Auctioning Carbon Units in Australia s Carbon Pricing Mechanism

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Auctioning Carbon Units in Australia s Carbon Pricing Mechanism submission: Legislative instrument for auctioning carbon units 28 February 2012 Emma Herd T: 61 2 8254 8967 eherd@westpac.com.au A division of ing Corporation ABN 33 007 457 141

Summary is an active participant in ongoing public policy dialogue on an appropriate national response to climate change. We welcome the opportunity to provide a submission on the legislative instrument for auctioning carbon units in Australia s carbon pricing mechanism (the Discussion Paper ). has had a consistent position on climate change for over a decade and under three consecutive governments. recognizes climate change as an environmental, economic and business risk and is committed to developing practical solutions to assist Australian business and the community to respond and position for the low-carbon economy of the future. supports the policy objectives as set out in the Discussion Paper. Namely, that the auction process should promote allocative efficiency, efficient price discovery and support revenue raising for the funding of related while not specifically pursuing the aim of maximizing revenue from the auction process. s comments on the Discussion Paper are consistent with feedback provided under previous consultation processes on the design of the auction process for carbon units in Australia. supports design measures which promote maximum market transparency, liquidity and efficiency, while minimising compliance costs for liable entities and seeking to avoid unnecessary price volatility. This includes: Monthly auctions Auctions of advance vintages on a semi-annual basis The commencement of auctions as early as is possible The ascending clock auction format Broad participation in the auction process alongside reasonable checks and balances; and Reasonable requirements for collateral to cover participatory financial risks. This submission also provides further commentary on a number of specific design aspects as set out in the Discussion Paper. s submission draws upon the s considerable experience in factoring environmental considerations into business policies, systems and procedures, our investment and lending experience, as well as our practical participation in carbon and environmental markets across jurisdictions where we operate. would be happy to discuss these matters further with the Department of Climate Change and Energy Efficiency. Page 2

Submission 1. response 1.1 Auction frequency and size believes that auctions should be held more frequently than quarterly. Increasing the frequency of auctions will help to promote price transparency and avoid irregular bidding behavior. believes that during the compliance year, auctions of that particular vintage should be held more frequently than quarterly. would support monthly auctions, although we note that even bi-monthly would be preferable to quarterly. would disagree with the premise that smaller auctions would lead to a less competitive bidding field, thereby achieving to a lower price outcome. This is due to the role played by market intermediaries and liable entities with discretion in their hedging policy. would argue that, given a clear price signal from the secondary market and international market, rational behavior would drive market participants would step in to buy and warehouse permits if the price of carbon units at auction was seen as cheap. Accordingly the auction would inevitably clear close to the market. believes that larger, less frequent auctions would result in more unpredictable outcomes. With quarterly auctions, approved hedging policies for liable entities would be more likely to insist on execution at every auction. More regular and frequent issuance of supply calms bidding behaviors, simply because there are more opportunities to obtain carbon units to meet compliance obligations for that year and there is less waiting time before the next auction if the cleared price for that particular auction is unattractive. would support more frequent auctions of the current vintage during the corresponding compliance year. 1.2 Advance auctions of future vintages broadly supports the proposal to auction the current vintage plus advance auctions of the next three vintages. However, believes it would be preferable if the auction of future vintages was semi-annual rather an annual event. As per above, experience has shown that the more frequently supply is released the more orderly the market will behave. 1.3 Post-vintage year auction is not overtly opposed to the true-up auction proposed in the Discussion Paper. However, would caution against too much emphasis being placed on its role and would certainly be against any increase from withholding 1/8 th of volume from the auctions held throughout the year. Our experience both in the New Zealand Emissions Trading Scheme (NZ ETS) and in Europe is that the vast majority of liable entities choose to manage their exposure either prior to the commencement of the compliance year or an ongoing basis throughout the year. Companies are also generally very adept at predicting total annual emissions for the compliance year. Therefore, would suggest that the Page 3

withholding of a whole 1/8 of volume is potentially excessive for the purpose of error correction and would definitely caution again any further increase. would also note that provisions have already been put in place to allow for liable entities to meet any unforeseen requirements for additional carbon units after the finalization of the compliance year. This lies in their ability to borrow 5% from the subsequent year s vintage to meet compliance purposes (whose auctions will already be underway at that time). Secondly, there will be a liquid secondary spot market for both domestic and international units. This must be compared to the potentially larger effect of only having 7/8ths of supply issued by the end of the compliance year. 1.4 Auctions without a pollution cap in place understands the legislative restriction on the volume of carbon units which can be issued ahead of the setting of caps for that year and no further specific comment on the quantum of 15million. However, is very supportive of the conducting of auctions as early as is possible in order to allow companies to begin to manage their future liabilities. Price transparency and certainty will calm and inform the behavior of all market participants, thereby smoothing out the price on the early stages of the market. 1.5 Timing of first auction As per above, would strongly support auctions being conducted as early as possible ahead of the commencement of the floating price period. 1.6 Auction schedule would be broadly supportive of the Auction Schedule contained within the Discussion Paper and the indicative proportions for each compliance year, as published in the table. As per our comments above, however, would recommend increasing the frequency of the auctions to monthly and supporting the auctioning of forward vintages more frequently than annually. 1.7 Unsold units supports the proposal that the Regulator have no discretion to withhold carbon units from auctions on the basis that they were unsold at the previous auction. Having unsold units offered for sale at the subsequent auction would be consistent with the principle of the regulator not withholding supply or demand based on price. Once offered for addition to supply, that volume of carbon units should remain available. This renders supply / demand analysis more predictable for market participants and therefore promotes less price volatility. Page 4

1.8 Auction of relinquished units As per above, units which have been added to supply, if forced to have been relinquished, should remain available for purchase. 1.9 Auction type supports the ascending-clock auction format. believes that this model promotes greater ease-of-use, transparency and fairness for all participants. Some potential market participants, such as intermediaries, may have significantly more tactical experience with other formats such as a sealed-bid format. This could constitute an advantage. A sealed-bid format does not allow for this, with it s single clearing price and with participants able to adopt various mechanisms to achieve their objectives under the auction including lodging instructions which are not subsequently altered during the auction for those who choose not to participate live. Consideration of sequential or simultaneous auctions for multiple vintages is inter-twined with other broader considerations. Simultaneous auctions would increase price-discovery and transparency of the forward curve, one of the objectives of forward auctions. This is because the clearing price of each vintage could be directly compared to each other, having been conducted in the same market conditions. If sequential, other market variables such as foreign exchange rates or the outcome of the previous auction would cloud this transparency. On the other hand, sequential auctions would allow for adjustment of bids in the next auction based on a company s success in the previous auction. would strongly counsel that sequential auctions should only be considered if the intra-bid interval is short, specifically a matter of minutes and not 30 minutes as has been discussed in some forums. On balance, believes that simultaneous auctions would be preferable. Those participants who would likely engage in the auction of forward vintages are generally sophisticated risk managers and would have strategies for the distinct compliance years. This would support greater allocation efficiency and more transparent price signals. 1.10 Participation would strongly support broad participation in the auction process, to promote greater liquidity, price transparency and efficiency across the market. would support the proposal to provide tailored training for all participants as a pre-condition to participation. We would also recommend a Know-Your-Customer (KYC) process around registration for participation in auctions, to ensure the credentials of registered participants. would also note that requirements for technical competency are minimal under a true ascending clock format, but will greatly increase if another format is chosen. Page 5

1.11 Collateral Decisions regarding exact requirements for collateral from auction participants, and the quantum of that collateral, will ultimately depend on the specific risks which the government is trying to address. would view potential risks as falling into two categories: 1. The risk of a participant trying to deliberately inflate the price; and 2. The risk of failure to pay at the end of the three day settlement period. Assuming registration includes an adequate KYC process to ensure they are a genuine participant, believes that misconduct and sanctions provisions set out in the Discussion Paper should be sufficient to dissuade potentially disruptive bidding behavior. For the second category of risk, three days is a relatively short period of time for credit risk to be carried. Further, would note that the risk is only material if the market moves substantially between the original auction and the subsequent one where the volume in question would be offered again. Collateral is appropriate for this risk, however the requirement for it to fully cover the maximum bid may be somewhat excessive. Given the low probability of this risk occurring, would suggest requiring collateral for a percentage of the volume on which participants would like to bid and to base this calculation on an observable market price or previous auction price. 1.12 Misconduct and sanctions supports strong regulations in this regard to discourage misconduct and to ensure the highest levels of process integrity. We would support the provisions set out in the Discussion Paper. 1.13 Reserve price Given the existence of a floor price as well as the need to ensure maximum expediency of the auction process, recognises the need for a reserve price on the auction. However, publication of this price 14 days in advance is very excessive and in fact, destructive to the objective of an efficient process. As a market-based scheme, prices can and will on occasions move quickly as a result of international events. Requiring the reserve to be set 14 days in advance would consequently dictate it be set conservatively low to account for possible events. In most cases, this would not be needed and would merely lengthen the auction process considerably. Given the protection of an ascending-clock format, the reserve price should only need to be published the day prior and should be chosen as a percentage of the observable secondary market price, for example at 80% as has been suggested by some academic studies. 1.14 Minimum number of units in a bid supports a minimum bid of one carbon unit and the proposal in the Discussion Paper that a bid be any multiple of one whole carbon unit. Page 6

1.15 Maximum parcel size is broadly supportive of the need to protect the market from a single bidder cornering the auction. However, has some concern that, applying the limit to individual participants rather than the controlling entity and having the potential to appoint a third party to bid on your behalf at auction would likely render the proposal set out in the Discussion Paper somewhat ineffective in practice. 1.16 Variation of bids strongly agrees that bidders will not be permitted to increase their bid quantity as the auction progresses. This would simply destroy the fundamental principles on which an ascending-clock auction operates. 1.17 Proxy bidding supports allowing proxy bids. 1.18 Bidding Window would broadly support the proposal that the length of the bidding window be publicized in advance however, strongly believes this interval should be brief. It is critical that the auction be conducted in as short a timeframe as possible given that market-conditions will move if conducted over too long a period of time. Accordingly, the adjustment of proxy bids should only be allowed in circumstances where pre-prescribed volumes at various levels are electronically adjusted. Proxy bidding exists as a method of simplification for less sophisticated entities. These entities are also unlikely to want or need to adjust their schedule midbidding. If they do, another bidding avenue should be encouraged thereby avoiding the need to slow up the entire auction process to facilitate one portion of the market. 1.19 Bid increments would strongly recommend that the Regulator determine the size of bid increments commensurate with the over-subscription of the market at the current bidding price. That is to say, the bid increment should be large if the ratio of demand to supply is large and should reduce as this ratio drops. Further, the level of demand (in aggregate only) should be visible at each price level so as to promote greater transparency for the market as to why the price increments are what they are. This would result in a more efficient process of price-discovery and a much faster auction overall. Page 7

1.20 Intra-round bidding is strongly opposes the use of intra-round bidding. It goes fundamentally against the key principle of creating a single auction clearing price. believes that intra-round bidding would significantly complicate many other products and commercial agreements aimed at facilitating the emergence of an efficient market for little appreciable gain. Alternately, would recommend applying the ascending-clock format the following manner: At the price level where demand outstrips supply, the auction clearing price should be set at the previous price level. Participants who continue to bid at the last price should receive 100% of their volume at the lower auction clearing price. Those who dropped out above the auction clearing price should receive a portion of the remaining volume on offer based on a pro-rata of their bid volume. Participants should be aware of this potential outcome and agree to it in advance. If the process of deciding on bid increments is undertaken correctly, this format would result in 100% clearance of the auction and negligible impact to auction revenues to the government, given it is based on the residue only. 1.21 Electronic auction platform believes an electronic platform for the auction is essential to the requirement for the process to be quick and efficient. 1.22 Suspension or cancellation of auctions While recognises that the Regulator will need to retain the right to cancel or suspend the auction, we would recommend that this be limited to force majeure type events, such as system failure or connection outage rather than market events. This is particularly relevant in the period between the auction and settlement where entities will have made consequential decisions following the auction result. 1.23 Payment timing and method agrees that settlement should be T+3 in Australian dollars only. We would also strongly advocate that settlement be via a settlement system which requires payment for settlement in order to reduce settlement risk for the government. Page 8

2. Concluding comments s position for over a decade has been to support flexible market-based mechanisms as part of a wider policy response to climate change. We acknowledge that the transition into a carbon constrained operating environment may be challenging for some of our customers. We are actively working with those customers as we would during any other period of regulatory uncertainty and change. is also actively seeking to develop products and solutions to support clean energy, energy efficiency and low emission technologies and to facilitate a smooth transition into a carbon constrained operating environment. will continue to work with Government, with other market participants and with our customers as investment frameworks and opportunities continue to emerge. Page 9

Appendix A About ing Corporation ( ) was founded in 1817 as the of New South Wales, and has a long and proud history as Australia s first bank. With a market capitalisation of $69bn billion and total assets of A$618 billion as at 30 September 2010, is one of Australia s top five listed companies. Our financial strength and risk management practices have been recognised by investors and rating agencies globally. Today provides a broad range of retail, commercial and wholesale banking services to around ten million personal, business, corporate and institutional clients., a division of ing Corporation, manages the financial needs of corporate, institutional and government clients that are based, or have interests in, Australia and New Zealand. We are a leading provider of wholesale banking services in the region and are consistently recognised as a leading bank for Australian and New Zealand dollar-denominated financial products and risk management. We are located in Australia, New Zealand, London, New York, Singapore, Hong Kong and Shanghai, with representative offices in Beijing, Mumbai and Jakarta. In late 2007, brought together financial markets teams trading commodities markets and the National Energy Market (NEM) in Australia, along with Group Sustainability and emerging carbon market expertise to form an integrated trading team Commodities, Carbon and Energy (CCE). This approach recognizes overlapping market dynamics and resource conditions influencing pricing as well as how our clients look to manage their own price risk exposure. CCE continues to build a strong track record of market firsts: s Energy Team has been trading in the National Electricity Market (NEM) in Australia since 1999 and has consistently been the single largest financial intermediary in the derivative wholesale swaps market. Carbon and carbon cost pass through is an increasingly significant influence in forward pricing. was the first bank to commence trading of Renewable Energy Certificates (RECs) in Australia in 2002. has been trading the EU ETS since 2006. undertook the very first trade of Australian compliance credits in May 2008. was the first and remains the only financial institution making a market in the New Zealand Emissions Trading Scheme (NZ ETS), which has been operating since January 2010. In 2011 and Perenia partnered to develop a joint primary CER (pcer) deal, where agreed to offtake pcers for sale into New Zealand and Australian compliance markets. In 2010 and 2011, was voted by our clients Best Trading Company Australasia for emission trading expertise in the global industry publication Environmental Finance. believes that managing the risks and opportunities posed by climate change will be a defining factor in achieving long term profitability for our clients and for business. is committed to developing practical and effective solutions for our customers at every level of the economy. 2010 28 February 2012 Page 10