Spotlight on integrity as consultation begins on Australia’s new emissions compliance market

The government yesterday commenced consultation on exposure draft legislation to enable the creation of a new unit type (Safeguard Mechanism Credits), and to allow for crediting and trading of units under the under new Safeguard Mechanism framework.

While the government’s legislative package is primarily an administrative vehicle, its political significance is much greater given it represents the only opportunity for the Senate to influence the design of Australia’s new emissions compliance market.

Support in the Senate will therefore come at a cost for the government, with the crossbench likely to seek assurances on key elements of scheme design, including the treatment of new facilities and the integrity of crediting, ahead of the release of a more detailed design policy proposal in December.

With this in mind, we expect the design of Safeguard Mechanism Credits (SMCs) to focus on the integrity of units, with each SMC to represent 1 tonne of emissions.

This would enable SMCs to be traded, and used to reduce another facility’s net emissions (emissions above the regulated limit), while ensuing that the Safeguard Mechanism compliance market contributes real emissions reductions in net emissions.

Government releases draft Safeguard crediting framework

The government yesterday commenced consultation on exposure draft legislation to enable the creation of a new unit type (Safeguard Mechanism Credits or SMCs), and to allow for crediting and trading of units under the under new policy framework.

While the Minister is able to regulate many of the more material changes to the Safeguard Mechanism[1], such as the setting of emissions baselines, and the baseline decline rate, legislation is required to allow for the creation and use of SMCs.

Specifically, the draft bill outlines changes to the National Greenhouse and Energy Reporting Act 2007, the Australian National Registry of Emissions Units Act 2011 and the Carbon Farming Initiative Act to create SMCs and enable their transfer, surrender (to meet compliance obligations), and tax treatment, among other amendments.

Notably, the draft bill proposes to add SMCs as a “prescribed carbon unit” under Section 22XM of the National Greenhouse and Energy Reporting Act, enabling Safeguard facilities to reduce their net emissions by surrendering SMCs.

Under the NGER Act, prescribed units “must represent abatement that is able to be used to meet Australia’s climate change targets”[2]. ACCUs are currently the only prescribed units that can be used to meet Safeguard Mechanism compliance obligations – and contribute towards Australia’s targets[3].

In line with our earlier updates, we therefore expect the design of SMCs to focus on the integrity of units, with each SMC to represent 1 tonne of emissions.

This would enable SMCs to be traded, and used to reduce another facility’s net emissions (emissions above the regulated limit), while ensuing that the Safeguard Mechanism compliance market contributes real emissions reductions in net emissions.

Scheme design likely to zero in on the integrity of SMCs

As noted in our earlier updates, the integrity of new SMCs is a live issue for policymakers given that units may be traded, and used by other Safeguard facilities to reduce their net emissions (and could be counted toward Australia’s climate targets).

Integrity concerns would be heightened under an “industry average” framework.

This is because the “default values” used to set industry averages (calculated using data from 2012-13 to 2016-17) are much higher than current practice, given they do not account for improvement in intensity over the past 10 years.

The use of default values to set industry averages would therefore embed (new) headroom into the scheme, creating an oversupply of low-quality SMCs (which we refer to as “grey” SMCs given they would not initially correspond to 1 tonne of emissions).

This over-crediting is different to current “headroom” created by legacy baseline setting, currently estimated to be 43 Mt, which will be largely eliminated when all facilities transition to a common baseline methodology (either industry average or site-specific).

As noted in our earlier updates, the integrity of SMCs could be improved via the implementation of an accelerated decline rate under an “industry average” scheme (for example under the first phase) to flush out “grey” carbon units (e.g. to expedite aggregate baselines falling below reported emissions).

Importantly, this would also require a stronger rate of decline in the second phase of the scheme, from 2025-26, to ‘catch up’ abatement lost during the transition period (when emissions reductions were not genuine).

This double layer of stronger baseline decline rates could, however, impose prohibitively high constraints on above-average facilities, which are already required to abate a higher proportion of their emissions.

Alternatively, policymakers could elect to implement a more simple “site-specific” baseline framework, which would align aggregate baselines with reported emissions from day one, meaning SMCs would represent 1 tonne of emissions.

This approach aligns with recommendations made by the King Review in the initial creation of the Safeguard Crediting Mechanism (which flagged that crediting under an industry average framework would “undermine the integrity of the scheme”).

While it is sometimes suggested that the implementation of facility-level emissions baselines could penalise ‘cleaner’ facilities (because all facilities would be required to contribute emissions reductions, rather than only more intensive facilities), in practice, facilities with below-average intensity (particuarly in fossil fuel industries) may still be among Australia’s highest emitting facilities in absolute emissions terms.

Unlike other sectors (such as electricity generation where renewables are self-evidently ‘clean’), all industrial facilities are “high emitting” by virtue of their inclusion within the Safeguard scheme. A strong argument can therefore be made for all covered facilities to contribute towards Australia’s targets, consistent with voluntary commitments.

Irrespective of the policy pathway ultimately selected, we expect policymakers to prioritise the integrity of crediting to ensure that new SMCs represent 1 tonne of emissions, ensuring the market establishes a robust and effective price signal.

A site-specific framework (calculated using a two- or three-year average intensity) may ultimately be a more simple way to achieve this outcome, and would avoid the cascading risks (and unintended consequences) of “over-engineering” an industry-average scheme to achieve the desired policy outcomes.

Senate crossbench may seek assurances on scheme design

Given legislative changes will be required to create new SMCs, the government is likely to initially look to the Coalition to support the passage of its Bill, with the proposed changes similar in concept to the Coalition’s former Safeguard Crediting Mechanism proposal (August 2021), one of the adopted recommendations of the King Review.

This support is unlikely, however, with the Coalition voting against the government’s recent bill to implement Australia’s new 43% emissions target, with Liberal MP Bridget Archer the only member of the Coalition to vote in favour of the new target.

The government may instead look for the support of the Greens and Senator Pocock, who are likely to play a more constructive role to improve the Safeguard Mechanism, rather than vote to maintain the current (weak) policy framework.

This may come at a cost. While the government will not agree to ban new fossil fuel projects, the Greens may instead seek assurances that new Safeguard Mechanism Credits are of a high integrity, and that crediting does not lead to emissions increases and windfall gains for fossil fuel facilities (under an industry average scheme).

The crossbench may also seek further input on scheme design, including limits on banking, the treatment of new facilities (for example holding new facilities to a best practice standard rather than industry average), and the scheme’s interaction with Australia’s carbon budget (such as a recommended new entrant reserve).

As a result, while the government’s new Safeguard Mechanism (Crediting) Amendment Bill is primarily an administrative vehicle, its political significance is much greater given it represents the only viable opportunity for the Senate crossbench to influence the design of Australia’s new emissions compliance market.

Let the games begin.

[1] The legislative framework gives the Minister power to make decisions about the details of the laws. This is called delegated legislation because the power has been delegated to the Minister. These powers are subject to disallowance in the Senate.

[2] DCCEEW, Safeguard Crediting Mechanism (August 2021) and Section 22XM of the National Greenhouse and Energy Reporting Act 2007

[3] Most countries count carbon units used in compliance mechanisms towards their national targets. This is because compliance markets impose standards for unit integrity and registers for tracking the trading of units. ACCUs surrendered voluntarily currently do not contribute to Australia’s targets. Emissions from every sector are counted in Australia’s greenhouse gas inventory, however, voluntary offsetting is treated as additional to the target. Refer to the Climate Change Authority for more.