Introduction

In our recent legal update we covered the Australian government’s announcement of the linking of the Carbon Pricing Mechanism (CPM) with the European Union Emissions Trading Scheme (EU ETS). This update provides further information about the EU ETS and considers how developments within this scheme may impact upon the CPM.

What is linking and what effect will it have?

The idea of “full” or “direct” linking is that allowances or units representing tonnes of carbon dioxide equivalence used in one scheme can be “surrendered” to satisfy compliance obligations of emitters in another scheme. These are EU Allowances or EUAs in the case of the EU ETS and Australian carbon units or ACUs in the case of the CPM. Linking increases liquidity in the emissions market for the linked schemes and broadens the range of opportunities for cost-effective emissions abatement. The practical effect is that if, by way of example, a power station in the EU did not have enough allowances to surrender in respect of its emissions, it could purchase allowances not just from other entities in the EU, but from a linked scheme such as the Australian CPM. 

What is proposed?

Full linking is proposed between the EU ETS and CPM. This will be a two-stage process. From 1 July 2015, a “one-way” link will be established, whereby liable entities in Australia will be able to surrender EUAs to fulfil up to 50 per cent of their compliance obligations under the CPM. From 1 July 2018, (subject to a bilateral agreement being completed) EU entities will be able surrender ACUs to fulfil their EU ETS liabilities. In essence, EUAs and ACUs will become fully “fungible”, creating a single market for allowances. The Australian Government and the European Commission are aiming to have the bilateral agreement completed by mid-2015. 

Implications

Many Australian companies will be seeking to understand the likely impact of design of the EU ETS on demand and price drivers in Australia. In many respects, the EU ETS is the CPM’s “big brother”, with CPM-regulated emissions being roughly the size of those of Germany alone. We have set out below some of the key issues for consideration. Before considering these issues, we provide an overview of key aspects of the EU ETS.

Overview of the EU ETS

Compliance entities

Installations covered under the EU ETS include a broad range of activities, subject to specified thresholds being reached. These sectors and activities include certain combustion installations, oil refineries, production of various metals, cement clinker, lime, glass, ceramic products, mineral wool, gypsum, pulp/paper, carbon black and certain chemicals. Carbon capture and storage facilities are also subject to the EU ETS. Emissions from aircraft operators in respect of flights into and out of the EU have been covered since the beginning of 2012.

Phases

The EU ETS is implemented by way of Phases. The first Phase of the Scheme ran from 2005 to 2007. The second and current Phase began in 2008 and ends in 2012. The third Phase of the EU ETS runs from 1 January 2013 to 31 December 2020. A fourth phase will be implemented from 2021. The EU ETS does not have a fixed price mechanism or any price collar.

Caps

Under the EU ETS, the cap has been set at 2,039,152,882 EUAs in 2013. This will decrease each year by 1.74% of the average annual total quantity of allowances issued by the Member States in 2008-2012. In absolute terms this means the number of allowances will be reduced annually by 37,435,387. This annual reduction will continue beyond 2020 but may be subject to revision not later than 2025. This figure does not account for aviation, which has a separate cap.

Whether or not the EU’s cap will be further tightened, driving up the EUA price (and Australia’s price ceiling), is discussed below.

Allocation of allowances

Compliance entities in the EU ETS have historically received free allocation of allowances. It is proposed that industrial sectors will transition to full auctioning of allowances. They will have to purchase 20 per cent of their allowances in 2013, increasing to 70 per cent in 2020 and 100 per cent in 2027. The power sector will not be granted any free allowances in Phase III. Sectors that are identified as being at significant risk of carbon leakage will receive up to 100 per cent of their emission allocation for free. 

In Phase III, benchmarks for free allocation have been set based on the average performance of the 10% most efficient installations in a sector or subsector in the EU in the years 2007-2008. It is expected that roughly half of the allowances under the EU ETS will be auctioned, i.e. some one billion allowances per year. 120 million allowances for Phase III are being auctioned in 2012, the year before Phase III starts. 

Under Phase III of the EU ETS, there is no limit on banking of EUAs. Entities allocated with any free allowances will receive them more than a year in advance of the surrendering deadline for a year’s emissions and can use them for compliance for the current year’s emissions or bank them for use in future compliance years. 

Penalties

In the EU, a penalty of EUR 100 is paid for each tonne of carbon dioxide equivalent emitted for which the operator has not surrendered allowances, and the operator must also make up for the unsurrendered allowances (i.e. purchase and surrender allowances to cover the shortfall).

Use of international units

For Phase II, Member States allowed their operators to use significant quantities of CDM and JI project credits for compliance purposes.

The right to use these credits has been extended into Phase III. A limited additional quantity can be used in such a way that the overall use of CDM and JI credits is limited to 50% of the EU-wide emission reductions over the period 2008-2020.

Existing operators will be able to use CERs and ERUs up to a limit which is yet to be determined but which will be a minimum of 11 per cent of their allocation during the period 2008-2012.

New sectors and new entrants in Phase III will have minimum access to CERs and ERUs of 4.5 per cent of their verified emissions during the period 2013-2020 (again, exact limits are yet to be determined). Aircraft operators can use credits for 15 per cent of their surrendering obligation in respect of 2012 and 1.5 per cent thereafter.

From Phase III, all CERs from CDM and JI projects registered before 31 December 2012 (except those from afforestation, reforestation and nuclear projects, or those from projects which destroy the two industrial gases HFC-23 and adipic acid N2O) can still be used. Special rules apply to the approval of large-scale hydro projects.

For CDM projects registered after 31 December 2012, only credits from projects in least developed countries will be allowed to be used in Phase III. It is notable that Australia does not currently impose this restriction on the use of CERs and the Australian Government has not flagged any intention to do so.

In the table at the end of the article we have provided a comparison of the key elements of the EU ETS and the CPM.

Key Issues

The following issues are likely to be important in the context of the linking arrangements.

Stringency

A particularly important issue will be an assessment of the overall stringency of the CPM and EU ETS and to what extent the effort required by entities regulated under the schemes is comparable. This has perhaps been the greatest design challenge faced by the EU ETS. Before considering the structural changes currently being discussed to enhance the EU ETS price signal, it is worthwhile considering how this has been tackled to date.

The objective of the EU ETS is not only to reduce absolute emissions but also to prompt investment in emission reductions within installations and the development of new low carbon installations. That objective is undermined where there is insufficient scarcity of allowances to underpin a strong price signal because a weak price makes it more difficult to justify these types of investments given the time scales involved for some of these projects. The EU ETS is based upon the allocation of emission allowances in respect of each Phase of the scheme which are less than a baseline of historically verified emissions, thus creating the required level of scarcity.

The impact of the financial crisis in 2008 and attendant recessions within a number of key Western economies, including in Europe, resurrected the question of whether an unfettered market-based scheme can generate a strong long-term carbon price signal. In essence, the decline of economic activity in Europe during Phase II (2008 - 2012) has resulted in significant falls in the price for allowances within the EU ETS (as market participants align the allocation of allowances for the Phase with the lower emissions profile such economic downturn implies). This has occurred despite the steps taken by the European Commission prior to the commencement of Phase II to address the drivers of the price collapse in Phase I. Those included: (i) issuing detailed guidance to Member States outlining the rigour with which it would assess proposed member state caps; and (ii) forcing further reductions on Member States that it considered failed to comply with that guidance.

The core design elements of Phase III were settled by Europe in 2009 with the passage of the amendments to the EU ETS Directive. The key tools they sought to employ to prevent further incidences of reductions in the strength of the EU ETS price signal were the “linear reduction” structure of the Phase III cap, the ability to bank allowances and greater levels of auctioning.

Unfortunately, the depth of the financial crisis and its impact on European industrial activity has resulted in continuing depressed prices for allowances in the EU ETS. The European Commission has commenced a process of legislative reform to address this. These reforms can be separated into near term measures and long term measures.

Near Term Measures - Backloading auction volumes

In late July 2012 the Commission set out how it proposes to amend the timetable for auctioning of EUAs in Phase III. The Commission’s proposals set out several options of adjustments that could be made to the amount of EUAs that will be auctioned at certain points during Phase III. The objective is to tackle the potential surplus of EUAs at the beginning of Phase III as the Commission has concluded that the EUA demand and supply balance at the beginning of Phase III is no longer aligned with what was envisaged when the auction profiles were originally decided. In essence, the Commission has decided that unforeseen economic and regulatory changes represent “exceptional changes” which justify it putting forward the adjustment measures.

Although the Commission initially considered pushing forward with delayed auction volumes without seeking amendments to the EU ETS Directive, the Commission has decided to seek formal amendments to the EU ETS Directive and associated auction regulation. This is likely driven by the Commission’s painful experience of losing in the European Court of Justice after European Member States such as Poland challenged the Commission over aggressive interpretations of its scope of authority. With evidence that certain European Member States were preparing to challenge the Commission if it pushed ahead, the Commission decided for legal certainty over speed of action. 

The Commission proposals are that a given volume of EUAs would be removed from the current auction timetable for 2013, 2014 and 2015 and these EUAs would instead be auctioned in an amount to be divided between 2018, 2019 and 2020. No permanent set-aside of EUAs is currently envisaged in these proposals.

The earliest the backloading proposals are likely to be in place is 2013. 

Longer Term Measures - Structural reform

European Commission representatives have acknowledged that backloading is only a temporary measure which may not do enough to prop up a strong carbon price in Europe. As such, they are due to release a report later this year on more permanent measures to address over-supply in Phase III. Little detail is available at this point but the likely options that will be consulted on are:

  • Permanent removal of the auction volumes that are delayed under the near term actions discussed above;
  • Revision of the linear reduction factor of 1.74 per cent that is currently specified in the EU ETS so as to reduce volumes to be allocated across the Phase (for instance, adjusting this to 2.2 to 2.4 per cent);
  • Increase demand in the EU ETS by extending the scope to other parts of the economy such as residential or transport sectors (although there are existing measures that would need to be considered in these sectors that are already seeking to reduce emissions); or
  • Agreement to increase the ambition of the EU from a 20 per cent target to a 30 per cent target (as has been offered by the EU under international climate change negotiations).

The timing of such fundamental changes is currently unclear and depends in large part on the political dynamics of a stressed Eurozone. In light of that, the period for discussion and implementation of such measures could occur in 2013 but could also be envisaged extending through until 2015.

Offsets

Another fundamental design characteristic is the extent to which schemes continue to allow cost containment by way of the use of “offsets” (being credits imported into the scheme from emissions reduction projects outside of the relevant cap). This issue relates both to the nature and type of offsets permitted for use and also to the extent to which they can be used. Australia appears broadly to have mirrored the EU’s offset criteria. This is to be welcomed from the point of view of linking. 

However, it will be interesting to see whether Australia eventually follows the EU in implementing requirements in respect of the use of the CERs coming only from Least Developed Countries for CDM projects registered from 2013. We also note that unless the current provisions are changed, Australia risks becoming a “dumping ground” for CDM projects registered after 2012 whose credits are not eligible under the EU ETS. The implications of this would need to be assessed in terms of linking the two schemes. It also remains to be seen whether the EU seeks to impose further restrictions on the use of different kinds of offsets.

Regulation

Perhaps of paramount concern will be the extent to which respective regulators trust each other to adequately guide schemes through the inevitable turbulence of the carbon markets. 

Faced with uncertainties about the ongoing international negotiations, the legal nature of domestic targets going forward and the offset pipeline, schemes will have to be robustly managed to ensure that they respond to surrounding policy uncertainty and attract investor confidence. Issues such as registry security and fraud which have dogged the EU ETS are likely to continue to niggle at the edges of emissions trading schemes. Each jurisdiction will have to ensure that it trusts the other to properly respond to such challenges. It may be difficult for the schemes to interact if there are greater levels of policy uncertainty and risk on one side.

Registries

Another technical aspect of emissions trading implementation relates to the registries architecture. For schemes to link there will inevitably require to be a certain degree of connectivity between different registries. Registries rules and practices may be different between jurisdictions. However, we do not believe that such regimes would necessarily require to be fully harmonised in order for two systems to link. We note though that the EU’s system of registries is becoming ever more complicated. This is partly in response to relevant security breaches. Recent changes have included factors such as movement to a single registry, enhanced security measures and improved ”know your client” requirements.

Conclusion

How smoothly the EU - Australia link will be implemented and whether or not it will help lead to a significant rejuvenation of the carbon markets remains to be seen. To date, significant concern has focussed around the dangers of increasingly fragmented carbon markets, in light of the limited international progress with respect to negotiating a fully fledged post-2012 climate agreement. The linking of the EU ETS and the CPM is likely to serve as a useful blueprint for how linking can be done. Nonetheless, the idea of an integrated OECD-wide carbon trading system, which was mooted in 2009 to be possible by 2015, still seems a long way off.

CPM and EU ETS comparison chart