03 Apr 2014

Eight questions the Emissions Reduction Fund White Paper needs to answer

by Brendan Bateman, Alison Packham

Ideally, the White Paper for the Emissions Reduction Fund should deliver details on how the ERF will achieve its three guiding design principles.

The White Paper for the Emissions Reduction Fund (ERF) is expected to be released in April, accompanied by draft legislation, and industry is hoping it will resolve some outstanding queries.

A Green Paper outlined the Government's options for the design of the ERF, the centrepiece of the Direct Action Plan (DAP) to reduce Australia's emissions, and sought public comment.

The White Paper will reveal the outcome of this consultation and the Government's policy position on the DAP's design. Ideally, it should deliver details on how the ERF will achieve its three guiding design principles:

  • Lowest-cost emissions reductions;
  • Genuine emissions reductions; and
  • Streamlined administration,

and answer eight important questions about the DAP's operation.

What we know about the ERF

The ERF is intended to be the focal point of the Government's DAP to reduce emissions. It will operate within a restricted budget ($1.55 billion for three years and $1 billion in the fourth year) to produce low cost emissions abatement through a commercial reverse auction process. The ERF will use the current methodologies of direct action policies, primarily an expanded version of the Carbon Farming Initiative (CFI). It will approve additional CFI methodologies that will apply at both a facility and activity level.

The Clean Energy Regulator (CER) will be administer the fund and will issue Australian Carbon Credit Units (ACCUs) for verified emission reductions.

At the reverse auction, the Government will enter into contracts to purchase ACCUs with eligible entities who bid the lowest cost ACCUs. The CER will be responsible for setting the benchmarks for the auction prices. These contracts will span five years and the Government will not pay for the ACCUs until they are issued, i.e. until abatements are actually achieved.

The Green Paper puts forward various issues for stakeholder comment. However, the detail missing from the Government's preferred design of the ERF as articulated in the Green Paper has raised further questions regarding the practical operation of the ERF and its integration with Australia's international emission reduction obligations. We will have to wait and see whether the White Paper and draft legislation address these additional issues.

Question 1: How will the ERF encourage early participation?

The critical issue with participation is securing funding for participants, particularly given that the grant provided to projects through the ERF will not be provided until the emission abatements are achieved. Banks have warned that they will be cautious to commit to provide funding for ERF projects.

The viability of the ERF to achieve meaningful emissions reductions will be compromised if there is an undersupply of emissions reductions projects or insufficient scale of projects, particularly if some projects would not be viable without upfront payment and these projects have difficulty securing funding. The strength of the market for ACCUs will also impact on the level of participation in the ERF.

The five year contract period may deter companies that have longer-term investments and whose emission reductions will take longer to realise. So too will the fact that the policy imperative at this time is only to achieve a 5% reduction target by 2020. This will drive funding to those projects that can deliver abatement quickly and potentially distort the market away from those projects or methodologies that deliver abatement over a longer period. The Government could consider having options to renew in the terms of the contract to attract these potential participants.

Question 2: How will additionality be calculated and guaranteed?

Ensuring that the levels of emission abatement achieved through the ERF are in fact over and above business as usual levels is complex. The data supplied by National Greenhouse Energy Reporting Scheme (NGERS) will be instrumental in ascertaining additionality in relation to facility-based methods, however, reductions in emissions can be attributed to factors other than the investment in technology or new practices, such as a decrease in demand or commercial factors. The additionality test currently used for the CFI is to be utilised at an activity level. The White Paper will need to identify the preferred methodology for ensuring that abatements generated through the ERF are in fact genuine and additional.

Question 3: What are the details of the "safeguard mechanism"?

We know that the ERF is to be supported by a "safeguard mechanism" to come into effect on 1 July 2015. The details of this mechanism have not been disclosed and given the expected commencement date, may not be disclosed in the upcoming White Paper.

The Green Paper indicates that the "safeguard mechanism" is a proposed tool to incentivise businesses to keep their emissions below historical levels. It is intended to operate to safeguard the value of funds expended under the ERF and to provide businesses with a stable and predictable policy landscape in which to make new investments.

The Green Paper indicates that the "safeguard mechanism" will only operate over facilities, whose emissions are recorded under NGERS. However, as the ERF is also expected to operate at an activity level, the safeguarding of emissions reductions at an activity level under the ERF is unclear.

Potential elements of the "safeguard mechanism" include:

  • Treatment of scope 2 emissions;
  • Treatment of new technologies;
  • Capping emissions, which could involve a series of declining baselines for facilities;
  • Imposing a financial penalty for emissions above baselines, though the Government has indicated this is not its preferred option; and
  • Offset mechanisms involving the purchase of ACCUs to meet the shortfall of an entity's contractual obligations. This could include the purchase of both domestic and international credits.

Question 4: What are the compliance options for non-performance of ERF contracts?

Securing emissions reductions under the ERF is reliant on the performance of contracts by participants. The Green Paper cited make-good provisions as a potential measure to ensure compliance. Requiring non-compliant entities to purchase ACCUs and surrender these to the Government to meet their contractual commitments makes the most sense as a way to develop a domestic market for ACCUs.

A make-good provision may act as a deterrent from entry into ERF contracts as it represents an increased risk for the project. An alternative to a make-good obligation would be for an early termination right if a project is unlikely to reach its abatement target. However, this too introduces commercial uncertainty for project proponents and their financiers. Other compliance mechanisms might include non-monetary penalties.

Question 5: How will the auction process be run and benchmark prices be set?

The rules of the auction process will probably be set out in guidelines rather than in the ERF legislation, to allow the frequency of the auctions and the auction process to be adapted as the level of participation is known.

The CER will set benchmark prices using market data, which will not be disclosed prior to the auction. This is problematic as it assumes that project proponents are able to establish and operate a project where the return is unknown and will bid in the auction because the opportunity is available. Disclosing the value of participation in the ERF would assist potential participants in structuring their project strategies and reduce the cost of doing so, would send a price signal in relation to future auctions and would also reduce the administrative costs of the ERF in assessing the eligibility of potential participants.

The Government has not provided detail as to how the CER will set these benchmarks. Setting benchmarks too low will increase the risk of contract failure, as participants who bid low to win the auction may then fail to deliver the project. Setting benchmarks at an appropriate price is also key to encouraging a vibrant market for ACCUs.

Question 6: Will the ERF meet Australia's international emissions reduction obligations?

While the Green Paper recognises that the ERF is only part of the Government's DAP to reduce emissions, it is not clear that the voluntary participation of the ERF will be sufficient to meet Australia's obligation under the Kyoto Protocol to achieve a 5% reduction on 2000 levels by 2020. The abatement that the ERF will achieve is unknown and depends on levels of participation, baselines and compliance.

The Green Paper requested submissions on complementary measures that the Government can employ to assist in meeting Australia's emission reduction goals. Several submissions have emphasised the role that the Renewable Energy Target scheme (RET) will play in the electricity supply sector. As this question of complementary direct action measures is separate to the operation and management of the ERF, it is likely that the White Paper will not provide much detail on the Government's preferred complementary measures. The RET is subject to a separate Government review process, to take place this year.

Question 7: Will the timing of the ERF review be realigned to complement international reporting requirements?

The Green Paper contemplates that the review of the ERF will occur in late 2015. This in itself may create uncertainty for participants in the ERF, which would only have been in operation for 12 months or so. At COP19 in Warsaw in 2013, Australia committed to providing the UNFCCC with its post-2020 emissions reduction targets in early 2015. These international ambition targets should be the result of an analysis of Australia's emissions reductions programs, including the ERF. In any event, as the ERF is only expected to commence in mid-2014, it may be that as of early 2015, the ERF will have generated insufficient activity to assist Australia's international submission. If the ERF review occurs after Australia has submitted its post-2020 ambition, ideally these levels will be taken into consideration in this review.

Question 8: How will the Government manage delay in the Carbon Price Mechanism (CPM) repeal process?

The Government wants the ERF to commence operation on 1 July 2014 to align with the removal of the CPM. However, as the Senate voted on 20 March 2014 to reject the CPM repeal bills the Government might have to wait until the new Senate commences sitting in July 2014 – although it's far from certain that this new Senate will pass these bills either.

Nonetheless, the Government has committed to the implementation of the ERF on 1 July 2014, with no contingency plan in case the CPM remains law as at that date. Commerce and industry both require certainty as to the emissions reductions requirements that will apply over the short term.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.