ERF price discovery: bid the 'min' or the 'max'?

ThE staggered start to the Emissions Reduction Fund is set to create an opportunity for early movers to navigate the ‘dark’ auction process and capitalise on potentially higher contract prices.

Reputex Market Insider

The past four weeks have been a rollercoaster ride for the Coalition, with the passage of the CFI Amendment Bill through the Senate delivering a significant domestic policy win, only for celebrations to be cut short by the announcement of a landmark deal between China and the United States – placing renewed pressure on the Coalition to set a strong 2030 target ahead of next year’s climate conference in Paris.

While Australia’s long-term climate ambition will continue to come under scrutiny through the first half of 2015 – from international and domestic stakeholders, including the Climate Change Authority, which will table its draft targets report by June 30 next year – in the immediate short term the Australian market is turning its attention to the commencement of the Emissions Reduction Fund and the new format of pay-as-bid, ‘reverse auctions’.

The ERF catches a scheduling break ...

Due to the number of amendments made in the Senate, the CFI Amendment Bill will again be tabled in the House of Representatives during the next sitting period (commencing on Monday) prior to receiving royal assent, with the first auction expected to be held in March, following the conclusion of the Carbon Price Mechanism true-up period.

Fortuitously for the government, the legislative delay for the first auction (from the government’s July 2014 timeline) will mean that the ERF does not come under competitive pressure from the CPM when it opens, with sellers of Australian Carbon Credit Units to have only one market to bid into, rather than two should the ERF and CPM have operated in parallel.

In light of the delayed implementation of the government’s scheme, the first ERF auction will operate unencumbered by competitive offset prices under the CPM, ensuring optimal participation in the ERF from ACCU holders following the conclusion of the CPM true-up on February 2, while also ensuring that the Regulator will be free to set its benchmark price strategy free from related policies.

The new price disovery ... 'strategic bidding'

While ACCU supply will be influenced by benchmark prices – with the potential for the initial benchmark price to either lift or deflate supply over the next 12-18 months – the design of the ERF’s reverse auction format is also likely to have a significant impact on market participation, particularly the ability for proponents to undertake price discovery.

In a standard multi-round auction process, the market is given an opportunity to discover prices and incrementally adjust bids in subsequent rounds, supported by price information available through a secondary market.

Under the ERF’s discriminatory price “pay-as-bid” auction format, a lack of transparency is instead likely to see the auction process operate akin to a “dark market”, with no information expected to be available to bidders on the benchmark price, while the single round, blind tender process will further prevent market price signals as only one bid per project will be allowed per auction.

Given the contract price will be offered based on the bid price, there is considerable risk for participants that bid too low, meaning that the risk of over or under-estimating the number of abatement credits is firmly on the seller rather than the government.

Such a dynamic is likely to lead to uncertainty among early movers, potentially resulting in low participation in initial auction rounds as proponents take a ‘wait and see’ approach to price formation.

Should early supply remain low, this may lead to favourable dynamics for early movers, with low competition potentially providing participants with more scope to inflate bids in order to lock in higher contracts with the Regulator.

This approach is counter to the theoretical design of the ERF, whereby the government proposes to purchase abatement ‘at least cost’, and the best chance of success (according to the Clean Energy Regulator) is to offer bids at “the lowest price at which it is worth your while to do the project”.

Speaking at the All-energy conference in October, Clean Energy Regulator CEO, Chloe Munro noted:

“The best strategy for auction success is to price realistically – the lowest price at which it is worth your while to do the project…including financing costs, that are not covered by other revenue or offsetting cost reductions such as electricity savings. In other words, you will need a well thought out business plan to decide whether you are likely to be eligible and at what price it would be worth your while to participate.”

While strictly true, the definition of “what price it would be worth your while to participate” remains to be seen, with firms more likely to search for the “maximum” price rather than the “minimum” with their bids as they seek to seek to discover the upper range of where they expect prices to form and lock in more acceptable returns.

As we discussed in our November Market Update, in a market not favourable to price discovery, this strategic approach to bidding, based on an understanding of abatement supply by type, cost and market bidding behaviour, is likely to be widespread.

Watch this space

As we approach the end the year, the market awaits further advice from Regulator, which will publish a series of guidance notes on its own role over the coming period, along with rules for the auction process and advice on the date of the first auction.

In parallel, the release of new draft ERF methods is likely to continue to open the market to a broader range of proponents, notably from industry, with high emitting companies forecast to ultimately supply up to 80 per cent of all emissions reductions into the ERF.

Industry ramp up times will be highly dependent on initial market prices, with potential for methods such as industrial building energy efficiency, building energy efficiency and facility emissions methods to play a much larger role in 2015 should approvals be quickly given, and confidence in available market prices incentivise early participation.

While the Department of Environment (and the Emissions Reduction Assurance Committee) is working to develop and approve as many broad methodologies as possible before the ERF begins, it will inevitably take time for new projects to be scoped, estimated and approved internally.

This dynamic, along with a lack of market transparency, may create an opportunity for early movers to navigate the ‘dark’ auction process and capitalise on potentially higher contract prices to achieve more acceptable rates of return – rather than bidding the minimum and being locked into ‘worst case’ prices.

The RepuTex Market Insider publication is a monthly review of the key events and activity shaping the Australian emissions markets. It was originally published by RepuTex under its Australian emissions markets research service. For more information please click here.