Carbon Market Institute. Submission Emissions Reduction Fund Terms of reference. 18 November 2013

Transcription

1 Carbon Market Institute Submission Emissions Reduction Fund Terms of reference 18 November 2013

2 TABLE OF CONTENTS About the Carbon Market Institute... 3 Executive Summary Background to the submission Key issues and principles framing CMI s submission Key design features Appendix I Carbon Market Institute Members Appendix II Criteria to shortlist the import of international methodologies and criteria used to assess and adapt methodology to Australian conditions

3 ABOUT THE CARBON MARKET INSTITUTE The Carbon Market Institute is an independent membership-based not-for-profit organisation. Our aim is to assist Australian businesses in meeting the challenges and opportunities associated with the evolving national and international carbon markets and thereby build capacity to grow in a lowcarbon world. As the peak body for carbon market participants, CMI has established an important role in the evolution of the carbon market in Australia. The Institute facilitates the networks, knowledge exchange and commercial interaction amongst key government policy makers and regulators, industry, financiers and investors, professional services companies and technology solution providers. CMI s Working Groups play a key role in connecting government and industry to facilitate constructive development and evolution of carbon markets. CMI membership represents a broad range of professionals, organisations and industry providers. Our members include leading professional service providers, NGERs reporting entities, secondary market participants, offset providers, academia and international organisations. Individuals within the CMI membership base are some of the most respected Australian carbon market innovators and leaders (see Appendix I for CMI members). As Australia undergoes a transition to a low carbon economy, CMI will play an increasingly important role in helping companies deal with the risks and opportunities that this transformation presents. CMI will continue to build the platforms and networks for knowledge exchange and commercial interaction, provide an important conduit between industry and government, track international developments and identify solutions and efficient market-based approaches to meet the challenges of meeting our emissions reduction targets.

4 EXECUTIVE SUMMARY Environment Minister, Greg Hunt, in his paper to a workshop with the Carbon Market Institute (CMI) on 24 October 2013 stated that the centrepiece of Direct Action is a market-based mechanism for reducing carbon emissions. The Emissions Reduction Fund (ERF) is the main component of this approach but there will also be a mechanism that will work with the ERF in helping Australia to meet its emission reduction target to deal with companies emissions above their business-as-usual baseline. The Minister outlined that this market mechanism will also help encourage co-investment by business and that ongoing Government funding should not be necessary once technologies are mature and become business as usual. 1 Based on the parameters outlined by the Minister, CMI believes that the design and operation of a market mechanism would involve establishing a baseline-and-credit system that is linked to the design and operation of the ERF. This submission outlines how the design features of the ERF and the baseline-and-credit mechanism can be linked to meet the Government s emissions reduction policy objectives. In early 2013, CMI established a Working Group to focus on options for implementation of the design of the Direct Action Plan. The working group has held workshops with Environment Minister Greg Hunt in his current role and former capacity as Shadow Minister, and with the Department of the Environment s Emissions Reduction task force. CMI s submission takes into account the significant input from CMI members as well as the outcomes of these workshops. In framing our submission on the ERF design features, we have also taken into account the following key issues and principles: The ERF will be a market-based solution. The commitment to a 5% reduction on 2000 emissions levels by 2020 is maintained as a minimum and the ERF should make a significant contribution to meeting this target. Achieving the 5% target emissions reduction target will involve significant investment from the public and private sector. The initial scheme should be designed so it is an enduring mechanism that provides long-term policy certainty for the market-based approach. Where possible, the existing infrastructure, governance and resources should be used. All projects funded by the ERF should achieve real, measurable, additional and verifiable emissions reduction. Bipartisan agreement in climate policy is necessary to alleviate uncertainty for business. A summary of the key design features detailed in this submission include: i) The existing CFI framework should be used to provide governance and environmental integrity to projects funded under the ERF. There is scope to streamline the existing CFI methodology development and approval process (see 3.1). ii) There should be a single tradable unit, an Australian Carbon Credit Unit (ACCU) representing a tonne of CO2e of abatement that can be sold to the ERF, to businesses 1 Paper to CMI Workshop

5 wishing to offset liability under the baseline-and-credit mechanism or into the voluntary market (see 3.2). iii) iv) The range of methodologies under CFI can be expanded to CFI+. This can be implemented through: new methodologies being proposed and approved under the existing CFI, importing and adapting methodologies that have been approved under other international standards and adapting methodologies from existing national schemes (see 3.3). For the range of abatement projects that are likely to bid into the ERF, the relevant methodologies that cover those projects should be prioritised to ensure eligibility to bid into the ERF (see 3.4). v) The ERF should incorporate banding to ensure funding allocation for a diverse portfolio of low cost abatement projects across a range of eligible methodologies (see 3.5). vi) vii) viii) ix) The fund manager of the ERF should have the appropriate experience in managing a range of investment risks relevant to the portfolio of projects that will potentially be funded (3.6). In addition to details on the eligibility, timing and platform, the auction design could include rules on banding or a relative weighting system to enable investment in a diverse portfolio of projects (see 3.7). The contracting and financing arrangements of the ERF should minimise private sector investment risks and provide confidence in abatement delivery (see 3.8). A baseline-and-credit mechanism linked to the ERF should provide incentives for companies to operate below their baseline and costs for companies exceeding their baseline. Baselines allocated could be adjusted over time to help meet current and future emissions reduction targets. Any penalties could be in the form of purchasing ACCUs, a cash contribution to the ERF or purchasing international permits. Further investigation, analysis and consultations are required to determine who should be covered under the mechanism, how baselines should be set and what the penalties will be (see 3.9). The following diagram summarises the conceptual design features outlined in this submission and how the ERF and the baseline-and-credit mechanism is linked through a market-based approach.

6 Figure 1: Summary of the design features of the Direct Action Plan, linking the ERF and the baseline-and-credit mechanism

7 1. BACKGROUND TO THE SUBMISSION The Carbon Market Institute s Working Groups have played a key role in connecting government and industry to facilitate constructive development and evolution of carbon markets. Drawing on the expertise of the CMI membership which includes some of Australia s most respected carbon market innovators and leaders, the Working Groups have provided a vital forum for the exchange of information between market participants, policy makers and government agencies. CMI has consistently maintained active engagement with key government agencies including the Clean Energy Regulator, the Department of the Environment and the former Departments of Industry, Innovation, Climate Change, Science, Research and Tertiary Education and Agriculture Fisheries and Forestry. In 2013, both prior to the Federal Election and since the new government was formed in September, CMI conducted Working Groups consultations with Environment Minister Greg Hunt on the design features of the Emissions Reduction Fund. In February 2013, in consultation with Greg Hunt, the Shadow Minister at the time, a number of key issues and questions regarding the design of the Direct Action Plan were identified about which CMI members could provide feedback. CMI held two Policy Working Group workshops to discuss these issues and questions and CMI undertook extensive consultation one-on-one with CMI members. In April 2013, CMI established a Policy Working Group to provide direct feedback to the then Federal Opposition on the options for implementation and implications of Coalition emissions reduction policies, should they win government. Since the Federal Election, CMI has maintained ongoing consultations through the Policy Working Group as well as on a one-on-one basis with members. In more recent times, CMI has engaged actively with the Department of the Environment s Emissions Reduction Fund Taskforce on design features of the ERF. Timeline April 2013 First CMI Direct Action Working Group with a focus on constructive input to the Opposition s proposed plan. 14 August 2013 Presented options to Shadow Minister for Climate Action to consider in the design and implementation of the proposed Emissions Reduction Fund. 7 September 2013 Federal Election polling day. October 2013 CMI Direct Action Working Group review of the Emissions Reduction Fund Terms of Reference with a focus on design features. 24 October 2013 Workshop with Environment Minister Greg Hunt. o CMI initial position and response to the Terms of Reference. o Clarification of key principles. o Key questions addressed by the Minister. 12 November 2013 CMI workshop with the Department of the Environment s Emissions Reduction Fund Taskforce.

8 2. KEY ISSUES AND PRINCIPLES FRAMING CMI S SUBMISSION In framing CMI s submission on the ERF design features we have taken into account the following key issues and principles: The ERF will be a market-based solution. Consistent with the Coalition s position before and after the September 2013 election, the Direct Action Plan will involve a market-based solution. The final design of the ERF could allow for a secondary market, facilitating trading between entities participating in the ERF, covered under a baseline-and-credit mechanism or as part of a voluntary market. The continuation of the Carbon Farming Initiative (CFI) provides an opportunity for Kyotocompliant credits to be generated and traded in the primary and secondary market established under the scheme. Australia s commitment to a 5% reduction on 2000 emissions levels by 2020 is maintained as a minimum and the ERF should make a significant contribution to meeting this target. No single policy will, in isolation, enable Australia to meet its 2020 emissions reduction target. The ERF, the baseline-and-credit mechanism, complementary policies, private sector investment and the possible purchase of international units will be required to contribute to meeting the target. There is a risk that current budget commitments to the ERF are insufficient to fund abatement activities necessary to meet the reduction target in Adjusting allocations under the baseline-and-credit mechanism and purchasing international permits may be required to meet targets. Where possible the existing infrastructure, governance and resources should be used. The CFI framework can be used to manage the development and expansion of methodologies. The Clean Energy Regulator can maintain the role of issuance of ACCUs. The National Energy and Greenhouse Reporting (NGER) data could be used in baseline setting. Industry baselines set under the Jobs and Competitive Package (JCP) could potentially be applied to set baselines. Expertise within the Clean Energy Finance Corporation could be deployed to manage the ERF. All projects funded by the ERF should achieve real, measurable, additional and verifiable emissions reduction. Publicly funded emissions reduction/avoidance projects through the ERF or projects submitted for funding by companies operating below their baseline should be covered under an approved methodology and verified abatement issued in the form of ACCUs from the Clean Energy Regulator.

9 Funding the 5% emissions reduction target will involve significant investment from the public and private sector. The Government is committed to using public funds to fund emissions reduction projects to achieve the maximum abatement for funds invested. In applying a market mechanism in the form a baseline-and-credit mechanism there will be a cost for businesses covered under the mechanism that exceed their baselines. Figure 2: An overview of who pays to achieve emissions reduction under the Direct Action Plan The initial scheme should be designed so it is an enduring mechanism that provides long-term policy certainty for the market-based approach. Currently, there is little detail of how the Government s policy will be extended to achieve emissions reduction targets beyond If the ERF is to continue as the primary basis for reducing emissions beyond 2020, the call on the Government budget may increase to very high levels. Therefore the full transition into a marketbased scheme such as a baseline-and-credit mechanism will be necessary to defray the public cost of funding emissions reduction. The initial design of the ERF and the complementary market-based mechanism should include the ability to adjust allocated industry baselines to meet future abatement targets. The Australian market mechanism will evolve in parallel with developments in other international carbon markets. Bipartisan agreement in climate policy is necessary to alleviate uncertainty for business. It is critical that the design of the ERF and the baseline-and-credit mechanism have bipartisan support so that industry, the market and investors can invest in emissions reduction with an increased level of certainty.

10 3. KEY DESIGN FEATURES 3.1 The existing CFI framework should be used to provide governance and environmental integrity to projects funded under the ERF. The existing Carbon Farming Initiative (CFI) should be maintained as the overarching framework to govern the development and approval of methodologies and the issuance of credits in the form of Australian Carbon Credit Units (ACCUs). The infrastructure and governance is in place and project developers and proponents are familiar with process from registering as an Offset Entity, to conducting a project through to being issued ACCUs and then subsequently transacting them. All projects bidding into the ERF should be covered under an approved CFI methodology determination or a new methodology developed under a CFI+ (see section 3.3). In parallel with the design and implementation of the ERF, there is an opportunity to streamline the CFI methodology development and approval process. A number of CMI members have proposed actions directly to the Government to improve the efficiency of the process for the approval of methodologies and the operation of the CFI. Some of the proposed actions suggested by CMI members include: Reviewing the role and make-up of the Domestic Offset Integrity Committee. Improving the process and timeline for responding to applications for new methodologies. Improving transparency of the decision making process for approval of methodologies. Fast-tracking the approval of international methodologies (see section 3.3). Revising rules for carbon accounting. More direct ongoing industry involvement in implementing improvements. 3.2 There should be a single tradable unit representing a tonne of CO2e of abatement. Under the ERF or the complementary baseline-and-credit mechanism, all abatement should be issued with ACCUs as the consistent, unitised, tradable unit. The principle of a single commoditised unit where a tonne is a tonne is a tonne is core to the integrity of a market-based approach. ACCUs earned under the CFI framework can be sold to the ERF, to businesses wishing to offset liability under the baseline-and-credit mechanism or to the voluntarily market. ACCUs should remain financial products and advisory services and/or trade in ACCUs should continue to be governed by an Australian Financial Services Licence (ASFL). An ACCU is transferable within Australia between accounts in the Australian National Registry of Emissions Units (ANREU). 3.3 The range of methodologies under CFI can be expanded to CFI+. Environment Minister Greg Hunt has advised that the Government s intention behind the Direct Action plan is to expand the CFI methodology development, validation and verification process to include other forms of abatement projects/methodologies not currently eligible under the CFI. Although the CFI has produced methodologies that have focused on land-based emissions avoidance

11 and sequestration, methodologies do not exist under CFI for energy efficiency, waste coal mine gas, transport, biofuels, soil carbon, compost/recycling and other sector specific emissions reduction processes. If key eligibility criteria for bidding into the ERF includes that a project must sit under an approved methodology, then the range of approved methodologies needs to be expanded. Expanding the range of abatement projects, to increase the range of projects to be eligible to be funded under the ERF, will be akin to creating a CFI+. The range of methodologies that projects could bid into the fund can be expanded in three main ways: New methodologies proposed and approved under the existing CFI. Import and adapt methodologies that have been approved in other jurisdictions. Adapt methodologies from existing Australian schemes. These are each discussed below: a) New methodologies proposed and approved under the existing CFI. Currently the Domestic Offsets Integrity Committee (the DOIC) accepts methodology proposals for assessment. Project proponents can follow the existing (and revised) process to propose new methodologies. Methodologies must relate to activities that are eligible under the CFI these activities are on the positive list. 2 The CFI covers activities that will deliver additional reductions in emissions from agriculture or landfill waste generated before 1 July 2012, or additional increases in carbon stored in plants or soil. b) Import methodologies from international markets. Internationally, credits for the abatement of greenhouse gases have been generated in Kyoto markets, voluntary markets, compliance markets and bilateral schemes. A range of government and non-government agencies have overseen the development and approval of methodologies and issuance of credits. Some of the leading global organisations involved in the development of methodologies include the CDM Executive Board, Gold Standard, Verified Carbon Standard (VCS), the Climate Action Reserve and American Carbon Registry. Collectively these organisations have developed 270 methodologies which have resulted in over 2.2 billion tonnes of emissions reductions. 3 Some of the benefits of importing and adapting internationally approved methodologies and protocols include: fast tracking the number of abatement projects to be eligible to be funded under ERF; avoiding the need to undertake detailed methodology development, assessment and approval domestically; ensuring the availability and use of high quality methodologies that will enable quantification of emissions reductions under funding from the ERF and ensuring a high level of environmental integrity and the use of Kyoto compliant methodologies (to contribute to Australia s 5% target) CMI research.

12 Adapting international methodologies can be done on i) methodology specific basis or by ii) establishing the California model for a carbon Offsets Project Registry. These two options are detailed below. i) Adapting international methodologies. The process to import and adapt methodologies developed under international standards would involve a number of key stages that can potentially be aligned with the critical timeline for the initial operation of the ERF. ii) The first stage would be to identify and assess the global suite of approved methodologies. CMI has already undertaken this exercise and met with the key international agencies involved in methodology development and governance. 4 In those discussions the organisations have indicated their interest in collaborating to progress the potential adaptation of international methodologies to be used under the ERF. The second stage would be to identify a shortlist of international methodologies for the so-called CFI+. This could be done by establishing a CFI+ Project Steering Committee to establish eligibility criteria, to assess eligibility and to rate and rank the global suite of 270 methodologies to identify a short list of suitable methodologies. For each shortlisted methodology, a review would need to be undertaken to assess and identify any changes that need to be made to adapt the methodology to Australian conditions. The assessment for each methodology may include technical, scientific, legal and commercial criteria (see appendix II for proposed CFI+ methodology shortlist eligibility criteria and assessment criteria). Once the review is completed, and the proposed adaptations to the shortlisted methodologies identified, the new CFI+ methodologies can then be submitted through the existing process for methodology determination and ministerial approval. Establishing a carbon Offset Project Registry To increase the range of methodologies that could be used under CFI+, the Californian model for the establishment of carbon Offset Project Registries (OPR) could be adapted. In California, the regulator of the cap-and-trade program, the Air Resources Board (ARB), accredits organisations to help facilitate the listing, reporting and verification of offset projects and to issue registry offset credits. These OPRs, include the CAR and ACR, who develop their own suite of methodologies or protocols to create credits that can be converted into offset credits used for compliance in the capand-trade program or sold into the voluntary market. In Alberta, Canada, under the Specified Gas Emitters Regulation, C3, is a non-profit climate change and sustainability agency, that facilitates the protocol development and review process for Alberta s offset system on behalf of the provincial government. This model could be adapted to the ERF and would enable Australia s Clean Energy Regulator to set the rules for the role of the OPR and to recognise the methodologies developed under internationally credible third party standards. Organisations such VCS, Gold Standard, the American 4 The Carbon Market Institute held meetings in 2013 with senior representatives from the CDM, Gold Standard, VCS, the Climate Action Reserve and the American Carbon Registry.

13 Carbon Registry and the Climate Action Reserve could be registered to oversee the adaptation of methodologies they have developed that are applicable to adapting to Australian conditions and abatement projects. These organisations have significant experience in the operation of all aspects of carbon offset programs including the methodology development, project verification, registration and issuance. Involvement of these organisations could help leverage significant international expertise into the Australian system. Alternatively a national not-for profit organisation could be engaged to work with the Government to coordinate the integration of these offset programs and the adaptation and ongoing development of the methodologies. c) Adapt methodologies from existing domestic schemes. A number of domestic schemes have established guidelines for assessing emissions reductions through energy efficiency projects that could be adapted as new methodologies under the ERF. Two of those examples include the Victorian Energy Efficiency Target (VEET) scheme 5, and the New South Wales Energy Savings Scheme (NSW EES). 6 In the VEET scheme, activities that generate certificates are known as Prescribed Activities. The VEET has 15 broad categories of Prescribed Activities that are confined to either the business or residential sectors. Prescribed Activities that are currently included in the scheme include: the installation of high efficiency hot water systems, air heater/coolers, lighting, high efficiency motors, refrigerated display cabinets, refrigeration fan replacement and commercial lighting upgrades. In the NSW EES, Registered Energy Saving Activities (RESAs) are specific activities implemented by an Accredited Certificate Provider that increase the efficiency of electricity consumption or reduce electricity consumption, by: modifying equipment or its use, replacing equipment, installing new high efficiency equipment, and/or removing equipment and reducing electricity consumption. Another domestic initiative for commercial buildings that could be adapted into a methodology to cover commercial buildings is the National Australian Built Environment Rating System (NABERS). 7 Through NABERS, the Australian property industry has a credible standard that uses a national rating system to measure the environmental performance of Australian buildings There is also the federal mandatory reporting requirement for the sale and lease of buildings over 2000 square metres under Commercial Building Disclosure (CBD). 3.4 The type of abatement projects eligible for funding under the ERF should be identified and relevant methodology development prioritised. There has been some significant recent research to identify the range of abatement activity undertaken by Australian industry to reduce greenhouse gas emissions and in building a low-carbon 5 VEET scheme is to reduce greenhouse gas emissions, encourage the efficient use of electricity and gas, and to encourage investment, employment and technology development in industries that supply goods and services which reduce the use of electricity and gas by energy consumers. See 6 The Energy Savings Scheme is established under NSW legislation. Its main objective is to assist households and businesses to reduce electricity consumption and electricity costs. Businesses that save energy by installing, improving or replacing energy savings equipment can gain financial incentives by participating in the scheme. 7 See

14 economy. ClimateWorks Australia in its Tracking Progress Towards a Low Carbon Economy 8 has produced the first whole-of-economy report on Australia s progress in reducing emissions. It covers the following key sectors power, industry, buildings, land-use, waste and energy efficiency. CMI has also undertaken research related to the potential investment in abatement in the Australian economy including the State of the Australian Carbon Market 2013 and Lessons Learnt from the First year of the Carbon Pricing Mechanism. 9 Building on this research and other information sources such as the Energy Efficiency Opportunities (EEO) database, key abatement technologies and a potential pipeline of future low carbon investments can be identified. Before expanding the suite of approved methodologies to be implemented under the CFI+, it will be important for industry and government to identify the priority areas for potential abatement and develop relevant methodologies accordingly. The methodologies to prioritise are those that sit at the intersection of the following three key criteria: Scale of potential abatement What is the potential volume of the emissions reduction? Cost competitiveness of the methodology What are the least cost opportunities? Sector appetite to implement projects under the methodology Which sectors are likely to develop projects? Figure 3: Priority areas for abatement and new methodology development To better understand the prospects and abatement potential, a modelling exercise should be undertaken. The abatement pipeline and prospects could then be matched against the range of international methodologies (CMI has already begun to assess and categorise the 270 international methodologies for their potential to be imported and/or adapted to become an approved methodology under the CFI+.). The modelling would be based upon research and scenario analysis and include: Potential uptake for each methodology shortlisted. Emissions reduction potential based on examples of abatement outcomes in other regions See

15 Approximate cost per project type under each methodology based on previous project examples using each methodology. Expected crediting period for abatement for each international methodology. Consideration in the modelling should be given to the emissions reduction profile (the timing of ACCU generation) associated with the priority methodology. Availability of methodology specific technologies and the readiness of the sector to invest in and integrate the technologies into their processes should also be considered. The outcome of the modelling would be to identify an indicative portfolio of projects, the range of volume of abatement and the range of funding required under the ERF for the prioritised CFI+ methodologies. 3.5 The ERF should be banded to ensure funding allocation for a diverse portfolio of low cost abatement projects across a range of eligible methodologies. Across Australian industry, a wide range of carbon abatement projects are in different stages of being developed and deployed. As technologies and abatement processes mature and commercial deployment increases, the cost per tonne of abatement typically reduces. Currently many project developers and technology providers have invested in carbon abatement and emissions reduction projects and processes that could benefit from funding from the ERF, in particular projects that have been developed or are in development under existing CFI methodologies. There is also an existing pipeline of 91 registered CFI projects which have to-date generated approximately 2.7 million ACCUs. 10 It is expected that these projects will continue to generate ACCUs which can be bid into the ERF. The ERF could be banded to ensure funding allocation for categories of abatement projects that have a different cost per tonne of abatement. Banding would enable projects competing in an auction to compete on costs with other projects in their band on a like-for-like basis. Banding is consistent with the Coalition s Direct Action Plan policy document which stated: To ensure the Fund supports a broad range of direct action initiatives, measures considered for support by the Fund will be assessed against similar proposals from similar sectors. 11 These bands could be quite large and encompass CFI/CFI+ methodology groups, technology applications or sectoral opportunities. 12 The bands established could be correlated with the existing project pipeline and with future abatement opportunities (see section 3.4). Banding would also encourage a diversity of abatement projects across the economy. Through banding the ERF would ensure innovation and build greater industry abatement capability by 2020 across all sectors, where the costs of abatement continue to decline. If the reverse auction process of the ERF only funds lowest cost abatement, there is no guarantee that different types of abatement projects will be funded or be financially viable, putting at risk the The Coalition Direct Action Plan The UK Renewable Obligation Certificate (ROC) uses banding based on technology groupings (see

16 involvement of many experienced project developers (including a number of CMI members) from participating in the ERF auctions. Banding through allocations to specific categories of abatement projects avoids abatement being absorbed by large volume low cost projects and the associated risks that that would bring for potential non-delivery for those large projects. Risk management through investing in a portfolio of projects is a critical design feature of the ERF (see section 3.6). The main trade off, if the ERF incorporates banding, is the potential to impact the funding of absolute lowest cost abatement. One way for the ERF to fund a diverse portfolio of projects is to provide a relative abatement weighting to projects bidding into the auction (see section 3.7). 3.6 The fund manager of the ERF should have the appropriate experience in managing a range of investment risks relevant to the portfolio of projects potentially funded. To manage the ERF it would be important to select a fund manager with the appropriate experience in managing investment risks and preferably with private sector experience. One option to leverage the existing capability and skills built up in investing in energy efficiency, low carbon technology and clean energy is to draw from the expertise in the Clean Energy Finance Corporation/Low Carbon Australia. The fund manager will need to manage a range of risks in each stage of the project approval, bid evaluation and contracting of projects and delivery of the abatement. Some of these risks include: Delivery risk: The risk the contracted project does not deliver the abatement. Technology risk: the risk the technology deployed on the project does not deliver at the level required to achieve the abatement contracted. Counterparty credit risk: assessment of the creditworthiness and financial status of the project proponent. Regulatory risk: the ability to manage the investment strategy based on changes to regulations and policy. One way to manage the risks of the ERF not delivering the maximum abatement from funds allocated would be to use a portfolio management model whereby the ERF would create a portfolio of different projects where funds are allocated to a range or bands of abatement types and managed over a multi-year period not dissimilar to an asset allocation model used by institutional fund managers. Diversification of abatement projects across various methodologies lowers delivery risk across the portfolio. This would be particularly important in the project approval/pre-auction phase as in the auction process the fund manager would take more of a passive role. In adopting a portfolio approach the fund manager would consider factors such as: a diversity of project types, term of finance, risk of delivery and emissions reduction potential. The fund manager could also be mandated to transact as a seller as well as a buyer of ACCUs. This would have the impact of creating liquidity in the market, allowing the fund manager to manage the balancing of the portfolio of ACCUs, if required, and supply the potential demand from entities covered under the baseline-and-credit mechanism.

17 3.7 The auction design could include banding or a Relative Abatement Weighting system. In addition to details on the eligibility, timing and platform, the auction design could include rules on either banding or a relative weighting system to enable the ERF to use the auction system to invest in a diverse portfolio. a) Participation eligibility Prospective bidders would be required to successfully complete a pre-approval process in advance of auction participation. The pre-approval process could be administered by the Clean Energy Regulator. Pre-approval criteria would build on the existing CFI framework and could include the following: Fit and proper person test. Project proponent being a Recognised Offset Entity. Project to be undertaken based on an approved CFI/CFI+ methodology. Project to be registered with the Clean Energy Regulator. Other financial and commercial due diligence criteria. b) Timing Assuming four years of ERF funding of $300 million, $500 million, $750 million and $1 billion, quarterly auctions could be run with a quarter of the annual allocated funding being available at each auction. Each quarterly run of the reverse auction will generate a single clearing price for successfully bid ACCUs. The post-auction release of single clearing price as well as information on the successful projects (methodology, volume, etc) will generate a transparent price signal which can be used to inform project proponents and aggregators bidding into future rounds of the auctions, as well as those participating in the secondary market. This will have the effect of creating a transparent, incentive-based price on carbon. c) Platform A reverse auction platform could be used to select winning bids. The auction would open at a predetermined price with the price gradually stepping down until the value of the remaining bids just covers the total value of the funds allocated to the auction. The auction would then clear at a single auction clearing price. Successful bidders would be forward contracted to deliver a set number ACCUs at given points in time at the auction clearing price. Auction parameters to consider include: An auction reserve price to be set in advance. The auction would start at this reserve price. Should there be insufficient demand to clear the allocated auction funds, those bidding would receive the auction reserve price. Minimum and maximum bid size should be set in advance. The timing of ACCU delivery is an important consideration and needs to be aligned with the ERF s objective for achieving pre-2020 and post-2020 emissions reductions.

18 d) Using a banding vs weighting approach There are two options available to achieve the objectives of encouraging broad engagement and of managing risk through portfolio diversification. The first is for the ERF to be banded to ensure allocation for categories of abatement methodologies that sit at different price points along the economy wide Marginal Abatement Cost Curve (MACC). Separate auctions for each distinct band of methodologies could be run whereby a reverse auction could be established within each band to buy up the cost curve. The drawback of this approach is that there will be different classes of ACCUs generated with price points related to their band. This could fragment liquidity in an already small market. An option to consider is an approach that involves using what could be described as a Relative Abatement Weighting system to ensure that the reverse auction results in a diverse portfolio of low cost abatement projects across a range of eligible methodologies. In this option, each methodology is assigned a relative weighting depending on where the methodology sits on the MACC. As a purely hypothetical example methodologies could receive weightings as follows: building energy efficiency = 1.00 industrial energy efficiency = 1.05 coal mine methane = 1.10 forestry = 1.20 Setting relative weightings for approved methodologies at the start of each year will allow project proponents to bid into the reverse auction knowing their methodology specific price outcome. Relative weightings are likely to change over time as the uptake of abatement opportunities and their costs change with emerging technologies. In the example above, should the auction clear at $10.00 then successful bidders would receive contracts as follows: building energy efficiency = $10.00 per ACCU delivered industrial energy efficiency = $10.50 per ACCU delivered coal mine methane = $11.00 per ACCU delivered forestry = $12.00 per ACCU delivered. The advantage of the weighting approach is that it requires only one auction to be run to achieve a diverse portfolio of projects. It also helps to pool liquidity by creating one uniform price and one tradable unit for the market. There is international precedent for using such a weighting approach. The UK Government employs a similar model for their Renewable Obligation Certificate (ROC) scheme See

19 3.8 The contracting and financing arrangements of the ERF should minimise private sector investment risks and provide confidence in abatement delivery. Conducting appropriate due diligence on prospective auction participants in the pre-approval stage will help to screen out unsuitable bidders and will be an important tool in managing delivery risk. Those who pass the pre-approval process are eligible to participate in the auction. Bidders who are successful in the auction should receive a standardised forward contract specifying the following components: Price to be the auction clearing price. Volume the volume of each tranche of ACCUs to be delivered. Timing the timing of each tranche of ACCUs to be delivered. Term the total length of the contracting period. Underlying deliverable ACCUs. There is an implied commercial value to the contract terms and arrangements which may be included in bespoke contracts. Bespoke contracts would be subject to lobbying and could distort the price signal generated from the reverse auction. Using a post-auction standardised contract will streamline the contracting process and ensures probity. Standardised government backed off-take contracts for projects successful in the auction will provide payment upon delivery of abatement. Project proponents can then utilise ERF off-take contracts to leverage private sector finance. Using a standardised contract would assist with the financiers familiarity with the contract and would likely lead to greater levels of investment. Project finance can be in the form of debt or equity and will assist in meeting the potentially large upfront capital requirements to commission the project. Once a project generates abatement, ACCUs can issued by Clean Energy Regulator and then the project developer or aggregator can redeem those ACCUs for cash against ERF contract. An issue for consideration is the term of the off-take contract. Contracts that cover the full crediting period of the project reduce investment risks and will be better able to leverage private sector investment. The ERF will need to employ a mechanism to ensure that it meet its objective of substantially contributing to the 5% emissions reduction target and to do so with a preference for domestic abatement. To manage delivery risk across the portfolio, the off-take contracts could specify the guaranteed delivery of ACCUs. a) In instances where a project under-performs and is unable to deliver the required volume of ACCUs, there could be a make good provision. Project proponents could be required to make every reasonable effort to procure ACCUs from other sources (projects generating surplus ACCUs, aggregators, etc) and surrender these ACCUs to make up the shortfall upon which the balance of payment will be received. b) In instances where the project proponent is unable to purchase additional ACCUs to make up the shortfall (due to lack of ACCUs available at a fair market price ), payment will not be received for the shortfall volume. There will be no additional financial penalty.

20 c) The ERF could then potentially purchase the same volume of Kyoto compliant international units, for example Certified Emission Reductions (CERs), to ensure that ERF contributes towards Australia s Kyoto Protocol 2 (KP2) target. The balance of funds (expected to be considerable due to the low price of international units) would then be rolled over into the next auction to purchase domestic abatement. Such a mechanism would ensure that the ERF preferences domestic abatement and purchases international units only as a last resort. The international market could potentially be used as a back-stop to ensure the ERF meets its objective in absence of domestic abatement. 3.9 A baseline-and-credit mechanism linked to the ERF should provide incentives for companies to operate below their baseline and costs for companies exceeding their baseline. The Environment Minister, Greg Hunt, in a paper to a workshop with the Carbon Market Institute on 24 October 2013 stated that the centrepiece of Direct Action is a market-based mechanism for reducing carbon emissions. The Emissions Reduction Fund (ERF) is the main component of this approach. The Minister stated there will also be a mechanism that will work with the ERF in helping Australia to meet its emission reduction target to deal with companies emissions above their business-as-usual baseline. The Minister outlined that this market mechanism will also help encourage co-investment by business and that ongoing Government funding should not be necessary once technologies are mature and become business as usual. 14 Based on the parameters outlined by the Minister, CMI believes that the design and operation of a market mechanism applying to emissions above the business as usual would involve establishing a baseline-and-credit mechanism that is linked to the design and operation of the ERF. Key components for a viable, credible market mechanism will involve companies being covered under the scheme having a penalty or cost for exceeding baselines and there being incentives for companies to generate financial benefits for reducing emissions and operating below their baseline. However, a key issue to consider in adopting a baseline-and-credit mechanism is that, unlike a capand-trade scheme, overall emissions levels are not capped. In addition, increases in total production for an individual company can outweigh the emissions reductions associated with the project related reductions in a particular business unit that may be funded under the ERF. There are a number of questions and issues to consider in how a baseline-and-credit mechanism would operate including: Who is covered under the scheme? How are baselines set? What costs will there be for companies exceeding their baseline? How are credits issued for companies operating below their baseline? How are targets for emissions reduction in the baseline-and-credit mechanism set? How is the scheme administered? 14 Paper to CMI Workshop

21 We propose options to consider for each of these key questions. a) Who is covered under the scheme? A baseline-and-credit mechanism could be applied to a very broad range of companies/sectors or a relatively narrow set. One option, originally considered in the Direct Action Plan, was to use the existing NGERs data to determine historical baselines and proposed emissions reductions beyond overall base levels already determined for individual firms. 15 If all NGER reporting companies were covered under the baseline-and-credit mechanism, the scheme would extend to over 800 companies. 16 Another option would be to apply the baselines to the companies currently liable under the Carbon Pricing Mechanism (CPM), or a subset of those companies. 17 If for example, the top 100 emitters under the CPM were covered under the baseline-and-credit mechanism (perhaps excluding landfill/waste), it would mean that a large proportion of Australia s overall emissions were captured under the mechanism. In July 2013, CMI undertook an extensive survey of over 200 liable entities under CPM to determine lessons learnt under the first year of the scheme. One of the key findings was that there were two tiers of liable entities, with the top tier being larger companies that typically have the internal capacity, management capability and established systems to be able to effectively report and operate under the CPM. 18 These top tier companies are those that are positioned to potentially draw on this capability, meet compliance and optimise their position under a baseline-and- credit mechanism. b) How are baselines set? Baselines could be set in a number of ways including on an absolute basis, primarily using emissions reported under NGER or on an intensity-based approach (that is, emissions reduction per unit of production). There are pros and cons and levels of complexity and administrative challenges for either process. Some of the issues involved in determining the best approach to setting baselines include: NGERs numbers are a set of data which can vary in an operational year and don t necessarily reflect efficiencies. If baselines are set for the last five years, they may reflect conditions under the global financial crisis and companies would be penalised for increased production against a business as usual. Managing baselines at a corporate level may lead to significant variations in the emissions profile due to changes within the corporate structure such as the purchase or sale of assets, mergers and acquisitions, etc. The setting of baselines on an emissions intensity basis can be difficult to implement. While emissions intensity baselines work well for commoditised products such as electricity, cement, 15 Direct Action Plan This prospect was raised by the Environment Minister in the CMI workshop on October

22 aluminium and steel, they can create anomalies particularly where there is a degree of product differentiation across a company or a facility. A recent report by EY highlighted that the establishment of baselines will need to strike a balance between recognising business as usual improvement in emissions efficiency versus additional emissions abatement activity. 19 Further investigation, analysis and consultation are required to determine how baselines should be set whether on a sector, activity, facility or a corporate wide basis. If the option to incorporate a subset of CPM liable entities as those covered under the baseline-andcredit mechanism was adopted, some of the process and reporting could be leveraged to reduce time delays in ageing baselines, and administrative complexity. The Emissions Intensive Trade Exposed (EITE) activity definitions for sector specific base lines developed under the Jobs and Competitive Package (JCP) could be adapted to set sector based baselines and companies would be covered under the mechanism on a facility/activity basis. The framework The JCP provides a basis of sector wide baseline reporting and there are at least two years of audited historical data reported to the Clean Energy Regulator in submissions for government assistance that can be used to set revised baselines. Under the Clean Energy legislative package, the businesses that performed better than industry baselines were rewarded. Under the CPM, the EITE activities did not, however, extend to all industries that would require baselines under a new mechanism and many existing baselines would need to be updated. c) What costs will there be for companies exceeding their baseline? The penalty for companies exceeding their baseline could be in the form of a requirement to purchase ACCUs. This would provide an alternative market for project developers, stimulate secondary market activity and increase the quantum and likelihood of investment into CFI/CFI+ projects. Another alternative to make good for companies emitting above their baseline would be to make a cash investment into the ERF, increasing the funds available at auction. A third option would be for companies exceeding their baseline to meet their compliance obligations through the purchasing of international units. d) How are credits issued for companies operating below their baseline? Companies operating below their baseline can bid new project related opportunities into the ERF under an approved CFI/CFI+ methodology. New projects can generate emission reduction under a methodology and so it would be a project based credit issuance. Each credit represents one tonne of carbon dioxide equivalent abated and is issued in the form of ACCUs. Using a methodology based assessment will overcome the difficulty of defining real abatement which is a common criticism of baseline-and-credit mechanisms. Scheme rules setting out what 19

23 activities will be credited and how they are aligned with the CFI framework, should be established and updated over time. Companies incentivised to invest in abatement and generate ACCUs will create additional revenue generating opportunities as they will be able to trade their ACCUs in the secondary market, offer them into the ERF and be traded in the voluntary market. Credits in the form of ACCUs generated are not capped and their issuance will lead to a more liquid market. Companies do not have to be subject to baseline-and-credit mechanism to bid a project into the ERF. e) How are targets for emissions reduction in the baseline-and-credit mechanism set? A target under a baseline-and-credit mechanism is normally defined as the number of tonnes of abatement that must be secured in each year. For companies that are covered under the baselineand-credit mechanism, there should be a threshold that warrants a cost or penalty. In the initial years of the operation of the mechanism, baselines can be potentially set to track against business as usual, meaning that few companies will be required to pay a penalty (ie only in exceptional circumstances when their emissions intensity or overall emissions blow out). However, over time baselines can be set to decline against business as usual so increasing potential costs/penalties for covered firms and their incentive to invest in low carbon technologies or processes. This declining baseline is consistent with driving sustained decarbonisation of major emitting sectors to enable meeting the 5% emission target and to incentivise more industry funded abatement. If baselines for covered entities are reduced over time, it transfers the heavy lifting to meet emissions reduction targets to covered entities, rather than the tax payer funded ERF. The cost for emissions reduction is transferred to those who are required to buy the credits. Figure 4: Baseline-and-credit mechanism with a declining baseline against business as usual