTION
The introduction of the Carbon Pollution Reduction Scheme (CPRS) in July 2010 will fundamentally alter the regulatory environment within which entities that are liable under the scheme will operate.
In particular, liable entities will be subjected to a new suite of obligations aimed at reducing the level of national greenhouse gas emissions, including obligations to monitor and report emissions and to acquire and surrender a carbon pollution permit (permit) for every tonne of emissions produced each year.
The scope of entities that may be liable under the CPRS is broad, including:
- electricity generators
- fuel suppliers for road and rail transport
- entities involved in the production, processing, transport, storage and distribution of coal, oil and gas
- manufacturers, mineral processors and chemical and metal producers
- importers of synthetic greenhouse gases, importers of equipment containing synthetic greenhouse gases and domestic synthetic greenhouse gas manufacturers
- owners and operators of landfill sites, waste water treatment plants and solvent and clinical waste incineration facilities
The CPRS will also have consequences for financiers that have lent money to or have invested in entities that are liable under the scheme.
The CPRS will impose additional costs on borrowers, which may include the cost of acquiring permits and increased expenditure on capital items to reduce emissions or increase energy efficiency.
The facility agreements and supporting security documents between liable entities (in their capacity as borrowers) and their financiers could call for a review of the loan arrangements if these costs will or could have a significant impact on the borrowers' assets and/or revenue stream.
A lender's review may entail assessment of the impact of CPRS obligations on the borrower's with the obligation in the facility agreement to comply with all relevant laws and obligations, which would include the CPRS once legislation implementing the scheme is passed.
The lender may also need to consider the possibility of taking security over the permits, which the borrower is obliged to acquire under the CPRS.
There is currently some uncertainty surrounding the precise nature of the scheme that the government intends to introduce to reduce national greenhouse emissions. Nevertheless, the White Paper is likely to form the basis for the government's approach.
Accordingly, we consider that it would be prudent for financiers to use the White Paper as a basis to undertake a comprehensive risk assessment of the implications of the CPRS for their facility agreements with entities that may be liable under the CPRS, particularly in light of the current global economic crisis.
Such a risk assessment will involve consideration of each of the relevant elements of the CPRS to determine the likely impact and probability of consequences for liable entities.
The risk assessment may need to be reviewed when the CPRS legislation is finally released. This paper will help guide financiers in undertaking that risk assessment and will assist in determining what action needs to be taken, if any, to protect their financial position prior to the implementation of the CPRS.
FRAMEWORK FOR A FINANCIER'S RISK ASSESSMENT OF THE CPRS
Objectives
It is important to articulate the objectives underlying a risk assessment of the CPRS as this will affect the nature of the assessment undertaken. More specifically, the objectives will help determine the criteria to be used to assess the overall level of risk associated with a particular aspect of the scheme.
For financiers, the objective is clear: to determine whether obligations under the CPRS will or may affect the borrower's assets and/or revenue stream.
This will entail determination of whether a borrower is liable under the CPRS, the extent of liability and whether such liability will or could have a significant impact on the borrowers' assets and/or revenue stream.
Some CPRS obligations will entail a greater risk of affecting borrowers assets and/or revenue stream than others. A comprehensive risk assessment will allow financiers to rank CPRS obligations and monitor how individual borrowers are addressing the high risk provisions.
This will place financiers in a better position to decide upon appropriate action to ensure borrowers adequately address the risk before and after the CPRS comes into effect so as to avoid an adverse impact upon their business.
Criteria
'Risk' is most commonly defined in terms of the expected impact that may be caused by a situation or event and the probability of that situation or event occurring. Generally speaking, the greater the impact and probability, the higher the overall risk.
Applying these elements in the CPRS context, a financier's risk assessment will entail consideration of the actual or possible impact of each relevant element of the CPRS on the borrower's assets and/or revenue stream and the probability of that impact occurring.
Impact Factors
There will be several dimensions to the consideration of impact under the CPRS. In particular, it will be important to understand both:
- the nature of the impact: that is, whether or not the particular CPRS obligation affects the borrower's assets and revenue stream and, if so, how; and
- the degree of impact: that is, the extent to which the CPRS obligation affects the borrower's assets and revenue stream.
Financiers need only be concerned if obligations under the CPRS are of a kind that will significantly affect the borrowers' assets and/or revenue stream in the medium to long term.
There are a number of obligations in the CPRS that impose on-going costs on liable entities, some of which may be significant. These types of obligations are likely to be ranked by financiers as having a 'high impact' and, depending upon the probability of the impact eventuating, need to be closely monitored by financiers.
Obligation To Acquire And Surrender Permits
Under the CPRS, entities are free to emit greenhouse gases at whatever level they choose. However, if they do decide to emit, they are obliged to acquire and surrender a permit for every tonne of greenhouse gases emitted in a particular year.
The impact of the obligation to acquire and surrender permits on a borrower's assets and revenue stream will depend upon a variety of factors, including:
- the number of permits that must be obtained (corresponding to the level of the borrower's emissions)
- the timing of permit acquisition
- the prevailing price for permits
Large emitters, like the coal-fired generators, will bear the heaviest liability under the CPRS. These entities have limited ability to pass on the costs of meeting their liability under the CPRS to consumers because they compete with other less emissions-intensive generators whose CPRS liability will not be as great. Consequently, the impact on their assets and revenue of this CPRS obligation is likely to be significant.
Obligation To Monitor And Report Emissions
Liable entities are required to monitor their emissions according to defined methodologies to determine the extent of their CPRS obligations each year.
They are also required to keep appropriate documentation and records to enable reported emissions to be assured. O nce liable entities have monitored and estimated their emissions, they are obliged to report them.
Compliance with these CPRS obligations will involve the initial costs of establishing and installing monitoring and reporting mechanisms as well as the ongoing costs of monitoring emissions.
Depending upon the sector in which a particular borrower is operating and its relative size, these costs could impose a significant burden.
For example, facility-specific emissions measurement could be prohibitively costly for small-to-medium sized landfill owners and operators.
Despite the relatively small size of these entities, some may still be covered under the CPRS given that a lower emissions threshold is applicable to metropolitan and urban landfill sites.
Probability Factors
The probability that a particular CPRS obligation will have a significant impact upon a borrower's assets and/or revenue stream will depend upon a variety of factors, which largely revolve around the individual circumstances of the borrower.
These factors include:
- Terms of the loan agreement: the trigger thresholds for loan default may vary from sector to sector and from borrower to borrower. In general terms, the more highly leveraged the borrower, the lower the trigger thresholds may be. Nevertheless, ultimately, the terms of the relevant loan agreement must be assessed on a case-by-case basis.
- Borrower's debt structure: the borrower's overall debt structure, level of leverage, and the impact of CPRS on its cash flow and earnings may affect the borrower's ability to obtain additional finance to meet its CPRS obligations.
- Emissions abatement options available to the borrower: the abatement options might be limited for some entities and/or might be prohibitively expensive – for example, gas capture and storage for coal-fired generators. The more limited the abatement options, the greater the financial burden the CPRS will impose on the borrower.
- Competitive environment in which the borrower is operating: the more competitive the environment, the more limited the options for the borrower to pass on CPRS compliance costs to its customers.
Other Relevant Factors
There are a number of other factors that should be borne in mind when undertaking a risk assessment under the CPRS.
Interplay Of Elements Of The CPRS
It will be important for financiers to have a good understanding of the interplay of the various CPRS provisions so that an overall risk assessment can be undertaken. Specifically, with respect to a particular borrower's liability to acquire and surrender permits under the scheme, financiers will need to take into account matters including:
- Whether or not the borrower is entitled to any adjustment assistance under the scheme, for example, in its capacity as a member of an emissions-intensive trade-exposed industry or strongly affected industry. If so, the borrower's CPRS liability is likely to be reduced.
- Whether or not the borrower has access to Kyoto units to demonstrate CPRS compliance. Kyoto units are units related to the reduction of emissions that are recognised and tradeable under the Kyoto Protocol, including under the Clean Development Mechanism for offset projects in developing countries and Joint Implementation for offset projects in developed projects. Depending upon the price and availability of Kyoto units, the borrower's access to such units may also alleviate its CPRS liability.
- The prevailing price cap for permits in Australia, which will effectively set an upper limit on the quantum of liability that a borrower will face.
Dynamic Assessment
Given the known or possible changes to some key elements of the CPRS over time, it will be essential for financiers to have mechanisms in place to ensure that the risk assessment is dynamic and reflects those changes if and when they occur.
Some elements of the CPRS that will or may change over time include:
- Assistance to coal-fired generators under the Electricity Sector Adjustment Scheme: Under the scheme, the most emissions-intensive electricity generators will receive free permits to the value of $3.9 billion, to be allocated over a five year period. Assistance will terminate after this period has expired, which will, therefore, have an impact on the beneficiaries' financial position. Financiers need to account for the termination of such assistance in their risk assessment.
- CPRS targets: The government has made a minimum, unconditional commitment to reduce emissions by 5% below 2000 levels by 2020. However, the possibility has also been flagged that this target could be increased to 15% if a global agreement is struck under which all major economies commit to substantially restraining emissions and all advanced economies take on reductions comparable to Australia. If the target is increased, the number of permits available for purchase will be less, which will drive up the permit price and, therefore, increase entities' liability under the scheme.
- Permit price: Following the implementation of the CPRS and as the carbon market (where permits will be traded) evolves, the permit price is likely to change. Financiers' risk assessment should take into account the possible changes to the permit price over time.
Contextual Assessment
Finally, the risk assessment should be undertaken in the context of the broader policy and legal environment in which the CPRS will operate. Other policy initiatives, such as the Mandatory Renewable Energy Target Scheme (MRET) may increase or decrease the overall CPRS risk for a particular borrower.
For example, entities that are liable for emissions from landfill sites under the CPRS may be able to reduce their liability and simultaneously generate renewable energy certificates (RE Cs) under the MRE T scheme if landfill gas is converted to renewable energy.
In addition, account should be taken of other environmental obligations imposed upon the borrower under other legislative instruments or contained in the relevant facility and security documents, which may be complementary or supplementary to obligations contained in the CPRS.
MANAGING RISKS CREATED BY THE CPRS
A comprehensive CPRS risk assessment should provide financiers with a good sense of:
- what the risks are and their relative significance
- how those risks are likely to evolve over time as the CPRS matures
The risk assessment should also assist financiers in determining what pro-active action, if any, might be needed to monitor and respond to the CPRS risks.
Accordingly, prior to the introduction of the CPRS, financiers should consider:
- incorporating the results of their risk assessment of the scheme into their business plans to account for the various risks
- verifying that borrowers have undertaken their own CPRS risk assessment to identify the nature, extent and impact of CPRS obligations on their loan obligations
- requesting borrowers to disclose the steps they are taking to manage the costs of compliance with the scheme
- instituting regular credit reviews with borrowers to help address CPRS risks
In some cases, the facility agreement may need to be amended to ensure that the risks associated with CPRS compliance are appropriately allocated between the borrower and the financier.
In addition, it may be appropriate to incorporate an additional covenant in the finance documents requiring the borrower to provide regular reports on the current and future impact of the CPRS and on the borrower's compliance with its CPRS obligations.
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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.