Pricing in the carbon financing risk

With the fate of the carbon pricing scheme not likely to be known until late 2014, financiers of energy projects are facing great uncertainty.

The federal government's carbon pricing scheme raises a number of issues for the financing of emissions and energy intensive projects. 

The most obvious issue is that the scheme will impose additional costs on such projects. Emissions-intensive project proponents will be required to acquire carbon permits, while energy-intensive project proponents will face increased electricity and natural gas costs. These costs will have to be managed and factored into the modelling that financiers undertake to test 'bankability'.

Carbon permits will need to be surrendered in two tranches during the fixed price phase:

1)      a June 15 interim surrender late in the compliance year and;

2)      a subsequent February 1 balancing surrender

In the floating price phase permits will be surrendered in just one tranche on February 1 following the compliance year.

As a result, financiers will want their borrowers to build up appropriate reserves and to have appropriate carbon permit acquisition and hedging strategies in place. 

During the fixed price phase there will be little scope to manage the carbon price because emissions liabilities will generally only be able to be satisfied through the surrender of Australian carbon units. The fixed price of those units, their non-bankability and the ability of liable entities to access an unlimited number of them from the Clean Energy Regulator, will minimise trading opportunities.

However, this will change in the floating price phase. During this period not only can carbon units be banked indefinitely (and up to 5 per cent of a liable entity's annual emissions liability acquitted by borrowing units from the next year), but up to 50 per cent of an entity's annual emissions liability can be satisfied using international emissions units (such as certified emissions reductions under the Kyoto Protocol).

This will give liable entities a variety of carbon price mitigation strategies, including through forward-purchasing and hedging. Having said this, the three-year price collar, with the associated top-up payment that is required to be made where cheaper international units are surrendered, will limit the cost savings able to be made from acquiring and surrendering international unit.   

Also, as 2020 approaches, there will be 'balanced budget' pressure on the federal government to restrict the use of cheaper international units, given the use of those units will reduce the revenue raised by the carbon pricing scheme and therefore the source of funds for the government's household and industry assistance packages. 

Another issue for financiers is the process for auctioning floating phase carbon units. The government is considering a ludicrous requirement that the amount bid at auction be fully covered by a bank letter of credit – even though units that are bought, but not paid for, can be subsequently auctioned. Only the marginal exposure should be collateralised, and then only if the buyer does not meet a minimum credit standing.  As well, the government does not seem inclined to permit deferred payment for units purchased at forward auctions.

Credit markets are tight and the capital adequacy rules make letter of credit facilities expensive, so  these 'cash upfront' rules will cause serious problems.

Overlaying this is the uncertainty generated by the Coalition's policy to abolish the carbon pricing scheme without compensation. Although constitutionally feasible, this would mean that entities that take prudent steps to hedge their exposure – by buying units forward (or related derivatives) –  will be running the risk of paying good money for a commodity that could become valueless. 

Assuming the Coalition wins government at an election held in November 2013 but does not win control of the Senate (it will be a half-Senate election), the Coalition will only be able to have the legislation repealed if it wins a subsequent double dissolution election.  So the fate of the carbon pricing scheme is unlikely to be known until the second half of 2014.

An important issue for new projects will be structuring the allocation of emissions liability and costs.  While emissions liability initially attaches to the entity that has operational control over the emitting activities or (in the case of natural gas) the entity that supplies the natural gas, there is substantial flexibility to transfer this liability to other entities. 

The downside for financiers is that, in the absence of appropriate covenants, they could find themselves lending to a company that has assumed an unanticipated emissions liability from another entity.  For example, while the purchase of natural gas under an 'obligation transfer number' divests the natural gas supplier of liability for the emissions embodied in the natural gas, if that gas is combusted in an above-threshold facility then liability for the resultant emissions will be effectively assumed by the entity with operational control over the facility and not the gas purchaser.

Financiers will also be keen to ensure that the entity which bears the emissions liability is also the entity that receives any entitlement to free carbon units under the industry assistance programs.  Not only does this depend on an application for free units being made within time, but it also means that restrictions need to be included in financing documents to ensure that the entity that is eligible for the free units (which, broadly speaking, is the liable entity as at the end of the preceding financial year) is not able to subsequently transfer its emissions liability to an entity within the borrower group while still retaining its entitlement to the free units.

Finally, there are some legal technicalities to be considered. Carbon units exist as an entry in an electronic register, and can only be transferred by the registered holder.  They are personal property for the purposes of the Personal Property Securities Act, so security over them should be registered, noting 'control'.

They are also 'financial products' for the purposes of the financial services regulatory regime, which means that entities that deal in carbon units or in derivatives over them will need to hold an Australian financial services licence unless the dealing falls within an existing exemption or a 'hedging own exposure' exemption proposed under draft regulations.

Grant Anderson and Phillip Cornwell are partners at law firm Allens Arthur Robinson.