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Focus: Carbon pricing scheme

12 July 2011

In brief: The Federal Government has released details of its proposed carbon pricing scheme, which will operate initially like a carbon tax with a fixed (but increasing) carbon permit price and will then transition into a cap and trade scheme after three years. This scheme is the result of negotiations within the Multi-Party Climate Change Committee and is set to be implemented in legislation that is to be introduced into Parliament later this year. Partner Grant Anderson and Lawyer Fergus Green report.

How does it affect you?

  • The Multi-Party Climate Change Committee has agreed the details of a new carbon pricing scheme. The scheme will operate in two phases: a fixed price phase commencing 1 July 2012; followed by a floating price phase commencing automatically on 1 July 2015.
  • The scheme will cover emissions from the stationary energy, industrial processing, mining and waste sectors. Entities that have operational control of a facility that emits more than 25,000tCO2-epa in greenhouse gas emissions from activities covered by the scheme will be required to surrender carbon permits to cover those emissions. Natural gas retailers will be liable for the greenhouse gas emissions embodied in the gas that they supply.
  • Transport fuels will be excluded from the carbon pricing scheme. However, an effective carbon price will be applied to transport fuels used by some businesses and industries (but not by households) through changes to the fuel tax credit and excise regimes. An effective carbon price will also be applied to certain synthetic greenhouse gases that are excluded from scheme coverage through changes to import and manufacturing levies applicable to those gases. Emissions reductions in the agricultural and land sectors (which will not be covered by the scheme) will be encouraged through the Federal Government's Carbon Farming Initiative.
  • Emissions-intensive trade-exposed industries and coal-fired power generators will be eligible to receive assistance, primarily in the form of free carbon permits, under arrangements that are broadly similar to those that would have applied under the Carbon Pollution Reduction Scheme. In addition, the Government will seek to negotiate to buy-out some 2,000 MW of Australia's most emissions-intensive coal-fired power generation and will provide loans and other measures to ensure stability in electricity supply markets.
  • The Government will establish a Clean Energy Finance Corporation to invest $10 billion of new funds into the commercialisation of renewable energy and energy efficiency technologies, along with a raft of other programs to encourage business and community investment in renewable energy, energy efficiency and land sector abatement.
  • Liable entities will need to consider how they allocate liability under the carbon pricing scheme within their corporate group or within the unincorporated joint ventures of which they may be members. This will require a consideration of both statutory and contractual liability and cost transfer and allocation mechanisms. 
  • Entities that supply or purchase emissions-intensive or energy-intensive goods or services will need to consider whether their existing contractual arrangements provide for the pass through of costs associated with the carbon pricing scheme and will need to take into account the allocation of such costs when negotiating future contracts. It is highly desirable that contractual provisions for the pass through of carbon pricing scheme costs are tailored to the particular transaction and include appropriate incentives designed to minimise those costs.
  • Directors of liable entities should put in place strategies to manage their companies' liabilities under the carbon pricing mechanism, including by implementing appropriate purchasing and hedging strategies and through the implementation of effective compliance programs.
  • Listed companies should consider whether the announcement of the details of the carbon pricing mechanism triggers an obligation under the ASX Listing Rules and the Corporations Act 2001 (Cth) to disclose to the market the likely impact of the carbon pricing scheme on their operations.

Overview of the carbon pricing scheme

The fixed and floating price phases

The carbon pricing scheme will operate in two phases: a three-year, fixed price phase from 1 July 2012 to 30 June 2015; moving to a floating price phase on 1 July 2015.1 In both phases, liable entities will be required acquire and surrender carbon permits equivalent to their annual emissions from activities covered by the scheme.  

In the fixed price phase, the carbon price will commence at $23/tCO2-e, indexed annually at a real rate of 2.5 per cent pa.2 In this phase, the Federal Government will sell to liable entities an uncapped number of permits at the applicable fixed price, which will be automatically surrendered by those entities to meet their liability and cannot be traded or banked for future use. While international permits (such as certified emissions reduction units generated under the Kyoto Protocol Clean Development Mechanism) will not be able to be used to acquit liabilities under the scheme during the fixed price phase, an entity will be able to acquit up to 5 per cent of its annual liability during this phase by surrendering Kyoto-compliant carbon credits generated under the proposed Carbon Farming Initiative.3 A limited number of carbon permits with a vintage year that occurs during the floating price phase will be auctioned during the fixed price phase so as to enable the establishment of a forward price curve. 

In the floating price phase, the Government will set annual caps on the number of carbon permits to be issued in each year and the price of those permits will be determined by the market forces of supply and demand.  The exception is that, for the first three years of this phase, there will be a carbon permit floor price of $15 (increasing at 4 per cent per annum in real terms) and a carbon permit ceiling price of $20 above the 'expected international price'4 (which will increase by 5 per cent per annum in real terms). This collar is intended to minimise the price volatility that may otherwise ensue upon the switch to the full market trading of carbon permits under the floating price phase. As under the fixed price phase, liable entities will be able to acquit their liabilities under the carbon pricing scheme using Kyoto-compliant Carbon Farming Initiative carbon credits – but unlike for the fixed price phase, there will be no limit on the number of such carbon credits that may be used for this purpose. In addition, international permits5 will be able to be used to acquit carbon pricing scheme liabilities up to a maximum of 50 per cent of a liable entity's carbon permit surrender obligation. Carbon permits issued for the floating price phase will be able to be banked without limit, and liable entities will be able to 'borrow' such carbon permits from one vintage year (up to 5 per cent of their liability) in order to meet their liability for the immediately preceding vintage year.

Critical to the operation of the floating price phase is the establishment of annual scheme caps and targets. The Government has announced a 2020 emissions target of at least 5 per cent below 2000 levels, and has increased its 2050 emissions target from 60 per cent to 80 per cent below 2000 levels. A new independent Climate Change Authority will be established to advise the Government on the annual scheme caps, which will be set on a five-year rolling basis. The Authority will be required to recommend annual scheme caps for 2015/16 to 2019/20 by 28 February 2014 and the Government will be required to table regulations setting out the first five years of scheme caps by 31 May 2014 (if the Government does not adopt the Authority's recommendations, it will need to table its reasons for this before Parliament). Every year the Authority will need to recommend, and the Government will need to promulgate by regulation, a scheme cap for the compliance year 5 years out. Under the previously proposed Carbon Pollution Reduction Scheme (CPRS), provision was made for the setting of gateways for a further 10 years beyond the next five years' scheme caps, with the scheme caps for those 10 years generally being required to fall within the lower and upper bounds of the relevant gateway. It would assist investment certainty if this mechanism were adopted for the carbon pricing scheme as investment horizons typically extend well beyond 5 years, although it is acknowledged that such gateways would constrain the ability of the Government to set more stringent annual scheme caps consistent with a more ambitious emissions reduction trajectory.6 

The initial scheme legislation will provide for five years worth of 'default' scheme caps, consistent with the 2020 emissions reduction target of 5 per cent below 2000 levels, that will apply if the scheme cap regulations are disallowed by either House of Parliament. A similar mechanism will apply for the subsequent year scheme caps should regulations establishing those scheme caps be disallowed. Keen observers will note that the latest the next federal election can be held is 30 November 2013 – six months before the initial scheme cap regulations must be tabled in Parliament – and that Opposition Leader Tony Abbott has threatened to repeal the carbon pricing scheme if the Liberal/National Party coalition is elected.  However, given that the Greens are likely to hold the balance of power in the Senate until at least 1 July 2017, Labor and the Greens will be able to combine in the Senate to block any attempts to repeal the scheme legislation and/or to pass a motion in the Senate to disallow any regulations that would impose scheme caps weaker than those that would be needed to achieve the 2020 emissions reduction target.

The Climate Change Authority will be empowered to make recommendations about Australia's longer term emissions reduction trajectory.  Given that some commentators believe that the conditions for Australia adopting a 2020 emissions reduction target of 15 per cent below 2000 levels have already been met, it will be interesting to see what these recommendations are. 

Perhaps understandably there is not much detail about future linkages with carbon schemes in other countries. However, this is a very significant issue. On the one hand, access to lower cost emissions reductions in other countries will provide liable entities with a more cost-effective way of meeting their obligations, and the Treasury modelling certainly assumes that Australia will have to buy a substantial quantity of international permits to meet its 2020 emissions reduction target.7 On the other hand, the use of such emissions reductions will depress the Australian carbon permit price and diminish the revenue that the scheme raises, being revenue that is necessary to provide assistance to households and industry, and to invest in low-emissions technologies. It seems that the role of international permits in Australia's abatement challenge was a matter of contention among the Multi-Party Climate Change Committee members, resolution of which has been shunted to a future date. But given the importance of this issue to the carbon price trajectory, and in turn to the future shape of the Australian economy, it deserves to be debated more openly with a view to early resolution.

Carbon pricing scheme coverage

The carbon pricing scheme will cover the emission of four of the six Kyoto Protocol greenhouse gases (carbon dioxide, methane, nitrous oxide and perfluorocarbons) from the following economic sectors:

  • stationary energy (eg electricity generation);
  • industrial processing (eg aluminium smelting);
  • fugitive emissions (other than from decommissioned coal mines); and
  • emissions from landfill waste and waste water treatment (with an exemption for emissions from legacy waste, ie landfill waste deposited before 1 July 2012).

As such, it is proposed to cover around 60 per cent of Australia's emissions (compared with 75 per cent under the CPRS). 

Like the CPRS, agricultural emissions (which account for about 16 per cent of Australia's greenhouse gas emissions) and land sector emissions will not be covered by the carbon pricing scheme. Unlike the CPRS, however, Kyoto-compliant forests will also not be able to be opted into the carbon pricing scheme for the purpose of creating carbon permits through carbon sequestration. These exclusions are justified on the basis that the Government's Carbon Farming Initiative is intended to stimulate carbon biosequestration and greenhouse gas emissions reduction in the land and forestry sectors. Under this initiative, farmers and other land holders will be able to create tradeable carbon credits that are either Kyoto-compliant (eg as where they relate to forests established since 1990 on cleared land) or non Kyoto-compliant (eg as where they relate to soil carbon sequestration or crop management). As stated above, Kyoto-compliant Carbon Farming Initiative carbon units will be able to be surrendered to acquit liabilities under the carbon pricing scheme. Moreover, the Government has adopted Professor Garnaut's recommendation that it should purchase at least some non Kyoto-compliant Carbon Farming Initiative carbon units (it will spend $250 million over six years for this purpose). This is necessary because, in the absence of such support, there is likely to be a considerable price differential between these two kinds of carbon units and this could render unviable projects that would generate non Kyoto-compliant Carbon Farming Initiative carbon units.

The other major exclusion from the carbon pricing scheme is transport fuels (transport accounts for about 17 per cent of Australia's greenhouse gas emissions). However, transport fuels will face an effective carbon price, to be applied through changes to the system of fuel tax credits and fuel excise effective from 1 July 2012, in certain circumstances – namely in the case of:

  • liquid fuels for business transport (other than in the agriculture, forestry and fisheries industries), including liquid fuels used in the domestic aviation, shipping and rail sectors;
  • liquid fuels used for non transport purposes (eg diesel used for power generation); and
  • compressed natural gas, liquefied natural gas and liquefied petroleum gas used for off road transport and non-transport uses.

Ethanol, biodiesel and renewable diesel will remain unaffected. The effective carbon price will be applied through periodic adjustments to credits and excise – annually during the fixed price phase and every six months (based on the average carbon price over the previous six months) during the flexible price phase. The Productivity Commission will conduct a review of fuel excise arrangements and will examine the merits of moving to a regime based explicitly on the carbon and energy content of fuels. This review was reportedly secured by the Greens in exchange for supporting the exemption of transport fuels used by households and light vehicles from exposure to an effective carbon price.

Emissions from the combustion of biofuels and biomass (including emissions from the combustion of methane from landfill facilities) will also be excluded from coverage by the carbon pricing scheme.8 

Finally, hydrofluorocarbons and sulphur hexafluoride will be excluded from the carbon pricing scheme. However, they will be subject to an equivalent carbon price through changes to existing import and manufacturing levies applicable under the Ozone Protection and Synthetic Greenhouse Gas Management Act 1989 (Cth). These levies will be adjusted annually to reflect the prevailing carbon price. The policy papers foreshadow the introduction by 1 July 2013 of incentives for the destruction of waste synthetic greenhouse gases, including ozone depleting substances, recovered at end of life, although the nature of these incentives is unclear.

Structural adjustment assistance

The carbon pricing scheme includes a number of measures designed to provide structural adjustment assistance to those industry sectors that are likely to be particularly adversely affected by the introduction of a carbon price. Two of these measures entail the provision of free carbon permits to affected industry participants. Given that there is unlikely to be much of a market for carbon permits issued during the fixed price phase, those entities that receive a free allocation of permits under these measures will be able to realise their value by selling them back to the Government at the applicable fixed price (indeed, they will need to sell these permits either to the Government or to a liable entity because those permits that have a vintage year during the fixed price phase cannot be used to acquit liabilities under the carbon pricing scheme for a year after that vintage year).

Jobs and Competitiveness Program

There is a risk that the carbon pricing scheme will adversely affect Australia's international competitiveness by imposing on those industry sectors that compete in global markets costs they cannot recover because their output is sold at a world price. These costs may take the form of the costs of acquiring the carbon permits that are required to cover their emissions and/or the increased costs of energy-intensive or emissions-intensive inputs that they use. 

In order to provide some assistance to these 'emissions-intensive trade-exposed' (EITE) activities, the carbon pricing scheme incorporates a Jobs and Competitiveness Program under which free carbon permits will be allocated to these industry sectors.  This program is very similar to the EITE assistance program that formed part of the previously proposed CPRS (see our Focus of December 2008 and our Client Update of November 2009).  Under this program:

  • the highest emissions-intensive activities (ie those for which emissions exceed 2,000tCO2-e/$m in revenue or 6,000tCO2-e/$m in value-added), such as aluminium smelting, will receive free carbon permits sufficient to cover 94.5 per cent of their average emissions initially (ie for 2012/13), decreasing at the rate of 1.3 per cent per annum; and
  • moderate emissions-intensive activities (ie those for which emissions are between 1,000 to 2,000tCO2-e/$m in revenue or 3,000 to 6,000tCO2-e/$m in value-added), such as LNG production, will receive free carbon permits sufficient to cover 66 per cent of their average emissions initially (ie for 2012/13), decreasing at the rate of 1.3 per cent per annum. 

These are the same assistance rates as proposed under the CPRS and, notwithstanding a recommendation to the contrary by Professor Ross Garnaut, include the 5 per cent global recession buffer despite Australia having largely weathered the global financial crisis. 

The emissions covered by this assistance are not just direct greenhouse gas emissions from the covered activities but also indirect emissions attributable to the consumption of electricity, and the production of steam and natural gas (for use as feedstock), used in those activities. This ensures that the assistance gives some relief for increases in the prices of electricity, steam and natural gas which will occur as a result of the imposition of a carbon price. 

These assistance rates are to be reviewed by the Productivity Commission in 2014-15 and one of the things that will be considered during this review is whether the assistance arrangements should be altered so as to move to Professor Garnaut's suggested model where the assistance is to be based on the gap between the world product prices for the relevant activities that are expected with a global carbon price and those that are expected with only an Australian carbon price. The adoption of such a model would significantly reduce the assistance available to EITE activities. However, the Government has stated that it would adopt any such recommendation made by the Productivity Commission. The Productivity Commission will periodically review the assistance arrangements, including the existence of windfall gains and the introduction of comparable carbon restraints in competing countries, in 2014/15 and thereafter every five years, with any changes that the Government decides to make to them to take effect after a three-year notice period.

In recognition of Australia's substantial LNG reserves and the fact that LNG can be combusted with significantly less greenhouse gas emissions than coal, LNG producers will receive an additional allocation of free carbon permits to the extent this is necessary to ensure that they receive sufficient free permits to cover 50 per cent of all the emissions associated with the LNG production process (ie extraction, production, transport and energy use in compression). 

Coal-fired electricity generation

In recognition of the significant impairment of the value of coal-fired electricity plant that will result from the imposition of a carbon price,9 and despite Professor Garnaut's opposition, $5.5 billion worth of assistance will be provided to emissions-intensive coal-fired electricity generators (ie those with an emissions intensity of more than 1tCO2-e/MWh of electricity). This assistance, which will take the form of cash in the first year (2012/13) and free carbon permits in subsequent years, will be provided in equal annual instalments over the five year period to 2016/17.  The on-going provision of this assistance to a generator will be conditional on:

  • the generator adopting a clean energy investment plan showing how it will reduce its emissions; and
  • the capacity of the generation plant not being reduced unless the market operator determines that such a reduction in capacity will not have an adverse impact on power system reliability (including because the generator replaces that capacity with lower emissions-intensity capacity). 

This is a comparable arrangement to that provided under the CPRS (see our Focus dated January 2009 and our Client Update of November 2009): while the CPRS assistance package equated to $7.3 billion in free permits, this was to be spread over 10 years and (unlike the CPRS) the Government has made no mention of including in the carbon pricing scheme a windfall gain review that could see assistance withdrawn from electricity generators in the later years of the assistance program. 

The Government will also seek to negotiate the closure, by 2020, of around 2,000MW of the most emissions intensive coal-fired electricity generation (ie generation the emissions-intensity of which is greater than 1.2tCO2-e/MWh). This proposal is directed at Victoria's brown coal-fired electricity generators (particularly Hazelwood) and potentially at the Playford power station in South Australia. It will be important that this buy-out is managed in such a way as to ensure that sufficient replacement capacity is on hand to avoid undue increases in electricity prices as a consequence of supply constraints.

In order to alleviate the potential financial stress on electricity generators as a result of the imposition of a carbon price, an Energy Security Council will be established to make recommendations as to any assistance (eg in the form of loans) that the Government should provide to help those generators to refinance their existing debt or to purchase carbon permits on a forward basis, during the fixed price phase, for use in the flexible price phase. 

Steel Transformation Plan

The Government proposes to allocate $300 million over five years to encourage investment in the steel industry in low-emissions and energy efficiency technologies. However, this proposal does not have the unanimous support of the Multi-Party Climate Change Committee (it is currently opposed by the Green members) and so it will not form part of the carbon pricing scheme. Instead it may need to be progressed as a separate measure, the passage of which will be dependent upon the support of the Liberal/National Party Opposition.

Coal Sector Jobs Package

The Government proposes to provide assistance of $1.3 billion over six years to gassy coal mines, ie those the fugitive emissions of which account for more than 0.1tCO2-e/ton of saleable coal, to cover 80 per cent of their fugitive emissions above this threshold. In addition the Government proposes to allocate assistance of $70 million over 6 years (in matched grants) to assist the coal mining sector to introduce emissions abatement technology. This package is comparable to the corresponding assistance contained in the CPRS. However, like the Steel Transformation Plan, this measure is currently opposed by the Greens and so may need to be separately progressed with the support of the Liberal/National Party Opposition if it is to be implemented. 

Clean Technology Program

In order to assist in the adoption of the low-emissions and energy efficiency technologies, the Government is committed to providing:

  • $800 million over seven years (by way of 1:3 in matched grants) to manufacturing businesses that consume over 300MWhpa of electricity or 5TJpa of natural gas, or that are otherwise covered by the carbon pricing scheme; and
  • $200 million over six years (by way of 1:3 in matched grants) to food processors and metal forges/foundries.

In addition the Government will provide $200 million over five years (by way of 1:1 in matched grants) to support business investment in research and development for renewable energy, low-emissions and energy efficiency technologies.

Complementary measures

While a market-based carbon pricing scheme is generally recognised as the most cost effective way to deliver a given amount of abatement, 'complementary' measures (particularly emissions reductions programs funded by direct spending or regulatory intervention) are comparatively expensive.10 It is imperative that governments review federal and state schemes to determine whether they continue to be justified where there is a carbon price. So, for example, it seems reasonably clear that both the New South Wales Greenhouse Gas Abatement Scheme and Queensland Gas Electricity Certificate Scheme should (and will) be terminated when the carbon pricing scheme is introduced – although appropriate transitional arrangements will need to be put in place. 

The carbon pricing scheme proposal includes a number of new complementary measures and related governance designed to promote renewable energy, improve energy efficiency and conserve biodiversity and carbon stocks in the land sector.

An independent Clean Energy Finance Corporation will be established with $10 billion (over five years) in government funding to support the deployment and commercialisation of renewable energy, low emissions intensity and energy efficiency technologies (excluding carbon capture and storage).11 This funding will be provided through equity investments and loans (including loan guarantees). Investments will be divided into two streams: a renewable energy technologies stream and a broader stream focused on renewable energy, energy efficiency and other low-emissions technologies, with approximately $5 billion to be allocated to each stream. 

Another new independent body, the Australian Renewable Energy Agency, will be established to administer the $3.2 billion worth of funds allocated (or planned to be allocated) to various existing government programs (such as the Solar Flagships program) that support the research, development, demonstration and commercialisation of renewable energy technologies. This will replace the current patchwork of programs and institutes administering these different programs. Further funding may flow from revenue derived in the future from the carbon pricing scheme (to the extent compensation for EITE industries is reduced after 2014/15) and/or from discretionary dividends paid by the Clean Energy Finance Corporation. The Agency is expected to provide a more streamlined and strategic approach to early-stage grant funding for renewable energy technologies.

The Government will also establish a working group to consider governance and design issues for a National Energy Savings Initiative to replace existing state schemes such as the Victorian Energy Efficiency Target as the primary means of driving energy efficiency in Australian households and industry. The working group will consult with the states and other relevant stakeholders and will consider scheme design issues such as energy savings targets, eligible activities and scheme coverage. It will report by the first quarter of 2012.

As a parallel initiative, the Government has committed to continuing the Energy Efficiency Opportunities Program through to at least 2016-17 and expanding it to include energy transmission and distribution networks, major greenfield and expansion projects, and a voluntary scheme for 'medium' energy-intensive businesses (ie. that use less than 0.5PJ per year).

Finally, in addition to the Carbon Farming Initiative, the Government will establish a Biodiversity Fund of $946 million (over six years) that will be applied to:

  • establish biodiverse carbon plantings in areas of high conservation value such as wildlife corridors, riparian zones and wetlands;
  • prevent the spread of invasive species across connected landscapes; and
  • manage existing biodiverse carbon stores, including on land already under conservation covenants or subject to land clearing restrictions, and publicly owned native forests.

An independent Land Sector Carbon and Biodiversity Board will be established to administer the Biodiversity Fund along with a suite of other programs and funds to promote carbon abatement, biodiversity conservation and sustainable natural resource management across Australia.

What you should do

The carbon pricing scheme is a far-reaching economic reform which will affect a range of businesses. While only 500 businesses are expected to be directly liable under the scheme, the imposition of a carbon price will increase the cost of energy-intensive and emissions-intensive inputs (such as electricity, gas, aluminium, steel, glass and cement) that are used by many businesses. Overall, this is expected to increase the CPI by 0.7 per cent initially and a further 0.2 per cent when the scheme transitions from its fixed price phase to its flexible price phase. 

Determination and structuring of liability

For those businesses in sectors that are covered by the carbon pricing scheme it will be necessary to determine whether they are directly liable under that scheme. They will be directly liable if:

  • they undertake an activity in the stationary energy, industrial processing, mining or solid landfill/waste water treatment sectors that produces direct greenhouse gas emissions (including fugitive emissions) in excess of 25ktCO2-epa, and the greenhouse gas emissions take the form of carbon dioxide, methane, nitrous oxide or perfluorocarbons (a lower threshold of 10ktCO2-epa applies to landfills that are located close to large landfill facilities); or
  • they are a natural gas retailer. 

These businesses will need to decide how to manage their carbon liability – that is, to which company within their corporate group the liability should be allocated, how that liability is to be acquitted (eg the strategy that is to be adopted to enable the acquisition of the necessary carbon permits in the most cost effective way) and whether the costs associated with that liability can be passed through to customers. 

In terms of the imposition of liability, the carbon pricing scheme has made some significant improvements on the CPRS.  Under the CPRS, it was the ultimate Australian holding company of the subsidiary that had operational control over the emitting facility ('activity') that was liable to surrender the necessary carbon permits (although this liability could be transferred to the subsidiary, with the cooperation of the subsidiary, under a liability transfer certificate mechanism).  As we pointed out at the beginning (see our Focus of January 2009 and February 2009), this created a number of issues:

  • it will often be the subsidiary that operates the facility that has contracts for the supply of the goods or services produced by the facility – while these contracts might provide for the pass through of costs arising from a change in law (as would occur with the introduction of a carbon tax or emissions trading scheme), such provisions would typically not capture costs arising from the imposition of a legal obligation on the subsidiary's holding company (as opposed to the subsidiary itself) and nor would they typically cover costs arising from a liability that is voluntarily assumed by (as opposed to imposed by law on) the subsidiary (as would be the case where the subsidiary applied for a liability transfer certificate); and
  • in the case of a partially-owned subsidiary, the minority shareholders might be able to exercise contractual or statutory rights to resist the transfer of liability for the subsidiary's emissions from its holding company to the subsidiary, thereby leaving 100 per cent of that liability with the holding company even though it owned less than 100 per cent of the subsidiary.

These issues have now been addressed as the carbon pricing scheme will impose the liability to surrender carbon permits on the entity that has operational control over the emitting facility (although provision will be made for that liability to be transferred to another company within the group under a liability transfer certificate mechanism). An entity will have 'operational control' over an activity where it has the authority to introduce or implement operating, health and safety, or environmental policies for the activity or (if more than one entity has such authority) the entity has the greatest authority to introduce and implement operating and environmental policies for the activity.

Under the CPRS, where the emitting activities were undertaken by an unincorporated joint venture (which are particularly prevalent in the mining and energy industries), the joint venturers were required to nominate one of their number as the entity that was liable for 100 per cent of the emissions of the joint venture activity. The nominated joint venturer would then have to rely upon its fellow joint venturers to indemnify it for their proportion of that liability and, as a result, the nominated joint venturer would effectively be exposed to the credit risk of its fellow joint venturers. If the joint venturers could not agree on a nominated joint venturer for these purposes, each of the joint venturers was to be liable to a civil penalty and liability for the emissions of the joint venture activity was to be allocated between the joint venturers in proportion to their number (as opposed to their joint venture interests). Such an allocation would obviously be most prejudicial to minority joint venturers. Consistent with suggestions that we made in the context of the CPRS (see our Focus of January 2009 and February 2009), this issue has now been addressed in the carbon pricing scheme: to the extent it is an unincorporated joint venture that has operational control over the emitting activity, liability for those emissions will now be allocated between the joint venturers in proportion to their joint venture interests. It appears that, where the operator of an unincorporated joint venture (as opposed the to joint venturers) has operational control over the joint venture activities, that operator will also have the ability to transfer its liability for joint venture activity emissions to the joint venturers (as the financial controllers of those activities) in proportion to their joint venture interests. 

In addition to considering how to structure their carbon pricing scheme liability, entities that are eligible for structural adjustment assistance, eg under the Jobs and Competitiveness Program or the coal-fired electricity generation assistance package, should be aware of the information that they will need to provide, and the procedures that they will need to follow, in order to qualify for such assistance.

Of course the carbon pricing scheme will also present significant opportunities for companies to improve their competitive position by managing their emissions intensity and energy consumption, and for companies in low-emissions industry sectors, such as gas-fired and renewable energy generation.  As part of assessing the impact of the carbon pricing scheme, it is important that companies look not just at the risks, but also the opportunities. 

Pass through of carbon costs

Both directly liable entities, and other entities that (while not directly liable under the carbon pricing scheme) supply or purchase energy-intensive or emissions-intensive goods or services, should review their existing contracts to determine the extent to which they will be able to pass through (or resist the pass through) of costs associated with the carbon pricing scheme. There are two pass through mechanisms that are commonly included in contracts:

  • change in tax clauses; and
  • change in law clauses.

Despite the carbon pricing scheme commonly being referred to as a 'carbon tax' it is not, in fact, a 'tax' but an emissions trading scheme (albeit one that operates as a fixed price permit scheme for the first three years).  Accordingly, it should not be assumed that a supplier will be able to rely on a change in tax clause to pass through to its customers the costs it incurs under the carbon pricing scheme. Having said this, change in tax clauses sometimes extend to 'levies, charges and imposts' and it is conceivable (although by no means certain) that at least a fixed permit price might be regarded as coming within these terms. 

While the introduction of the carbon pricing scheme will clearly constitute a change in law, change in law clauses are not necessarily ideally suited to the pass through of costs associated with a scheme such as the carbon pricing scheme.  The first reason for this is that change in law clauses are predicated on being able to identify an upfront and once-off cost adjustment arising from a legal obligation that can be spread across the unit price for the remaining term of the contract.  However, at least during the flexible price phase, it will be very difficult to predict the permit price for more than a few years in advance, which will mean that a once-off adjustment to the unit price is likely to either over or under compensate the supplier for the costs it incurs under the carbon pricing scheme in purchasing carbon permits.  The second limitation of a typical change in law clause is that, because it assumes that it is possible to quantify a fixed total cost for pass through, it provides little incentive for the supplier to manage that cost.  However, under the carbon pricing mechanism, a liable entity will be able to manage to some degree the cost of the carbon permits that it is required to surrender.  For example, the supplier will be able to hedge against the carbon price by the forward purchase of carbon permits. 

These limitations suggest that contract counterparties should consider negotiating amendments to their existing long-term contracts, or including in new contracts, tailored carbon pass through clauses that, for example:

  • provide for the periodic assessment and pass through of carbon costs (eg every few years during the contract term);
  • incentivise the supplier to manage the cost of its carbon permits (eg by deeming the cost of permits for pass through purposes to be an average long-term carbon price, which will encourage the supplier to hedge those costs) or provide for the purchaser to acquire permits to acquit the supplier's liability (so that the purchaser is able to control the carbon costs that it bears); and
  • properly take into account any free carbon permits that the supplier receives or is entitled to receive for the emitting activities so that the supplier does not make a windfall gain out of the carbon cost pass through. 

It appears that natural gas retailers will be required to surrender carbon permits sufficient to cover the greenhouse gas emissions that are embodied in the natural gas that they supply, but that large purchasers of natural gas will have the ability to buy the gas under an 'obligation transfer number' the effect of which will be to transfer that liability from the retailer to the purchaser. This is similar to the arrangements that applied under the CPRS to the importers, manufacturers and suppliers of a range of solid, liquid and gaseous fossil fuels. Natural gas retailers will therefore need to sell their natural gas at a carbon-inclusive price unless they are dealing with a large purchaser who buys that natural gas under an obligation transfer number (in which case the natural gas price will need to be carbon-exclusive). If natural gas retailers wish to compel a large customer to purchase gas under an obligation transfer number, then they will need to include a provision to that effect in their gas supply contract.  However, such purchasers should be aware that the voluntary assumption of carbon liability under such a mechanism might not trigger a change in law provision pass through (because the liability is not being imposed by law).12

Where the contract is not with an entity that is directly liable under the carbon pricing scheme, a cost pass through clause will typically not permit the pass through of increased input prices where that increase results from the imposition of a legal obligation to surrender permits that is imposed on an entity further up the supply chain. Nonetheless, a supplier may wish to provide for a price adjustment to reflect carbon-related input price increases. In these circumstances, the supplier can be incentivised to manage its upstream costs by the price increase being linked to the average input price increases of its competitors rather than its actual price increases. Given the once-off increase in CPI resulting from the carbon pricing scheme, such parties may also wish to 'stagger' any CPI-indexed price increase across a few quarters.

The Government has flagged that, just as with the introduction of the GST, the Australian Competition and Consumer Commission will be empowered to investigate price gouging in the context of the pass through of carbon costs,13 and so businesses will also need to comply with yet-to-be-released pricing guidelines relating to this matter.

Finally, as discussed above, even though transport fuels and certain synthetic greenhouse gases (hydrofluorocarbons and sulphur hexafluorides) are not covered by the carbon pricing scheme, an effective carbon price is to be imposed on them in certain circumstances through adjustments to the fuel tax credit/excise system and import/manufacturing levies.  Participants in these industry sectors will therefore need to consider whether they are able to pass through such increased costs under their existing contracts and to provide for the pass through of these costs under new contracts.

Continuous disclosure

Under ASX Listing Rule 3.1, once a listed company becomes aware of any information that would reasonably be expected to have a material effect on the price of its listed securities, it is required to immediately disclose that information to the Australian Securities Exchange. A failure to do so attracts sanctions under the Corporations Act 2001 (Cth) (s.674). During the course of the development of the carbon pricing scheme, various companies have made public statements that the imposition of a carbon price will cause them to close existing operations or not proceed with planned projects. Given the level of detail that has now been disclosed in relation to the carbon pricing scheme, and that the scheme seems to have the support of the necessary numbers in Parliament, these companies (and others that are likely to be materially affected by the carbon pricing scheme) will need to consider whether they should be making disclosures to the market regarding the likely affect of the carbon pricing scheme on their operations.14 This may be the case where, for example, the introduction of the carbon pricing scheme causes a revision in previously released forecasts in the order of 10 to 15 per cent.15 

Liability of directors and officers

Directors are required to exercise their powers and discharge their duties with reasonable care and diligence.16 Accordingly, the directors of companies that are liable under the carbon pricing scheme are under a duty to ensure that the company has in place strategies to manage that liability including by introducing lower-emissions technologies and processes and implementing purchasing and hedging strategies to mitigate the company's carbon costs. 

It is expected that, as with the CPRS, the executive officers (ie directors and senior management) of a company that is liable under the carbon pricing scheme may be exposed to personal liability if the company fails to comply with the carbon pricing scheme legislation and that officer, being in a position to do so, fails to take reasonable steps to prevent the contravention. The implementation of an effective compliance and education program will be an important part of an officer's defence in such a case. This is in addition to the obvious benefit of a compliance program – which is to minimise the risk of any breach by a company of its carbon pricing scheme obligations in the first place.  A key obligation is the annual surrender of carbon permits to acquit the company's liability for a compliance (financial) year. During the fixed price phase, liable entities will be required to surrender permits to cover 75 per cent of their annual emissions by 15 June of the compliance year, with a true-up surrender for the remaining permits by the following 1 February. During the floating price phase, liable entities will be required to surrender permits to cover 100 per cent of their annual emissions by the 1 February following the compliance year. A failure to meet the surrender obligations will attract an emissions charge of 1.3 times the fixed price for permits during the fixed price phase and twice the average price for permits during the floating price phase.

Australian Financial Services Licence

Because carbon permits will be 'financial products' for the purposes of the financial services regulatory regime under the Corporations Act and the Australian Securities and Investments Commission Act 2001 (Cth), entities that wish to trade in such permits will typically be required to hold an Australian Financial Services Licence. While trading is likely to be limited during the fixed price phase, carbon permits for the floating price phase will be auctioned during the fixed price phase with the aim of creating a forward price curve. Accordingly, potential traders should consider applying for the necessary licence (or a modification of their existing licence if required) in preparation of the commencement of the carbon pricing scheme. 

Next steps

The Government has indicated that it intends to release an exposure draft of legislation to implement the carbon pricing scheme on 31 July 2011, following which the legislation will be introduced into Parliament by the end of this year. The aim is to commence the carbon pricing scheme on 1 July 2012. 

Footnotes
  1. This automatic switch over will provide an important element of certainty for industry investment: The Australian Financial Review, 'Remove the uncertainty, AGL pleads', 17 May 2011, p.7; see also The Australian Financial Review, 'Carbon price pros and cons', 8 April 2011, p.56.
  2. Assuming CPI of 2.5 per cent, the price of carbon permits will rise to $24.15/tCO2-e in 2013-14 and $25.40/tCO2-e in 2014-15.  
  3. The legislation to implement the Carbon Farming Initiative is currently before Parliament and will be the subject of a forthcoming Focus article when it becomes law.
  4. By which the Government seems to mean the price of certified emissions reduction units under the Kyoto Protocol Clean Development Mechanism. The exact starting ceiling price will be set in regulations by 31 May 2014. 
  5. Such international permits include certified emissions reduction units (CERs) under the Kyoto Protocol Clean Development Mechanism, emission reduction units (ERUs) under the Kyoto Protocol Joint Implementation arrangements, removal units issued by a Kyoto Protocol country on the basis of land use, land use change and forestry activities and any other international units that the Government may allow by regulation (eg units from the European and New Zealand emissions trading schemes).  However, there will be some quality restrictions imposed – for example, forestry CERs, nuclear CERs/ERUs, and CERs/ERUs from the destruction of trifluoromethane (HFC-23) or of nitrous oxide from adipic acid plants or from non-compliant large scale hydro electric projects, will not be eligible for surrender under the carbon pricing scheme.
  6. See The Australian Financial Review, 'Carbon threat to power supply', 16 May 2011, pp.1, 6.  
  7.  'At last, a tax they want you to avoid', The Age, 11 July 2011, pp.1, 2. Treasury has yet to provide updated modelling based on the precise model of the carbon pricing scheme that has been proposed.
  8. The Renewable Energy Target scheme will be amended to exclude biomass from native forests (including by-products and waste associated with the clearing or harvesting of native forests) from being an eligible renewable energy source.
  9. A report by the Investor Review Group (commissioned by Energy Minister Martin Ferguson) found that, while a carbon price might result in the retirement of the coal-fired generation plant, investors might be weary of committing to new generation investment if the value of existing generation plant were to be substantially impaired without compensation: The Australian Financial Review, 'Carbon threat to power supply', 16 May 2011, pp.1, 6.
  10. See Productivity Commission, 'Carbon Emissions Policies in Key Economies' (May 2011), pp.151-153, 155.  A review of 17 Federal Government Schemes designed to reduce greenhouse gas emissions (such as the rooftop solar panel rebate) found they cost an average of $168/tCO2 abated and had little effect: The Age, 'Climate change up in smoke', 15 February 2011, p.1.  See also Grattan Institute, 'Learning the hard way: Australia's policies to reduce emissions', (7 April 2011).
  11. This is still somewhat less than the $2-3 billion pa over 10 years recommended by Professor Garnaut.
  12. The use (and acceptance) of an obligation transfer number will be mandatory in respect of certain gas supply contracts entered into before the carbon pricing legislation comes into operation.
  13. The Australian Financial Review, 'ACCC to police carbon rorts', 5 July 2011, pp.1, 6.
  14. The Australian Securities Exchange has already put companies on notice of this issue: 'ASX warns boards on carbon costs', The Australian Financial Review, 7 July 2011, p.1.
  15. ASX Guidance Note 8, par.93.
  16. Corporations Act, s.180.

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