Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension

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1 A joint project with the Institute of Chartered Accountants in Australia and Ernst & Young Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension Adjusting Australia s tax framework to support the Emissions Trading Scheme March 2008

2 The Institute of Chartered Accountants in Australia (the Institute) is the professional body representing Chartered Accountants in Australia. Our reach extends to more than 56,000 of today s and tomorrow s business leaders, representing some 46,000 Chartered Accountants and 10,000 of Australia s best accounting graduates who are currently enrolled in our world-class post-graduate program. Our members work in diverse roles across commerce and industry, academia, government, and public practice throughout Australia and in 114 countries around the world. We aim to lead the profession by delivering visionary thought leadership projects, setting the benchmark for the highest ethical, professional and educational standards and enhancing and promoting the Chartered Accountant brand. We also represent the interests of members to government, industry, academia and the general public by actively engaging our membership and local and international bodies on public policy, government legislation and regulatory issues. The Institute can leverage advantages for its members as a founding member of the Global Accounting Alliance (GAA), an international accounting coalition formed by the world s premier accounting bodies. The GAA has a membership of 700,000 and promotes quality professional services to share information and collaborate on international accounting issues. The Institute is constituted by Royal Charter and was established in For further information about the Institute visit charteredaccountants.com.au About Ernst & Young s Tax Services Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Our 1,100 tax professionals in Australia provide you with deep technical knowledge, both global and local, combined with practical, commercial and industry experience. We draw on our global insight and perspectives to build proactive, truly integrated direct and indirect tax strategies that help you realise sustainable business growth, in Australia and wherever else you are in the world. Our talented people, consistent methodologies and unwavering commitment to quality service help you to build the strong compliance and reporting foundations and sustainable tax strategies that help your business achieve its ambitions. It s why our Tax practice has been recognised as the country s leading tax adviser by International Tax Review magazine. It s how Ernst & Young makes a difference. For more information, please visit Disclaimer: This paper is provided as general information only and does not consider your specific objectives, situation or needs. You should not rely on the information in this paper or disclose it or refer to it in any document. We accept no duty of care or liability to you or anyone else regarding this paper and we are not responsible to you or anyone else for any loss suffered in connection with the use of this paper or any of its content. The Institute of Chartered Accountants in Australia Ernst & Young. March 2008 All information is current as at March 2008 First published March 2008 Published by: The Institute of Chartered Accountants in Australia Address: 33 Erskine Street, Sydney, New South Wales, Australia 2000 Ernst & Young Address: The Ernst & Young Centre, 680 George Street, Sydney NSW 2000 Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension First edition Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension ISBN ABN The Institute of Chartered Accountants in Australia Incorporated in Australia Members Liability Limited ABN Ernst & Young.

3 3 Foreword by the Institute of Chartered Accountants in Australia The global acceptance of the need to regulate carbon emissions, and to take action to reduce global carbon emissions, is one of the major international regulatory initiatives of this century. However, this initiative also requires adjustment to Australia s tax system, to ensure that Australia remains competitive, and remains an attractive location in which to conduct business. These issues are important for the maintenance of Australia s employment, for the ongoing development of our welfare system and the prosperity of the Australian economy. The Institute of Chartered Accountants in Australia (the Institute) commissioned Ernst & Young to produce this report as part of the Institute s leadership role in setting tax policies aimed at maintaining and enhancing Australia s economic attractiveness. I would like to acknowledge the work of the Institute s Tax Counsel, Ali Noroozi and his tax team for all the work they invested in producing this document, in addition to other Institute staff. I would also like to thank the various Ernst & Young authors involved in the development of this publication including: > David Burns, Partner, Business Tax Services > Andrew van Dinter, Executive Director, Business Tax Services > Tony Stolarek, Partner, National Tax > Rodger Muir, Partner, Indirect Taxes > Peter McMahon, Partner, Indirect Taxes > Peter Ferguson, Partner, Indirect Taxes > Trevor Hughes, Partner, Business Tax Services > Trent van Veen, Partner, Environmental & Sustainability Services > Chad Dixon, Partner, Business Tax Services Andrew Arkell, FCA President, 2008, Institute of Chartered Accountants in Australia Foreword by Ernst & Young Australia Australia s plans for strong action as part of the international effort to reduce greenhouse gas emissions represent a significant but worthy challenge for Australia, its businesses and people. These initiatives, if introduced with the right balance for all, will potentially lead to significant growth opportunities for Australia and Australian businesses. To achieve the most effective adjustments to the new reduced emissions environment, and to best position Australia and Australian businesses to seize the opportunities, tax issues are relevant in the policy development process. As recognised by the Federal Government and in the interim report of the Garnaut Review, appropriate competitive policies are needed. Otherwise certain industries or businesses might relocate or remain overseas, to the detriment of Australia s growth and the global action to reduce greenhouse emissions. Tax is one element of those internationally competitive policies for attracting and retaining investment in Australia. We are pleased to partner with the Institute in this project and trust that this work will play a useful part in assisting Australia to develop appropriate policies in this major national effort. I would like to recognise not only the major authors listed above, but also various other people who assisted in this study, including Ernst & Young people in the Environmental & Sustainability Services and Taxation Services groups, and also Catherine Deane, an external consultant currently in the UK. Trevor Hughes Managing Partner, Business Tax Services, Australia

4 Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension

5 5 Contents 1 Executive summary 6 2 Australia s climate change initiatives: An issue for business Global context Overview of climate change related policy and regulation in Australia The Australian Emissions Trading Scheme Credit for early action Future scenarios and key considerations for business Examples of how the AETS would operate 14 3 Tax issues associated with emissions trading in Australia The types of participants and their likely transactions under the AETS Income tax issues arising from the AETS GST implications of the proposed AETS Stamp duty implications of the AETS Petroleum Resource Rent Tax Issues arising from the AETS 28 4 Tax issues and incentives other than direct AETS issues, to drive behavioural change to reduce emissions Innovation, research & development by Australian businesses to deal with climate change policies will require consideration of R&D incentives Considering existing tax capital allowances and potential tax incentives for capital expenditure and business processes geared to reducing emissions Income tax administration issues under the current tax laws 37 5 Best-practice tax policy development processes on tax issues to enhance Australia s position Responsibility Approach Revenue costings will need analysis of second round effects 39 Appendix 1: Complete listing of recommendations 40 Appendix 2: Listing of abbreviations 43

6 1. Executive summary Australia is moving rapidly towards integrated action to reduce carbon emissions including developing an Australian Emissions Trading Scheme (AETS) to commence in Senator the Hon. Penny Wong, Minister for Climate Change and Water, has stated this will constitute the most significant economic and structural reform undertaken in Australia since the trade liberalisation of the 1980s These are times which require careful and prudent economic management. 1 The AETS will be a cap and trade system under which: > The cap (ie. emissions target) for Australia will be determined by the Government based on a report by Professor Ross Garnaut (the Garnaut Report), scheduled for September 2008 > Emissions permits and offset credits will be tradeable amongst participants > Emission permits and offset credits for each tonne of carbon emitted will be surrendered to the Government as emissions arise > Penalties will be imposed on participants to the extent their emissions exceed their emission permits and offset credits. Australia is not alone in having an Emissions Trading Scheme (ETS) as schemes are in operation or proposed in various countries and regions globally. Australia has also recently ratified the Kyoto Protocol and plays an increasingly significant role in international activities and processes leading to emissions trading, storage of emissions, development of carbon credit offset activities such as carbon sink forests and other global initiatives. Whilst the tax implications of an ETS have received little attention to date, it is clear that the tax issues and the tax policy framework will be an important element in Australia s response to climate change initiatives, as the tax implications and incentives will have a major influence on business responses and the resulting emissions trajectories. Scheme participants and business generally: > Will need certainty about the tax consequences of the AETS, through the clarification of the law > Are entitled to expect neutrality from the tax consequences of implementation of the AETS (that is, the AETS should not create tax traps, blackholes or disadvantages) > Will potentially require incentives to help compensate for economic effects and to drive change, to help achieve a permanent and ongoing reduction in the level of carbon emissions produced. The effects of the AETS therefore need to be properly addressed by the Australian tax system including income tax (including the international tax issues involved with global trading), the goods and services tax (GST), Petroleum Resources Rent Tax (PRRT), state stamp duties and other taxes and charges. Potential tax issues associated with the AETS need to be fully explored, and clear strategies developed for tax policy adjustments where required. Governments and their advisers including Treasury are already working on these issues. This report sets out the key Australian tax issues which will emerge, recognising that the precise tax implications of transactions under the AETS will depend on the legal form the scheme under the AETS legislation when released. The tax issues relate to: > The AETS itself, with respect to the issue and use of emissions permits and offset credits and trading in Australia and, eventually, internationally > The significant capital expenditures which will be undertaken by Australian businesses to deal with the new environment of carbon constrained business activities, including new equipment, modifications and retooling of existing equipment, new projects and abatement activities (particularly relating to sequestration activities) > The significant research and development activities which will be undertaken in relation to business processes. This report focuses, first, on assessing whether the existing tax framework will cope effectively with the AETS. Second, any potential opportunities are identified to use tax policy to drive behavioural change in order to encourage the transition to an emissions constrained environment. The analysis considers the tax treatment of the following participants in the AETS: > Business the covered organisations included in the AETS, which will be granted free permits from the Government > Offset providers and other participants engaged in carbon offset and sequestration activities in the renewable energy and carbon offset sectors, such as wind farms and forest projects, and other project mechanisms that will emerge for reducing or offsetting emissions > Traders and investors businesses buying and selling permits in an efficient market mechanism, providing liquidity to facilitate efficient transfer and use of emission permits, and other Australian businesses which will have investment decisions arising from the emissions constraints. While the report focuses on Australian tax issues, the tax consequences that may arise in foreign jurisdictions need to be considered when designing the AETS, initially to ensure competitiveness of Australian business and also to enable the international transfer of emissions permits and offsets from a tax perspective. 1. Senator the Hon. Penny Wong Minister for Climate Change and Water to the Australian Industry Group, 6 February 2008 Climate Change: A Responsibility Agenda. Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension

7 7 Assessment of existing tax framework income tax, GST, indirect taxes and state taxes This review suggests that the existing tax law will not properly deal with the AETS in a number of areas. However the changes should not require major revisions to the income tax law and no increase in the complexity of the law. The recommendations, summarised below, are set out in full in Appendix 1. Australian tax law provides multiple potential outcomes for the allocation, acquisition, sale and use of AETS permits in a domestic environment. This will lead to an unacceptable level of uncertainty in respect of income tax, GST, stamp duty and PRRT outcomes, delaying business responses and might risk Australia not achieving its emissions reduction goals. A clear codification of the tax impact of the AETS is needed to: > Ensure that the initial allocations of free permits are not taxable to the recipients > Align the tax treatment of purchases and sales of AETS permits and offset credits with ordinary business expenses > Clearly specify the tax status of international trades of permits and offset credits > Clearly specify the tax status of emissions fees > Clarify the tax status of approved offset activities such as the use of carbon sink forests. The analysis and detailed recommendations in section 3 of this report cover: > Income tax (section 3.2) > GST (section 3.3) > Stamp duty (section 3.4) > PRRT (section 3.5) > Income tax administration issues under current tax laws (section 4.3). Use of the tax system to drive behavioural change and investment into emissions-reducing activities In addition to the tax treatment of emissions trading under the AETS, to reduce carbon emissions, the report considers the tax treatment of: > Business expenditure on altering assets and equipment > Business expenditure on capital equipment > Research and development (R&D). The goal of reducing the overall emissions is likely to involve various business expenditures on abatement and emissions reduction activities such as: > Retrofitting equipment and modifying existing assets to reduce their emissions profiles > Acquiring new equipment with improved emissions profiles to replace economically viable existing equipment > Carbon sequestration and carbon offsets activities. There is concern that the AETS alone will not result in the necessary investment in emissions reduction equipment, due to the muted price signals in early years and also to business caution in making investments at a time of economic uncertainty. As a result, Government climate change policy should include consideration of tax incentives geared towards reducing the burden on business of the significant capital expenditures and adjustments, which will be required as a consequence of the introduction of mandatory emissions targets and the AETS. Any introduction of incentives will need to be precisely designed so as not to create unintended tax revenue effects. It will need to be appropriately costed in light of the final shape of the AETS and it will be difficult to forecast precisely the benefits and behavioural outcomes. However the transition to an emissions-constrained future for Australia is so major that consideration should be given to focused tax changes. Some incentives might be more appropriate for consideration on a transitional basis, covering only the initial wave of expenditure dealing with emission abatement and structural changes in the initial years of the AETS, whereas other incentives might be enduring. This report identifies some potential incentives, to be validated, with an assessment of the cost in the light of the Garnaut Report and the exact structure and levels of emissions targets. These include: > Enhancing Australian climate-related innovation and R&D by adjusting the R&D concession, by: Increasing the deduction for eligible R&D expenditure on clean technology (cleantech) (for example, from 125 per cent to 200 per cent) Extending the scope of the Refundable Tax Offset by removing the thresholds for companies developing clean technologies Allowing companies using depreciating assets for R&D on clean technologies to claim an annual one-third write off for qualifying plant expenditure at the current rate of 125 per cent or another rate considered appropriate in the circumstances Recognising the role of grants as an adjunct to tax incentives. (Reference section 4.1). > Enhancing the commercial outcomes of costly capital expenditures to replace existing equipment or alter equipment so as to achieve lower emissions profiles, where such expenditure might be expensive and commercially risky at a time of economic volatility. Potential incentives include: Increasing depreciation rates for capital expenditure that can be demonstrated to reduce carbon emissions, for example, to 120 per cent of the rates otherwise available

8 Introducing an emission reduction investment allowance providing an additional tax deduction of say 20 per cent of the capital expenditure on equipment which is additional to, attached to or related to existing equipment and which is primarily designed to reduce the carbon emissions produced by or the energy use of that existing equipment Introducing specific concessions in the tax loss rules for companies in emissions-intensive industries, so that companies undertaking major capital expenditures will not have the risk of creating a large stream of tax losses which cannot be used or is at risk of being lost in the event of a change of ownership. (Reference section 4.2). > Timely decision making on the part of Government, to achieve tax clarification and certainty parallel to the introduction to the strategic design of the AETS. Delay in resolving the tax issues might impair business decision making, delay the necessary investments, and risk slowing the adjustment process of the Australian economy to the new carbon constrained environment > State and Federal Government interaction on state tax issues, to ensure that state stamp duty changes discussed in this report are managed effectively. Government will need to consider, additionally, other income tax, FBT and related rules to ensure that they deal appropriately with such expenditures and consider the role of tax incentives to encourage business investment in these activities. (Reference section 4.3). Also an ATO initiative will be desirable, focused on existing tax laws and existing climate change programs (consistent with the responsibility and function of the ATO) to ensure there are no unresolved tax issues which are impediments to effective business decision-making on climate change issues. In due course this consultative process will move to consider the AETS when that is legislated (reference section 4.3 and 5). Consultation process on tax issues Tax policy direction needs to be developed and communicated to the business community in conjunction with the policy development of the AETS itself. To give business clarity on the tax issues so as to drive business behaviour and the transition to the AETS, the tax issues consultation should commence in The Office of the Prime Minister and Cabinet are moving to establish a panel of expert consultants, including tax specialists, to support work on the design and implementation of the AETS. The introduction of the AETS, and the election of the new Federal Government, provide an opportunity to demonstrate best practice consultative approaches to achieve the maximum benefits and minimum disruption to Australia s economy. The process should include (as discussed in section 5): > The greatest possible transparency in considering policy options, seeking input into policy options (this report is intended as a strategic resource to accelerate that process) > Co-operative consideration of the revenue impacts, ensuring that the tax policy decision processes include appropriate consideration of the second round effects Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension

9 9 2. Australia s climate change initiatives: An issue for business This section reviews Australia s climate change initiatives, particularly the proposed Australian Emissions Trading Scheme (AETS). The first pillar of Australia s climate change initiatives is marked by our existing commitment to a target of reducing emissions by 60 per cent of 2000 levels by The Government is also committed to setting a medium term target. 2 As noted by Senator Wong, the significance of emissions trading should not be underestimated. Achieving our goal of delivering deep cuts in emissions by the middle of the century means significant transformation in the way our communities and economy function. 2.1 Global context The United Nations Framework Convention on Climate Change took effect in and was supplemented by the Kyoto Protocol 4 (the Protocol) in On 16 November 2004, the Russian Federation ratified the Kyoto Protocol, paving the way for it to come into force in February The Protocol sets legally binding greenhouse gas (greenhouse) emission reduction targets for Annex 1 parties (ie. industrialised countries) that have ratified the Protocol. To date all Annex 1 countries, with the exception of the United States, have ratified the Protocol. Australia ratified the Protocol in December To help countries meet the binding targets set out in the Protocol, several mechanisms operate under the Protocol: > The Joint Implementation Mechanism (JI) allows Annex 1 parties to earn Emission Reduction Units (ERUs) as a result of emission reducing projects in other Annex 1 countries, and to transfer or acquire ERUs among Annex 1 parties > The Clean Development Mechanism (CDM) operates similarly in relation to non-annex 1 countries (ie. in developing nations). The CDM allows Annex 1 countries to earn Certified Emission Reduction Units (CERs) by undertaking emission reducing projects in non-annex 1 countries. These CERs can then be used by Annex 1 parties to meet their own target > Kyoto Emissions Trading Mechanism commencing in 2008, it will allow an Annex 1 country to sell its own emissions permits under the Protocol directly to other Annex 1 countries. Several other domestic and multilateral emissions trading schemes have been established. > The European Union Emissions Trading Scheme (EU ETS), which commenced operation in 2005, continues to be the largest existing scheme with all 25 member states of the European Union obliged to participate. The first phase of the EU ETS ended in December 2007, followed by a second phase in operation until 2012 (in parallel with the first Kyoto commitment period) > Switzerland and Norway, which do not belong to the EU, have developed national emissions allocation plans which should allow them to trade within the EU ETS. It is not yet clear how other countries outside the EU that have accepted Kyoto caps on emissions (eg. New Zealand, Japan, and Canada) will operate their own trading schemes or whether they will be able to dovetail with the EU ETS. The lack of federal level commitment by the US and, until recently, Australia has resulted in smaller ETSs being developed by a number of state governments and in various voluntary trading schemes: > In Australia, most trading has occurred under the New South Wales Greenhouse Gas Abatement Scheme (NSW GGAS) which commenced in Voluntary schemes include the restructured Greenhouse Challenge Plus program and the Greenhouse Friendly Certification Program which focus on voluntary greenhouse reporting and offsetting, although registration in the Greenhouse Challenge Plus program might be required for businesses to be entitled to diesel fuel credits > In the US, the Regional Greenhouse Gas Initiative is being developed by nine North East and mid-atlantic States. In addition, 10 western states have also proposed a regional emissions reduction plan > In Chicago, voluntary ETS trading occurs on the Chicago Climate Exchange (CCX) which commenced as a pilot programme to build trading skills and institutions. The CCX has now established joint venture exchanges in Europe (the European Climate Exchange) and Canada and intends to expand into Japan and Russia. 2. Senator the Hon. Penny Wong Minister for Climate Change and Water to the Australian Industry Group, 6 February 2008 Climate Change: A Responsibility Agenda. 3. Australia adopted the Convention in December 1992, one of the first countries to do so. 4.

10 2.2 Overview of climate change related policy and regulation in Australia Under the former Federal Government, Australia focused on implementing a range of unilateral climate change related policies and regulation including: > Voluntary schemes discussed above > Fiscal incentives such as the Low Emissions Technology Development Fund (LETDF) and Renewable Energy Development Initiative (REDI) > Renewable energy targets including the national Mandatory Renewable Energy Target (MRET) > Direct regulation including the Energy Efficiency Opportunities (EEO) program and the more recent National Greenhouse and Energy Reporting (NGER) Act 2007 mandating facilities and companies emitting over a specified threshold. In 2006, the Federal Government established the Prime Ministerial Task Group (Task Group) to investigate the viability of a federal emissions trading scheme. On 31 March 2007, the Task Group presented the Report of the Task Group on Emissions Trading, and on 3 June 2007 the Federal Government announced its commitment to a cap and trade AETS. The enactment of the NGER is a precursor to the AETS, with a coordinated and streamlined national greenhouse and energy reporting system, which is central to a future AETS. The information collected on Australian emissions levels can facilitate setting caps under the AETS. The NGER Regulations Discussion Paper, released in October 2007 by the Australian Greenhouse Office, addressed various issues arising from the NGER Act. In April 2007, Professor Ross Garnaut was commissioned by the states and the Federal ALP to undertake a review of Climate Change and its Economic Impacts (the Garnaut Report). The terms of reference of this review are that it should recommend medium to long-term policy options for Australia, and the time path for their implementation which, taking the costs and benefits of domestic and international policies on climate change into account, will produce the best possible outcomes for Australia. 5 The Garnaut Report is due on 30 September An interim report (the Garnaut Interim Report) was issued on 21 February 2008 and various papers and a draft are to be issued by 30 June The interim report has noted that: Australia s interest lies in the world adopting a strong and effective position on climate change mitigation. This interest is driven by two realities of Australia s position relative to other developed countries: our exceptional sensitivity to climate change; and our exceptional opportunity to do well in a world of effective global mitigation. Australia playing its full part in international efforts on climate change can have a positive effect on global outcomes. The direct effects of Australia s emissions reduction efforts are of secondary importance The ETS is the centre-piece of a domestic mitigation strategy. To achieve effective mitigation at the lowest possible cost, the ETS will need to be supported by measures to correct market failures or weaknesses related to innovation, research and development, to information, and to network infrastructure. 6 The Federal Government has, since entering power, announced its aim to introduce the AETS by The details of the scheme (such as abatement goals, permit allocation and caps) will be determined based on the release of the Garnaut Report and using the emissions reporting data obtained under the NGER Act, for the fiscal year 2009 at a minimum. The Federal Government intends to implement a range of other climate change policy and regulations, including a proposed new Mandatory Renewable Energy Target of 20 per cent by 2020 and an aspirational target of 60 per cent by As to the global actions after the current Kyoto commitment period (ie. post 2012), the Federal Government has stated that it will not commit to a post-kyoto target unless India and China are included. The Protocol comes into effect for Australia in March At this stage, it is uncertain as to how the ratification of the Kyoto Protocol will impact Australian businesses. It is possible that Australia will be able to invest in JI and/or CDM projects in other countries as a means to reduce national emissions to meet Australia s binding target under the first commitment period of the Protocol, to limit any increase in greenhouse emissions to eight per cent above Australia s 1990 emissions level. It is also possible that other Annex 1 country participants may invest in JI projects within Australia. 5. Garnaut Review, Terms of Reference ( 6. Garnaut Interim Report, 21 February See also Garnaut, R Will Climate Change Bring an End to the Platinum Age? Public Lecture au/ca25734e0016a131/pages/public-forums-public-lectures 7. At the Council of Australian Governments (COAG) meeting in December 2007, the Commonwealth and States agreed to work cooperatively, commencing early in 2008, to bring the existing MRET and the various state-based targets into a single, expanded national MRET scheme by early An implementation plan and interim report on progress is to be put to COAG at its March 2008 meeting. The final design is to be provided to COAG for consideration at its September 2008 meeting. greenhouse.gov.au/markets/mret/index.html Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension

11 The Australian Emissions Trading Scheme The Task Group recommended that an AETS is feasible, and, with a carbon price set by the market, would improve business investment certainty. The Task Group s recommendation that an AETS be based on a cap and trade model was accepted by the former and current Federal Government. The Federal Government has committed to introduce such a scheme by 2010 but, as with most government policy, the devil lies in the detail. The focus in 2008 will continue to be on the creation of the AETS, with an exposure draft to be presented for public discussion. While the design and structure of the AETS is in progress, it may look similar to that proposed by the National Emissions Trading Taskforce (NETT), a State/Territory Government led initiative for a nationwide ETS. A cap and trade scheme involves the setting of an overall cap on the volume of emissions of scheme participants. Emissions permits (permits), usually representing one tonne of CO 2 -e are allocated among scheme participants. Participants which emit less than their allocation of permits are entitled to trade their excess permits with those whose emissions exceed their allocation. The permit price is determined by the relative supply of, and demand for, the permits. The Task Group concluded that a cap and trade model should include: > A long term aspirational emissions abatement goal > An overall emissions reduction trajectory > Maximum practical coverage of all sources and sinks, and of all greenhouse gases > A system of permit allocation and issuance > A safety valve emissions fee > Recognition of credible domestic and international carbon offset regimes > Capacity to link to other national and regional schemes > Banking of permits but not borrowing from future allocations > Providing credit for early action towards reducing carbon emissions, before the AETS is introduced. While detailed decisions regarding the design of the scheme have yet to be made and the Garnaut Interim Report has noted: The discussion paper to be released shortly by this Review will independently and openly re-examine ETS design features Aspirational long term emissions goal and overall emissions trajectory The announcement of a precise long-term national emissions reduction goal will assist in determining the cap on emissions under the AETS. Emissions reduction goals also serve to increase market certainty, helping to predict the future price of carbon and to drive investment in long-lived sustainable technology. The Task Group recommended the establishment of a longterm aspirational goal, along with a combination of short term annual quantity caps and medium term gateways, as shown in the figure below. Gateways are essentially points in time (for example, at five year intervals) at which broad targets are set and are flexible enough to be reviewed and modified according to changes in climate science, technology or international policy. 9 Figure 1: Short term fixed emissions targets and medium-term emissions gateways 10 Emissions Indicative emissions gateways Firm emissions cap Business as usual emissions Abatement path consistent with aspirational goal (for illustration only) Aspirational goal (for illustration only) Time The Federal Government has committed to a long term overall goal for greenhouse gas emissions reduction for Australia of 60 per cent on year 2000 levels by The economic analysis from the Garnaut Report will be used to further inform the Government s precise and detailed setting of goals and overall emissions trajectory with regards to the AETS. these recommendations of the Task Group are summarised below. 8. Garnaut Interim Report, p.51. See also interviews with Professor Garnaut reported on 29 and 30 January 2008 in the Australian Financial Review, and the plan for further reports mentioned in the Garnaut Interim Report. This transparent exploration of issues is welcome as part of the policy development process Prime Ministerial Task Group on Emissions Trading, Report of the Task Group on Emissions Trading, 2007.

12 2.3.2 Maximum practical coverage of all sources and sinks, and greenhouse gases The Task Force recognised that all sectors should contribute to greenhouse gas reductions. However, it also recognised that for some emission sources (such as waste and agriculture), there is a higher complexity and uncertainty for which there may be a lack of reliable, cost-effective measurement methodologies. The associated cost of verifying emissions would therefore be high. The Task Group proposed that the AETS should initially include all energy, industrial and fugitive emissions from inception and that emissions from agriculture and land use be excluded. The Task Group also recommended all greenhouse gases be included in the AETS to achieve maximum practical coverage. Sectors not covered by the AETS do not have a liability to reduce emissions although it is expected that they will be able to participate in the scheme by generating emissions abatement that can be sold as offset credits to covered parties (discussed in section 2.3.5). For those sectors that would be covered, the point of permit liability along the supply chain must also be determined (ie. a decision must be made regarding who should be liable for emissions under the scheme). This is a key determinant of the compliance burden that will be imposed by the scheme as it will determine which party is required to surrender emission permits. The Task Group recommended that for the most part, permit liability be placed on direct emitters. However, in the case of emissions from fuel, it is suggested that permit liability be placed on the upstream fuel suppliers (ie. producer of the fuel), in order to enable emissions from small individual sources such as residential and commercial transport to be covered in a cost-efficient way. The proposed coverage will capture approximately per cent of Australia s total emissions Permit allocation and issuance Permit allocation and issuance generally involves administrative allocation of free permits, auctioning off the permits for a price or a mixture of the two. The Task Group recommended a system of permit allocation and issuance that: > Is based on time-dated single year emission permits > Includes once-off free allocation of permits to those companies suffering a disproportionate loss in asset value > Involves free permits allocated to existing investments in trade-exposed, emissions intensive sectors every five years to avoid damaging their international competitiveness > Ensures progressive auctioning of the remaining permits over a period from the start of the scheme until the first short term cap Safety valve emissions fee In the case of permit shortages caused by limited market liquidity or where the cost of permits is considered by the Government to be excessive, the Task Group recommended the use of an emissions fee to act as a safety valve, which limits the unanticipated costs to the economy and to business while ensuring a continuing incentive to abate Recognition of credible domestic and international carbon offset regimes Offset credits play an important role in a cap and trade scheme, particularly their capacity to reduce the costs of greenhouse gas abatement. The Task Group recommended that a wide range of offsets be recognised under the scheme including the following: > Participants covered by the scheme should be able to purchase offset credits generated by sectors outside the scheme > Offsets from forestry and agriculture and from carbon geosequestration should be a priority > Credible international offsets. In September 2007, under the former Government, the Department of the Prime Minister and Cabinet released a discussion paper, Abatement Incentives Prior to the Commencement of the Australian Emissions Trading Scheme Discussion Paper (the Abatement Incentives Discussion Paper ) Senator Wong has said, op cit. There is wide agreement that over 70 per cent of our national emissions can be practically covered by emissions trading and we will proceed towards scheme design on this basis. We will consult with the agriculture and forestry sectors on the question of their inclusion in the system and on the timeframe for that inclusion. See also Turnbull, M, 2007 National Greenhouse and Energy Reporting Bill - Second Reading Speech Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension

13 Scheme linkages It is possible that the AETS could be linked to an international emissions trading market. The Government supports a global scheme and it is therefore likely that the AETS will be designed with this in mind. While the Task Group recommended the inclusion of credible international offsets in the AETS, it did not specify the exact schemes or mechanisms under which these offsets should be generated. The Garnaut Interim Report notes the need for robust institutional arrangements 13 and observes that: Australia would benefit from linking its market with others It would be better to define opportunities for international trade as fully as possible from the beginning, rather than to cause surprise while the ETS is operating. An announcement at the beginning of the ETS of the conditions on which international trade in permits would be introduced should cover timing of planned expansion of opportunities for trade, and the conditions that would need to be met before the scope for trade would be expanded. 14 The New Zealand Government, when introducing in 2007 its exposure draft Climate Change (Emissions Trading and Renewable Preference) Bill, set out the linkage of its scheme to international trading 15 as follows: > A New Zealand Emission Units Register (NZEUR) will allow New Zealand Units (NZUs) to be created, held, transferred between account holders, and surrendered (together with other units including Kyoto units) to meet their emissions trading scheme obligations > The NZ emissions trading scheme is proposed to be linked to: The international Kyoto market to allow conversion of NZUs into Kyoto units for transfer to overseas buyers) Other countries domestic trading schemes, where overseas registries and emission units are be approved for linking to the emissions trading scheme by regulation when such linking is considered appropriate. That timing will doubtlessly include consideration of issues of governance and integrity in other countries processes for issue and trading of emissions permits, as well as certification of emissions and credits Banking and borrowing of permits Banking and borrowing of permits enables linkages between the different phases of an emissions trading scheme. Banking (carry forward) allows permits from one trading phase to be carried over to another, whereas borrowing (advance use) allows future permits to be brought forward, to retire against current liabilities. According to the Stern Review 16, banking and borrowing can reduce the risk of permit price spikes and crashes at the end of a trading period, which distorts business responses and achievement of the government s goal of emissions reductions The Task Group recommended that banking should be allowed under the AETS, to allow companies to manage the natural year-on-year emissions fluctuations that can occur due to production variation and the business cycle. The Task Group stated that borrowing of expected future permit allocations should not be allowed. 2.4 Credit for early action The Abatement Incentives Discussion Paper sought to address abatement incentives organisations can pursue in the period leading up to the commencement of emissions trading. It highlighted key considerations for stakeholders including: > Defining those existing assets and activities that are eligible to generate early action credits > Associated administrative arrangements > Arrangements for transitioning early action credits into the emissions trading scheme. 2.5 Future scenarios and key considerations for business Although an AETS will address the current market failure related to climate change by placing a price on greenhouse gas emissions, it is only one mechanism among a suite of measures required to effectively reduce Australia s greenhouse gas emissions over time. 17 In addition to the AETS, it is expected that a likely future federal regulatory scenario will comprise: > Direct regulation, focusing on energy efficiency > Renewable energy targets > Fiscal incentives, focusing on funding for technologies such as clean coal 13. Care would need to be given to the design of the institutional arrangements for administering the allocation and use of permits. Variations in the number of permits on issue or the price would have huge implications for the distribution of income, and so could be expected to be the subject of pressure on Government. There is a strong case for establishing an independent authority to issue and to monitor the use of permits, with powers to investigate and respond to non-compliance. Garnaut Interim Report p Op.cit. p A Guide to the Climate Change (Emissions Trading and Renewable Preference) Bill, Prime Ministerial Task Group on Emissions Trading Report of the Task Group on Emissions Trading (2007) (

14 > Voluntary schemes including awareness raising programs and other capacity building initiatives for those businesses not impacted by the above elements (eg. voluntary reporting programs such as Greenhouse Challenge Plus) > International collaboration through initiatives such as the Asia Pacific Partnership on Clean Development and Climate, an agreement between six Asia Pacific nations that adopts a voluntary approach to greenhouse gas reductions with a focus on technology collaboration. As a result, it is likely that markets will develop which will encourage private investment, particularly around low emission technology. While the introduction of emissions trading will help bring cleaner technologies into the market over time, it is expected that mandatory renewable energy targets will exist independently to accelerate the use of renewable energy. If this is the case, it is expected that mandatory renewable energy targets will drive cost reductions through economies of scale. As the AETS matures and lower-cost renewable energy technologies are introduced, it may be that renewable energy and clean energy targets will be phased out in the long term. A future scenario may include investment in research and development of clean technologies (such as clean coal) and an increase in awareness-raising programs particularly for households and for businesses that do not necessarily meet thresholds or are regulated by mandatory schemes. It is expected that the Federal Government will review and build upon regulations and policy instruments currently in place, as well as implement the policies proposed during the election campaign. While a study completed in 2006 for the States National Emissions Trading Scheme initiative suggested that NSW GGAS and Queensland s 13 per cent gas scheme could continue to operate in parallel with an AETS, these schemes may well become redundant once the AETS is in place. The increasing level of regulation will place an increased compliance and administrative burden upon industry. The cost of regulatory compliance is initially borne by businesses, which then pass on the cost through to consumers. In the context of the electricity industry, this cost may be passed on in the form of higher electricity prices. These higher prices will flow into business inputs for downstream businesses using the electricity, and will affect the cost structure and pricing of their products, with implications for Australia s overall economy including inflation and potential impacts on wages. For this reason it is critical that the cost issues, and the integration with Australia s tax system, of the AETS and all related measures need to be carefully modelled, understood and appropriate policy initiatives be introduced in a timely manner. Gearing up to comply with reporting requirements under the proposed NGER and the introduction of an AETS are just two issues for businesses to contend with. The new environment will create opportunities for businesses, not only from the viewpoint of customer perceptions and marketing issues, but also new categories of business. As Senator Wong has noted, the Government expects that: It will create a major new financial market aimed at achieving an environmental obligation. It will spur progress in production techniques, capital investment, research and development. And it will result in challenges for some industries while creating significant opportunities for existing and new industries. 18 It is critical that business leaders obtain an understanding of the risks posed and opportunities presented by new Government policy, emissions caps and a carbon market more broadly to enable the development of appropriate management strategies. 2.6 Examples of how the AETS would operate The impact of the cap and trade system from a commercial perspective is illustrated in this simplified example. Assume there are two unrelated companies that are subject to the AETS, Company A and Company B. Each company will receive a free allocation of emissions permits, which will be lower than the permits required to cover their projected emissions. The shortfall of permits as compared with projected emissions will be 10,000 tonnes, in total being 5,000 tonnes for each company. 18. Op. cit. Australia s Proposed Emissions Trading Scheme The Tax Policy Dimension

15 15 Table: 1.1 Example reduction in emissions Cap only No trading Company A Company B Total of A + B Permits allocated (tonnes) 95,000 95, ,000 Projected emissions (tonnes) 100, , ,000 Reduction required (tonnes) (5,000) (5,000) (10,000) The businesses will have the following broad options: a) To pay an emissions fee, which is assumed for illustration purposes to be set at $14 per tonne b) To reduce their emissions, for example through the introduction of clean technology and altered business processes. In this regard, assume in this example that the actions required to reduce emissions will have a cost of $6 per tonne for Business A and $12 per tonne for Business B for the year in question. On this basis, the emission reduction activity required would result in a total cost for both companies of $90,000 ($6 x 5,000 for Company A and $12 x 5,000 for Company B) c) To acquire emission permits either through a government auction process or the secondary market. Table: 1.2 Example Options to deal with shortfall of emissions Company A Company B Total of A + B Prima facie costs Cost Cost Total Cost Pay emissions fee ($14 per tonne) ($70,000) ($70,000) ($140,000) Reduce emissions projected price per tonne $6 $12 total projected cost ($30,000) ($60,000) ($90,000) Acquire or sell emission permits See below See below In this case, neither company would choose to pay the emissions fee since they could reduce their emissions for a lower cost. Assuming Company A could further reduce its emissions by 5,000 tonnes at a cost of $6 per tonne (total of $30,000), it could sell its excess credits from the further emission reductions to Company B for a price of say $10 per tonne, yielding $50,000 revenue for a cost of $30,000. Table: 1.3 Example Effect of the AETS Business A Business B Total of A + B Impact of trading Tonnes Cost Tonnes Cost X Reduce emissions total projected cost (5,000) ($30,000) (5,000) ($60,000) ($90,000) Cost to reduce emissions by 5,000 $6 (5,000) ($30,000) ($30,000) Cost to reduce emissions by a further (5,000) ($30,000) ($30,000) 5,000 $6 A sells 5,000 tonnes permits to $10 5,000 $50,000 (5,000) ($50,000) 0 Y Net cost for each business of reducing emissions (5,000) ($10,000) (5,000) ($50,000) ($60,000) Benefit of AETS, being the reduced (increased) net cost of reducing emissions compared with the position in the absence of AETS (ie. X Y) $20,000 $10,000 $30,000 In the above example the overall impact of the AETS is to reduce the net economic cost of emissions reduction activities from a projected $90,000 in the absence of trading to $60,000, therefore benefiting the businesses, their competitiveness and the Australian economy by $30,000. From the viewpoint of the Australian economy, the trading system would facilitate the most efficient achievement of the emissions targets. From the viewpoint of the individual businesses, Company A will have reduced its cost of its own emissions reduction activities by the gain from the further emissions trading, and Company B will have achieved its target through purchasing emission permits on the market at a lower cost than it would be required to undertake to reduce emissions directly or pay the emissions fee or penalty). As a consequence, the total cost of reducing emissions is reduced from $90,000 to $60,000 with Company A and B sharing the savings.