Adding up to a worst-case scenario

Ahead of the upcoming election, RepuTex was commissioned by WWF-Australia to assess the environmental effectiveness of the two major political parties’ climate change policy platforms – the Coalition’s Direct Action Plan and the Labor Party’s Emissions Trading Scheme.

The full results of the report were released last week, finding that based on current policy and funding settings, the Coalition’s Direct Action Plan would lead to emissions growth of 16 per cent on 2000 levels by 2020, driven by higher power and industrial sector emissions. For the policy to meet Australia’s unconditional 5 per cent emissions reduction target, additional funding of $5.9 billion per year would be required – or an additional $35 billion in total.

RepuTex’s report came one week after similar analysis from Monash University and Sinclair Knight Merz, which estimated that the Coalition would require an additional $4 billion to meet its commitment to reduce emissions by 5 per cent below 2000 levels by 2020.

Both reports suggest the Coalition is likely to fall short of its emissions reduction objectives – but why the budget discrepancy between the reports?

As with most research, the detail behind the numbers and the modelling approach tells an important story. On request from the team at Climate Spectator, we have put together a brief summary of our results, and some analysis on the differences between the RepuTex and Monash-SKM findings.

A brief recap – the RepuTex modelling approach

In undertaking its analysis, RepuTex examined two core policy scenarios: the effectiveness of an emissions trading scheme to meet Australia’s 5 per cent emissions reduction target (ETS scenario), and the ability of the Coalition’s Emissions Reduction Fund to achieve the same target, in place of the government’s ETS (ERF scenario).

Each scenario assumed the policy settings being taken to the election by each of the parties, i.e. an ‘early’ shift to an ETS, with a floating carbon price to be brought into effect on July 1, 2014 (rising from $6 in FY15 to $38 in FY20); versus the repeal of the carbon tax, and its replacement with the Coalition’s ERF from July 1, 2014.

Given the ambiguities in the Direct Action Plan policy platform, we assumed that the ‘baseline and credit’ aspect of the Coalition’s scheme would apply some settings from the NSW GGAS scheme, applying a 5-year historic average as the baseline, based on the Kyoto period from 2008-2012. Furthermore, we assumed a company average emission intensity baseline, based on physical levels of production (e.g. tonnes of metal or MWh) over the same period.

A consequence of that baseline is that Australia’s emission intensity has been declining in every sector from the Kyoto period through to today. As a result, our outputs led to no companies exceeding their baseline, meaning no penalty price was imposed under Direct Action - consistent with the Coalition’s intention.

RepuTex then simulated the operation of the Emissions Reduction Fund within our Marginal Abatement Cost (MAC) model, across all sectors of the Australian economy; with modelling simulating the actual investment barriers and costs facing a company in undertaking each project within the MAC curve in the forecast period.

Why the discrepancy – $35 billion or $4 billion shortfall?

One key factor that probably best explains the discrepancy in modelling results is due to assumptions on the operation of the Coalition’s ERF and the reverse auctioning process.

Whereas Monash-SKM assumed the ‘perfect implementation’ of abatement projects and price discrimination in the ERF, RepuTex assumed ‘imperfect implementation’ of abatement projects, with efficiencies for each mechanism based on overcoming sectoral project barriers and failures. In undertaking our modelling, we attempted to take a realistic view of the operation of the policy, rather than theoretical.

As a result, RepuTex and Monash-SKM came to different conclusions on timing and cost – specifically how much abatement could be achieved in each financial year, and the cost of that abatement.

Timing of projects has a significant impact on the cost of the ERF, as under a reverse auction, projects compete to achieve abatement over the same timeline – the next 12 months – meaning the application of funding is not done in a simple linear approach from cheapest to most expensive as one would traditionally see in MAC analysis. Less-costly projects that achieve abatement over longer timeframes must factor in significant risk given abatement is not purchased until their projects deliver actual emissions reductions – this risk is greatest where projects are dependent on reverse auction financing alone. The risk of not winning a reverse auction tender therefore makes the bids of land-use abatement in particular much higher than if a developer reliably recouped their costs over 10-20 years.

As a result, in an imperfect market setting, we found that more expensive projects were critical to achieving short-term abetment via a reverse auction mechanism. RepuTex’s MAC model recognises the time value of emissions reductions and assigns a realistic value to the amount of abatement that can be achieved for a fixed amount of funding in any given year. As a result, more expensive abatement supply is required to fulfil each year’s abatement target to 2020 – a different outcome than if one only considers the long-term view. For example a coal-fired power plant could be replaced by a large array of modular solar PV panels much faster than building a new gas-fired power plant, but the PV plant would likely have a much higher cost on a $/MWh basis.

This ‘realistic’ approach becomes very expensive as more abatement is required, while the fastest payback projects are quickly exhausted. Such a result is evidenced by the large offset potential of Australia’s forests being bypassed in favour of more expensive coal carbon-capture and storage or solar thermal power plant construction bids which would both have a faster payback period under the ERF.

This time value of abatement is also exacerbated by the allocation of the ERF according to a series of annual reverse auctions. Since ERF funds are proposed to be paid only upon verified abatement, the system favours projects with quick-paybacks rather than absolute lowest cost. For example, it is relatively easy to calculate the emissions saved by replacing an existing boiler fired with black coal with a gas fired boiler, and any abatement can be counted to have occurred every time the new boiler is fired. On the other hand, it is more difficult to calculate the emissions offset by afforestation or grassland management practices. In these instances abatement can only credited as vegetation grows, which is often non-linear, and in many cases does not reach steady-state sequestration rates until after the fifth year of growth – too little too, late to make a meaningful contributing to a 2020 target.

As a result, the reverse auction system alone does not provide enough capital certainty to developers, making project planning and delivery difficult, and ultimately expensive. When these factors are considered in ‘imperfect’ modelling of the market, costs very quickly spiral – ultimately constraining the effectiveness of reverse auction systems.

In order to provide more certainly, our analysis indicated that should Direct Action be restructured to apply an ‘absolute emissions baseline’ and long-term penalty price, emissions reductions could be achieved more efficiently, and projects developed with more certainty. This approach however, would still be at a cost higher than both the Coalition’s stated budget, and significantly more than the government’s ETS.

Hugh Grossman is executive director of carbon advisory firm, RepuTex. Bret Harper is associate director of Research at RepuTex, leading the company’s power and carbon modelling team. To access RepuTex’s full report, Direct Action versus Emissions Trading: Achieving Australia's Emissions Reduction Objectives click here.