Evolution of the Australian Carbon Market by Emmy S

EVOLUTION OF THE AUSTRALIAN CARBON MARKET LESSONS FROM COMMODITY AND FINANCIAL MARKETS

JULY 2012

Copyright and Disclaimer Copyright © 2012 the Carbon Market Institute (CMI). No part of this document may be reproduced without consent. Permission is granted for normal and limited quotation provided that credit is given to CMI. The opinions expressed in this publication do not necessarily reflect the opinions of the CMI directors, sponsors, partners or members. The information, statements, statistics, material and commentary (together the “Information”) used in this Report have been prepared by PwC on behalf of CMI from publicly available material, information provided by CMI and from discussions held with a range of CMI stakeholders. PwC has relied upon the accuracy, currency and completeness of the Information provided to it by CMI and the CMI stakeholders and takes no responsibility for the accuracy, currency, reliability or correctness of the Information and acknowledges that changes in circumstances after the time of publication may impact on the accuracy of the Information. The Information may change without notice and PwC is not in any way liable for the accuracy of any information used or relied upon by a third party. PwC has provided this advice solely for the benefit of CMI and disclaims all liability and responsibility to any other parties for any loss, damage, cost or expense incurred or arising out of any person using or relying upon the Information. No responsibility is accepted by CMI, its directors, sponsors, partners, or members or the authors for the accuracy of information contained in this publication or the consequences of any person relying upon information. The contents of this publication should not be relied upon as a substitute for professional advice.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

About the Carbon Market Institute The Carbon Market Institute is an independent membership-based not-for-profit organisation. Our aim is to assist Australian businesses in meeting the challenges and opportunities associated with the developing national and international carbon markets and thereby build capacity to grow in a low-carbon world. Established with support from the Victorian Government, our Asia-Pacific wide membership represents a broad range of professionals, organisations and industry providers for whom carbon will have a direct impact on their businesses both in terms of liabilities and potential opportunities. The Institute has a strong research program and provides market analysis, education and training, business networking and information services and international engagement. CMI is also developing professional standards and an accreditation program. CMI incorporates and builds on the networks, partnerships and services developed by the former Asia-Pacific Emissions Trading Forum (AETF) which began operations in 1998. CMI commenced operations on 1 January 2011 with a mandate to assist Australian businesses with the implementation of climate-related markets, both in terms of managing risk and realising business opportunities. To find out more about becoming a member of CMI, email info@carbonmarketinstitute.org

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

About the authors

At PwC, asking questions is at the heart of what we do when helping clients. Our clients range from the largest, global organisations, to governments and other not-for-profit organisations, to start-ups so we take the time to listen and understand their goals and their competitive and regulatory environment. We then tap into our global network, deep industry expertise, and strong judgement and experience to help each client create the kind of value they are looking for. This report was prepared on behalf of the Carbon Market Institute (CMI) in accordance with agreed terms of reference and drawing on the sustainability and climate change and commodity markets expertise of our Risk Consulting practice. Our sustainability and climate change professionals advise our clients on the range of strategic, commercial and operational risks and opportunities arising from carbon pricing. Our commodity markets professionals provide solutions to clients aimed at managing commodity market related risk and at maximising market returns on risk taken. This combined capability allows PwC to provide a unique perspective on the factors that are likely to influence the evolution of the Australian carbon market.

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Evolution of the Australian Carbon Market Lessons from commodity and financial markets

ACKNOWLEDGEMENTS The Carbon Market Institute and PwC would like to acknowledge the important contribution made by the many market stakeholders consulted during the development of this report. They provided a wide range of perspectives and some valuable insights. In particular we wish to thank: »» AGL - Tim Nelson - Head of Economics, Policy and Sustainability »» ASX - Paul Roberts – Manager Energy and Environmental Markets »» Carbon Banc - Ken Edwards – Head of Trading »» Carbon Market Institute (CMI) - Les Hosking – Chairman and former Managing Director and CEO of Sydney Futures Exchange »» Department of Climate Change and Energy Efficiency (DCCEE) »» Financial and Energy Exchange Group (FEX) - Adam Goern – Senior Manager OTC Markets »» Tullet Prebon Energy (London) - Richard Wilson - Director Energy and Commodities, Dan Thompson - Head of Emissions »» Westpac Institutional Bank - Emma Herd – Executive Director Emissions and Environment

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

SUMMARY This report explores the range of factors that are likely to influence the evolution of the Australian Carbon Market. The passage of the Clean Energy Legislative Package (CELP) by the Australian Senate on 8 November 2011 has laid the foundations for Australia’s first national carbon market targeted at reducing Australia’s greenhouse gas emissions by five per cent in 2020 and 80 per cent in 2050 based on 2000 levels. While the 2020 emissions reductions target currently has bipartisan support in the parliament, the 2050 target and the most appropriate mechanism to achieve both targets does not. From its beginning with a fixed price for carbon units from 1 July 2012 through to the commencement of a “cap and trade” scheme on 1 July 2015, the evolutionary pathway of this market will be watched with interest by market participants and a range of other stakeholders.

The emissions profile of participants will influence early participation in the market. The Australian carbon market is expected to be large, with up to 500 liable entities (from a diverse range of industries) generating over 300 MtCO2-e of liable emissions in the 12 months to June 2013. Nearly 300 entities have been confirmed to date. The large number of participants suggests the potential for rapid establishment of liquidity and price discovery, assuming there is an appropriate balance of buyers and sellers. Demand for eligible units will be concentrated in the energy sector (indicative analysis by PwC suggests that over 60 per cent of emissions in 2009 were created from the “public electricity and heat production” sector). There will be “supply” from companies with EITE activities that will need to monetise freely allocated carbon units related to their indirect emissions. The major banks are also expected to be early active participants, fulfilling a range of roles, but in particular providing access to capital and utilising their deep knowledge of tradeable markets for the brokering of transactions on behalf of less experienced market participants. Ultimately the strategies adopted by “liable entities” to balance the range of risks and opportunities presented by their demand will evolve gradually as patterns of behaviour of different market participants, regulators and operators emerge.

Stakeholders highlighted a number of factors which could support the development of a successful market. The following factors were highlighted by market stakeholders consulted during this project as important in supporting confidence in the market, encouraging and sustaining participation and encouraging liquidity: »» Bipartisan political commitment and a stable policy environment. »» Finding the right balance in regulatory oversight over the market. »» Robust arrangements for release of market sensitive information. »» Robust systems and processes for registration, trade settlement and transfer of ownership. »» Mechanisms to support information and signals for price discovery. »» Emergence of centralised clearing mechanisms for management of counterparty credit risk.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

A range of financial intermediaries and market infrastructure providers are likely to emerge to meet demands of market participants. Lessons from other markets suggest that alongside the development of the underlying spot market, an active derivatives market will develop to assist in managing volume and price risk for liable entities. While OTC trading is expected to be the dominant form of trading in the initial years of the scheme, it is anticipated that exchange-based trading will grow over time as market liquidity builds, products become increasingly standardised and the global regulatory landscape continues to tighten over OTC derivatives.

The international political environment will have a fundamental impact on the evolution of the market. Developments in international carbon markets and Australiaâ&#x20AC;&#x2122;s linkages to those markets will also play a fundamental role in the development of the Australian carbon market. International negotiations over the future of Kyoto mechanisms such as the Clean Development Mechanism and the development of emissions trading schemes in other countries and regions will all influence the supply of, and demand for eligible international units. The way in which the Australian market interfaces within overseas carbon markets will also have a crucial influence over the achievement of successful outcomes.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

CONTENTS Summary

Purpose of this report

Overview of the Australian carbon market

2.1 Background

2.2

Structure of the market

2.3

Overview of supply and demand

Characteristics of a successful market

3.1

Typical characteristics of a successful market

3.2

Stakeholder perspectives of success

Factors which could support the evolution of a successful carbon market

4.1

Stable policy environment

4.2

Appropriate regulatory oversight to support market integrity

4.3

Arrangements for the release of market sensitive information

4.4

Robust systems and processes for registration, trade settlement and transfer of ownership

4.5

Information and signals for price discovery

4.6

Access to central clearing for management of counterparty credit risk

How the carbon market could evolve

5.1

What do we already know?

5.2

Less predictable aspects of the market evolution

6 Conclusion

Glossary

Industry terms

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Evolution of the Australian Carbon Market Lessons from commodity and financial markets

PURPOSE OF THIS REPORT

The establishment of a carbon pricing mechanism (CPM) as outlined in the Clean Energy Legislative Package (CELP) and passed into law by the Australian Senate on 8 November 2011 will drive the evolution of primary and secondary markets in the trade of eligible emissions units and derivatives.

the price determined by the market. This report is focused on considering how this “flexible pricing” carbon market might potentially evolve. It is important to recognise that the evolution of the carbon market will be influenced not only by the design of the Mechanism as outlined in the Package, but also by a wide range of future political and legislative developments in Australia and overseas, and ultimately by the behaviour and actions of market participants.

The mechanism commenced on 1 July 2012, with a price that will be fixed for the first three years. The price will start at $23 per tonne and will rise at 2.5 per cent per annum in real terms. On 1 July 2015, the carbon price will transition to a flexible price under an emissions trading scheme, with

Figure 1: The Australian Carbon Pricing Mechanism AUSTRALIAN CARBON PRICING MECHANISM $35

PRICE CEILING

$30

CARBON PRICE (AUD)

$25 $23

$24.15

PRICE CEILING $20 ABOVE CER PRICE

$25.40

$20

PRICE FLOOR

$15

$16

$15 CER SURRENDER CHARGE

$10

$17.05

CER PRICE $5

JULY 2012

JULY 2013

JULY 2014

FIXED PRICED PERIOD

JULY 2015

JULY 2016

JULY 2017

FLEXIBLE PRICED PERIOD

JULY 2018

JULY 2019

JULY 2020

FINANCIAL YEAR

FREE FLOATING PRICED PERIOD

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

To date, there has been much debate related to the design of the CPM and the CELP itself, but limited discourse on: 1) the way in which other factors might ultimately influence the evolution of the carbon market, and 2) on identifying and potentially supporting the desired outcomes (or “characteristics of success”) for this market. The Carbon Market Institute commissioned PricewaterhouseCoopers Australia (PwC) to conduct research into the potential evolution of the carbon market to compare and contrast this view with what has been seen in other markets, with a view to addressing this gap in the debate. The research has been undertaken through consultation with a range of carbon market stakeholders, including liable entities under the Clean Energy Act 2011, financial intermediaries and regulators. This report, which presents the findings of the research, aims to address the following questions: »» Who will the key stakeholders be in the carbon market and how might they interact as the market evolves? (Chapter 2 – Overview of the Australian carbon market). »» What are the characteristics of a successful carbon market and how does this differ for key stakeholders? (Chapter 3 – Characteristics of a successful market). »» What key factors could help to support the development of a successful carbon market? (Chapter 4 - Factors which could support the evolution of a successful carbon market). »» How might the carbon market evolve over time and what factors are likely to influence this? (Chapter 5 – How the carbon market could evolve). It should be noted that there is a range of possible “evolutionary paths” associated with, and measures that could be considered to support the development of the carbon market. This report does not aim to forecast the future or provide definitive recommendations, but instead aims to stimulate debate on the possible evolution of the market based on experiences in other environmental, financial and commodity markets.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

2. OVERVIEW OF THE AUSTRALIAN CARBON MARKET

2.1 BACKGROUND On 8 November 2011, following extensive negotiation and debate, the Senate passed the CELP, which sets out a framework for the establishment of the CPM and therefore the introduction of a carbon price into the Australian economy from 1 July 2012. (See CMI report, Australia’s Clean Energy Legislative Package: A Guide for Business.) The CPM will drive the evolution of a carbon market – comprising both primary and secondary markets (Box 1) in the trading of eligible emissions units1 and derivatives.

BOX 1: DEFINITION OF A PRIMARY AND SECONDARY MARKET The primary carbon market is a market in which a participant purchases or acquires the eligible emissions unit directly from the issuer. The issuers of carbon units and Australian carbon credit units (ACCUs) will be the Clean Energy Regulator. The issuers of eligible international emissions units include the CDM Registry Administrator (as instructed by CDM Executive Board) and administrators of other national registries as provided for under the Kyoto Protocol. The secondary carbon market is a market in which one market participant purchases an eligible emissions unit from another market participant rather than the initial issuer of the unit, or enters into a derivative contract directly linked to the underlying emissions units. The secondary carbon market plays a crucial role in: »» Allowing liable entities to more effectively manage their compliance obligations and associated financial risk through providing different avenues to purchase carbon units. »» Adding market liquidity and depth, therefore offering entities confidence that they can trade as and when required. »» Promoting allocative efficiency within the market. Eligible emissions units are defined in the CELP as: carbon units; eligible international emissions units and eligible Australian carbon credit units (ACCUs). 1

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

2.2 STRUCTURE OF THE MARKET The carbon market will comprise a range of interacting stakeholders with regulatory and market facilitation roles (Figure 2), each with an influence on how the market evolves.

Figure 2: Overview of the Australian Carbon Market Australian Government Makes major policy decisions

International authorities e.g. CDM Executive Board

Clean Energy Regulator

Climate Change Authority

Productivity Commission

Reviews pollution caps and operation of the CPM Australian carbon market

Australian Securities and Investments Commission (ASIC)

Reviews and reports on various aspects of the CPM

Regulates aspects of the secondary market

Free allocation of carbon units

Primary market

Liable/EITE entities

Auctions

Carbon units

Company 1 Company 2 Etc

Carbon Farming Initiative projects

International carbon reduction projects

ACCUs

CERs, ERUs, RMUs

The Government and Government Statutory Authorities ÂťÂť The Australian Government (the Government) is responsible for policy decisions related to the CPM and other climate initiatives. It has led the consultation process and has drafted the CELP, which will bring the CPM into effect. It is now driving implementation of the legislation which

Banks Trading eligible emissions units and derivatives Brokers

Non-liable entities (e.g. speculators)

Exchanges

Company 1 Company 2 Etc

The key stakeholders are:

Secondary market

Clearing and settlement

includes development of, and consultation on regulations covering a range of issues including transitional assistance packages, the functioning of the Registry, and recordkeeping requirements.2 The Government will continue to play a lead role in determining policy direction and changes (including future international links with other schemes) and releasing associated market information (including data that will both inform and quantify supply and demand).

DCCEE (2011), Securing a clean energy future: Implementing the Clean Energy Legislation, Australian Government, viewed 9 December 2011 <http://www.climatechange.gov.au/en/government/clean-energy-future/implementation/the-way-ahead/ regulations.aspx> 2

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

»» The Climate Change Authority (CCA) will provide independent advice to the Government on the performance of the CPM. It will review progress towards Australia’s carbon pollution reduction targets (completing its first review by February 2014), and will make annual recommendations covering a rolling five-year period to the Government on the level of “pollution caps”.3 As such, its recommendations and the way in which it releases information on these recommendations will have an important influence on supply and demand dynamics within the carbon market as it evolves over time. »» The Clean Energy Regulator (the Regulator) is a statutory authority that will administer the CPM and enforce the legislation within the CELP. The responsibilities of the Regulator will include:4

As such, its primary role will relate to administration of the primary carbon market. However, it will also have an important influence on the broader carbon market, for example, through its interface with the Australian Securities and Investments Commission (ASIC) which will play an important role in regulating financial markets. The Regulator will be independent from Government with a remit to administer the CPM within a limited and legislatively prescribed discretion. This is intended to reduce the risk that the Regulator’s decisions are based on factors other than CPM objectives, and to contribute to efficient and effective administration. The Regulator could also be a source of important market information that both informs and quantifies supply and demand (for example, NGERS and auction data).

– Providing education on the CPM, particularly on the administrative arrangements. – Assessing emissions data to determine each entity’s liability. – Operating the Registry (Box 2). – Monitoring, facilitating and enforcing compliance with the CPM. – Issuing carbon units. – Operating, maintaining records and publishing results of auctions (Box 3). – Administering the National Greenhouse and Energy Reporting System (NGERS), the Renewable Energy Target (RET) and the Carbon Farming Initiative (CFI) (Box 4). – Accrediting auditors for the CFI and NGERS.

DCCEE (2011), Climate Change Authority, Australian Government, viewed 9 December 2011 <http://www.climatechange.gov.au/ government/initiatives/climate-change-authority.aspx> 3

The Parliament of the Commonwealth of Australia House of Representatives (2011), Clean Energy Bill 2011: Explanatory Memoranda, Australian Government, viewed 9 December 2011 <http://parlinfo.aph.gov.au/parlInfo/download/legislation/ems/ r4653_ems_512dd113-81cb-415a-82e0-7ee25a13213a/upload_pdf/360036.pdf;fileType=application%2Fpdf> 4

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 2: THE REGISTRY The Registry was established in September 2009 to meet one of Australia’s commitments under the Kyoto Protocol. It is an electronic system which ensures accurate accounting of the issuance, holding, transfer, acquisition, cancellation, retirement and carry-over of Kyoto units.5 Amendments made to legislation extend the function of the Registry to track location and ownership of carbon units and ACCUs. Administration of the Registry now falls under the responsibility of the Clean Energy Regulator. In order to track eligible emissions units as they are transferred between market participants, the Registry will need to interface with a wide range of parties and market infrastructure including financial intermediaries and trading exchanges. The Registry will play a key role in ensuring the integrity of the carbon market, with safeguards against fraud and theft of eligible emissions units. (See CMI report, Carbon Market Integrity: A Review of the Australian Carbon Pricing Mechanism.)

BOX 3: AUCTIONS Auctions, including advance auctions during the fixed price period, will be held by the Regulator for issuance of carbon units to be used for compliance in the flexible price period of the CPM (i.e. from 2015 onwards). At the time of issuing this report, submissions have been made in response to a policy paper authored by the Department of Climate Change and Energy Efficiency. As a result, a range of details on auction design are still to be established, and regulations are being developed for further consultation in mid-2012.6 The primary policy objectives of the auctions will be to promote allocative efficiency and efficient price discovery7 (discussed in section 3.1 of this report).

BOX 4: THE CFI The CFI is a carbon offsets scheme which allows farmers and land managers to earn carbon credits through implementation of projects which store carbon or reduce greenhouse gas emissions on the land. These credits can then be sold to people and businesses wishing to offset their emissions. The scheme is operational at the time of issuing this report.8 CFI projects may lead to the creation of credits which are “Kyoto-compliant” or “non-Kyotocompliant”. Kyoto-compliant credits created under the CFI can be used for compliance with the CPM subject to a five per cent limit in the fixed charge period.9 (See CMI report, Implementing the Carbon Farming Initiative: A Guide for Business.)

DCCEE (2011), Australian National Registry of Emissions Units, Australian Government, viewed 9 December 2011 <http://www. climatechange.gov.au/government/initiatives/anreu.aspx> 5

http://www.climatechange.gov.au/en/government/submissions/closed-consultations/auctioning-carbon-units/auction-discussionpaper.aspx 6

DCCEE (2011), Carbon Farming Initiative, Australian Government, viewed 9 December 2011 <http://www.climatechange.gov.au/cfi>

The Parliament of the Commonwealth of Australia (2011), Clean Energy Bill 2011: Explanatory Memoranda, Australian Government, viewed 9 December 2011 <http://parlinfo.aph.gov.au/parlInfo/download/legislation/ems/r4653_ems_512dd113-81cb-415a-82e07ee25a13213a/upload_pdf/360036.pdf;fileType=application%2Fpdf> 9

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

»» The Australian Securities and Investments Commission (ASIC) is Australia’s corporate, markets and financial services regulator. It plays a key role in ensuring that Australia’s financial markets are fair and transparent, and supported by confident and informed investors and consumers. Under the CELP, a carbon unit has been defined as a financial product, and as such will be covered by financial services laws which are administered and enforced by ASIC.10 ASIC will regulate the market for carbon units as it would for other financial products, for example, applying its existing Regulatory Guides (including Regulatory Guide 172 - Australian market licences: Australian operators and Regulatory Guide 146 - Licensing: Training of financial product advisers), and the recently released Regulatory Guide 236 – Do I need an AFS license to participate in carbon markets? It will have a key role to play in: – Licensing of financial services businesses that are seeking to participate in the Australian carbon market (issuing Australian Financial Services licences). – Dealing with applications for licensing of market operators (Australian Market Licences), advising the Minister (who approves the licences), and monitoring compliance. – Licensing of financial advisors. – Overseeing disclosure requirements which have been set by the Government in relation to product disclosure statements for retail investors (although in practice retail participation is expected to be extremely limited). – Overseeing disclosure of carbon within financial statements.11

Market Operators Market operators facilitate and enable trading to take place. There may be circumstances in which they take and pass on title of eligible emissions units, but generally only for the purpose of facilitating trade amongst others as opposed to taking a position in the market. Market operators include exchanges, brokers, clearing house and settlement services. »» An exchange is a marketplace (typically an electronic platform) where buyers and sellers come together to trade standard products or contracts for example, commodities, securities, derivatives, etc. An exchange acts as a central counterparty with clearing guarantees, reducing the credit exposure of the parties involved. The definition of a carbon unit as a financial product means that carbon exchanges will be required to hold an Australian Market Licence, and as such will be regulated by ASIC. In Australia, exchange trading is dominated by the Australian Securities Exchange (ASX) Group. With respect to environmental products, the ASX currently provides for trading of futures and options contracts on Renewable Energy Certificates, and has announced its intention to list carbon instruments (Certified Emission Reductions (CERs) and carbon units) with the introduction of the CPM. 12 In Europe, the European Climate Exchange (ECX), owned by the Intercontinental Exchange (ICE), is the largest exchange for trading of carbon instruments, currently offering derivative contracts on European Union Allowances (EUAs), CERs and Emission Reduction Units (ERUs). In addition to traditional exchanges, a number of electronic trade execution facilities are emerging in Australia, which provide a platform for bringing buyers and sellers together, but as yet do not have clearing and settlement facilities or act as a central counterparty.

Based on discussion with ASIC.

Australian Securities Exchange (2011), ASX Limited, viewed 9 December 2011 <http://www.asx.com.au>

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

It could be expected that other exchanges or electronic trading platforms may become established in Australia over time. For example, the Financial and Energy Exchange (FEX) Group, which develops marketplaces with a focus on commodity, energy and environmental products, intends to launch both an OTC product on Mercari13 and exchange traded markets for trading of carbon units, subject to licensing by ASIC.14 »» Clearing and settlement agencies refers to post-trade processes which ensure that the seller gets paid and that the buyer gets ownership of the product it has paid for. Through a legal process known as novation, a trade that is dealt between two counterparties can be given up to a central counterparty (CCP), which assumes responsibility for the credit obligations associated with the trade. This mechanism allows the numerous bilateral exposures of a market participant to be substituted for a single net exposure to a financially and operationally robust central counterparty.15 Central clearing substantially reduces the size of outstanding obligations for trading entities, and therefore capital or collateral requirements across the market.16 Operators of clearing and settlement facilities are licensed by the relevant Minister under the Corporations Act on the advice of ASIC. There are currently five licensed clearing and settlement facilities in Australia – four of which are held by the ASX Group (the other by IMB Ltd).17 Clearing and settlement facilities are more commonly used for exchange-based trading as opposed to OTC trading, although evolving global regulation in the financial services sector may change this over time (discussed in section 4 of this report).

Market Participants »» Liable entities are entities with an obligation to acquire and surrender carbon units to the Government under the rules of the CPM. This primarily comprises entities with operational control over facilities with emissions from stationary energy, industrial processes, fugitive emissions and non-legacy waste, which exceed the threshold of 25,000 tonnes CO2-equivalent as prescribed within the CELP.18 »» Liable entities will be the key driver of demand for eligible emissions units within the market. Their behaviour, including their willingness to participate in trading, their understanding of the market and options for trading, their risk appetite and their preferred mechanisms for trading will have a fundamental influence on how the carbon market evolves. Potential supply and demandside dynamics based on the profile of liable entities in Australia are discussed in further detail in section 2.3 of this report. »» A broker is a party which facilitates a transaction between a buyer and a seller without being a direct party to the transaction, and takes a commission on the transaction (predominantly acting on behalf of the seller). Brokers typically have access to substantial information and knowledge of the markets in which they trade, including potential buyers, market conditions and prices. A broker may execute transactions on behalf of their principal either through an exchange or directly with another principal (“over the counter” or “OTC”). The definition of a carbon unit as a financial product means that brokers will be required to hold an Australian Financial Services Licence, and as such will be regulated by ASIC.

Mercari operates licensed and regulated electronic markets for over the counter (OTC) products.

Mercari eSEF Technology (2011), Mercari, viewed 9 December 2011 <http://www.mercari.com.au> Based on discussion with FEX.

Council of Financial Regulators (2011), Central Clearing of OTC Derivatives in Australia, Australian Government, viewed 9 December 2011 <http://www.rba.gov.au/publications/consultations/201106-otc-derivatives/pdf/201106-otc-derivatives.pdf> 15

The ASX has two CCP clearing subsidiaries for efficient clearing and settlement of transactions – the ASX Clear Pty Limited and ASX Clear (Futures) Pty Ltd, and two central securities depositories - ASX Settlement Pty Ltd and Austraclear. 17

An additional, lower threshold applies to landfill facilities to prevent diversion of waste from large landfill facilities to facilities below the 25,000 tonnes of CO2-e threshold. 18

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

A range of organisations provide brokerage service for environmental products, including banks, traditional brokers and dedicated environmental brokerage companies such as TFS Green or Nextgen (a subsidiary of Envex) – which facilitates trade in a range of environmental products, including Renewable Energy Certificates (RECs), NSW Greenhouse Gas Abatement Certificates (NGACs), and CERs. These brokerage services could be expected to expand their offerings to include brokerage of ACCUs and carbon units once the CPM is introduced. »» A bank may typically conduct one or more of the following activities within a carbon market: – Act as a “market maker” i.e. quoting a buy and sell price simultaneously with a view to making a profit on the bid-offer spread. – Provide finance to projects which generate carbon credits (for example, ACCUs or CERs). – Take on and manage credit risk associated with transactions, and therefore act as an intermediary between buyers and sellers that would not normally transact. – Speculate or take a principal position in a trade with the potential for making a profitable return. – Provide trade execution and related services to clients. As such, the banks have an important role in promoting liquidity, price discovery, and enabling market participants to reduce or transfer risk. The major banks operating in Australia have specialist teams focused on environmental products including carbon markets, and could be expected to expand their range of activities upon the introduction of the CPM. Emerging regulation following the global credit crisis may limit the scope of services offered by Australian banks. For example, the current Volcker Proposal in the US (capturing any

non-US bank which trades with the US and scheduled for implementation during 2012) would prohibit retail banks from conducting speculative or proprietary trading activity. As a result, banks may be less likely to partake or require higher returns from some of these activities (for example, speculative trading) in the longer term.19 »» Project developers are developers of projects which result in the reduction or removal from the atmosphere of carbon emissions against a baseline, under the rules of an approved project mechanism, for the creation of “carbon credits”. These include developers of Clean Development Mechanism (CDM) projects which result in the creation of CERs, and Carbon Farming Initiative (CFI) projects which result in the creation of ACCUs. Project developers have the potential to play an important role in the creation of primary eligible emissions units which liable entities can use for compliance with the CPM. Major project developers internationally include EcoSecurities and Camco. Perenia is an Australian headquartered company with services which include project development, registration and optimisation amongst others. »» Carbon funds are investment funds that generally enter into a forward agreement to receive credits generated by carbon reduction projects for which they may have also provided funding. This commitment to purchase credits increases the bankability of projects, reducing the risks of commercial lending or grant finance, and therefore leveraging new private and public investment into carbon reduction projects. There are a range of carbon funds operating at an international level which typically invest in projects under the CDM. Here in Australia, the Government has established a Carbon Farming Initiative non-Kyoto Carbon Fund ($250 million over the first six years of the program) which will provide incentives for non-Kyoto compliant land use activities (not eligible for use in compliance with the CPM), including revegetation and soil carbon projects.

http://www.nytimes.com/2011/10/14/business/new-dodd-frank-rules-muddled-by-congress-that-wants-it-both-ways.html?_ r=1&src=recg 19

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

»» Speculators are market participants which take a principal position on transactions, often taking relatively high risk positions with a view to making a profitable return consistent with the level of risk taken. Speculation is particularly popular in developing markets such as the carbon market, where price volatility may be expected and opportunities for arbitrage are substantial. Speculators can perform a valuable role in developing markets by providing liquidity.

A wide range of market participants include speculation within their activities – including liable entities, banks and other companies operating within the Australian market. Speculation is most commonly undertaken by banks, other financial services and trading organisations which have a high level of knowledge on the dynamics of markets, and the necessary risk capital for entering into speculative transactions as a part of core business activity.

2.3 OVERVIEW OF SUPPLY AND DEMAND The Australian Government has announced that there will be up to 500 liable entities under the CPM, approximately distributed across industries as follows: »» ~60 primarily involved in electricity generation. »» ~100 primarily involved in coal or other mining. »» ~40 natural gas retailers. »» ~60 primarily involved in industrial processes (cement, chemicals and metal processing). »» ~50 operating in a range of other fossil fuel intensive sectors.

A review of Australia’s national emissions profile (with a focus on those industries which are likely to attract a liability under the CPM), and of allocative baselines for emissions-intensive trade-exposed (EITE) activities20 can provide insight into possible supply and demand dynamics when the CPM commences. Table 1 shows an indicative breakdown of liable industries, illustrating that the vast majority of demand for eligible emissions units is expected to come from the energy sector (public electricity and heat production, which generated over 60 per cent of emissions in 2009 based on this analysis), with the remainder spread across a diverse range of activities.

»» ~130 operating in the waste disposal sector. Nearly 300 entities have been confirmed to date. The exact volume of permits estimated to be issued under the scheme remains uncertain and dependent upon a range of economic factors. Based on carbon price revenue contained within Treasury Budget Estimates, it would be reasonable to expect that the market size will be somewhere between 300 MtCO2-e and 350 MtCO2-e per annum.

DCCEE (2011), Establishing the eligibility of emissions-intensive trade-exposed activities, Australian Government, viewed 9 December 2011 <http://www.climatechange.gov.au/~/media/publications/eite/activity-eligibility-2011-pdf.pdf 20

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Table 1: Indicative distribution of demand for eligible emissions units under the CPM (2009)21 Emissions Category

Sector

Energy

Public electricity and heat production

Energy

Petroleum refining

Energy

Brown coal briquette production

Energy

Coke production

Energy

Coal mining

Energy

Oil and gas extraction

Energy

GHG emissions Proportion of (kt CO2-e) total emissions 206,743

61%

5,170

241

1,069

195

10,287

Iron and steel

2,676

Energy

Non-ferrous metals

11,886

Energy

Petroleum and coal product manufacturing (nec)

119

Energy

Basic chemical manufacturing

1,002

Energy

Other chemicals, rubber and plastic products

981

Energy

Pulp, paper and print

2,046

Energy

Food processing, beverages and tobacco

2,641

Energy

Other

8,757

Energy

Mining (Non-energy)

2,120

Energy

Cement, lime, plaster and concrete manufacturing

3,554

Energy

Ceramic manufacturing

1,071

Energy

Glass and glass product manufacturing

548

Energy

Non-metallic mineral product manufacturing (nec)

628

Energy

Machinery and equipment

246

Energy

Other manufacturing

Energy

Other metal manufacturing

Energy

Textile, clothing, footwear and leather manufacturing

339

Energy

Transport

428

Energy

Commercial/institutional

2,551

Energy

Residential gaseous

7,178

Energy

Fugitive emissions from coal

27,244

Energy

Fugitive emissions from oil and natural gas production

10,949

Industrial processes

Mineral products

6,507

Industrial processes

Metal production

9,528

Industrial processes

Other production

Waste

Total

170

14,045

341,012

100%

Source: Australian Greenhouse Emissions Information System: http://ageis.climatechange.gov.au/, as reported to UNFCCC for 2009. Notes: 21

1. Energy: Energy use emissions comprise those from combustion of solid and gaseous fuels only. Liquid fuels have been excluded (on the basis that coverage under Fuel Tax Credit and Excise regimes not necessitating permits). 2. Analysis does not take into account existence of facilities within abovementioned sectors with emissions below 25 ktCO2-e (and therefore not subject to a permit liability).

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Table 2 illustrates one aspect of the supply side of the market â&#x20AC;&#x201C; EITE entities that will be allocated free carbon units for their Scope 2 emissions (i.e. related to purchased electricity consumption). Under the CELP, companies only have a direct permit liability for Scope 1 emissions. However, assistance under the Jobs and Competitiveness Program is provided on the basis of both Scope 1 and Scope 2 emissions.

will have no direct liability, resulting in them having an excess of carbon units. These entities may need to develop strategies for monetising these units, for example, through selling on the market or entering into arrangements directly with electricity providers (as was seen in the NZ ETS with the agreement of â&#x20AC;&#x153;barteringâ&#x20AC;? transactions between EITE companies and power generators).

The table below shows that many EITE activities will receive a significant portion of their carbon units for their scope 2 emissions for which they

Table 2: Indicative estimates of freely allocated carbon units for scope 2 emissions which will need to be monetised by EITE companies22 EITE activity

Percentage of carbon units associated with Scope 2 emissions

Fused alumina

99%

Pulp and paper (bone dried pulp from wood)

98%

Zinc

97%

Magnesia (saleable electro fused magnesia)

97%

Pulp and paper (bone dried pulp from recovered paper)

91%

Silicon

89%

Aluminium

88%

Copper (copper cathode produced from bought-in copper anode)

87%

Carbon steel from cold ferrous feed (saleable continuously cast)

86%

Polyethylene

83%

Carbon steel from cold ferrous feed (saleable flat products)

79%

Integrated iron and steel (saleable flat products carbon steel)

79%

Copper (saleable cathode)

78%

Packaging and industrial paper (air dried pulp)

78%

Cartonboard (air dried pulp)

78%

Printing and writing paper (air dried pulp)

78%

Dry pulp (air dried pulp)

78%

Tissue paper (air dried pulp)

78%

Copper (saleable anode)

76%

Tissue paper (saleable rolls)

72%

Manganese (saleable silicomanganese alloy)

70%

Magnesia (saleable deadburned magnesia)

66%

Estimated using allocative baselines (per unit of production, prior to the application of assistance rate) as per Australian Government (2011) Establishing the eligibility of emissions-intensive trade-exposed activities 22

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

EITE activity

Percentage of carbon units associated with Scope 2 emissions

Manganese (saleable ferromanganese alloy)

65%

Carbon steel from cold ferrous feed (saleable long products)

64%

Integrated iron and steel (long hot rolled carbon steel)

64%

Packaging and industrial paper (saleable uncoated)

62%

Printing and writing paper (saleable rolls)

59%

Pulp and paper (air dried newsprint)

58%

Methanol

54%

Carbamide (urea)

48%

Cartonboard (saleable rolls)

47%

Integrated iron and steel (iron ore pellets)

39%

Glass containers

38%

White titanium dioxide pigment

38%

Dry pulp (saleable rolls)

32%

Alumina

27%

Flat glass

25%

Integrated lead and zinc (saleable lead metal)

24%

Integrated lead and zinc (zinc-in-fume)

21%

Petroleum

21%

High purity ethanol

19%

Synthetic rutile

16%

Carbon black

16%

Integrated iron and steel (iron ore sinter)

15%

Sodium carbonate (soda ash) and sodium bicarbonate

14%

Ethene (ethylene)

13%

Manganese (saleable manganese sinter)

10%

Integrated iron and steel (saleable continuously cast carbon steel products and ingots)

Integrated iron and steel (coke oven coke)

Clinker

Magnesia (saleable caustic calcined magnesia)

Integrated iron and steel (lime)

Lime

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

In addition, credits may be sourced in the form of ACCUs from the Carbon Farming Initiative (CFI). The CFI credits are expected to originate from abatement in agriculture, legacy waste, land use change and sequestration in the forestry sector.23 However, there is significant uncertainty regarding the volume of ACCUs expected to be generated under the CFI, which is only to be expected given that the scheme and many of the project types are new. In April 2011, DCCEE released a set of indicative emissions reduction estimates likely to be achieved under the CFI in 2020. The DCCEE paper estimates “likely” emissions reductions to be achieved in 2020, not on a cumulative basis, for both Kyoto (compliance) activities and non-Kyoto (voluntary) activities. It concludes that compliance activities are expected to reduce emissions by between 4.7 MtCO2-e and 15.6 MtCO2-e in 2020. Voluntary activities are expected to reduce emissions by between 1 MtCO2-e and 6 MtCO2-e.24 Certified Emission Reduction (CER) credits will also play a role in the supply of credits for liable entities. CERs are credits for emissions which are reduced through projects in the Clean Development Mechanism (CDM) program. This program allows industrialised countries to make the most cost-efficient investment in emissions reductions globally.25 CER credits will not be effective in Australia until 1 July 2015, which is the start of the flexible price period. Under the CPM, a liable entity will be able to purchase international credits to offset up to 50 per cent of its emissions liability from 1 July 2015. Due to a combination of factors, including European economic growth and the changing CER eligibility criteria under schemes such as the EU ETS, the likely prevailing CER price in 2015 remains highly uncertain.

http://cache.treasury.gov.au/treasury/carbonpricemodelling/content/report/downloads/Modelling_Report_Consolidated.pdf

Carbon Market Institute “Implementing The Carbon Farming Initiative-A Guide For Business” February 2012 <http://www. carbonmarketinstitute.org/publications/implementing-the-carbon-farming-initiative-a-guide/> 24

http://www.econ.cam.ac.uk/rstaff/grubb/publications/J36.pdf

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

3. CHARACTERISTICS OF A SUCCESSFUL MARKET

3.1 TYPICAL CHARACTERISTICS OF A SUCCESSFUL MARKET

certain stakeholders (i.e. the government acting in the greater public interest) may be placed above other potential market participants such as speculators.

A â&#x20AC;&#x153;successful marketâ&#x20AC;? could be defined as one that meets the objectives of a wide range of potential stakeholders. The challenge in defining a successful market is that many of the market attributes which would commonly be considered as key to a well-functioning market may be considered important by some stakeholders and not by others. There is a social value question implied here which suggests that the interests of

While there is no standard framework or commonly accepted definition of a successful market, a range of characteristics are widely recognised as indicators of, and important for, a well-functioning market (Figure 3). These features are overlapping and mutually supportive in many cases as they build confidence in the market and encourage participation.

Figure 3: Characteristics of a successful market

Enables management of counterparty credit risk Facilitates mgmt of compliance obligations and price risk

Allocate efficiency Adequate liquidity

Adequate depth Characteristics of a successful market

Low transaction costs

Adequate transparency

Market integrity

Efficient price discovery Market certainty

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

3.1.1 ALLOCATIVE EFFICIENCY Allocative efficiency refers to the ability of a market to efficiently transfer tradable units (in this case, eligible emissions units) to where they have the highest value use, at low cost and minimum risk. In theory, this should facilitate low cost abatement for the market as a whole. The goal of maximising allocative efficiency builds on the premise that certain allocations are objectively better than others. For example, an economist might say that a change in policy increases allocative efficiency as long as those who benefit or â&#x20AC;&#x153;winâ&#x20AC;? from the intervention (for example, the public) gain more than the losers lose (for example, impacted industries). The concept of allocative efficiency is the basis for the use of market-based mechanisms for climate change mitigation. As the physical location of carbon reductions achieved does not affect the overall impact over those reductions, it makes sense that carbon is reduced where this is most cost effective. Full allocative efficiency can rarely be achieved in practice due to physical, regulatory or other constraints. For example, carbon markets are constrained by the need for the Government to balance socio-economic objectives in their design, as was seen through the allocation process adopted in the EU ETS (Box 5). This is also the case in the design of the Australian CPM, where limits and other restrictions have been placed on the availability and transferability of tradable units.

BOX 5: CONSTRAINTS TO ALLOCATIVE EFFICIENCY IN THE EU ETS National Allocation Plans (NAPs) were used to set out the total quantity of EUAs that Member States were to grant their companies in the first (2005-2007) and the second (2008-2012) trading periods of the EU ETS.26 Only a small proportion of EUAs were auctioned.27 The free allocation of EUAs, whilst required to support political acceptability of the scheme and facilitate its initial establishment, limited allocative efficiency and led to windfall profits for many participants.28 From the start of the third trading period in 2013 about half of the allowances are expected to be auctioned. This is expected to promote the achievement of allocative efficiency as it encourages those who value allowances most to pay for them.

European Commission Climate Action (2010), Directorate General for Climate Actions, viewed 9 December 2011 <http:// ec.europa.eu/clima/policies/ets/allocation/index_en.htm> 26

European Commission Climate Action (2010), Directorate General for Climate Actions, viewed 9 December 2011 <http:// ec.europa.eu/clima/policies/ets/auctioning/index_en.htm> 27

World Bank (2010), State and Trends of the Carbon Market 2011, Carbon Finance at the World Bank, viewed 9 December 2011 <http://siteresources.worldbank.org/INTCARBONFINANCE/Resources/State_and_Trends_Updated_June_2011.pdf> 28

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

3.1.2 ADEQUATE LIQUIDITY A liquid market is one in which there is a significant number of ready and willing buyers and sellers at all times. A liquid market offers entities confidence that they can trade as and when required to meet compliance obligations and manage risk, and ensures that pricing will reflect a “fair market price”. It is often stated that “liquidity begets liquidity” – i.e. increased liquidity increases the confidence of market participants, therefore encouraging further participation and liquidity. Furthermore, many of the other market characteristics (for example, market certainty and adequate transparency) support the development of liquidity. Liquidity in a new environmental market typically builds over time, as was seen in Australia’s National Electricity Market (NEM) (Box 6). Liquidity can be increased or reduced by a wide range of factors. For example, the global carbon market saw five consecutive years of robust growth, stalling at a value of US$142 billion in 2010, with various components of the market suffering from regulatory uncertainty, particularly impacting the value of the CER market, the Assigned Amount Unit (AAU) market, and the market for allowances under the US Regional Greenhouse Gas Initiative (RGGI) (Figure 4).

BOX 6: DEVELOPMENT OF LIQUIDITY IN THE NEM & GLOBAL FX MARKETS In the initial years of the NEM there was a lack of liquidity in the financial contracts market for short-term contracts. This situation arose because state governments vested generators and retailers with financial power purchase contracts to cover the sale of electricity to the non-contestable franchise customers who were on a fixed retail tariff. In the first year of the NEM, the level of vested contract cover averaged 95 per cent in Victoria and NSW. The level of vested contract cover declined over five years as retail contestability was introduced for more customers by tranche (for example, customers whose annual consumption exceeded a threshold level were eligible to choose their own retailer). As the volume of contestable customer load grew, so did the liquidity in the financial contracts market for short and medium term contracts, which were traded either OTC or in the Sydney Futures Exchange. A market with perhaps the highest level of liquidity is the global foreign exchange market, and particularly the EUR/USD market. This has arguably the largest trading volumes of any financial market (with approximately US$4 trillion average daily turnover), significant liquidity, and a large number of participants trading across multiple geographies (often with low regulatory constraints) 24 hours per day, with many factors influencing supply and demand. This market consequently is characterised by very tight bid/offer spreads which may be no more than two basis points.29

http://au.ibtimes.com/articles/110821/20110210/what-is-foreign-exchange-currency-conversion-financial-markets-forex-foreignexchange-markets.htm 29

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Figure 4: Growth of the global carbon market30

150

90 60

US$ billion

120

30 0 2005 EU ETS Allowances

2006

2007

Other Allowances

»» Market liquidity is typically supported by: The presence of financial intermediaries (exchanges, brokers, banks, etc) and speculators. »» The involvement of “market makers” who are willing to quote bid and offer prices simultaneously. In the Australian carbon market, factors which could be expected to influence liquidity include: »» The extent of linking with international markets (which increases the number of buyers and sellers as well as the number of eligible emissions units available for trading). »» Certain features of auction design, including frequency of auctions, limits on parcel sizes, the range of allowable participants and ontradability. »» Controls to prevent “hoarding” of carbon units (such as disclosure requirements for significant holdings, though any resulting reduction in banking of eligible emissions units to meet future needs could have an impact on longer term liquidity).

2008

Primary CDM Secondary

2009 Secondary CDM

2010 Other Offsets

3.1.3 ADEQUATE DEPTH Depth refers to the ability of a market to handle large trade volumes without a significant impact on prices. The concept of market depth is closely linked to that of liquidity in that a deep market is also a liquid market, and vice versa. Market depth can be affected by a range of factors, including market trading restrictions, price movement restrictions, parcel size and tick size. Market depth is particularly important in the secondary market (for a discussion of primary and secondary markets see section 2.1). Without adequate depth, the secondary Australian carbon market is at risk of significant liable entities and/or banks with large balance sheets being able to consistently move the market. Another example of the importance of market depth can be found in the Dated Brent crude oil assessment, where changes in traded volumes have impacted vulnerability to major price movements (Box 7).

World Bank (2011), State and Trends of the Carbon Market 2011, Carbon Finance at the World Bank, viewed 9 December 2011 <http://siteresources.worldbank.org/INTCARBONFINANCE/Resources/State_and _Trends_Updated_June_2011.pdf> 30

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 7: IMPACT OF MARKET DEPTH ON PRICE VOLATILITY IN THE DATED BRENT (BFOE) ASSESSMENT A significant amount of the world’s crude oil is priced off the Platts daily Dated Brent (BFOE) assessment. This assessment was originally based on the price of physical trades of Brent crude oil itself, and over time the depth of this market declined in reflection of the physical supply of this marker crude. However, the natural decline in production of Brent crude oil led to the inclusion of physical trades in other similar light sweet crude oils (Ekofisk, Forties and Oseberg) within the benchmark assessment. As a result, the assessment became less vulnerable to significant price movements based on only a small number of physical trades, and ultimately led to an overall increase in market depth.31

Transparency includes availability of “fundamental” and “transactional” data. In a carbon market, fundamental data primarily relates to market supply and demand. For example: »» Emissions of liable entities. »» The dynamics of the primary market, including volume of permits allocated free by sector and details of auction activity. »» Shortfalls in surrender and extent of noncompliance.33 The reporting of some fundamental data is being made available to market participants by the Clean Energy Regulator (CER) through the use of the Liable Entities Public Information Database. The database will use a phased approach, but will ultimately contain a comprehensive list of liable entities with detailed information such as34: »» Liable entities’ emissions numbers (from 1 July 2013). »» Estimated total emission numbers (before 28 February 2014).

3.1.4 ADEQUATE TRANSPARENCY

»» Surrendered eligible emissions units (from 15 June 2013).

Adequate transparency relates to the provision of sufficient information to the market on trading activity while still respecting commercial sensitivities. Transparency also applies to the data that validates the underlying physical supply and demand positions. Market transparency increases the ability of participants in a specific market to make informed trading decisions. It is important to the efficient operation of the secondary market, helping to reduce transactions costs and achieve price discovery, which will reduce price volatility and encourage participation (therefore promoting liquidity).

Transactional data, in contrast, relates to actual and forecast activity in the secondary market, including eligible emissions unit volumes and pricing. The majority of transactional information requirements in a market are typically fulfilled by the private sector, which undertakes analysis and communicates results based on data provided by organisations.

At the same time, transparency is one of the basic tools available to counter various forms of market misconduct.32

»» Unit shortfalls (from 2 February 2014).

Market transparency has been limited in the EU ETS due to a range of factors, including the absence of a harmonised regulatory and market surveillance system,35 and numerous commentators have proposed changes to support its improvement, including the International Emissions Trading Association (IETA) (Box 8).

http://www.platts.com/IM.Platts.Content/methodologyreferences/methodologyspecs/crudeoilspecs.pdf

European Commission (2010), Communication from the Commission to the European Parliament and the Council, European Commission, viewed 9 December 2011 <http://ec.europa.eu/clima/news/docs/communication_en.pdf> 32

For full details on information which will be published by the Regulator in an electronic, web-based Liable Entities Public Information Database, see: Carbon Market Institute (2011), Carbon Market Integrity: A Review of the Australian Carbon Pricing Mechanism, CMI, viewed 9 December 2011 <http://www.carbonmarketinstitute.org/about> 33

http://www.cleanenergyregulator.gov.au/Carbon-Pricing-Mechanism/Public-information-databases/Pages/default.aspx

République Française Ministère de l’économie, de l’industrie et de l’emploi, 2010, La régulation des marchés du CO2 -Rapport de la mission confiée à Michel Prada. 35

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 8: PROPOSALS TO IMPROVE TRANSPARENCY IN THE EU ETS In a position paper on market integrity and transparency for the EU’s carbon market,36 IETA recommends measures to improve transparency over fundamental data. These include more frequent, and at least, quarterly estimations of aggregate emissions (by sector and by country) in the system, as well as data on emissions projections by sector assembled from all Member States published at least annually. In relation to transactional data, it notes that the availability of pre-trade data – for example, liquidity, price level, bidoffer spread, etc – is generally good in the carbon market due to the high level of transactions executed on exchanges/ via platforms. It suggests that delayed data (published reasonably close to “real time”) which respects critical commercial sensitivities related to the occurrence and volume of all transactions executed in an electronic trading system (for example, on exchanges/MTF) could provide reliable price information on liquid standardised contracts, helping parties to gain a better understanding of market evolution and key trends.

It is not yet clear how much transactional data will be readily available in the Australian carbon market. Much will depend on how much transactional data will be released by the Clean Energy Regulator (CER) or through brokers and exchanges. In the global carbon market, transparency is limited by the absence of harmonised accounting standards for emissions allowances. After a failed attempt to establish accounting rules in 2004 (IFRIC 3 which was withdrawn), the International Accounting Standards Board (IASB) started a joint project in 2008 with the Financial Accounting Standards Board (FASB) in the United States to develop comprehensive guidance on the accounting for emissions allowances.37 However, to date this work has not been completed. (See CMI report, A Guide for Business: Reporting and Accounting Requirements for the Australian Carbon Market.)

3.1.5 EFFICIENT PRICE DISCOVERY Price discovery is the process of determining the price of a tradable asset (in this case an eligible emissions unit) through the interaction of buyers and sellers. In a market with efficient price discovery, price-relevant carbon market information is available to market participants in a timely manner, and the price of eligible emissions units reflects this information. Efficient price discovery enables market participants to develop forward curves, mark trading positions to market, and builds confidence in trading. Outside of the market, it also enables participants to make informed investment decisions on investment in carbon abatement. The concept of efficient price discovery is closely linked to that of transparency in that a transparent market is important to support efficient price discovery. Efficient price discovery is supported by the unrestricted interaction of price drivers (exogenous and endogenous) such as weather, fuel prices, economic growth, availability of working capital and the issuance of eligible emissions units into the primary market, so that prices realistically reflect fundamental supply and demand and enable price discovery. Short-term trading or the regular release of pricing information typically supports price discovery, as seen in the Australian electricity market (Box 9). By definition, price discovery in the Australian carbon market will be extremely limited during the fixed price period. Thereafter, price discovery could be constrained by the floor and ceiling prices within the CPM, and by other limitations such as constraints on the use of international carbon offsets and any future market intervention made by regulatory bodies. In addition, certain OTC transactions may not be discoverable.

IETA (2010), Market integrity and transparency regime for the EU’s carbon market IETA Position Paper, IETA, viewed 9 December 2011 <http://www.ieta.org/assets/PositionPapers/ieta%20final%20position_oversight%208-06-10-web.pdf> 36

IFRS (2010), Emission Trading Schemes, International Accounting Standards Board, viewed 9 December 2011 <http://www.ifrs. org/Current+Projects/IASB+Projects/Emission+Trading+Schemes/Emissions+Trading+Schemes.htm> 37

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 9: PRICE DISCOVERY THROUGH SHORT-TERM TRADING IN THE NEM AND AUSTRALIAN GAS MARKETS The NEM has a physical spot market which is critical for the real-time balancing of electricity demand by consumers and generation supply by the Australian Energy Market Operator (AEMO). The half-hourly spot prices promote a high level of price discovery, providing important price signals which allow generators and retailers to manage their spot exposures (price and volume) through financial derivative contracts. This in turn has enabled the development of an active OTC and exchange traded forward market which trades two to three years out. This makes for an interesting comparison with the Australian gas markets where the majority of the gas volume is still largely transacted through confidential bilateral contracts between gas producers and users. However, a more transparent physical spot market with good price discovery has been established in Victoria, which is used by participants to trade imbalances between the actual amount required on a given day as compared to their contracted amount for that day. In addition, a short-term trading market which also allows price discovery in balancing markets has now been rolled out by the AEMO for gas hubs in Sydney, Adelaide and Brisbane. It is possible over time that this daily balancing price may be used by participants to price more of the overall gas volume.

3.1.6 MARKET AND REGULATORY CERTAINTY All markets benefit from operating within a secure regulatory framework around which there is broad political consensus. Longer term markets can develop and less risk needs to be priced into those markets. Market certainty is crucial in building confidence of market participants and encouraging liquidity. It enables participants to make informed decisions, which in a carbon market relates to trading and investment in carbon abatement outside of the market. Market uncertainty can be a particular issue with regards to carbon markets which – rather than being natural – are markets established by government policy, and therefore are vulnerable to political and policy changes by the Government. Important areas of possible uncertainty relate to the future existence and design of the market, and the level of any “pollution caps” (which fundamentally influences demand for eligible emissions units). In the Australian carbon market, pollution caps will be set by the Climate Change Authority (CCA), established as an independent authority which will recommend caps based on rolling five-year periods. The function will operate independently with no affiliation to either political party, similar to the Reserve Bank of Australia (RBA), and will be headed up by exRBA Governor Bernie Fraser. However, there could still be further Government intervention, and changes to legislation in the future depending on the prevailing political climate. The EU ETS and the Australian REC market have both been subject to some uncertainty which has impacted the dynamics of the market at one or more points in time (Box 10).

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 10: UNCERTAINTY IN THE EU ETS AND THE AUSTRALIAN REC MARKET In the EU ETS there has been significant uncertainty for a number of years over the role of the CDM and the use of CERs post2012. This uncertainty relates to: »» Whether the CDM will continue to operate post-2012 as it does today, and whether delays at the level of the CDM Executive Board continue to affect volume forecasts. »» Whether CERs from particular countries or projects (such as HFC23 or other industrial gas projects) will be restricted, and if so, how these restrictions would apply (when would these restrictions come into effect, and whether they would impact existing or future projects).38 This uncertainty was reflected in the price of EUAs and secondary CERs. As at October 2010, the forward price of EUAs extended to 2014, while the price of CERs was much less clear post-2012. In the Australian REC market there have been various changes by the Government which have led to uncertainty for investors, and significant volatility in the spot price for RECs since its launch in 2001. These changes include: »» Expansion of the Renewable Energy Target (RET) in August 2009 (some 18 months after announcement of the intention to expand by the then Opposition Leader Kevin Rudd).

3.1.7 MARKET INTEGRITY Market integrity refers to a fair and orderly market which is free from fraud and other manipulative behaviour. Market integrity is important for building the confidence of market participants and encouraging liquidity. Market integrity is typically supported by an appropriate governance process, well-resourced regulators with clear roles and responsibilities, and a robust set of systems and processes for transacting on the primary and secondary market. Both the Clean Energy Regulator (CER) and the Australian Securities and Investments Commission (ASIC) will play important roles in the effective regulation of the Australian carbon market. For further discussion of the Australian carbon market regulatory framework, refer to section 4.2.1. One way in which a failure in market integrity can arise is when one participant or a small number of colluding participants are able to build a large enough position in a product to artificially manipulate the market price. There have been a number of such examples in commodity markets. One well-known example occurred when a trader allegedly inflated the price of copper for nearly a decade up to 1995. Ultimately, the scheme collapsed, resulting in a reported loss of US$2.6 billion for the company and imprisonment for fraud for the trader.39 A number of incidences of fraud and other manipulative behaviour in the EU ETS during 2009-2011 highlight the vulnerability of a carbon market to issues of integrity (Box 11).

»» An increase in Government rebates for solar hot water systems and heat pumps which led to a significant surplus of RECs and depressed prices. »» Less than six months after the Expanded RET scheme was enacted, the scheme was split into two separate markets – the Large-scale Renewable Energy Target (LRET) and the Smallscale Renewable Energy Scheme (SRES).

PwC (2010), Carbon Valuation Post 2012, PwC, viewed 9 December 2011 <http://www.environmental-finance.com/download. php?files/pdf/4cc005308d8b2/PwC%20carbon%20valuation%20post-2012%2019Oct10.pdf> 38

http://www.nytimes.com/2000/05/25/business/international-business-merrill-to-pay-sumitomo-to-settle-copper-losses. html?ref=yasuohamanaka 39

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 11: MARKET INTEGRITY ISSUES IN THE EU ETS BETWEEN 2009-2011 The following incidents took place within the EU ETS between 2009-2011, highlighting vulnerability to issues of market integrity: »» January 2011: Discovery of an EU ETSwide theft of €45 million worth of EU allowances led to the closure of national carbon registries, the suspension of spot trade, and the implementation of an EU-wide upgrade of registry security. »» November 2010: An incident of unauthorised access to EU ETS registry accounts in Romania resulted in the theft of 1.6 million EUAs.

3.1.8 LOW TRANSACTION COSTS It is important within any market that there are low transaction costs, encouraging participation and therefore liquidity. Allowing competition between competing exchanges and the various OTC platforms may support lower transactional costs. Several exchanges evolved to service the EU ETS market, which are outlined in section 3.1.10. At the time of this report, the range of potential Australian exchanges includes ASX, Mercari FEX and CTX. Additionally, the design of the Government auction process and associated costs of participation will also be important in encouraging a broad range of market participants.

»» November 2010: The German Registry closed due to Trojan virus Nimkey. »» March 2010: Hungary sold CERs that had already been surrendered to it under the EU’s emissions trading system. In response, the EU amended the registry regulations to prevent CER recycling. »» September 2009: European Commission proposed measures for a consistent response to deal with VAT or carousel fraud detected in the market in 2009–2010. »» January 2009: Widespread phishing attacks on users of EU ETS registries prompted the EU to revise internet security guidelines. Numerous lessons have been learned from issues related to market integrity in the EU ETS. Implications for regulatory oversight in the Australian carbon market are discussed in section 5 of this report.

3.1.9 FACILITATES MANAGEMENT OF OBLIGATIONS AND UNDERLYING PRICE RISK It is important that market participants are able to manage both volume and price risk i.e. to acquire sufficient eligible emissions units in a timely manner to meet market or compliance obligations, and manage the risk that the price of eligible emissions units may change significantly over time. An active derivatives market can contribute to this outcome. Indeed, the Brent futures market developed over time through the need for participants in the spot market to manage both price and volume risk (Box 12).

For a more detailed discussion of market integrity, please refer to the CMI report, Carbon Market Integrity: A Review of the Australian Carbon Pricing Mechanism.40

http://www.carbonmarketinstitute.org/carbon-market-reports/attachments/comms_communications/web-carbon-marketintegrity-aus-cpm-290312.pdf 40

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 12: THE DEVELOPMENT OF AN ACTIVE DERIVATIVES MARKET FOR BRENT CRUDE OIL Nationalisation of oil production in OPEC countries during the 1970s meant that the major oil companies no longer had access to their own crude oil, and had to buy oil on the open market. Non-OPEC oil production also grew, which further created the need for spot markets to replace volumes previously contracted under traditional term markets. The development of the active spot markets, the need for price discovery and the need to manage both price and volume risk led to the development of the 15-day Brent forward contract, and the light sweet crude oil futures market on the Nymex. These in turn supported the development of the Brent futures market on the International Petroleum Exchange and other derivatives markets.41 Hence, the market evolved from term contracts to spot delivery supplemented by OTC forward and exchange traded futures, and more complex derivatives markets.

The EU ETS also offers an example of how a derivatives market can emerge for management of carbon price risk – discussed in section 5 of this report.

3.1.10 ENABLES MANAGEMENT OF COUNTERPARTY CREDIT RISK It is important that market participants are able to assess and manage counterparty credit risk associated with trading activity i.e. the risk that a counterparty may fail to pay for or fail to deliver eligible emissions units in line with an agreement. Indeed, the recent global financial crisis has increased the focus on the management of counterparty credit risk across financial and commodity markets.42 The presence of exchanges - which act as a central counterparty (CCP) with standard contracts and clearing guarantees - reduces the credit exposure of the parties involved. In addition, growing regulatory incentives under the Dodd Frank Act and Basel III are moving banks towards cleared and settled derivatives products (discussed in section 5 of this report). In the EU ETS, the benefits of clearing and settlement played an important role in the growth of exchange trading. During phase 1 of the scheme, 70 per cent of trades were OTC,43 with remaining trades taking place through six trading platforms: »» European Climate Exchange (ECX). »» Bluenext. »» Nordpool. »» The European Energy Exchange (EEX). »» Energy Exchange Austria (EXAA). »» Climex Alliance. During 2008, the deepening of the global financial crisis increased concerns over counterparty credit risk, encouraging the growth of exchange trading relative to OTC (Figure 5), although some market participants continue to prefer managing this risk by trading OTC with known counterparties. 44

P.Horsnell and R.Mabro (1993), Oil Markets and Prices, The Brent Market and the Formation of World Oil Prices, Oxford Institute For Energy Studies 41

http://www.rba.gov.au/speeches/2011/sp-ag-201011.html

A.Kossoy and P.Ambrossi (2010), State and Trends of the Carbon Market 2010, World Bank, viewed 9 December 2011 <http:// www.economicsclimatechange.com/2010/06/state-and-trends-of-carbon-market-2010.html> 43

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Figure 5: Transactions in the EU ETS on exchanges versus OTC from 2005 to 201045 100% 90% 80% 70% 60% 50% 40% 30% 20%

Exchanges

3.2 STAKEHOLDER PERSPECTIVES OF SUCCESS As discussed in 3.1, it is important to recognise that different stakeholders within a carbon market will have different objectives, and would therefore place differing levels of emphasis on the above attributes. »» Government perspective: The carbon market is created by Government to meet a policy objective i.e. to introduce a mechanism which will assist Australia in meeting its carbon reduction targets in a cost effective manner. Allocative efficiency could therefore be regarded as a key indicator of success. However, the Government also balances broader related socio-economic objectives that impact on design features of the CPM, such as:

Jan-10

Sep-09

May-09

Jan-09

Sep-08

May-08

Jan-08

Sep-07

May-07

Jan-07

Sep-06

May-06

Jan-06

Sep-05

May-05

Jan-05

10%

OTC

– In the flexible period from July 2015 to July 2018, the use of an initial floor price of $15, rising at four per cent annually in real terms, and a ceiling on the price of eligible emissions units of $20 above the international price.47 »» Liable entity perspective: For liable entities, the primary objective may be compliance with the CPM at a lower cost than competitors. Characteristics such as liquidity, depth, price discovery, certainty, integrity and transparency will all be very important, as will the ability to hedge risk. »» Speculator perspective: Speculators, in contrast, may prefer some level of volatility in the market, and therefore may be less concerned about market liquidity and depth. They may however be particularly concerned by other factors, such as market integrity and the ability to mitigate counterparty credit risk.

– Provision of transitional assistance to EITE industries, which includes assistance rates of 94.5 per cent for highly emissions intensive activities and 66 per cent for moderately emissions intensive activities. These allocations will be reduced by a rate of 1.3 per cent per annum.46

»» Market infrastructure provider perspective: Market infrastructure providers make a profitable return through provision of these services based on volumes transacted. It is likely therefore that their view of success will involve greater use of their infrastructure for the purposes of trading.

– Prohibiting the use of international units during the fixed price period, and then limiting to a maximum of 50 per cent from commencement of the flexible price period.

Equally, there will be different perspectives on what constitutes a “market failure”. Market failure may occur because of imperfect knowledge, differentiated non-standardised goods, concentrated market power (for example, monopoly or oligopoly) or the existence of externalities.

– A five per cent limit on the use of ACCUs during the fixed price period, and then no limit from the commencement of the flexible price period.

Australia’s Clean Energy Legislative Package, pg 74, Appendix 2

http://www.cleanenergyfuture.gov.au/clean-energy-future/securing-a-clean-energy-future/

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

4. FACTORS WHICH COULD SUPPORT THE EVOLUTION OF A SUCCESSFUL CARBON MARKET There are a number of factors which were highlighted by stakeholders during this research as important for success of the carbon market. The following factors were identified to support confidence in the market, encourage and sustain market participation and encourage liquidity: »» Stable policy environment. »» Appropriate regulatory oversight for market integrity. »» Robust arrangements for release of market sensitive information. »» Robust systems and processes for registration, trade settlement and transfer of ownership. »» Information and signals for price discovery. »» Access to central clearing for management of counterparty credit risk.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

4.1 STABLE POLICY ENVIRONMENT As outlined in section 3.1.6 of this report, market and regulatory certainty is one of the key characteristics of a successful market. A number of stakeholders highlighted the importance of a stable policy environment for the evolution of a successful carbon market in Australia. Indeed, “sovereign risk”, “regulatory risk” and the “risk of legislative repeal” were all cited as key concerns amongst those interviewed. Stakeholders suggested that current discounts in the cost of carbon traded by power sector participants are evidence that regulatory risk is already being “priced in” to the market. Potential consequences of an unstable policy environment highlighted by stakeholders include: »» Trading of Australian carbon units at a discount to international units (as international units would be more likely to retain their value in the event of legislative repeal in Australia). »» Possible constraints to forward contracting, and a preference to “buy and bank” eligible emissions units over buying forward to hedge exposure (participants will not be able to bank units from the fixed to flexible price period other than ACCUs, eligible international units or carbon units purchased in 2014 auction for use in the flexible price period). »» Increased perception of counterparty credit risk linked to a reversal of transitional assistance packages. »» Limited ambition in relation to, and slow development of, the Carbon Farming Initiative (influenced in part by the experiences of investors in Greenhouse Friendly projects). »» Slow transformation of the existing electricity supply mix in Australia. Bipartisan support was recognised as a key factor in reducing the current level of perceived sovereign risk. Currently, the minimum five per cent emissions reduction by 2020 has bipartisan support; however the policy mechanism to achieve the emissions reduction target does not have such support. One stakeholder suggested that “we need five years without change in order to build investment and gain an understanding of how the market works”.

Ultimately, the success of the Australian market in meeting its overarching environmental objectives will depend on the level of investment made in low carbon abatement, which will be necessary to drive a reduction in greenhouse gas emissions over time. As with any long-term investment decision, a stable policy environment will be critical in reducing project risk and enabling companies to secure the finance required. Furthermore, a stable policy environment will be crucial in providing stakeholders in the Australian carbon market with confidence to participate by taking trading positions or developing infrastructure and business services to support trading activity, thus supporting the overall development of the market.

4.2 APPROPRIATE REGULATORY OVERSIGHT TO SUPPORT MARKET INTEGRITY As identified in section 3.1.7 of this report, market integrity is a key feature of any successful market. The Australian carbon market will need to be a fair, efficient and transparent market in which people can participate with confidence. As with any market, there is potential for abuse to take place, for example, in the form of collusion, market manipulation, fraud and theft of eligible emissions units. This risk could be heightened during the early days of the market while there are relatively few participants, experience is limited, and systems and processes are new. In the medium to long term, bilateral links established with international schemes could also increase exposure of the Australian carbon market to market integrity risk (either arising due to the control environment in linked systems or at the interface between systems). Stakeholders consulted for this report made a range of observations in relation to the: »» Roles of the various organisations involved in regulation of the market and promotion of market integrity. »» Interaction between regulators. »» Need for a balanced approach to regulation of the carbon market.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

4.2.1 ROLES OF ORGANISATIONS INVOLVED IN REGULATION ASIC will play an important role in the oversight of the Australian carbon market to support market integrity. As discussed in section 2 of this report, it will apply its existing regulatory regime for financial products (and in particular its licensing framework) to the Australian carbon market. In fulfilling this role, ASIC will need to give consideration to the following: »» There may be “nuances” pertaining to risks in the carbon market which ASIC will need to consider in its regulatory approach. These may relate, for example, to the lack of an underlying physical product and the associated difficulty in ascertaining ownership, as well as the number and experience of expected market participants (which may be limited in the early days of the market). »» The skills and credentials which should be required of market participants in order to secure a licence (either an Australian Financial Services Licence or a licence to be an Australian Market Operator) and develop processes for assessing these. The recent release of ASIC’s RG 236 has helped to clarify this issue. »» Its oversight role in relation to accounting disclosures will be complicated by the fact that there are no accounting standards for treatment of eligible emissions units, and a wide range of different practices adopted by companies in other countries. »» As the Clean Energy Regulator is the operator of the auction, it will have immunity of the Crown, and will therefore not need to be licensed under the Corporations Act (unless legislation is made to indicate otherwise). ASIC will therefore need to work closely with the Clean Energy Regulator to ensure overall integrity of the system, and will need to ensure that arrangements are in place to manage the interaction between the auction process and the secondary market.

The Clean Energy Regulator was established on 2 April 2012 through the CELP, and will be responsible for management of both the Registry and the auction. The Regulator will need to ensure that there is robust security within the Registry, and controls to prevent fraudulent behaviour, learning lessons from recent thefts of emissions allowances from registries within the EU (the situation in Europe was complicated by the existence of different registries in each countries which are now being replaced by a single EU Registry).48 One stakeholder suggested that management of the Registry by the Regulator would create a conflict of interest since the Regulator is also the primary issuer of eligible carbon units, and so is in effect regulating itself. They proposed a similar approach to that used in the Australian bond market (where Austraclear effectively acts as an independent “sub-registry”). The Regulator will also need to ensure that the auction has robust controls in place to prevent fraudulent or manipulative market behaviour. As outlined above, the auction will not be licensed by ASIC, but will need to have equivalent controls in place to support its integrity and prevent abuse of this market by participants. The Government will have an overarching role in making policy decisions rather than direct responsibility for day-to-day regulatory oversight of the primary or secondary markets. However, stakeholders suggested a possible role for the Government in guaranteeing eligible emissions units accepted into the Registry, in order to support market confidence (unless this is already explicit by acceptance on to the Registry). The Government can also support ongoing market integrity risk through its negotiations and agreements on international linking with country governments of other emissions trading schemes.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

4.2.2 THE INTERACTION BETWEEN REGULATORS

4.2.3 A BALANCED APPROACH TO REGULATION

Stakeholders noted that the interaction between regulators will be important for market integrity. This will include the way in which information is shared, the design of systems and processes for linking of the registry with the primary and the secondary markets (including mechanisms for transfer of ownership between participants). Recent legislation passed in France provides a useful example of collaboration between regulators in relation to a carbon market (Box 13).

While stakeholders supported the development of a robust regulatory framework for market integrity, they also highlighted the importance of maintaining a “balanced approach” to regulation which would not “stifle” the emergence of the carbon market, particularly in the context of increasing global financial market regulation. One stakeholder suggested that special consideration should be given to the Australian carbon market so that an appropriate level of regulation is applied to:

BOX 13: MEMORANDUM OF UNDERSTANDING FOR REGULATION OF THE FRENCH CARBON MARKET The new French Law on Banking and Financial Regulation (LBFR), based on recommendations in the Prada review,49 provides for oversight of the carbon market and its operators through two regulators: Autorité des Marchés Financiers (AMF) and Commission de regulation de l’énergie (CRE).50 AMF and CRE have signed a memorandum of understanding on the exchange of information, control and supervision of markets in greenhouse gas emissions allowances, electricity, natural gas and their derivatives.51 The memorandum of understanding is one of the LBFR’s applications, and it defines cooperation between AMF and CRE. Under the memorandum of understanding, AMF is responsible for overseeing the operation of the market in allowances and their derivatives, and CRE is responsible for the supervision of transactions carried out in allowances by energy market participants. CRE is also responsible for analysing the behaviour of allowances in relation to the economic and technical factors underpinning energy markets.

»» Short selling – which could make a contribution to price discovery and liquidity in the forward market. »» Sophisticated versus retail investors in the carbon market – which could be particularly relevant in relation to the Carbon Farming Initiative. »» Requirements for a financial services licence. Organisations such as the International Emissions Trading Association (IETA) and the Australian Financial Markets Association (AFMA) have developed precedent purchase and sale agreements in order to standardise and streamline risks and documentation between parties, and accordingly to facilitate and implicitly regulate trade. The IETA Master Agreement and the AFMA EP Spot Contract may be freely used.52 The transfer of emissions units and interests in emissions units via private OTC trades and/ or through licensed or exempt financial markets will only require the transmission of an electronic transfer instruction from the vendor to the Regulator if it is necessary to reflect a change in legal ownership.53 An example of a balanced approach to regulation can be found in the oil industry. The North Sea oil taxation regime in the UK created incentives for vertically integrated oil companies to enter in to arms-length transactions with third parties rather than transfer it directly in to their own refining systems. This promoted both liquidity and price transparency during the development of the spot and forward markets, but as the market became established, procedures and regulations were tightened and reduced those incentives.54

http://www.minefe.gouv.fr/services/rap10/100419rap-prada.pdf Access date 22 February 2011

http://www.amf-france.org/documents/general/9767_1.pdf Access date 22 February 2011

http://www.carbonmarketinstitute.org/carbon-market-reports/attachments/comms_communications/web-carbon-marketintegrity-aus-cpm-290312.pdf 52

http://www.carbonmarketinstitute.org/carbon-market-reports/attachments/comms_communications/web-carbon-marketintegrity-aus-cpm-290312.pdf 53

P.Horsnell and R.Mabro (1993), Oil Markets and Prices, The Brent Market and the Formation of World Oil Prices, Oxford Institute For Energy Studies 54

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

4.3 ARRANGEMENTS FOR THE RELEASE OF MARKET SENSITIVE INFORMATION Many of the stakeholders interviewed for this report stressed the need for clear and transparent arrangements for the release of market sensitive information. Stakeholders indicated that these arrangements should cover: »» The timing and process for release of market sensitive information. »» The accuracy and clarity of information released to the market.

4.3.1 THE TIMING AND PROCESS FOR RELEASE OF MARKET SENSITIVE INFORMATION Stakeholders interviewed suggested that the Government and organisations involved in the regulation of the carbon market should identify which aspects of information could be deemed “market sensitive”, and define a clear process for release of this information so that all market participants gain access to this information at the same time. Vulnerability to insider trading and volatility from leaks of market sensitive information can be a problem in a carbon market. The nature of the market – as an artificial government construct operating under the policy direction of the Government - creates a level of political risk and information asymmetry not present in many other markets. A select group of individuals often gain access to information (for example, regarding market design changes, pollution caps and emissions positions) in advance of the market.55

days leading up to both NAP and verifications information becoming public, suggested the occurrence of ‘systematic leakage of information across (all types of) announcements’.56 In Australia, there was an increase of more than six per cent in the share prices of both BlueScope Steel and One Steel in the week before announcements about the steel industry transitional assistance package. This increase equated to more than $300 million being added to their combined share market value. Some commentators attributed the rise to “information leaks” and resulting insider trading.57 One stakeholder suggested that the approach followed by the Reserve Bank of Australia (RBA) could be a good model to emulate in this regard. In this model, market information is released on pre-determined dates. Information is published by a single source, which helps to reduce information leakage. The model has proven successful in promoting the development of efficient markets.

4.3.2 THE ACCURACY AND CLARITY OF INFORMATION RELEASED TO THE MARKET The Government should ensure that any information released to the market, particularly related to policy announcements which will affect market design, is communicated with accuracy and clarity. Any inaccuracy or uncertainty as to the meaning of a specific announcement has the potential to stimulate trading based on “misinformation”, and/or act as a “handbrake” on the market, reducing liquidity. The release of information related to the banning of CERs from industrial gas projects (HFC-23 and N2O) from the EU ETS, and the price to be paid for Small-scale Technology Certificates (STCs) in the Australian REC market, provides an example of the impact that unclear information can have on a market (Box 14).

In the EU ETS, a number of “information leaks” related to National Allocation Plans (NAP) and verification announcements were blamed for volatility in the market. A study by the University of Sydney found significant returns on

http://www.sfe.com.au/content/sfe/trading/market_insights_issue_32_201007_july_2010.pdf

http://www.smh.com.au/business/insider-trading-canberra-leaks-then-seeks-answers-20110721-1hqwl.html

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 14: RELEASE OF INFORMATION IN THE EU ETS AND THE AUSTRALIAN REC MARKET In the EU ETS, a number of mistakes made over the release of information on the decision to ban CERs from industrial gas (HFC-23 and N2O) projects had a significant impact on the market. Information released to the market on the EU Commission, which was subsequently rescinded and revised, caused significant volatility in the price of EUAs during the course of a single trading day. Furthermore, as noted by a stakeholder consulted for this report, based on the initial announcement that CERs from HFC projects would not be eligible from January 2013, it was not clear whether CERs for compliance year 2012 (surrender date April 2013) would be eligible.58 This has since been clarified, and CERs from HFC will be eligible for the 2012 compliance year only. Similarly, as noted by a stakeholder consulted for this report, in March 2010 the Australian Government made an announcement that a $40 fixed price would be paid for a Smallscale Technology Certificate (STC) in the Australian REC market. Market participants believed that this was a floor price for the whole market for several months, prior to clarification that the $40 is the maximum that Small-scale technology certificates (STCs) are worth if they are settled through the clearing house at the end of each quarter.

In November 2011, the Australian Financial Markets Association (AFMA) released best practice guidelines on “Handling Confidential and Price Sensitive Information and Soundings”,59 which could be applied to the release of confidential and price-sensitive information in the carbon market. While these guidelines are quite specific in their application, the principles and objectives are broadly applicable: »» Assist to ensure commercially sensitive confidential information received is suitably protected. »» Minimise market risks that leaks prejudice undisclosed transactions, balanced against the need for price discovery processes necessary to facilitate corporate transactions. »» Assist market integrity and efficiency through the timely and orderly release of confidential and potential price sensitive information. »» Minimise the risks of insider trading occurring in relevant financial products. »» Assist in complying with applicable licensing and conduct rules. »» Protect and enhance the reputation of participants.

http://www.guardian.co.uk/environment/2011/jan/21/emissionstrading-eu

http://www.afma.com.au/afmawr/_assets/main/lib90010/afma%20sounding%20guidelines%20final.pdf

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

4.4 ROBUST SYSTEMS AND PROCESSES FOR REGISTRATION, TRADE SETTLEMENT AND TRANSFER OF OWNERSHIP Stakeholders consulted for this report noted that there will need to be robust systems and processes in place for registration, clearance and settlement of trades and transfer of ownership of eligible emissions units. The starting point for this is a robust registry and transfer of entitlement as permits moves through primary and secondary markets. There will be a need for frequent, timely and transparent dissemination of emissions, allowance and offset market data, including volume, price and a clear audit trail. For registration and clearance in the primary market in the Australian context, the Australian National Registry of Emissions Units (ANREU) is a system designed to meet one of Australia’s commitments under the Kyoto Protocol. The Protocol requires each country with an emissions reduction target to establish a national registry to ensure accurate accounting of the issuance, holding, transfer, acquisition, cancellation, retirement and carryover of Kyoto units. The ANREU links with the international carbon market through the International Transaction Log (ITL). The ITL is managed by the United Nations Framework Convention on Climate Change (UNFCCC) Secretariat. It verifies the validity of transactions of Kyoto units, including issuance, transfer and acquisition between registries. The projected scale of secondary market activity for eligible emissions units will require participants to have trade capture and settlement systems, information technology infrastructure, security, back-up systems, geographically redundant data centres, webbased access and reporting, and a robustness commensurate with the needs of the financial market. Even with seemingly strong system infrastructures, there will be risks that will need continuing assessment and mitigation actions as evidenced by the significant incidents which have occurred on registries used within the EU ETS (as highlighted in section 3.1.7 of this report).

4.5 INFORMATION AND SIGNALS FOR PRICE DISCOVERY As outlined in section 3.1.5 of this report, price discovery is one of the key characteristics of a successful market. The development of mechanisms to facilitate price discovery will be crucial for informing carbon abatement investment decisions, and therefore for the achievement of underlying environmental objectives which have driven the creation of the market. Furthermore, they will enable market participants to effectively develop a “forward curve” with which they can trade in the carbon market with confidence – thus promoting development of liquidity and the growth of the market as a whole. Indeed, stakeholders consulted during this research highlighted the importance of access to information and price signals for price discovery, and noted various factors which could limit price discovery in the Australian carbon market. These include: »» The existence of “dark pools”. Dark pools or non-transparent trading blocks may arise, where emissions intensive tradeexposed entities contract directly with power generation companies through bartering transactions, or where entities contract directly with CFI project proponents rather than buying units through the secondary market. »» A small number of market participants. This could increase the risk of large trades creating significant price movements and/or the risk of market manipulation, and may be particularly relevant during the early days of the market. »» Lack of understanding amongst liable entities of their emissions profile and abatement opportunities. This could be more prevalent amongst those at or near the liability threshold, and could limit their ability to accurately base carbon procurement decisions on their marginal cost of abatement. »» Lack of controls in place to prevent collusion or other forms of market manipulation. (For example, controls over the auction process.)

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Stakeholders noted several measures which could help to support price discovery in the Australian carbon market: »» Five-year pollution caps: Stakeholders generally considered the release of the Climate Change Authority’s (CCA) five-year pollution caps, extended every year, to be adequate for price discovery. »» Release of market information by the Government or the Regulator: To the extent that information required for price discovery is in the public domain, then the Government can allow the market to provide this. However, where critical information is in fact held by the Government or the Regulator, it should play an active role in the analysis and release of such data in a way that is orderly, predictable and respects critical commercial confidentiality. In order to develop a forward price curve, and therefore be able to trade with confidence in the market, market participants need access to rolling forward supply and demand projections, which are updated regularly (for example, covering the next five to ten years, updated on an annual or even quarterly basis). In order to overcome limitations in price transparency (for example, in the OTC trading environment and/or in dark pools), stakeholders suggested a possible role for the Government in requiring the release of certain market information (price, period and volume) on a regular basis to a regulatory or authorised body. The information could then be issued as part of a broader market report without revealing commercially sensitive details. This principle of legislated price transparency is one of a number of related aspects of the European Markets in Financial Instruments Directive (MiFID) that was designed

to increase competition and consumer protection in investment services.60 The London Energy Brokers Association, which handles a significant volume of OTC emissions trade, has issued guidelines to its members for execution policy under MiFID.61 »» Auction design: The auction process will play a key role in price discovery. Stakeholders noted various auction design parameters which could help to promote price discovery, including: – More frequent auctions, which could increase the regularity of price signals. – Earlier auctioning of units for the flexible price period (as committed to within the CELP), which would encourage price discovery in the forward market. Currently, a post-election auction is being discussed in the first half of 2014.62 – Involvement of non-liable entities in the auction process, which would promote liquidity and therefore price signals in the market. Indeed, broad participation is seen in the development of many successful commodity markets, including the 15-day Brent forward market.63 In the Australian carbon market, involvement of nonliable entities could possibly come with an obligation or an incentive to act as a “market maker” so as to promote liquidity and price discovery while limiting the opportunity for market manipulation. The ASX, for example, provides incentives for market makers in options markets.64 These design parameters appear to have been adopted by the Government in the proposed auction design. Below is an indicative auction schedule as set out by the Climate Change Authority (CCA):65

http://www.fsa.gov.uk/pages/About/What/International/mifid/background/index.shtml

http://www.leba.org.uk/execution.php

http://www.climatechange.gov.au/government/submissions/closed-consultations/auctioning-carbon-units/auction-discussionpaper.aspx 62

P.Horsnell and R.Mabro (1993), Oil Markets and Prices, The Brent Market and the Formation of World Oil Prices, Oxford Institute For Energy Studies 63

http://www.asx.net.au/products/option-market-makers.htm

http://www.climatechange.gov.au/government/submissions/closed-consultations/auctioning-carbon-units/auction-discussionpaper.aspx 65

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Table 3: Indicative schedule of carbon unit auctions COMPLIANCE YEAR – AUCTION SCHEDULE VINTAGE

2013-14

2014-15

2015-16

2016-17

2015-16

15m*

1/8 + (28 – 15m)**

4/8

1/8

2016-17

15m*

1/8 + (1/8 – 15m)***

1/8

4/8

1/8

4/8

1/8

4/8

1/8

4/8

1/8

4/8

1/8

4/8

2017-18 2018-19

2012-13

2019-20 2020-21

2017-18

2021-22

2018-19

2019-20

2020-21

2021-22

* 15m refers to the 15 million unit limit, without a pollution cap in place. ** The number of 2015-16 vintage units available for auction in 2014-15 will be 1/8 of the total vintage allocation plus the excess units that were unable to be auctioned in 2013-14 due to the 15 million unit limit. *** The number of 2016-17 vintage units available for auction in 2014-15 will be 1/8 of the total vintage allocation plus the excess of units that were unable to be auctioned in 2013-14 due the 15 million unit limit.

»» The development of exchange-based trading: Exchanges are widely regarded as being important for promoting price discovery, and are expected to play an important role within the Australian market (although could be seen as less important than in other markets where there is no primary auction process). One stakeholder suggested that the Government could potentially choose to mandate or support the use of a particular exchange platform in order to concentrate liquidity and promote price transparency. »» The development of analysis, reporting and price signalling services in the OTC market: OTC transactions often take place on a private and confidential basis, with prices not reported to the market and therefore generally not as transparent as exchangebased trading, thus limiting the achievement of price discovery. However, there are various ways in which this can be overcome:

The OTC market can provide price signalling services (although independent assessment of these signals by market reporter/assessors may still be required). These include the development of online OTC platforms for trading of eligible emissions units similar to the Mercari (FEX) platform of RECs, and the establishment of “price setting windows” by Platts at specific times of the trading day, where complying trades will be used to set a benchmark price.66 Since OTC trading is expected to play a key role, particularly in the early stages of carbon market evolution, the existence of such services in Australia will be important for promoting price discovery.

– Brokers and participants may be willing (or required) to provide market information to an independent agency for commercially sensitive analysis and reporting. Information for many markets, including carbon, is reported in this way by the likes of Platts and the London Energy Brokers Association.

http://www.platts.com/IM.Platts.Content/methodologyreferences/methodologyspecs/asiaoilproductspecs.pdf

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

4.6 ACCESS TO CENTRAL CLEARING FOR MANAGEMENT OF COUNTERPARTY CREDIT RISK The ability to manage counterparty credit risk will be extremely important for participants in the Australian carbon market, as in all markets. Stakeholders noted that access to clearing through a CCP could support the development of confidence and liquidity in the market, although it is important to note that relevant

BOX 15: THE BENEFITS AND RISKS OF CONCENTRATED CLEARING THROUGH A CENTRAL COUNTERPARTY (CCP) A widely recognised benefit of a welldesigned CCP is its role in reducing credit risk between two counterparties by interposing itself as the legal counterparty to both sides of a transaction. For market participants, the credit risk of the CCP is substituted for that of the traditional counterparties. Novation replaces market participants’ exposure to bilateral credit risks with a standard credit risk to the CCP. However, there is an alternative view that forcing derivatives through CCPs could intensify risk in the system because it would not remove risk, but rather centralise and concentrate it into a single CCP, which becomes systemically critical to the well-being of the system.

discourse suggests both advantages and disadvantages to the concentrated use of one or several CCPs (Box 15). A key benefit of exchange trading over OTC trading is access to central clearing and settlement, and settlement of trades. Indeed, one stakeholder consulted for this report noted the important role that the European Climate Exchange (which uses ICE Clear Europe for clearing of all trades) played in supporting the functioning of the EU ETS during the Global Financial Crisis. Another, as highlighted above, suggested that the Government could potentially choose to mandate or support the use of a particular exchange platform. However, regulatory reforms around the world (for example, in the US through the Dodd-Frank Wall Street Reform and Consumer Protection

BOX 16: REGULATORY REFORMS RELATED TO THE USE OF CCPs FOR OTC DERIVATIVE TRADING Following the 2008 financial crisis, authorities around the world sought to improve post-trade infrastructure for OTC derivatives transactions. The Financial Stability Board has identified a need to further enhance safety in the OTC market. This led G-20 leaders to agree in September 2009 that by the end of 2012 all “standardised” OTC derivative trades should, where appropriate, be traded on exchanges or electronic trading platforms, and cleared through central counterparties (CCP).

As the CCP is counterparty to each cleared transaction, the failure of the CCP would itself pose a systemic risk; such risk increasing with the volume of trades cleared.

Authorities in G-20 jurisdictions have put forward policy initiatives aimed at encouraging greater use of CCPs for OTC derivatives markets. The Dodd-Frank Act reforms in the US, which are scheduled to come into effect during 2012, are having a major additional influence on derivatives trading and clearing around the world.

Links between CCPs create their own systemic risk because of contagion, where the weakest link in the chain could bring others down if it were involved in a default, and was insufficiently capitalised to meet margin calls.67

In Europe, the OTC derivatives market represents approximately 15 per cent of derivatives transactions. The European Commission has proposed that standard OTC derivative contracts be cleared through central counterparties (CCPs).68

AFMA (2011) http://www.afma.com.au/afmawr/_assets/main/lib90013/2011%20afmr.pdf

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Act) are exploring options to mandate or otherwise-incentivise the use of central clearing and settlement for OTC derivative transactions (Box 16).69 In Australia, there is currently no central clearing of OTC derivatives. A discussion paper, â&#x20AC;&#x153;Central Clearing of OTC Derivatives in Australiaâ&#x20AC;?, released by the Council of Financial Regulators (the Council) in June 2011 suggested potential scope for mandated, domestic central clearing of dollar-denominated interest rate derivatives due to the systemic importance of this market in Australia,70 although other OTC derivative markets would not (based on current discussion) be included within this initiative. The discussion paper did not specifically address carbon units, and as at the date of this report, no recommendations have been made by the Council of Financial Regulators.71 Until further regulatory change or strong market demand drives further change, then Australian carbon market participants that are seeking use of a CCP for central clearing of OTC trades will need to explore the option of using overseas CCP facilities, or rely on exchange trading to provide domestic access to central clearing.

http://www.afma.com.au/afmawr/_assets/main/lib90013/2011%20afmr.pdf http://www.rba.gov.au/publications/consultations/201106-otc-derivatives/pdf/201106-otc-derivatives.pdf

http://www.carbonmarketinstitute.org/carbon-market-reports/attachments/comms_communications/web-carbon-marketintegrity-aus-cpm-290312.pdf 71

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

5. HOW THE CARBON MARKET COULD EVOLVE

In the preceding sections of this document we have considered a wide range of factors that may ultimately influence the way in which the carbon market evolves. While some aspects of future market evolution have already been “mapped” out, the influence of varying collective stakeholders will also help shape the way forward.

5.1 WHAT DO WE ALREADY KNOW? The evolution of the Australian carbon market will be influenced by factors such as: »» The detailed design and implementation of the CPM by the Australian Government, including the form of regulations, which are introduced to support the CELP (refer to Table 4). »» The resources allocated, and systems and processes implemented during establishment of the Regulator (by 2 April 2012) and the CCA (by 1 July 2012).

– The evolution of the Californian ETS. – Decisions related to the introduction of emissions trading schemes in countries such as South Korea, Mexico, Japan and China. – International negotiations through the UNFCCC process (including for example, decisions related to the future of Kyoto mechanisms such as the Clean Development Mechanism). »» Negotiations between the Government and international governments on the possibility of bilateral linking with overseas emissions trading schemes.

»» Developments in international markets which could influence the supply and demand for international carbon credits include: – Decisions made following the recent review of the New Zealand Emissions Trading Scheme (NZ ETS). – Decisions made in relation to the design and implementation of phase three of the EU ETS (2013-2020).

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Table 4: CELP regulation timeline72 When is consultation scheduled to occur?

When are regulations proposed to be made?

Assistance to coal-fired generators

Sept-Oct 2011

Nov-Dec 2011

Landfill coverage

Oct-Dec 2011

Jan-Mar 2012

Jobs and Competitiveness Program

Sept-Oct 2011

Before 1 March 2012

Australian National Register of Emissions Units Regulations

Nov 2011

Nov-Dec 2011

Regulations on National Greenhouse and Energy Reporting Scheme, natural gas coverage, obligation transfer numbers, joint ventures, liability transfer certificates, significant holdings of units, record keeping, administrative issues and international unit surrender charge

Late 2011 and early 2012

March-May 2012

Regulations on fuel tax, the Optin Scheme and auctions

March-June 2012

June-Sept 2012

Mid 2012

Late 2012

Issues covered by regulations

Regulations on eligible international unit surrender

An outline of significant activities and events, together with known or preliminary key dates which could influence the evolution of the Australian carbon market is shown in Figure 6.

http://www.carbonmarketinstitute.org/carbon-market-reports/attachments/comms_communications/20111104-celpimplementation-note-2-pdf.pdf 72

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Figure 6: Significant events during the evolution of the Australian carbon market

1 July 2012

1 July 2013

1 July 2014

1 July 2015

July 2012 – June 2015 Aus CPM - Fixed Price Period To end 2012 Developing CPM Regulations

1 July 2017

1 July 2020

July 2015 onward Aus CPM - Floating Price Period

Prior to 2015 Advance auctions By 31 May 2014 Government tables regulations specifying pollution caps for first five flexible charge years.

2 April 2012 Clean Energy Regulator is established

Australian CPM

1 July 2016

30 Nov 2013 Australian Federal Election deadline

1 July 2015 International credits can be purchased to offset up to 50% of a firm’s emissions

1 July 2015 Possible linking of CPM and NZ ETS

By 1 July 2014 Heavy on-road transport may be included in the CPM (subject to further negotiation)

2008 – 2012 EU ETS Phase 2

EU ETS

2013 - 2020 EU ETS Phase 3 May 2013 EU bans use of carbon credits generated from HFC-23 destruction

2012 - 2015 1 Jan 2013 NZ ETS – surrender obligation for stationary energy, liquid fossil fuels and industrial process sectors progressively increases (recommended by Review Panel) Jan 2013 – Jan 2015 NZ ETS price cap of $25/NZU may increase by $5/year (recommendation from NZ ETS Review Panel)

NZ ETS Jan 2013, Waste included and synthetic gases removed from the NZ ETS

Jan 2015 Agriculture enters the NZ ETS

31 Dec 2012 One-for-two obligation scheduled to finish based on current legislation. May be extended and phased out smoothly based on recommendations from NZ ETS Review Panel.

Other International developments

Nov 2011 UN Climate Change Conference - Durban

Dec 2012 COP 18 - Qatar 1 Jan 2013 Start of first compliance period for California ETS

Jan 2015 Possible commencement of Korean emissions trading scheme

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

There are a number of features already embedded into the design of the CPM which will evolve in a predetermined way over time. These are:

5.1.2 CHANGES TO RULES RELATING TO PRICE CEILING AND FLOOR

5.1.1 TRANSITION FROM A FIXED TO FLEXIBLE PRICE MECHANISM

A price ceiling and floor will apply for the first three years of the flexible price period. The price ceiling will be set at $20 above the expected international price and will rise by five per cent in real terms each year. The price floor will be $15, rising annually by four per cent in real terms.73

The CPM will commence on 1 July 2012, with a price that will be fixed for the first three years like a tax. The price will start at $23 per tonne and will rise at 2.5 per cent per annum in real terms. On 1 July 2015, the carbon price will transition to a collared flexible price under an emissions trading scheme, with the price determined by the market. The fixed price scheme in the first period is sometimes referred to as a carbon tax. During this time, the carbon price is known but the emissions reduction outcome is difficult to predict. The emissions trading (or cap and trade) scheme in the second period has in place a fixed emissions reduction target (or cap) for liable entities and a variable carbon price (the trade) that is difficult to predict. This will be a significant step change in the evolution of the Australian carbon market, and will result in all participants having to manage carbon price risk for eligible emissions units to be surrendered from compliance year 2015-16 onwards. It is likely to encourage the emergence of a derivatives market, and introduce a greater level of liquidity into the market as a whole. In practice, trading could be expected to commence earlier than the beginning of the flexible price period. Certain companies (for example, electricity generators) may seek to hedge forward their anticipated exposure post 2015; companies undertaking EITE activities may have emissions units for scope 2 activities that they need to monetise; and other participants may commence trading units as and when the first auctions begin.

The introduction of a price ceiling and floor is intended to reduce volatility and mitigate the risk of significant price movement for market participants in the early years of the CPM, while companies are still learning how to trade in a carbon market. However, artificial market constructs are less favoured by speculators which have opportunity for a greater profit in a more volatile market, and are claimed by some commentators to create administrative complexity and dampen the emergence of a secondary market.74 75 The transition to a fully flexible price without artificial constructs from 2018-19 will be an important step change in the evolution of the carbon market. This will require increased focus on price risk management by market participants, and will increase the importance of market integrity and transparency to avoid significant price movement events (such as price spikes or crashes) which undermine confidence in the market as a whole. The removal of the floor linked to the international carbon price will increase the opportunity for companies to look for more cost effective eligible international emissions units from overseas. This could involve greater investment in the CDM to acquire primary CERs, or purchase CERs in the secondary market.

http://parlinfo.aph.gov.au/parlInfo/download/legislation/ems/r4653_ems_512dd113-81cb-415a-82e0-7ee25a13213a/upload_ pdf/360036.pdf;fileType=application%2Fpdf 73

http://www.garnautreview.org.au/CA25734E0016A131/WebObj/D0836448ETSpaper-FINAL-fullcolour/$File/D08%2036448%20 %20ETS%20paper%20-%20FINAL%20-%20full%20colour.pdf 74

http://www.climatechange.gov.au/government/submissions/clean-energy-legislative-package/~/media/government/submissions/ cel/public/CEL-Submission-WestpacBankingCorporationLimited-20110922-PDF.pdf 75

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

The surrender charge for international units trading below the floor price is of much interest to many market participants. At this time, the Department of Climate Change and Energy Efficiency (DCCEE) has presented four options for the potential surrender of international units which are outlined below.76

There are a number of trade-offs to be considered in the implementation of the surrender charge, and the options presented have generated lively discussion among Australian carbon market participants. Indeed, market participants acknowledge the complexity of the issue.77

Table 5 Proposed options for implementing the surrender charge

Based on the price at time of purchase

Based on the market price at time of surrender

Option 1

The surrender charge for international units is based on the difference between the floor price and the actual price paid.

Option 2

The surrender charge for international units is based on the difference between the floor price and the observed market price of such units at the time the contract to purchase was entered into, irrespective of the actual price paid.

Option 3

The surrender charge for international units is based on the observed market price for such units at the time of surrender.

Option 4

The surrender charge for international units is based on the observed market price for such units at the time of surrender. However the liable entity may also enter into a forward contact with the Regulator to surrender a given number of units at a set date in the future. The surrender charge will determine based on the forward price curve published by the Regulator each day.

5.1.3 INTRODUCTION OF AUCTIONS Auctions will take place for carbon units with vintages for the flexible price period. In the fixed charge years of the CPM, advance auctions of future vintage carbon units will assist in the development of forward price signals and help promote business certainty about future carbon prices. The primary policy objectives of the auction are to promote allocative efficiency and efficient price discovery. The detailed policies, procedures and rules for the conduct of auctions will be determined by the Minister in a legislative instrument. This instrument will provide detail on a range of features, including:78

– Type of auction. – Timing of auctions. – Maximum number of units in bids. – The total number of carbon units with a specific vintage year that may be auctioned. – Limits on the number of carbon units of a type that may be acquired. – Guarantees for payments and securities that may be provided. The detailed design of the auctions will also have an impact on the evolution of market liquidity, depth and transparency in the wider Australian carbon market. A position paper for the auctioning of carbon units has been published by the DCCEE, and submissions from stakeholders are being considered at this time.79

http://www.carbonmarketinstitute.org/carbon-market-reports/attachments/comms_communications/cmi-review-issue-5/cmireview-issue-5-march-2012.pdf 76

http://www.carbonmarketinstitute.org/carbon-market-reports/attachments/comms_communications/cmi-review-issue-5/cmireview-issue-5-march-2012.pdf 77

http://www.climatechange.gov.au/government/submissions/clean-energy-legislative-package/~/media/publications/cleanenergy-legislation/Commentary-on-the-Clean-Energy-Bill-2011-PDF.pdf 78

http://www.climatechange.gov.au/government/submissions/closed-consultations/auctioning-carbon-units/auction-discussionpaper.aspx 79

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

5.1.4 LINKS WITH INTERNATIONAL MARKETS International linking to credible international carbon markets and emissions trading schemes will be allowed from the commencement of the flexible price period. At least half of a liable party’s compliance obligation must be met through the use of domestic units or credits.80 The Government is currently in discussion with governments and administrators of the EU and NZ ETS schemes, and will determine the extent and design of links which are formed. It has suggested that a link with the NZ ETS is possible from 1 July 2015 – the start of the flexible price period.81 International linking will have a fundamental effect on the supply and demand dynamics of the scheme, and will promote liquidity and depth of the market. Furthermore, a more open scheme will offer market participants increased opportunity to access lower cost units for compliance, and encourage increased allocative efficiency. However, the potential establishment and design of international linkages creates some market uncertainty, and it will be important for the Government to carefully manage announcements in relation to these changes (see section 4.3 of this report) in order to avoid reducing market confidence. Furthermore, the Australian carbon market will be more vulnerable to any future market integrity issues in linked markets.

5.1.5 REDUCTION IN TRANSITIONAL ASSISTANCE There are a number of components of “transitional assistance” embedded within the design of the CPM which will be subject to change over time. These include:82

– The Jobs and Competitiveness Program will allocate free carbon units to liable entities which conduct “EITE activities”.83 The initial rates of assistance accorded each EITE activity will be reduced in the Regulations by a “carbon productivity contribution” of 1.3 per cent a year. The Program will be reviewed by the Productivity Commission in the third year of the mechanism (2014-15) and thereafter consistent with the timing of general scheme reviews. A review of assistance provided to a particular activity could be conducted earlier than 2014-15 if requested by the Government. – An Energy Security Fund will provide free carbon units to the most emissionsintensive coal-fired generators from 2013-14 to 2016-17. It will also provide for assistance to highly emissions-intensive coal-fired generators of $1 billion in the form of cash payments in 2011-12, and payments for the closure of some of Australia’s most emissions-intensive generation capacity. – The Coal Sector Jobs Package will provide an allocation of free carbon units to Australia’s most emissions-intensive coals mines for the first five years of the CPM. These transitional assistance measures aim to fulfil a number of policy objectives, including prevention of carbon leakage (where businesses, and therefore carbon emissions move overseas), maintenance of Australia’s energy security, and help to ease the transition to a low carbon economy for Australia’s most emissionsintensive industries. However, allocation of free carbon units may reduce market liquidity and depth in the early years of the scheme as business will need to acquire a smaller proportion of carbon units on the open market. Review of transitional assistance arrangements will create an element of significant uncertainty for market participants. As for announcements related to international linking, the Government and the Productivity Commission will need to carefully manage the release of information on any changes to be made (see section 4.3 of this report).

http://www.climatechange.gov.au/government/submissions/clean-energy-legislative-package/~/media/publications/cleanenergy-legislation/Commentary-on-the-Clean-Energy-Bill-2011-PDF.pdf 80

http://www.reuters.com/article/2011/12/05/us-australia-newzealand-carbon-idUSTRE7B40AK20111205

http://www.climatechange.gov.au/government/submissions/clean-energy-legislative-package/~/media/publications/cleanenergy-legislation/Commentary-on-the-Clean-Energy-Bill-2011-PDF.pdf 82

For a full definition see the Clean Energy Bill (2011) Commentary: http://www.climatechange.gov.au/en/government/submissions/ clean-energy-legislative-package/~/media/publications/clean-energy-legislation/Commentary-on-the-Clean-Energy-Bill-2011-PDF. pdf 83

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

The Government has agreed to provide three years’ notice of any modifications to the EITE allocations that will have a negative effect on recipients of assistance under the CPM, unless the modifications were required for compliance with Australia’s international trade obligations. Furthermore, the Government is committed to providing a minimum of five years of assistance from the start of the mechanism, and an assurance that any modifications to the assistance arrangements that will have a negative effect on recipients will not occur before 1 July 2017.

5.1.6 ROLE OF THE CARBON FARMING INITIATIVE (CFI) Kyoto-compliant credits created under the CFI can be used for compliance under the CPM subject to a five per cent limit in the fixed charge period, and will be unlimited in the flexible charge period. However, in practice, the CFI will take time to develop, and supply of ACCUs is expected to be significantly below the five per cent threshold. The generation and use of ACCUs for compliance purposes is expected to increase gradually over time (as methodologies become approved and demonstrated and market awareness of the opportunity increases). One stakeholder consulted for this report suggested that the CFI would be unlikely to play a major role in the early stages of the Australian carbon market due to the cost of project establishment, and the relatively low price of eligible international units. They suggested that a low market price could discourage CFI participants from entering into ACCU sale agreements – noting similar behaviour from forestry participants under the NZ ETS.84 However, another stakeholder noted that the ability to lock in supply of ACCUs at a known price for a long period of time could be attractive to certain participants.

5.2 LESS PREDICTABLE ASPECTS OF THE MARKET EVOLUTION In addition to the aspects of market evolution that are already embedded into the design of CPM, there are a number of features which can be expected to evolve over time in a less predictable way. While there is no standard model for market evolution, and different outcomes could eventuate based on a wide range of interrelated factors, four possible trends based on experience in other markets and feedback from stakeholders consulted for this report are as follows: »» Increased number and diversity of market participants. »» Growth of derivatives trading based on the forward market. »» Development of OTC vs exchange-based trading. »» Increasing trade with international markets.

5.2.1 INCREASED NUMBER AND DIVERSITY OF MARKET PARTICIPANTS A key feature of market evolution will be the extent of participation in trading by entities, and the rate at which liquidity and depth builds over time. Each market participant has different characteristics and objectives which will influence their involvement in the market, including the size of their permit liability, their skills in trading, their credit rating and access to working and risk capital.

Based on discussion with stakeholders.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Stakeholder perspectives

This would in part be driven by the fact that demand for eligible emissions units is expected to be highly concentrated in the electricity generation and gas sectors. These companies will need to manage carbon price risk along with their risk in electricity and gas markets, and could therefore be expected to be amongst the earliest participants in the market. The power companies also have existing trading teams and skills which would enable them to participate quickly in the market.

Stakeholders consulted for this report suggested possible evolutionary outcomes in terms of rate of liquidity development (number of participants and trades) and the diversity of market participation: »» Rate of liquidity development: As highlighted in section 2 of this report, the Australian market is expected to have up to 500 liable entities across a diverse range of sectors, many with experience in trading on domestic or global commodity markets. Almost 300 entities have been identified to date. This is significantly larger than the NZ ETS – which has 76 liable entities, plus forestry companies (sellers).

However, the power companies may be limited by access to working capital, creating an important role for banks in leveraging their strong balance sheets for the finance of carbon procurement.

One stakeholder consulted for this report noted that liquidity in the NZ ETS was quick to develop – suggesting that the potential exists for a similar trend in the Australian market (assuming there is an adequate balance between net buyers and sellers within the market).

Section 2.3 of this report highlights the substantial number of companies with EITE activities that will be “long” in the market with freely allocated units for indirect emissions that they will need to monetise. It is not clear at this stage what strategies they will employ to achieve this. For example, they may enter into direct arrangements with power companies (as was seen in the NZ ETS), or sell these units into the secondary market (either OTC or through an exchange).

However, another stakeholder noted that the market uncertainty which exists until there is bipartisan support may limit trading to the minimum required for compliance purposes, therefore slowing the growth of liquidity relative to that which could be expected in more stable political conditions (without risk of legislative repeal).

With the appropriate design and active regulatory support, the market can move relatively quickly to a point where there are many buyers and sellers that are active in the market (see Figure 7). However, as illustrated above, there is a risk that the market takes a long time to reach that point or never gets there at all.

»» Diversity of market participation: Stakeholders consulted for this report suggested that trading within the secondary carbon market may initially be dominated by electricity companies, gas companies and banks, with other large and then mediumsized companies entering the market at a later date as they build skills and confidence in trading.

Figure 7: Alternative market structures

Many

CONCENTRATED MARKET Often long term contracts dominate with limited price signals

BUYER DOMINANCE Buyers strongly influence pricing and market structure

SELLER DOMINANCE Sellers strongly influence pricing and market structure

EFFICIENT MARKET Transparent price signals in short and long term supporting allocative efficiency

Buyers Few

Few

Many Seller

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

The current EU ETS market is an example of buyer dominance where the buy side is far more concentrated than the sell side. The short position is not only concentrated in the electricity sector but also in one country: Germany. The electricity companies make the market, and this causes trading to be concentrated in specific time periods, resulting in spot markets that are illiquid and price formation that is unclear and volatile.85 This is clearly a risk for the Australian market which has some similar characteristics. The seaborn iron ore market is a good example of seller dominance where the majority of the supply is managed by just three sellers. This has enabled the market to be restructured when many of the buyers were not looking for change. A spot market has been introduced, leading to more responsive and transparent price signals. In addition to the intrinsic structural benefits of such a change, there was an immediate benefit to sellers in a market where demand was growing faster than supply. The petroleum industry provides good examples of both concentrated and efficient markets. The LNG market with few buyers and sellers is an example of a concentrated market where long-term contracts dominate, and the spot market is still relatively small. The lighter, lower sulphur crude oil market (based around Brent and WTI) provides a good example of an efficient market with transparent and effective price signals in both the short and long dated (forward) markets, as well as a mixture of actively traded OTC, exchange, spot, term, physical and derivative markets.

5.2.2 GROWTH OF DERIVATIVE TRADING BASED ON THE FORWARD MARKET The development of a derivatives market could be expected to commence slowly due to the fixed price period for the first three years of the Australian carbon market. However, as the Australian carbon market moves from a fixed to a floating price, it will be essential for market participants to have the ability to manage price risk and a derivatives market can be expected to emerge. The emergence of the derivatives market is not only important for enabling market participants to manage their compliance risk, but will also support the development of liquidity and confidence in the market as a whole. This is because derivatives typically trade in large multiples to, and generate more liquidity in the underlying market. Liquidity in one market gives rise to liquidity in the other, and so they feed off each other and accelerate growth (or decline). Table 6 illustrates the types of derivatives that might emerge in the Australian carbon market.

https://www.carbon-financeonline.com/index.cfm?section=features&action=view&id=14493

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Table 6 Typical derivatives in a carbon market Contract type

Contract description

Forward contracts

Forward trades resemble immediate settlement trades, with the difference being that terms are set on the trade date, but delivery of permits and payment are deferred to a future date also specified at the time of trade. This function of futures contracts allow those who use them to better manage day-to-day price volatility, gain more certainty about their level of exposure and transfer and manage the risk of price fluctuations.

Options

Derivative products in which the parties buy or sell the option, or the right to decide whether or not to enter into a specified cash transaction at (or before) a specific future date. The most common types of options are call options and put options. While there are different forms of options, in broad terms, call options give the option buyer the right to purchase permits at a specified price on or before a specified date. Conversely, put options give the option buyer the right to sell permits at a specified price on or before a specified date. Exotic options provide a wide range of varying pay-off and risk return profiles. Typically, many of these instruments also have a varying degree of leverage (potential payoff relative to upfront cash outlaid to secure the instrument).

Average price contracts

Average price contracts involve an agreement to buy on a set date a specified quantity of permits at the average price for the preceding (for example) three months. Such contracts are likely to be appealing to buyers with compliance obligations who would prefer to pay an average price over a period of time rather than a spot or forward fixed price. For buyers like liquid fuel suppliers this may be attractive as it will enable them to ensure that the carbon price they pass on matches exactly the carbon price they pay for the permits to cover fuel-use related emissions.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Contract type

Contract description

Repurchase contracts (“repos”)

At the more sophisticated end of the market, repurchase agreements or “repos” are financing arrangements that provide working capital collateralised against a holding of the permits themselves. These contracts allow companies that might have bought carbon units at auction early in the compliance year, but do not need to use them until later in the year, to free up working capital. They sell their carbon units to the bank with an agreement to buy them back at a premium that provides a margin to the bank over and above its costs. Within the EU ETS, a number of financial intermediaries successfully used repos to target mid-cap/small-cap players.

Swaps

Swaps contracts involve agreeing on a fixed price and settling against a market indexed price sometime in the future. No actual units are exchanged. They tend to be used by those speculating on the likely carbon price, rather than by end-buyers with compliance obligations. Under a swap contract, if the index settlement price is different to the fixed price agreed, a payment is made between the two parties.

In commodity markets, the development of liquid and transparent spot and forward OTC markets with sufficient credit flexibility are generally important for the development of a broader derivatives market. Stakeholder perspectives Stakeholders noted that derivatives will be important in managing the move from a fixed to a flexible price, and that a forward market would emerge quickly in the Australian carbon market – particularly due to the uncertainty over the international carbon price and the restrictions on banking emissions units from the fixed to the flexible price period. Participants will not be able to bank units from the fixed to flexible price period other than ACCUs, eligible international units or carbon units purchased in 2014 auction for use in the flexible price period. This would mirror the development of the market on a forward basis as was seen in the EU ETS (Box 17).

They also suggested that the use of “repos” would be popular – particular for those with experience in trading – as a way to manage price risk and free up working capital. However, they also noted that the current level of political uncertainty in Australia could create a preference for buying and banking units during the flexible price period over forward trading. This is due to the fact that the Government might buy back carbon units in the event of a legislative repeal.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 17: EVOLUTION OF THE FORWARD MARKET IN THE EU ETS The EU ETS principally evolved on a forward basis. During 2009, approximately 73 per cent of transactions were in futures, 22 per cent in spot, and the remaining five per cent were in options.86 The spot market grew by 450 per cent during 2008-09 as companies monetised allowances to raise funds during the global financial crisis87 – illustrating the even greater weighting towards the futures market which existed prior to this date (Figure 8). One plausible explanation for the strength of the forward market relative to the spot market is that since EUAs are only required once per year for compliance purposes, there is no advantage in holding spot EUAs. Whereas a spot position requires an immediate investment, a long futures position only needs the capital necessary for covering margining requirements.88 Furthermore, since power generation companies – where the bulk emissions under the ETS is concentrated89 - typically hedge forward their power price risk several years ahead, there may have been a natural tendency to manage carbon price risk in a similar way.

Figure 8 Development of the derivatives market in the EU ETS – Monthly volumes for each contract modality since 200590 800 700

(in millions)

600 500 400 300 200 100

Options

Futures

Jan-10

Oct-09

Jul-09

Apr-09

Jan-09

Oct-08

Jul-08

Apr-08

Jan-08

Oct-07

Jul-07

Apr-07

Jan-07

Oct-06

Jul-06

Apr-06

Jan-06

Oct-05

Jul-05

Apr-05

Jan-05

Spot

World Bank (2010) State and Trends 2010

Daskalakis et al (2009)

World Bank (2011) State and Trends 2011

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

5.2.3 DEVELOPMENT OF OTC AND EXCHANGES Another key element of market evolution is the growth of OTC trading91 relative to trading on regulated exchanges. The development of OTC and exchange-based trading are somewhat interrelated. OTC trading can be beneficial where the product is less welldefined, and/or where participants are seeking to hedge exposure in a certain way. In such cases, brokers will typically tailor a structured transaction, using their market knowledge and contacts to find one or more counterparties to take on the other side of the required position. Over time, as entities seek to manage similar risks, transactions tend to “standardise” (for example, in relation to duration, volume, and delivery schedules), and therefore become tradable on an exchange. In this way, an OTC market can act as a precursor to the development of an exchange traded market. This was seen, for example, in the Australian electricity, world oil markets and the EU ETS. OTC markets continue to be important where there is a lack of product homogeneity or a basis for ongoing non-standardisation, as has been seen in relation to CERs in the EU ETS (Box 18).

BOX 18: PREFERENCE FOR TRADING OF HETEROGENEOUS CERS IN THE EU ETS

If the Australian market develops along the lines of other markets, it will begin as predominantly OTC with subsequent development and growing importance of exchanges. Stakeholders expressed differences in opinion on the speed with which exchange trading would be likely to emerge. One suggested it may emerge quickly given the homogeneous nature of carbon units. Another suggested that it may be around five years before exchange-trading develops significantly. However, as both OTC and exchange markets serve different purposes, the demand for both is likely to remain. Exchange trading will offer the advantage of domestic access to central clearing, and the ability to trade standard products without the need for special terms and conditions associated with OTC trading. OTC trading will remain important where it meets the needs of a particular transaction (for example, hedging carbon price risk in a bundled transaction with electricity or gas). OTC trading may also be encouraged where any uncertainty over the acceptability of certain units for compliance (particularly as international linking discussions proceed) creates a natural premium or discount (for example, for certain ACCU types or eligible international emissions units). Finally, in the long term, its relative merit may be enhanced if regulatory or otherwise incentivised reforms on OTC clearing and settlement are introduced thereby helping to manage counterparty credit risk.

In the EU ETS, regulatory uncertainty over certain CERs has reduced “homogeneity” – with certain CER credits being perceived as less risky than others. Those “higher risk” CERs (for example, from HFC-23 and N2O industrial gas projects) have traded at a discount to “lower risk” CERs (for example, from renewable and energy efficiency projects in least developed countries), and owners of the most desirable CERs have preferred to trade OTC to avoid dilution of their natural premium (reported to reach up to €0.50). In general, such assets have been traded OTC and subsequently cleared at the exchanges.92

OTC transactions are direct bilateral arrangements between counterparties, sometimes facilitated by a broker, which do not take place on a trading exchange. 91

World Bank (2010) State and Trends

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

5.2.4 GROWTH OF INTERNATIONAL TRADING International markets have the potential to play an important role in the evolution of the Australian carbon market. A more open scheme generally offers access to lower cost carbon abatement, and therefore compliance options. However, it also increases vulnerability to political uncertainty, changing economic conditions and price volatility in overseas markets. Furthermore, where a market becomes exposed to extremely low international prices, the incentive to invest in domestic carbon abatement and the transition to a lower carbon economy can be reduced. For example, in the EU ETS oversupply and low prices resulting from the global financial crisis have prompted the UK Government to commit to introducing a “Carbon Price Support Mechanism” (a price floor) from April 2013 to maintain a minimum incentive for domestic low carbon investment.93 94 As highlighted earlier in this report, there are legislative provisions to increase the role of international trading over time. The role of international markets can also be expected to change based on:

Stakeholder perspectives Stakeholders consulted for this report suggested that trading in the international carbon market may initially be dominated by a small number of international companies, with increased participation occurring as the dynamics of international markets become more widely understood. Project developers for example, EcoSecurities, Camco and Perenia, along with banks and brokerage firms, have a potentially important role to play in education and awareness-raising, and could encourage participation by “taking ideas” to liable entities. In the short to medium term (during the fixed price period and the first three years of the flexible price period), the existence of a $15 price floor, and the associated International Unit Surrender Charge (Box 19) may provide an additional constraint on the use of any lower cost credits available from overseas and so reduce the role of international markets. However, in the longer term (i.e. once the price floor has been removed), the use of international units could increase and comprise a significant portion of trading within the limits of scheme design.

»» The extent to which Australian market participants choose to transact in the international carbon market. »» The supply and demand for eligible international units which will be influenced by: – International climate change negotiations. – The development of emissions trading schemes in other countries and regions. – The design of future linkages with the Australian CPM. To date, the extent of trading by Australian market participants in international carbon markets has been limited. However, the major banks in Australia have brokerage teams that are capable of trading international units, and some liable entities are entering into transactions now for the procurement and/or hedging of exposure related to compliance obligations from compliance year 2015-16 onwards.

http://www.hm-treasury.gov.uk/consult_carbon_price_support.htm

http://www.pwc.co.uk/eng/issues/plan-for-the-carbon-price-support-mechanism.html

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

BOX 19: THE INTERNATIONAL UNIT SURRENDER CHARGE For the first three years of the flexible price period, while the price floor is in operation, there will be an International Unit Surrender Charge (â&#x20AC;&#x153;surrender chargeâ&#x20AC;?) to be paid by liable entities for any eligible international unit surrendered. The details of this surrender charge (including how it will be calculated, what international reference price will be used, when the charge will become payable, etc) have yet to be established in regulations. However, the DCCEE has released a discussion paper outlining four potential surrender options which are outlined in detail in section 5.1.2. The application of the surrender charge will mean that liable entities that buy eligible international units forward to meet their obligation will face various elements of exposure depending on the surrender option chosen by the DCCEE:95 1. The loss they incur on the forward trade itself, being any drop in the spot price of the eligible international emissions unit below the actual purchase price that was initially paid for the unit. 2. The difference between the actual price paid and the observed market price for such units at the time the contract to purchase was entered into. 3. The difference between the actual price paid and the observed market price for such units at the time of surrender. 4. The difference between the actual price paid and the forward price curve published by the Regulator. Until resolved, the uncertainty over the design of this International Unit Surrender Charge in the near term could act as a disincentive to the use of eligible international emissions units for compliance. Stakeholders consulted for this report raised concerns over the possible complexity of reference pricing for the International Unit Surrender Charge, and the competitive disadvantage which smaller and less sophisticated market participants may have in trading under this rule. One suggestion proposed was for the charge to be calculated with reference to the actual price paid for an eligible international emissions unit, rather than a Governmentdetermined or formulaic price (particularly where units are to be immediately surrendered for compliance purposes).

http://www.carbonmarketinstitute.org/carbon-market-reports/attachments/comms_communications/cmi-review-issue-5/cmireview-issue-5-march-2012.pdf 95

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

6. CONCLUSION There are a variety of possible “evolutionary pathways” that the Australian carbon market could follow, dependent on a wide range of inter-related factors. In order to understand what pathways may eventuate and identify measures which could support the achievement of successful outcomes, we may look to lessons learned in financial and commodity markets, including other international carbon markets.

Regulatory bodies (the Clean Energy Regulator and ASIC) will have a key role in developing systems and processes to support market integrity and price discovery. These will include the registry, the auction process, and the licensing regime for financial service companies and market operators. In this regard, there are many lessons to be learnt from the EU ETS in particular.

It is important to recognise that the nature of a carbon market as an artificial market created by the Government gives rise to particular market objectives and risks which require special consideration. While the ultimate purpose of creating the market is to drive a reduction in Australia’s greenhouse gas emissions, the Government must balance a range of other policy objectives in its design which will all influence the achievement of successful outcomes.

The interaction between regulators and systems will also be crucial in ensuring a robust marketplace, with adequate processes for clearance, settlement of trades, transfer of ownership and appropriate record-keeping.

In considering what we mean by “successful outcomes”, it should be noted that there is no standard model for a “successful market”. However, a range of characteristics can be identified which are typically regarded as attributes of a successful market. Different stakeholders will accord different priority to these characteristics depending on their objectives. The emissions profile of market participants will have a fundamental influence on how the market evolves. The number and diversity of participants in the Australian market suggests potential for rapid establishment of liquidity and price discovery, assuming an appropriate balance of buyers and sellers. The concentration of demand in the power sector, and of supply (at least initially) amongst companies with EITE activities suggests an important role for these companies in early trading, along with the major banks. Ultimately though, for the market to evolve successfully, its underlying structure must quickly give rise to a reasonable balance between a good number of buyers and sellers willing to actively participate in the open spot market. It must also prevent any large, dominant participants from either bypassing the open spot market or otherwise distorting price signals. The key role of the Government in the evolution of a successful market will be in providing market and regulatory certainty. It can influence this in particular through the way in which it releases information, including policy decisions and fundamental data (with implications for supply and demand) to the market.

Financial intermediaries and market infrastructure could be expected to emerge to meet the demands of market participants. Lessons from other markets suggest that alongside the development of the underlying spot market, there could be a strong emergence of a forward market to manage the transition from the fixed to the flexible price period, and the uncertainty created by an international carbon price. Furthermore, there could be a transition from OTC to exchange trading over time, although a role for both mechanisms is likely to continue. This could be influenced in the longer term by developments in the global financial regulatory landscape. Arguably, the other fundamental factor influencing the successful evolution of the Australian carbon market will be the supply and demand dynamics for eligible emissions units. Therefore, the international political environment, and the way in which the Australian market interfaces with overseas carbon markets will also have a crucial influence on its development. The development of a successful market is generally predicated on meeting the needs of the market participants and being free to evolve within a supportive and balanced regulatory framework. The successful evolution of a carbon market is arguably riskier as it is much more dependent on the Government, which has to also create and maintain the market need. However, the EU ETS has so far survived numerous problems during its development in a very complex political environment. Hence, the Australian carbon market can evolve into an efficient and successful market on the proviso that the right balance can be found across the wide range of interdependent factors.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

GLOSSARY

markets to take advantage of price discrepancy without taking a risk.

Abatement Refers to a reduction in the degree or intensity of greenhouse gas emissions. A project or activity that reduces or otherwise prevents emissions of greenhouse gases from entering into the atmosphere.

Assigned amount units (AAUs) The emissions units allocated to the Annex B countries under the Kyoto Protocol on the basis of their quantified emissions target (listed in Annex A) for the first commitment period from 2008 to 2012. One AAU is equal to one tonne of carbon dioxide equivalent.

Additionality Under the Kyoto Protocol, certificates from JI and the CDM (see explanations below) will be awarded only to project-based activities where emissions reductions are additional to those that otherwise would occur. Additionality is also important in relation to voluntary greenhouse gas projects. Afforestation Afforestation generally refers to planting of new forests on lands that historically have not contained forests. AFSL An Australian Financial Services Licence is a license for any Australian businesses involved in the provision of financial services. It is issued by the Australian Securities and Investments Commission as required by the Corporations Act 2001. Allocation This term generally refers to the allocation of emissions permits or allowances among greenhouse gas emitters to establish an emissions trading market. The division of permits/allowances can be done through free allocations and permit auctioning. Allocative Efficiency A measure of the benefit one derives from distributing or investing in assets in one way as opposed to another. Allocative efficiency is difficult to measure, especially in advance. However, rational individuals /firms attempt to maximise their allocative efficiency. Allowances This term generally refers to a government issued instrument giving the bearer the right to emit a fixed amount of greenhouse gas emissions into the atmosphere (tonnes of CO2-e). Also see permits. Anthropogenic greenhouse gas emissions Greenhouse gas emissions that arise from human activities. Arbitrage Generally refers to the simultaneous purchase and sale of similar commodities in different

Auctioning A method of allocating units in which government releases units into the market through an auction process. See also Allocation. Auctions An auction is a process of buying and selling goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder. In economic theory, an auction may refer to any mechanism or set of trading rules for exchange. There are several variations on the basic auction form, including time limits, minimum or maximum limits on bid prices, and special rules for determining the winning bidder(s) and sale price(s). Participants in an auction may or may not know the identities or actions of other participants. Depending on the auction, bidders may participate in person or remotely through a variety of means, including telephone and the internet. The seller usually pays a commission to the auctioneer or auction company based on a percentage of the final sale price. Austraclear Austraclear provides clearing and settlement services in relation to transactions in “Securities as defined in these Regulations and that service is known as the Austraclear “System”. Austraclear is a licensed Clearing & Settlement facility (CS facility) under the Corporations Act 2001 (Cth) in relation to the System and users of the System are called “Participants”. The Austraclear Regulations relating to the System are the “Operating Rules” of the licensed CS facility, as requires by the Corporations Act 2001. Austraclear also provides a clearing and settlement service for the financial component of electronic conveyancing transactions (the “EC Settlement Facility”) which is a service provided outside the Austraclear System. Australian Carbon Credit Units (ACCUs) ACCUs are the units created under the Carbon Farming Initiative (CFI). Australian Competition and Consumer Commission (ACCC) An independent Commonwealth statutory authority. The ACCC promotes competition

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

and fair trade in the market place to benefit consumers, business and the community. It also regulates national infrastructure industries. Its primary responsibility is to ensure that individuals and businesses comply with the Commonwealth’s competition, fair trading and consumer protection laws. Banking The ability to hold permits created in one compliance period for use in a future compliance period. Parties to the Kyoto Protocol may ‘bank’ some emissions allowances or credits to use them in subsequent commitment periods. Basel III BASEL III is the third of the Basel accords. It is a proposed global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage Basis Points A basis point is a unit related to the change in an interest rate, and it is equal to 1/100th of a percentage point. Put another way: 1 bp = 0.01% Benchmark Assessment Benchmarking is the process of comparing the performance of a business to an industry or market. Dimensions typically measured are quality, quantity, time, cost and price. Bid The price a potential buyer is willing to pay for an asset. Bilateral Affecting or undertaken by two sides equally; binding on both parties: a bilateral agreement; bilateral negotiations. Bond Market The market for the buying and selling of bonds. The bond market involves both government and corporate bonds in both the primary market (the first sale at issue) and the secondary market (all subsequent sales). Most transactions involving bonds occur over-the-counter. Bond prices both affect and are affected by the current state of the stock market. Broker A person or firm that conducts transactions on behalf of a client. Some brokers only conduct transactions while others also offer different types of investment advisory services. Brokers derive their profit from commissions on orders given. That is, they usually collect a percentage

of the value of each transaction, though some charge flat fees. Clients may give orders in a variety of ways. One may meet with a broker, call on the telephone, or give orders over the internet. Business As Usual Scenario (BAU) An estimate of the future pattern of greenhouse gas emissions, which assumes that there will be no major changes in attitudes and priorities of governments, business and the community. The term BAU is often used in conjunction with the term additionality. Call and Put An option which conveys the right to buy something at a specific price is called a call; an option which conveys the right to sell something at a specific price is called a put. Cap and Trade Cap and trade is a common phrase used to explain the design of an emissions trading system, where total emissions are limited or ‘capped.’ The Kyoto Protocol is a cap and trade system in the sense that emissions from Annex B countries are capped and that excess permits might be traded. Capitalisation The amounts and types of long-term financing used by a firm. Types of financing include common stock, preferred stock, retained earnings, and long-term debt. A firm with capitalisation including little or no longterm debt is considered to be financed very conservatively. Carbon dioxide (CO2) The main GHG, accounting for some 81% of Annex I countries’ GHG emissions in 1990, and one of the six GHGs controlled by the Kyoto Protocol. Used as the gas of reference for calculating GWPs, and thus given a 100-year GWP of 1. Carbon dioxide equivalent (CO2-e) A standard measure that takes account of the global warming potential of different greenhouse gases and expresses the cumulative effect in a common unit, relative to carbon dioxide. Carbon Footprint A company’s carbon footprint is generally referred to as a measure of the impact its activities have on the environment in terms of the amount of greenhouse gases produced, measured in units of carbon dioxide equivalent. It is also known as a GHG inventory.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Carbon Intensity CO2-e emissions per unit of economic output (such as tonnes of CO2-e per dollar of GDP). Carbon Market A shorthand term for an international or domestic market where greenhouse gas emissions units are exchanged between buyers and sellers. The terms carbon market, greenhouse gas market and emissions market can be used interchangeably. Carbon Tax A tax applied to CO2-equivalent emissions. The New Zealand Government’s 2002 climate change policy package included a carbon tax on energy, industrial and transport emissions, capped at $25 per tonne of carbon dioxide equivalent (CO2-e). In December 2005 the Government decided not to proceed with the announced carbon tax. A carbon tax is a price based measure designed to change consumer behaviour. Carbon Trading See Emissions Trading. Carbon Unit (CU) Carbon Units are the units issued by the Government under the Clean Energy Act 2011. Central Counterparty Clearing House An organisation that exists in many countries that helps facilitate trading done of derivatives and equities markets. These clearing houses are often operated by the major banks in the country. The house’s prime responsibility is to provide efficiency and stability to the financial markets that they operate in. Certified Emission Reduction Unit (CER) A Kyoto Protocol unit equal to 1 metric tonne of CO equivalent. CERs are issued for emissions reductions from CDM project activities. Two special types of CERs called temporary certified emission reduction (tCERs) and long-term certified emission reductions (lCERs) are issued for emissions removals from afforestation and reforestation CDM projects. Clean Development Mechanism (CDM) One of the three Kyoto mechanisms, the CDM aims to promote sustainable development in developing countries as well as to help Annex I Parties achieve compliance with their QELRCs. It allows Annex I countries to invest in emissionsaving projects in developing countries and gain credit for the savings achieved through the generation of CERs that they can use to contribute to compliance with part of their QELRCs. The CERs will be added to Annex I Parties’ assigned amounts.

Clean Energy Regulator The Clean Energy Regulator is an independent statutory authority established by the Clean Energy Regulator Act 2011 responsible for administering the legislation that will reduce carbon emissions and increase the use of clean energy. Clearing The procedure by which an organisation acts as an intermediary and assumes the role of a buyer and seller for transactions in order to reconcile orders between transacting parties and provides a central point for the management of credit risk. Climate Change As defined by the UNFCCC, a change of climate that is attributed directly or indirectly to human activity that alters the composition of the global atmosphere and that is in addition to natural climate variability over a comparable time period. Commitment Period The period within an emissions trading scheme which the emissions reductions commitments apply to. For example, under the Kyoto Protocol Annex I parties’ emissions are averaged over the first commitment period which runs from 20082012. Compliance This is a term used in both the regulatory and voluntary markets. At an international level it means the achievement by a Party of its quantified emissions limitation and reduction commitments under the Kyoto Protocol. Conference of the Parties (COP) The supreme body of the UNFCCC, charged with the task of regularly reviewing implementation of the Convention and any related instruments, such as the Kyoto Protocol. The COP meets annually. Contestable Market A contestable market refers to a market served by a small number of firms, but which is nevertheless characterised by competitive pricing because of the existence of potential short-term entrants. Its fundamental features are low barriers to entry and exit; in theory, a perfectly contestable market would have no barriers to entry or exit. Counterparty Risk Counterparty risk, known as default risk, is the risk that an organisation does not pay out on a bond, credit derivative, trade credit insurance or payment protection insurance contract, or other trade or transaction when it is supposed

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

to. Even organisations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues. Counterparty The other party that participates in a financial transaction. Every transaction must have counterparty in order for the transaction to go through. More specifically, every buyer of an asset must be paired up with a seller that is willing to sell and vice versa. Credits This term generally refers to a third party verified and certified instrument that is evidence that a financial investment was made that either reduced or prevented a fixed amount of greenhouse gases from entering the atmosphere. Dark Liquidity or Dark Pools In finance, dark pools of liquidity (also referred to as dark liquidity or simply dark pools) is trading volume or liquidity that is not openly available to the public. The bulk of these represent large trades by financial institutions that are offered away from public exchanges so that trades are anonymous. Default The failure to make timely payment or otherwise fail to comply with the terms of an agreement. Depth The ability of a security to withstand greater or smaller demand without affecting the price. Deep securities tend to be highly liquid and can be bought or sold in large quantities without their prices greatly moving in either direction. Among the factors affecting depth is the minimum price increment at which trades can be made (the tick size), market transparency, and restrictions on trade due to a futures or option contract on the security. Derivatives A financial contract whose value is based on, or “derived” from, a traditional security (such as a stock or bond), an asset (such as a commodity), or a market index. Dodd-Frank Act An Act proposed to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

Economic leakage An economic activity being displaced from one country to another, with a consequent reduction in economic welfare in the former country. Elasticity A measure of a variable’s sensitivity to a change in another variable. In economics, elasticity refers the degree to which individuals (consumers/producers) change their demand/ amount supplied in response to price or income changes. Emissions-Intensive Trade-Exposed industries (EITE) EITE industries are those industries which will be eligible for assistance in order to maintain international competitiveness. Emission Reduction Unit (ERU) Carbon credits created by Joint Implementation projects. These projects generate ERUs for Annex I investor countries in proportion to the amount of GHG emissions each project saves. The investor country can then add the ERUs to its assigned amount under the Kyoto Protocol, while the host country must deduct them from its own emissions allocation. Emissions The release of greenhouse gases into the atmosphere over a specific area or period of time. Emissions Trading A mechanism which can be used by participants under emissions trading schemes to meet their obligations. For example, Kyoto Protocol parties listed in Annex B can trade their assigned amounts for the purposes of fulfilling their emissions commitments. European Union Allowances (EUA) EU Allowances, the tradable unit under the EU ETS. Equals 1 tonne of carbon dioxide. European Union Emissions Trading System (EU ETS) Trading Scheme within the European Union. The phase I was from 2005 to 2007, phase II continues from 2008 to 2012 and phase III will run from 2013-2020. Exchange A market place in which securities, commodities, derivatives and other financial instruments are traded. The core function of an exchange such as a stock exchange - is to ensure fair and orderly trading, as well as efficient dissemination of price information for any securities trading on that exchange. An exchange may be a physical location where traders meet to conduct business or an electronic platform.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Exotic Option In finance, an exotic option is a derivative which has features making it more complex than commonly traded products (vanilla options). These products are usually traded over-thecounter (OTC), or are embedded in structured notes. Exposure The proportion of the value of a market position at risk. Financial Product or Instrument A financial product or instrument is a facility through which, or through the acquisition of which, a person does one or more of the following: (a) makes a financial investment (b) manages financial risk (c) makes non-cash payments Forward Contract An agreement to buy or sell an asset at a certain date at a certain price. Forward contracts are identical to futures contracts except that their provisions are not standardised. That is, forwards may be written with any provisions the parties desire. While this allows for greater flexibility, this makes the contracts less liquid on the secondary market and prevents them from being traded on an exchange. Forward Curve The prices prevailing today at which the market is willing to transact future business at different points in time. Forward Market An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. Contracts entered into in the forward market are binding on the parties involved. Forward Price The predetermined delivery price for an underlying commodity, currency or financial asset decided upon by the long (the buyer) and the short (the seller) to be paid at predetermined date in the future. At the inception of a forward contract, the forward price makes the value of the contract zero. Fraud Any attempt to deceive another for financial gain. Fundamental Analysis When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and management. When analysing a stock, futures contract, or

currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis. The term is used to distinguish such analysis from other types of investment analysis, such as quantitative analysis and technical analysis. Fungibility Possibility to exchange different types of reduction credits achieved under different mechanism (e.g. CERs and AAUs etc). Futures A standardised derivative contract to buy or sell a certain instrument (such as a carbon permit) at a certain date in the future for a certain price. Global warming potential (GWP) Term used to describe the relative potency, molecule for molecule, of a GHG, taking account of how long it remains active in the atmosphere. The GWPs currently used are those calculated over 100 years. Carbon dioxide is taken as the gas of reference, with a 100-year GWP of 1. Greenhouse Gas Abatement Scheme (GGAS) An Australian scheme which commenced on 1 January 2003. It is one of the first mandatory greenhouse gas emissions trading schemes in the world. GGAS aims to reduce greenhouse gas emissions associated with the production and use of electricity. It achieves this by using project-based activities to offset the production of greenhouse gas emissions. Insider Trading A trade one makes using material information about a company that has not been released to the public. Insider trading is a serious crime when it is done without proper authorisation. Institutional Investor A business devoted to holding and managing assets, either for clients or for itself. Examples include mutual funds, banks, holding companies, and brokerages. Interest rate derivative An interest rate derivative is a derivative where the underlying asset is the payment or receipt of a notional amount of money at a given interest rate. Intermediary An intermediary is a third party that offers intermediation services between, for example, two trading parties. Typically the intermediary offers some added value to the transaction that may not be possible by direct trading.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Joint Implementation (JI) One of the three Kyoto mechanisms and a successor to AIJ. JI allows Annex I Parties to invest in emission-saving projects in other Annex I countries and receive credit, in the form of ERUs, for the emissions saved. The host country must deduct the ERUs from its own assigned amount of emissions. Like Emissions Trading, JI must be supplemental to domestic actions. Kyoto Market The emissions trading market for emissions units included under the Kyoto Protocol. Kyoto Mechanisms Three procedures established under the Kyoto Protocol to increase the flexibility and reduce the costs of making greenhouse-gas emissions cuts; they are the Clean Development Mechanism, Emissions Trading and Joint Implementation. Kyoto Protocol A protocol to the United Nations Framework Convention on Climate Change that includes emissions limitation or reduction commitments for ratifying countries listed in its Annex B (developed countries and Economies in Transition). Leverage The use of debt financing to take a greater financial exposure than would be possible using only equity (self-funding). Also, commonly known as Gearing in Australia. Liquid Market A market with many bids and offers that allows the buying and selling of large quantities of an asset at any time with a relatively small impact on price and at low transactions costs. The market is characterised by high liquidity, low spreads, and low volatility. LRET The Large-scale Renewable Energy Target creates a financial incentive for the establishment and growth of renewable energy power stations in Australia, such as wind and solar farms, or hydro-electric power stations. It does this by legislating demand for Large-scale Generation Certificates (LGCs). These LGCs are created based on the amount of eligible renewable electricity produced by the power stations. LGCs can be sold or traded to liable to entities, in addition to the power station’s sale of electricity to the grid. RET Liable entities have a legal obligation to buy LGCs and surrender them to the Clean Energy Regulator on an annual basis.

Major Banks Currently, the Australian banking sector is dominated by four major banks: Australia and New Zealand Banking Group, Commonwealth Bank of Australia, National Australia Bank and Westpac Banking Corporation. Margin Call An order by a brokerage for an account holder to deposit more cash or securities into a margin account when the value of the cash and securities currently in it falls below some defined percentage. Every margin account has a maintenance margin requirement, which is money or securities an investor must keep in their margin account in order to be able to borrow from the brokerage Market Failure An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents equilibrium. Market Integrity A high level of market integrity is associated with a market where participants do not engage in prohibited trading behaviour. Market Maker A broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Market Manipulation The act of artificially inflating or deflating the price of a security. Market Power Market power is the ability of a firm to profitably raise the market price of a good or service over marginal cost. In perfectly competitive markets, market participants have no market power. A firm with market power can raise prices without losing its customers to competitors. Market participants that have market power are therefore sometimes referred to as “price makers,” while those without are sometimes called “price takers.” Significant market power is when prices exceed marginal cost and long run average cost, so the firm makes economic profits.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Market Value The price at which a willing buyer would pay a willing seller for a given asset, assuming both have a reasonable knowledge of the asset’s worth. Methane (CH4) A greenhouse gas with emissions coming from ruminant livestock, landfills, coal mining and other sources. It is the second most common gas in the basket of six GHGs controlled by the Kyoto Protocol. Methane has a 100-year GWP of 21. Mitigation In the context of climate change, a human intervention to reduce the sources or enhance the sinks of greenhouse gases. Examples include using fossil fuels more efficiently for industrial processes or electricity generation, switching to solar energy or wind power, improving the insulation of buildings, and expanding forests and other “sinks” to remove greater amounts of carbon dioxide from the atmosphere. Monetisation Monetisation is the process of converting or establishing something into legal tender. Monetisation may also refer to exchanging securities for currency, selling a possession, charging for something that used to be free or making money on goods or services that were previously unprofitable. Monopoly A situation in which one company that has total or near total control of a given market. This state allows the monopolist to dictate the price most people pay in that market. While monopolies are often the result of competition, they are, by their nature, anti-competitive. Antitrust laws are in place in many countries to prevent monopolies from forming. National Greenhouse and Energy Reporting Act 2007 (NGERs) An act that establishes a national framework for Australian corporations to report greenhouse gas emissions, reductions, removals and offsets, and energy consumption and production, from 1 July 2008. New Zealand Emissions Trading Scheme (NZ ETS) Announced in September 2007, and passed into legislation on 10 September 2008. A nation wide emissions trading scheme which is intended over time, to include all major sectors (forestry, transport, stationary energy, industrial processes, agriculture and waste) and the six greenhouse gases specified in the Kyoto Protocol.

New Zealand Unit (NZU) Unit issued by the New Zealand Registrar and designated as a New Zealand unit. Novation The transfer of a contract from one party to another by mutual consent of the original counterparties and the concurrence of the new party. NSW Greenhouse Abatement Certificate (NGAC) A certificate that represents one tonne of carbon dioxide equivalent that would otherwise have been released into the atmosphere. NGACs are the main way in which accredited abatement certificate providers turn their electricity related abatement activities into ‘currency’, which benchmark participants will purchase and use to acquit their obligations. Offer or Ask or Sell The price a potential seller is willing to take for an asset. Offset An activity that compensates all or part of the CO2-e emissions of an emitting entity, by reducing the emissions, or increasing the CO2 absorption of another entity. Oligopoly A situation in which a small number of companies split all or nearly all the market share of a good or service. There are two major models for oligopoly. Option In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike). The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfil the transaction. OTC - Over-the-counter A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase “over-the-counter” can be used to refer to stocks that trade via a dealer network as opposed to on a centralised exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network. Participants A term used in many emissions trading schemes to describe persons participating in the relevant scheme.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

Pass-through The increase in the consumer price of a product resulting from the imposition on the producer or supplier of a price for the product’s greenhouse gas emissions. Permit Permits are often used for denoting the tradable units under the Kyoto Protocol, such as AAUs, ERU or CERs. Emissions permits are treated as a commodity giving its holder the right to emit a certain quantity of GHGs. Emissions permits are designed to be tradable between countries and other legal entities. Price Ceiling The maximum price level in a financial transaction that is either imposed by a market regulator or as agreed between market counterparties. Price Discovery The process by which buyers and sellers interact to determine the fair market price of an asset.

Regional Greenhouse Gas Initiative (RGGI) A regional initiative by states in the northeastern United States region to reduce greenhouse gas emissions. The RGGI is designing a cap and trade program for greenhouse gas emissions from power plants. Ten states currently participate in the initiative. Removal Unit (RMU) Derived from sink activities that result in net removal of GHG and specifically designated as an RMU by an Annex B country registry. Renewable Energy Certificate (REC) Electronic form of currency initiated by the Renewable Energy (Electricity) Act 2000, and may be created on the internet based registry system (known as the REC Registry), by eligible parties for each megawatt-hour of eligible renewable electricity generated.

Price Floor The minimum price level in a financial transaction that is either imposed by a market regulator or as agreed between market counterparties.

Repurchase Agreement A Repurchase Agreement, also known as a Repo or Sale and Repurchase Agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price will be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate.

Price Index A price index (plural: “price indices” or “price indexes”) is a normalised average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time.

Retail Investor An investor who invests small amounts of money for himself/herself rather than on behalf of anyone else. Retail investors are the opposite of institutional investors, which are large firms who invest on behalf of clients.

Price Mechanism A price mechanism or market-based mechanism is any of a wide variety ways to match up buyers and sellers.

Risk Profile A measure of how risk averse an investor is. One may conduct a risk profile to determine what securities will likely fit an investor’s investment goals.

Price signal A price signal is a message sent to consumers and producers in the form of a price charged for a commodity; this is seen as indicating a signal for producers to change supply and/or consumers to change demand. Price-based measures Also referred to as economic instruments and market instruments, price-based measures can be applied to integrate the costs (or opportunity costs) of greenhouse gas emissions into decision-making in the marketplace. Quantified Emission Limitation and Reduction Commitment (QELRC) Legally binding targets and timetables under the Kyoto Protocol for the limitation or reduction of greenhouse gas emissions by developed countries. 62

Scope 1 Emissions Described in the GHG Protocol as the direct greenhouse gas emissions from sources that are owned or controlled by an organisation (such as emissions resulting from on-site combustion of fossil fuels, or PFC emissions from aluminium smelting). Scope 2 Emissions Described in the GHG Protocol as the indirect GHG emissions from consumption of purchased electricity, heat or steam which is purchased by an organisation. Scope 3 Emissions Described in the GHG Protocol as the other indirect emissions, such as the extraction and production of purchased materials and fuels, transport-related activities in vehicles not owned

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

or controlled by the reporting entity, electricityrelated activities (such as Transmission and Distribution losses) not covered in Scope 2, outsourced activities, and waste disposal. Secondary market A market where investors purchase securities or assets from other investors, rather than from issuing companies themselves. The national exchanges - such as the Australian Securities Exchange, New York Stock Exchange and the NASDAQ are secondary markets. Security Collateral used to guarantee repayment of a debt. Sequestration The uptake and storage of carbon. Carbon can be sequestered by plants and soil and in underground/deep sea reservoirs. (Underground storage is also called geological sequestration.)

SRES The Small-scale Renewable Energy Scheme creates a financial incentive for owners to install eligible small-scale installations in Australia such as solar water heaters, heat pumps, solar panel systems, small-scale wind systems, or smallscale hydro systems. It does this by legislating demand for Small-scale Technology Certificates (STCs). STCs are created for these installations according to the amount of electricity they produce or displace. RET Liable entities have a legal requirement to buy STCs and surrender them on a quarterly basis. Standardisation Standardisation is the process of developing and agreeing upon standards. A standard is a document that establishes uniform engineering, technical or financial specifications, criteria, methods, processes or practices.

Settlement The process in which a buyer makes payment and receives the agreed-upon good or service and vice-versa for the seller. This term is used on exchanges to indicate when a security actually changes hands, which often occurs several days after a trade is made.

Structured Finance Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities. This risk transfer as applied to securitisation of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc) has helped to open up new sources of financing to consumers.

Short Sale The sale of borrowed securities. In a short sale, one borrows securities, usually from a brokerage, and sells them. One then buys the same securities in order to repay the brokerage. Selling short is practiced if one believes that the price of a security will soon fall.

Supplemental, Supplementarity The Protocol requires use by Annex I Parties of Emissions Trading and JI to be supplemental to domestic actions to limit or reduce their emissions. Such supplementarity also applies in the case of the CDM, which Annex I Parties may use to meet only part of their QELRCs.

Speculation In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the lending of money or the purchase of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment.

Surrender The transfer of a Carbon Unit, ACCU or Eligible International Unit from an individual account to the Governmentâ&#x20AC;&#x2122;s surrender account in the registry for the purpose of compliance with a unit obligation.

Spot Market A market in which an asset bought or sold is delivered immediately or as soon as is practical given any physical and scheduling constraints. To give a basic example, if one buys a stock and it is delivered immediately, one utilises the spot market. It differs from derivatives markets like futures. Perhaps less commonly, it is called the cash market.

Swap The exchange of two financial instruments (for example, securities, interest rates, currencies) for the mutual benefit of the exchangers. Systemic Risk A risk that is carried by an entire class of assets and/or liabilities. Systemic risk may apply to a certain market or to the entire global economy. Systemic risk is also called systematic risk or undiversifiable risk. Term The period of time during which a fixed-income security, investment, or agreement is in force.

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

For example, term life insurance lasts only for a certain number of years and the exact number of years is called the term. Tick Size The minimum price increment at which trades can be made. Transaction Costs The total cost of a security transaction after commissions, taxes, and other expenses. For example, a security has a price, but transaction costs include the fee one must pay the broker, capital gains taxes, among other things. Transactional data Data describing an event (the change as a result of a transaction). Transaction data always has a time dimension, a numerical value and refers to one or more objects (i.e. the reference data). Transparency The extent to which investors have ready access to any required financial information about a company or a market such as price levels, trade details, market depth and audited financial reports. Classically defined as when “much is known by many”, transparency is one of the silent prerequisites of any free and efficient market.

engaging in proprietary trading that is not at the behest of its clients, and from owning or investing in a hedge fund or private equity fund, as well as limiting the liabilities that the largest banks could hold. Voluntary Market Voluntary markets for emissions reductions cover those buyers and sellers of Verified Emission Reductions (VERs), which seek to manage their emissions exposure for nonregulatory purposes. Working Capital Working capital is calculated by subtracting current liabilities from current assets. That is, one takes the value of all debts and obligations for the current year and subtracts that from the value of all cash and assets that might reasonably be converted into cash in the current year.

Underlying Price The price of the underlying asset of a derivative. United Nations Framework Convention on Climate Change (UNFCCC) Adopted at the June 1992 ‘Earth Summit’ in Rio de Janeiro and in force since March 1994. The Convention’s ultimate objective, and that of the Kyoto Protocol and any other instruments attached to the UNFCCC, is ‘to achieve ... stabilisation of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic (man-made) interference with the climate system.’ Volatility In a market context, it is a measure of risk based on the standard deviation of the price of a particular asset. Volcker Proposal The proposal is often referred to as a ban on proprietary trading by commercial banks, whereby deposits are used to trade on the bank’s personal accounts, although a number of exceptions to this ban were included in the Dodd-Frank law. The rule’s provisions are scheduled to be implemented as a part of Dodd-Frank on July 21, 2012, with preceding ramifications. The proposal specifically prohibits a bank or institution that owns a bank from

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

INDUSTRY TERMS AAU – Assigned Amount Unit ACCU – Australian Carbon Credit Unit AEMO – Australian Energy Market Operator AFMA – Australian Financial Markets Association ANREU – Australia’s National Registry of Emissions Units AMF – Autorité des Marchés Financiers ASIC – Australian Securities and Investments Commission ASX – Australian Securities Exchange CCA – Climate Change Authority CCP – Central Counterparty CDM – Clean Development Mechanism CELP – Clean Energy Legislative Package CER – Certified Emission Reduction CFI – Carbon Farming Initiative CPM – Carbon Pricing Mechanism

IASB – International Accounting Standards Board LBFR – French Law on Banking and Financial Regulation LME – London Metals Exchange LRET – Large-scale Renewable Energy Target ICE – Intercontinental Exchange IETA – International Emissions Trading Association IFRIC – International Financial Reporting Interpretations Committee ITL – International Transaction Log NAP – National Allocation Plan NEM – National Electricity Market NGAC – NSW Greenhouse Gas Abatement Certificate NGERS – National Greenhouse and Energy Reporting System

CRE – Commission de regulation de l’énergie

OPEC – Organization of the Petroleum Exporting Countries

ECX – European Climate Exchange

OTC – Over the counter

EEX – European Energy Exchange

RBA – Reserve Bank of Australia

EITE – Emissions-intensive trade-exposed

REC – Renewable Energy Certificate

ERU – Emission reduction unit

RET – Renewable Energy Target

EUA – European Union Allowance

RMU – Removal Unit

EXAA – Energy Exchange Austria

SRES – Small-scale Renewable Energy Scheme

FASB – Financial Accounting Standards Board

STC – Small-scale technology certificate

FEX – Financial and Energy Exchange Group

UNFCCC – United Nations Framework Convention on Climate Change

HFC – Hydro-fluoro carbons

Evolution of the Australian Carbon Market Lessons from commodity and financial markets

If you have any questions, please contact Lloyd Vas, Markets and Research Manager at

Carbon Market Institute Level 1, 486 Albert Street, East Melbourne VIC 3002 Australia P 03 9245 0900 E info@carbonmarketinstitute.org www.carbonmarketinstitute.org

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