28 September, 2015
WHAT YOU NEED TO KNOW
- The safeguard mechanism of the Federal Government's Emissions Reduction Fund is scheduled to commence on 1 July 2016.
- Upon commencement of the safeguard mechanism, businesses that exceed their emissions baseline will incur additional costs in either meeting those baselines, paying penalties for exceeding the baselines or complying with other regulatory enforcement action.
- There is considerable complexity around how the costs associated with meeting and complying with the safeguard mechanism may be passed on to counterparties under current supply contracts and commercial agreements.
WHAT YOU NEED TO DO
- Businesses should review their commercial arrangements to determine whether current arrangements facilitate a pass through of the costs.
Introduction
The safeguard mechanism of the Emissions Reduction Fund (ERF) is given its shape through amendments to the National Greenhouse and Energy Reporting Act 2008 (Cth) (NGERS Act) and its substance through the National Greenhouse and Energy Reporting (Safeguard Mechanism) Rule 2015 (currently still in draft) (Draft Safeguard Rule). The Draft Safeguard Rule is scheduled to commence on 1 July 2016.
In anticipating the commencement of the Draft Safeguard Rule, businesses are facing the challenge of how to manage liability and distribute costs that may arise in meeting emissions baselines (ie by reducing net emissions through the surrender of Australian Carbon Credit Units (ACCUs) acquired through the ERF) or paying penalties for baseline exceedances under the safeguard mechanism.
For more information on the Draft Safeguard Rule and the safeguard mechanism generally, including how baselines are set and met, penalties and enforcement.
Key issues for industry
Unlike the previous "carbon price" established by the former Labor Government under the now repealed Clean Energy Act 2011 (Cth), as yet no "market mechanisms", such as the AFMA Carbon Benchmark Addendum, have been developed that provide for an industry standard to pass through the costs expected to be incurred under the safeguard mechanism.
The pass through of potential costs arising as a result of the safeguard mechanism is more complex. It gives rise to bespoke clauses reflecting the risk allocation in the underlying transaction as compared to an industry standard or market benchmark position.
We set out below the key issues for businesses to consider in negotiating the pass through of these costs.
Quantifying costs
Under the safeguard mechanism it is difficult for businesses to accurately quantify the anticipated costs or penalties that may be incurred. The hierarchical nature of the enforcement action, the options for meeting baselines and the method for calculating baselines proposed under the Draft Safeguard Rules (which, industry insiders have suggested will result in baselines being set for the majority of facilities at levels which are unlikely to encourage emissions reductions) means that only a handful of those businesses which actually exceed their baselines will incur civil penalties.
Timing of penalties or mitigation steps
The timing of penalties or mitigation steps (such as acquiring ACCUs to reduce the net emissions below the baseline) will pose a challenge for a number of businesses seeking to pass through costs.
We expect that:
- a business will not look to acquire ACCUs until near the end of the reporting year (ie after June) when its emissions are known or more certain; and
- for a baseline exceedance, the civil penalties/ potential enforcement action to be taken by the Regulator will not be known until after the National Greenhouse and Energy Report for the facility is filed around 31 October each year. At that time the Regulator assesses the outcomes of that report against the facility's emissions.
To this end, there could be a delay of anywhere up to one and a half years between the supply under a commercial agreement and the application of penalties or the implementation of measures to reduce baselines.
We have started to see the use of change in law type clauses where the parties try to be clear about who is to bear these costs. However, there has been limited work on the mechanism to calculate the extent of the pass through to the end consumer if costs are incurred or obligations on how the supplier might mitigate its potential liability.
Agreement with counterparties
Given the pecuniary nature of the safeguard mechanism, and the fact that many of the costs associated with the safeguard mechanism are incurred in either complying with law or as a result of prosecution, counterparties to agreements may be reluctant to agree to a process by which those costs will be passed through.
Sectorial-baseline for grid-connected electricity generators
The use of the sectorial-baseline for grid-connected electricity generators makes it unclear how the costs associated with the safeguard mechanism will be passed through to consumers. Although work is being done by industry bodies on this, there has been no tangible proposal and it may end up being a "cost of business" pass through (ie an increase in the underlying price).
What you need to do
There is no doubt that complying with the ERF and the Draft Safeguard Rules is likely to result in additional costs for industry – especially those high-emitting industries that are expected to have the largest exposure to exceeding baselines (for example electricity generators, existing metals manufacturing, coal mining, oil and gas, and transport facilities).
Businesses should review their commercial arrangements to determine whether the current arrangements facilitate a pass through of the costs. If current arrangements do not facilitate pass throughs, businesses should contemplate entering into negotiations with counterparties. Given the uncertainty that surrounds the nature of the risk and liability posed under the safeguard mechanism, and the lack of an industry standard mechanism, it is likely that these negotiations could be difficult and protracted.
For further information, please contact:
Paul Newman, Partner, Ashurst
paul.newman@ashurst.com
