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Focus: Detailed analysis of White Paper – carbon pass through

12 February 2009

In brief: Following on from our summary of the Federal Government's White Paper on its Carbon Pollution Reduction Scheme, Australia's Low Pollution Future, Partner Grant Anderson (view CV) discusses in greater detail the implications of the White Paper proposals for the contractual provisions that should be included in supply contracts, outsourcing contracts and joint venture agreements. This is the seventh in a series of articles that examines in more depth the principal proposals contained in the White Paper.

• Background
• Existing contracts
• Carbon pass through clauses in contracts with parties that are directly liable under the CPRS
• Carbon pass through clauses in contracts between parties that are not directly liable under the CPRS
• Outsourcing contracts
• Joint venture agreements
• National greenhouse and energy reporting system scheme
• The next step

Background

The Federal Government's proposed Carbon Pollution Reduction Scheme (CPRS) will impose substantial costs on entities that are directly liable under it, as those entities will be required to acquire and surrender Australian Emissions Units (AEUs) or eligible international units to cover the greenhouse gas emissions attributable to their activities. The CPRS will also result in entities that are not directly liable under it incurring increased costs, because it will lead to a price being put on carbon that, in turn, is factored into the price of energy-intensive and emissions-intensive products and services such as electricity, gas and petrol. Treasury modelling suggests that the CPRS will cause inflation to increase by between 1.0 per cent and 1.5 per cent in 2010–11, with average retail electricity and gas prices for that year increasing by between 17 per cent to 24 per cent and 11 per cent to 15 per cent respectively.

Nonetheless, because of the wide variety of circumstances in which contracts have been entered into, the Government does not currently intend to legislate for the pass through of carbon costs that may be incurred under the CPRS.¹

It will therefore be important for businesses to determine whether existing contracts to which they are a party enable the pass through of cost increases associated with the CPRS, and to take into account the impact of the CPRS in negotiating new contracts that have a term that extends beyond the date the CPRS comes into operation (currently scheduled for 1 July 2010). This issue will be important not just for large businesses but also for small and medium-sized enterprises that may have less capacity to absorb the increased costs resulting from the CPRS.²

Existing contracts

While existing contracts may contain general provisions that provide for the pass through of increases in taxes or of increases in costs as a result of a change of law, it is unlikely that these provisions will adequately address the pass through of costs that are incurred by virtue of the introduction and operation of the CPRS.

In so far as change in tax clauses are concerned, it is highly unlikely that the CPRS will be able to be characterised as a tax. Its primary purpose is to encourage a reduction in greenhouse gas emissions rather than to raise government revenue and, while the sale of AEUs at auction will generate revenue for the Federal Government, the AEUs that liable entities receive in return are valuable rights. In any event, AEUs may be bought at auction by entities that have no liability under the CPRS, whereas liable entities themselves need not buy the AEUs they require at auction (they can instead buy them on the secondary market, in which case the revenue from their sale accrues to the seller and not the Government). It is true that the surrender of AEUs to acquit liabilities under the CPRS results in the Government receiving something of value. However, the surrender of those AEUs is a necessary part of the scheme that permits AEU holders to emit greenhouse gases and does not contribute to Government revenue (once surrendered, AEUs cannot be used again or resold). Even the monetary amount that a liable entity will be required to pay where it fails to surrender sufficient AEUs to cover its greenhouse gas emissions is more appropriately characterised as a penalty than as a tax.

The introduction of the CPRS legislation will, of course, constitute a change in law. However, the more standard change in law clauses are unlikely to be sufficiently flexible to accommodate all of the intricacies associated with the CPRS. In particular:

• Change in law clauses often exclude changes in law where details of those changes have been announced as at the date of the contract. This presents something of a challenge in the context of the current stage of development of the CPRS. On the one hand, the White Paper contains a considerable amount of detail on the proposed design of the CPRS, and it is evident that some industry participants are already factoring a carbon price component into the prices of their products and services.³ On the other hand, important elements of the CPRS (such as the actual emissions caps and trajectories) still need to be announced and it seems likely that a number of the design features of the CPRS will be changed, if not in the course of consultation on the draft exposure CPRS legislation, then during the passage of that legislation through Parliament later this year.
• A change in law clause typically requires that the costs resulting from a change in law be calculated on a once-off basis for the balance of the contract term. However, the costs associated with the CPRS are likely to change over time in such a manner that they cannot be predicted accurately, at least for longer-term contracts. This is because the costs that a liable entity incurs in acquiring AEUs will vary depending on the entity's acquisition strategy (it may purchase AEUs at auction where their prices will, during an initial five-year period, be capped or on the secondary market where no such cap will apply), and on the entity's hedging strategy (it may purchase AEUs on the spot market, where the prices are subject some volatility, or on the forward market, in an attempt to hedge against this volatility). The price of AEUs will also be influenced by external factors such as the demand for AEUs, economic circumstances, fluctuations in the weather and policy or regulatory changes.
• An entity that is directly liable under the CPRS has a variety of options available to it to address this liability, with none of these options being mandated by law but each of them having a different cost impact. For example, a liable entity could purchase AEUs on the spot or forward market, or could alternatively choose to purchase transitional price cap AEUs or pay the penalty for failing to have sufficient AEUs to cover its emissions (although this is unlikely to be a preferred option, given the cost and reputational issues associated with it). Yet another alternative would be for the entity to reduce its emissions by investing in some form of emissions reduction technology or in improved emissions management.
• Change in law clauses are frequently limited to allowing the pass through of direct, rather than indirect, costs. This is of particular significance where neither of the parties to the contract is directly liable under the CPRS but the supplier of the products or services under the contract faces a CPRS-induced increase in the price of its inputs that it wishes to pass through to the purchaser. In these circumstances, the change in law represented by the CPRS imposes obligations on the upstream producers of the products and services that the supplier uses as inputs into its own products or services, rather than on the supplier itself. As a consequence, the supplier will not be able to claim the benefit of a change in law clause where that clause only permits the pass through of costs that result from a change in law that imposes obligations directly on the supplier.

The upshot of this is that parties should review their existing contracts, and should enter into new contracts, with a view to including in them a carbon pass through clause that is specifically tailored both to the operation of the CPRS and to the parties' circumstances.

Carbon pass through clauses in contracts with parties that are directly liable under the CPRS

This section sets out some of the matters that should be considered in drafting a carbon pass through clause for inclusion in a contract for the supply of products or services where the supplier is directly liable under the CPRS.

The first matter is that, particularly in a long-term contract, it will be very difficult to estimate up front the costs that will be imposed on the liable entity (ie the supplier) by the CPRS: these costs are likely to arise not just at the outset of the CPRS as a consequence of its introduction, but also to vary over the life of the contract as a result of the on-going operation of the CPRS. This issue can be addressed by including a periodic pass through mechanism under which the contract price can be adjusted at specified points in time during the term of the contract, with that adjustment to apply for a few years at a time. This will enable a more accurate estimate of the supplier's CPRS-related costs to be made, which takes into account both the forward price and the supplier's carbon price hedging arrangements. However, it will still be necessary to ensure that these costs are spread appropriately over the intervening years, meaning that the parties will need to agree a discount rate and a methodology for the allocation of those costs to the contract so as to avoid the purchaser bearing a disproportionate share of the costs merely because the supplier's other customer contracts do not include a carbon pass through clause.

The second matter is to ensure that the carbon pass through clause is sufficiently broadly drafted to encompass all relevant costs. Under the White Paper proposals, the primary obligation to surrender AEUs will generally be imposed on the controlling corporation of the member of the group that has operational control over the emitting facility.⁴ However, the party to the contract will often be a subsidiary of the controlling corporation and so, in defining the costs that qualify for pass through, it will be necessary to do so in such a way that they include not just the CPRS-related costs of the subsidiary (if any) but also those incurred by the controlling corporation. It is partly in an attempt to enable pass through clauses in existing contracts to extend to CPRS-related costs that the White Paper contemplates that a controlling corporation may transfer its CPRS liability to a subsidiary, providing that certain criteria are satisfied (including that the subsidiary takes on reporting obligations for the relevant facility under the national greenhouse and energy reporting scheme).⁵ But even where use is made of this transfer mechanism, it would be prudent to ensure that the pass through clause is drafted so as to extend to CPRS-related costs that are voluntarily assumed in accordance with the CPRS legislation. This is because the subsidiary's agreement is required to such a transfer of liability. In addition, where a group operates a number of facilities that generate emissions required to be covered by AEUs, the contract should include a methodology for the allocation of the total cost of the AEUs that the group purchases as between all contracts under which the relevant products or services are supplied. This will ensure that higher cost AEUs are not disproportionately allocated to a particular contract.

The third matter is the need to structure the carbon pass through clause so that it is capable of accommodating all the ways in which a liable entity may address its CPRS-related liabilities (see above). Where the supplier meets its CPRS-related liabilities by purchasing AEUs, the costs it incurs are variable costs that will translate reasonably directly into a per unit price adjustment. Conversely, if the supplier instead invests in a lower emissions intensity production technology, so as to reduce its CPRS-related liability by reducing its emissions, it will face an increase in its fixed costs. In this case, it will be necessary for the supply contract to provide for that fixed cost to be spread across the life of the technology and to apportion that cost both to the term of, and to the units of the product or service supplied under, the contract. Translating a fixed cost increase into a per unit price adjustment may entail making assumptions about the operation of the supplier's production plant, and it might also be desirable to reference these assumptions in the contract.

Given the variety of options open to a supplier to meet its liabilities under the CPRS, a more innovative approach is for the carbon pass through clause to build in an incentive structure that encourages the supplier to adopt the most cost-efficient of those options. A supplier will have no incentive to manage its emissions or its carbon price exposure in such a way as to minimise its costs if it is simply permitted to pass through its actual costs to the purchaser. One possibility is to include in the contract an obligation on the supplier to adopt good industry practice in addressing the effect on it of the CPRS or to take such action as is necessary to minimise the cost pass through to the purchaser. More elaborate structures allow the supplier to recover only a proportion of its CPRS-related costs where its emissions-intensity per unit of output is greater than the industry average, thereby giving the supplier an incentive to reduce its emissions-intensity and associated carbon cost. Conversely, a supplier whose emissions-intensity per unit of output is below the industry average could be rewarded by being permitted to pass through not just its CPRS-related costs but also a premium on those costs.

Where the CPRS-related costs that may be passed through are to be calculated on the basis of the price of AEUs, it will be necessary to determine the appropriate price for that purpose. In order to provide an incentive for the supplier to manage its carbon costs, this should not necessarily be the actual cost of those AEUs. Instead it might, for example, be preferable to deem the price of the AEUs for pass through purposes to be the market price at which AEUs are trading on the date that they are required to be surrendered or to be an average price of AEUs over a reasonable period of time. This will encourage the supplier to hedge against its exposure to high carbon spot prices. Yet another alternative that avoids these issues is for the purchaser of the products or services under the contract to take responsibility for acquiring the AEUs and transferring them to the supplier. In this way the purchaser is able to manage the price risk associated with those AEUs.

Indeed, under the White Paper proposals, a similar mechanism will be included in the CPRS legislation in the form of the Obligation Transfer Number (OTN) scheme. Under this scheme, suppliers of products (such as petroleum, coal and natural gas), who are directly liable under the CPRS because they are the point of obligation for emissions produced by the downstream combustion of their products, are able to have their liability transferred to the purchaser of those products where the purchaser buys those products using an OTN. In some cases the purchaser is obliged to use an OTN, while in others the use of an OTN is at the purchaser's discretion. The purpose of the OTN scheme is to enable (or require) the transfer of CPRS liabilities from such an upstream supplier to a purchaser, where the purchaser is better placed to manage the associated carbon costs (eg because the supplier does not have sufficient information about the downstream use to quantify accurately the emissions and consequent carbon costs associated with that use).⁶ In effect, the OTN scheme is another means of passing through CPRS-related costs. Even where the use of an OTN is voluntary, it may be that, as a condition of the supply contract, the purchaser will be required to use an OTN so that the supplier is able to transfer its CPRS liability to the purchaser.

The final matter that should be considered in crafting a carbon pass through clause is the need to ensure that the pass through takes into account not only cost increases but also cost decreases and other benefits. For example, under the CPRS a coal-fired electricity generator will incur costs through having to acquire AEUs to cover its emissions, but it will also receive the benefit of higher electricity prices. In such a case it could be argued that the increase in the electricity price should be netted off against the CPRS costs that the generator is able to pass through to a purchaser of its electricity. Equally, a supplier that receives free AEUs because the production of its goods qualifies as an emissions-intensive trade-exposed activity should arguably be required to apply the value of those free AEUs against any CPRS-related cost increase that it can otherwise pass through to the purchaser – after all, the allocation of free AEUs to such activities is based on the assumption that the supplier is constrained by international competition from passing through the costs associated with the CPRS. Other benefits that could similarly be taken into account, where the cost to be passed through relates to the cost of installing new low emissions technology, include tax benefits (eg the amount of increased depreciation that can be claimed on the new plant) and cost savings (eg as where the new plant requires less expenditure on maintenance). Moreover, it might be that the parties choose to negotiate a 'pain sharing' arrangement under which, in recognition that the purchaser may not be able to pass through to its downstream customers the full CPRS-related cost pass through that it would otherwise face, the supplier agrees to absorb some of those costs itself.

Carbon pass through clauses in contracts between parties that are not directly liable under the CPRS

Where the contract for the supply of products or services is between parties neither of whom is directly liable under the CPRS, the principal issue that needs to be addressed is whether the indirect cost increases that the supplier may face should be able to be passed through to the purchaser and, if so, how those costs are to be quantified. Obviously, a fixed non-adjustable price is the best means of precluding the pass through of CPRS-related costs to the purchaser. However, assuming that cost pass through is to be permitted, one option is to index the contract price to CPI on the basis that increases in carbon-related costs will be reflected by increases in the CPI. Of course, the cost increases that a supplier actually incurs due to the operation of the CPRS are unlikely to be entirely reflected by changes in the CPI, and so a more precise approach would be to index the contract price to a weighted basket of either the supplier's input costs or industry average input costs. The latter approach will have the added benefit of giving the supplier the incentive to review its supply chain to ascertain where carbon costs can be reduced so as to ensure that its input costs are no greater than the industry average. In either case, however, the issue is to identify the carbon component of the price of these inputs. While this may be relatively simple where the input price is subject to a discrete carbon price pass through to the supplier, it will be considerably more difficult where the carbon component is merely included in a general price increase.

It is also important that when a carbon pass through clause is drafted, the other provisions of the contract and their potential interaction are kept in mind. For instance, if the contract price is indexed to CPI and the contract contains a carbon pass through clause, there is a risk that the supplier will over-recover its costs because the CPI will already incorporate some component for carbon costs. In addition, if the contract price is indexed to CPI, the parties may wish to agree to stagger any price increase resulting from the initial CPRS-induced shock to the CPI over a few quarters rather than to allow for it in just one quarter.

Outsourcing contracts

Under the White Paper proposals, the controlling corporation of a group will be liable for surrendering the AEUs that are required to cover the greenhouse gas emissions of facilities that are under the operational control of a group member. For these purposes, and consistently with the national greenhouse and energy reporting scheme,⁷ a group member will have 'operational control' over a facility where it has the authority to introduce and implement operating policies, health and safety policies or environmental policies for the facility. Where more than one entity could satisfy this requirement, it will presumably be the entity that has the 'greatest authority' to introduce and implement operating and environmental policies for the facility that will be taken to have operational control over the facility.⁸

Where a facility owner outsources the operation of the facility, it may be possible to structure the contract so as to confer operational control on either the facility owner or the contractor by appropriately allocating responsibility for the introduction and implementation of the relevant policies. Such an allocation will then dictate whether it is the facility owner or the contractor that incurs liability for the facility under the CPRS. Of course, there may be very good reasons, quite apart from the CPRS, for conferring authority to determine policies for the facility on one or other of the facility owner and the contractor. Where authority to introduce and implement the relevant policies is shared, the question of whether it is the facility owner or the contractor that has operational control over the facility can be a difficult one. The Federal Government has suggested that, where the facility owner has the authority to introduce policies but the implementation of them rests with the contractor, the contractor will generally be considered to have operational control over the facility because the operator is still likely to be able to introduce some policies.⁹ However, this is not necessarily quite so clear where the outsourcing contract provides for any policies the contractor introduces to be approved, or subject to veto, by the facility owner.

Where the contractor has operational control over the facility, and is therefore liable for that facility's emissions under the CPRS, consideration will need to be given to whether the outsourcing contract should provide for the contractor to be reimbursed by the facility owner for (or for the facility owner to pay) the contractor's costs, both in acquiring the AEUs necessary to meet the contractor's obligations under the CPRS in relation to the facility and in reporting on the facility for the purposes of the CPRS. Again, it must be remembered that the contractor might not be the party that incurs primary liability under the CPRS, so any such cost reimbursement clause will need to be drafted sufficiently broadly to capture costs incurred by the controlling corporation of the group to which the contractor belongs. An alternative would be for the facility owner and the contractor to agree to the transfer of the contractor's CPRS liability to the facility owner, on the basis that the facility owner has financial control over the facility (ie has the ability to direct the financial and operating policies of the facility, with a view to gaining economic benefits from its activities).¹⁰ The White Paper proposals permit such a transfer to occur where certain criteria are satisfied. One of these is where the transferee (ie the facility owner) accepts responsibility for reporting on the facility under the national greenhouse and energy reporting scheme. Accordingly, if this alternative is implemented, the outsourcing contract will need to provide for the facility owner to have access to the information it requires to fulfil this obligation.

Joint venture agreements

In the case of an unincorporated joint venture (or a partnership), the threshold question is whether it is the operator (if any) of the joint venture, or instead the joint venturers themselves, that have operational control over the facility that emits the greenhouse gases. If the operator has operational control, then the operator will be liable for surrendering the AEUs that are necessary to cover the emissions attributable to the joint venture's activities. However, whether the joint venture agreement is sufficiently broadly drafted to allow the operator to recoup the costs of complying with its CPRS-related obligations from the joint venturers will depend upon the characterisation of the capacity in which the operator incurs recoverable costs under the joint venture agreement. In this regard, it needs to be borne in mind that CPRS-related liabilities will constitute a primary liability of the operator, rather than a liability of the joint venturers that the operator discharges for them as their agent. Moreover, unlike in the case of an outsourcing contract, it will not be possible for the operator to transfer its CPRS liability to the joint venturers on the basis that they have financial control over the facility. This is because one of the criteria for such a transfer is that the transferee must be one entity, not multiple entities. In these circumstances, the operator will retain primary liability for the joint venture's CPRS-related obligations, and will need to rely on contractual arrangements with the joint venturers for the reimbursement of the costs it incurs in discharging those obligations (an alternative would be for each joint venturer to agree to transfer to the operator sufficient AEUs to meet its share of the operator's CPRS liability).

Conversely, if the joint venturers (rather than the operator) have operational control over the joint venture's activities, the White Paper proposes that they will be required to nominate one of their number to be liable for the joint venture's CPRS-related obligations.¹¹ While the joint venturers are able to break up the task and cost of purchasing AEUs for the joint venture in accordance with their contractual arrangements, this does not absolve the nominated joint venturer from primary liability under the CPRS. The effect of this is that the nominated entity, rather than the Federal Government, will be exposed to the credit risk of its joint venturers.

Unlike the position under the national greenhouse and energy reporting scheme, it is not clear whether, in circumstances where the joint venturers nominate one of their number to be responsible for the joint venture's CPRS-related obligations, the CPRS liability is intended to be imposed on the nominated entity or is instead to accrue to the controlling corporation (if any) of the nominated entity. If the latter is the case, the intra-group transfer of liability provisions (see above) could then be used to transfer this liability to the subsidiary group member that is nominated as the responsible entity for the joint venture under the CPRS.

Where a joint venturer is nominated as responsible for discharging the CPRS-related obligations for a joint venture, it will be necessary to ensure that a contract is in place that:

• permits the installation and maintenance of the necessary measurement and reporting equipment and systems;
• grants the nominated joint venturer access to that equipment and those systems for the purposes of data collection;
• entitles the nominated joint venturer to report that data as required under the CPRS legislation; and
• provides for the funding of that equipment and those systems, as well as of the necessary AEUs.

It is unlikely that the nominated joint venturer will have these rights under the joint venture agreement – even if it is the operator of the joint venture, it will not be discharging its CPRS-related obligations as the agent of the other joint venturers. Instead, it may be necessary for there to be a separate agreement that provides for these matters.

National greenhouse and energy reporting system scheme

Many of the issues discussed above will also be relevant to the treatment of costs under the national greenhouse and energy reporting scheme. Under this scheme, the controlling corporation of a group that has operational control over facilities that emit greenhouse gases, consume energy or produce energy in excess of certain specified thresholds is required to measure and report on that greenhouse gas production, energy consumption and energy production. In order to fulfil these obligations, it may be necessary to implement administrative structures and reporting systems, as well as to install measurement equipment. Where the relevant facility is operated by a third party or by a joint venture that has nominated one of its members as the responsible entity, the contractual arrangements will need to take into account the costs the scheme imposes and (if necessary) provide for their reimbursement by the facility owner or the other members of the joint venture (as the case may be). In addition, a facility owner may be required under that scheme to report on the greenhouse gas emissions, energy consumption and energy production of major contractors at facilities over which the facility owner (rather than the contractor) has operational control. In these circumstances, it would be sensible to include in the relevant outsourcing contract a requirement for the contractor to provide this information to the facility owner.

The next step

The Federal Government proposes releasing an exposure draft of the CPRS legislation for public comment in late February 2009. If you would like further information in regard to the White Paper proposals that will form the basis of this draft legislation, or any other information, please contact any of the people below.

Footnotes

1. However, the Government will continue to monitor the nature of contractual issues that arise, particularly following the release of the exposure draft of the CPRS legislation: White Paper, p.15-17.
2. The Australian Financial Review, 'SMEs hope it's not all hot air', 15 December 2008; see also 'State threat to energy retailers', 20 January 2009 (in relation to electricity retailers).
3. The Australian Financial Review, 'Electricity futures jolted into life as ETS looms', 8 October 2008.
4.  While this will be the case for entities where the relevant activities directly emit greenhouse gases, this does not seem to be so where liability under the CPRS accrues due to the downstream combustion of products produced as a result of that activity (eg as in the case of petroleum and natural gas production).
5.  White Paper, pp.7-6 to 7-7.
6. See White Paper, pp.6-17, 6-18, 6-19, 6-23, 6-24, 6-25; see also p.7-23.
7. National Greenhouse and Energy Reporting Act 2007 (Cth), section 11(1)(a).
8. See National Greenhouse and Energy Reporting Act, s11(3)(4).
9. Department of Climate Change, National Greenhouse and Energy Reporting System Regulations Policy Paper (February 2008), pp.23-24; National Greenhouse and Energy Reporting Guidelines (2008), s1.4.1.
10. See White Paper, pp.7-4 to 7-5, 15-15.
11. White Paper, pp.7-8 to 7-9.

Published 12 February 2009.

For further information, please contact:

• Grant AndersonPartner, Melbourne
  Ph: +61 3 9613 8928
  Grant.Anderson@aar.com.au
• Chris SchulzPartner, Melbourne
  Ph: +61 3 9613 8772
  Chris.Schulz@aar.com.au
• John GreigPartner, Brisbane
  Ph: +61 7 3334 3358
  John.Greig@aar.com.au
• Ben ZillmannPartner, Brisbane
  Ph: +61 7 3334 3538
  Ben.Zillmann@aar.com.au
• Matthew SkinnerPartner, Singapore
  Ph: +65 6535 6622
  Matthew.Skinner@aar.com.au
• Jim ParkerPartner, Sydney
  Ph: +61 2 9230 4362
  Jim.Parker@aar.com.au
• Darren MurphyPartner, Singapore
  Ph: +65 6535 6622
  Darren.Murphy@aar.com.au
• Campbell DavidsonHead of Greater China M&A, Hong Kong
  Ph: +852 2840 1202
  Campbell.Davidson@aar.com.au

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