Direct Action's shades of grey

Reputex Market Insider

While the proposed Direct Action Plan is likely to remove or at least reduce the downside risk for the majority of Australian firms, for many companies, it remains to be seen whether the new scheme will provide enough upside potential to incentivise their participation in the new Emissions Reduction Fund.

The potential for companies to generate 'abatement credits' for operating under a prescribed baseline is likely to play a key part in the government’s Green Paper on the design of the ERF, creating a supply link between the ‘baseline and penalty’ and ‘reverse auction’ mechanisms of the Direct Action Plan, and developing a financial incentive to encourage industry greenhouse gas emissions reductions.

However, while the ‘pay to reduce’ carrot makes sense in theory, in practice industry participation in the scheme will be determined by how emissions baselines will be set, how industry will receive abatement credits and how they might be bid into the ERF.

Emissions baselines – risk of a 'grey' credit influx into the ERF?

The setting of emissions baselines will have critical implications for industry, determining the net position of each firm under the proposed ‘baseline and penalty’ scheme, and the amount of abatement credits that could be bid into the ERF from companies operating below their baselines.

As we explored in our earlier analysis, should emissions intensity baselines be set relative to physical production, most companies would initially find themselves below their five-year historic emissions intensity average and immediately in a position to obtain abatement credits for free based on emissions reductions that had already occurred.

Our initial forecasts indicate that under this ‘loose’ baseline scenario we would see high supply of abatement credits from industry into the ERF, leading to ERF auction prices of approximately $13 on average in year one, rising to around $20 on average to FY18.

In such a scenario, more than 75 per cent of all credits bid into the ERF would be likely to be ‘grey’ credits – non-additional abatement credits created by an arbitrary baseline – and could potentially lead to a windfall of nearly $2 billion over the first 4 years of the scheme as companies bid these free credits into the ERF.

‘Green’ credits from an expanded set of Carbon Farming Initiative methodologies would supply the remaining 25 per cent of abatement into the ERF, however supply from these sources would be limited by the ability of ‘grey’ credits to bid into the ERF at lower prices.

While the financial upside for industry is clear in such a situation, the design of emissions baselines and the application of ‘additionality’ rules are key issues yet to be resolved by the government. It is difficult to imagine the government knowingly directing resources to non-additional abatement; however, industry designing rules to completely avoid crediting their own previous efforts may be even harder to imagine.

Risk of tighter emissions baselines

We continue to encourage firms to stress test a range of emissions baselines, with the potential for ‘tight’ baselines to be established should the government pursue higher auction prices, or seek to better scale baselines with future emissions reduction targets.

With the Greens and the ALP concerned over the ability of the government’s policy to meet the national emissions reduction target, and the scheme’s inability to be scaled up, a declining baseline may well be considered – be it now or during a subsequent review of the DAP.

In the Alberta Specified Gas Emitters Regulation scheme, emissions intensity targets are set 12 per cent below historic emissions intensity baselines. Yet despite these declining baselines, absolute emissions from covered facilities has continued to increase, causing the Alberta Government to revisit its emissions targets. Such an approach in Australia may mean that domestic scheme could be continually ‘tightened’ to ensure the market keeps up with improving emissions intensities.

A ‘tight’ emissions baseline could considerably change the upside proposition for Australian companies in participating in the ERF. The setting of ‘tight’ baselines would significantly curb the supply of ‘grey’ abatement credits from industry, as well as tilt the supply balance towards ‘green’ credits from the expanded CFI.

In such a scenario, we find that the resulting lower supply of abatement credits could result in the ERF auction price rising to an average of $40 from FY15-18.

The stricter baseline methodology would help to curb any industry windfall, and a higher ERF price would unlock considerable abatement potential from industry.

Ultimately, the auction price must stabilise to create a market price that will efficiently guide participation in the ERF, and lower the risk of bidding into the reverse auctions.

Watch this space

Given that the Direct Action Plan is unlikely to initially provide a ‘stick’ to incentivise companies to reduce emissions, industry participation will be almost entirely based on the ability of the ‘baseline and credit’ mechanism to encourage industry participation in the scheme.

How baselines and penalties are set, the eligibility of sources of low-cost, large scale abatement and the design government contracts will be critical watches for the market – particularly how policy settings influence supply of abatement (from baselines and the CFI), auction prices, and each firm’s ability to bid into the ERF.

This Market Insider Article was originally published by RepuTex under its Australian Carbon Market Intelligence service. For information on how to subscribe to RepuTex’s Australian emissions markets research, data and analysis, click here.

As a reminder, Reputex will be holding a Webinar on its initial ERF auction price and abatement supply expectations on December 11. Register here. 

A summary of our ERF auction price scenarios can be found in our public submission to the government’s consultation process, here.