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Focus: Detailed analysis of White Paper: emissions reduction targets and the use of international units

30 January 2009

In brief: Following on from our summary of the Federal Government's White Paper on its Carbon Pollution Reduction Scheme, Australia's Low Pollution Future, Partner Grant Anderson (view CV) and Lawyer John Henderson discuss in greater detail the emissions reduction targets and the use of international units proposed for the Scheme, and give some international context to these proposals. This is the fifth in a series of articles that examines in more depth the principal proposals contained in the White Paper.

• Emissions reduction targets
• Use of international units
• International linking
• International opportunities for Australian companies
• The next step

Emissions reduction targets

Medium and long-term targets

Under the Kyoto Protocol, Australia is required to limit its greenhouse gas emissions to an average of 108 per cent of 1990 levels over the period 2008–12. While the emissions reduction commitments that Australia might adopt under a post-2012 international agreement are not yet known, in order to provide industry with a degree of medium-term certainty the Federal Government has decided to establish an emissions reduction target for Australia for 2020. This target is expressed as a range, rather than as a specific number, so as to provide some flexibility to accommodate the outcome of any international negotiations.

Specifically, the Government has committed to reducing Australia's greenhouse gas emissions by between 5 and 15 per cent below 2000 levels by 2020. This is consistent with stabilising greenhouse gas concentrations at 550ppm and 510ppm respectively by around 2100, and implies an initial carbon price of between A$23/tCO₂-e and A$32/tCO₂-e (in nominal terms). Once projected population growth is taken into account, these targets are broadly comparable to the commitments of the European Union and the United Kingdom (as well as proposals President Barack Obama made during the United States election campaign) as shown in the following table:¹

The precise 2020 emissions reduction target that the Government ultimately chooses within this range will depend on international developments: while a 5 per cent reduction represents Australia's minimum commitment, regardless of other countries' actions, the Government has signalled that it is amenable to moving closer to a 15 per cent reduction 'in the context of global agreement under which all major economies [including China and India] commit to substantially restrain emissions and advanced economies [ie developed countries] take on comparable reductions to Australia'.² This range represents the Government's assessment that, while stabilising greenhouse gas concentrations at around 450ppm would be in Australia's interests, a global commitment to the emissions reductions necessary to achieve this stabilisation concentration is unlikely in the near future.³

In setting this range, the White Paper emphasises that Australia faces relatively greater structural adjustment costs than many other developed countries, particularly given its projected population growth, its large share of energy and emissions-intensive industries, and its heavy reliance on fossil fuels. This seems a dangerous path to pursue, as it then opens the way for other developed countries to plead special circumstances that would justify them being given relatively more favourable treatment under any international agreement. Nonetheless, it reflects the Government's previously expressed view that the allocation of emissions allowances between countries should take the form of a uniform percentage reduction from each country's reference case.⁴ Moreover, a comparison based on per capita emissions reductions simply serves to highlight the need for Australia to make a bigger effort to reduce its emissions and, in any event, Australia's high emissions are not necessarily linked to its population.⁵ The Government's approach also downplays the fact that the country's Kyoto Protocol commitment for 2008–12 has enabled Australia (unlike most other developed countries) to increase its 1990 level of emissions.

The Government is relying on this commitment, and the corresponding caps under the Carbon Pollution Reduction Scheme (CPRS), to demonstrate Australia's credibility on climate change matters, and so enhance the nation's ability to influence international negotiations for a post-Kyoto climate change agreement. However, a number of commentators maintain that the Government's proposed emissions reductions are not sufficiently ambitious to encourage other countries to cooperate in achieving an international agreement with strong emissions reduction targets.⁶ Having said this, some industry participants are arguing that even achieving a 5 per cent reduction is likely to be difficult, given the current global financial crisis.⁷

In the White Paper, the Government has specified Australia's indicative emissions trajectory for the period 2010–11 to 2012–13 as a percentage of its 2000 emissions levels: 109 per cent (for 2010–11), 108 per cent (for 2011–12) and 107 per cent (for 2012–13). The Government will specify Australia's indicative emissions trajectory for the period 2013–14 to 2014–15 in 2010 at the same time as it announces the initial caps and gateways for the CPRS, and each subsequent year it will extend this trajectory by a further year.

The White Paper also confirms the Government's commitment to a long-term goal of reducing Australia's greenhouse gas emissions to 60 per cent below 2000 levels by 2050.

Both the 2020 and 2050 emissions reduction targets are net targets, in the sense that they include emissions reductions purchased overseas and exclude emissions reductions that occur in Australia but are sold overseas.

Caps and gateways under the CPRS

The annual emissions caps set under the CPRS will be less than those implied by Australia's indicative emissions trajectory because, unlike this trajectory, the CPRS does not cover all sources of emissions and all emitters. However, the CPRS caps will be set in line with that trajectory. Specifically, the CPRS cap for a year will be calculated as the difference between the indicative emissions trajectory for that year and the projected emissions for that year that are not covered by the CPRS. To ensure that these uncovered emissions are reduced as part of Australia's emissions reduction effort, the Government will introduce alternative mitigation measures (such as mandatory emissions standards and the required use of low emissions technologies and practices) that are intended to elicit abatement in these uncovered emissions at a cost that is comparable to the carbon price under the CPRS.

The annual emissions caps are a fundamental element of the CPRS as they determine the number of carbon permits (Australian emissions units (AEUs)) that are to be issued each year. Emissions that exceed the cap in any year will need to be covered by the surrender of international units or additional AEUs (such as AEUs issued for reforestation or synthetic greenhouse gas destruction or AEUs issued under the transitional price cap). Importantly, the CPRS caps apply to emissions from all sectors covered by the CPRS, rather than to individual sectors or liable entities.

The Government will announce the annual emissions caps that are to apply under the CPRS five years in advance, and each subsequent year it will announce the annual cap for the fifth year out.⁸ This means that, in 2010 (before the CPRS commences but after the Copenhagen conference⁹). the Government will announce the CPRS caps for the first five years of the CPRS (ie those that will apply during the period from 1 July 2010 to 30 June 2015).¹⁰ The cap for the year commencing 1 July 2015 will then be announced in 2011, at the same time as the announcement of the indicative national emissions trajectory for 2015–16, and so on.

The Government will also set gateways (ranges within which future CPRS caps will fall) to provide some certainty over its longer-term cap-setting intentions. In this regard, it will announce up to 10 years of gateways beyond the minimum five years of caps. The gateways will be extended by five years every fifth year, at which time the first five years of gateways will be narrowed. This means that, in 2010 (and at the same time as it announces the first five years of CPRS caps), the Government will announce gateways for each of the years in the period 2015–16 to 2024–25. The gateways for 2025–26 to 2029–30 will then be announced in 2015, at which time the gateways for 2020–21 to 2024–25 will be narrowed.

If an international agreement results in Australia adopting more stringent emissions reduction commitments than those implicit in the announced caps and gateways, the Government will purchase international units to cover any deficit, rather than change the announced caps and gateways. Such caps and gateways will only be able to be changed where a new sector (such as agriculture) becomes covered by the CPRS.

Unlike the indicative emissions trajectory, the CPRS caps and gateways will be set out in legislation, albeit in the form of regulations. Further, the CPRS legislation will provide that, if regulations are not in place to specify a cap by the commencement of the year for which it is to apply, the cap for that year will be 1 per cent less than the previous year's cap. It is not clear how gateways will be set if the necessary regulations are not in place at the relevant time.

Use of international units

The following units are recognised under international arrangements:

• certified emissions reductions (CERs), which are generated under the Kyoto Protocol Clean Development Mechanism where a developed country undertakes an emissions reduction project in a developing country – China is currently the major generator of CERs;
• emissions reduction units (ERUs), which are generated under the Kyoto Protocol Joint Implementation arrangements where a developed country undertakes an emissions reduction project in another developed country – the previous USSR and Eastern European block countries, such as the Ukraine and Bulgaria, have the most potential to generate ERUs;
• assigned amount units (AAUs), which represent the emissions entitlements allocated to developed countries under the Kyoto Protocol; and
• removal units (RMUs), which are issued under the Kyoto Protocol for net removals of greenhouse gases from land-use, land-use change and forestry activities.

Liable entities will be able to satisfy their obligations under the CPRS not just by surrendering AEUs but also by surrendering eligible international units. The following international units are eligible for this purpose:

• CERs that are issued in the first Kyoto commitment period (2008–12) or are issued after the end of that period but are generated by projects established during it – These CERs are able to be used by the Federal Government to acquit Australia's international emissions reduction obligations after the end of this commitment period. Conversely, at least initially, CERs that are generated by projects established after the first Kyoto commitment period will not be eligible for surrender to meet CPRS obligations. This is because there is no guarantee that such CERs will be recognised under a post-Kyoto international agreement, and so accepting these CERs into the CPRS would expose the Federal Government to the risk that it would not be able to use them to meet its international obligations. Temporary CERs (tCERs) and long-term CERs (lCERs) will also not be able to be used to meet CPRS obligations (irrespective of when they are generated) because these units, which are generated from afforestation and reforestation activities, have a limited life and so would need to be replaced by the Federal Government on their expiry. The exclusion of tCERs and lCERs is consistent with the approach adopted under both the European Union and New Zealand emissions trading schemes.
• ERUs that are issued in the first Kyoto commitment period – Like the eligible CERs referred to above, these ERUs are able to be used by the Federal Government to acquit Australia's international emissions reduction obligations after the end of the first Kyoto commitment period. Conversely, at least for the time being, ERUs that are generated after the end of this period will not be eligible for surrender to meet CPRS obligations because such ERUs are not currently recognised under an international agreement. ERUs that have been converted from RMUs will also not be eligible for surrender to meet CPRS obligations after the end of the first Kyoto commitment period because such ERUs cannot be used by the Federal Government to meet Australia's international obligations after the end of that period.
• RMUs that are issued in the first Kyoto commitment period – These RMUs will only be eligible for surrender to meet CPRS obligations where they are surrendered during that period (such RMUs cannot be used by the Federal Government after that period to meet Australia's international obligations).

At least initially, AAUs will not be eligible for surrender to meet CPRS obligations. This is for two reasons. First, there are concerns about the environmental credibility of some AAUs as countries whose economies have contracted considerably since 1990 (principally the previous USSR and Eastern European block countries) have a number of 'hot air' AAUs that are well in excess of their actual emissions. Second, there are concerns about the likely effect of AAUs on Australia's carbon price because there is expected to be a considerable surplus of AAUs, which will significantly depress prices. This prohibition on the use of AAUs is broadly consistent with the approaches adopted under the European Union and New Zealand emissions trading schemes, which do not permit the unrestricted use of AAUs. However, the Government will review this prohibition in 2012–13, in the context of any international agreement that replaces the Kyoto Protocol.

In a modification of the position in the Green Paper, there will be no quantitative restrictions on the number of eligible international units that may be surrendered to satisfy obligations under the CPRS. This will provide liable entities with unlimited access to international units (ie a cheaper source of compliance) where the price of AEUs exceeds the price of these international units. The current price of CERs on the secondary market is around A$20.50/tCO₂-e.¹¹ This compares with an expected initial price of AEUs under the CPRS of between A$23/tCO₂-e and A$32/tCO₂-e, which suggests that it may not be long before Australia's carbon price will be set by international prices.¹² Unlimited access to cheaper international units also means that Australia will be able to achieve its emissions reduction targets by buying overseas emissions reductions rather than by reducing its own emissions – indeed, its own emissions could even increase but be covered by imported international units. This has attracted some criticism.¹³ While access to international units is advantageous to liable entities under the CPRS, it is important to note that, under the Kyoto Protocol, there are restrictions on the amount of CERs and ERUs that can be carried over from the first commitment period. If the number of international units the Government and other participants hold in Australia's national registry exceeds any such restriction, this restriction will be applied pro rata to all such holders, ie participants run the risk that they will be precluded from using a portion of their CERs and ERUs in a subsequent period.

It is quite conceivable that the kinds of international units that may be surrendered under the CPRS will be changed from time to time, depending on whether such units become, or cease to be, recognised under international agreements as units that can be used by the Federal Government to meet Australia's international emissions reduction obligations.

It should also be noted that, like AEUs, eligible international units will be regulated as 'financial products' under Chapter 7 of the Corporations Act 2001 (Cth), with the result that entities that trade in them may need an Australian financial services licence.

International linking

By accepting international units into the CPRS, the CPRS will effectively be linked (albeit indirectly) to other emissions trading schemes, such as the European Union and New Zealand schemes, which also accept these kinds of units. Looking to the future, the CPRS has been designed using internationally accepted principles so that it can be linked more directly with other emissions trading schemes in the longer term in such a way that permits specific to those schemes can be used to acquit CPRS obligations and/or Australian AEUs can be used to acquit obligations under those schemes. Linking in this way has the potential to provide liable entities under the CPRS with access to an even greater pool of lower cost international emissions reductions to offset their domestic liabilities. The possibility of linking the CPRS with other emissions trading schemes will be addressed at the five-yearly strategic reviews of the CPRS (or at such interim reviews as the Government convenes from time to time). In this regard, the Government will provide at least five years' notice of the establishment of a bilateral (reciprocal) link with another scheme, except where:

• an independent review finds that establishing the link will not have a significant impact on the price of AEUs; and
• the responsible minister agrees to a shorter notice period.

Linking the CPRS to another emissions trading scheme will require consideration of (among other things) the compatibility of the two schemes, the relative levels of mitigation commitment, and the relative stringency of the monitoring, reporting, verification, compliance and enforcement mechanisms. However, at least in the initial years of the CPRS (2010–11 to 2014–15), an impediment to linking is likely to be the transitional price cap that will apply under the CPRS.

At least in the early years of the CPRS, the Government will also not permit AEUs to be converted into international units and effectively exported from Australia. This is because, where the transitional price cap applies and international prices exceed that price cap, liable entities will have an incentive to convert their AEUs into international units (which they will sell at the higher international price) and purchase AEUs to meet their CPRS obligations at the (lower) price cap. Having said this, the Government recognises that the export of AEUs is likely to increase domestic abatement in Australia (through reducing the supply, and therefore increasing the price, of AEUs) and to attract foreign capital into Australia. Accordingly, it has left open the possibility that, in the longer term, it will allow the export of AEUs following a review and notification process that is similar to that described above in respect of scheme linking.

The introduction of emissions trading that covers all emissions sources and sectors, and under which permits are freely traded between countries, is a key assumption that underlies Commonwealth Treasury's modelling of the economic impacts of the CPRS. In the absence of such trading, the costs to Australia of achieving its emissions reduction targets will increase.

International opportunities for Australian companies

An alternative to purchasing CERs and ERUs on the secondary market is for liable entities under the CPRS to invest in a project that generates those emissions reductions and to acquire the units that result from them. This also gives investing entities an opportunity to commercialise low emissions technologies in developing countries that have an expanding market.

In the case of Clean Development Mechanism (CDM) projects (which generate CERs), there are a number of criteria that a project must satisfy. One of these is that the project must be approved by the Designated National Authority of the developed country participant. Although some Australian entities are already participating in CDM projects, this has been made difficult by the fact that, up until now, the Federal Government has not been issuing letters of approval authorising entities to participate in the CDM. Instead, Australian entities have had to seek approval from other developed countries participating in the CDM project.

In 2009 the Department of Climate Change will be appointed as Australia's Designated National Authority for the purposes of authorising participation by Australian entities in CDM projects. Similarly, in the case of Joint Implementation (JI) projects, the Department of Climate Change will be appointed as Australia's Designated Focal Point. This will make it easier for Australian entities to take part in CDM and JI projects overseas, and to generate international units that can be used to meet their obligations under the CPRS.

However, the Government has decided that Australia will not itself host any JI projects, at least in the short term. This is because JI projects in sectors covered by the CPRS are not likely to deliver any additional abatement to that delivered in response to the CPRS. In so far as JI projects in sectors that are not covered by the CPRS are concerned, the Government will decide in 2012–13 whether Australia will host such projects, bearing in mind that (although these sectors are not covered by the CPRS) it is intended that they will be subject to complementary measures designed to reduce their emissions. The existence of these kinds of measures may bring into question the additionality of those JI projects.

The next step

The Federal Government is proposing to release an exposure draft of the CPRS legislation for public comment in late February 2009. If you would like further information in regard to the White Paper proposals that will form the basis of this draft legislation, or any other information, please contact any of the people below.

Footnotes

1. White Paper, p.3-3; see also pp.3-9 to 3-10.
2. White Paper, p.4-17.
3. If such a commitment were to be made in the context of a post-Kyoto agreement, this would only be reflected in post-2020 domestic targets, and the Government would need to purchase eligible international units to make up any difference between the pre-2020 domestic targets and Australia's international obligations for that period.
4. White Paper, p.4-10.
5. The Australian Financial Review, 'Rudd misread the weather', 18 December 2008; The Age, 'The heat is on over policy', 20 December 2008.
6. Eg see The Age, 'Garnaut slams climate plan', 20 December 2008; 'Warming gets cold shoulder in Canberra', 29 January 2009.
7. The Australian Financial Review, 'Rudd defends cautious climate plan', 16 December 2008.
8. This five-year period may be extended to the end of any longer international commitment period that may be agreed as part of an international climate change agreement.
9. The outcomes of this conference will inform the cap-setting process, as will the reports to be lodged for the first reporting year (2008–9) under the national greenhouse and energy reporting scheme.
10. The first two years of caps, for 2010–11 and 2011–12, will be aimed at meeting Australia's commitment under the Kyoto Protocol.
11. The recent fall in the price of CERs is partly the result of companies covered by the European emissions trading scheme selling off European Union allowances to raise funds, given the current global financial crisis, thereby creating an increase in the supply of carbon permits: The Australian Financial Review, 'Carbon price corrodes policy', 29 January 2009; 'Power fall-off brings credits rort claim', 29 January 2009.
12. The Australian Financial Review, 'Rudd defends cautious emissions reduction plan', 16 December 2008; 'Scheme a link to opportunity', 16 December 2008; 'Rudd links cautious stance to economy', 17 December 2008.
13. Eg see The Age, 'Warming gets cold shoulder in Canberra', 29 January 2009.

For further information, please contact:

• Grant AndersonPartner, Melbourne
  Ph: +61 3 9613 8928
  Grant.Anderson@allens.com.au
• Chris SchulzPartner, Melbourne
  Ph: +61 3 9613 8772
  Chris.Schulz@allens.com.au
• John GreigPartner, Brisbane
  Ph: +61 7 3334 3358
  John.Greig@allens.com.au
• Ben ZillmannPartner, Brisbane
  Ph: +61 7 3334 3538
  Ben.Zillmann@allens.com.au
• Matthew SkinnerPartner, Singapore
  Ph: +65 6535 6622
  Matthew.Skinner@allens.com.au
• Jim ParkerPartner, Sydney
  Ph: +61 2 9230 4362
  Jim.Parker@allens.com.au
• Darren MurphyPartner, Singapore
  Ph: +65 6535 6622
  Darren.Murphy@allens.com.au
• Campbell DavidsonPartner, Sydney
  Ph: +61 2 9230 4465
  Campbell.Davidson@allens.com.au