Two months into the operation of the fixed price phase of Australia’s carbon pricing mechanism (CPM) the Federal Government has announced a major policy change to the design of the CPM. Starting on 1 July 2015, the CPM will be directly linked to the European Union Emissions Trading System (EUETS).

The changes

The details of the arrangement made between the Federal Government and the European Commission to allow this linking are:

  • from 1 July 2015 EU emissions allowances (EUAs) will be available for use by Australian liable entities to comply with their obligations under the CPM;
  • from 1 July 2015 Kyoto units (emissions units created from emissions reduction projects certified under the Kyoto Protocol) will be restricted to only 12.5% of compliance for a liable entity (while maintaining the limit of 50% for all eligible international emissions units);
  • the proposed floor price of A$15 per eligible emissions unit will not be implemented and the proposed price ceiling (which is currently to be set at $20 above the expected “international price” for a particular year) will be set against the expected price of EUAs; and
  • an agreement will be completed by mid-2015 to enable the full bilateral linking of the EUETS and the CPM by no later than 1 July 2018 (this will enable European liable entities to use Australian carbon units for compliance in the EUETS).

These policy changes are not entirely unexpected in a context where it had always been the plan for Australia’s CPM to link to the European EUETS, however they have perhaps happened earlier than had been anticipated.

Part of the rationale behind these changes is that for emissions trading schemes to “link” there needs to be compatibility in some of the key parameters of the respective schemes. For example, the EUETS does not have a price floor for its EUAs and it has limits over the amount of Kyoto units that can be used for compliance purposes by European liable entities.

Future developments

In terms of a full linking arrangement, which is expected to be in place by 2018, the Federal Government and the EU Commission have reached a “shared understanding” and will need to “seek mandates from their respective authorities to negotiate and conclude an agreement to facilitate the full linking of their respective carbon markets”.

The EU Commission will need to seek a mandate for this further agreement through complex rule making procedures involving Member States in Europe, which will likely take time.

The list of matters that the later agreement will cover highlights that a range of critical issues are yet to be determined. The agreement will cover, among other things:

  • measurement, reporting and verification arrangements;
  • the types, quantities and other relevant aspects of third party units that can be accepted into either scheme;
  • the role of land-based domestic offsets;
  • implications, if any, for supporting the competitiveness of European and Australian industries in particular sectors exposed to a risk of carbon leakage; and
  • comparable market oversight.

What is the impact for business?

There are a range of impacts that will flow from this decision for a number of different industry sectors.

With the restriction of the use of Kyoto units from the beginning of the flexible price period to 12.5 per cent of liability, and the ability to make up the balance of liability with EUAs to a maximum of 50 per cent of liability, the price of both carbon units issued under the CPM and Australian carbon credit units (ACCUs) issued under the Carbon Farming Initiative (CFI) will be taken from the market for EUAs (that is, the Australian carbon price will track the European carbon price).

Analysts seeking to predict future carbon prices for the purposes of investment decisions (whether in long term energy investments or short term derivative transactions) will now need to look to European policy makers to determine the macro market settings that will influence the levels of supply and demand that affect prices. This will be particularly important for project developers seeking to develop projects under the CFI who previously would have considered the fixed price and the floor price as the principal price points for assessment of a project’s financial viability.

Key decisions are set to be made by the EU Commission later this year to deal with oversupply of EUAs in the market and, if these issues are resolved satisfactorily, stronger demand may see prices rise to levels which could see significant investment in CFI projects.

A further issue for CFI project proponents is that the current announcement sheds little light on the availability of ACCUs for use in the EUETS following full bilateral linking. This is, however, noted as a matter for consideration in the agreement which will ultimately reached between Australia and the EU.

The removal of the floor price takes away a key uncertainty for business looking to invest ahead of time in the procurement of eligible emissions units for the flexible price period. Investment in international emissions units had been hampered because of the uncertainty around how the “surrender charge1 would apply.

The changes announced yesterday now mean that it is much more likely that liable entities will look to enter into hedging arrangements through forward contracts or options to secure lower cost forms of compliance.