How can Australia respond to Europe's carbon crisis?

The shockwaves from the European Parliament’s rejection on Tuesday of the EU ETS ‘backloading’ proposal have rapidly spread to Australia’s shores. 

The decision resulted in the European carbon price crashing to a low of €2.63 (A$3.33), and forced Treasurer Wayne Swan and Climate Change Minister Greg Combet to acknowledge that the government will need to re-examine Australia’s own carbon price forecasts before the May budget.     

What has caused the crisis in Europe?

The price of European Union Allowances (EUAs) under the EU ETS has been in steady decline since its heady days of €30 before the global financial crisis. A surplus of EUAs in the system has been the principal cause, and Europe has been grappling for some time with the challenge of how to increase demand and therefore the EUA price. Efforts intensified with the start of Phase III of the EU ETS in January 2013.   

After considering a number of adjustment options, the European Commission opted for a proposal which involved delaying or ‘backloading’ the auction of 900 million EUAs from 2013-2015 to 2018-2020. This was intended to be a short term measure, and a precursor to more fundamental structural reforms to address over-supply in Phase III and the setting of a 2030 EU-wide carbon emissions cap. 

The European Parliament’s rejection of the backloading proposal (334 to 315 votes) immediately dented market confidence and the EUA price dropped some 40 per cent in response. Under the European Parliament’s rules of procedure, the Commission could seek to revive the proposal but the balance of opinion seems to be that this is a long shot.       

How is this relevant to the Australian carbon market? 

The Australian government announced last August its agreement with the EU for a two-stage linkage between the EU ETS and Australia’s Carbon Pricing Mechanism. 

From July 1 2015, a ‘one way’ link will be established whereby liable entities in Australia will be able to surrender EUAs to fulfil up to 50 per cent of their compliance obligations under the CPM. From July 1, 2018, subject to a bilateral agreement being completed, EU entities will be able to surrender Australian Carbon Units (ACUs) for their EU ETS liabilities. 

In essence, EUAs and ACUs will become fully fungible, creating a single market for allowances.  

Amending legislation to the Clean Energy Act 2011 was passed in December 2012 which established the one way link. The practical effect of this is that from July 1, 2015, the ACU price is expected to mirror the EUA price. 

With the ACU price fixed at $23 to $25 until June 30, 2015, the ACU price would drop by over $20 overnight if EUA prices were to remain at current levels. Contrast this to the existing Treasury modelling, which projected the ACU price for 2015-2016 to be $29.      

Could the government do anything to increase Australia’s carbon price from July 2015?

Prior to the linkage announcement last year, the CPM had a floor price (starting at $15) built into its legislation. However, as part of the deal struck with the EU, this was removed from the CE Act in December 2012 and it is extremely unlikely this could be revived.

We have had a look at other parts of the CPM design under the CE Act to see if we can come up with any options which could be used by the government to achieve a higher carbon price.  Possibilities include: 

1. Defer start of linkage with EU ETS to July 2018

The amendments made to the CE Act in late 2012 firmly entrench the ability for liable entities to use EUAs from the start of the flexible price period on July 1, 2015. This has been done by including EUAs within the “eligible international emission units” that can be surrendered from that date.

Any proposal to defer the use of EUAs under the CPM would therefore require further amendments to the legislation to provide that EUAs cannot be surrendered until July 1, 2018. 

Given the timing of the election and the current workload of the Department of Industry, Innovation, Climate Change, Science, Research and Tertiary Education, this may not be a feasible option, even if it was politically acceptable.  Whether it could be pursued post election will depend upon the election result.

2. Use the auction process to inflate the ACU price

The CE Act provides that ACUs for use in the flexible price period will be sold at auctions conducted by the Clean Energy Regulator. The provisions include the ability for the minister for climate change to set a 'reserve charge amount' through a ministerial determination for a specified auction. 

Could this be used to inflate the ACU price at auction? Probably not, and it is certainly not its intention. The Explanatory Memorandum for the CE Act makes it clear that the purpose of the reserve charge mechanism is to enhance price discovery of the auction and to counteract bid shading or collusion by auction participants. It is therefore unlikely that it could be used to artificially inflate the reserve price to a level well beyond the secondary market price or to essentially operate as a ‘quasi’ floor price. 

Each auction will include an 'opening price'. This approach is outlined in the exposure draft of the Clean Energy Determination 2013 released for public consultation in March 2013. The government’s proposal is that the opening price will be determined by referencing market prices for emissions units. Domestic market prices will be used if a liquid market price can be obtained, in which case the opening price will be 80 per cent of the market price. Otherwise, the EUA market price will be used and the opening price will be 60 per cent of that market price.  

Based on the proposal outlined in the Draft Auction Determination, the opening price would be firmly pegged to a percentage of the market price at the time of the auction. For example, assuming the EUA price is used for the first auction, the 'opening price' would be about $2.50 based on current EUA prices (eg 60 per cent x $4.32). 

Although the Draft Auction Determination is still in draft and the proposed approach could be altered, it is difficult to see that the government would entertain using this as a legitimate mechanism to artificially inflate the opening price at auctions. 

3. Delay the auction of ACUs

The government has committed to holding at least two advance auctions of 2015-2016 vintage ACUs in the first half of 2014. This is outlined in the Draft Auction Determination and so any change to this proposed timetable would need to be reflected in the final Auction Determination released following consideration of public submissions. The government has consistently flagged its intention to hold advance auctions before the start of the flexible period, so any change to this scheduling seems unlikely. It would also be a pointless exercise, unless it was likely that the EUA price would increase over the short- to medium-term.   

4. Set tighter carbon pollution caps

Carbon pollution caps will be set for flexible price years of the CPM by regulations made under the CE Act, which are required to be made by May 30, 2014.  The Climate Change Authority is currently undertaking a review of the emissions caps and targets which should be set for the period 2015-2020, and will make appropriate recommendations to the Government on these caps and targets in October 2013. It is a statutory requirement for the minister to have regard to this report when determining the carbon pollution cap.

It is likely that the CCA will have regard to the state of the European carbon market and the fact that liable entities can use up to 50 per cent of EUAs, when they consider an appropriate cap. One option, therefore, would be for the CCA to recommend a cap which acknowledges this likelihood. If the cap is set tightly enough, and there is no significant diminishing of demand in the lead up to 2015, then this could act to produce a higher ACU price than the market EUA price.

However, given the other considerations that the CCA is required to have regard to, which include the 'economic' implications associated with various levels of carbon pollution caps and the principles which govern its functions, which include ensuring that measures are 'economically efficient' and take account of the impact on households, business, workers and communities, it is unlikely that the CCA would recommend a cap purely aimed at producing a higher ACU price.

Our conclusion from the above analysis is that the government is likely to be stuck with the EUA price unless it decides on some major policy shifts in relation to the CPM’s relationship with the EU ETS. This would most likely require renegotiation with the EU and further amendments to the CPM legislation.    

Given that there are still two years to run before the flexible period begins, the government may decide not to jump the gun and wait to see what unfolds as the EU draws breath and works out its next move in the structural reform of the EU ETS. 

Elisa de Wit is a Partner at Norton Rose. Damon Jones is a Senior Associate at Norton Rose.