Carbon market reforms set to drive prices higher
Carbon prices trading at a discount compared to a looming surge in demand for, and restrictions in the supply of, Australian carbon credits.
- The Chubb Review of the Australian Carbon Credits Scheme highlighted a number of changes that could potentially reduce the supply of Australian Carbon Credit Units particularly via the mandatory cancelation of a percentage of ACCUs.
- Further more, changes to the Safeguard Mechanism have the potential to increase the demand for, as well as reduce the supply of, Safeguard Mechanism Credits (SMCs) which can be used in place of ACCUs by Safeguard Mechanism (SM) facilities.
- Having the potential to significantly increase the cost of abatement by SM facilities that exceed their agreed emissions limits the Government has proposed a cap of $75 for SMCs in 2023-24. The current price of an ACCU is $38.50 while the use of SMCs is restricted to SM facilities.
- These changes confirm our view that ACCU prices are undervalued and the growing demand for carbon offsets by corporate Australia is set to drive prices higher by at least 2025 if not sooner.
Chubb assures that Australian Carbon Credit Scheme is sound while delivering a number of recommendations to improve the credibility and integrity of the programme.
The Chubb Review into the Australian Carbon Credits Scheme was released on January 9th 2023 and was authored by Professor Ian Chubb AC (Chair), the Hon Dr Annabelle Bennett AC SC, Ms Ariadne Gorring and Dr Steve Hatfield-Dodds. Professor Ian Chubb was formally Australia’s Chief Scientist.
The key finding of the Review was that the “ACCU1 scheme arrangements are essentially sound” and, as such, had a marginal impact on the outlook for the ACCU market balance. The panel made some important recommendations in regards to methodology but more importantly they also provided a number of recommendations to improve the credibility and integrity of the Scheme. The Review made 16 recommendations with a large number focusing on structural and transparency issues: These recommendations covered:
- The separation and clarification of duties including replacing the Emissions Reduction Assurance Committee with a Carbon Abatement Integrity Committee and recommending the Clean Energy Regulator (CER) does not purchase ACCUs for the government.
- Appropriate resourcing of the main bodies contributing to the integrity of the scheme
- Scheme governance and integrity including the rejection of projects to avoid deforestation (about 14% of ACCU supply in 2021-22), stopping the adjustment of the baseline for Land Fill Gas Projects (LFG) over the life of a project which will result in less ACCUs being issues (about 20% of supply).
- Improving data transparency and information sharing.
- The clarification and enhancement of Offsets Integrity Standards along with developing a better way to account for and value co benefits.
- Ensuring the participation of rural and remote communities including First Nations Australians.
- Nullify the plan to require climate active participants to use a minimum of 20% of ACCUs.
- Carbon service providers and carbon market advisors to be accredited and regulated.
- The implementation of a scheme-wide buffer by the mandatory cancellation of a percentage of ACCUs to ensure a conservative supply of ACCUs.
The recommendations focused on providing a framework to allow the Scheme to evolve with the highest standards of integrity resulting in the generation of ACCUs of the highest quality where the credits generated were additional, permanent and not double counted in reduced, avoided or sequestered carbon dioxide.
Overall, the proposed changes result in a rebalancing of the supply and demand of ACCUs rather than a net increase or decrease with the removal of the 20% minimum for climate active participants reducing demand. In contrast, the recommended changes to the treatment of LFGs and avoiding deforestation projects will reduce supply. In addition, while the Panel did view that the current methodologies for Human Induced Regeneration (HIR) projects are sound the recommended structural changes and enhanced data transparency could have an uncertain impact on the supply of ACCUs from this method.
In addition, the report also noted that the mandatory cancellation of a percentage of ACCUs could result in an undersupply of ACCUs putting upwards pressure on prices thus increasing the cost effectiveness of abatement.
1An ACCU is a unit issued to a person by the Clean Energy Regulator by making an entry for the unit in an account kept by the person in the electronic Australian National Registry of Emissions Units . Each ACCU issued represents one tonne of carbon dioxide equivalent (tCO2-e) stored or avoided by a project. An ACCU can only be issued to a person if the person has a Registry account and a Registry account can only be opened by a person after the Regulator has considered whether they are a ‘fit and proper person”.
Changes to Safeguard Mechanism limit the supply of SMCs and increases demand for ACCUs
The Australian Safeguard Mechanism (SM) was introduced in 2016 to ‘safeguard’ the environmental gains made by the Emissions Reduction Fund. It was designed to regulate the largest industrial facilities (those that emit more than 100,000 tonnes of Scope 1 carbon dioxide per annum) which in 2020-21 accounted for 28% of national emissions. The SM can be thought as being similar to a cap and trade programme that creates market for carbon. Facilities that exceed their agreed baseline are required to purchase and surrender to the government ACCUs or SMCs equal to their excess emissions. Facilities whose emissions fall below target will earn SMCs which can be sold to higher emitters. However, SMCs will not be eligible for use more broadly beyond safeguard facilities.
In January the Australian Government announced changes to the SM to push the mechanism from having a focus on disincentivising emissions growth to direct incentivisation of emissions reduction via flexible and credible pathways towards the target for a 43% reduction in CO2 emissions by 2030.The SM 2030 target is for annual emissions from the sector to be no more than 100Mt with a goal of 1,233Mt in cumulative emission reductions between 2021 and 2030 representing a proportional share of the national target.
The key changes make emitters accountable for CO2 reductions without making such reductions too cost prohibitive via a $75 cap for ACCUs in 2023-24 (increasing with the CPI plus 2% from there). The changes removed a long identified problem of “headroom” where baselines (a baselines is the defined amount of carbon emissions the facility is permitted to emit) had been set well above the facilities’ actual emissions. Removing available headroom is essential to incentivise the adoption of low emissions production methods and should result in an increase in demand for ACCUs.
The proposed changes have been summarized below.
Changes to baseline estimates
The focus was on improving the credibility of baseline estimates. Previous baseline estimates could be based on industry averages or site- specific standards. The changes have removed any headroom the emitter may have on day one by combining site specific emissions and an industry average. For year one 90% of the baseline will be based on site specific emissions and 10% on the industry average. This will see the baseline estimate being closer to the actual site emissions and so the issuance of Safeguard Mechanism Credits (SMCs) will be restricted as it will be very difficult for facilities to reduce their emissions by 5% in year one.
If there was a greater focus on the industry average there would be some facilities (most likely newer facilities with lower emissions) that would be significantly below the baseline and thus eligible SMCs. From year one the baseline would then transition to industry average by 2030 by changing the split between facility emissions and industry average by 10% each year.
The baselines are set to decrease by 4.9% per year through to 2029-30. From there the decline rate to 2034-35 would be determined by July 2027 following the required NDC update.
New facilities will not be held to the same baseline but have more stringent requirements to meet. New facilities’ baselines will be based on international best practice adapted for Australian circumstances. In addition, existing SM facilities will also be subject to international best practice benchmarks if they begin to produce new products. However, the relevant framework is not yet in place to determine what those international benchmarks are.
Emissions crediting, trading and cost containment
The new SM will function as a baseline and incentivise credit emissions trading. Crediting and trading is set to commence on 1st July 2023 and all SM facilities with emissions below their baseline will be able to generate SM Credits, except for landfill and facilities accessing multi- year monitoring periods. If they emit more than baseline then they must surrender SMCs or ACCUs equal to their excess emissions.
Note also that international voluntary units cannot be used to meet SM obligations, restricting carbon credit demand to ACCUs and SMCs.
Unlimited banking of SMCs to 2030 means any SMC can be used for Safeguard compliance to 2030 irrespective of when they were issued. The 2026-27 SM review will consider post-2030 arrangement for banking and borrowing.
There are also borrowing arrangements for SMCs and facilities can borrow up to 10% of their baseline to be repaid the following year with a 10% interest rate.
To help reduce uncertainty over compliance costs the government has proposed a cap to the cost of ACCUs, but not for SMCs, for regulated facilities. The price cap has been set at $75 as at 2023-24 increasing by 2% plus the CPI annually. ACCUs are currently trading at $38.50.
Impact on the price of ACCUs
It is expected that these policies will generally boost ACCU prices, at least to 2025. With ACCUs currently trading at $38.50 the $75 price cap provides as strong indication for where the government expect prices to head. However, it is important to note that this could have a detrimental impact on potential emission reductions as the cost containment settings are less ambitious than they are in the EU or NZ. Furthermore, if $75 is less than the marginal cost of low emission technology these facilities could use then there is little economic incentive to pursue emissions reduction internally.
The reality though is that the new supply of ACCUs is limited and SMCs can only be earned by emission reduction. Hence the price of carbon credits will inevitably adjust to the real world cost of emissions reduction.
To preserve integrity and avoid double-counting with SMCs, the proposed changes provides that new projects that reduce covered emissions at a safeguard facility will no longer be able to create ACCUs. Existing safeguard facilities will continue to be able to buy and surrender ACCUs as an alternative to reducing on-site emissions, or purchasing and surrendering SMCs.
Protecting emissions intensive trade exposed (EITE) industries
It has been acknowledged that there needs to be some flexibility for industries that are vulnerable to competition from international markets to ensure that local production does not simply leak out to jurisdictions with less ambitious environmental regulation. This will be split into two groups: Trade Exposed facilities which will include all facilities undertaking trade exposed activity; and, Trade Exposed Baseline Adjusted facilities, a sub-set of Trade Exposed facilities facing an elevated risk of carbon leakage.
Both groups could be eligible for assistance from the newly established $600mn Safeguard Transformation Stream of the Powering the Regions Fund (PRF) to fund projects that reduce emissions on site. They will also receive preferential access to other PRF streams.
The most vulnerable Trade Exposed Baseline Adjusted facilities can apply to the CER for a reduction in the 4.9% decline rate, up to a minimum decline rate of 2%, effective over three years.
There is also debate on the introduction of a Carbon Border Adjustment Mechanism (CBAM) which would place a tariff on imports that have not yet paid a price for the carbon emissions in production. This policy is currently favoured by industry participants and is being pioneered by the EU.
Why the policy is bullish for ACCUs
- From day one there will be very limited SMC issuance as most of the head room for industry has been removed, pushing credit demand to ACCUs.
- As banking of SMCs is allowed and the demand/supply imbalance for credits is expected to grow, the supply of SMCs being traded is likely to be further restricted.
- Cheaper international offsets are not allowed.
- The government has made a clear signal in the price cap that it sees the risk of ACCU prices rising aggressively.
- It is estimated that if 25% of facilities do not meet the 4.9% target then they will need to buy around 1.75 million ACCUs – last year it was just 419 thousand.
- Reduced supply of Land Fill Gas (LFG) projects ACCUs will also help to support prices (see Chubb review for more details on LFGs).
Potential offset to bullish scenario
- Facilities can borrow up to 10% of their baseline each year for a 10% interest rate. This will allow firms to effectively defer some of their liabilities.
- Facilities can apply for a 5-year monitoring period so they won’t be penalized for being over target if they can demonstrate a firm and credible plan to reduce emissions.
- Some facilities have already forward purchased ACCUs for future liabilities.
- As ACCUs rise in price it will incentivise not just contracted projects to exit the ERF and release their ACCUs into secondary market but also those firms that have banked excess SMCs may find the price is now higher than their cost of abatement and so release addition SMC into the secondary market.
- The current concessions for EITE industries are likely to be less effective than implementing a CBAM as lower targets and new funding flexibility may simply result in a reduction in the decarbonisation efforts by key industrial sectors.
Timeline for the Safeguard Mechanism
- The first year for compliance to the Safeguard Mechanism will be July 2023 to June 2024.
- Facilities will then have till 31st October 2024 to report on both production and emissions.
- Any required ACCU or SMC surrender will have to occur by 31st March 2025.
- The first SMCs will be issued on 31st January 2025.
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