Australia's forthcoming carbon pollution reduction scheme

Australia's Carbon Pollution Reduction Scheme, scheduled for a 2010 launch, has already spurred forward trading in carbon pollution permits in the country's over-the-counter (OTC) markets, even though the design of the Scheme is yet to be finalised.

The handful of (very) early trades to date has established a starting point for factoring the cost of carbon pollution into critical investment decisions and forward trading within carbon intensive sectors.

Forward markets are essential to 'informed' investment decision-making, be it in the form of primary market (asset formation) or secondary market (asset allocation) activity.  In the absence of accurate forward prices, either form of investment activity can be inefficient.  Informed investment decision-making uses forward prices to determine the economics of investment.  The existence of forward market price discovery underpins capital formation and asset allocation through risk reduction and by providing attractive returns for investors. 

A significant hurdle to investment is the inability for investors to hedge their risks and obtain certainty on their investment returns.  In the absence of transparent forward prices underpinning efficient markets, investors will require far higher rates of return to protect themselves from adverse market events.  Often these hurdles prove to be too high for projects to be economically justifiable, with the consequence being that the investment is not made.  Exchanges, such as ASX, play a critical role in reducing the cost of capital that encourages investment, capital management and portfolio efficiency activities.

Legislative certainty, slated for the third quarter of 2009, will be the catalyst for the standardisation of OTC and futures products needed to facilitate robust price discovery and meaningful levels of market liquidity (risk transfer).

Subject to the timely passage of legislation, price discovery and liquidity (risk transfer) within the forward markets for pollution permits should be well established before the first auction of pollution permits currently scheduled for the first quarter of 2010.

Australia's emissions profile

In 2006, Australia's net greenhouse gas emissions using the Kyoto accounting provisions were 576 million tonnes of Co2-equivalent. The sectoral breakdown of these emissions is shown in figure 1.

Figure 1 - Australia's national emissions profile in 2006.
Source: National Greenhouse Gas Inventory 2006, Department of Climate Change

The bulk of Australia's emissions come from stationary energy (predominately electricity generation but also fuels consumed in the manufacturing, construction and commercial sectors), transport and agriculture. With the inclusion of the agricultural sector deferred until at least 2015, Australia's electricity generators alone will initially account for almost 50% of total compliance obligations under the Scheme.

What bodes well for an efficient market to service Australia's Scheme is that the 21 generators in the National Electricity Market (NEM), other large compliance buyers and the financial trading community supporting them are au fait with trading OTC and futures markets for related energy markets, such as electricity, to manage their price and counter-party risks.

Figures 2 and 3 illustrate the growth of electricity futures and options at ASX since their inception. Given that all of the participants in Australia's financial markets (including almost every compliance buyer under the forthcoming Scheme) are existing users of its infrastructure, the ASX anticipates that its futures and options markets for carbon pollution permits will emerge much faster and quickly become significantly larger than those for electricity.

Figure 2 - Electricity Futures & Options: Volumes 
Source: www.d-cyphatrade.com.au

Figure 3 - Electricity Futures & Options: Open Interest
Source: www.d-cyphatrade.com.au

The forthcoming scheme

The aims of the Carbon Pollution Reduction Scheme are to:

• help Australia meet its emissions reduction targets in the most flexible and cost-effective way;
• support an effective global response to climate change; and,
• provide transitional assistance for the most affected households and firms.

The following summarises the preferred positions on the design of Australia's Scheme as outlined in the Government's Green Paper released in July. 

Coverage

• The Scheme will cover the stationary energy, transport, fugitive emissions, industrial processes and waste sectors, and all six greenhouse gases counted under the Kyoto Protocol from the time the Carbon Pollution Reduction Scheme begins.
• In general, the emissions threshold for direct obligation under the Scheme would apply to all entities with facilities which have direct emissions of 25,000 tonnes of carbon dioxide equivalent (CO2-e) a year or more.
• The Government is disposed to include agriculture by 2015 and will make a final decision on this by 2013.
• Reforestation (as defined for the first commitment period of the Kyoto Protocol) would be included, on a voluntary basis, from Scheme commencement in 2010.
• Given broad coverage there is limited scope for offsets.

Emissions targets and scheme caps

• The Government will set 5 years of firm caps extended annually or as per an international agreement;
  • a further 10 years of gateways (ie minimum and maximum cap levels) extended every 5 years to let industry and financial markets know the upper and lower bounds of what the cap will be;
  • firm caps will not be finalised until Q1 2010 so to factor in the outcome on negotiations on the post Kyoto Period at Copenhagen in late 2009; 
• At the end of 2008, in the context of the white paper, the Government will announce a medium term national target within upper and lower bounds for 2020 together with broad guidance on the pathway to it to give investors and market participants information on directions and retain sufficient flexibility for the Government.
• As stated in the paper "the government's intention is that there would be scheme caps for each year to 2015, followed by a gateway at 2020 and a gateway at 2025". In 2013 there will be scheme caps for each year up to 2018, with a gateway at 2020 and 2025, with the 2030 gateway to be set for the first time following a review in 2015.

A safety value

• In a bid to ensure a smooth transition in the early years of the Scheme, the Green Paper proposes capping the carbon price in the first five years. The price cap would be 'set high enough so to ensure a very low probability of use'.

The allocation of permits

• No less than 70% of permits (including some future date stamped permits) to be auctioned.
• The first auction would take place as early as is feasible in 2010, prior to the start of the Scheme. 
• Four years of vintages would be auctioned (current vintage plus advance auction of three future vintages). 
• Auctions would be held each quarter with the fourth one month after the financial year in the lead up to the relevant surrender date. The advance auction of future year vintages would occur once each year.
• Over the long term the Government proposes moving to 100 per cent auctioning.

International linking

• Liable entities would be able to meet their obligations by using eligible Kyoto units (JI, Removal Units and CERS) for compliance in the Scheme, limited to a maximum percentage of each entity's obligation.
• It is not proposed to accept Assigned Amount Units (AAUs) (albeit this position to be reviewed in light of international developments). 
• In order to facilitate a smooth start, the Scheme would prohibit the export of Australian permits.
• The Green Paper reiterates Australia's position will be to argue for the inclusion of avoided de-forestation in a post Kyoto Period framework.

Banking and borrowing

• Unlimited banking of permits would be allowed under the Scheme.
• The Scheme would permit a limited amount of short-term borrowing by allowing liable entities to discharge up to a certain percentage (less than 5 per cent) of their obligations by surrendering carbon permits dated from the following year.

Compensation

• All revenues from auctioning are to be used to assist households and business with the adjustment to the Scheme.
• The Government intends to shield motorists from higher fuel bills by decreasing fuel taxes on a cent for cent basis.

Commentary on the proposed positions

Since the release of the Green Paper the public debate has appropriately centred around: the level and form of transitional assistance (compensation) for business and households; the commencement date for the Scheme; and what caps on carbon pollution should be imposed on the economy over-time relative to efforts by other countries.

The proposed early commencement and level of auctioning, together with the existence of forward markets, should enable price discovery to quickly establish the marginal cost of abatement across all impacted firms covered by the Scheme including those firms receiving transitional assistance in various forms. The auctioning of future year dated carbon pollution permits will benefit the efficiency of forward price discovery and risk transfer.

Setting caps (the supply constraint) for five years will support a robust forward market. The ability to bank permits for use in future years will ensure (if the market is efficient) that the price for the immediate compliance year reflects the market's expectations on the future value of pollution permits. In this context, the proposed five year reviews and gateways provide a balance between providing some certainty for business whilst retaining some flexibility to reflect the outcome of on-going international negotiations on climate change.

The proposed price cap, whilst not ideal (in the absence of a make good provision it is a form of tax), will not diminish the role of the financial markets to help firms to raise capital and mitigate their compliance risks.  The safety value, endorsed by the earlier Prime Minister's Emissions Trading Task Group and National Emissions Trading Taskforce (NETT) proposals, is intended to assist with a smooth transition to having a carbon constraint on the economy. That said, the proposal for unlimited banking may undermine the temporary price cap (and the environmental integrity of the Scheme) if the market prices the future value of permits at a higher level. It is worth noting that the price cap implies that the cost of making up any difference between national emissions and an internationally negotiated target will be borne by Government, eg tax payers.

How are the carbon markets likely to evolve in Australia?

The fundamentals of the proposed Scheme design (namely broad coverage, unlimited banking, the central role of auctioning and the early of issuance of permits) together with the sophisticated risk management practises of the larger compliance buyers in Australia bodes well for a vibrant OTC and futures market. Australia already has emissions reporting legislation, which together with the unlimited ability to bank permits for future use, addresses the deficiencies in the first phase of Europe's emissions trading scheme.

As per the experience in Europe, early trades have commenced in the OTC market prior to the Scheme design, commencement date and trajectory being finalised. Significantly, these early trades have established a starting point for factoring carbon into critical investment decisions and forward trading in carbon intensive sectors such as electricity. Unsurprisingly, most participants in these early trades have a requirement to 'pass through' their forthcoming carbon exposure to customers and/ or hedge their renewable energy portfolio.

Liquidity in the forward markets will continue to build as details regarding the Scheme design and start date becomes more certain. It is important to note that key aspects of Scheme design may not be resolved until the Bill is actually passed. The recent difficulties in passing the Climate Change Bill in New Zealand highlights just how politicised the passage of such a Bill can become.

Legislative certainty will be the catalyst for the standardisation of OTC and futures products needed to facilitate robust price discovery and meaningful levels of market liquidity (risk transfer).

Of the estimated 1,000 firms with compliance obligations under the forthcoming Scheme, the 50 largest compliance buyers (accounting for 80% of total carbon pollution) will be active users of forward markets. Smaller compliance buyers are more likely to manage their carbon risks through intermediaries such as banks like they currently do when managing their interest rate, currency and commodity price exposures.   

The Treasury modelling due in October 2008, together with further details in the White Paper that will be published before the end of 2008, should assist the market to price forward.  The signalling of a shallow trajectory, as predicted by many pundits, will reduce the demand for eligible Kyoto units that may be value higher in other schemes, eg the EU ETS. Conversely, a steep trajectory (or the unlimited banking provision) may see carbon pollution permit prices reach or exceed prices in markets for eligible Kyoto units.

In its first few years, it is likely that the market price for carbon pollution permits in Australia will be driven by the Scheme Caps and their inter-play with inter-related energy markets more so than the international market for eligible Kyoto units.

Figure 4: The likely evolutionary path of emissions trading in Australia
 Source: ASX

It will be the price discovery and risk transfer occurring within the forward markets for pollution permits that will enable firms, regardless of their size, to make informed investment decisions and in turn innovate and compete to provide carbon inclusive goods and services at least cost.

For investors, the price of emission permits will rise to a level that rewards investment in abatement comparable to other investment opportunities. The proven depth of Australia’s debt and equity markets are particularly well placed to help raise the requisite capital from investors that firms need to develop and/ or deploy new low-emissions technologies. In Victoria alone there is currently more than $3 billion in gas, clean coal and solar projects under consideration.

Investors in new and existing companies are likely to be beneficiaries of their investment in the development and deployment of new clean technologies including carbon capture and storage, hot rocks, solar, wind, tidal, carbon sequestration and new modes of more carbon efficient transport.

The final form of Australia’s Scheme will be refined over the coming months to reflect feedback on the options and preferred approaches set out in the Green Paper.

Irrefutably, the cost of investment uncertainty due to the lack of a market mechanism to manage exposure to the cost of carbon pollution outweighs the cost of climate change or mitigation efforts. It is therefore in Australia’s national interest to facilitate the smooth introduction of a market price for carbon pollution sooner rather than more abruptly at a later date.

As soon as the Government provides legislative certainty, robust price discovery and meaningful levels of market liquidity (risk transfer) within the forward markets for pollution permits it will facilitate better informed investment.

More information

Visit the emissions trading section of the ASX website for more information.