Adapting to an earlier ETS

Liable businesses have plenty to think about if the Australian government moves to a floating carbon price in 2014. So what should they be doing to prepare?

Should the federal government legislate an accelerated move to a floating carbon price period, as proposed by Kevin Rudd, then Australian businesses liable under the scheme will need to quickly adapt to the change.

Meeting compliance under an ETS involves a number of commercial and strategic risk factors that need to be considered. This may involve developing a carbon risk management framework along with a strategy to optimise their portfolios under the revised scheme.

Outlined below are a range of key factors that industry will need to consider as they move towards an ETS.

1. Understand the different types of carbon units: Become familiar with a range of carbon units that can be used to meet compliance obligations under the Australian ETS such as Carbon Units, Australian Carbon Credit Units and eligible international units.

2. Understand the characteristics and price drivers of eligible carbon units: Eligible carbon units have different characteristics (sources, usage limitations, etc) and supply and demand characteristics that affect their prices.

3. Incorporate carbon into the risk management framework: Risks related to carbon emissions are complex, inter-related and sector specific. Such risks need to be identified and integrated into the organisational risk framework.  

4. Develop a carbon cost optimisation strategy: In developing a strategy to optimise a company’s position under an ETS, the following is a range of carbon procurement and risk management strategies should be considered:

a) Evaluate internal abatement projects: Taking into account cashflow requirements, evaluate possible internal abatement projects and select the ones that provide the most cost effective mitigation and/or reduction of emissions. Marginal Abatement Cost Curves (MACCs) can be used for the company wide evaluation of such projects.

b) Cash flow management: Liable entities receiving freely allocated carbon units from the government can use these permits to improve their cashflow by selling these units back to the government or to the banks and later repurchasing enough units to meet their liability.

c) Auction participation: Carbon units can be purchased through an auction process managed by the Clean Energy Regulator. Businesses wanting to participate in the auction need to register with the Regulator, hold an ANREU registry account, comply with auction competency criteria and agree to certain rules and regulations. Businesses need to provide the Regulator with collateral to participate in the auction. Lastly, businesses should decide whether to participate in auctions directly or to employ an agent to act on their behalf.

d) Registry account optimisation: There is the possibility of the parent company having corporate control over multiple liable facilities. Taking into account their corporate structure, management should consider the optimal strategy (consolidated or separate) to manage their registry accounts.

e) Surrendering and banking strategies: There are a number of eligible carbon units which have different characteristics and surrender limits. Liable entities taking a portfolio approach should consider these characteristics when deciding on which units to surrender and which units to bank for future compliance years.

f) Development of internal hedges: Taking into consideration their appetite for risk, investment horizons and cashflow requirements, management may wish to develop a rolling hedge to limit exposure to carbon price volatility.

g) Primary market investments: Direct investment in carbon sequestration or emissions avoidance projects under the Carbon Farming Initiative can generate Australian Carbon Credit Units which can then be used to meet compliance obligations or on-sold into the secondary market.

h) Secondary market investments: In addition to auction participation, receipt of free permits and primary market investments, liable entities also have the option to procure eligible carbon units through secondary market transactions such as:

i. Spot or forward contracts.

ii. OTC or exchange traded contracts.

iii. Use of structured products such as options, swaps, etc.

5. Evaluate internal capacity to participate in the ETS: Where a liable entity decides to manage carbon in-house, management will need to undertake a detailed evaluation of the organisational infrastructure and internal competencies required to effectively engage in the market. Where a liable entity decides to outsource the activity, management should investigate the range of service providers available, for example consultants, brokers, trading desks and banks.

6. Licensing requirements: As carbon is a financial product regulated by ASIC it is important to consider the appropriate licensing and training requirements.

7. Understanding international ETS policy developments: With the proposed linkage to the EU ETS possibly renegotiated to start sooner than July 1 2015, Australia will be a price taker due to the size of the EU market. Policy decisions taken in Europe will impact the Australian carbon price. Other new market developments in China, South Korea, America etc may also impact on future domestic carbon price movements.

Peter Castellas is CEO of the Carbon Market Institute.

The Carbon Market Institute has developed Carbon Decision Making and Risk Management: A Guide for Business which provides liable entities with a decision-tree type framework and accompanying software tool to identify and analyse their key risk exposures under an ETS. 

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