Carbon: More than Compliance

For many treasury practitioners outside Europe carbon pricing is still a fringe issue. The market, which was created by the move to price carbon, is already significant and was estimated at US$141.9bn in 20101.

While it is true that negotiations towards an internationally legally binding successor to the Kyoto protocol have progressed very slowly to date, to regard carbon pricing as a temporary impost would be a grave mistake. Around the world numerous domestic and regional initiatives continue to be developed. The need to comply with the supporting regulations means that emissions units will become an unavoidable factor of production for many businesses. And in some jurisdictions, for example in New Zealand, non-compliance can result in both civil and criminal penalties for company officers.

Earlier this month Australia’s Clean Energy Future package passed through the Lower House of parliament. As Australia’s Senate is effectively controlled by the Green party, the expectation is that package will pass into law in early November this year, and Australia will be set to become the latest country to adopt a broad-based carbon price. If it becomes law, a carbon price will apply to many businesses from 1 July 2012.

The political path towards carbon pricing has not been a smooth one for Australia; the issue has already claimed a former prime minister and the leader of the opposition. Indeed it has been little more than a year since Julia Gillard ousted Kevin Rudd following his loss of nerve and deferral of the earlier proposed Carbon Pollution Reduction Scheme.

Gillard’s own minority government has struggled to attract and retain the numbers required to support the bill, which slipped through the Lower House with the slimmest of majority (74 in favour, 72 against). And as a further illustration of the level of regulatory uncertainty, even as the bills were passed, Tony Abbott, the leader of the opposition, took a ‘pledge in blood’ to repeal the legislation, should he get the chance, even specifically warning off emitters from forward contracts.

ETS Down Under

Neighbouring New Zealand has had in place an Emissions Trading Scheme (ETS) since late 2008, when the outgoing Labour government pushed through the necessary legislation in its twilight days. The incoming federal government immediately sought to review the scheme, creating considerable uncertainty for most of 2009, but the review affirmed the ETS as the most appropriate policy tool with which to meet New Zealand’s obligations under the Kyoto protocol and its longer term goal of a 50% reduction by 2050. The ETS now enjoys support from all the major political parties.

Earlier this year, in anticipation of Australia’s carbon price, the Australian Parliamentary Secretary for Climate Change Mark Dreyfus met with New Zealand’s Climate Change Minister Nick Smith. Their discussions acknowledged the long term importance of aligning their respective approaches, and a joint working group has been set up to work towards a trans-Tasman carbon market from 2015.

This will not be without its challenges, however, as the Australian scheme proposed differs from that in place in New Zealand in some very fundamental ways.

While the New Zealand ETS has seen the carbon price determined by market forces from the outset, the Australian approach is to initially fix the carbon price at AUD$23 per tonne in from 1 July 2012, rising by 2.5% in real terms each year until it is allowed to float from 1 July 2015.

Once the price ‘floats’, a price floor will apply for three years, starting at AUD$15 and increasing by 4% real each year. A price cap would also apply, to benchmark the Australian carbon price at not more than AUD$20 above an ‘expected world price’, although this is yet to be defined.

The New Zealand scheme’s design will also pose a challenge to linking. Effectively the NZ ETS has no ‘cap’ on emissions; as allocations to industry reflect output and are made on an ‘intensity’ basis, in theory industrial expansion could lead to an increase in the number of emissions units freely given out by government on an absolute basis.

The Australians, in contrast, will announce the first of their pollution caps in the 2014 budget and thereafter intend to extend the cap by one year each year such that at all times a five-year trajectory is known by market participants.

New Zealand’s ETS is an all-sectors-all-gases approach, and under current legislation will include agricultural emissions – even biological emissions – from 2015 – a world first. However, the Australian scheme specifically excludes emissions from the land and agriculture sectors, but nonetheless offers the ability for landowners to earn carbon credits from alternative land-management options – a carrot, rather than a stick-based approach to changing behaviour.

The New Zealand ETS is unusual, in that much of the potential domestic supply of credits is to come from plantation forestry. Owners of forests planted since 1 January 1990 are able to claim New Zealand Units on an annual basis, to reflect the CO2 sequestered in their trees. While Australian landowners are expected to be able to earn a similar unit, the Australian Carbon Credit Unit (ACCUs) this initiative looks set to largely exclude Australian plantation forestry.

Fundemental Difference

But perhaps the most fundamental difference to date is that once the floating price begins and full trading is allowed. Australia appears to have a clear vision of the emissions reduction effort that should take place domestically; although eligible international units such as Certified Emissions Reductions (CERs) will be able to be imported and used from mid-2015 until 2020, liable parties must meet at least 50% of their annual liability with domestic units.

The New Zealand approach is in stark contrast; no such restrictions have been imposed and emitters are able to surrender eligible international units to cover up to 100% of their liability.

On one hand this makes sense: the rationale for having a market-based mechanism rather than a simple tax regime is to facilitate trade. A tonne of CO2 (and its equivalents) removed from the atmosphere is exactly that, wherever the reduction physically occurs. So by recognising abatement that occurs in other jurisdictions, we can ensure that the lowest cost abatement takes place first, lowering the cost of compliance and pursuing decarbonisation efficiently.

CERs also provide an important source of flexibility for New Zealand emitters, and a link to a much larger, more liquid and exchange-traded carbon market – the European ETS. However a proposal to ban particular kinds of CERs, recently announced by the New Zealand government, highlights the dangers of longer-dated contracting in a market that is still evolving and is of a regulatory construct.

In November 2010 the UN Executive Board (UNEB), the body responsible for approval and ultimately issuance of the CERs, announced that it had concerns with a methodology used to generate CERs from HFC23 destruction. Because of the scale of these emissions reductions projects (HFC23 has a global warming potential that is 11,700 times that of one tonne of CO2) that single methodology was responsible for some 60% of CERs issued to date.

Not content to await the response of the UNEB , in January 2011 the European Commissioner for Climate Action announced that CERs from projects involving the destruction of HFC23 and those involving the destruction of N2O arising from adipic acid production will no longer be acceptable for use in the EU ETS after April 2013. Australia’s Clean Energy Future legislation includes a similar ban on such credits.

With several hundred million such CERs now homeless (save for New Zealand), the New Zealand government has been forced to act swiftly to propose a similar ban, lest the country’s tiny demand of some 20 million credits per annum be satisfied for years to come with credits of questionable environmental integrity, and whose abundance might rapidly drive towards zero the carbon price that is supposed to reform the economy and deliver a lower carbon future. But the action comes too late, as the market is already awash with such credits, and many participants have contracted for forward purchases out to 2013. So nervous emitters long on industrial gas credits, the acceptance of which is no longer assured, must now look on, trying to decide what mitigating actions they might take.

Conclusion

The story gives some insight into the wider difficulty faced by treasurers tasked with procurement of carbon credits. The real challenge in navigating this global carbon market is that it is not really global, but rather a rapidly evolving patchwork quilt of regional and domestic policy approaches, caked with regulatory uncertainty and bogged down with differing rules on eligibility and linkage. Navigating this acronym-filled market can be challenging and expensive, particularly for multinationals or for those seeking entry to new markets.

The lesson is simple: take advice, preferably not just from the banks that seek to sell the carbon credits you need. Adopt the most basic of risk management strategies and take a portfolio approach to the purchase of your emission units. Finally, and above all, understand and acknowledge the relative quality of the purchases you make. Environmental integrity is fundamental to the very survival of the carbon market, so wherever this is questionable you can expect policy-makers working in this area to act accordingly, sooner or later.

1State and Trends of the Carbon Market 2010, World Bank. 

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