• Introduction
• All recent publications
• Climate Change publications
• Climate Change services

Focus: Climate Change – March 2008

Professor Garnaut releases emissions trading scheme proposals

In brief: Professor Ross Garnaut has released his discussion paper on the design of an Australian emissions trading scheme. The proposals contained in the paper will be an important input into the design of the Federal Government's scheme and some of them are likely to engender vigorous debate. Partner Grant Anderson (view CV) reports.

• Background
• Coverage
• Targets
• Allocation of permits
• Price cap
• Offsets
• Administration
• Renewable energy schemes
• Way forward

Background

The Federal Government recently announced its detailed timetable for the introduction of emissions trading¹ :

This is an ambitious timetable, particularly as the National Greenhouse and Energy Reporting System (NGERS) will only have delivered one year's worth of data by 2010. Teething problems in NGERS, or the need to amend NGERS to accommodate the Australian emissions trading scheme (eg to require the upstream reporting of emissions for transport), might conceivably delay the date the scheme is able to come into operation. This has been recognised by the most recent report of the National Emissions Trading Taskforce (the 2008 NETTS report).²

The ultimate design of Australia's emissions trading scheme will draw on a range of inputs, including the reports by the National Emissions Trading Taskforce³ and the previous Federal Government's Task Group on Emissions Trading⁴, the Garnaut Review's final report (which is to be delivered in September 2008), Treasury's modelling on the economic impact of an emissions trading scheme under different emissions trajectory scenarios (due to be completed in the middle of 2008), and the outcomes of the consultations contemplated by the Federal Government's timetable (above).

Professor Garnaut's proposals in his discussion paper on the design of the proposed Australian emissions trading scheme will also be a valuable contribution to this process, although there are early indications from the Federal Government that not all of his recommendations, some of which were foreshadowed in his interim report⁵ and public speeches, will be adopted.

Set out below are the key proposals contained in Professor Garnaut's discussion paper (the discussion paper).

Coverage

The Federal Minister for Climate Change and Water has stated that Australia's emissions trading scheme will have 'maximal coverage of greenhouse gases and sectors, to the extent that this is practical', and that it should cover more than 70 per cent of Australia's emissions.⁶ Consistent with this, the discussion paper proposes that all six Kyoto gases should be covered: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride. This means that emissions of all six Kyoto gases would need to be covered by permits issued under the scheme, and that offsets could be created for reducing or sequestering the emissions of those gases.⁷

Similarly, the discussion paper advocates that the scheme should cover (ie require permits to be held for) emissions from the stationary energy, transport (including domestic civil aviation and sea transport), industrial processing and waste sectors, with emissions from the agriculture and forestry sectors being included (possibly even progressively) as measurement and monitoring issues are resolved. The inclusion of waste is consistent with the 2008 NETTS report, which has suggested that an emissions trading scheme could cover landfill sites that accept at least between 12,000 and 22,000 tonnes per annum of municipal and commercial waste. Moreover, the uncovered sectors could still contribute to the scheme by creating domestic offsets through emission reduction activities undertaken in those sectors. This is particularly so in the forestry area where (despite the second-rate treatment accorded to forestry offsets by the European Union emissions trading scheme and the Kyoto Protocol) a baseline and credits approach could be adopted.

Like previous reports, the discussion paper recognises that it will not always be feasible to impose the obligation to acquit emissions permits on the source of those emissions. In some cases (such as the use of petroleum for transport or the use of natural gas by smaller end users) an upstream point of obligation will be necessary (eg at the point of import or production of the relevant fuel, or at the point of payment of excise). However, this means that care will need to be taken to avoid double liability, for example:

• as where the petroleum is not used for transport (which entails the combustion of that fuel) but is used for plastics manufacture (which does not entail petroleum combustion and so does not result in the emission of greenhouse gases); or
• as where the natural gas is supplied to both large users (eg gas fired power stations that would be directly liable for greenhouse gas emissions from the combustion of gas at their power stations) and small users (who do not have such a direct liability).

This could be addressed by a netting out or crediting system, but the operation of this system would depend on the ability to link the downstream use of the petroleum or gas with a particular upstream entity. Moreover, depending on the type of scheme adopted, it may be necessary to amend NGERS to accommodate the reporting of scope 3 emissions (eg emissions resulting from the downstream supply of liquid fossil fuels).

Targets

As previously foreshadowed by Professor Garnaut, the discussion paper does not consider it sufficient to merely establish an end year target (eg a target for the level of greenhouse gas emissions to be achieved by 2020 or 2050). This is because there are a number of different emissions trajectories that can be used to achieve such a target, but each trajectory will result in different cumulative emissions and stabilisation concentrations. For this reason, the discussion paper proposes the establishment of an emissions budget that is directed at achieving a specified stabilisation concentration, accompanied by annual targets (or at least multi year targets for a specified number of years).

While the discussion paper does not propose any specific targets (the Garnaut Review will recommend a 2020 target in its final report), it does propose four trajectories for Australia's greenhouse gas emissions:

• a short-term trajectory for the period from 2010 to 2012, derived from Australia's Kyoto first period commitment of 108 per cent per annum above 1990 levels;
• a trajectory for the period from 2013 to 2020, based on Australia's emission reduction commitments being similar to those of other developed countries;
• a trajectory for the period from 2013 to 2050, with an end year target of a 60 per cent reduction of greenhouse gas emissions from 2000 levels (this being the Federal Government's current commitment), which Australia would follow once other developed countries have accepted a comparable commitment; and
• a trajectory for the period from 2013 to 2050, with an end year target of between, say, a 70 per cent and 90 per cent reduction of greenhouse gas emissions from 2000 levels, which Australia would follow once a comprehensive international agreement (involving both developed and developing countries and targeting a stabilisation concentration of between 450ppm and 550ppm CO²-e) has been reached.

These trajectories would dictate the release of emissions permits over time, in accordance with annual caps set five years in advance, with Australia moving between trajectories on five years' notice. The trigger for a change in trajectory would be increasingly stringent emissions reduction targets adopted at the international level (which, it is assumed, would incorporate changes in both scientific knowledge and technological and economic developments). To allow the flexibility necessary to enable cost effective emissions reduction to occur within the associated multi year emissions budget, the discussion paper proposes:

• unlimited banking, ie the ability to use permits issued for a past year to acquit liabilities in a later year. This is consistent with the approach advocated in previous reports and has wide acceptance by government and industry;
• borrowing, ie the ability to use permits issued for a future year to acquit liabilities in an earlier year. This is a far more contentious proposal because of the risk of delays in emissions reduction and of future non compliance.⁸ To address this issue, the discussion paper suggests that an independent Carbon Bank (see below) should be authorised to lend permits, within prudent limits, to creditworthy parties who would be required to provide security and repay the loan by returning a permit and also paying interest (possibly expressed as a fraction of a permit); and
• the ability to use both domestic offsets and international offsets or permits (eg Clean Development Mechanism (CDM) credits and New Zealand or European Union units) to acquit obligations under the Australian emissions trading scheme.

To the extent that Australia's international commitments are (temporarily) more stringent than the caps applicable to Australia's domestic emissions trading scheme, the Carbon Bank would purchase international offsets.

Significantly, the discussion paper points out that, to be internationally acceptable, any emissions budget (and its associated emissions trajectory) will need to be based on per capita emissions. These are currently much higher for Australia (approximately 17-20tCO² pa) than for the major developing country emitters such as China (3tCO² pa) and India (1tCO² pa).

Allocation of permits

The discussion paper favours the auctioning of emissions permits because auctioning will result in a more efficient allocation of permits, facilitate price discovery, and yield revenue that can be used to address market failures (eg through funding research and development or public infrastructure) or to provide assistance to both low-income households and communities that are adversely affected by the structural changes that will be driven by a carbon price.

To date, the Federal Government's position has been that both trade exposed, emissions intensive (TEEI) industries and 'strongly affected' industries should be compensated for the impact on them of an emissions trading scheme.⁹

However, the discussion paper strongly opposes the allocation of free permits for this purpose because of the complexities of establishing the baseline emissions profile against which a business' allocation of free permits is determined, the difficulty of collecting the necessary data, the susceptibility of the allocation process to political pressure, the non transparent value of the compensation, and the need to avoid penalising 'early movers'. Somewhat ominously, the discussion paper states that the introduction of a free permit allocation system¹⁰:

could have a material effect on the time required for introduction of an ETS. Indeed, it would seem to be impractical for Australia to administer a free allocation scheme prior to introduction of the ETS in 2010.

Nonetheless, the discussion paper recognises that TEEI industries are price takers (ie they must accept the world price for their goods) and that the introduction of an Australian emissions trading scheme may lead to a material misallocation of resources in those industries because it will restrict their output below that which would be produced if the world price incorporated a carbon price. Accordingly, the discussion paper suggests that compensatory payments should be made to firms in TEEI industries on the basis of the product of:

• the difference between the relevant world price and that which would prevail under an international carbon price similar to that applying in Australia; and
• the trade exposed sales of the relevant firm,

discounted for subsequent years by an emissions efficiency factor that is intended to represent industry best practice. These payments would be calculated and made yearly by the Carbon Bank and could be met by the allocation of free permits (the important point being that, because of the contemporaneous nature of the calculation and payment, such an allocation of permits is tantamount to the payment of cash). Irrespective of the merits of this approach, it must be noted that the payments calculation methodology, which will vary between products and technologies, is likely to be quite complicated and suffers the same drawbacks in that regard as the development of a methodology for the allocation of free permits.¹¹

Conversely, the discussion paper reiterates Professor Garnaut's previously expressed views that there is no economic or environmental reason to compensate industries in the non traded sector (the 'disproportionately affected' industries) for the reduction in profits they may suffer as a result of the introduction of an emissions trading scheme. Indeed, the discussion paper questions whether their profits will in fact be reduced, stating that producers will generally be able to pass on the carbon price to consumers. Having said this, the discussion paper accepts that the introduction of a carbon price will impact substantially on emissions intensive electricity generators, leading to their displacement in the merit order by gas fired baseload generators and their eventual replacement by gas fired and renewable generation. The point the discussion paper seeks to make is that a decision to compensate disproportionately affected industries is a political one that should be taken in the context of other competing claims for assistance (eg by low-income households). The only olive branch that the discussion paper holds out in this regard is that some of the revenue from auctioning permits could be used to support the development of carbon capture and storage, which would assist in the preservation of employment in regions where coal fired generation is substantial.

The suggestion that fossil fuel generators should not receive an allocation of free permits has already generated considerable opposition from the National Generators Forum¹² and the New South Wales Government, which (despite the Unsworth Committee's recommendation against lobbying for such compensation) has come out in support of the allocation of free permits because a failure to compensate coal fired generators for the impact of the carbon price is likely to have a detrimental effect on the proceeds that it hopes to realise from the privatisation of its Macquarie, Eraring and Delta black coal fired power stations. Opponents of Professor Garnaut's approach point out that the electricity generation industry is characterised by long-lived investments (the costs of which are sunk) and that fossil fuel generators may not be able to pass through the carbon price because their output will be reduced through competition with less emissions-intensive plant.¹³ They also warn that the costs of transitioning away from coal-fired generation are likely to be substantial, given the increase in the price of electricity that this will entail and the significant costs of investing in replacement generation.

Price cap

Another position previously advocated by Professor Garnaut, and adopted in the discussion paper, is the undesirability of adopting a price cap. Previous reports¹⁴ have recommended that a firm with an emissions permit deficit should be subject to a pecuniary penalty for the deficit but should not be required to make up that deficit in the subsequent year (ie should not be subject to a make-good obligation). The consequence of this is that the emissions penalty acts as a cap on the price of emissions permits. While it is acknowledged that this would dampen the impact of the carbon price, it has been justified as a 'safety valve' that protects Australia against the cost of a high (or volatile) carbon price.

The discussion paper argues that the other flexibility mechanisms it proposes (see 'Targets' above) render such a safety valve unnecessary and that the imposition of a price cap would jeopardise Australia's ability to achieve a specified absolute level of greenhouse gas emissions. It also correctly points out that a price cap will impede the ability to link Australia's emissions trading scheme with those schemes, such as the European Union and New Zealand schemes, that do not have a price cap. The discussion paper therefore proposes that:

• an emissions penalty should be imposed at a sufficiently high level to discourage non compliance; and
• a make good obligation (or at least a further financial penalty that would cover the Carbon Bank's costs of acquiring permits and offsets equivalent to the defaulting firm's deficit) should be imposed to preserve the environmental integrity of the scheme.

Offsets

As stated above, the discussion paper favours the use of offsets, although the broad coverage of the Australian emissions trading scheme will reduce the range of offsets available. However, while it acknowledges that international linking (and the use of internationally recognised offsets) will bring added flexibility to an Australian emissions trading scheme, and would allow Australia to set more stringent targets, the discussion paper does consider that there might be good reasons to limit the import of international offsets – for example, it suggests that:

• the import of CDM credits could be limited to those generated in the least developed countries that are unlikely to take on targets in the foreseeable future. While this might encourage other developing countries to adopt binding targets, it would have a significant impact on the potential for Australian investment in CDM projects in China and Indonesia, which has recently become far more practical following Australia's ratification of the Kyoto Protocol; and
• the import of substantial international offsets could be subject to a condition that the revenue raised be used by the host country to fund climate change mitigation or adaptation.

In addition, Australia's international credibility might be affected if the ability to import international offsets lessened domestic emissions reduction activity to a substantial degree.

The discussion paper also suggests that the voluntary carbon offset market is likely to be cannibalised by an emissions trading scheme. However, as the voluntary market serves a different purpose and market to the compulsory market¹⁵, the voluntary market is still likely to have a robust future, which will be enhanced by the introduction of a regulated standard (as is proposed by the Federal Government).

Administration

The discussion paper proposes that the emissions trading scheme should be administered and enforced by an independent Carbon Bank, ie a statutory authority that has a high degree of independence from government. This is intended to ensure that decisions about, for example, the release of permits and the compensation payments to TEEI industries, are made without being subject to political interference. This is perhaps a greater degree of independence than the Federal Government is currently inclined to allow.¹⁶

Renewable energy schemes

The discussion paper questions the desirability of renewable energy schemes (such as the Federal Government's proposed renewable energy target of 20 per cent by 2020) on the basis that such schemes encourage the use of more expensive renewable technologies that may displace lower cost non renewable (but relatively low emissions) technologies, and may depress the carbon price. This is not a position that is likely to be welcomed by the renewable energy industry, given the significant regulatory uncertainties that have already beset it.

Way forward

Submissions in response to the discussion paper are due by 18 April 2008.

If you would like assistance in preparing your submissions, or further information about the proposed Australian emissions trading scheme and the opportunities and risks it presents for your business, please contact any of the people below.

Footnotes

1. Media release, Senator Penny Wong, Government announces detailed timetable on emissions trading, 17 March 2008.
2. p 180.
3. See AAR Focus: Energy – 15 September 2006. The Taskforce recently issued a revised report, although the recommendations of this revised report have not yet been endorsed by the relevant governments.
4. See AAR Client Update: Climate Change – 1 June 2007.
5. See AAR Client Update: Climate Change – 29 February 2008.
6. See speech to the Australian Industry Group Luncheon, Climate Change: A Responsibility Agenda, 6 February 2008, p7.
7. While this is consistent with the 2008 NETTS report, it may be that, as this report recognises, fugitive emissions of hydrofluorocarbons and sulphur hexafluoride will need to be excluded because of measurement difficulties.
8. The NETTS 2008 report has suggested that only limited borrowing be allowed, being 1 per cent of a covered party's permits for the following year.
9. See also the 2008 NETTS report, p 49.
10. Discussion paper, p 33.
11. See the 2008 NETTS report, pp 72-73.
12. See submission dated 7 March 2008 to the Garnaut Review.
13. See the 2008 NETTS report, pp 56, 68.
14. eg see the 2008 NETTS report, pp 117, 125.
15. See AAR Focus: Climate Change – 7 February 2008.
16. See the 2008 NETTS report, pp 167-1 72.

For further information, please contact:

• Grant AndersonPartner, Melbourne
  Ph: +61 3 9613 8928
  Grant.Anderson@aar.com.au
• Matthew SkinnerPartner, Sydney
  Ph: +61 2 9230 4038
  Matthew.Skinner@aar.com.au
• Chris SchulzPartner, Melbourne
  Ph: +61 3 9613 8772
  Chris.Schulz@aar.com.au
• Jim ParkerPartner, Sydney
  Ph: +61 2 9230 4362
  Jim.Parker@aar.com.au
• John GreigPartner, Brisbane
  Ph: +61 7 3334 3358
  John.Greig@aar.com.au
• Darren MurphyPartner, Perth
  Ph: +61 8 9488 3768
  Darren.Murphy@aar.com.au
• Ben ZillmannPartner, Brisbane
  Ph: +61 7 3334 3538
  Ben.Zillmann@aar.com.au
• Campbell DavidsonInternational Partner, Shanghai
  Ph: +86 21 6841 2828
  Campbell.Davidson@aar.com.au

Bookmark with What are these?