The Government's announcement today that the Australian Carbon Pricing Mechanism (CPM) will link to the European Emissions Trading System (EU ETS), initially through a "one-way" link, from 2015, is significant for Australian liable entities, carbon market stakeholders, and for the broader international carbon market.
An initial "one-way" link will enable Australian liable entities to use European units (EUAs) to meet up to 50 per cent of their annual liability. This is until a full two-way link is established, which will enable Australian units to be used by European liable entities in the EU ETS.
While Australia's scheme was designed to link with other credible emissions trading schemes, the discussions between Australia and Europe have progressed at a faster pace than many in the market anticipated. Increasingly, bilateral and regional links between systems, rather than UNFCCC, will shape the global carbon market. The combined Australia-EU market will be the largest carbon market globally.
So what does it all mean for Australian liable entities?
(i) international trading opportunities
Many carbon market stakeholders have been anxiously waiting for the rules on the price floor to be clarified in order to inform the structure and form of carbon transactions. Today's announcement goes further and gives rise to many opportunities for Australian liable entities in the international carbon market.
The removal of the floor price means that Australian liable entities will no longer have to pay a surrender charge on international units. This presents significant opportunities in the current carbon market environment. It enables liable entities to purchase eligible international units, while both CERs and EUAs are at record low prices, for use in the carbon price mechanism from 2015-2016. There is nothing preventing Australian liable entities with existing registry accounts in the European registry from purchasing EUAs today and holding these units until they can be surrendered in the Australian scheme.
The low European prices are unlikely to remain for long, as the European Commission is taking measures to increase the price over the short and long term. The upward momentum these developments will give to the price of EUAs means that the EU ETS and the Australian Carbon trading scheme may become linked at the bottom of the market for EUAs. This provides Australian buyers with an opportunity to acquire EUAs at prices significantly below the current floor price. While these units can't be surrendered in Australia until 2015/16, if the price of EUAs increases between now and 2015, the current EUA price may be significantly below the price compliance buyers will be required to pay on the market in 2015. This may provide liable entities with an arbitrage opportunity.
While a repeal risk still hovers over the Carbon Price Mechanism, purchasing international units (that is, CERs, ERUs and EUAs) minimises the impacts of any repeal on Australian buyers, as these units will be able to be sold on the international market, in the event they can't be used in Australia under a Coalition Government. There are, in any event, signs (although no formal policy) that a Coalition Government may allow companies to purchase some abatement internationally. Again this suggests there are good opportunities for companies to forward purchase these units, or options over them, now.
(ii) Implications for CFI and other domestic abatement in Australia
The removal of the floor will have implications for the price of Australian permits, including Carbon Farming Initiative ("CFI") units. The initial floor price of $15, increasing at 4 per year each year, would have set the price for Australian and CFI units. This is where the second element of the deal with the EU becomes critical. With the new "sub-limit" of 12.5% on eligible Kyoto units expected to be binding (at least after the first year), the Australian price will likely track the European price, instead of the CER price. This provides an important safeguard on the price of Australian permits.
A main strength of the price floor was the certainty on return that it provided to CFI investors. There have been concerns expressed about the impacts the current low prices in the EU ETS will have on the feasibility of CFI, and other emission reduction, projects in Australia. However, these concerns do not take into account the measures that the European Commission is taking to increase its carbon price in the short and longer term. In late July 2012, the European Commission released its proposal to "back-load" or delay the auctioning of between 400-1200 million allowances over phase III of its scheme which runs to 2020. This is considered by the Commission to be the first step in addressing the low price due to oversupply of permits in their system. Over time, it is likely that the Commission will take other measures to permanently remove European units from the market.
At a policy level, the link with the EU ETS means that Australian carbon market stakeholders will need to be more informed about developments in the EU ETS as these will now have a direct impact on Australia's scheme. It makes sense for Australia's price to be linked to the price in the largest, most liquid and longest running carbon market.
(iii) A reduced demand for CDM in Australia
Units from the Clean Development Mechanism ("CERs") will continue to play an important role in assisting liable entities meet their obligations. While the new sub-limit of 12.5% on eligible Kyoto units will reduce demand for CERs by Australian liable entities, this is balanced with the need to safeguard the Australian permit price from tracking the CER price. The Government's decision reflects trends in other schemes to increase limits on CER use. CERs are currently trading at record lows (around 3 euros) and are forecasted to continue downwards. The reasons for this are the increased restrictions in the EU ETS and in South Korea and oversupply; it is estimated that the global CER/ERU market will be oversupplied by almost 1 billion tonnes in the 2008-2020 period. An Australian price tracking the CER price would have had serious impacts on investment in CFI, and other domestic abatement, projects in Australia.
What are the next steps?
(i) Legislative amendments
The Government will need to make amendments to the Carbon Pricing Mechanism legislation in order to implement these changes. At the very least, the introduction of the sub-limit on eligible Kyoto units will require an amendment to the Clean Energy Act 2011. While, technically, amendments are not required in order to not proceed with the price floor, it would make sense to remove references to the price floor and auction floor price in the legislation so that these cannot be reinstated in the future.
Regulations will also likely be required, at the very least, to add the European unit as an eligible international unit under the Australians National Registry and Emissions Units Regulations.
(ii) Registry Arrangements: details on how EUAs can be used in Australia
The rules for how exactly Australian liable entities can use EUAs in the Australian scheme are not yet determined. Broadly there are two models available (i) Australian liable entities can set up an account in the EU ETS registry and then transfer them to an Australian Government account in the EU registry for surrender or (ii) a physical link could be established between Australia and the EU's registries and EUAs could be transferred into Australia's registry for surrender. Regardless of the model used, Australian liable entities with existing accounts in the EU ETS are able, from today, to purchase EUAs and hold them until the rules for surrendering them in the Australia scheme have been settled.
(iii) A two-way link
The challenge for the Government will be to keep up the momentum of linking discussions with the European Commission and agree a two-way link by 2018, which is quite a challenge, given treaty negotiations are notoriously complex and slow going. However, given the promising rate of progress so far, this could well be achieved.
Katherine Lake is Senior Associate within the energy and climate change practice of legal firm Ashurst (formerly Blake Dawson) and used to work within the International Linkages team at the Department of Climate Change.