Opportunities for Australian business as regulators scramble to shore up the EU ETS?

19 Dec 2012Archived News Climate Change Matters

The August 2012 announcement to link the Australian and European Union Emissions Trading Scheme (EU ETS) was welcomed by many. However, from an Australian vantage point, the world’s largest and most established carbon market appears to face significant challenges as the European Union Allowance (EUA) hits an all time low. What are the implications for emissions intensive Australian businesses? 

The $148-billion EU ETS market is poised to enter its third phase. During Phase 3, free permits will be progressively replaced with auctioning and the emissions cap gradual decreased by 1.74% per annum. Furthermore the following scheme design changes will be introduced:

  • scope of greenhouse gases covered extended from CO2 to also include nitrous oxide and perfluorocarbon
  • emissions from petrochemicals, ammonia, aluminium and aviation (1) sectors will be covered for the first time;  and
  • the compliance cycle is longer than the previous phases, spanning from 2013 to 2020. 

In spite of these improvements in the design of the scheme, regulators are scrambling to prevent the scheme form collapse, whilst Germany lead calls for a long-term structural reform of the EU ETS. December 2012 saw both the EUA and the U.N-backed Certified Emission Reductions (CERs) (2)  hit fresh lows of € 5.78 and €0.32 / tCO2e respectively as illustrated in Figure 1.  With prices at current levels, no new investment in emissions abatement initiatives can be expected.

Figure 1: EU and UN Carbon Price trend and analysts forecasts (3)

The collapse in the price of the EUA is due to the imbalance between supply and demand for carbon units in the EU ETS. The EU ETS is facing multiple headwinds as European economic woes suppress demand from liable entities, whilst new sources of demand for carbon credit are lagging. Only 30 mainly EU countries, representing only 15 % of global emissions committed to track 2 of the Kyoto Protocol during the recent Doha talks. (4) Furthermore, early auctions of Phase 3 EUA brought fresh supply to the market at a time when “oversupply” due to past policy setting continue to “wash through” the market. (5) 

The U.N.-backed CERs and ERUs are products of the Kyoto Protocol …

Certified Emissions Reductions (CERs) originate from Clean Development Mechanisms projects in developing nations and Emission Reduction Units (ERUs) from Joint Implementation initiatives in Annex I countries, i.e. industrialised countries (and countries in transition to a market economy) which took on obligations to reduce their greenhouse gas emissions under the Kyoto Protocol.

  

Are regulators doing enough to support the EUA?

European regulators appear committed to boost the EUA price in an attempt to revive investment in emissions reductions projects, domestically and abroad. In addition to the expanded scope of greenhouse gasses and sectors covered during Phase 3, the following factors may provide short term price support to EUAs:

  • The “backrolling” of EUAs is being proposed by the European Commission and will be voted on by EU member states in the first quarter of 2013. If passed 900 million carbon permits will be removed from the market between 2013 and 2015, to be reintroduced in 2019 and 2020. Poland and Malta opposes the plan, with Germany remaining internally divided on the issue. (6)
  • The European Commission’s Climate Change Committee (EU CCC) is pursuing linkages with other carbon markets at regional, national (e.g. Australia) and sub-federal (e.g. California) levels. 
  • A reduced flow of U.N.-backed credit volumes into the EU ETS compliance market is expected during 2013/ 14. In addition to the ban on credits from HFC-23 and N2O acidic acid, from 2013  CERs from new projects will be limited to those from Least Developed Countries. (7) 
    The EU CCC also proposes to restrict the use of ERUs during 2013 by banning EU firms from importing new Emissions Reduction Units (ERUs) from countries that refuse to sign up to a second phase of the Kyoto Protocol. Furthermore, a proposal will be tabled to ban member states from issuing ERUs for emission cuts directly or indirectly related to the sectors covered by the EU ETS. However, most significantly for the EU ETS, the use of CERs / ERUs is likely to exceed the allowable import quota for the 2008 to 2020 period by 2014. (8)  At this point all CERs/ERUs will lose their utility in the EU ETS compliance market and the CER/ERU price will decouple from the EUA. 

The forecast, as illustrated in Figure 1, suggest that the above measures are too little, too late to support a price recovery to levels above €15 in 2013, from current levels of below € 7 in 2013. Analysts’ forecast for the 2013 to 2020 period remains fairly subdued with EUA average price forecast at €11.34 and CERs at €3.85. However, a double digit EUA price in by 2015/16 appears likely.


What does this mean for Australian businesses? 

During the fixed price period of the Australian carbon scheme to July 2015, trade in carbon permits will be restricted to Australian Carbon Credit Units (ACCUs). Consequently, developments in the EU ETS will have no direct bearing on Australian business paying a carbon tax. At present the ACCU is only issued under the Carbon Farming Initiative (CFI) and its use is restricted to 5% of the liability of Australian entities until July 2015. After July 2015 restrictions on the use of ACCUs are lifted. However, the expected price differentials between the ACCU and EUA/CER and ACCU supply constraint (9) suggest that the linkage of the Australian and EU ETSs will provide more cost effective abatement opportunities to Australian business.

The start of the variable price period of the Australian carbon scheme coincides with the date of the “unilateral” (10)  linkage between the EU ETS and the Australian carbon scheme. Liable Australian entities are thus likely to first utilise their 50% international offset allowance (11)  to cover their liability, before procuring ACCUs. A bilateral linkage will be established from July 2018 onwards whick may in time lead to a increase in demand for ACCUs from EU ETS member states (see the kick out box explaining the impact of the linkages).

The measures intended to provide price support for the EUA as discussed in the previous section will have played out by January 2015, when the unilateral linkage takes effect (See illustrated timeline in Figure 2 below). The re-introduction of back-loaded units will occur after the establishment of the bilateral link. This will in all likelihood drive down the value of 2019 EUAs, making it more difficult for ACCUs to compete in the EU ETS market.

 

Implications of linkage…

During the unilateral linkage period between July 2015 to July 2018, the linkage will facilitate a reduction in the cost of abatement for Australian companies, if the ACCU is priced above the EUA. Otherwise no flow will occur and the unilateral linkage will have no effect on either market.

During the bilateral linkage period after July 2018, the linkage will reduce price differences between the two geographically isolated markets, but price convergence is not assured due to restrictions on the number of permits that can be imported, i.e. 50%. This restriction is intended to stimulate domestic action, but it acts in a similar way to price containment measures (e.g. price ceilings and floors). Initially difference in the price between the two schemes will cause prices to move towards each other until the point of maximum allowable import of permits is reached. If this happen before the two prices converges, the schemes will remain differently priced.

 

Key considerations for 2013

As of July 2014 forward purchase of eligible international carbon permits are likely, but trade will be limited unless there is political certainty on the future of the scheme.

The Liberal-National Coalition indicated it will repeal the price on carbon if it comes to power (elections expected in second half of 2013). If this eventuates, the Australian Senate is still required to vote for the repeal of the CEF package.  If the Coalition succeeds in repealing the price on carbon, it is likely to be a marathon affair to untangle the web of legislation and associated budgetary allocations. It is therefore probable, irrespective of the outcome of the 2013 Federal elections that substantive parts of the CEF-legislative package will still be in effect in July 2015. 

Doing nothing to cover the potential carbon liabilities in the flexible period carries significant financial risk for Australian liable entities, as delaying the purchase of EAUs to 2015/16 could result in liable entities under the Australian carbon scheme paying a 60% premium for EUAs over current prices. On the flipside, Australian policy uncertainty makes the forward purchase of EUAs and CERs, even at these current low prices, a risky proposition.

The market for financial instruments, required by emissions intensive Australian businesses to manage their exposure to the financial and political risk of carbon in the flexible period (i.e. after July 2015) is still developing. However, Australian liable entities can take steps in 2013 to mitigate the above risks.

The risk of holding EUA in the post-2015 period, if the CEF package is repealed, can to some extent be mitigated by the fact that the EU ETS is likely to exist well beyond 2015. EUAs will therefore hold some value and can be traded at a future point in time if and when the Australian carbon scheme is repealed. The future value and market for CERs are less certain. Forward purchases of CERs therefore carries a bigger risk but at €0.32 / tCO2e may still have a role when considering voluntary and compliance options.  

Since EUA prices are unlikely to show signs of recovery until late 2013 or early 2014, the current convergence of negative sentiment may present Australian business with a window of opportunity to assess their options for a post 2015 compliance market. Companies wishing to manage the risk of their carbon liability during the post-July 2015 period need to consider:

  • Step 1: Develop a robust understanding of their medium term carbon footprint profile.
  • Step 2: Review the impact of the different regulator scenarios on the organisation’s carbon liability.
  • Step 3: Evaluate risk management options, including an analysis of the optimal mix and / or desirability of emerging financial instruments to manage risk exposure.


Key reference sources

1 The aviation sector demand alone is expected to grow to more than 100 Mt CO2e per year by 2020. 2 Installations in the EU ETS are allowed to use for compliance a finite amount of Kyoto / U.N. backed credits (CERs and Emission Reduction Units – ERUs). 3 Data sourced from Point Carbon / Thomson Reuters – forecast based on Reuters poll of 14 Analysts published on 5 /12/2012. 4 In the absence of a legally binding global commitment to emissions reductions, regional and sub-regional carbon markets (i.e. New Zealand, Japan, California, South Korea, Mexico and many others) are required to take on more ambitious emissions targets if the glut of CERs are to be absorbed. However, these markets have not signed up to track 2 of the Kyoto protocol and are being shut out of the U.N.-backed credit markets. 5 CERs from the destruction of gases at refrigerant and chemical plants are flooding the market ahead of the EU ETS ban on new HFC-23 and N2O adipic acid projects effective end of 2012 (complete ban from all projects effective May 2013). credits from these project types represent the vast majority of CER issuance to date. 6 If the “back-rolling” plan fails 819 million permits will be sold in 2013, compared to 519 million if it passed. 7 This list excludes China and India, which have traditionally accounted for the vast majority of CERs issued. 8 The right of use of U.N.-backed credit has not been spread out over the 2008 to 2020, resulting in a frontloading of demand.  Total Certified Emission Reductions (CERs) issuance to December 2012 is expected to reach more than 1.16 billion, with a further 500 million ERUs likely to be issued by the end of the year. 9 Most CFIs are in early stages of development. It is not anticipated that these CFI projects will produce an adequate supply ACCUs even though prices will closely track the carbon price of $23/ tCO2e in 2012/13, increasing to $24.15 in 2013/14 and  $25.40 in 2014/15. The removal of the post-July 2015 price floor of $15 / t CO2e, as part of the EU ETS linkage, has increased the price risk for these projects and may have impacted on the viability of some initiatives. 10 Australian entities can purchase EUA s to meet domestic obligations, but Australian Carbon Credit Units (ACCUs) cannot be used by liable entities under the EU ETS to meet compliance obligations) 11 U.N.-backed units limited to 12.5%, EUAs is likely to constitute 37.5%.
 

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