Price floor for Australia s Carbon Pricing Mechanism submission: Implementing a surrender charge for international units 13 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 as part of the consultation process for A Price Floor for Australia s Carbon Pricing Mechanism: Implementing a surrender charge for international units (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. In making recommendations, the following considerations have informed our position. The market must support: Investment certainty Market confidence Environmental outcomes Innovation and economic transformation at scale Affordable and efficient greenhouse gas abatement across the economy; and A clear understanding of ongoing liabilities. has consistently opposed the application of price controls to any market based policy response. However, recognizing that this is the approach to be implemented, has actively engaged in the design of the price floor to ensure that it functions as efficiently as possible, with the least possible impact on the day-to-day operation of the market. In summary, would support either Option 3 or 4 as the most appropriate means of implementing a surrender charge on international units. does not believe that Options 1 or 2 are workable, effective or desirable for reasons outlined in more detail below. In finalizing a position, s focus has been on the need to find an appropriate balance between the effective operation of the market and the need to minimize the cost of compliance for liable entities impacted by the scheme. This submission also provides additional commentary on the flow on design issues of implementing a surrender charge on international units, as set out in the second half of the Discussion Paper. This 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 Implementing a surrender charge for international units In responding to the Discussion Paper, has sought to briefly outline the key advantages / disadvantages of each option. In the majority of instances, agrees with the DCCEE s assessment, therefore for the most part, has sought to comment only when highlighting key points for emphasis. Overall, views the options proposed in the Discussion Paper as falling into two categories principally defined by the level of government involvement in the process of provision of price certainty. Options 1,2, & 4 require government involvement in the process of the provision of the price certainty for advance purchases desired by the liable entities. Option 3 would require those liable entities who desire price certainty to seek it solely from the private sector. Within the first category (Options 1,2 & 4), does not believe that Options 1 or 2 are workable, effective or desirable for reasons outlined in more detail below. Option 4, while still containing some residual undesirable optionality, does represent a reasonable compromise position and should allow the continued efficient operation of the market. In the second category, Option 3 is the purest from a financial markets perspective with minimal levels of government intervention. However, as with all other financial markets, accessing price certainty from the private sector generally comes at a cost. Therefore Option 3 would likely result in an overall higher cost of compliance for those liable entities wishing to access forward price certainty. could support either Option 3 or 4 as the most appropriate means of implementing a surrender charge on international units. In deciding between these two options, we would argue that other government considerations regarding assistance to liable entities should include the following: Financial markets and price risk management products form in response to a demand for price risk management capability from end users, not ahead of it. Therefore, and despite not being in place today, markets are expected to form in response to client demand. Current Australian domestic environmental markets are a poor basis on which to draw conclusions due to the low true demand for price certainty from the private sector by liable entities. The projected size of real market demand is a factor, as only a percentage of liable entities will seek to hedge their carbon price risk several years in advance. Of those who do, expects that the percentage of exposure that they would hedge would decrease in line with the tenor of that exposure. Finally, also believes that the production of a forward price curve (ie: including the uplift factor ) against which a top-up fee could be calculated is a comparatively easy issue to resolve relative to the overall design element of the floor price. Accordingly, feedback on this issue is set out in the Design Issues section in part two of this submission. Page 3
(a) Option 1 would agree with the Discussion Paper where it states that Option 1 is not viable in practice. believes that, while conceptually appealing, in practice it would be administratively cumbersome and very difficult for regulators and auditors to monitor true adherence. One of the most significant challenges is that it would contain significant optionality for the purchasers of international permits. This optionality would result from the ability to unwind a purchase and hence unwind the top-up fee, if the market price had risen, Market participants could then purchase again in a fresh contract at the higher price resulting in a lower fee being calculated. Entities would be very capable of calculating the value of this option. Option 1 also creates difficulties for involvement in primary CDM. This is an avenue which should be available to liable entities to take project risk with the aim of reducing their overall cost of compliance. Taking project, methodology and delivery risk should be rewarded with a lower cost of compliance. Calculation of the top-up fee simply using the purchase price would remove this incentive which is rightly due to the risktaker. (b) Option 2 would agree with the Discussion paper that Option 2 effectively addresses several of the issues with Option 1. Specifically, it resolves many of the administrative elements, the potential difficulties in verifying the true cost of permits and the above issues with primary CDM. However, Option 2 retains the key issue of inherent optionality evident in Option 1, continuing to allow flexibility in the form of the ability to cancel a contract and hence the top-up fee and replace it with another contract. would note that Option 4 has been designed to address this issue. Specifically, Option 4 states that upon making a commitment to surrender and locking in the quantum of a top-up fee, this commitment is firm and non-rescindable. Finally, would note that, if Option 2 were for some reason to be selected, a real-life forward curve rather than estimated cost of funds be used to calculate the top-up fee. This is due to the possibility for the real market forward curve to be in backwardation (forward prices lower than spot) rather than contango at various times. (c) Option 3 As expressed above, believes that Option 3 differs fundamentally from Options 1,2 & 4. Obviously, all options outlined in the Discussion Paper involve government intervention the extent that, by design, it is the government demanding a minimum price of $15 /MT CO2-e. Options 1,2 & 4, however, involve the government also providing the mechanisms by which forward price certainty of the top-up fee can be achieved by those liable entities who desire it. Option 3 is different in that it requires those who desire forward price certainty to look to the private sector in order to achieve that. Page 4
The principal advantage of Option 3 is precisely the absence of further government influence in the operation of the emissions trading scheme beyond the application of a floor price itself. The simplicity of the top-up fee calculation would result in there being no significant optionality arising as a by-product of a mechanism designed to give price certainty. Option 3 does, however, rely on the ability of the private sector to meet the demand for forward price certainty that has been expressed by larger liable entities. This would most likely be in the form of options with a strike price around A$15. Whilst there is currently little options-related activity in international carbon markets for strikes at this level and tenor, would be reasonably confident in the formation of this OTC market in response to the demand once the scheme design is in process. It is further likely that exchanges would also recognize the need for a margined (and hence cashflow effective) solution and would implement an ETO with these specifications. The full size of the demand for these solutions would need to be carefully considered in order to best estimate whether the private sector could meet this demand. The most significant disadvantage of Option 3 is the higher cost above the $15 floor price that this approach would result in. The cost of these options would ultimately be determined by market supply and demand for this protection and the expected volatility of the international carbon price at the time. By way of an estimate, at current markets levels would anticipate the cost of these $15 call options to settle somewhere between $2 and $3 for the first compliance year of the floating price period. This would raise the overall cost to levels above the $15 price for those desiring forward price certainty and would undoubtedly be passed on. In a large number of financial markets, achieving price certainty generally comes at a cost / premium. However, this case is slightly different in that it is regulatory intervention which has resulted in the stipulation of a price of $15 as the minimum required and Option 3 would effectively result in this floor price being higher for those desiring price certainty. This point would go to the Discussion Paper s criteria of effectiveness. It would also likely result in a bias to domestic units as and when they become available. Finally, Option 3 would likely result in the continued and increased use of carbon-pass-through agreements with commercial negotiations deciding who would take the carbon-price risk and at what cost. Sophisticated liable entities with options experience may also choose to simply manage their exposures by delta-hedging the $15 put option they had effectively sold the government. (d) Option 4 believes Option 4 is by far the most workable of those options where the government is providing the mechanisms to achieve forward price certainty for liable entities (Options 1,2 & 4). Option 4 would allow the market to continue to operate essentially unfettered and permit the full range of products to be available to liable entities to meet their obligations. If this Option were chosen it would be important that the commitment be non-rescindable. It is this element which minimizes the undesirable elements of Options 1 & 2. Issues such as force majeure, lower production levels than anticipated or closure (all resulting in lower than forecast emissions) would all be factors to be considered by the liable entity in making the commercial decision to commit. This is something which the vast majority of large liable entities are already accustomed and adept at doing. The ability to carry-over excess surrendered permits to the following year would also constitute a partial safety-valve for most of these events. Page 5
would note that Option 4 would continue to result in some optionality, inherent in the ability to register intent to submit the full 50% possible if and when the (adjusted) forward price rose to $15.01. However, the optionality is less than in Options 1 & 2 and would be offset to some extent by the reduction in flexibility to surrender the lowest cost permit if, closer to expiry, such opportunities were to present themselves. believes Option 4 represents a fairly robust compromise given the large range of factors involved in the choice of a mechanism to implement a floor price. (e) Other options: Following the release of the Discussion Paper, another potential design option has arisen as a result of debate by market participants which is worthy of mention. Most liable entities who desire forward price certainty are sophisticated risk managers and recognize the floor price as a $15 put option that has been sold to the government. A top-up fee for a certain tonnage of CO2-e could be calculated by an agreed methodology and paid to the government ie: essentially buying-back the sold option. For similar reasons to Option 3, this would likely result in a disadvantageously higher cost of compliance than $15, however it would remove concerns expressed by liable entities around whether the private sector would grow to provide sufficient options product. 1.2 Design issues There are a number of design considerations which need to be taken into account when implementing different options under consideration. s response to the particular questions the Discussion Paper is seeking feedback on are set out in the table below. How to define a class of unit Which exchanges to use How to observe market prices Classes should be defined on the basis of the criteria which would cause a price differential in the secondary market. Price differentials (material ones at least) generally result from the combination of eligibility in the various ETSs (increasingly) and (decreasingly) unit origin. It should also be limited to those international unit types which are sufficiently active as to result in a transparent market price. None see below strongly believes that, given the incredible range of unforeseen events which may impact the price of international units in the Australian CPM, market prices should be arrived at via a process of contributory curves overseen by an independent body such as AFMA. Given the full range of unknown, unknowns, defining a methodology now for the future in a regulatory market could prove destructive. However, contributory curves would address this as panel members would factor in all such events, the probability of those events occurring, all relevant exchange prices and OTC market trends. Price curves could be submitted as regularly as daily Page 6
in the Australian morning at which time panel members would likely be using the previous night s European close and current forward exchange rates. The panel would be requested to provide indicative prices for a certain number of tonnes of the various unit types, delivered on key annual dates, to a counterparty of credit rating X. The process would then for example discard the high and low outliers and average the remainder before publishing. Exchange rates Significant effort should be undertaken to ensure the balance of the members of the panel given that perception of price correctness would be as important as the logic of the process applied See above Whether to take into account futures prices Futures prices, spot prices, unit type, possibility of regulatory intervention, change of contract specifications etc would all be included by price contributors in the method prescribed above. Time value of money considerations Any calculation of uplift factors should be done against real, transparent market forward curves. This is due to the possibility of forward prices being in backwardation or contango an issue which dwarfs any concerns around calculating the precise cost of a credit. The contributory curve process described above could provide this by using a methodology which would require prices to be submitted for a market average credit rating. 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 7
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. s climate change credentials has maintained a consistent position on climate change risks for business and the need for an effective market based policy response for over a decade and under three consecutive Governments. s commitment to working with clients to transition into a low carbon operating environment is built upon our broader commitment to sustainability as a key differentiator of our business. is determined to play a constructive and positive role in promoting effective and practical solutions for our customers and across our business. As a facilitator of the growth of the Australian economy for the last 200 years, we will work with all of our customers to make this transition happen. Recent significant achievements include: was the only Australian to be recognised as one of the Global 100 Most Sustainable Corporations at the 2011 Davos World Economic Forum in Switzerland. In 2011, was ranked number one out of 190 banks globally as a leader in sustainability by the Dow Jones Sustainability Index, and included for the 10th year running. The Group was ranked sixth in the world in the Carbon Disclosure Project (CDP) 2011 Global 500 report and was rated the top Australian company. has been included in the global Carbon Disclosure Project Climate Leadership Index since 2003. was the only Australian bank, and one of only three banks globally, to be named as one of the 2010 World s Most Ethical Companies by the Ethisphere Institute. In 2010 and 2011, was voted Best Trading Company in Australasia in the global Environmental Finance awards. received the 2010 Money Magazine inaugural Climate Leadership award in Australia. In 2003, was the first Australian bank, and one of only ten founding signatories globally to sign the Equator Principles, a voluntary global set of guidelines developed for managing social and environmental issues related to the financing of projects. Today there are over 50 signatories worldwide. 2010 13 February 2012 Page 8
In 1991 was one of six founding members of the United Nations Environment Programme Finance Initiative (UNEP FI). Today there are over 250 signatory institutions, in more than 45 countries. first launched an Environment Policy in 1991 and began measuring and reporting on operational greenhouse gas emissions and broader environmental impacts in 1996. reduced our emissions by over 40% between 1996 and 2008, and is targeting a further 30% reduction by 2013. The Climate Change Position Statement was published in 2008 and is endorsed by the Group Executive and the full Board. Progress is reported to the Board on a quarterly basis and performance against Key Performance Indicators is built into the remuneration scorecard of the full Group Executive. s climate change strategy focuses on managing carbon risk in credit systems and processes, developing lending and investment products and services, engaging employees, advocacy and community engagement and reducing operational greenhouse gas emissions. is working with clients across our Corporate and ing division along with agribusiness and Commercial ing clients, to understand where customers are seeing emerging risks and opportunities, and implementing practical products and solutions to assist. s Renewable Energy Strategy was revitalized in 2008 to increase our involvement in clean energy and large scale renewable financing. Today, now more than 50% of our global infrastructure and utilities financing is directed towards hydro and renewables. s involvement in the renewable energy market includes: Financial relationships with energy retailers with significant liabilities under mandatory renewable energy supply frameworks (eg the Renewable Energy Target in Australia) Financial relationships with energy intensive trade exposed entities Financing for large scale renewable energy projects Support for small businesses involved in the distribution and installation of small and mid-size solar generation and solar hot water units; and Portfolio trading in electricity, Renewable Energy Certificates, carbon and other commodities and energy markets. WIB has also established a dedicated team of carbon specialists to hothouse carbon and carbon related solutions. This team brings together expertise from across the business to focus on delivering integrated carbon solutions for our customers. This includes debt and equity funding for emerging business opportunities in the domestic offset sector (forestry and agriculture), clean energy opportunities, energy efficiency, internal abatement financing requirements and carbon credit off-take, price risk management or origination activities. This team has a global mandate across. 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. 2010 13 February 2012 Page 9
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. More recently, 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. 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 13 February 2012 Page 10