Safeguard Mechanism: What to make of the “industry-average” baseline scheme

RepuTex has today released its submission to the Department of Climate Change, Energy, the Environment and Water (DCCEEW) on proposed amendments to the Safeguard Mechanism.

The decision to implement an “industry average” or “site-specific” baseline framework represents a major crossroads for Safeguard policy design, and will have notable consequences for market development.

In particular, we believe that the implementation of an industry-average framework would risk the efficient development of Australia’s carbon market given below-baseline Safeguard Mechanism Credits (SMCs) would not represent 1 tonne of emissions (like a carbon permit), or 1 tone reduced (like a carbon offset). Instead, free SMCs issued to below-average facilities would be designed to convey a financial benefit (like a green certificate), but would not have any CO2 attributes.

Given SMCs would be used as “offsets” (to reduce emissions above the regulated limit), this would raise serious questions over the integrity of emissions reductions reported by industry – and Australia’s ability to reach its 2030 emissions target.

In this article, we consider the key policy settings required to develop a credible, scalable emissions market under the Safeguard Mechanism, and the potential risks for policymakers in adopting an industry-average framework.

An ‘industry average’ scheme is akin to the Coalition’s “low-emissions technology deployment scheme”

Under an ‘industry-average’ scheme, all facilities would, by definition, be classified into above- and below-average groups.

‘Above-average’ facilities would be required to purchase and surrender carbon credits to bring their emissions in line with the industry average, while below-average facilities would be automatically issued free SMCs for being below the industry average (these facilities would not be required to reduce emissions until later in the decade).

Under the construct of this market framework, SMCs would not be intended to have any CO2 attributes – 1 SMC would not correspond to 1 tonne of emissions (like a carbon permit), or 1 tonne reduced (like a carbon offset).

SMCs would instead be created to confer a financial benefit (or subsidy) to “cleaner” facilities below the industry average.

Conceptually, this is like an LGC created under the federal Renewable Energy Target, where the LGC represents 1 MWh of zero-emissions renewable energy – which provides an economic advantage (or subsidy) for renewable energy development – however the unit itself has no direct CO2 attributes, it is simply a financial instrument.

To avoid confusion with carbon “permits” or “offsets” (that are intended to represent 1 tonne of emissions allowed or 1 tonne of emissions reduced) we refer to these SMCs as “grey” certificates, given they do not have any direct CO2 attributes.

The original framework for this type of scheme was outlined by Grant King in May 2020, adopted by the Coalition, referred to under the King Review as a “low-emissions technology deployment incentive scheme” (similar to the RET).

The King Review flagged “significant risks” in using an industry average for crediting

While such a scheme could create an effective economic signal for cleaner processes (e.g. it makes more intensive processes more expensive)[1], it can create undesirable outcomes where units with no emissions value are incorrectly used as “offsets”.

This was flagged as a “significant risk” in the King Review, which noted that issuing credits to facilities under “sector-based defaults” would:

“Result in issuance of credits for non-additional abatement at facilities whose emissions-intensity is below the sector default. This would reward early action but undermine the integrity of the scheme.”

The King Review therefore recommended that a more robust crediting reference level be established, based on “historical emission intensity levels at the facility”.

This was supported by DCCEEW (formerly the Department of Industry) – and the Coalition Government in August 2021 – when it noted:

“…the use of published industry average default values may not give buyers confidence that credits are supported by a genuine emissions reduction project. By definition, around half the facilities are already performing better than the industry average.”

DCCEEW therefore recommended that the crediting of SMCs be aligned to each facility’s historical emissions intensity (calculated using a two or three year average).

This is the same as a “site specific” baseline approach tabled within the new Safeguard Mechanism Consultation Paper.

Hang on, doesn’t the Consultation Paper say that SMCs ‘need not be additional’?

It does, but the Consultation Paper doesn’t really tell the full story.

The Consultation Paper notes that:

“…(SMCs) will not be carbon “offsets”, because they are generated within a regulated emissions limit. The integrity of SMCs arises from the regulated emissions limit, which constrains the overall emissions of Safeguard participants…This means that, unlike ACCUs – which are offsets – SMCs will not need to be ‘additional’”

While this makes an SMC sound like a carbon “permit” (which is created under a cap, and is equivalent to 1 tonne of emissions), this confuses the two units.

SMCs under the Safeguard scheme are fundamentally different to emissions “permits”.

Emissions permits (or emissions allowances) are used in a ‘cap-and-trade’ framework where all reported emissions are matched with a permit, and total permit issuance is capped to achieve a specific carbon budget or emissions outcome. Although Australia implemented a similar scheme via the Carbon Price Mechanism, the Safeguard Mechanism is not a ‘cap-and-trade’ framework.

Under the Safeguard Mechanism, total covered emissions are not matched to the allocation of carbon permits, and the total number of SMCs is not capped to match the aggregate limit on emissions.

Indeed, there is no proposed cap or limit on SMC issuance.

For example, production could double, and if that production is below-average intensity, more and more SMCs would be issued. Therefore, one SMC does not represent 1 tonne of emissions allowed within a carbon budget, but rather, represents one tonne of ‘less emissions intensive’ production.

As above, its easier to think of an SMC as a certificate – like an LGC – it creates a financial benefit (in this case to below average facilities), but has no CO2 value.

To describe an SMC as a “permit” as used in a ‘cap and trade’ framework (which is implied in the Consultation Paper) would therefore be a fundamental error.

This is because these units would, in effect, be used as an “offset” – to reduce emissions above a facility’s baseline (to lower net emissions). Their use would therefore not lead to any real emissions reduction.

In line with the King Review, all SMCs must instead represent a “genuine” emissions reduction unit that can be used to meet Australia’s climate change targets.

If we get rid of “headroom”, will SMCs be higher quality?

“Headroom” is built into the current Safeguard Mechanism framework because companies are currently given the option to adopt either an individual facility level baseline, or an ‘industry average’ baseline.

Given the choice, facilities currently select the more lenient option, which creates a gap between reported emissions and the baseline for almost all covered facilities. In aggregate, this gap is referred to as ‘headroom’, because emissions can increase without exceeding individual facility baselines.

Issuing credits for this headroom would obviously mean that SMCs do not represent genuine abatement.

Once all facilities are transitioned to a consistent site-specific or industry average baseline, most of this headroom will go, or soon will as baselines decline.

While such an outcome is good (and needs to occur), it will not have a bearing on the quality of SMCs allocated to ‘below-average’ facilities after this point.

These SMCs would still not represent 1 tonne of emissions.

As above, this is because, from this point, SMCs would be freely issued to facilities where they are below the industry average, creating the financial benefit.

As noted by the King Review, these credits would not be additional, nor would they have any CO2 attributes (they are therefore different to, and should not be confused with emissions allowances).

Could an accelerated decline of industry benchmarks help?

As industry average intensity benchmarks decline over time, the integrity of below-baseline credits will improve.

This is because, over the long-term, the industry average baseline will eventually be at or below each facility’s reported emissions.

From this point – essentially where a ‘site specific’ scheme would start from – SMCs issued for below baseline emissions would likely equal one tonne of emissions reduced.

Under a linear reduction, we model this to occur by around 2028-30 – too late to meaningfully contribute to achieving Australia’s 2030 emissions reduction target.

A faster decline could resolve the issue, but may be constrained by two factors:

1. A very strong decline rate would be required to get to this point. This would come at greater expense to above-average facilities, which are already required to abate a higher proportion of their emissions. This raises the principle of equality (and economic risk for above average facilities).
2. If the objective is to align baselines with reported emissions, why not simply create a “site-specific” framework, where baselines are reset to reported emissions?

One other thing… the ‘industry average’ is not really an average of current industry intensity

Industry averages would be calculated by repurposing “default” intensity values, set by the Department, reflecting “industry average emissions-intensity”.

However, current default emissions intensity values do not reflect the true average of current industry emissions. This is because:

• Current default emissions intensity values were originally calculated using data for the five years from 2012-13 to 2016-17 (now up to 10 years old).
• Industry “averages” therefore do not reflect current average intensity, given default values do not account for BAU improvements in intensity over the past 10 years.

Default values are therefore likely to be higher than the current industry averages.

The use of default values as a proxy for industry average intensity would therefore systematically embed new crediting headroom into the scheme, and is forecast to create an oversupply of carbon credits in the new Safeguard scheme.

Low SMC prices may undermine the incentive to reduce emissions, and is modelled to collapse the ACCU market

The effectiveness of the Safeguard Mechanism is directly tied to the carbon price signal, which provides the financial incentive to reduce emissions, whether as an additional carbon credit revenue stream or as an avoided cost for emissions.

We currently view the crediting of SMCs under industry-average benchmarks as a downside risk for price development. This is because:

• SMCs would be automatically issued to below-average facilities, at no cost, to create a financial benefit (much like a subsidy).
• We expect initial SMC issuance to strongly outweigh demand.
• This is attributed to out-of-date “default values” (created over 2012-13 to 2016-17) that do not fully account for improvements in intensity over the past 10 years.
• The low cost of SMC creation, and the oversupply, would be reflected in the SMC price, which would be lower than the ACCU price for most of the pre-2030 period.
• This would undermine the signal for investment in low emissions technologies by above-average facilities, and would erode the strength of the incentive for below-average facilities to improve their performance (to create more credits).

The low price (and integrity) of SMCs would have significant implications for the Australian Carbon Credit Unit (ACCU) offset market, given low SMC prices (and a likely oversupply) would erode compliance demand for higher quality ACCUs.

This is because the creation of an SMC as a financial instrument – rather than a “genuine” permit or offset – would distort the market for carbon units eligible to be surrendered under the Safeguard Mechanism, whereby ACCUs (and any “high-quality” international offsets) would be held to a higher integrity standard than SMCs.

This would create a two-speed market for ‘green’ carbon units (ACCUs) versus ‘grey’ carbon units (SMCs with no emissions reduction value), with the low SMC price (and oversupply) eroding compliance demand for ACCUs.

So why is the government even proposing an ‘industry average’ approach?

It’s administratively easier for the Department to use default (industry average) values rather than transition around half of all facilities to site-specific baselines.

Just because its easier, however, does not mean it is better.

It also does not mean that a “site-specific” approach cannot be implemented prior to 1 July 2023, the start date for the new framework.

For example, in its August 2021 discussion paper on the Safeguard Crediting Mechanism, the Coalition Government (via the Department) recommended that “site-specific” reference levels be established for each facility, given that industry average baselines were deemed to not be suitable for crediting.

The Department proposed that a ‘pilot phase’ could commence just 10 months later – which is where we find ourselves today ahead of the commencement of the Safeguard Mechanism 2.0 scheme on 1 July next year.

By the Department’s own estimates, such a timetable should therefore be achievable to transition the remaining facilities to site specific baselines.

To reduce costs for business, and expedite the baseline setting process for the Department, we recommend that a streamlined approach be adopted for the first phase of the scheme (the transition period), whereby site-specific baselines would be set using previously reported emissions and production under the NGERs framework, utilising a simplified calculation formula.

An industry average scheme could work, but a site specific system will be easier and more effective

Is it possible to make an industry average scheme work? Yes, with enough gaffer tape.

Is it the best pathway to take? Maybe not.

In our opinion, a “site-specific” approach is likely to be simpler, more equitable, and much more effective.

Under this construct, each facility would receive its own site-specific emissions-intensity benchmark. Instead of setting a single “base year” for the commencement of declining emissions baselines, an “average historical reference level” could be established – as proposed by DCCEEW in August 2021 – taking account of a wider variety of operational circumstances (including any recent emissions reduction actions by early movers, inter-annual variation in intensity, specific events such as an outage in production meaning emissions intensity could be artificially high, and so on).

We prefer a site-specific framework for the following reasons:

• Every facility would be accountable for a proportion of its emissions and would receive a gradual, and long-term trajectory to reach net-zero emissions.
• 157 facilities (74% of covered facilities) have already adopted a voluntary emissions reduction target consistent with net-zero emissions between 2030 and 2050. (83% of emissions covered by the Safeguard Mechanism).
• The setting of site-specific baselines is therefore consistent with the way industry currently sets its voluntary commitments, and the ALP’s earlier objective to “align federal policy with corporate commitments to reach net-zero emissions”.
• The start point for baselines would be re-set to align with each facility’s recent historical intensity, automatically removing current “headroom”, and creating a robust reference for future crediting as baselines decline.
• Crediting of new SMCs would require each facility to beat a baseline declining from their previous emissions intensity. Therefore, any crediting is highly likely to represent a “genuine” reduction in emissions, and would be beyond BAU improvements and small fluctuations in emissions intensity.
• One SMC would therefore be “additional and genuine”, representing 1 tonne of CO2e reduced relative to previously reported emissions.
• The crediting of “genuine” emissions reductions would create a more robust price signal, with the price of SMCs reflecting the cost of industrial greenhouse gas mitigation options, helping to guide investment in low-emissions technologies.
• ACCUs (and high-quality international offsets if deployed later) would compete with “genuine” SMCs on an even playing field, such that their prices may converge.
• Credits underpinned by robust additionality protocols (be they SMCs or ACCUs) may support international linkages between different schemes, providing an opportunity for both high-quality ACCU offsets, and high-quality industrial SMCs to be exported – potentially including Australia’s emerging CCS storage industry.

[1] Economic theory suggests that in a highly competitive environment, lower cost (subsidised) production should eventually win out of over the higher cost (taxed) production. While this theory works well in sectors such as electricity production, where the exact same product is produced by different facilities and can be instantaneously substituted, this is not the case in heavy industry. Given the limited number of businesses and facilities in each industry, products cannot be instantly substituted for each other, nor are facilities highly competitive. In addition, for some products (particularly fossil fuels), end-buyers are ultimately unlikely to void existing supply contracts, while substituted products are not “clean”, but are only relatively less emissions intensive. Much of this “relative performance” is due to legacy decisions (e.g. based on where projects are located) rather than specific emissions improvements.