Over the past 12 months Australian businesses have been implementing the processes required to comply with the Carbon Pricing Mechanism (CPM) legislation, but many have not gone far enough with some businesses still believing that ‘trading’ or other market-based activity is risky.
While some businesses are choosing to ‘play it safe’, others are just getting on with the job despite the continued uncertainty. This includes assessing various internal abatement projects and investigating the market based options available or those that may be available in the future. To not consider and compare these options is as big a risk as not doing anything at all.
Although the Opposition has suggested it will repeal the CPM if it is voted into office at the next election (due to take place in the second half of 2013), there obviously remains significant uncertainty about how and when this might be achieved. It is critical that businesses not view a potential repeal as the basis for a ‘do nothing’ approach, though it is a scenario that should be taken into consideration and factored in decision making.
For example, businesses are unlikely to forward purchase significant volumes of Carbon Units (CUs) at advance auctions (expected to commence in FY14) until it is clear that this will be necessary, or alternatively that there will be some form of compensation for the CUs they purchase (which at this stage appears unlikely under the Opposition’s policy).
Domestically, across both the fixed and flexible price periods, there are a range of options for buying and selling CUs that can benefit businesses by improving cash flow and reducing the cost of compliance. What we are seeing domestically is while businesses are still unlikely to buy advanced options they are selling their freely allocated CUs now to the major banks.
Internationally, with the recent changes announced by the government to the legislation linking the CPM with the European Union Emissions Trading Scheme and the removal of the floor price, international trading has become a more important consideration for business. In particular, the government’s decision to remove the price floor in the flexible price period (originally proposed to be the $A15) has resulted in many businesses revisiting the option to purchase and bank Certified Emission Reduction Units (CERs), which are currently valued at just above €1, now, ahead of the flexible price period. If your business has not already assessed the viability of this option, now is the time to consider doing so.
There are obviously many market-based options available for businesses currently seeking to reduce costs associated with their obligations but the challenge lies in knowing which options will work and what returns they will bring for your business, as well as assessing the risks.
While answering these questions can be challenging and will vary from business to business, adopting a structured approach that takes into account the risks, values and capital implications of the different alternatives is crucial to making a decision based on all the information available.
Obviously, each option will have different capital requirements and the cost of capital is extremely important when it comes to performing net present value analysis. The CPM introduces a range of specific risks and considerations, which need to be integrated into the NPV analysis by adjusting the cost of capital. These risks include the following:
-- Pricing risk: particularly important due to the volatile nature of carbon markets;
-- Delivery risk: associated with the expected ‘on time’ delivery of committed carbon credits;
-- Counterparty or default risk: where third parties, such as a broker or financial institution (where applicable), are unable to live up to contractual obligations;
-- Liquidity risk: arising from a lack of depth in certain markets or a mismatch in timing related to the outflows and inflows of cash;
-- Longer term debt risk: where the timeframes for calculating the NPV can extend out for many years (in the waste sector for example, it could be as long as 80 years).
Regardless of the approach each business chooses to execute it is critical that their governance framework and risk management policies be updated to incorporate carbon trading. The decision on whether to conduct trading in-house or outsource to an external party, such as a broker of financial institution is also important.
Navigating through a portfolio of options and strategies to achieve carbon mitigation objectives, while minimising negative profit and loss impacts is a challenge. But if businesses are prepared to look beyond the standard ‘purchase and surrender’ regime and explore, compare and assess the available options, they may have significant value to gain.
Mathew Nelson is Oceania Climate Change and Sustainability Leader at Ernst & Young.
Ernst & Young has issued a report Beyond Implementation which is designed to help businesses optimise their strategy under the CPM and to manage liabilities beyond the implementation phase. Copies are available at www.ey.com/au/climatechange.
The views expressed in this article are the views of the author, not Ernst & Young. This article provides general information, does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Liability limited by a scheme approved under Professional Standards Legislation.