Making the EITE workable: The Government's draft CPRS Regulations

What the k^a_t (EI^a x AP^ia_t) + k^a_t (EP^a x EAFⁱ_t x AP^ia_t) + k^a_t (NGP^a x NGAFⁱ_t x AP^ia_t)?

No, this is not the latest computer virus infecting your hard drive but the formula to be used to determine the number of free Australian emissions units (AEUs) to be given to qualifying applicants under the Emissions-Intensive Trade-Exposed assistance program of the Carbon Pollution Reduction Scheme. But what does it mean?

On 19 June 2009, the Federal Government released important details of how the emissions-intensive trade-exposed (EITE) assistance program, established by Part 8 of the Carbon Pollution Reduction Scheme Bill 2009, will work in practice. The draft Carbon Pollution Reduction Scheme Regulations 2009 (released with a commentary paper) are open for public comment until 14 August 2009.

The Bill contains very little in the way of detail about the program, simply noting that regulations may formulate a program for the issue of free Australian emission units (AEUs) in respect of activities that, under the program, are taken to be emissions intensive trade exposed activities.

The draft regulations released in mid-June contain the first eight activities that will be eligible for EITE assistance: carbon black production, bulk flat glass production, glass container production, methanol production, silicon production, white titanium dioxide pigment production, zinc smelting, and newsprint manufacturing. Further activities are intended to be added to the list of qualifying EITE activities in the draft regulations.

The Government also released an explanatory paper, "Establishing the eligibility of activities under the emissions-intensive trade-exposed assistance program", explaining the assessments that have been made under the program to date.

Allocation of free AEUs

The allocation of free AEUs is intended to provide assistance in relation to an EITE entity's increase in direct and certain indirect costs resulting from the commencement of the CPRS.

The general principle underlying the allocation of free AEUs is that they will be allocated on the basis of a portion of a baseline level of direct emissions, electricity use and the use of natural gas as a feedstock from an activity, calculated by using the applicant’s previous year’s production of the relevant product. Special provisions are made for new entrants and where there will be a significant expansion of a facility.

The method of calculating the number of free AEUs to be issued to an eligible person for a qualifying EITE activity is set out in Division 5 of Part 9 of the draft regulations, and involves the application of a complex formula. The proposed regulator, the Australian Climate Change Regulatory Authority, may only issue free AEUs to an applicant using this formula.

The formula can basically be broken up into three parts where:

• k^a_t (EI^a x AP^ia_t) represents the amount of free AEUs in respect of direct emissions based on production
• k^a_t (EP^a x EAFⁱ_t x AP^ia_t) represents the amount of free AEUs in respect of increased electricity costs based on production; and
• k^a_t (NGP^a x NGAFⁱ_t x AP^ia_t) represents the amount of free AEUS in respect of increased natural gas feedstock costs based on production

Activity assistance rate

In respect of each of the three components of the formula the assistance rate for an activity (k^a_t) is applied. The assistance rate is determined by whether it is classified by the regulations as a high or moderately intensive emissions intensive activity.

These rates are initially 90 percent and 60 percent respectively, or 94.5 percent and 66 percent allowing for the recently announced Global Recession Buffer (these additional buffers apply only for the first five years of operation of the program).

The assistance rates reduce by 1.3 percent per annum. For instance, for a highly-emissions intensive activity with an assistance rate of 94.5 percent in 2011-12, the assistance rate reduces to 93.2 percent in 2012-2013 and 92.1 percent in 2013-2014.

Direct emissions

The entitlement to free AEUs based on direct emissions is determined by reference to the baseline level of direct emissions per unit of production for the relevant product (EI^a). The product relates to the activity prescribed in Part 3 of the draft regulations as EITE, such as glass containers, methanol, carbon black etc. This baseline is multiplied by the volume of product produced in the previous financial year, adjusted for expected annual production (AP^ia_t).

Electricity

In the case of assistance for the increased costs of electricity, the baseline level of electricity per unit of production of the relevant product (EP^a) is multiplied by the electricity allocation factor (EAFⁱ) and the adjusted volume of production (AP^ia_t). The electricity allocation factor relates to the effect of the carbon price on the price of electricity. That factor is generally set at 1 unless modified for large electricity users (which we look at below).

Natural gas

Similar to the calculation of assistance for increased electricity costs, assistance is also provided for increased costs in natural gas feedstock used in the production of the relevant products. In this case, the baseline level of natural gas feedstock used per unit of production (NGP^a) is multiplied by the natural gas feedstock allocation factor (NGAFⁱ_t), which relates to the effect of the carbon price on the price of natural gas, and the adjusted volume of production (AP^ia_t). The allocation factor is determined by the place of production so, in the case of NSW, the factor is 15.7 tonnes of CO₂-e per terajoule, in Victoria, 4.4 tonnes, Queensland 3.2 tonnes and WA 4.1 tonnes.

The "X" factor for large electricity users

Division 6 of Part 9 of Schedule 1 to the draft regulations deals with large electricity users and pre-existing contracts. This division permits a person to apply to the Authority in respect of a facility that consumed more than 2000 gigawatt-hours of electricity in the financial year starting 1 July 2008, for a large user energy certificate. If issued, the certificate will modify the electricity allocation factor for the EITE activity carried on at that facility. The purpose of the certificate is to address the problems that may arise from long-term electricity supply contracts where there may be impediments to the pass through of increased electricity costs resulting from the commencement of the CPRS.

In addition to providing the Authority with copies of the pre-3 June 2007 contracts, the applicant must also detail how the CPRS has changed the price for electricity under that contract and submit a legal opinion from senior counsel as to how the provisions of the relevant pre-existing contract deal with increases in costs resulting from the CPRS.

The Authority is authorised to determine what is referred to as the "X" factor which represents its reasonable estimate of the carbon cost pass-through in the relevant contracts. The "X" factor is then factored into another formula to determine the level of assistance in respect of increased electricity costs resulting from the CPRS. The result of that calculation is the modified electricity allocation factor.

The application to modify the electricity allocation factor must be made before 1 January 2011, otherwise the Authority must use an electricity allocation factor of zero in respect of the EITE activity for the first five years of the CPRS. So, there is obviously incentive to apply for the certificate.

The Department of Climate Change has advised us that if the pre-3 June 2007 pre-existing power supply contracts have been amended at all before 1July 2010, the Department considers them not to be "still in force" for the purposes of Division 6, and therefore no longer a relevant pre-existing contract for the purposes of Division 6 to which an "X" factor applies.

The effect of this is that if an EITE activity has a large pre-existing power supply contract, and it offers only a small pass-through revision to the power supply contract which is accepted so that the original contract is not still in force, the EITE operator will be able to apply for and receive 100 percent of the compensation attributable to increased power prices from the CPRS, notwithstanding that it may not be passing on 100 percent of the increased power prices. Even if it negotiates to pass on some of the EITE compensation attributable to power prices, it may have a windfall gain in relation to that component not passed on.

Rather than constituting an incentive for the EITE operator to pass on the EITE compensation to its power suppliers under pre-existing contracts, it is an incentive to withhold as much compensation as possible while still negotiating a minor change to the contract.

In our opinion it would be more equitable if, where the relevant pre-existing contract is non-reviewable for CPRS purposes, the power supplier was entitled to apply for that component of the EITE compensation attributable to the scope 2 emissions constituted by the supply of power under that non-reviewable pre-existing contract. This would provide an incentive to the EITE operator to negotiate the review of the pre-existing contract, and would prevent the award of windfall compensation in respect of assumed increased costs under contracts that are not in fact reviewable.

As a transitional matter, this solution has a precedent. The solution that we propose is similar to the solution adopted for pre-existing non-reviewable contracts at the time of the introduction of the GST - the recipient of the supply was denied an input tax credit, and the supplier received the benefit of a GST exemption, until the parties reviewed the contract under which the supply was made, to allow for an increase in the GST cost levied on the supplier. In the case of the GST, there was a mutuality of incentive to renegotiate, which does not yet exist under Division 6 of the EITE regulations.

What else is covered by the draft regulations?

The draft regulations also contain details of the assurance standard required for applications for assistance under the program, how applications will be assessed, details of relinquishment obligations triggered by closure of a facility and "true up" mechanisms where allocations have been made to new entrants and for significant facility expansions based on expected production.

Stakeholder responses to the draft regulations

The Government has indicated that it is interested in hearing from stakeholders on the practical implications of the draft regulations, and whether there is need for any additional clarity or certainty in relation to the program. It is particularly interested in receiving feedback on the compliance burden imposed by the program, and whether there are any unintended outcomes by the application of the rules-based approach of the program. Industry stakeholders are invited to provide details of situations that have arisen in their industry over the past ten years, if necessary, in confidence, to demonstrate any unintended outcomes or implementation difficulties.