Safeguard 2.0—managing risk under Australia's new carbon scheme

By Louis Chiam, Yu Zhang, Anne Beresford, Bill McCredie
Climate Change Energy Environment, Social, Governance

Top tips for managing carbon risk from 1 July 2023 under Australia's new carbon scheme 5 min read

With Australia's revamped baseline-and-credit carbon trading scheme, the Safeguard Mechanism (starting on 1 July 2023), many of Australia's large emitters—and their investors, financiers and customers—are grappling with how to comply with the scheme and manage carbon risk.

The amended Safeguard Mechanism rules—outlined in this Insight—impose new mandatory net carbon emissions limits on around 215 facilities across the mining, manufacturing, transport, oil & gas and waste sectors. Covering some 28% of Australia's emissions, the rules represent a key plank in the Australian Government's net zero plans.

While the final regulatory filings for the first compliance year (July 2023 to June 2024) are not required until March 2025, there are a number of steps that affected companies should be taking now to ensure they can comply with the Safeguard Mechanism rules and manage the associated carbon risks.

In this Insight, we outline the key components and explain what compliance entities need to be doing now to comply.

Key takeaways

  • The Safeguard Mechanism introduces new compliance requirements for responsible emitters, which require careful consideration as to how these should be appropriately managed once the regime comes into effect on 1 July 2023.
  • Affected entities should assess how the new regime will impact their facilities, and consider any additional carbon costs or revenue opportunities from trading carbon credits.
  • Responsible entities with excess carbon emissions will face a carbon cost of up to $75 per tonne of carbon dioxide equivalent.

Carbon cost accruals

From 1 July 2023, the 'responsible emitter' for each Safeguard facility (typically, the entity with operational control) will be required to ensure the facility's net emissions are less than its target (baseline) emissions, either by reducing actual emissions or procuring approved carbon offsets.

Where the facility is likely to have excess emissions (above the baseline) it will face a carbon cost from 1 July. For example, a manufacturing facility with excess emissions will need to buy approved carbon offsets to reduce its net emissions and, as a result, its per tonne production cost will rise.

Conversely, a facility that can outperform its target (and keep emissions below the baseline) will earn carbon credits. For a manufacturing facility, this would mean that each tonne of production in effect earns additional revenue in the form of carbon credits. However, credits earned by facilities that outperform their target may only be ultimately used by either the generating facility or another Safeguard facility (so are unlikely to have value outside the Safeguard 'ecosystem').

In certain circumstances there is also an option to 'borrow' part of the baseline from the next compliance year to help satisfy the baseline targets, which further complicates this analysis.

In each case, these carbon costs and revenues will need to be estimated and properly captured in financial statements, which may be challenging in the absence of a clear reference carbon price.

Passing on carbon costs to customers

Some facilities may be able to pass on their additional carbon costs to customers, eg if the market price rises to reflect carbon costs or if they sell products under long-term supply contracts that include an applicable 'change in law' or 'carbon cost' clause.

Relying on contract terms will require care and planning. There is no general right under contract law or the Safeguard Mechanism to change prices simply because of a new regulatory impost. Instead, any price increase will depend on the precise wording of the contract terms. And while the Safeguard Mechanism (in its previous incarnation) has been in place for several years, existing long-term contracts may not reference it directly.

Similarly, a facility's long-term contracts may impose detailed procedural requirements on the supplier, ranging from time limits on giving notice through to providing evidence of the applicable costs and how they are being treated by the supplier.

Preparing for regulatory filings

The Safeguard Mechanism rules set out a strict timeline for the reporting and compliance steps that will need to be completed. While some of these are not required until late 2024 or early 2025, the regulatory filings will require detailed supporting material and, in some cases, an independent audit report.

For example, all existing facilities will have a site-specific emissions-intensity value set, based on the facility's historic data. For the first compliance year, these facilities need to apply for site-specific emissions-intensity values by 30 April 2024, with some applications accompanied by an audit. Unsurprisingly, these applications will be very detailed and will take time to collate, prepare and audit. It is important that compliance entities start this process now.

Similarly, trade-exposed facilities will need to consider whether to apply for a more favourable 'adjusted baseline' (a process that helps to ensure these businesses are not competitively disadvantaged, and that emissions do not ‘leak’ overseas). These applications, which are first due on 31 October 2024, will require careful data collection and verification, must be independently audited and must be signed by the CFO.

Facility boundary

An important, long-lead-time reporting item is confirming the facility boundary (both technical and financial). The Safeguard Mechanism applies on a facility (rather than corporate group) basis and adopts the existing National Greenhouse and Energy Reporting Act (NGER) framework. However, this framework is deliberately broad in defining the boundaries of a 'facility' and the individual production processes within it. For example, an integrated LNG project might comprise one large facility or, alternatively, separate production, transport and processing facilities. Similarly, a chemical plant might comprise a series of individual processes which produce multiple products (and by-products).

While these facility boundaries have been, to date, principally associated with NGER emissions reporting obligations, the new carbon liability regime may trigger a need to revisit their facility boundaries. Issues to consider include: is a facility boundary that dates back several years still fit for purpose; and does the relevant entity have the capability and resources to comply with the new rules?

Carbon trading strategy

As a baseline-and-credit carbon scheme, the start of the Safeguard Mechanism means all compliance entities should develop a carbon trading strategy.

To begin with, each compliance entity will be either structurally 'long' or 'short' carbon offsets, depending on whether it expects its actual emissions to be lower or higher than its baseline. This means each compliance entity will need a framework for making important buy, sell or hold decisions for carbon offsets, including forming a view on the likely future path of carbon offset prices. As supply increases and trading activity develops, we expect more liquidity in the secondary market which will further facilitate the sale and purchase of carbon offsets.

In addition, compliance entities may need to consider complex strategies such as banking/borrowing offsets, participating in carbon trading platforms and entering into carbon derivatives including forwards and options. These may help manage financial risk, including hedging against price rises. They will require both substantial assessment and execution capability, either in-house or via trusted service providers.

Broader regulatory compliance

In developing these strategies, it is important to be mindful of the impact of other regulatory regimes. For example, Safeguard Mechanism credits are classed as financial products for the purposes of the Corporations Act. While there are relevant exemptions available, this means it is important to consider implications of Australian Financial Services licensing and other regulations that may be relevant, including anti-money laundering.

Similarly, a number of financing solutions (eg abatement or offset funds) may themselves be heavily regulated and introduce detailed compliance requirements.

What's next?

Preparation for the regulatory filings should begin immediately, if not already underway. So, too, steps to implement your organisation's compliance plan.

Please reach out to our team below if you would like any advice or guidance on the Safeguard Mechanism reforms, the new Safeguard Mechanism credits or any other aspects of the new rules.