Emissions Reduction Fund Green Paper released

In brief

The Federal Government has released its Green Paper on the design of the Emissions Reduction Fund. Partner Grant Anderson reports on this proposed centrepiece of the Government's Direct Action Plan.

Background

The Federal Government has recently reaffirmed its commitment to reduce Australia's greenhouse gas emissions to 5 per cent below 2000 levels by 2020 – estimated to require a reduction of 431MtCO₂-e from 2014 to 2020 – and to review this target as part of the international climate change negotiations in 2015.¹ The centrepiece of the Government's plan to achieve this reduction is its proposed Emissions Reduction Fund, which will be administered by the Clean Energy Regulator and is intended to operate from 1 July 2014 to at least 2020 (although only the first three years' funding, amounting to $1.55 billion, has currently been committed).

Following the release of terms of reference for the design of the Emissions Reduction Fund and a call for submissions on its design, the Federal Government has now released for public comment a Green Paper on the design of the Fund. This Focus outlines the proposals for the Fund, as set out in the Green Paper.

Operation of Fund

The Emissions Reduction Fund will buy the lowest-cost emissions reductions offered to it by running a reverse auction process, with bidders being required to submit bids (probably in the form of 'once-off' sealed, or confidential, bids) that offer up a specified quantity of emissions reductions from an identified project at a specified price. It appears that, despite some earlier policy uncertainty (including in the Direct Action Plan itself²), the Government is now of the view that the sole criteria to be applied by the Fund in purchasing emissions reductions is, indeed, lowest cost:

While many co-benefits of emissions reductions will naturally arise, the overriding objective of the Emissions Reduction Fund should be to purchase emissions reductions at the lowest available cost. Establishing multiple objectives for the design of the Emissions Reduction Fund could raise costs, as Australia would have to forgo lowest-cost emissions reduction projects in order to allocate funds to deliver other benefits.³

 

It also appears that successful bidders are likely to be paid for their emissions reductions at the price at which they bid those emissions reductions into the auction, rather than at the (typically higher) auction clearing price.

It is expected that, initially, there will be frequent auctions (to bring forward emissions reductions, as methodologies and projects are established), with bids being able to be submitted at any time and tender rounds being run regularly. However, it is anticipated that, over time, a set number of auctions will be held each year according to a predetermined schedule, subject only to there being a minimum quantity of emissions reductions offered at the auction (to ensure adequate supply) and a minimum number of independent bidders participating in the auction (to ensure adequate competition). In addition, consideration is being given to imposing a minimum quantity on the emissions reductions that a bidder may bid into an auction, so as to reduce bid assessment costs and to encourage project aggregation. Conversely, the Government is not inclined to impose an upper limit on the quantity of emissions reductions that a bidder may bid into an auction, as this could exclude large low-cost projects; instead, the Green Paper suggests that very large projects could be assessed through a separate tender process, although how this would work is unclear.

It is also likely that there will be some form of price ceiling that applies to each auction, so as to protect the Fund from paying an unduly high price for emissions reductions; this ceiling could take the form of an undisclosed maximum price, or an allocation of funding to each auction that declines as the clearing price increases. Moreover, it is possible that a funding constraint will be applied to each auction, so as to enable the annual budget for the Fund to be spread over that year's auctions.

Creation and sources of emissions reductions

The Emissions Reduction Fund will purchase emissions reductions from bidders, in the form of Australian carbon credit units (ACCUs). This is the form of unitised tradeable emissions abatement that is currently issued by the Clean Energy Regulator for land sector emissions abatement that occurs under the Carbon Farming Initiative (CFI). ACCUs are a form of transferable personal property, the legal title to which is created through registration in the Australian National Registry of Emissions Units.⁴ However, for the purposes of the Fund, a broader range of emissions abatement than that currently qualifying under the CFI will be capable of generating ACCUs. It is in this sense that the Emissions Reduction Fund scheme is referred to as 'CFI+'.

In order to create emissions reductions that can be used to generate ACCUs under CFI+, it will be necessary for those reductions to be created in accordance with an approved methodology. The Government's guiding principle for this purpose is that credits will only be issued for 'new and voluntary actions to reduce emissions that have not been counted or paid for under another programme or involve the displacement of emissions to another location'.⁵ In this regard, the Green Paper contemplates that there will be two broad types of methodologies.

The first type of methodologies are activity methodologies, which will apply to specific emissions reduction activities such as forestry/soil sequestration, waste coal mine gas destruction, landfill gas capture and combustion, energy efficiency activities, fuel efficient transport and the diversion of waste from landfills. The methodologies for such activities will include those already developed under the CFI, as well as methodologies that are used in other Australian schemes⁶ or that are used in foreign and international schemes⁷ (but have been suitably adapted for use in Australian conditions). It is anticipated that these activity methodologies will themselves specify the applicable additionality requirements,⁸ and that there will be no overarching financial additionality test.⁹ Arrangements will also be made to facilitate the aggregation of smaller-scale activities – eg by allowing forestry and soil carbon project proponents to register projects on land for which they do not hold the carbon property rights, provided that they have the agreement of the relevant landholders to use their land for the purposes of the project. In addition, the Green Paper contemplates allowing forestry, revegetation and soil carbon projects to choose between the existing 100-year permanence obligation (with an undiscounted issue of ACCUs) or a 25-year permanence obligation (with a discounted issue of ACCUs).

The second type of methodologies are facility-wide methodologies, under which emissions reductions (typically from multiple activities at a facility) will be measured using facility data collected under the National Greenhouse and Energy Reporting Scheme (NGERS). Emissions reductions could be generated for these purposes by measures such as switching to less emissions-intensive fuel sources, optimising boiler efficiency and recovering waste heat within the facility. The integrity of emissions reductions at the facility level will very much depend upon the establishment of an appropriate facility-level baseline against which emissions reductions can be assessed. This is likely to be quite challenging, as the chosen baseline (which will typically be based on past practices and use a multi-year average of historical data) will need to be normalised so as to remove any unrepresentative data and to ensure that only below-baseline emissions that derive from improvements in technology or practices are credited. Raw NGERS data is not sufficient for this purpose because it merely reflects actual historical outcomes. If the assigned baselines are too generous, there is a risk that the auction process will be undermined by false emissions reductions that can be sold cheaply into the Fund because they have been 'created' at minimal cost, thereby crowding out more expensive, but real, emissions reductions. As with the activity methodologies, the Government is not proposing to require that 'below-baseline' emissions reductions should satisfy a financial additionality requirement. Instead, to exclude emissions reductions at a facility that would have occurred without the incentives provided by the Emissions Reduction Fund, it is proposed that the period for calculation of the baseline will be reset at the end of each crediting period.

Although the Government has previously contemplated banding within the Emissions Reduction Fund,¹⁰ such that similar projects would compete against each other for funding,¹¹ the Green Paper has moved away from this concept. Banding (eg on the basis of methodology groups, technology applications or sectoral opportunities) would result in the Fund potentially supporting a diverse portfolio of emissions reduction projects, and so encourage innovation in emissions reduction projects, as well as ensure that the Fund is not over-exposed to the risks that may be inherent in a limited number of different kinds of projects. However, it is contrary to the strict objective of purchasing the lowest-cost available abatement.

In addition to using the CFI architecture as the basis for the accreditation of projects that can bid emissions reductions into the Fund and for the issue of ACCUs, the Government proposes to use the NGERS framework for the reporting and verification (including audit) of emissions reduction projects, albeit with modifications that could include:

• a risk-based approach to verification under which the need for independent verification depends on the nature (ie risk profile) of the project; and
• more frequent reporting and, therefore, ACCU issuance.

To preserve the integrity of the auction process and maximise the likelihood of emissions reductions being delivered, projects will only be able to participate in the auction process if they pass through a prequalification process. This process will assess matters such as the commercial readiness of the project, the credibility of the emissions reduction estimates and the compliance of the project with the applicable methodology, as well as the fitness and propriety of the seller of the emissions reductions.

Contracts for the purchase of emissions reductions

For the auction process to work efficiently and equitably, it is necessary that bids be submitted in the form of a standardised contract. Where a project has already generated the relevant ACCUs, the Fund will be able to purchase those ACCUs immediately upon the bid to sell them being accepted.¹² Where this is not the case, the Fund will forward-contract with the bidder for the purchase of such number of ACCUs as represents the quantity of emissions reductions that are successfully bid into the auction. The Government contemplates that such forward contracts will be for a maximum term of five years.¹³ While the form of the standardised forward contract has yet to be released, it is likely to include at least the following kinds of provisions:

• an obligation on the seller to secure (or ensure the securing of) any necessary project finance and regulatory approvals (eg planning and environmental approvals) within a specified timeframe, failing which the Clean Energy Regulator can terminate the contract;
• an obligation on the seller to deliver to the Clean Energy Regulator the contracted amounts of ACCUs (representing emissions reductions achieved by the project and the subject of a successful bid at auction) in accordance with a specified delivery schedule – this obligation could conceivably be suspended where it cannot be fulfilled due to the occurrence of a force majeure event in relation to the project, or due to a disruption to the operation of the electronic registry that precludes the transfer of the ACCUs to the Clean Energy Regulator;
• an obligation on the Clean Energy Regulator to pay for the ACCUs only once they have been delivered to the Clean Energy Regulator;
• a regime that deals with any under-delivery of emissions reductions from the project – this could entail the seller being required to obtain substitute ACCUs from another source or to satisfy its delivery obligations using international emissions units (albeit with an accompanying reduction in the purchase price payable out of the Fund to the extent the cost of such units is less than the bid price for the ACCUs),¹⁴ failing which the Clean Energy Regulator could have the right to terminate the contract and possibly require the payment of some form of compensation;¹⁵
• events of default, the occurrence of which would entitle the Clean Energy Regulator to terminate the contract (and possibly require the payment of some compensation: see above) – such events could include material non-compliance of the project with the applicable approved methodology or with other requirements relating to monitoring, reporting or verification, and a failure to rectify that non-compliance within a stipulated time period, as well as insolvency of the seller/project proponent; and
• the right of the seller to grant security over the contract, this being a means by which the project can secure advance funding (conversely, the seller would presumably not be permitted to transfer the contract without the Clean Energy Regulator's consent).

Management of emissions increases

The Green Paper contemplates that there will be, what it somewhat euphemistically terms, a 'safeguard mechanism' to incentivise businesses not to increase their emissions above historical levels. This mechanism will apply to facilities (or a subset of facilities) that are currently reported under NGERS, and will come into effect from 1 July 2015 (or after some other transition period during which businesses would have had the opportunity to invest in emissions reduction projects and so reduce their emissions profiles). It appears that the safeguard mechanism is intended to be implemented through the establishment of baselines at the facility level, which are generally to be determined by reference to the relevant facility's historical aggregate scope 1 and scope 2 emissions (adjusted for any unrepresentative data).¹⁶ The exception is that, for new entrant facilities (or significant expansions of existing facilities), the baseline could be set by reference to industry average emissions or possibly, in the case of facilities (or expansions) where a final investment decision has not been made, best practice¹⁷ emissions.

Under this safeguard mechanism, exceeding the applicable baseline (either on a single-year basis or on average over a multi-year period) could attract some compliance obligation. This compliance obligation could conceivably take the form of a 'make good' obligation under which the business must purchase emissions reductions in the form of ACCUs (or, possibly, international units¹⁸) to offset the above-baseline emissions. Although not stated, there will presumably need to be a financial penalty imposed on a business that fails to comply with such a make good obligation.

Market for emissions reductions

To the extent emissions reductions are not purchased by the Fund (including because the Fund does not take all of the reductions generated by a particular project), they can be sold on the voluntary market. However, it remains to be seen whether the voluntary market will elicit prices that will be sufficiently high or sufficiently certain, in conjunction with the Fund, to underwrite investment in emissions reduction projects. While there may be some demand for ACCUs from those businesses whose emissions exceed their prescribed baseline under the safeguard mechanism, this demand is unlikely to be significant or sustained, given that the level of that baseline is likely to make above-baseline emissions relatively exceptional.¹⁹ An alternative would be to progressively reduce such baselines, thereby creating an increased demand for ACCUs to satisfy any associated make good obligation; however, this could be characterised as imposing a compliance obligation that begins to look somewhat similar to the carbon pricing scheme.

Achievement of emissions reduction target

The Emissions Reduction Fund does not entail the imposition of an overall cap on emissions and so there is no guarantee that it will enable Australia to meet its minimum target of reducing its emissions to 5 per cent below 2000 levels by 2020. Certainly the baselines proposed for the safeguard mechanism, at least to the extent they are based on businesses' 'high point' historical emissions, will not impose an effective cap, and there can be no assurance that emissions increases in some areas of the economy will not substantially negate any emissions reductions that are generated through the Fund mechanism. Moreover, it is only Kyoto-compliant emissions reductions that count towards Australia's international climate change commitments, and many of the potential emissions reductions that are eligible to be sold into the Fund are not Kyoto-compliant.

In this context, it is also relevant to note that the Government has announced a review of the Renewable Energy Target, with early indications being that it intends to reduce the target.²⁰ This is despite the fact that, as the Green Paper itself acknowledges, the scheme has played, and would otherwise continue to play, a significant role in reducing emissions from electricity generation.

Finally, the Green Paper states that there will be a review of the Emissions Reduction Fund towards the end of 2015. Significantly, this is also around the crunch time for the international climate change negotiations, and the outcome of these negotiations is likely to be a critical determinant of the Government's attitude to the future operation of the Emissions Reduction Fund.

Next steps

Submissions on the Green Paper are due by 21 February 2014, with a White Paper containing the final policy design of the Emissions Reduction Fund to be released in early 2014. The Government proposes that the Fund will commence operating from 1 July 2014. However, as the Green Paper recognises, establishing the Fund by legislation is necessary to provide certainty and predictability both as to its operation and as to the rights and obligations of entities that wish to sell emissions reductions to the Fund. Given that the new Senators elected at the September 2013 federal election will not take their seats until 1 July 2014, it is not at all clear that the Government will be able to have the necessary legislation in place for a 1 July 2014 start date. Indeed there is no guarantee that even the new Senate will be willing to pass such legislation; for this to occur, the Government will need to rely on the support of either the newly elected 'independent' Senators (a number of whom have indicated their opposition to the Fund) or the Labor opposition or Australian Greens (both of which oppose the repeal of the carbon pricing scheme).

If you would like further information, or assistance in responding to the Green Paper, please contact any of the people below.