Reforming the Safeguard Mechanism no easy task

What you need to know

• Last month, the Federal Government released its wide-reaching Safeguard Mechanism Reforms Consultation Paper, which is open for submissions from industry and the public until 20 September 2022.
• We discussed the Government's key proposed reforms in more detail in our 29 August 2022 alert Federal Government seeks feedback on proposed reforms to Safeguard Mechanism.
• In this alert, we discuss key implications arising from the Consultation Paper (including some relevant contributions from other commentators) and other factors that will impact how Safeguard Facilities respond to the stronger regulations. 

What you need to do

• Companies will need to consider whether their emissions reduction commitments should align with the Australian Government's Paris Agreement targets.  Increasingly stakeholders will expect the targets to align.  Companies should develop a credible pathway to achieving this outcome.
• Safeguard Facilities should consider making a submission in response to the Safeguard Mechanism Reforms Consultation Paper (due by Tuesday 20 September 2022).
• Safeguard Facilities should assess the return on investing in emissions reductions projects which may allow them to earn safeguard mechanism credits, that could in turn finance those investments.  The cost of action needs to be compared against the costs of not doing so, which should include the cost of acquiring safeguard mechanism credits s (or ACCUs) to meet falling baselines over time.  
• Companies that have, or intend to, enter into arrangements to procure ACCUs, or develop projects to create ACCUs, should pay attention to the ACCUs Review, including considering whether to make a submissions to the Review (due by Monday 26 September 2022).

Recap regarding the Consultation Paper

Safeguard Mechanism Reforms Consultation Paper

Last month, the Federal Government released its wide-reaching Safeguard Mechanism Reforms Consultation Paper, which is open for submissions from industry and the public until 20 September 2022.

The Consultation Paper outlines the Government's proposed reforms to the Safeguard Mechanism, which covers approximately 215 of Australia's highest emitting facilities (Safeguard Facilities) which each emit more than 100,000 t CO2-e of scope 1 emissions each year and collectively produce approximately 28% of Australia's CO₂-e emissions (137 Mt out of 489 Mt of CO2-e from Australia's total scope 1 emissions in 2020/2021).

We discussed the Government's key proposed reforms in more detail in our 29 August 2022 alert Federal Government seeks feedback on proposed reforms to Safeguard Mechanism.

In this alert, we discuss:

• key implications arising from the Consultation Paper (including some relevant contributions from other commentators); and 
• other factors that will impact how Safeguard Facilities respond to the stronger regulations. 

Climate Change Bill passed - rapidly changing regulatory landscape

The Consultation Paper is just one part of the Federal Government's wider agenda for action on climate change, which has no prospect of slowing down.

The Australian Government's Climate Change Act 2022 has passed the Senate and received Royal Assent.  The effect of the Act is to enshrine in law Australia's commitments under the Paris Agreement to reduce Australia's national CO₂-e emissions to:

• 43% below 2005 levels by 2030; and
• net zero by 2050.

For those companies that have adopted a net zero by 2050 target (and particularly those that have also established interim targets), stakeholders will increasingly ask: does the company have a credible plan to achieve its commitments and is that plan aligned with the national emissions reduction trajectory set by the Australian Government? 

What the proposed Safeguard Mechanism reforms mean for Safeguard Facilities

How will Safeguard Facilities handle the new baselines?

The proposal to reset baselines to remove up to 43 Mt CO₂-e in aggregate headroom (and then to reduce baselines gradually over time) will make it increasingly difficult for Safeguard Facilities to comply with the Safeguard Mechanism without investing in additional emission reductions.

For businesses that have already picked the low hanging fruit, incremental reductions may be difficult but opportunities may exist to undertake more ambitious projects that achieve a material stepdown in emissions. These projects may, in effect, be underwritten by the Government's proposed Safeguard Mechanism Credits (SMCs) system. 

Safeguard Facilities that emit less than their baseline in a given year will be issued with SMCs which they can sell to other Safeguard Facilities that have emissions above their baseline.  For companies investing in emissions reduction projects, the revenue earned from SMC sales could recover some or all of the costs of an emissions reduction project over time.. As such, SMCs may represent a means of financing emissions reduction projects.  

The choice of the method by which the new baselines are set is also likely to have significant implications for the efficacy of these reforms. As Reputex have noted, if baselines are set according to industry average emissions, rather than at the facility level, for many facilities significant "emissions headroom" will be retained, at least for a few years until baselines reduce to absorb this headroom.  This is likely to result in a slow start to the operation of these reforms as it will result in low SMC prices that will effectively reduce the incentive for emissions reductions. It will also reduce demand for ACCUs, reducing their price and with it the incentive to invest in ERF projects.

How steep will the baseline decline be? 

The Consultation Paper identifies an "expected" decline rate range of 3.5% - 6%. However, it notes that the "final decline rates cannot be settled until other policy settings have been finalised". For most Safeguard Facilities, reducing emissions is unlikely to be linear which will mean that the flexibility offered by the Government's proposed "banking and borrowing" scheme will be particularly important.

The rate of decline will also be influenced by how the Safeguard Facilities baselines are set. If industrial activity averages are used, emissions reductions in the early years are likely to be less than otherwise, meaning that the annual decline rate will need to be steeper than otherwise to achieve the Paris Agreement targets.  This may give some Safeguard Facilities time to plan for and implement the "step down" emissions reduction targets that will be necessary to achieve these targets. However, it will also mean that facilities that are already sitting below the industry average emissions will be issued SMCs, without having achieved any emissions reductions.  This may create some concerns about SMC integrity as they won't necessarily represent additional abatement (in the way that an ACCU does).

Should Safeguard Facilities contribute a proportional share to Australia's national emissions reduction target?

We expect that a driving factor behind how the decline rates for baselines is set will be whether the Government commits to ensuring that Safeguard Facilities contribute a proportional share of Australia's national emissions reduction target of 43% below 2005 levels by 2030.

A proportionate contribution from Safeguard Facilities will mean:

• As noted in the Consultation Paper, Safeguard Facilities will collectively need to reduce scope 1 emissions from 137 Mt in 2020-21 to 99.1 Mt in 2030 (ie a reduction of 28%).
• The Safeguard Mechanism Rule will need to achieve a balance between facilitating new economic activity (particularly in key sectors such as gas production where there is currently a critical market demand) and achieving the national emissions reduction target.
• The more new entrants or expansions there are, the steeper the baseline declines will need to be to ensure the Safeguard Mechanism achieves a given target overall.
• Assuming that new facilities are built to reflect best practice (which existing Safeguard Facilities do not generally meet), there may be equity issues if they are required to decrease emissions at the same rate as existing Safeguard Facilities.
• If gentler decline rates are imposed for emissions-intensive trade-exposed (EITE) facilities, the decline rates for other Safeguard Facilities will need to be correspondingly steeper to achieve the same overall reduction. 

Accordingly, what special treatment is afforded to new facilities and EITE facilities (noting that we consider some special treatment is likely) will be an issue for the owners of all Safeguard Facilities. Businesses that are currently covered by the Safeguard Mechanism should consider the implications of any such special treatment and, in particular, whether:

• it is appropriate for Safeguard Facilities to be treated as a block; or
• it is more appropriate for the remaining share of Australia's emissions reduction target to be spread across all non-EITE facilities (not just Safeguard Facilities) given the economic benefits that EITEs deliver to the economy as a whole. 

What impact will the proposed reforms have on demand for ACCUs? 

The proposal to reset and gradually reduce baselines for Safeguard Facilities will significantly increase demand for ACCUs (subject to our comments above about how new baselines are set). The creation of SMCs will only go so far to meet demand for offsets because any genuine reset of baselines should result in fewer Safeguard Facilities emitting below their baseline than above (intentionally resulting in a shortage of SMCs). In addition, the Consultation Paper has identified that international carbon offsets will not be permitted as "part of the initial enhanced Safeguard Mechanism".  

Together this will result in a narrow pool of available offsets, which will increase the overall cost borne by Safeguard Facilities in contributing to Australia's emissions reduction targets at least in the short term. In fact, as Reputex has identified, on the day of the release of the Consultation Paper, the price of a generic ACCU (that is, an ACCU regardless of what kind of carbon offsets project underlies it) rose by 6%, suggesting that the market is already anticipating the increased demand for ACCUs in 2023. 

However, while the cost of compliance with the Safeguard Mechanism may increase, this same increase in demand for ACCUs is likely to increase investment in domestic carbon abatement. More carbon offsets projects will become financially viable by the sale of ACCUs at a higher price to Safeguard Facilities instead of having to rely on securing a carbon abatement contract to sell ACCUs back to the Clean Energy Regulator. This price differential already exists, as the ACCU spot price has been consistently above $25/t this year, well above the average price in the most recent Emissions Reduction Fund auction in April 2022 ($17.35/t).  

What about international offsets? 

The Federal Government has made clear that international offsets will not be permitted in the initial enhanced Safeguard Mechanism. However, the Consultation Paper suggests that international offsets may be permitted in the future, so long as they are of high integrity and are capable of counting towards Australia's commitments under the Paris Agreement. 

Article 6 of the Paris Agreement creates a mechanism for the trading of carbon credits between countries, but has yet to be activated. Once activated, it could provide the means by which Australia gains access to additional carbon markets, which in turn would provide Safeguard Facilities with access to a broader pool of offsets. 

Will the proposed transition period ease the pressure?

The proposal to reset baselines, and issue SMCs to Safeguard Facilities that outperform their reset baselines, is likely to result in imperfect outcomes initially given the diversity in carbon intensity and abatement opportunities among the ~215 Safeguard Facilities. The Consultation Paper identifies the need to smooth out operational issues, and suggests two phases to ease the transition to reformed Safeguard Mechanism, as follows:

• a 2-year transition period commencing 1 July 2023 (Phase 1); and

• changes taking effect in full from 1 July 2025 until 30 June 2030 (Phase 2).
  

At this stage, the Government has not indicated which reforms are likely to commence in Phase 1 and which reforms will be postponed until Phase 2. That decision will necessarily affect when particular kinds of Safeguard Facilities will need to begin to reduce their emissions. However, this will not be clearer until early December 2022 when the Government is expected to publish an exposure draft of the new Safeguard Mechanism Rule. 

Next steps

Independent review of ACCUs

 Soon after the Safeguard Mechanism Rule exposure draft is published in early December, the independent expert panel reviewing the integrity of ACCUs (ACCUs Review) is due to report to the Minister for Climate Change and Energy, Chris Bowen, by 31 December 2022. 

Given the important role that ACCUs will play under the reformed Safeguard Mechanism, the report by the ACCUs Review may have significant implications. For instance, if the ACCU Review determines that some ACCU methodologies are insufficiently robust, and recommends changes to tighten them, the future supply of ACCUs may be reduced.  This may tend to increase the price of ACCUs and so increase the cost for Safeguard Facilities to meet their baseline.  It may also have implications for the value of the investment that Safeguard Facilities have already made to procure or create ACCUs.   

Therefore, we recommend that Safeguard Facilities closely monitor the progress of the ACCU Review and consider making a submission to the ACCUs Review, particularly to reinforce the integrity and value of any existing ACCU portfolios. 

Authors: Jeff Lynn, Partner; Sophie Westland, Senior Associate; and Fergus Calwell, Lawyer