Linking Australia’s carbon pricing mechanism to the EU’s trading system

The Australian government’s announcement on 28 August that the Australian carbon pricing mechanism (CPM) will link to the European emissions trading system (EU ETS), initially through a “one-way” link from 2015, is significant for Australian liable entities, carbon market stakeholders, and for the broader international carbon market. An initial “one-way” link will enable Australian liable entities to use European units (EUAs) to meet up to 50% of their annual liability. This is until a full two-way link is established, which will enable Australian units to be used by European liable entities in the EU ETS.

The linkage also has implications for Chinese investors that own all or part of liable entity companies in Australia, that operate in the clean development mechanism (CDM) market in China, or that own or invest in renewable energy technologies in China. As the link between Australia and the EU is the first of its kind, it will be of interest to the Chinese public and private sectors, particularly as China develops its national emission trading scheme, and further linkages between schemes are likely to be the main driver in shaping the global carbon market.

What was announced?

In summary:

• Australia’s CPM is linked to the EU ETS. From 1 July 2015, Australian liable entities will be able to meet up to 50% of their liability with European units, and from 1 July 2018 Australian units will be able to be used in the EU ETS when a full “two-way” link will commence.
• The price floor will not be implemented.
• A quantitative restriction of 12.5% will be introduced on the use of eligible Kyoto units within the overall 50% annual limit on the surrender of international units by liable entities.
• The price ceiling will be set by reference to the European unit price.

Effect on business in Australia

(i) International trading opportunities. The removal of the floor price means that Australian liable entities will no longer have to pay a surrender charge on international units. This presents significant opportunities in the carbon market environment. It enables liable entities to purchase eligible international units, while both certified emission reduction units (CERs) and EUAs are at record low prices, for use in the CPM from 2015-2016. There is nothing preventing Australian liable entities from purchasing EUAs today and holding these units until they can be surrendered in the CPM. This can be achieved through existing registry accounts in the EU registry, or through establishing a new account in the EU registry.

The low European prices are unlikely to remain for long, as the European Commission is taking measures to increase the price over the short and longer term. The upward momentum these developments will give to the price of EUAs means that the EU ETS and the Australian CPM may become linked at the bottom of the market for EUAs. This provides Australian buyers with an opportunity to acquire EUAs at prices significantly below the current floor price. While these units can’t be surrendered in Australia until 2015-2016, if the price of EUAs increases between now and 2015, the current EUA price may be significantly below the price compliance buyers will be required to pay on the market in 2015. This may provide liable entities with an arbitrage opportunity.

Purchasing international units – that is, CERs, emission reduction units (ERUs) and EUAs – minimises the impacts of any repeal of the CPM on Australian buyers, as these units will be able to be sold on the international market in the event they can’t be used in Australia under a change of government. There are, in any event, signs that a coalition (opposition) government may allow companies to purchase some abatement internationally.

(ii) Implications for CFI and other domestic abatement in Australia. A main strength of the price floor was the certainty on return that it provided to investors in carbon farming initiative (CFI) units. The initial floor price of A$15 (US$15.50), increasing at 4% each year, would have set the price for Australian and CFI units. The removal of the floor will have implications for the price of Australian permits, including CFI units. The new sub-limit of 12.5% on eligible Kyoto units will mean that the Australian price is likely to track the European price, instead of the CER price. This makes the return on investment in CFI projects more volatile, but not necessarily less profitable. There have been concerns expressed about the impacts the current low prices in the EU ETS will have on the feasibility of CFI, and other emission reduction projects in Australia. However, these concerns do not take into account the measures that the European Commission is taking to increase its carbon price in the short and longer term. The European unit price could be above the floor price if the commission implements its proposals to increase the price.

The link with the EU ETS means that Australian carbon market stakeholders will need to be more informed about developments in the EU ETS as these will now have a direct impact on the price of Australian units.

(iii) A reduced demand for CDM in Australia. Units from the CDM (CERs) will continue to play an important role in assisting liable entities to meet their obligations. While the new sub-limit of 12.5% on eligible Kyoto units will reduce demand for CERs by Australian liable entities, this is balanced with the need to safeguard the Australian permit price from tracking the CER price. A number of opportunities exist to purchase CERs in the current market at record low prices. Unlike in the EU ETS, Australia will continue to accept CERs from China, subject to some qualitative exceptions.

Current opportunities

These changes have significant implications for Australian liable entities and carbon market players in Australia and China. They also present many new opportunities for liable entities to minimise the cost of compliance with the CPM, as well as for green technology suppliers globally to assist Australian energy-intensive businesses to reduce their emissions. Australian businesses will need to consider:

• implications of linking for investments in CFI and other domestic abatement
• implications for the implementation of carbon reduction strategies
• the legal requirements for trading international units in Australia
• purchasing European units, including setting up a registry account in the EU Registry
• purchasing other eligible international units, including CDM units
• developments and the direction of the international carbon market

Michael Sheng is a partner at Ashurst in Shanghai, and Jeff Lynn is a partner at Ashurst in Melbourne. Katherine Lake, a senior associate at Ashurst in Melbourne, also contributed to this article