Going greener in Australia

The Australian government has bowed to pressure to introduce a federal emissions trading scheme. Roderick Bruce examines the market's potential

Australia's greenhouse gas emissions - last verified by the Australian Greenhouse Office at 559 million tonnes in 2005 - represent just 1.5% of the global total. Yet the country's per capita emissions in 2004 were 4.5 times the global average, says Australia's Commonwealth Scientific and Industrial Research Organisation, and over the past 25 years the average growth rate of Australian emissions was almost twice the average global rate, five times that of Europe and twice that of the US. According to the World Bank, in 2005 only the US' 20 tonnes of emissions per capita was ahead of the Australian figure of 18 tonnes.

Even though Australia would be close to meeting its theoretical commitments under the Kyoto Protocol (108% of 1990 emissions levels by 2008-2012), the federal government has not ratified the treaty because, says the Australian Greenhouse Office, "while it (Kyoto) has some positive elements, it does not provide the basis for a comprehensive or environmentally effective long-term response to climate change".

The federal government also says the protocol does not provide a clear pathway for emissions reduction by developing countries whose emissions are growing rapidly. "Without commitments by all major emitters, the protocol will deliver only about a 1% reduction in global greenhouse gas emissions," says a Greenhouse Office report.

But now, after longstanding pressure from individual Australian states and the opposition Australian Labor Party (ALP), the federal (Liberal) government in December recommended in July that a federal cap-and-trade scheme be developed by 2011.

Forced into a rethink

The federal government was forced into a rethink on an emissions trading scheme (ETS) for several reasons. The first was a seismic shift in concern about the link between climate change and emissions among the general public. "The shift in opinion has come in the past eight months, caused partly by (former US presidential candidate) Al Gore's documentary, An Inconvenient Truth, and partly by a lot of companies saying they're going carbon-neutral," says Martijn Wilder, a partner at law firm Baker & McKenzie's Sydney office.

The country's current drought has also played a part. "The drought has affected not only our farmers and agricultural production, but also the cities, through water restrictions," says Petrea Bradford, Sydney-based manager of carbon markets at utility Origin Energy. "People have now made a connection between that and climate change."

Big business and industry have also experienced a shift in opinion in recent months. In November, the Business Council of Australia (BCA) abandoned its previous ambivalent attitude to emissions trading and called for a national cap-and-trade scheme that can be linked to existing and emerging trading markets in other countries. "The BCA was split a couple of years ago, and that's where the government took its steer, that a couple of the big emitters weren't really behind an ETS," says Anthony Collins, general manager of emerging markets at the Australian Securities Exchange (ASX) in Sydney. "That has now changed and businesses have seen that this is something that needs to be embraced."

A third factor is growing concern among industry participants about new electricity generation capacity. "Electricity demand is growing and additional capacity is needed," says Tony Beck, manager and senior consultant at the Australasian Emissions Trading Forum (AETF) in Canberra. "It's not critical yet, but new capacity will be needed in a few years. Without a clear idea of costs associated with managing emissions, there is going to be some difficulty securing the investment needed."

A final, key, factor is the imminent election, which is likely to be in October or November. Surveys suggest the environment will be one of two key issues, along with the economy, and the government is behind the ALP in the polls.

The ALP, which leads the governments of every individual Australian state, still holds the upper hand in the emissions trading debate. "The state governments have been pushing for an emissions trading scheme for quite some time," says John Taberner, partner at Sydney-based law firm Freehills. On the back of this longstanding drive from the states, December saw the federal government announce the establishment of the Prime Ministerial Task Group on Emissions Trading to report by May. The state governments responded. "In February 2007 the state governments said they would implement a state-based trading regime if the government didn't impose a federal one after May," says Taberner.

Ironically, many of the recommendations made by the ALP-controlled state and territory governments in their proposal - instigated by the National Emissions Trading Taskforce (Nett) - have been adopted by the federal (Liberal) government's own Task Group. "The Task Group proposal does not make significant mention of the Nett's proposed National Emissions Trading Scheme (Nets), yet it adopts a lot of its philosophy," says Baker & McKenzie's Wilder. "In many respects, the proposed scheme is quite similar to Nets."

The Prime Ministerial Task Group has recommended that any future scheme should be based on a cap-and-trade model, with trading to start in 2011. A purpose-built mechanism to monitor, report and verify emissions data should be in operation before the scheme begins, and the National Greenhouse and Energy Reporting Bill, put before federal parliament on August 15, lays the foundation for this mechanism. "The information collected and reported under this bill will inform crucial decisions during the establishment of the emissions trading system, such as the allocation of emissions permits and incentives for early abatement action," says Malcolm Turnbull, minister for the environment and water resources. The government has committed A$26.1 million ($23.3 million) to establishing the system by July 2008.

The Task Group also recommends that a long-term aspirational goal for emission reductions, covering all greenhouse gasses, be set, along with a series of short-term annual caps for overall emissions, initially to 2020. Wilder says: "Significantly, the Task Group did not specify a goal or set cap levels, instead recommending that further modelling and analysis take place before specifying a target."

Annual caps for overall emissions would be supplemented by 10-year 'gateways', which would provide upper and lower bounds for emissions caps, initially for 2021 to 2030. Both annual caps and gateways would be updated at five-yearly scheme reviews, providing the industry with a minimum of five years' certainty on cap levels.

The scheme is likely to cover stationary energy (emissions from electricity generation and fuels consumed in the manufacturing, construction and commercial sectors, along with domestic heating), fugitive emissions (deliberate but not fully controlled emissions that result from leaks from pumps, pipes and valves), industrial processes, and transport, where facility-level emissions exceed 25 kilotonnes of carbon dioxide equivalent (CO2e.)

Coverage would generally be of direct emissions for large facilities, but with upstream coverage of fuel suppliers (non-industrial coal, natural gas and petroleum) for other energy emissions. Agricultural and land-use emissions and possibly the waste sector would initially be excluded, with the possibility of later inclusion.

"Broadly speaking, the sectoral coverage proposed by the PM's taskforce is pleasing, as one of the greatest risks to the establishment of any trading scheme is a lack of participants with 'real' trading positions," says Marc Barrington, manager for carbon and renewables at AGL in Melbourne, Australia's largest utility.

Caps would be implemented through annual, date-stamped permits, with free permits issued to businesses likely to be adversely affected by the introduction of a carbon price, such as fossil fuel-fired generators and emissions-intensive industries. "The balance of the permits would be auctioned, with an increasing proportion of permits auctioned as time goes on," says Beck.

A significant proposed feature is a 'safety valve' price. "The 'safety valve' emissions fee provides a mechanism to limit the cost to firms and the economy of mistakes that might be made in the management of carbon exposures in the early years, as the scheme is bedded down and as firms learn to manage their carbon liabilities more actively," says the Australian Treasury's Martin Parkinson, deputy secretary of the federal government's climate change group.

Offset credits from domestic and international abatement projects, such as Kyoto's Clean Development Mechanism (CDM), would be recognised by the scheme from as early as 2008, even though the Task Group rejects the Kyoto Protocol. This means that, while the scheme is being designed with linkages to other international schemes in mind, it could not be linked to the European Union (EU) ETS. "It is the European Commission's position that it will not create links with schemes in countries that have not ratified the Kyoto Protocol," says Wilder.

There is still relatively little known about the opposition's proposed scheme, although its main features are likely to have much in common with the government's proposal, given its heritage in the Nett study. However, Labor's scheme will have a more aggressive reduction target, given its planned commitment to Kyoto. Should the party win the forthcoming election, it hopes to cut Australia's emissions by 60% by 2050.

"The biggest difference between the proposals relate to the ratification of Kyoto," says AETF's Beck. "Also, the government is proposing that the scheme should replace industry- and state-based schemes. A number of industries want to see those continue, and the Labor party would run them in parallel to an ETS. However, a well managed ETS should be able to replace some of those schemes." Exact targets and solid details of any Australian ETS will only become clear after the election.

Lessons learnt

In designing an ETS, Australia can draw on the experience of the world's two largest emissions trading schemes - the EU ETS and one closer to home: the Greenhouse Gas Abatement Scheme (GGAS), a voluntary scheme in the state of New South Wales (NSW), launched in 2003, two years before the EU scheme.

Perhaps the biggest pitfall is that which befell phase 1 of the EU ETS: over-allocation. "The scheme in Australia needs to be longer-term, in order to give long-term pricing signals for carbon," says Wilder. "The allocation of permits needs to be done in a very strict manner to ensure we have a result."

Permits will be provided by a mixture of free allocations and auctioning of single-year dated permits. "Auctioning is economically efficient, helping promote liquidity and price discovery at a low administrative cost," says the Australian Treasury's Parkinson. Allocation by auctioning also has advantages over the EU technique of 'grandfathering' (allocation based on a company's historical emissions profile). AETF's Beck says: "We're cautious about the windfall gains and pass-through of costs associated with grandfathering, and that's why there is more of an emphasis here on auctioning."

The NSW GGAS scheme also offers perspective. It sets an annual state-wide reduction target of 7.27 tonnes per capita and requires electricity retailers to meet benchmarks based on their share of the power market. If an emitter exceeds a target, it can pay a penalty fee of A$9 a tonne or buy a NSW Greenhouse Abatement Certificate (Ngac). Around 20.2 megatonnes CO2e was traded via this scheme in 2006 with a total value of $225.4 million, says the World Bank.

But the scheme's integrity and scalability is questionable. "The problem with the NSW scheme is that it's a baseline-and-credit, not cap-and-trade scheme," says Wilder. "We really need to move into something more robust. It has reduced emissions, but not by the volumes people would like."

ASX's Collins agrees, saying the NSW scheme - mostly a bilateral over-the-counter market - lacks the critical mass for people to trade unilaterally. "It's large enough to support a fledgling, but workable OTC swap market - but lacks the critical mass to underpin new investment in generating capacity," he says. "No new generating capacity has come online in NSW since the scheme's introduction." Collins adds that in 2006 the value of the NSW scheme was six times that of Chicago Climate Exchange (CCX), making it the biggest scheme of its kind globally, after the EU ETS. "This helps put it in perspective that emissions trading is still in its absolute infancy," he says.

One company at the cutting edge of emissions-abatement techniques is Origin Energy. Along with trading in the NSW GGAS, the company, with around three million energy customers, runs its own carbon-reduction scheme with nationwide coverage. "It enables us to put a robust, credible and transparent framework behind selling voluntary carbon offsets," says Origin's Bradford. "The framework gives customers confidence that what they are buying is real and (that we) are actually reducing greenhouse gas emissions."

Origin has one of the biggest carbon portfolios in Australia and since 2001 has been trading carbon and renewables certificates in local schemes such as those in Victoria and Queensland, and in voluntary markets. "We're trading up to 10 different fragmented schemes, so it will be nice to have one national scheme," says Bradford.

Meanwhile, AGL was the first Australian company to join CCX, in March. Barrington says AGL wants to gain early experience within a legally binding, international trading scheme. "Membership of the CCX requires AGL to make real and lasting emission reduction commitments of 1.5% a year from 2000 levels between 2007 and 2010, allowing the company to lead by example," he says.

Encouraging futures

One obstacle to the development of a trading scheme is the lack of homogeneity in the current domestic market for carbon credits, says ASX's Collins. "The value of credits is largely dependent on the nature of the project and the quality of the issuer," he says.

A key aspect to the full development of a successful ETS is the emergence of a futures market. The significance of a futures market for risk management and price discovery is illustrated by the EU ETS, where 95% of the total traded volume has been in the form of derivatives trades - forwards, futures and options - with the rest being spot trades.

"While the spot price for carbon will be relevant for businesses required to pay for current carbon emissions, a forward price is critical to guide business investment decisions and help drive longer-term technology development," says the Federal Treasury's Parkinson.

AGL's Barrington says OTC and futures markets are of "primary importance to the liquidity and transparency of an ETS". The Australian Financial Markets Association's (AFMA) Carbon Market Committee is already working to ensure governmental policy development is focused on issues aiding a fluid operation of the market.

ASX plans to introduce a futures market prior to the issuance of permits to help industry participants manage risk. In the EU ETS, the OTC market started in 2004 and futures trading in 2005, well before the first commitment period. "Futures markets are very good in terms of price discovery - more so than OTC, as it's multilateral trading, in which all the bid and offers are reported," says Collins.

The best way to build a market, he adds, is to consult with buyers from the financial sector and the largest emitters as to what the contract design should look like. "We've learnt from other markets that flexibility in the way contracts can be traded is important," says Collins. "It's important not to be discriminatory between on-exchange or OTC. We accept both into the futures clearing house."

ASX already has the infrastructure in place for a carbon futures market, and all the likely participants in an ETS - utilities, investment banks and energy-intensive companies - already have futures accounts on ASX for managing risk. Collins expects a fast take-up as a result. "We've had a good response, particularly from the energy sector, who realise they don't have to jump through hoops to manage their risks," he says. Origin Energy's Bradford agrees. "With any market, a futures market adds value and liquidity, and helps parties to manage their risk," he says.

Australia now awaits the election result later this year to find out what shape the scheme will take. "All eyes are on the design of the ETS and the short- and long-term emission-reduction targets," says Collins. "The introduction of an ETS will represent the largest microeconomic reform Australia has ever seen."

And in New Zealand...

The New Zealand government has said that trading on an emissions trading scheme (ETS) could start as early as 2008, although it's likely a market will take some time to establish. 2008 represents the start date of the first commitment period of the Kyoto Protocol, a major driver for formulating the policy.

Development of an ETS for New Zealand began in earnest in the first quarter of this year after the government indicated its preference for an ETS over a carbon tax in late 2006. No details have yet been released regarding key points, such as how credits will be allocated or which sectors will be covered by the scheme.

"The Government has announced that the scheme will be an 'all gases, all sectors' approach," says Murray Dyer, director of New Zealand Carbon Exchange, a carbon credit trading intermediary based in Wellington. "It would therefore cover not only stationary emitters, but also transport, forestry and agriculture.

"Agriculture is a sector that is hugely influential over New Zealand's greenhouse gas emissions and that accounts for 48% of the country's total greenhouse gas emissions," says Dyer.

The Industry has voiced its concerns about indications from the government as to the speed with which policy and legislation will be implemented. "If anything, industry has voiced its strong concerns that it is better to get things right from the start than to rush policy through," says Dyer.

Several financial institutions are assessing this emerging market and their role within it. "Whereas many UK-based financial institutions have energy and commodity trading desks, this is not the case in New Zealand," says Dyer. "Therefore the infrastructure and skills that allowed European financial institutions to add carbon into their portfolio is not prevalent here."

It is not yet clear how an NZ ETS might link up with one in Australia, as New Zealand has ratified the Kyoto protocol while Australia has not, but this may change after the Australian election.