Coalition’s ‘grey’ baseline and credit scheme could pay companies to increase emissions

The federal government on Tuesday released the findings of its Expert Panel review (the King Review), accepting 21 of 26 recommendations to incentivise greenhouse gas (GHG) emissions abatement from industry.

Below, we summarise the key recommendations and provide initial analysis on what’s in, what’s out, and the implications for the Australian carbon market.

Crediting for emissions below safeguard baselines

As we noted in our latest Market Update, a key focus of the Expert Panel review is the development of rules to credit emissions reductions below Safeguard Mechanism baselines. Credits created under the proposed mechanism could then be used to meet compliance obligations under the Safeguard Mechanism, or be purchased by federal, state and territory governments, or via voluntary transactions.

As expected, new credits generated under scheme, potentially known as Safeguard Mechanism Credits (SMCs), would be differentiated from Australian Carbon Credit Unit (ACCU) offsets. Crediting would be for ‘transformative’ abatement projects based on changes in emissions intensity rather than absolute emissions.

As noted in our earlier update, while the crediting of industry emissions intensity improvements may incentivise increased supply from the industrial sector, key issues remain with the demand component of the policy framework.

While the proposal would establish a crediting mechanism similar to a ‘baseline and credit’ scheme, the elephant in the room continues to be the ‘baseline’ component of the framework, with Australia’s largest emitting facilities unaccountable for absolute emission increases (given emissions baselines reset annually to reflect actual production). Increases in absolute emissions therefore remain unchecked.

The design of a separate emissions intensity crediting baseline, and the focus on ‘transformative’ projects, could mitigate the risk of a large influx of ‘automatic’ SMC issuance to facilities with headroom below their emissions reporting baseline.

However, the crediting of emissions intensity improvements raises considerable additionality risks, with crediting to potentially reward ‘anyway’ projects for investment that does not represent additional abatement. As noted in earlier updates, we refer to these as ‘grey’ credits, with these units of lower environmental integrity due to the lower threshold for additionality.

In addition, crediting reductions in emissions intensity improvements can result in the perverse outcome of paying high emitting businesses to invest in projects which increase absolute emissions, even if emissions intensity decreases.

The price of SMCs… A two-speed market is now likely

As we discussed in our earlier update, the limiting of newly created industry-credits to safeguard mechanism compliance (subject to any compliance obligation) or a separate class of credit eligible for the Climate Solutions Fund will result in the development of a ‘two-speed’ Australian carbon price, with different price bands reflecting the different value of abatement, additionality, time-value, and underlying costs of crediting relative to sequestration offset projects.

The Review notes that new SMCs could be purchased at a price set by the market or at a fixed price. The price may also be pegged at a discount to the prevailing ACCU price to reflect that SMCs are not bankable, and are not subject to strict additionality.

As noted, while the Expert Panel recommendations may support increased industry crediting, the low levels of demand under the safeguard mechanism framework and the relatively low quality of abatement will strongly impact price formation.

While SMCs may potentially be used for Safeguard compliance, this is a nominal market given the lack of compliance obligations created under the safeguard framework. The lack of a large source of compliance demand is therefore likely to be the Achilles heel for SMCs, as it is for the ACCUs, limiting the development of a robust market.

At a higher level, the lack of alignment between industry demand and an emissions target trajectory means that SMC prices will be influenced by ACCU prices and estimates of likely SMC volumes, rather than being calibrated to incentivise large-scale emissions reductions required to meet national or sectoral emissions reduction goals.

As we noted within the King Review (Figure 2.4), while Australia has many low cost abatement opportunities, with potential for over 200 million tonnes of abatement in 2030 at a marginal cost of less than $15/t (The marginal cost of net-zero emissions under the Paris Agreement, 2019), the alignment of policy mechanisms like the safeguard mechanism with emissions target trajectories will be critical to provide a meaningful investment signal for the private sector. These opportunities are unlikely to be unlocked within a voluntary framework.

Untapping the abatement value of LGCs?

The Review recognises the potential for Large-scale Generation Certificates (LGCs) to increasingly be considered for use in carbon markets due to their implicit carbon abatement value. However, no direct link is proposed for the use of LGCs in the ERF or safeguard scheme, with application likely to be limited to voluntary markets.

The Panel proposes the adoption of a “carbon exchange rate” to reflect the carbon value of LGCs as either the average grid carbon intensity per MWh or the state-based grid average emission factor for the jurisdiction in which the generator is located.

As we modelled in August 2019, “Could LGCs deliver least cost external abatement?”, the use of LGCs as a form of carbon offset has the potential to reduce the marginal cost of external abatement for industry, while establishing a floor price for LGCs, and incentivising new investment to support renewable energy development. However, any hope for the transformation of the LGC market into a carbon linked scheme also remains tied to a robust source of demand being developed, or lack thereof.

The elephant in the room – more supply, no demand

While the King Review lays out a sensible framework for improvements to Australia’s carbon market framework, subject to its ability to navigate concerns over the additionality of ‘grey’ SMCs, the elephant in the room remains the ability for large emitting companies to increase emissions, and update emissions baselines to reflect actual production, without triggering compliance obligations.

Beyond the obvious implications for Australia’s emissions reductions objectives, this remains a key limit on any policy recalibration that seeks to incentivise supply, without addressing demand.

This article was published under RepuTex’s Carbon Market Intelligence (CMI) service, which provides in-depth coverage of Australian carbon market and pricing dynamics, including ACCU spot prices, long-term ACCU price forecasts and scenarios under the Paris Agreement and sectoral marginal abatement costs (MAC). Click here to learn more.