The carbon pricing mechanism: an industry focus

July 2011

Contacts

Introduction

On 10 July 2011, the Australian Federal Government announced details of its proposed carbon pricing mechanism (the Mechanism). This policy has been referred to by government and commentators as the largest economic and environmental reform for a generation. 

View our legal update released on 10 July Carbon pricing mechanism snap shot: key features, certainty and flexibility.

While the Mechanism will have a broad impact on industry, commerce and the community, it will have particular implications for some specific sectors of the economy. With this in mind, we have developed a short series of briefing papers that provide insight into the implications of the carbon pricing mechanism and "securing a clean energy future" policy announcements for particular industry sectors, including construction and engineering; mining; power; oil and gas; and transport. We have also prepared a further briefing which provides specific detail on tax implications.

Draft legislation is due to be released for public comment by the end of July 2011. With the legislation expected to go before the House of Representatives in September and the Senate in November, it is important for businesses to begin assessing the implications of this policy for industry sectors in general, as well as companies covered by the mechanism in particular.  

A construction industry focus

by James Morgan-Payler and Lucy Watts

Introduction

The carbon pricing mechanism (the Mechanism) will have particular implications for the construction industry.  This paper focuses on the implications for construction, including in particular:

  • Costs for the industry.
  • Risk allocation.
  • Carbon liabilities.
  • The implications for both existing and future construction projects (and contracts).

Application of carbon tax

The residential and commercial building sectors produce 23 per cent of Australia’s greenhouse emissions.  Although the carbon tax covers a broad range of industry sectors, it is important to note that only facilities directly responsible for emitting carbon pollution will have obligations under the Mechanism to reduce their emissions or purchase carbon permits. As the construction industry principally contributes to emissions indirectly, through its acquisition of materials, resources and services (for example cement, steel, electricity, transport and waste disposal) the industry itself is unlikely to have any direct obligations under the Mechanism.  

The major source of direct emissions in the construction industry is the use of transport and other liquid fuels either on site or in transportation. The use of such fuels may be captured by the complementary regulatory arrangements designed to impose an equivalent carbon price on the use of transport and other liquid fuels. The equivalent carbon price is imposed through reductions in fuel tax credits available for businesses, and where that option is not available, by increasing fuel excises.

Light commercial vehicles (4.5 tonnes or less) and household vehicles will be exempt from the imposition of an equivalent carbon price. Other business use of transport fuels will be subject to the equivalent carbon price on all transport fuels (and some other liquid fuels in certain situations) from 1 July 2012. For more information on the treatment of liquid fuels, please refer to the transport industry focus.

Indirect costs for the industry

The Mechanism is likely to result in increased costs passed down from direct emitters who are suppliers to the construction industry.  

The majority of increased costs to the industry are likely to be as a result of higher electricity prices, manufacture of carbon intensive materials such as cement, and the transportation of goods.  Although increased electricity rates will be experienced by industries and households alike the construction industry will be particularly exposed to higher supply costs.

Production costs of carbon intensive materials used in construction, such as aluminium, concrete, bricks, glass and steel are expected to increase. The additional costs of production in these industries are likely to be passed on to customers. Most of these industries however will be supported as “emissions-intensive trade exposed” industries or through bespoke assistance arrangements, being provided with either free carbon permits commensurate with their exposure, or with cash payments. This is likely to lessen the extent of the carbon liabilities for those industries, and as such the costs actually passed through to construction consumers.

The assistance schemes referred to above that are of particular relevance to the construction industry are the Jobs and Competitiveness Program, the Steel Transformation Plan and the Clean Technology Program.

Jobs and Competitiveness Program

Under the Jobs and Competitiveness Program about AUD$9.2 billion of assistance will be provided to help business and support jobs in the first three years of the Mechanism.  The assistance aims to prevent ‘carbon leakage’, that is moving activities offshore to countries without a carbon pricing mechanism to allow for cheaper production.  Emissions-intensive trade exposed industries, including many manufacturers of construction materials, may be eligible.  We note that although steel, aluminium and glass manufacturers are all considered to be eligible for assistance under the Jobs and Competitiveness Program, the brick manufacturing industry is excluded as it is not considered to be exposed to competition from cheaper overseas markets.

Steel Transformation Plan

The steel industry will be one of the most heavily affected sectors under the Mechanism.  In order to ease the transition the Government will provide AUD$300 million to encourage investment, innovation and productivity in the Australian steel manufacturing industry.

Clean Technology Program

The introduction of the Mechanism will see higher standards of energy efficiency in design and materials as demand for buildings with lower operating costs increases.  Although the construction industry has already been implementing processes for more energy efficient buildings and facilities through programs such as the Green Building Program the increased use of such design and materials will be further assisted by a number of Clean Technology Programs aimed at supporting investments in energy efficient capital equipment and low-pollution technologies, processes and products:

  • Clean Technology Investment Program: AUD$800 million in grants will be provided to manufacturers.
  • Clean Technology Food and Foundries Program: over six years up to AUD$50 million in assistance will be provided to the metal forging and foundry industries.
  • Clean Technology Innovation Program: AUD$200 million over five years for development in renewable energy, low-emissions technologies and energy efficiency.

Notwithstanding the assistance schemes being implemented by the Government some increased costs are likely to still be incurred by the industry.  The consideration of which party is liable for these rising costs under the construction contract will now be an issue for parties to existing contracts and those entering into construction contracts in the future.

Energy efficiency trading scheme

The policy announcement made on 10 July 2011 included the expedition of the development of a national energy savings initiative, a market-based tool for driving economy-wide improvements in energy efficiency. The federal government will “immediately establish a working group” to seek agreement on the replacement of existing state mandatory energy savings schemes (such as exist in New South Wales, Victoria and South Australia) and to report in the first quarter of 2012. The development of such a scheme is consistent with the findings of the Prime Minister’s Task Group on Energy Efficiency, which reported to the government in late 2010.

The development of a national energy savings initiative is unlikely to have a significant impact on building processes, however more broadly it is likely to impact on the environmental and efficiency standards that construction customers demand.

Contracts

Following the announcement of the Mechanism it is essential to conduct a review of existing contracts to determine what liabilities may be incurred and whether any contractual rights or obligations, concerning the pass through of costs, have arisen.  A similar review should also be undertaken with respect to any contracts that are currently being finalised or tendered for. Key issues to be aware of in the contractual pass-through of carbon cost include:

  • The scope of the triggering event, whether defined as a “change of law”, “change of tax” or as a specific “carbon cost pass-through” clause.
  • The scope of the costs that may be passed through, whether indirect costs may be passed through as well as direct costs;.
  • The mechanisms for transparency in disclosure of how carbon costs are to be calculated; and
  • The procedures for the cheap and efficient resolution of disputes.

For construction contracts that will be in operation after 1 July 2012, it is necessary to consider whether the Principal or Contractor will be liable for cost increases passed through from suppliers, as well as for direct carbon cost increases (which will rest with the party that has “operational control” over the relevant facility).  

Contract structure

There is a range of contractual structures generally used in the construction industry, and the type of contract entered into will impact upon any cost liabilities arising from the Mechanism.  In particular, whether the contract is cost plus, lump sum, schedule of rates or a mixture, will go some way to determining whether the contract sum may be increased as a result of the Mechanism.  

For example, under a ‘cost plus’ contract the Contractor will be entitled to be paid for costs incurred, as well as an additional amount (usually a percentage or commission).  The risk therefore of any increase in the cost of construction materials is borne by the Principal (subject to any guaranteed maximum price mechanism).  By way of contrast where the contract price is a fixed sum Contractors are less likely to be able to pass on increases in the costs of construction materials, unless that fixed sum is subject to a valid carbon cost pass through arrangement.  Similarly, where a schedule of rates or bill of quantities is used the costs incurred by a Contractor are also usually in effect ‘fixed’ and the Contractor will most likely remain responsible for any increase in the cost of construction materials.  It is important to note that under contracts for domestic building works, cost escalation is only permitted in limited circumstances and in most instances Contractors will be unable to pass on increased costs as a result of the Mechanism.

Specific contractual entitlements

Where a specific clause allocates liability for increases in the cost of materials flowing from a carbon tax, liability will be allocated according to the terms of the specific clause. However, with the exception of recent major projects, most contracts already on foot in the construction industry are unlikely to specifically allocate the risks associated with the Mechanism.
 
Although most contracts will specifically address the rights and obligations of the parties where there is a change in law, whether the provision adequately deals with the introduction of the Mechanism will depend on the drafting.  It is not unusual for these clauses, even where they do provide an entitlement to claim costs, to require that extra works actually has to have been carried out (so cost increases alone may not be claimable).  Parties need to careful check their existing contracts (and in-house standard forms) to see whether or not an entitlement arises and importantly whether any time limits are required to be complied with in order to access such entitlements.    

Importantly change in law clauses will ordinarily require that for a claim to exist the change must be unforeseeable.  Clearly, since the federal government’s announcement, this will be difficult to argue.  Accordingly, going forward contractors will need to ensure that any increased costs are either expressly dealt with or a contingency included within the agreed price.

Of course a general “rise and fall” clause may also provide an entitlement subject to its terms.  However, increasingly such clauses are not being included on standard construction projects unless in response to some specific and foreseen price risk.    

Next steps

The costs impact of the Mechanism will be widespread across the economy and will need to be accounted for by the construction industry. In particular, participants in the construction industry should consider:

  • Risk allocation under both supplier and purchaser side contract arrangements for contracts currently under consideration, including consideration of the scope and triggers for the pass-through of costs.
  • With respect to current contracts, whether any contractual obligations have arisen, what liabilities may be incurred and whether there are any entitlements that can be exercised.
  • Their existing contracting policies to ensure that going forward this risk is either priced or otherwise expressly provided for.
  • Assessment of the direct carbon liabilities that may be incurred, in particular through the use of transport and other liquid fuels.
  • The impacts of the Mechanism and its complementary measures on the broader strategic focus of the construction industry, including its affect on the prices of certain materials, the types of technologies being used in the construction process and the demands of customers operating in a regulatory environment that places an impost on the emission of carbon and other greenhouse gases.  

Related updates

Carbon pricing mechanism snap shot: key features, certainty and flexibility 

A framework for pricing carbon in Australia 

Carbon Farming Initiative legislation tabled 

Mineral Resources Rent Tax update 

Further information

If you would like further information or advice about any aspect of the policies underlying, or the proposed legislation implementing, the Government's Clean Energy Future package, please contact a member of our Construction and Engineering team.

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A mining industry focus

by Robert Milbourne, Mei-Li Ng and Dale Gill

Introduction

The carbon pricing mechanism (the Mechanism) will have particular implications for the mining industry.  This paper focuses on the implications for mining, including in particular:

  • The specific transitional arrangements pertaining to the coal industry.
  • The interaction between the Mechanism and the MRRT.

The implications for the Mechanism for the mining industry

The Mechanism will result in many consequences for the Mining Industry including: (i) charges per tonne of carbon dioxide equivalent (CO2-e) emissions, (ii) potentially increased indirect costs for goods and services as the broader industry begins to adapt to the carbon pricing regime, and (iii) significant implications for planned project development or expansion.  In certain circumstances, and depending on contractual terms, proponents may be able to pass-through certain of these costs to end users, and therefore mining industry proponents should, as a priority, review and consider amending their carbon cost pass-through clauses in supply and procurement contracts, in mining services agreements, and in commodity sales agreements to take into consideration the impact of the Mechanism.

Under the proposed framework the Mechanism will be implemented in two stages. There will be:

  • An initial fixed price period of three years – there is a starting fixed price of AUD$23 per tonne which will increase by 2.5 per cent per year in real terms.
  • A transition to a flexible price cap and trade emissions trading scheme on 1 July 2015 - the price will be determined by market forces.

The Mechanism will directly apply to entities that produce more than 25,000 tonnes of carbon dioxide equivalent (CO2-e) emissions per annum. Liable entities will also have continuing reporting obligations under the National Greenhouse and Energy Reporting System (NGERS). Significantly, liability under the Mechanism:

  • Is incurred by the entity with operational control of the emitting facilities.
  • May be shared among unincorporated joint venture participants according to their proportionate interests.

Fugitive emissions

The Mechanism will include in its coverage the emission of fugitive gasses (principally methane) from mine production.  Where adequate abatement technologies are not identified, proposed mine expansions and developments may be significantly impacted financially. Government analysis concludes that whereas the average non-gassy mine is likely to face an additional cost of around AUD$1.40 per tonne of saleable coal, the average gassy mine is likely to face an additional cost of around AUD$7.40, and the gassiest mines may face additional costs of up to AUD$25 per tonne.

For mines that are in operation, the government has sought to mitigate potential job losses through its proposed Coal Sector Jobs Package to support “gassy mines” (those that had a fugitive emissions intensity in 2008-09 of at least 0.1 tonnes of carbon dioxide equivalent per tonne of saleable coal produced).  

Assistance will be provided to eligible coal mines for up to 80 per cent of their fugitive emissions exposure above the 0.1 tCO2-e per tonne of saleable coal threshold. Assistance will be based on production up to a cap of base period production levels (the higher of 2007-08 or 2008-09). Such support will not be available for new production or expansion of mines with high fugitive emissions intensity.

Transitional assistance for trade exposed industries

The initial cost of CO2-e emissions may be lower than the set price of AUD$23 per tonne as a result of transitional assistance support.  General assistance in the form of free allocation of permits will be provided to industries that are both emissions-intensive and trade-exposed (the Emissions Intenstive Trade Exposed Assistance Scheme). The allocation of free permits will be based on the historical industry average levels of emissions per unit of production. In order to reward innovation and responsibility, if the liable entity is more efficient than the industry average, it will receive more free carbon permits per unit of production than less efficient competitors. The Mechanism will allow such entities to sell these excess permits either back to the Government (in the fixed price phase) or to third parties (in the flexible price phase) for their market value as an additional source of revenue.

In satisfying its obligations under the Mechanism and in addition to the use of carbon permits for compliance, liable mining entities are entitled to:

  • During the initial fixed price period - use Kyoto Protocol compliant emission offsets from the Carbon Farming Initiative (Kyoto ACCUs) to reduce up to 5 per cent of their total liability.
  • During the floating price period - use Kyoto ACCUs for 100 per cent of their liability or opt to buy (potentially cheaper) international offsets for up to 50 per cent of their liability.

Further, it should be noted that carbon permit and offset purchases are tax deductible expense items. Specific legislation for the accounting and taxation treatment of carbon permits will be introduced into the existing taxation regime. For more information on the taxation issues that arise under the Mechanism, please refer to our focus on the carbon tax.

Transitional arrangements for the coal industry

The coal industry does not meet the thresholds set out in the relevant tests for the EITE assistance scheme but the Mechanism does set out specific measures for assisting the coal sector, in particular gassy mines. The proposed assistance packages include:

  • The AUD$1.3 billion Coal Sector Jobs Package which will offer transitional assistance over six years, described above in relation to “fugitive emissions”.
  • The Coal Mining Abatement Technology Support Package which will provide AUD$70 million over six years to assist coal mines in developing and deploying new technologies.  Funding will be provided by grants on a co-contribution basis for the research and demonstration of new technologies, and grants on a two to one basis to assist smaller coal mines in developing abatement technology.

Interface between the Mechanism and the Mineral Resources Rent Tax

Proponents should consider the combined effect of the Mechanism with the Mineral Resources Rent Tax (MRRT) when assessing project and financing structures in the resources industry. On 24 March 2011, the Commonwealth Government announced it would accept all the recommendations made by the Policy Transition Group (PTG) that was established to review the MRRT as proposed on the 2 July 2010. If adopted, these recommendations will also take effect on 1 July 2012, simultaneously with the proposed CPM.

Whether a project will be subject to both the Mechanism and the MRRT will depend on a number of factors - for example, the emissions profile and profitability of the project. The MRRT is a project-based tax which applies to iron ore and coal extraction projects which exceed a profit threshold. It can also extend to encompass (1) coal mine methane extracted as a necessary and integral part of a coal mining operation; (2) coal mining operations where gas is extracted from the underground conversion of coal; (3) incidental production of coal or iron ore as part of a broader mining operation.  

Pass-through of costs

Mining firms may be able to pass-through certain costs associated with the Mechanism. Mining related contacts may include “change in law”, “change in tax”, “carbon cost pass-through” or other like clauses that could permit the pass-through of additional costs which are imposed through the Mechanism.  Proponents should carefully consider the language used, in particular, the nature of the thresholds and events that can trigger the pass-through of carbon costs.  In this context it is worth noting that the Mechanism may not be strictly interpreted as a tax, but rather an emissions trading scheme that, during the initial fixed price period, in practice operates in the manner of a tax.  A generic contractual pass-through of “taxes” may not capture costs imposed under the Mechanism.

Mining firms may also seek to negotiate carbon cost pass-through arrangements for the sale of commodities to end users; although any such arrangement will of course have significant commercial implications which will need to be considered in light of arrangements other producers are subject to in other jurisdictions.  

Liable entities

Under the Mechanism, the liable entity for direct emissions is generally the person exercising control over operations of the emitting facility.  Where the facility is operated by an unincorporated joint venture, then all of the venture parties will be liable entities in proportion to their respective interests in the facility (provided no one entity has “operational control”).

Entities that are directly liable under the Mechanism will need to develop policies and procedures setting out how they intend to manage that liability, including determining:

  • Which entity within the corporate group has operational control of the project or facility.
  • Whether it is entitled to and appropriate to transfer that liability.  Currently, the Mechanism allows for the operator to apply for a liability transfer certificate to transfer liability to another member of its corporate group, a person outside of its corporate group that has financial control over the facility or in respect of an operator of an unincorporated joint venture, to the joint venture participants in proportion to their interest in the facility.
  • How to manage and mitigate that liability (for example, through the purchase of carbon permits or domestic or international offsets in the most cost effective way including, after the Fixed Priced Period, by forward purchasing permits in order to provide price certainty, by accessing international carbon markets, and by trading permits).
  • Whether the costs associated with that liability can be passed-through under the various contractual arrangements entered into with third parties.
  • Whether any of the financial assistance measures detailed by the Government are available.  

Continuous disclosure under the ASX Listing Rules

Finally, listed entities should consider the extent to which, amongst other things, the Mechanism will affect its existing or planned operations, and whether that information should be disclosed to the market in compliance with ASX Listing Rule 3.1

Related updates

Carbon pricing mechanism snap shot: key features, certainty and flexibility 

A framework for pricing carbon in Australia 

Carbon Farming Initiative legislation tabled 

Mineral Resources Rent Tax update 

Further information

If you would like further information or advice about any aspect of the policies underlying, or the proposed legislation implementing, the Government's Clean Energy Future package, or the MRRT, please contact a member of our Energy and Resources team.

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A power industry focus

by Vincent Dwyer and Natasha Vyrnwy-Jones

Introduction

The carbon pricing mechanism (the Mechanism) will have particular implications for the power industry.  This paper focuses on the implications for power, including in particular:

  • The impact of the Mechanism on electricity prices.
  • How the Mechanism will assist the power industry transition to a carbon price.
  • Implications for how electricity will be generated following the introduction of the Mechanism.
  • Implications for the renewable energy industry.

Moving away from coal

The key driver of the Mechanism’s impact on the electricity sector in Australia is the encouragement, through a market-based scheme, of the movement over time to lower carbon emitting power generation and the increase in the efficiency of the use of electricity.  That will comprise a range of measures, including: the closure of the highest carbon emitting generators (brown coal power stations); the encouragement of carbon capture and storage (through existing measures); the development of additional gas and renewable energy generators; and the implementation of energy efficiency measures.

Whilst the Mechanism does not provide for any additional investment in carbon capture and storage technology (which is supported through existing programs such as the Carbon Capture and Storage Flagship Program), a Clean Energy Finance Corporation will be established to invest in renewable energy, low pollution and energy efficiency technologies.  Further details on the Clean Energy Finance Corporation are set out below.

The Government hopes to drive approximately AUD$20 billion in investment in renewable energy by 2020 and treasury modelling forecasts that large scale renewable energy, excluding hydro, will be 18 times its current size by 2050, with 40 per cent of electricity generated from renewable sources by 2050. In addition, treasury estimates that gas-fired electricity will increase by over 200 per cent by 2050.  

Whether the initial price of AUD$23 per tonne is high enough for the development of sufficient gas-fired electricity generation in south-eastern Australia is a matter for debate (some have suggested that the carbon price needs to be significantly higher than AUD$23 to drive new gas fired power development). However, the initial importance of the Mechanism is that there is a clear cap trajectory out to 2020 and beyond, allowing for investments to be made now based upon expectations of future carbon prices. Regardless, until the Mechanism alone demonstratively drives significant investment in renewable energy, complementary measures such as the Large-scale Renewable Energy Target and other policies will be required to further develop the industry.

Electricity prices in Australia

Reflecting the availability of cheap and abundant coal reserves, Australia relies heavily on coal-fired electricity generation and, accordingly, the electricity sector is Australia’s largest source of greenhouse gas emissions.  A study undertaken by the Australian Bureau of Agricultural and Resources Economics in 2011 shows that black and brown coal currently represents approximately 75 per cent of Australia’s total electricity generation output with gas and oil representing approximately 17 per cent and renewable energy representing only approximately eight per cent.

There has been considerable debate on current and anticipated increases in the retail cost of electricity and how the pricing of carbon might affect that.  It is generally understood that the key drivers for these increases include:

  • More rigorous licensing conditions and other obligations for network security, safety and reliability.
  • Load growth and rising peak demand.
  • New connections.
  • The need to replace ageing assets (given the majority of the networks were developed between the 1950’s and the 1970’s).

While it is anticipated that the imposition of a carbon price will also increase retail electricity prices through its impact on the electricity price in the wholesale market, treasury modelling indicates the increase will be approximately AUD$3.30 per week (on average) in 2013 across households – far less than the increase in prices which can be ascribed to the rising costs of transmitting and distributing electricity. In respect of wholesale electricity prices generally, treasury modelling indicates that:

  • Without a carbon price, wholesale prices would rise strongly to 2030, driven by rising gas prices and new, higher capital cost plants entering the market to meet demand.
  • With a carbon price, the additional costs imposed on fossil fuel power plants will have an immediate impact on wholesale electricity prices (as changes in the prices of coal and gas have an immediate impact on prices), making them approximately $18 per MWh higher on average over the first five years.  Deployment of cleaner, more expensive technologies would then cause electricity prices to continue to increase over time (as, conversely to changes in the prices of coal and gas, changes in capital costs of new generators have a greater impact over time, as new generation capacity is required).

Transition to a carbon pricing mechanism

Any facility that produces at least 25,000 tonnes of direct carbon dioxide equivalent (CO2-e) emissions per year will be included in the carbon pricing scheme, unless exempt. The Government estimates that around 500 companies will be directly affected (including fossil fuelled electricity generators due to the emissions intensive nature of their business).

The Mechanism includes a number of Government assistance measures designed to assist the power industry transition to the introduction of a carbon price.

Power industry assistance

The Government will allocate free carbon permits to various industry sectors to assist them in transitioning to a carbon price. Assistance is designed to supports jobs and Australian industry, and also to ensure that emissions are not exported overseas if industry moves offshore. Eligibility for assistance will be based on an emissions intensity and trade exposure test. The domestic power industry does not fulfil the “trade exposure” aspect of this test, which includes meeting the threshold of having “a demonstrated lack of capacity to pass through costs due to the potential for international competition”. The stationary power industry will not meet this threshold because it is not exposed to international markets for electricity.

The Government will however provide assistance to coal-fired generators under its “energy security measures”. For “highly emissions-intensive” coal-fired generators (those with emissions intensities of more than 1tCO2-e/MWh of electricity), the Government will provide an assistance package of AUD$5.5 billion to assist in adjusting to the introduction of the carbon price. This assistance will take the form of cash in the first year (2012/13) and free carbon permits in subsequent years (which will be provided in equal annual instalments over the five year period to 2016/17). Eligibility for assistance will be dependent upon compliance with “power system reliability requirements” and on generators adopting clean energy investment plans to reduce their emissions.

The Government has outlined that generators may exit the market and still receive their administrative allocations if they satisfy the Australian Energy Market Operator that there is alternative capacity in the market available to meet demand, or where they have invested in new lower-emissions replacement capacity themselves. It is likely that the Energy Security Council (see below) will have a role in determining whether there is alternative capacity in the market, however as yet there is no criteria outlined which must be taken into account in making such a determination.

Closure of existing generation capacity and establishment of Energy Security Council

The Government will also seek to initiate a tender process to negotiate the closure of approximately 2000 MW of some of Australia’s most emissions-intensive generation capacity (particularly coal-fired power generation) by 2020. Eligibility for participation in this process is limited to coal-fired generators with an emissions intensity of greater than 1.2t CO2-e per MWh of electricity on an “as generated” basis. In particular, it is likely that the Government is targeting Port Augusta’s Playford B and Victoria’s Hazelwood power stations, two of Australia’s most energy intensive power stations.  The market will be closely monitoring the implementation of any buy-out, including timeframes, the development of replacement generation capacity and consequential implications for wholesale electricity prices.

Medium term financing uncertainty has also been an issue of significant concern for emissions-intensive generators (particularly brown coal-fired power stations).  For those generators that are not subject to Government negotiated closure, the Government will establish an Energy Security Council to advise on systemic risks to energy security arising from the financial impairment of any market participants. Further assistance dealing with financing uncertainties includes:

  • Government loans provided for the purchase at auction of future vintage carbon permits for the first three years of carbon permit auctions.
  • The consideration by Government of making loans available where generators need to refinance their debt, but finance is not available from the market, based upon advice by the Energy Security Council.

In both of these cases, loans will be priced on terms that encourage generators to obtain private finance where possible.

Duration of the assistance

It is also important to note that the Government assistance measures described above are not permanently enshrined, rather they are subject to ongoing assessments as to the continuing need for them. The Productivity Commission will review the impact of the Mechanism on the competitiveness of ‘emissions intensive’ industries in 2014-2015, and from then on at regular intervals consistent with the timing of general scheme reviews.  A review may also be conducted earlier at the request of the Government. Companies may also request a review of their sector under guidelines that are yet to be formulated. Following such a review the Productivity Commission may suggest changes to the rate of assistance received, however the final determination as to the assistance measures will rest with Government.

In addition, as the carbon price increases over time, particularly as we move into the floating price period, it is widely acknowledged that these Government assistance measures are likely to be reduced. The factors relevant to this consideration include the trade exposure of the relevant industries and the risk of “carbon leakage” (the risk that industry and emissions will relocate overseas).

State-based schemes

With the expected introduction of the Mechanism on 1 July 2012, State and Territory governments will need to consider the future of a range of regulatory schemes currently in operation in their jurisdictions. In particular, consideration will need to be given to existing carbon pricing schemes, gas and renewable target schemes, and direct renewable energy subsidisation programs.

It is widely recognised that as the federal carbon pricing policy is imposed, the state-based carbon pricing and gas fired generation target policies will fall away. The process through which this occurs will require coordination between the Federal Government and relevant State and Territory governments. Generators subject to state schemes should seek clarity as to the process through which this is to occur.

There is also debate, in the media and industry, as to the extent to which the introduction of the carbon price will negate the need for the direct subsidisation of renewable energy technologies, such as through solar feed in tariffs or other direct support mechanisms. The Federal government has made clear that it intends to continue the Large-scale Renewable Energy Target (LRET), Small-scale Renewable Energy Scheme (SRES) and other existing policies as the Mechanism is introduced. This is likely because there is a distinction to be made between the policy aims of the two kinds of policies. That is, the Mechanism is designed to drive lowest cost abatement of emissions economy wide, whereas the renewable energy support mechanisms are designed to accelerate the introduction and development of renewable energy technologies.

Considerations for the renewable energy industry

The Government has also announced a number of initiatives which are expected to encourage the further development of the renewable energy industry and increase demand for renewable products including:

  • The establishment of the Clean Energy Finance Corporation (comprising experts in banking, investment and clean energy and low emission technologies) to invest AUD$10 billion over five years from 2013-14. The Corporation will invest in the commercialisation and deployment of renewable energy and enabling technologies, energy efficiency and low-emission technologies. This will not be a grant program. Rather, funding will be provided through equity investments, loans and loan guarantees. Details of the investment criteria and levels of investment will be key to the success of this program, with quite different criteria and levels being required for differing renewable technologies.
  • The establishment of an independent body called the Australian Renewable Energy Agency which will administer the existing AUD$3.2 billion worth of funds that have or will be allocated to existing government grants programmes (such as the Solar Flagships scheme) which support the development of renewable energy technologies.

Issues that the renewable energy industry will need to monitor include:

  • the impact of the Mechanism on the Renewable Energy Certificate (REC) price - a price that, while still suffering from the overhang of small-scale RECs in the market, may become more volatile, particularly in the flexible price phase due to the changing differential between the increase to the wholesale pool price of electricity (through the imposition of the carbon price) and the reduction in technology costs (see below)
  • the consequences arising from the expiry of existing schemes, particularly the Mandatory Renewable Energy Target scheme (which includes both LRET and SRES) in 2030, which while still some time away is still within the horizon of longer term debt profiling, and
  • technology costs, particularly how these will change with the significant scale-up in renewable technology investments in China under the new Chinese Government “5 year Plan” which focuses heavily on renewable power and its expansion.

Please see Carbon pricing mechanism snap shot: key features, certainty and flexibility for further details of the measures being implemented in conjunction with the Mechanism. 

What this means for you

The Mechanism has the potential to significantly affect the power industry over the coming years.  As indicated above, although only 500 businesses are expected to be directly liable under the scheme, the imposition of a carbon price may significantly increase the costs of emissions for energy intensive industries such as the power industry.  To mitigate the impact of the Mechanism, businesses operating in the power industry will have a range of options available to them.

Pass through of costs

Entities that are directly liable under the Mechanism or that buy or sell energy intensive goods or services should review the ‘change in law’, ‘change in tax’, ‘carbon cost pass-through’ or other like clauses in their existing contracts and consider:

  • whether they are contractually able to pass through the additional costs that are imposed through the Mechanism
  • whether they are commercially in a position to pass through such costs (considering matters such as the effects of the pass through on competitiveness).

On the one hand, customers will wish to ensure that the relevant clauses incentivise the supplier to minimise the costs to be passed through under the Mechanism (for example, by including provisions requiring the supplier to use all reasonable endeavours to minimise these costs in accordance with good industry practice).  A customer will also wish to ensure that, where a supplier provides services to a number of other customers, the increased costs are allocated in an equitable manner.

On the other hand, suppliers will wish to ensure that the relevant clauses:

  • Provide for the ongoing, periodic assessment and pass through of both direct and indirect costs (as distinct from traditional change in law clauses which reflect the assumption that the cost impact of the change in law can be estimated up front and then applied over the unit price of the relevant goods and services).
  • Capture costs that are imposed on, or assumed by, another entity within the supplier’s group (such as the supplier’s holding company).
Liable entities

Entities that are directly liable under the Mechanism will need to develop policies and procedures setting out how they intend to manage that liability including determining:

  • Which entity within the corporate group has operational control of the project or facility.
  • Whether it is entitled to and appropriate to transfer that liability under existing corporate structures and joint venture agreements.  Currently, the Mechanism allows for the operator to apply for a liability transfer certificate to transfer liability to another member of its corporate group, a person outside of its corporate group that has financial control over the facility or in respect of an operator of an unincorporated joint venture, to the joint venture participants in proportion to their interest in the facility.
  • How to manage and mitigate that liability (for example, through the purchase of carbon permits or domestic or international offsets in the most cost effective way).
  • Whether the costs associated with that liability can be passed through under the various contractual arrangements entered into with third parties.
  • Whether any of the financial assistance measures detailed by the Government are available.  

The directors and officers of such companies should also ensure that the company has in place strategies to manage that liability including by investing in lower emission or renewable energy intensive technologies.  

Continuous disclosure under the ASX Listing Rules

Finally, listed entities should consider the extent to which the Mechanism will affect their existing or planned operations, and whether that information should be disclosed to the market in compliance with ASX Listing Rule 3.1.

Related updates

Carbon pricing mechanism snap shot: key features, certainty and flexibility 

A framework for pricing carbon in Australia

Carbon Farming Initiative legislation tabled

Further information

If you would like further information about the impact of the Government’s Clean Energy Future package on the power and renewable energy industries, please contact a member of the Australian energy team.  

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An oil and gas industry focus

by Alex Cull and Jehann Mendis

Introduction

The carbon pricing mechanism (the Mechanism) will have particular implications for the oil and gas industry, and in particular the export-orientated liquefied natural gas (LNG) industry.  This paper focuses on the implications for oil and gas, including in particular:

  • The application of the Mechanism to the oil and gas industry.
  • The assistance available under the Mechanism.
  • The impact of the Mechanism on the LNG industry.
  • The general effect of the Mechanism on Australia’s oil and gas industry.

How will the Mechanism apply to the oil and gas industry?

Who will it apply to?

The Mechanism is structured to only apply directly to the largest emitters of greenhouse gases, although others will be affected through indirect means.  Facilities that directly emit greenhouse gas emissions of at least 25,000 tonnes of CO2-e per year will be covered.  The assessment is made by reference to emissions by a ‘facility’ and not by an individual corporate entity, although the Mechanism will then identify a liable entity in respect of a covered facility (see below).

All scope 1 (direct) emissions, together with legacy waste emissions, will count towards this 25,000 tonne threshold, other than scope 1 emissions from fuels or other sources that are excluded from the emissions from some synthetic greenhouse gases as these will be subject to a separate mechanism using existing levies under the Ozone Protection and synthetic Greenhouse Gas Management for the purposes of the Mechanism.  Scope 2 emissions are the release of greenhouse gases emitted from energy that is consumed at a facility but which is generated elsewhere.  Scope 2 emissions for a facility will already be captured under the Mechanism as scope 1 emissions at the relevant generating facility.

According to the Government’s figures, only around 500 businesses will be required to pay for their carbon emissions.  A significant proportion of these operate in the oil and gas industry.

How will the Mechanism apply?

In the oil and gas industry, there are three main applications:

  • Direct application to large emitters: Any significant oil and gas facility is likely to pass within the direct operation of the Mechanism.  For example, BP reports that its refinery at Kwinana emits between 600,000 to 800,000 tonnes of CO2-e per year1.  The amount of emissions that an LNG production facility will emit depends on variables such as the size of the facility, the specification of the feed gas, the degree of flaring, venting and fugitive emissions, and the carbon efficiency of the refrigerant system used.  However, in order for an LNG project to be commercial, it will invariably be of a magnitude which will cause it to emit more than the 25,000 tonnes threshold, and will typically emit in excess of a million CO2-e per year.  For example, in the Environmental Impact Statement for the GLNG project, scope 1 emissions for the 3 million tonne per annum (mtpa) liquefaction facility (excluding emissions from upstream operations) are estimated to be 1,162,722 C)2-e per year, and for a 10mtpa facility the scope 1 emissions approach 3.5 million tonnes per year.2
  • Application of complementary measures: The oil and gas industry will also be affected by the amendments to the taxation position in relation to transportation fuels.  The development and operation of petroleum projects, especially LNG projects, requires significant use of transportation and other non-transport consumption of fuels.  This fuel consumption will fall outside of the direct permit obligations.  However, a carbon price will effectively be imposed on business use of liquid fuels by reducing the business fuel tax credits from their current levels.  Similarly for aviation fuels which do not currently attract a fuel tax credit, the fuel excise for domestic aviation will be increased.  The cost of other inputs may also rise due to the Mechanism.
  • Application to retail gas:  In addition to major emitters of carbon, suppliers of natural gas to domestic customers will also be directly liable in respect of emissions release from the use of the fuels by those customers.  Where the customer is a large carbon emitter, then it is possible to transfer responsibility for emissions derived from the use of that gas to the customer where the customer quotes an obligation transfer number (OTN).  For smaller companies, this is not possible and the retailer retains responsibility.  Where natural gas is not supplied by a retailer, the relevant emissions will count towards the liability of covered facilities.  Where the gas is not used at a facility covered by the Mechanism, the owner of the gas will be the liable entity.  The OTN for large customers will be a voluntary mechanism, except that as a transitional arrangement a retailer must accept an OTN where
    1. gas is supplied under a contract entered into before the Royal Assent to the legislation, and
    2. the gas is to be used as a feedstock or where more than 25,000 tonnes of CO2-e per year are attributable to gas supplied under the contract.

Oil and gas facilities whose relevant emissions reach the 25,000 tonnes threshold and so will be covered by the Mechanism will need to report their emissions, in a manner similar to existing obligations under the National Energy and Greenhouse Reporting Act 2007 (Cth) (NGER Act) (please refer to our briefing on the NGER Act).  Subject to any assistance afforded under the Mechanism, the liable entity or entities for those facilities will then need to buy and surrender to the Government on e carbon permit for every tonne of carbon pollution produced.

A description of the post 1 July 2012 market for, and pricing of, carbon permits is outlined in our overview of the Mechanism published on 10 July 2011.

Assistance provided under the Mechanism

Assistance available to all qualifying industries

The Mechanism includes a temporary assistance package for certain industries that will be heavily affected, based on an assessment of emissions intensity and trade exposure (EITE).  The duration of this assistance is discussed below.  The approach is consistent with the process, criteria and requirements currently used for Partial Exemption Certificate assistance under the Renewable Energy Target program.

Two tiers of initial rates of assistance have been established by reference to emissions intensity:

  • For activities which have an emissions intensity of at least 2,000t CO2-e/$m revenue, or at least 6,000t CO2-e/$m value added, companies will receive a free allocation of permits equivalent to 94.5 per cent of the industry average baseline.
  • For activities with an emissions intensity between 1,000t CO2-e/$m and 1,999t CO2-e/$m revenue or between 3,000t v and 5,999t CO2-e/$m value added, companies will receive a free allocation of permits equivalent to 66 per cent of the industry average baseline.

The industry average baseline for emissions intensity will be calculated using average industry emissions during the two financial years 2006-2007 and 2007-2008, divided by the industry average revenue or value added data taken from the financial year 2004-2005 through to the first half of 2008-2009.

Through the application of a ‘carbon productivity contribution’, these initial r4ates of assistance will reduce at a rate of 1.3 per cent per year.  This structure should encourage better carbon efficiency, by financially incentivising assisted facilities to ensure their covered emissions do not exceed 94.5 per cent or 66 per cent (as applicable) of the industry baseline average, and to reduce emissions on an ongoing basis by no less than 1.3 per cent per year.

Before qualifying for the EITE assistance however, in addition to the emissions intensity criteria, the relevant ‘activity’ must also satisfy the trade exposure assessment.  Trade exposure looks at all entities conducting the relevant activity during the reference years of 2004-2005, 2005-2006, 2006-2007 and 2007-2008, and requires that in any one of those years, the value of the international trade for that activity was at least 10 per cent of the value of the domestic production for that activity.  There must also be a demonstrable inability to pass through the additional Mechanism costs due to the potential for international competition.

For LNG projects specifically

The Plan states that LNG facilities will receive a Supplementary allocation’ of permits to ensure an Effective assistance’ rate of 50 per cent in relation to their LNG production each year.  However the Plan does not provide any detail on how this assistance will operate in practice, or interact with EITE rates of assistance described above.

It is also unclear from the Plan whether this ‘effective assistance’ rate of 50 per cent will be eroded by 1.3 per cent per year through the application of the carbon productivity contribution.  The language of the Plan is consistent with the carbon productivity contribution only applying to the two tiers of ‘initial rates of assistance’ for EITE outlined above, however the placement of the paragraphs could be read to suggest that the carbon productivity contribution will also apply to erode the LNG supplementary allocation.

Some guidance might be taken from the earlier proposed Carbon Pollution Reduction Scheme (CPRS), which adopted language consistent with the language used in the Plan.  In November 2009, the Australian Government amended its proposed CPRS to include an ‘additional supplementary allocation’ of permits under the EITE assistance for LNG projects.  The supplementary allocation was intended to ensure all LNG projects received an ‘effective assistance’ of at least 50 per cent in the LNG projects were eligible for that assistance, and would have been an ongoing measure and not a fixed-term transitional assistance program.  The supplementary assistance to LNG under the CPRS did not appear to be subject to an ongoing erosion Mechanism such as the carbon productivity contribution.

Relying on the CPRS design features to interpret the Plan and add ‘flesh’ to the Mechanism should be done cautiously.  The CPRS went through a number of changes during legislative action before lapsing in September 2010.  While the Mechanism incorporates a lot of the features of the CPRS, there are notable significant deviations, and the current Government is not bound in any way by the details of the previously proposed scheme.

The final language of the implementing legislation will therefore be important.  In particular, the definition of ‘LNG project’ and the specific ‘activity’ that will attract the supplementary assistance, will determine how far upstream the supplementary allocation of permits will stretch.  If the definition refers to only to the liquefaction processing facilities, then the upstream exploration, development and production operations will effectively operate under a different carbon pricing scheme compared to the liquefaction activities.  The legislation should take into account that some LNG projects will also be producing gas for domestic use and LPG, and the definition of the activity will need to cater for this in an equitable manner.  This may impact how developers wish to structure their holdings.

Whatever assistance is ultimately provided to existing LNG producers will also be provided to new LNG projects.  This equitable treatment is designed to ensure the Mechanism does not operate to discourage expansion of the industry.  A the same time, allocations to existing LNG projects will not be affected or adjusted by reason of allocations to new LNG projects.

Duration of the assistance

It is important to note that the assistance is not permanently enshrined.  The Productivity Commission will review the impact of the Mechanism on the competitiveness of EITE industries in 2014-2015, and from then on at regular intervals consistent with the timing of general scheme reviews.  A review may be conducted earlier at the request of the Government.  Following such a review the Productivity Commission may suggest changes to the rate of assistance received by, or the carbon productivity contribution applied to, a particular activity.  Companies may also request a review of their sector under guidelines that are yet to be formulated.

The Productivity Commission is specifically tasked with considering whether the LNG supplementary allocation policy remains appropriate.

Any changes in assistance “that will have a negative effect on business” will not occur before the sixth year of the Mechanism, with three years’ notice to be provided of modifications of EITE allocations that will have a negative effect on business.  For potential new LNG projects, the value of this assistance may need to be discounted when making a final investment decision to proceed, as it is theoretically possible that the EITE assistance and supplemental permit assistance could be reduced or removed altogether even before commercial operations at the LNG project have commenced or ramped-up to full production.

Possible Impact on LNG projects

The North West Shelf and Darwin LNG projects have been fully operational for many years.  Several other projects have taken their final investment decision and are in varying stages of development, including the Pluto, Gorgon, GLNG, Queensland Curtis and Prelude LNG projects.  It may be that these projects will all fall within the application of the Mechanism, notwithstanding their investment decisions were made in advance of the Mechanism being contemplated, formulated or legislated.

The additional Mechanism costs will also need to be factored in to the economic modelling and decision-making process by sponsors of new LN G projects, before they commit to development costs.  Projects under consideration include the Arrow, Australia Pacific, Bonaparte, Browse, Cash Maple, Ichthys, Sunrise and Wheatsone LNG projects.  It is yet to be seen whether the Mechanism will have any real impact on the appetite for future investment in these and other new LNG projects.

On one hand, the uncertainty surrounding the carbon rice beyond the Fixed Price period – even while the price collar is applied in the early years of the flexible Price period – combined with the additional uncertainty around the Productivity Commission review and adjustment process, may be cause for concern, for both LNG project developers and their financiers.  However, the Mechanism does provide a method for achieving some certainty in carbon pricing, by effectively providing two forward costs curves for the price of carbon:

  • On 1 July 2015 the Mechanism will move from the fixed carbon price period into the flexible cap and trade emissions trading scheme.  The 2014 budget will identify the pollution caps for the first five years of the scheme, with implementing regulations to be tabled by 31 May 2014.  Regulations will be introduced on an annual basis to extend the caps by one further year, which will ensure a constant five year price horizon which can be used to draw a short-term cost curve for the carbon price.
  • The legislation will also provide for a default pollution cap in the event that Parliament rejects the proposed caps in any of the regulations.  In respect of the 2014 regulations, the default position will be a cap that will ensure a five per cent reduction in emissions below 2000 levels by 2020, and thereafter a reduction consistent with the annual reduction in emissions implied by the five per cent emissions reduction target.

The default position cost curve will be the marginal abatement cost of reducing emissions to five per cent below 2000 levels by 2020, and projected in a linear fashion beyond 2020.  This provides a legislated bottom line for the setting of caps, providing business and industry with a yardstick by which to assume the levels of scarcity of carbon permits in supply, allowing them to extrapolate a carbon price beyond 2020 and in line with the time-scales of investment in major infrastructure.  In practice, however, regulations passed by Parliament may move the actual permit scarcity away from this legislated default position.

Given the high up front capital costs of developing LNG projects, and the long payback periods, the five year price horizon on carbon might not provide as much certainty as potential investors want or need.  This is particularly the case if there is scope for the reduction in caps to be accelerated (and therefore the carbon price increased due to scarcity) ahead of the legislated default position.

Overall, the Mechanism should operate to encourage LNG producers to reduce their emissions and thereby reduce their compliance costs.  Some high emitting activities however are largely outside of their control.  This includes the gas compression/refrigeration process – which is probably the highest emitting aspect of an LNG project – where there are only a small number of suppliers and the processes are heavily patented and licensed.

What this means for you

The Mechanism has the potential to significantly affect the LNG and oil industries over the coming years.  Although only 500 businesses are expected to be directly liable under the scheme, the imposition of a carbon price may significantly increase the costs of energy intensive industries such as the LNG and oil industry.  In order to mitigate the impact of the Mechanism, businesses operating in these industries have a range of options available to them.

Liable entities

Under the Mechanism, the liable entity for direct emissions is generally the person exercising control over operations of the emitting facility.  Where the facility is operated by an unincorporated joint venture, then all of the venture parties will be liable entities in proportion to their respective interests in the facility.

Entities that are directly liable under the Mechanism will need to develop policies and procedures setting out how they intend to manage that liability including determining:

  • which entity within the corporate group has operational control of the project or facility
  • whether it is entitled to and appropriate to transfer that liability.  Currently, the Mechanism allows for the operator to apply for a liability transfer certificate to transfer liability to another member of its corporate group, a person outside of its corporate group that has financial control over the facility or in respect of an operator of an unincorporated joint venture, to the joint venture participants in proportion to their interest in the facility
  • how to manage and mitigate that liability (for example, through the purchase of carbon permits or domestic or international offsets in the most cost effective way including, after the Fixed Priced Period, by forward purchasing permits in order to provide price certainty, by accessing international carbon markets, and by trading permits)
  • whether the costs associated with that liability can be passed through under the various contractual arrangements entered into with third parties and
  • whether any of the financial assistance measures detailed by the Government are available.  

The directors and officers of such companies should also ensure that the company has in place strategies to manage that liability including by investing in lower emission or renewable energy intensive technologies.  One means of achieving this would be to establish a committee which is responsible for, amongst other things, developing a carbon strategy addressing the issues identified above.

Pass through of costs

Liable entities and entities that buy or sell energy intensive goods or services should review the ‘change in law’, ‘change in tax’, or other like clauses in their existing contracts to determine:

  • whether they are able to pass through the additional costs that are imposed through the Mechanism, and
  • whether they are ideally suited to pass through such costs.

This requires a careful consideration of the language used.  In this context it is worth noting that the Mechanism is not strictly a tax, but rather an emissions trading scheme that, during the initial fixed price period, in practice operates in the manner of a tax.  A generic contractual pass through of ‘taxes’ may not capture costs imposed under the Mechanism.

If existing contractual arrangements do not adequately provide for the pass through of such costs, counterparties should consider negotiating amendments to their existing contracts by inserting pass through clauses that address (amongst others) the issues raised above.  Customers might not be willing to entertain such discussions, particularly where there is price uncertainty and therefore the exposure cannot be accurately ascertained, unless there are other benefits to be traded in return.

Australia has a relatively high unit cost for developing LNG projects compared to other host countries.  Competitors targeting the same LNG markets that largely underpin the Australian projects include Brunei Darussalam, Indonesia, Malaysia, Oman, Papua New Guinea, Qatar and the Russian Federation.  If those countries do not introduce an equivalent carbon pricing mechanism, Australian projects might only be able to pass through the additional Mechanism costs if their customers can identify other factors that justify paying a higher price for LNG from Australia, such as access to upstream interests and security of supply.

If costs are passed through, in new or revised contracts, customers may wish to ensure that the relevant clauses incentivise the supplier to minimise the costs to be passed through under the Mechanism (for example, by including provisions requiring the supplier to use all reasonable endeavours to minimise these costs in accordance with good industry practice).  A customer will also wish to ensure that, where a supplier provides services to a number of other customers, the increased costs are allocated in an equitable manner.

On the other hand, suppliers will wish to ensure that the relevant clauses:

  • provide for the ongoing, periodic assessment and pass through of both direct and indirect costs (as distinct from traditional change in law clauses which reflect the assumption that the cost impact of the change in law can be estimated up front and then applied over the unit price of the relevant goods and services), and
  • capture costs that are imposed on, or assumed by, another entity within the supplier’s group (such as the supplier’s holding company).

For existing long term LNG sale and purchase agreements in particular, the parties should consider the price review and re-opener provisions.  These are contractual provisions that entitle, or require, the parties to review and possibly amend the contractual pricing mechanism.  Whether these provisions can be used by an LNG supplier to pass through additional Mechanism costs will depend entirely on the drafting of the relevant clause.  These reviews may be structured to occur at a specific time or frequency, or on the occurrence of a trigger event which could be formulated as broadly as one party considers a substantial or material change in circumstances has occurred.  Buyers and sellers of LNG may wish to review their contracts to determine whether the Mechanism may trigger such a price review.  

Continuous disclosure under the ASX Listing Rules

Finally, listed entities should consider the extent to which, amongst other things, the Mechanism will affect its existing or planned operations, and whether that information should be disclosed to the market inn compliance with ASX listing Rule 3.1.

Related updates

Carbon pricing mechanism snap shot: key features, certainty and flexibility 

A framework for pricing carbon in Australia 

Carbon Farming Initiative legislation tabled 

Further information

If you would like further information about the impact of the Government’s clean Energy Future package on the power and renewable energy industries. Please contact a member of the energy team.


  1. BP Refinery Kwinana, Environmental Update, accessed on 15 July 2011
  2. GLNG Project – Environmental Impact Statement, Table 6.9.3 on page 6.9.10, accessed on 21 July 2011
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A transport industry focus

by Nikolina Babic, David Stavropoulos and Dimity Maybury

Introduction

The Federal government has confirmed that a carbon price will be imposed on the Australian transport sector, extending to domestic aviation, domestic shipping, rail and heavy road transport. It is critical to note that these sectors will not be covered by the proposed carbon pricing mechanism (the Mechanism), but rather an “effective carbon price” will be imposed by complementary adjustments to the taxation of transport fuels as outlined in the broader package.

This briefing provides the key details of the Government’s proposed Securing a Clean Energy Future package (the Package), announced by the Australian Government on 10 July 2011, that are relevant to the transport sector. We also examine the key issues and implications for our aviation and shipping clients.

For a general overview of the Mechanism and complementary measures, please refer to our client update ‘Carbon pricing mechanism snap shop: key features, certainty and flexibility’.

This paper focuses on the details and issues arising from the Package, including in particular:

  • The method and coverage of the imposition of an effective carbon price on transportation.
  • The legislative and administrative issues.
  • The management of carbon liabilities.
  • The international perspective.

Sectoral coverage and pricing method

The Government has confirmed that an effective carbon price will be imposed on emissions from transport fuel used in ‘domestic aviation’, ‘domestic shipping’ and rail transport. The terms ‘domestic aviation’ and ‘domestic shipping’ have not been defined. The Package does not seek to impose carbon liability on fuel used for international aviation or international shipping. Coverage uncertainties currently exist due to the lack of specific detail in the Package. A legal review of the parameters of these key definitions should be undertaken when the draft legislation is released by the Government.

The term “effective carbon price” is used because the transport activities which are covered will not fall within the Mechanism, but rather will be covered through changes to fuel tax credits and fuel excise arrangements in Australia’s taxation regime. Adjustments to credits and excise will be made annually during the fixed price period and then every six months (based on the average carbon price over the previous six months) during the flexible price phase.

The Package provides as follows:

  • Domestic aviation fuel excise will be increased by an amount equivalent to the effect of placing the carbon price on aviation fuel (from 1 July 2012). International aviation fuel use will not be covered. Additional revenue will not be allocated to the Civil Aviation Safety Authority.
  • Business transport emissions from liquid fuels (rail and shipping) and non-transport emissions from businesses using liquid fuels, will be subject to an equivalent carbon price applied through a reduction in business fuel tax credits (applied after 1 July 2012).
  • Fuel use in relation to light commercial vehicles (4.5t or less), vehicles for household use, and fuels used in agriculture, forestry and fisheries will not have a carbon price imposed.
  • On-road transport use of Compressed Natural Gas (CNG), Liquefied Natural Gas (LNG) and Liquefied Petroleum Gas (LPG) (such as freight transport) will not face a fuel tax credit reduction due to the imposition of the Road User Charge.
  • Off-road transport use of CNG, LNG and LPG (such as on a mine site) will face a reduction in fuel tax credits equivalent to placing the carbon price on emissions from that fuel use.
  • Non-transport use of CNG, LNG and LPG, which currently benefit from an automatic remission of excise, will be replaced by a partial remission to reflect the effective carbon price.
  • Ethanol, biodiesel and renewable diesel (collectively “biofuels”) will not incur fuel tax credit reductions or changes to excise as these fuels are zero rated under international carbon accounting rules.

Changes to fuel tax credits and excise to reflect the carbon price will be based on the specific emissions intensities of CNG, LNG, LPG, aviation gasoline, aviation kerosene, petrol and diesel, with all other liquid fossil fuels based on the diesel emission rate.

The Productivity Commission will undertake a review of fuel excise arrangements, including an examination of the merits of a regime based explicitly and precisely on the carbon and the ‘energy content’ of transport fuel. However no date has been given for this review and the Government has not specified what the consequences will be from the findings of the review.

As per other sectors, businesses in the transport sector (or those other businesses with a transport component to their emissions) will be only liable under the Government’s carbon scheme if they trigger the general compliance threshold of 25,000 tonnes of greenhouse gas emissions per year. These businesses are already likely to be reporting their greenhouse gas emissions to the Federal Government pursuant to the National Greenhouse and Energy Reporting Act 2007

Whilst a number of other sectors will receive transitional assistance or compensation, the Package does not provide any transitional assistance or compensation for the transport sector. However some facilities that receive transitional compensation because they fall within other sectors (such as gassy coal mines) may also have significant transport and logistical emissions aspects of their overall liability.

Legislative and administrative issues

We expect that the Government, in implementing these measures, will seek to make amendments to the Excise Tariff Act 1921 and the Fuel Tax Act 2006.

In practice, entities in the domestic shipping and rail transport sectors will generally pay the same amount at the pump for their fuel.  However, the size of the fuel tax credit that they currently claim in their Business Activity Statement will reduce.  Entities currently pay income tax on their fuel tax credits.  Accordingly, they should be in the same after tax position as entities that otherwise pay the corresponding carbon price through the purchase of carbon permits, which will be tax deductible.

Conversely, airlines will pay more for their fuel at the pump.  Manufacturers responsible for remitting the excise will simply increase the relevant amount added to their excise exclusive prices.

In both cases, the administrative burden from a taxation perspective is unlikely to significantly change.

Managing carbon liabilities in the transport sector

Liable entities in the aviation, shipping and heavy transport sectors will not benefit from the following market advantages available to those sectors which have a liability under the emissions trading scheme:

  • the ability to purchase carbon permits on the open market, or carbon offsets from domestic or international markets (which may be cheaper than domestic permits)
  • the ability to purchase and ‘bank’ the carbon permits not used for future use or sale
  • the ability to use the free allocation of allowances to fund investments in lower emissions plant or technologies, and
  • the ability to claim the costs of carbon permits as a tax deduction.

It will be important to review carefully the legislation when it is released and consider the extent to which these advantages are built into the consideration of the “effective carbon price” that is to be paid by the transport sector.

The remaining opportunities for the forward management of carbon liabilities include investing in lower emissions plant and technologies, and the use of biofuels which under the Package are zero rated in terms of emissions.

In order to capitalise on these opportunities, the transport sector will need to consider its ability to access funds from the AUD$10 billion Clean Energy Finance Corporation, which is to be set up to invest in and reduce finance risk in relation to innovative clean energy proposals and technologies. The Government will also provide an additional AUD$200 million over five years for grants to support business investment in research and development. These technology investments may help in the development of biofuels, and other clean energy and transportation efficiency developments.

In order to maximise the use of biofuels, the fuel will need to be available in commercial quantities with competent fuel supply infrastructure, and fuel supply contractual arrangements will need to be in place for the effective distribution of the fuel.

International perspective for aviation and shipping

The Australian Government’s decision to include domestic aviation and shipping fuel into its carbon liability scheme is significant as few other jurisdictions around the world have introduced a carbon price for transport fuel

At the international level, both aviation and shipping emissions are excluded from the Kyoto Protocol, partly because there was no consensus on how to treat emissions from the cross-jurisdictional transport sector. Both the Copenhagen Accord and Cancun Agreements were silent on transport emissions, and there appears to be a continued lack of international political impetus and cohesion at the UNFCCC level in respect of aviation and shipping emissions.

The International Civil Aviation Organisation (ICAO), the UN regulatory body for international aviation, considers that a global framework for the regulation of carbon emissions from aviation should be developed. At its general assembly meeting in October 2010, ICAO resolved to develop a global framework for market-based measures for aviation emissions, to be considered at the ICAO Assembly in 2013.  This resolution is an important step in ICAO’s potential global leadership of aviation emissions.  

Meanwhile, stakeholders in the aviation sector are well aware that the EU will include international aviation into its emissions trading scheme from 1 January 2012.  Several American airlines have challenged the legality of the scheme in a class action, arguing that the extra territorial effect of the scheme is in breach of the Chicago Convention and is unlawful (The Chicago Convention is an international treaty dealing with the regulation of internal civil aviation. It addresses, amongst other things, sovereignty over domestic airspace and airport duties).  The class action was heard by the European Court of Justice on 5 July 2011 and a decision is expected within the next 2 months. 

It is likely that ICAO will consider the effectiveness of both the EU scheme and the Australian scheme in its review of market mechanisms appropriate for the aviation sector in 2013. The International Maritime Organisation (IMO), the United Nations specialised agency with responsibility for the safety and security of shipping and the prevention of marine pollution by ships, at its meeting in London on 15 July 2011, considered a range of potential mandatory measures to reduce greenhouse gas emissions by the international shipping industry. At the meeting, the IMO agreed to amend MARPOL, the international convention on preventing pollution from ships, by adding a new chapter for energy efficiency regulations. The regulations will mandate that new ships meet requirements detailed in an Energy Efficiency Design Index and that all ships follow a Ship Energy Efficiency Management Plan. The regulatory requirements will apply to all ships of 400 tonnes gross and above, and are expected to enter into force on January 1, 2013.

Whilst many aviation and shipping stakeholders welcome the introduction of a carbon liability scheme for transport fuel, there is widespread concern that the development of ad hoc regulatory approaches for these international industries will result in a burdensome patchwork of regulation. Regardless, it will be important for the aviation and shipping industry to keep abreast of international developments and their domestic consequences.

Important information for transport sector clients to look out for

Some of the important questions, which stakeholders in the aviation and shipping industries should be seeking answers to when the draft legislation is released on 31 July 2011, include:

  • How the definitions of ‘domestic aviation’ and ‘domestic shipping’ will be set out in the legislation and what will that mean for competition with international carriers.
  • How the fuel tax credit and fuel excise adjustments will work in practice and upon what criteria the “effective carbon price” will be calculated every six months.
  • Whether the net carbon price for the transport sector will end up being higher then the carbon price other sectors are able to achieve on the open market, and
  • Whether the net carbon price will differ within the transport sector and what impact that will have on competition.  For example, will there be a price advantage between road transport and domestic shipping, or between international shipping carrying coastal cargoes and domestic shipping.

As draft legislation is expected within the next 2 weeks, any requests for changes to the Government’s proposed mechanism to include a cost of carbon on transport fuel for the domestic aviation and shipping sectors should be communicated to the Government as soon as possible.

Related updates

Carbon pricing mechanism snap shot: key features, certainty and flexibility 

A framework for pricing carbon in Australia 

Carbon Farming Initiative legislation tabled 

Mineral Resources Rent Tax update 

Further information

If you would like further information or advice about any aspect of the policies underlying, or the proposed legislation implementing, the Government's Clean Energy Future package, please contact a member of our Transport team.

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Carbon – a price or a tax

by David Stavropoulos and Anna Wilson

Introduction

Businesses will be eager to ensure that the costs of the carbon pricing mechanism can be passed on to consumers.
This analysis looks specifically at the taxation aspects of the carbon pricing mechanism (the Mechanism), and will in particular cover:

  • The income tax treatment that will apply to carbon permits.
  • The GST treatment of carbon permits.
  • The tax concessions to be introduced with the carbon pricing mechanism.
  • Whether the costs of the Mechanism can be passed on.

Carbon: price or a tax?

In the first three years of the scheme, it will operate like a tax, because businesses will be able to purchase as many carbon permits as required to cover the amount of carbon pollution they produce.  The price will be fixed, commencing at AUD$23 per tonne of carbon produced and rising annually in set increments.  However, from 1 July 2015, there will be a limited number of permits available for purchase and the price will then be market driven, although subject to a floor and ceiling for the first three years.  It will also be possible to purchase international permits (subject to certain restrictions) as there will be links to international schemes.

Income tax treatment of carbon permits

A specific tax regime is to be introduced for carbon permits, rather than relying on existing taxation law principles.  Under the new regime permits will be taxed in a manner similar to that which currently applies to trading stock. That is, the proceeds from selling a permit will be assessable in the year of sale.   A taxpayer will be deemed to have received market value for a permit in certain circumstances, such as a non-arm’s length transfer between related parties.

A deduction will be allowed for the cost of acquiring a permit, but the benefit of the deduction will be deferred until the year in which the permit is surrendered or sold.  

Taxpayers will need to elect whether to value permits on hand at the end of an income year at cost or market value for taxation purposes.  The default methodology will be cost and the ability to change methodology from year to year will be limited.  Where the value of permits is expected to rise, taxpayers may prefer to use the cost method rather than pay tax on the increased value of a permit at year end before it is sold or surrendered. Conversely, if the value of permits is expected to fall, taxpayers may prefer the market value method, effectively bringing forward a deduction for the drop in the permit's value at year end.  

Taxpayers will be limited to one change in the valuation methodology during the fixed price period (1 July 2012 to 30 June 2015) and from 1 July 2015 will only be permitted to change the valuation methodology after a methodology has been in use for four years.  The limited ability to change the valuation methodology from year to year is likely to see many taxpayers take a conservative approach and use cost as the preferred methodology. 

GST treatment of carbon permits

Subject to the agreement of the state governments, the supply of carbon permits will be GST free.   However, normal GST rules will apply to transactions involving financial derivatives of permits and payments of grants. Transactions involving financial derivatives of permits will generally be input taxed supplies, as they will be "financial supplies" for GST purposes.  Payments of grants can give rise to a GST liability on the part of the recipient of the grant under the principles set out in GSTR 2000/11 where the grant places the grantee under an obligation.  The grant can in such circumstances represent consideration for a taxable supply made by the grantee.

Accounting treatment of carbon permits

The accounting treatment for permit transactions will be determined in accordance with international accounting standards.

Tax cuts to ease the burden 

The Government has linked the carbon pricing mechanism to a range of taxation measures primarily aimed at reducing the taxation burden for lower to middle income earners.  

Individuals and small businesses will generally not be subject to the price on carbon, or the need to acquire carbon permits, as this requirement only applies once businesses generate more than 25,000 tonnes of carbon pollution per year.  However, because some business inputs will be more expensive due to the carbon pricing mechanism, the small business instant asset write-off threshold will be increased from the AUD$5,000 promised by the Government (but not yet legislated) to AUD$6,500 for depreciable assets from the 2012-13 year. 

From 1 July 2012 the tax free threshold will increase from AUD$6,000 to AUD$18,200 in conjunction with a reduction in the low income tax offset.  The Treasurer estimates that 1 million taxpayers will be removed from the tax system and will no longer need to lodge an income tax return.

Taxpayers earning up to AUD$80,000 will receive a tax cut of at least AUD$300 per year.  Family tax benefits and pension payments will also increase. The tax cuts are phased out for taxpayers earning over AUD$80,000.

Can carbon costs be passed on?

The tax cuts are designed to offset the expected higher costs to be faced by consumers.  With the introduction of the GST on 1 July 2000, consumers were concerned that business may take advantage of the tax changes in order to charge unreasonably high prices.  To counter this concern, a "price oversight regime" was established under the Trade Practices Act and administered by the Australian Competition and Consumer Commission (ACCC), which prohibited price exploitation during the transition to the "New Tax System".  

No specific additional powers will be given to the ACCC during the transition to a carbon emissions trading scheme,  However, to address its concerns regarding the exploitation of consumers during the lead up to and introduction of the carbon pricing mechanism and the trading scheme, the Government has announced that the ACCC will receive funding of AUD$12.8 million over four years.  This will allow the ACCC to employ additional staff to facilitate the investigation and prosecution of businesses that falsely attribute price increases to the new carbon tax.  It will also assist in the education of businesses on this issue.  Our legal briefing on this issue was released on 21 July. 

Provided businesses do not attempt to exploit the introduction of the Mechanism as a means to increase prices, there is no prohibition on businesses passing on the costs of the carbon pricing mechanism to consumers.  However, on the other hand, businesses will also have no statutory right to do so.  Accordingly, the wording of contracts will be very important. Contracts entered into going forward can be drafted to take account of the carbon pricing mechanism, with the benefit of knowledge of the scheme.  However, long term contracts already in existence may contain no specific provisions regarding the costs of a carbon pricing mechanism, or an emissions trading scheme. 

Businesses will not only need to assess their liability for direct costs under the scheme, in terms of their obligation to acquire permits, but also their indirect costs as consumers of goods and services that will suffer price increases as a result of the carbon pricing mechanism.  For example, businesses that lease their business premises need to consider whether they will be liable for increases in the cost of electricity and other outgoings under their leases either directly, or because the landlord will have the right to increase rents due to the changes in the law. 

Going forward, contracts will need to be drafted to ensure that parties clearly specify who is liable for the direct and indirect costs of the carbon pricing mechanism.  Existing contracts need to be reviewed to determine which party will be liable for these costs.  Existing contracts may include "pass-through clauses" allowing the costs of a carbon "tax" or a carbon emissions trading scheme to be passed on.  It is important to ensure that these clauses are sufficiently broad to capture the proposed mechanism. 

What is a tax?

A tax has been defined by the courts as being an exaction of money with three positive features, being:

  • it is compulsory

  • it is for public purposes

  • it is enforceable by law, and

  • one negative feature, being that it is not a fee for services rendered.  

During the first three years, the carbon pricing mechanism will operate like a tax because it will be compulsory, for public purposes and it will be enforceable by law.  However, the carbon pricing mechanism may not technically be a tax because businesses will receive property in the form of carbon permits in return for payment of the price per tonne of carbon emissions.  Therefore there is no “exaction of money”, notwithstanding that businesses have no choice as to whether to acquire the carbon permits or not.  Accordingly, and while in each case the result will depend on the exact wording used, contractual clauses allowing the pass through of a "carbon tax" may not be effective during this period. 

From 1 July 2015, the Mechanism will be an emissions trading scheme, and will lose some attributes of a tax because the market will establish the price payable for a carbon permit.  Accordingly, clauses which only allow a tax to be passed through may fail to have the desired effect of passing on the cost from 1 July 2015. 

We have developed a range of carbon cost pass through clauses, which have been refined in light of the latest announcements.  We can provide detailed advice regarding clauses in existing contracts, and recommend the best clauses for contracts under negotiation.

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