Penalties and price caps: How do they work together?

By Graeme Dennis.

Key Points:
Failure to acquit sufficient permits in a compliance year will give rise to both a "make-good" obligation in the next year and a non-deductible civil penalty.

The Green Paper discussed in general terms both a penalty and a price cap, and the White Paper gives us some specifics. However, it takes a bit of digging to understand how the penalty and price cap work together and should be reflected in permit trading contracts.

In each compliance year of the trading scheme (ending 30 June), liable entities will be required to submit a return reporting their emissions liabilities by 15 October, and then surrender to the Regulator sufficient permits (which have a vintage year of the just-passed year or earlier) to cover that liability.

What if they do not have sufficient permits? How do the penalty and price cap provisions interact?

1. Parties will be allowed to use up to 5% of "next year" vintage permits to acquit for a compliance year [see 8.4 of the White Paper].
2. After that, failure to acquit sufficient permits in a compliance year will give rise to both a "make-good" obligation in the next year [policy position 7.30] and a non-deductible civil penalty [policy position 14.8].
3. The non-deductible civil penalty will be set by regulations for each compliance year. Unless the regulations prescribe a lesser amount, the non-deductible civil penalty will be an an amount equal to the benchmark average auction price for permits auctioned in the previous financial year, plus 10 per cent [see 7.6.4 of the White Paper].
4. Accordingly, the effective cost of non-compliance will be about 250% of the benchmark auction permit cost (100% for the cost of buying a make-good permit, and 110%/(1-0.3) for the non-deductible penalty). Therefore, it is only if market prices for permits in the period coming up to compliance exceeded about 250% of the expected auction permit cost that a liable entity might opt for non-compliance as a cheaper course than buying in the market to cover its shortfall.
5. The above rules apply for the life of the scheme. However, in the first 5 years there will also be a "safety-valve" open to persons with a shortfall (policy position 8.10, and see 8.6.2 of the paper). They will have the opportunity (between the final reporting date (15 October) and the final surrender date (15 December)) to buy from the government an unlimited amount of special "price-cap" permits at the fixed price of $40/tonne (escalated at 5%pa real). These price-cap permits will be non-transferable, and non-bankable, available only for use by the purchaser in the year of purchase, but they will be deductible for income tax purposes similar to other permits. Purchase of the "price-cap" permits will enable entities to meet their surrender obligations at a capped price and therefore to avoid the more onerous make-good and non-deductible civil penalties that would otherwise be imposed for a shortfall.
6. The Government's plan to allow unlimited acquittal of international permits means that the prospect of having an absolute unavailability of supply in a compliance period is much reduced, and is in a sense another safety valve. You go offshore if you cannot buy locally.
7. The consequences of the above position for contracts in relation to the trading of permits is that, unlike REC and NGAC schemes, the scheme penalty price is not going to be a useful proxy for a party's loss or damage for non-delivery, and a market price measure (even an international market measure) is going to be much more appropriate.

For further information, please contact Graeme Dennis.