21 October, 2015
The commencement of the safeguard mechanism will be a key issue for businesses. Businesses should review their current commercial arrangements to determine whether the arrangements facilitate a pass through of the costs.
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.
Background
The $2.55 billion Emissions Reduction Fund (ERF) is the centrepiece of the Federal Government’s Direct Action Plan to cut greenhouse gas emissions to 5% below 2000 levels by 2020 and to 26 to 28% below 2005 levels by 2030.
The ERF comprises a fund to purchase emissions reductions and a safeguard mechanism to ensure that these reductions are not displaced by a significant rise in emissions above business-as-usual levels elsewhere in the economy.
The safeguard mechanism of the 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) (Safeguard Rules). The safeguard mechanism is scheduled to commence on 1 July 2016.
The foundation of the safeguard mechanism is the obligation on a responsible emitter to ensure that the net emissions from its facility does not exceed the emissions baseline of its facility. Where the net emissions do exceed the emissions baseline, a range of regulatory enforcement action, (including civil penalties of up to $1.8 million) may be imposed.
This article provides a summary of the key features of the safeguard mechanism, and the potential risks for businesses, which have been the subject of more detailed discussion in publications listed above.
Who is caught?
The safeguard mechanism applies to all "designated large facilities", which are defined as facilities with direct emissions in excess of 100,000 tonnes of CO2-e per year. The person with "operational control" of a facility (defined as the "responsible emitter") is responsible for meeting the requirements of the safeguard mechanism. Operational control is determined by applying the existing operational control test set out under the NGERS Act.
The transport, waste and electricity sectors will be treated slightly differently to other facilities under the Draft Safeguard Rule as follows:
- Transport – to accommodate interstate transport operations, transport businesses will have the option to define their facilities on a national or state basis.
- Waste – waste sector coverage will be limited to emissions from waste that is deposited at a landfill after the safeguard mechanism commences (ie after 1 July 2016). This will ensure that the safeguard mechanism does not retrospectively cover emissions from activities that occurred in the past (defined as "legacy emissions").
- Electricity – a sectoral-baseline of 198 million tonnes of CO2-e per financial year will apply to all grid-connected electricity generators with individual baselines to be applied if the sectoral-baseline is exceeded.
Meeting BASELINES and Enforcement
There are a range of options under the safeguard mechanism that allow responsible emitters to reduce any exceedances and meet their baselines. These include:
- the voluntary surrender of Australian Carbon Credit Units (ACCUs) acquired through the ERF in order to reduce net emissions;
- access to multi-year monitoring periods of up to three years; and
- exemptions for exceptional circumstances (for example, natural disaster or criminal activity).
If a responsible emitter fails to meet its baseline then the Clean Energy Regulator (Regulator) has access to a number of graduated
enforcement options including:
- issuing infringement notices;
- accepting enforceable undertakings;
- seeking injunctions to rectify an emissions exceedance; and
- seeking court-imposed civil penalties (which may be up to a maximum of $18,000 per day for a maximum 100 days (a maximum of $1.8 million in total)).
Although the Regulator has the discretion to seek court imposed civil penalties this is only considered a "last resort" option. This means that even if a responsible emitter fails to meet its baseline (for example by not surrendering the correct number of ACCUs), the responsible emitter is more likely to incur an infringement notice then a more onerous penalty, such as a court imposed civil penalty.
Our insights – key issues for industry
In anticipating the commencement of the safeguard mechanism businesses are facing the challenge of how to manage liability and distribute costs that may arise in meeting baselines (ie by reducing net emissions through the surrender of ACCUs) or paying penalties for baseline exceedances.
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.
There are a number of issues for businesses to consider in negotiating any 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 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 really 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 have been no tangible proposals 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 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 current commercial arrangements to determine whether the 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
