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Focus: Climate Change – July 2008

Release of Professor Garnaut's Climate Change Review draft report

In brief: Following on from his summary of the draft report of the Garnaut Climate Change Review released on 4 July 2008, Partner Grant Anderson (view CV) discusses in greater detail some of the principal findings and recommendations of the draft report.

• Background
• Emissions trading scheme
• Coverage
• Strongly affected businesses
• Trade exposed emissions intensive industries
• Auctioning of permits
• Use of international offsets
• Netting scheme
• Transitional arrangements
• Low-emissions technologies
• Other measures
• The next steps

Background

Professor Ross Garnaut has been commissioned by the Federal, state and territory governments to report on the likely effect of climate change on Australia's economy and environment, the scope for international policies to ameliorate that effect (including the role that Australia can play in the development of those policies), and the policies that Australia should adopt to address the climate change challenge.

The draft report by the Garnaut Climate Change Review (the Review) identifies an urgent need to reduce greenhouse gas emissions. While it does not specify actual emissions trajectories that should be adopted (these will depend on economic modelling that is currently being undertaken by the Review in conjunction with Federal Treasury), the draft report does state that:

... faster, more energy intensive and more emissions intensive growth in developing Asia is leading to substantially more rapid growth in emissions than had previously been understood by the international scientific community. The clear and unfortunate implication is that we have less time than previously understood to stem the growth of global emissions, if we are to avoid higher risks of dangerous climate change, as defined by mainstream science...1

A substantial part of the draft report is devoted to detailing the potential impact of (largely unmitigated) climate change on Australia to 2100. These include its adverse effects on agriculture (particularly in the Murray Darling Basin) and on international tourism, reduced water supply, coastal flooding and resultant damage to buildings, environmental damage (eg to the Great Barrier Reef and Australia's northern wetlands, alpine regions and tropical beaches), an increase in heat related deaths and diseases, political instability in the Asia Pacific, and a deterioration in Australia's international terms of trade.

The draft report recognises that the risks of dangerous climate change can only be held to acceptable levels through a comprehensive global agreement that includes both developed and major developing countries (such as China, India and Indonesia). Unfortunately it also concludes that there is only a 'slender chance that ... the world will manage to develop a position that strikes a good balance between the costs of dangerous climate change and the costs of mitigation'.² However, striking such a balance is particularly important to Australia given its vulnerability to climate change, and the draft report highlights the role that Australia can play in contributing to an effective global climate change agreement.

At the domestic level, one of the principal tools that the draft report identifies for addressing the climate change challenge is:

... an effective market based system [that is] as broadly based as possible, with any exclusions driven by practical necessity and not by short term political considerations.3

But even then, the Review focuses on such a scheme as purely justified by reference to, and essential for the achievement of, a comprehensive global climate change agreement:

There would be no point in Australia alone introducing mitigation policies. The entire purpose of mitigation is to support the emergence of an effective global effort.4

For this reason, the draft report devotes considerable space and thought to the appropriate form of a global agreement and how it can be achieved, and the Review's conception of Australia's proposed emissions trading scheme as a means of encouraging the development of a global agreement fundamentally shapes its approach to the design of that scheme.

Set out below are some of the key recommendations contained in the draft report.

Emissions trading scheme

In its discussion paper released in March, the Review outlined the parameters of a proposed emissions trading scheme for Australia. The draft report reinforces many of the proposals contained in the discussion paper, albeit with some small modifications. In particular, it reiterates its support for:

• five-year rolling annual caps, which have been criticised by some as providing too short a period to promote investment certainty;
• unlimited banking, but limited borrowing, of emissions permits – in the case of borrowing, an independent central authority would lend emissions permits to creditworthy borrowers for a period of up to five years, whereupon those permits would have to be replaced (with interest); and
• a deficit in emissions permits resulting in a penalty for breach of law rather than merely giving the liable entity an option to pay a monetary amount as an alternative form of compliance. Consistent with this approach, the draft report also supports the imposition of a 'make good' obligation (ie an obligation to acquire and surrender permits at least equivalent to the deficit). The combination of a penalty and a 'make good' obligation avoids the penalty acting as a de facto price cap.

The following sections provide a more detailed discussion of some of the other features of an emissions trading scheme as recommended by the Review.

Coverage

The draft report recommends that the emissions trading scheme should be as broadly based as possible, both in terms of the greenhouse gases that are to be covered (namely, all six Kyoto Protocol gases) and the industry sectors that are to be covered. In particular, the draft report is firmly of the view that the scheme should include transport and petroleum products. It also recommends that waste and forestry should be included within the scheme as soon as practicable, although forestry offsets should be able to be used to acquit obligations under the scheme from the outset. However, the draft report accepts that agriculture should only be covered by an emissions trading scheme to the extent that this is the most cost effective means of encouraging biosequestration and reducing net emissions from that sector. Where a sector remains uncovered, alternative policies will need to be developed to encourage emissions reduction in that sector.

Although the Federal Government has previously indicated that it favours an emissions trading scheme that has extensive coverage, it is under considerable political pressure to exclude petrol from the scheme, or at least to counteract the effect on consumers of including petrol in the scheme (eg by cutting the petrol excise). It has also been reported⁵ that the Federal Government is considering not just excluding forestry related emissions from the scheme but also forestry related offsets (eg offsets arising from the sequestration of carbon in trees).

Strongly affected businesses

The draft report emphatically states that:

... there is no basis for compensation arising from the loss of profits or reductions in asset values following the introduction of the domestic emissions trading scheme.6

According to the Review, giving domestic industries compensation or structural adjustment assistance for the effects of an emissions trading scheme is a political decision (rather than one compelled by economic or environmental reasons) that needs to be assessed in the context of the range of other competing claims on the revenues that the Federal Government will raise from auctioning emissions permits (these include assistance to low-income households and the funding of research and development into new low-emissions technologies). The draft report reinforces this view with the warning that, in any event, it will not be practical to develop and administer a free permit allocation scheme for such a purpose in time for the introduction of emissions trading in 2010. Although the Review's position is not unexpected, as it was flagged in the March discussion paper, it will serve to heighten the concerns of domestic industries (such as fossil fuel fired generators) about the impact on them of a carbon price.

While acknowledging that existing coal fired generators, in particular, will face 'acute pressures'⁷ as a result of the introduction of an emissions trading scheme, the draft report also points to opportunities for those generators arising from the availability of relatively low cost reductions in emissions (eg through coal drying) and increased electricity prices (particularly for generators that rely on brown coal that, unlike black coal, is not able to be exported and therefore is not subject to international price pressures).

Trade-exposed emissions-intensive industries

By way of contrast, the draft report comes out in favour of payments to trade exposed emissions intensive industries, these payments being made to level the international playing field on which those industries compete rather than by way of compensation. Even then, however, it sees such assistance as short term and only subsisting until global sectoral agreements, under which the main international producers in each industry are subject to a national emissions limit or a carbon tax, have been negotiated. The Review considers the conclusion of these agreements to be 'an urgent matter'⁸, stating that:

There can be no doubt that the inherent arbitrariness of such assistance measures will make them the subject of intense lobbying, with potential for serious distortion of policy making processes. Their continuation for more than a few years would be deeply problematic.9

Regarding payments to trade exposed emissions intensive industries, the draft report recommends the adoption of fairly high materiality thresholds, which are based on industry processes (rather than industry sectors) and are calculated as the permit cost of direct and indirect emissions as a proportion of sales revenue, so as to ensure that assistance is given only where there is a 'genuine risk of large, excessive reductions in domestic production'.¹⁰ Consistent with this, the amount of assistance would be based on the increase in the world price that would be expected if a carbon price were to be imposed on Australia's main competitors, multiplied by the expected output that Australian industry participants would produce at that price. Significantly, the draft report suggests that such assistance should be limited to permit costs in excess of the specified threshold, ie that the assistance would not cover all costs imposed by the emissions trading scheme as a result of trade exposure.

Applying these criteria, the draft report indicates that aluminium smelting, cement production, iron and early-stage steel manufacturing and (to the extent they are included within the emissions trading scheme) cattle and sheep products would be candidates for assistance. Various industries have been vigorously lobbying the Federal Government in an effort to be classified as trade exposed emissions intensive industries. However, it appears that, consistent with the recommendations of the draft report, the Government may be considering a relatively high threshold (based on 2000tCO₂ -e per million dollars of output), under which only 15 per cent to 20 per cent of Australia's industries would be eligible for assistance.¹¹ This seems to be motivated in part by the likely substantial growth in trade exposed industries (including in the agricultural sector) and the need to ensure that the economic burden of emissions reduction is widely spread.

While the draft report favours cash payments (made as closely as possible to the timing of acquittal obligations) as being a more transparent way of providing this kind of assistance, it recognises that this assistance could equally take the form of free permits, drawn from the relevant year's schedule, that have the same value as these cash payments. In either case, it suggests that no more than 30 per cent of permits (or permit value) should be allocated for this purpose. To the extent that all of this allocation is not utilised, the associated auction proceeds are to be returned to business (including those operating in trade exposed industries) through tax cuts that are tied to efficiency improvements.

Auctioning of permits

The Review's relatively restrictive approach to the allocation of free permits, including its proposed denial of assistance to coal fired generators, has already come under sustained criticism from state governments and generators, with claims that a carbon price of $45/tCO₂-e would result in the closure of three of Victoria's four brown coal fired power stations and a 50 per cent increase in power bills.¹² Indeed, recent newspaper reports suggest that the Federal Government will reject the Review's recommendations in this area.¹³

Considerable concern has also been expressed about the cashflow problems that liable entities may face where they have to acquire a significant quantity of emissions permits. For example, Caltex has estimated that, at a carbon price of $40/tCO₂ -e, it would need to purchase $1.4 billion of emissions permits each year to cover the petroleum that it sells. The Review's response to this is that provision could be made for the issue of deferred payment permits, which would be paid for at the time of their acquittal at the market price prevailing on the day of acquittal. This is unlikely to be satisfactory, however, as the liable entity is then exposed to the vagaries of the carbon price on that day (although it may able to take out some hedging cover). Moreover, while it addresses the carrying costs of the permits, it does not alleviate the size of the outlay.

Use of international offsets

The Review considers that access to international offsets (such as certified emissions reductions (CERs)) is likely to act as a disincentive for developing countries to adopt emissions targets. Instead, it considers that these offsets have a limited role – namely, to encourage participation in climate change mitigation by the least developed countries to the extent it is not appropriate for them to accept emissions targets. Consistent with this, the draft report suggests that the Australian emissions trading scheme should only accept CERs from those countries (as opposed to, for example, China and India), and that the number of such offsets should be restricted to a fixed proportion of Australia's emissions permits. The mechanism it proposes for this purpose is the issue of 'supplementary permits', each of which would entitle the holder to acquit one CER under the Australian scheme. The price of these supplementary permits would reflect the expected difference between the price of CERs and the price of Australian emissions permits. This is consistent with the Review's circumspect approach to international offsets, as evidenced in its March discussion paper.

Netting scheme

The draft report acknowledges the need for a netting or credit scheme where there is to be an upstream point of obligation, eg as in the case of the transport sector where permit liability seems likely to be placed on petroleum refineries and importers. While the possibility of permitting large downstream users to opt into the emissions trading scheme so as to allow them to assume responsibility for their emissions from combusting petroleum has already been raised, the draft report goes further and suggests that consideration be given to allowing all large energy users to opt into the emissions trading scheme in respect of their indirect stationary emissions, ie the scope 2 emissions attributable to their electricity consumption.

Transitional arrangements

Although the draft report favours an unconstrained carbon price with effect from the outset of the emissions trading scheme, it does accept that there are some advantages in imposing a fixed permit price (but not a price cap)¹⁴ to the end of 2012¹⁵. Under this option, fixed-price permits would be issued on demand rather than auctioned, including at the time of acquittal when liable parties may need them to meet any emissions permit deficit. During the transition period there would be little trade in emissions permits (except in post 2012 permits) and offsets would be used only to acquit scheme participant liabilities if they were available at below the fixed price. The disadvantage of such a 'false start' is that it might delay the development of a forward market, and the Federal Government is reported not to be supportive of this option.¹⁶ Moreover, it would be necessary to preclude pre 2013 permits being banked for use after 2012 so as to avoid post 2012 prices being artificially depressed.

Conversely, one of the advantages that the Review identifies in relation to such transitional arrangements is that it would obviate the need for assistance during this period to trade exposed emissions intensive industries (with its inherent methodological difficulties), and might avoid the need for that assistance altogether if global sectoral agreements can be concluded by 2013.

Low-emissions technologies

The draft report emphasises the need to develop and commercialise new low emissions technologies globally. It recommends that there should be a global agreement under which high-income countries commit to minimum levels of investment for this purpose – in Australia's case, a very substantial $3 billion per year. The Review suggests that much of the public funding required on Australia's part could be sourced from the revenues derived from the Federal Government auctioning emissions permits (20 per cent of total auction revenues would be set aside for this purpose), supplemented by funding transferred from existing programs, additional drawings on consolidated revenue, and industry levies. It is proposed that such funding should be given on the basis of it being matched one-for-one by private-sector funding.

Indeed, the draft report recognises that the future of coal based electricity generation in Australia depends on carbon capture and storage becoming commercially feasible, and that Australia has a potentially significant leadership role in testing and deploying this technology. In this respect, the draft report clearly acknowledges the need to transition to a zero carbon energy sector by 2050 and that public funding is necessary for this to occur. If Australia can continue to use coal based generation (with near-zero emissions due to carbon capture and storage), then it will be able to benefit from the export demand for gas from countries where carbon capture and storage is not physically or economically feasible. In addition to funding the development and commercialisation of carbon capture and storage, the draft report recommends a specific allocation of $1 billion to $2 billion (matched on an equal basis by industry) to accelerate the uptake of emissions reduction technology by existing coal fired generators.

Other potential areas for funding include soil sequestration, solar technologies, algal biosequestration and geothermal energy.

Conversely, the draft report considers that mandatory renewable energy targets, such as the 20% Renewable Energy Target that is being proposed by the Federal Government, should be phased out once the emissions trading scheme becomes fully operational.

Other measures

With the emissions trading scheme being the centrepiece of Australia's approach to managing climate change, the draft report is concerned to ensure that its efficiency is not compromised by other measures (including subsidies, tax laws, procurement polices, and technology standards). As the draft report states:

Other measures have a role if, and only if, they remove or reduce the costs of various market failures, the presence of which would otherwise raise the cost of adjustment to the emissions trading scheme.17

On this basis, in addition to funding the development and commercialisation of new low emissions technologies, the draft report supports government funding for improvements to network infrastructure so as to facilitate both the connection of alternative generation sources to the grid (including through building in excess capacity up front) and the deployment of large scale carbon capture and storage. Similarly, it supports the provision of incentives for embedded generation (including feed in tariffs based on gross, rather than net, metering), and the funding of schemes that promote information about distributed generation, energy saving opportunities in appliances, buildings and vehicles (eg mandatory efficiency standards and mandatory disclosure of energy efficiency ratings), and emissions reductions in agriculture, forestry and waste.

The draft report also recognises that the introduction of a carbon price will result in potentially substantial increases in the prices of petrol, electricity and gas, as well as in the prices of products and services that contain embodied energy (eg because they are manufactured using energy intensive processes or are transported significant distances). It therefore recommends that about half of the revenue derived from the auctioning of permits could be used in the early years of an emissions trading scheme to offset the regressive effects of a carbon price on low-income households. This revenue transfer would occur through the tax and social security system, and could be designed in such a way as to enhance the efficient use of energy by these households without dampening the carbon price signal.

The next steps

The Federal Government will release its Green Paper on the design of an Australian emissions trading scheme on 16 July 2008. It will be interesting to see to what extent the recommendations of the draft report are incorporated in this paper.

The Review will also be releasing a supplementary report in August 2008 and its final report in September 2008. The supplementary report will contain the results of the joint modelling being undertaken by the Review and Federal Treasury on the economic impact of an emissions trading scheme under various emissions-reduction scenarios. In addition, the supplementary report will set out the Review's modelling of the cost and benefits to Australia of mitigating the effects of climate change. These will be important inputs into the recommendations made by the Review as to the emissions trajectories that Australia should follow, as well as into the decisions that the Federal Government will need to make about the annual caps that are to be imposed.

Interested parties are invited to make submissions on the draft report. If you would like assistance in preparing such submissions, or further information about the proposed Australian emissions trading scheme and the opportunities and risks it presents for your business, please contact any of the people below.

Footnotes

1. Draft report, p.13.
2. Draft report, p.2.
3. Draft report, p.8.
4. Draft report, p.338; see also p.364.
5. The Australian Financial Review, 7 July 2008, 'Fight to save offset credits from trees'.
6. Draft report, p.384.
7. Draft report, p.499.
8. Draft report, p.351.
9. Draft report, pp.350-351.
10. Draft report, p.385.
11. The Australian Financial Review, 2 July 2008, 'Exporters cry foul on emissions'.
12. The Age, 5 July 2008, 'Tough love "vital" for polluters'; The Australian Financial Review, 1 July 2008, 'States warn on carbon trading costs'.
13. The Age, 7 July 2008, ' Climate change ideas on petrol and coal set to be dumped'.
14. A fixed price is recommended because, given the prohibition on banking between the 2010-12 period and the post-2012 period, there is a risk that the permit price would fall to close to $0 if Australia does better than its Kyoto target for the 2008 12 period (ie 108 per cent above 1990 emissions). This would damage the credibility of the scheme.
15. The cut-off date for these transitional arrangements is the end of 2012, as otherwise Australia's credibility as a party to international negotiations on any post 2013 international climate change agreement could be challenged. While the draft report describes such transitional arrangements as second best, it is evident that, at least at one stage, it was considering a transition period as a firm recommendation (see pp.472, 478).
16. The Age, 7 July 2008, 'Climate change ideas on petrol and coal set to be dumped'.
17. Draft report, p.14.

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, Sydney
  Ph: +61 2 9230 4038
  Matthew.Skinner@aar.com.au
• Jim ParkerPartner, Sydney
  Ph: +61 2 9230 4362
  Jim.Parker@aar.com.au
• Darren MurphyPartner, Perth
  Ph: +61 8 9488 3768
  Darren.Murphy@aar.com.au
• Campbell DavidsonPartner, Shanghai
  Ph: +86 21 6841 2828
  Campbell.Davidson@aar.com.au

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