Show me the money! Interest in latest ERF auction slumps

The fifth Emissions Reduction Fund (ERF) auction will take place on April 5–6, with $440 million in remaining in the government’s initial funding tranche. Just 17 new projects have been registered since the last auction, down from 28 ahead of ERF IV, and well below the average project registration rate (90) ahead of auctions 1-3.

While the Clean Energy Regulator (Regulator) notes that the fifth ERF auction is expected to be “smaller and more representative of business as usual”, we believe that low levels of participation are reflective of negative market sentiment, with the low average price of ACCUs, and the commercial and administrative complexity of the scheme, creating a significant barrier to participation for many firms, particularly high emitting companies.

In this context, even if funding for the ERF is topped up at the forthcoming policy review, we believe that we are unlikely to see the ERF abatement profile – concentrated in the land sector – align with Australia’s emissions growth profile, which is driven by the industrial sectors.

While additional funding may enable ACCU prices to rise, the bigger issue for policymakers therefore remains the failure of the ERF to achieve Australia’s absolute 2020 emissions reduction target, with emissions projected to grow 3 per cent from 2016 – driven by the safeguard sectors – to be 559 Mt in 2020, short of an absolute minus 5 per cent target (522 Mt).

In the short term, fortune appears likely to favour the brave at the fifth ERF auction, with modelling indicating that ACCU contract prices are likely to push higher at the fifth ERF auction, driven by lower participation and reduced competition. This is likely to see the spread between the lowest and highest contract prices again grow, with good upside for informed bidders operating at the top end of an auction bid-stack.

Recapping the fourth ERF auction

The fourth Emissions Reduction Fund (ERF) auction was held on the 16 and 17 November 2016, with 47 contracts entered by the Clean Energy Regulator (Regulator) for the delivery of almost 34.4 million (M) Australian Carbon Credit Units (ACCUs).

In line with our pre-auction expectations, the fourth ERF auction was a step down in size from previous events, with low participation leading to a nominal increase in the average price of abatement.

• 47 contracts were awarded to 49 projects.
• Close to 34.4 Australian Carbon Credit Units (ACCUs) were contracted, at an average price per tonne of $10.69, for a total value of nearly $367.4 million.
• 6 per cent of the volume of abatement offered below the benchmark price was accepted, up from 80 per cent at ERF I, 72 per cent at ERF II and 77 per cent at ERF III.

While the average price of abatement disclosed by the Regulator ($10.69) is a market reference point, in practice, it is of little help as a robust price signal given it does not reflect the wider value of contracted emissions reductions. To this end, modelling again indicates a broad spread of contract prices, with many proponents contracting at a premium above the weighted average price.

This upside is reflected in the broad spread of contracts accepted below the benchmark price, with 98 per cent of all bids accepted, a significant step up from earlier auction events (72-80 per cent). Analysis indicates that bidders seeking to capitalise on lower participation, by bidding above the average price, were therefore rewarded by favourable contract prices.

Show me the money? Low price signal stranding projects, dragging down sentiment

Of a total of 295 projects registered to participate in the fourth auction, only 49 were successful in securing contracts (down from 73 at ERF III), indicating that around 240 projects (approximately 80 per cent of all registered) did not participate, or bid above the benchmark price.

This low level of participation is expected to continue at the fifth ERF auction, with just 17 new projects registered to participate, down from 28 new projects registered ahead of ERF IV. As a result, the vast majority of registered projects (around 270) occurred prior to auctions two and three, with an average of 90 registration across the first three auctions, well above current registration rates.

These projects continue to be eligible to participate, yet remain content to sit on the sidelines, with the low average price of abatement – and the commercial and administrative complexity of the scheme – creating a significant barrier to participation for many firms, particularly high emitting companies.

In this context, most registered projects appear to be economically stranded under the ERF with little incentive for further bidding given the current low price environment. Looking forward, this may limit ACCU crediting and issuance, potentially dampening supply of domestic ACCUs for use as offsets. Furthermore, projects that continue to be registered are more likely to be non-additional “anyway” projects (those that would have occurred irrespective of the ERF), with greater tolerance for low contract prices. This reflects a broader design flaw in the scheme, with low-quality abatement being contracted by the Regulator.

While additional funding for the ERF will create the possibility for ACCU prices to rise at future auctions, potentially unlocking some higher quality abatement, the bigger issue for policymakers remains the design of a more effective long term scheme that is able to meet Australia’s emissions reduction commitments. In this way, the success of the ERF must be measured by the sum of its two parts – the ERF and the safeguard mechanism – with tighter emissions limits needed to curb Australian emissions growth, driven by covered sectors.

The re-setting of the safeguard mechanism to align with Australia’s 2030 target may therefore provide more accountability for high emitters – and a long-term source of demand for ACCUs – while ‘safeguarding’ ERF investment, and enabling the land-sector to be weaned off public sector investment.

Low participation likely to push prices higher at Auction Five

In the short term, we forecast low registration rates will result in ACCU contract price increases at the next auction, driven by lower participation and reduced competition. This is likely to see the spread between the lowest and highest contract prices grow, with modelling indicating good upside for informed bidders operating at the top end of the auction bid-stack.

Should large projects not participate, marginal projects may have an opportunity to exert greater influence at the top end of the bid-stack. This may push prices higher, and enable firms to access more favourable contract prices, subject to the variable clearing threshold.

As always, supply volumes, bidder behaviour, participation and competition will again dictate the unique shape of the fifth ERF bid-stack, and our expectations for where the highest clearing price will form.

To access RepuTex’s full ERF auction outlook and pricing simulations, click here. RepuTex is Australia’s largest provider of energy and emissions market analysis, with customers at over 150 of the region’s leading Power, Energy, Metals, Mining, Government and Financials firms.