Designing the Emissions Reduction Fund

16 Dec 2013Archived News Dr Gordon Weiss Climate Change Matters

The Federal Government has begun the process of fleshing out the Direct Action plan to define the mechanisms that will reduce Australia’s greenhouse gas emissions by 5% in line with our international obligations. Energetics has been proactive in speaking with our clients to get their views on Direct Action and in particular the Emissions Reduction Fund which is the centrepiece of the Plan.

This paper is a condensed version of a recent five-part series on the Emissions Reduction Fund, published in Climate Spectator. Energetics reports on the views of our clients and, informed by these, propose options for the ERF. These options are in keeping with the principles of Direct Action, will allow Australia to drive down its emissions and provide business with the certainty that it craves.

Climate change policy in Australia is set to change. The new government intends to repeal the Clean Energy Future package (with the carbon tax at its centre) and replace it with the Direct Action plan. The debate now centres on the design of the Direct Action plan and how it will be legislated. The plan includes a number of elements including support for solar energy (one million solar roofs), energy employment hubs and renewable energy. But the major element is the Emissions Reduction Fund which will purchase greenhouse gas abatement in pursuit of the national emissions reduction target of 5% compared to 2000 emissions levels.

Written in 2010, Direct Action exists essentially as a set of principles - some of which appear problematic and, at times, contradictory. It has been called the “do nothing” policy option, but this would benefit no one. There is no certainty in this option, as Australia’s international obligations will eventually require action to reduce emissions. We instead have an opportunity to design a scheme that is meaningful, equitable and positions Australia for future prosperity.
In this paper, Energetics will summarise the views of businesses on the Fund and outline a number of the challenges that the designers of the Emissions Reduction Fund (ERF) must address.

Both before and after the recent election, Energetics sought the views of the business community on the features of the Emissions Reduction Fund that would make it workable and acceptable. Some of the findings included:

  • A bias towards achieving equity rather than simplicity

  • Strong support for the protection of international competitiveness

  • An acceptance of the need for penalties for exceeding a fair baseline

  • A clear desire for a market based mechanism  

There are three major risks:

  • “additionality” - the requirement that the abatement project is beyond business-as-usual. In the absence of support from the ERF, the project does not meet investment benchmarks.

  • participation – voluntary vs compulsory whilst being equitable

  • delivery in a simple and robust way.

Trying to manage all three elements concurrently will be a balancing act.

What the market says

Australia’s largest energy users and emitters have been tracking, managing and reporting their greenhouse emissions for years. Leading companies have developed national energy efficiency programs, invested in greenhouse mitigation technologies and increasingly, renewable energy options. In this section, we report on the feedback received from a survey of some of Australia’s largest energy users, as well as the poll results from our Direct Action webinar series. More than 20 senior business representatives with responsibilities for energy and carbon management participated in a survey assessing their design preferences across key aspects of the government’s Emissions Reduction Fund.

The questions covered five major design issues: 

  • the type of baseline to be applied

  • penalties and how they will be imposed

  • voluntary versus mandatory participation in the Fund

  • types of emissions reduction projects that should be allowed into the Fund auction process

  • the timing of funding awarded, and the use of revenues raised through the operation of the Fund.

The results are summarised in Figure 1.

Figure 1: Direct Action survey feedback

The overwhelming feedback shows that business favours a scheme that is equitable even if it results in a degree of complexity. Australian companies believe in a ‘fair go’ and look for certainty to conduct business. This informs their view on climate policy.

Baselines, penalties and trading schemes

Our polling shows that business is prepared to accept appropriate penalties for underperforming businesses, provided there is a level playing field. There is also a clear message that the level of penalties should be determined by a market-based mechanism, and that funds raised from the levying of penalties for exceeding the baseline should be recycled to support all forms of abatement activities.

Direct Action speaks of penalties for businesses that produce emissions above their ‘business as usual’ levels. Yet there is limited information available on the type, form and extent of penalties. Surveyed businesses overwhelmingly (73%) indicated that penalties should be set at a level that matches the cost of efforts to reduce emissions.

Figure 2: Business feedback on the application of penalties

The role of the baseline (and how it is defined) is central to the operation of the Fund. The baseline:

  • dictates the extent to which a facility is potentially liable to pay penalties

  • establishes the volume of abatement (along with the pool of money available) which can be sold to the ERF.

Direct Action proposes that baselines will be adjusted to reflect changes in production. Across the briefings held, this principle was well received with strong support for site-specific baselines. Businesses want to see baselines derived from emissions intensity rather than absolute emissions levels, and emissions intensities used to determine the baselines should be site-specific where possible. If designed correctly, intensity based emissions baselines can create a level playing field.

However, concern was expressed as to how a baseline can be set for a new entrant where there is no existing site intensity factor. Deriving the historic average baseline from National Greenhouse and Energy Reporting (NGER) data is easy. Businesses and government have this information. But NGER data does not provide the appropriate denominators (e.g. unit volume, ROM tonnes, etc) for establishing site-specific emissions intensity nor does it take into account adjustments to reflect changing business activity. Also, defining and maintaining baselines at the site or facility level poses challenges, as businesses differ so much in age, type of activities, underlying foundations and the technologies used are often very different.

Finally, the use of site-level baselines can disadvantage businesses that have already taken action to reduce emissions. These companies are likely to have lower than average baselines, and fewer low cost abatement opportunities. Site-level baselines may not be equitable.

Following the establishment of robust and appropriate baselines, shifting straight into baseline and credit emissions trading makes sense and is relatively simple. Open to companies that create emissions reductions below their baseline, they could sell offsets into the ERF, provided the government is not the only buyer.

Show me the money

The Direct Action plan clearly spells out principles for an Emissions Reduction Fund which would purchase abatement from the market via a reverse auction. Two principles are stated: the Fund should only purchase realised abatement, and abatement must be beyond business as usual. Worthy aims, but the devil is in the detail.

“Additionality”, the requirement that the emissions reduction measure be beyond business-as-usual, means that without support from the ERF, the project would not meet the business’ investment benchmarks. However, what does a business need to do to show a measure is genuinely beyond business-as-usual, given every business is free to set its own financial hurdles? Also, demonstrating additionality for every measure may create an administrative burden that discourages businesses and especially small businesses from participating.

Businesses are concerned about monitoring, verification and compliance. The proposed approach of using forward contracts to purchase abatement as it is realised provides some payment certainty, but it will carry transaction costs and an administrative burden. Continued uninterrupted emissions reductions over time are hard to quantify and the risk of non-delivery is real. Further, as many abatement measures have long payback periods (eg. renewable energy generation), business participation in the auction process may be limited by cash flow and the need for assistance with capital expenditure.

How to do Direct Action

Energetics’ proposes a structure for the Fund that addresses the concerns raised by business and provides certainty, remains true to the principles outlined in the Direct Action plan, and considers a number of drivers.

The lack of bipartisan support for the mechanism to achieve the national emissions target is driving investment away from Australia. Given Labor’s support for an emissions trading scheme, Energetics believes that a failure to implement a scheme that largely satisfies the policy objectives of the current Opposition merely introduces uncertainty sometime in the future. Further, the Government needs to implement a scheme that can deliver abatement reductions deeper than the current target in keeping with our international obligations.

We believe Direct Action must consist of two components.

The first is a reward and penalty system centred on site baselines developed from industry-wide activity-based emissions intensities. Sites or facilities that achieve emissions below their baseline can offer the abatement for sale to the Fund or to any other buyer such as corporations whose emissions exceed their baseline. Sites or facilities that achieve emissions above their baseline must either pay a penalty or purchase verified abatement from other participants. The level of the penalties will be set at the current price offered by the Fund plus a margin.

The second is a project based program generating abatement for sale to the Fund and to other participants. The abatement generated by the project would be determined by approved methodologies. Abatement can be offered to sale to the ERF or to any approved participant in the reward and penalty system. Projects that have a payback of less than two years will be considered to be ‘business as usual’ and cannot sell abatement to the Fund. Beyond this, there will be no requirement to ensure financial additionality.

Several features will ensure that the scheme can evolve with Australia’s changing international obligations.

  1. The baselines can be adjusted to reflect changing international obligations. The mechanism is to adjust the emissions intensity factors used to generate the site or facility baselines. These adjustments can be made on a sectoral basis.

  2. Participants liable to pay a penalty, or the ERF itself should it be facing a shortfall in abatement, can supplement domestic abatement by purchasing approved international offsets.

The scheme defines a market for abatement which offers an economically efficient means to address changing obligations. It is essentially a baseline and credit trading scheme with a secondary mechanism to generate abatement beyond what is needed to meet the baseline targets.

Australia has been debating its response to climate change for more than a decade, and fighting elections over climate change for much of that time. The Direct Action plan is the latest chapter in this story. The Government insists it has a mandate to implement the Direct Action plan. Within the principles laid out in Direct Action, there is potential for a scheme that addresses the concerns of business for equity and certainty. A baseline and credit scheme could provide robust mechanisms to meet the national abatement target and ensure that Australia maintains its global competitive advantage for future generations.

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