The Commonwealth Government has accepted a number of recommendations from the King Review of Australia's Emissions Reduction Fund (ERF) that would incentivise abatement opportunities in sectors which have had limited participation in the ERF to date. These could allow carbon projects to earn revenue faster through compressed crediting; allow greater third party participation in method development; lower administrative costs for projects applying multiple methods; and provide greater market access for small projects through a clearing house. Proposed changes to the Safeguard Mechanism could also see large greenhouse gas emitting facilities rewarded for "transformational" projects to lower their emissions below baselines. While most of these changes have been welcomed by the sector, further work is needed to avoid the potential for unintended consequences to the market.

Introduction: The King Review into incentivising low-cost carbon abatement across Australia's economy

In late 2019, the Commonwealth Government appointed an expert panel to consider how best to fund projects, research and activities aimed at reducing Australia's emissions of greenhouse gases, in line with our obligations under international law.

The mandate of the panel—chaired by former Business Council of Australia president, Grant King—was to look to the future, and consider "how to incentivise low cost abatement opportunities from across the economy, with a focus on the industrial, manufacturing, transport and agriculture sectors, and energy efficiency."

The panel released its report—known as the King Review—in February 2020.1

In keeping with what the Government refers to as its "'technology not taxes' approach to reducing emissions," the panel's focus was on using existing and additional incentive schemes to encourage more and different types of projects and activities that could result in avoided emissions, or negative emissions through various types of sequestration.

On 19 May 2020, the Commonwealth Government released its response to that report, in which it accepted several key recommendations. Taken together, these changes could significantly alter Australia's carbon markets.

The key recommendations fall into the following areas:

  • Changes to the Emissions Reductions Fund
  • Incentivising voluntary action to reduce emissions, on a broader scale
  • "Unlocking" technologies needed to decarbonise the economy.

Some changes are likely to receive widespread support, such as a fund to support co-investment with the private sector to support innovative technologies to reduce and remove greenhouse gas (GHG) emissions. Some proposals will be welcomed by industry, but are likely to be more controversial among environmentalists, such as proposals to provide incentives for emissions reductions by large emitters without also requiring them to increase their ambitions for reducing those emissions. Other changes, in their current proposed form, could pose challenges to existing carbon abatement projects.

This alert outlines what we view as the most significant recommendations, elements that ought to be further considered, and opportunities that they present.

Changes to the Emissions Reductions Fund system

Much of the report focuses on shortcomings that the panel identified with the Emissions Reductions Fund (ERF) through the experience of its own members, along with industry and stakeholder consultations.

The ERF has been the centrepiece of Australia's carbon abatement program since its inception in 2014, when the Government provided initial funding of AUD 2.55 billion. Under the current arrangements, the ERF purchases carbon credits generated by projects that qualify under the Carbon Credits (Carbon Farming Initiatives) Act 2011 (Cth) and related laws and regulations.

In 2019, the Government established the Climate Solutions Fund (CSF) with AUD 2 billion in funding, to continue the work of the ERF as well as additional activities to support emissions reductions.

An over-arching theme of the panel's findings is that the current arrangements, while achieving some success, could be improved by reducing complexity, and the costs that result from that complexity. Much of the complexity arises from the rules in place to ensure that the Australian taxpayers—through the ERF—are in fact obtaining genuine reductions in the GHG emissions from the projects that they fund. The panel has therefore sought solutions that can reduce the regulatory burden contained in the system, without sacrificing its integrity.

One key proposal to address this issue, is to introduce a statutory burden of "utmost good faith", a concept they have borrowed from the insurance industry.

This requirement would mean that any participant in the ERF scheme would be bound by obligations to act with utmost honesty and integrity in all dealings with the scheme, at the risk of legal consequences for failure to do so. These consequences have not yet been determined, but in the insurance context, they can result in the cancellation of a policy. It is therefore conceivable that breach of that new duty could result in a requirement to relinquish ACCUs, the cancellation of carbon contracts, along with other potential penalties.

Imposing this over-arching duty appears to be one of the foundational innovations that the panel has recommended, and the Government is currently consulting stakeholders on how it should be formulated and implemented.

The remainder of this alert will discuss what we view as the key proposed changes, noting that those with close interest in the topic may wish to read the Government's summary of all key recommendations and its responses to them. 2

The panel concluded that the ERF system could be improved by addressing the following issues with the steps set out in this table:

Issue Identified Recommendation accepted by Government
Costs are incurred years before projects can earn income from selling the Australian Carbon Credit Units (ACCUs) they will generate, resulting in all risk being borne by developers, and excluding projects with relatively higher upfront costs as well as developers without the finance required to fund projects prior to receiving revenues. Allow certain projects to be awarded ACCUs on a compressed timeline.
The current system does not have methods for certain low-cost abatement that could prove effective at reducing emissions.

The panel viewed this as partly because the current system does not have a mechanism for third parties to contribute to method development, and to apply private capital to those efforts.
Establish a new process to provide third parties with the opportunity to propose and prepare ERF methods.

In response to the Panel’s recommendation, the Government has already given industry early-stage involvement in the initial scoping of a Carbon Capture and Storage/Carbon Capture, Use and Storage (CCS/CCUS) method.
The current requirements of the ERF system for assessing and overseeing projects are complicated and burdensome.
  • Introduce a formal "duty of utmost good faith" on participants in the ERF. Similar to the implied duty of utmost good faith that applies to insurance contracts under the Insurance Contracts Act 1984 (Cth), the duty would require ERF participants to act in the utmost good faith in their engagements with the scheme, including in relation to implementing projects, judging whether projects are additional, and measurement, reporting and verification.

  • Facilitate "method stacking", where multiple ERF projects are taken on the same property using different methods, by making rule changes to allow:

    • proponents of stacked projects to submit a single, aggregated offsets report covering each individual component of the stacked project; and

    • stacked projects’ audits to cover all projects at one time rather than auditing each individual component at different times
Small projects are effectively excluded by relatively high transaction costs associated with measurement, reporting and verification requirements under the current system, along with minimum bid requirements for ERF contracts. Create a fixed priced purchasing desk for small projects under the ERF.

The Clean Energy Regulator will further consult with stakeholders on the implementation of this recommendation.
Very few ERF projects have been undertaken by entities that are subject to emissions limits (or "baselines") under the "Safeguard Mechanism" contained within the ERF system.

These are large emitters who must offset any emissions above a determined level, which they can do by buying or generating (and retiring) ACCUs.

They are entities that could potentially undertake industrial-related abatement, such as replacement of plant and equipment with more efficient alternatives.

The problem arises partly from the ERF's requirement that any abatement steps be additional to what an entity would otherwise do. For these emitters, that is difficult to prove where plant or equipment would need to be replaced or upgraded at some stage regardless of the ability to reduce emissions.
Establish a "below-baseline crediting arrangement’ for large facilities using the Safeguard Mechanism architecture. The arrangement would provide credits to facilities who reduce their emissions below their Safeguard baselines by undertaking ‘transformative’ abatement projects."

These will likely be known as Safeguard Mechanism Credits, or SMCs.

Discussion

Of the recommendations listed above, the two with the most potential to change the current system are:

  • introducing a compressed timeline for certain projects to generate ACCUs (and therefore, revenue); and
  • the "below baseline" crediting arrangement for large emitters.

Compressed timeline for certain projects

Many ERF projects are expensive to establish, both in terms of the actual activities undertaken, but also in terms of ensuring that the project complies with the chosen methodology, along with various monitoring, reporting and verification requirements.

However, the projects only receive revenue once they are issued ACCUs that they can sell. In some cases, this occurs many years after the initial expenses have been incurred, and the price of those credits is not guaranteed.

This has resulted in several types of potential projects not being undertaken, because of the misalignment between who bears the risks and benefits of the project, as well as the reality that some potential developers cannot front the costs years before they begin to receive income.

The Government has accepted the panel's recommendation for how to address this issue, through enabling certain types of projects to receive ACCUs on a "compressed" timeline.

In practice, this will mean that certain types of projects can receive credits before the amount of carbon has been sequestered under the current requirements.

Not all types of projects will be eligible for compressed crediting. The panel recommended these be limited to projects that can demonstrate the following:

  1. Projects must involve significant upfront costs, in the form of resource outlays or foregone profits, which are not materially offset by carbon revenues and secondary benefits (e.g. reduced energy costs) in the early years of the project.
  2. The likely abatement from the projects must be able to be easily forecast with a reasonable degree of precision over the crediting period.
  3. The realisation of the forecast abatement must not be contingent on the recurrent outlay of significant resources for the conduct of the abatement activity.

The Government will consult with stakeholders on the best mechanisms to encourage projects with high upfront costs on a method by method basis.

"Below baseline" credits, also known as SMCs

The more controversial proposal is the creation of Safeguard Mechanism Credits (SMCs) for large emitters that are subject to limits, known as "baselines", on their GHG emissions under the ERF scheme. This is because of the concern that these credits could undermine the value of ACCUs from carbon abatement or sequestration projects generated by other developers, and that the credits would reward emitters for taking steps that they may have taken even without those credits.

Currently, the scheme is geared at requiring those emitters to offset the emissions they generate that are above those limits. The assumption in the current approach is that those emissions would inexorably rise in the absence of the baselines. Those emitters are eligible to generate their own ACCUs through carbon abatement and sequestration projects, which they can apply to their emissions that exceed their baselines. But, the panel noted, very few have taken up this opportunity, due in part to the difficulty of showing that such projects would be additional to actions they would take even without those incentives.

The new proposal is for emitters to be able to generate SMCs for reducing their emissions below those baseline limits. The SMCs would not be offsets; rather, they would amount to incentives for activities to reduce emissions. The panel also stressed that activities would need to be "transformational" in order to qualify, and proposed that those wishing to take up this opportunity would have to make a public "transformation" statement. Under Australian law, such statements would generally have legal force to the extent that they could not be false or misleading. The panel also made clear that they would be subject to the proposed new requirement of utmost good faith.

The Government has accepted this recommendation, as a way to incentivise technological solutions to reduce emissions that are not currently being supported by the ERF scheme.

While it is encouraging to see policy shifting to support additional emissions reductions activities, the new proposal risks adding a further layer of complexity to the Safeguard Mechanism and also undermining existing ACCU markets, particularly if the new SMCs were fungible with ACCUs or otherwise displace the need for facilities that exceeded their baselines to surrender ACCUs. Uncertainty about how SMCs would work, and how they would affect existing carbon projects, could have the unintended consequence of destabilising the whole scheme because it could dissuade potential purchasers from buying ACCUs, and therefore, could dissuade developers from undertaking additional projects.

A key issue that links to market viability is that the current baselines are set at levels that can be met by the large emitters with relative ease. This means that it would be relatively easy to achieve reductions that bring them below their baselines. Enabling large emitters to easily generate credits, without a price signal that acknowledges that relative ease, risks undermining the price of all credits, including ACCUs.

The Government could resolve this problem by bringing the baselines down meaningfully below current levels - noting that different trajectories may be required for different sectors. That would also put Australia on course to achieve our emissions reductions goals at a faster rate, or to exceed those goals, and to align with science-backed targets for emission reductions.

There is also concern within the carbon markets sector that this proposal could divert resources away from the existing and effective carbon sequestration projects such as afforestation, revegetation, and soil carbon in favour of seeking out new technological solutions.

Conclusion

It is encouraging to see the Government move to broaden the range of emissions reductions projects that can attract government support, particularly given the scientific consensus that we will need new and better technologies to remove carbon from the atmosphere if we are to meet the goals of the Paris Agreement, of limiting global warming to well below 2 degrees Celsius above pre-industrial levels and pursuing efforts to limit it to 1.5 degrees, "recognising that this would significantly reduce the risks and impacts of climate change".

In particular, the new proposals present opportunities for the private and academic sectors to better engage in the process of developing methodologies and technologies that can rapidly transform our ability to limit emissions.

It will be important to design the new systems in such a way that they maintain the integrity and financial stability of the existing crediting systems, while also promoting innovative and ambitious applications of existing and new technologies to achieve greater emissions reductions in line with Australia's international commitments.

To discuss this or any climate-related issues, please do not hesitate to contact us.


1 https://www.industry.gov.au/data-and-publications/government-response-to-the-expert-panel-report-examining-additional-sources-of-low-cost-abatement

2 https://www.industry.gov.au/sites/default/files/2020-05/government-response-to-the-expert-panel-report-examining-additional-sources-of-low-cost-abatement.pdf

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