Garnaut Review May 2011

Over the course of late 2010 and early 2011, Garnaut prepared eight update papers, released in a rolling road-show of speech events. These papers have now been collated into the Garnaut Climate Change Review: Update 2011 (2011 Review) and provided to the government on 31 May 2011. The 2011 Review (which at over 240 pages is referred to by Garnaut as his "book") is broken down into three parts and twelve chapters, with the parts being titled "The Global Shift", "Australia's Path" and "Australian Transformations". In short, these are Garnaut's assessment of the problem, the solution, and the impacts on Australia of that solution.

The key recommendations that come out of Garnaut's report are:

• The scientific evidence base has solidified around the notion of human caused dangerous climate change
• Other countries are taking action through local, national and regional policies, in the wake of a change in direction away from a single international mechanism to regulation emissions
• The best policy option for Australia to do its part in reducing emissions is a broad based carbon price, in the form of a fixed price carbon tax at the rate of $26 per ton and increasing yearly for three years, followed by a flexible price emissions trading scheme
• The carbon pricing mechanism should:
  - cover broadly the same sectors of industry as were covered by the CPRS
  - be regulated and governed principally by three new independent bodies to reduce the impact of vested interests
  - include compensation for low and middle income households (through taxation and social security reform), trade-exposed industry and include complementary support for new and developing low-emissions technologies
  - link with offsetting mechanisms domestically in the initial three year fixed price phase, and also with international offsetting mechanisms after the transition to a flexible price emissions trading scheme.

This legal update will outline in brief Garnaut's assessment of the problem, but will focus specifically on the detail of the policy solution recommended followed by a brief note on the impacts that Garnaut expects the policy to have on Australia's economy. We will then consider which of Garnaut's recommendations are likely to be implemented by the MPCCC in the detail of its carbon pricing scheme, and the implications of this for business.

The Review Update 2011

The problem

Part One of the 2011 Review "The Global Shift" describes the strengthening of the science on climate change, the effect of the global financial crisis on emissions and emissions forecasts and reviews the developments in international actions and commitments on climate change. In relation to these issues, Garnaut finds:

• The scientific evidence base for climate change has strengthened to the extent that it can now be claimed "beyond all reasonable doubt", that the globe is warming, and will continue to warm due to anthropogenic greenhouse gas emissions
• Emissions under business as usual are tracking slightly lower than his 2008 predictions, due largely to the impact of the global financial crisis. However, strong growth in developing economies will see business as usual emissions rising significantly, with 70 per cent  of global emissions coming from developing countries in 2030; and
• The global approach in response to climate change has fundamentally changed in the wake of the Copenhagen negotiations. The new direction for international cooperation under the Copenhagen Accord has resulted in a system of unilateral pledges of targets for both developed and developing economies, with over 80 per cent of global emissions covered by this system. Many pledged targets represent significant reductions of emissions in relation to business as usual, but the assessment of Australia's fair share has not changed. That is; a 5 per cent reduction in greenhouse gas emissions from 2000 levels by 2020, rising to a 25 per cent reduction against the same baseline in the context of a strong international agreement focused on holding greenhouse gas concentrations at 450 parts per million.

The proposed solution

Part 2 of the 2011 Review, "Australia's Path", explores the policy options open to Australia to respond to the challenge of climate change. This includes an investigation of market and non-market based approaches, an outline of Garnaut's preferred market based approach, the preferred arrangements for the use of revenues from that approach, and an investigation of the social and political special interests in Australia thwarting attempts to implement significant economic reforms such as the introduction of a carbon pricing mechanism.

Garnaut recommends the introduction in 2012 of an emissions trading scheme with a fixed price on carbon for three years and then transitioning to a floating price emissions trading scheme. He recommends that the fixed price begin at between $20 and $30 per ton, rising at 4 per cent in real terms per annum, with the midpoint being the most appropriate. Specifically, he has raised the figure of $26 per ton as his preferred starting price.

The guiding principles of Garnaut's plan include:

• Environmental integrity - confidence that genuine emissions reductions will be achieved on the scale required
• Cost-effectiveness - emissions reductions should be achieved at least cost to the community, by avoiding duplication and overlap with other policies, and using revenue from the scheme to reduce the costs of mitigation
• Swift revision of the scheme in response to the recommendations of regular, transparent and independent reviews - sound, independent governance will increase the chances that the scheme moves to its optimal design over time; and
• Autonomy - the scheme should minimise reliance on recurring judgments by government, and instead harness the efficiency of the market within an independently managed framework.

Garnaut recommends largely the same coverage of industry under his carbon pricing plan as he recommended in 2008. The principal change however is in the area of agriculture, which he considers should be initially exempt from the scheme, and its status reviewed upon the entry of agriculture into the New Zealand ETS. The treatment of agriculture in the plan also considers the role of the government's Carbon Farming Initiative (CFI), recommending that land sector offsets such as those created under the CFI should be available for compliance under the carbon pricing mechanism, starting in the fixed price period in 2012. However, it is also recommended that there should be strict limitations on the use of such offsets, with a recommended limit of 4 per cent offset usage in 2012, rising by 0.75 percentage points per year to 10 per cent in 2020. It is recommended that only Kyoto compliant CFI offsets be available for compliance in the scheme, but that non-Kyoto compliant offsets could be purchased by the regulator of the scheme from revenues derived from the sale of allowances (2 per cent in 2012 rising to 4 per cent in 2020).

An interesting design feature of Garnaut's plan is the recommendation of the early development of a forward price curve, which can be achieved through the auctioning of undated emissions allowances that can be used for compliance after the transition to the flexible price cap and trade scheme. This mechanism will provide policy makers with early indications of price expectations based on present policy signals, and can allow them to adjust policy accordingly to ensure a smoother transition to a flexible price mechanism.

The new Garnaut plan has an increased emphasis on the independence and rigour of its governance. Garnaut recommends the creation of three independent bodies each with discreet tasks in relation to the carbon pricing mechanism. He considers that these bodies are necessary in order for decision making to be independent and unaffected by the many vested interests that climate policy affects. He says:

"As soon as the parameters of the scheme are settled, business will focus on making money within the new rules, rather than on securing rules that make them money. That makes it essential that the rules really are settled. The governance arrangements proposed for the carbon pricing scheme are the key to establishing settled rules".

The independent bodies recommended by Garnaut include:

• An independent regulator or "carbon bank" to implement the scheme as established in legislation and to administer the assistance to trade exposed industries
• An independent committee, similar to the UK Committee on Climate Change, to provide advice to the government on national targets and scheme caps, progress towards meeting targets, the switch to a floating price and expanding coverage of the scheme; and
• An independent agency, possibly the Productivity Commission, tasked with considering issues surrounding trade exposed industry assistance.

One of the benefits of pricing carbon is that the revenue raised can then be distributed. A carbon price of $26 per tonne of carbon dioxide equivalent would generate around $11.5 billion in potential revenue from the value of permits in 2012–13. Garnaut recommends the division of this significant pie into three principal categories; compensation for households, compensation for industry and investment in low-carbon technologies. Table 1 below details Garnaut's compensation package as a breakdown of the expenditure of carbon pricing revenues out to 2022.

Table 1: Reducing emissions and economic reform – an illustration of a package (expenditure as a proportion of revenue) ^a

Note: This is Table 6.1 in The Garnaut Review 2011: Australia in the Global Response to Climate Change, p.87.

^a Fuel reform and aid monies are not drawn from permit revenue and are therefore not shown.
^b Includes the increase in revenues for the first three years from auctioning of permits for use at later dates. The sum of percentages may not add to 100% due to rounding.
^c Half the welfare payments under the CPRS package.
^d Proportion of assistance paid to EITEs assumed to fall by 1.5 percentage points each year after year 3.
^e This percentage includes existing innovation funding as outlined in section 3.2.
^f This percentage includes Kyoto Protocol offsets sold to liable entities (which do not represent a cost to the Government) as outlined in section 3.3.

Household assistance would be in the form of tax cuts (possibly through the implementation of reforms recommended in the Henry Tax Review), social security reform, and through targeted energy efficiency assistance programs. It is further recommended that fuel excise be reduced in a one off measure to compensate for the introduction of a carbon price (however the fuel excise reduction will not increase as the cost of carbon increases).

Garnaut recommends that industry assistance should be allocated similarly to plans for assistance thrashed out under the CPRS, but that after the first three years of the scheme (upon Garnaut's planned transition to a flexible price cap and trade scheme) the assistance measures should shift to a principled approach, periodically reviewed and considered by the independent agency. However, it is clear from the above table that Garnaut sees such an approach as one that increases the assistance to households over time, increasing investment in innovation, increasing investment in offsetting in the land sector, while at the same time steadily reducing assistance to industry. This is likely because of the expectation that as carbon markets develop in the economies of our major trading partners, Australian industry will require reducing amounts of assistance to remain globally competitive.

The impacts

The final part of the 2011 Review, "Australian Transformations", looks at the scale of the transformation in the economy that is required, the innovation required to make that transformation and the extent to which a carbon price can meet those needs.  It also considers what complementary policies are required to meet needs not met by a carbon price. The paper looks in great detail at the agriculture and energy sectors as two key sectors that will require significant transformation. In short, Garnaut finds:

Key recommendations covered in the review

• The carbon pricing mechanism will be the central policy instrument to encourage the use of established low-emissions technologies, but complementary support for innovation should extend from basic research and development to the demonstration and commercialisation of new technologies
• The basic research and development should be conducted principally but not solely through public institutions, requiring decisions on allocations of expenditure according to assessments of Australia's comparative advantage in research capabilities and national interest in successful outcomes
• Farmers should be able to sell the full range of legitimate bio-sequestration credits, including selling credits compliant with Australia's international obligations directly into the carbon pricing scheme for compliance (with appropriate limits) and for other genuine bio-sequestration credits to be purchased by the regulator (again, with appropriate limits)
• Transforming the electricity sector is critical to reducing Australia's emissions, and key to reductions in emissions in a range of sectors in the economy (including transport, building energy use and manufacturing). The carbon pricing mechanism will be the major policy transforming the electricity sector, however a range of complementary measures will be required in order to ensure a smooth and less costly transition, including energy market reform and the creation of an Energy Security Council that would consider and anticipate negative impacts of the carbon price on the security of the energy sector. For example, this new body may consider whether large closures in energy infrastructure due to the carbon price represent a threat to energy security.

Garnaut concludes his paper with a call to arms. He places Australia at a fork in the road with the ability to "choose the future". One choice is the "clever" policy option to apply market based mitigation measures that have relatively little effect on the progressive rise in our living standards in the years ahead.  The alternative choice is the entrenchment of the old political culture of governmental control of decision making, with abatement decisions being made by bureaucrats and politicians.

Scheme Expectations

Experience has shown that the views of Professor Garnaut are key indicators of policy to come. Of course, some aspects of policy "the Garnaut way" will not be picked up by the MPCCC, but many will be.  Casting a critical eye over the 2011 Review can shed some light on the Garnaut policies that we can expect to see in the final policy detail of the carbon pricing scheme that is soon to be released.

The 2011 Review is clearly a document more sensitive to politics than was the 2008 Review, which is more a reflection of the times than a criticism. The 2008 Review was conducted at a time when the primary criterion was to design the optimum regulatory framework to achieve the policy outcome required. This time around however we have the ingrained experience of carbon pricing legislation being defeated three times in Parliament, and the concomitant understanding that any regulatory framework must be politically achievable, socially acceptable and economically sound (as well as achieving emissions abatement).

A number of the recommendations in the 2011 Review are likely to be picked up in government policy because they comply well with the new criteria and political climate. In particular:

• The recommendation of independent market oversight will be very attractive to the MPCCC. The attraction will be in taking out of the present debate the key areas that Labor and the Greens disagree on, such as the setting of cap ambition and industry assistance. With these matters to be decided after legislation is in place and under guidance from independent bodies, the chances of getting legislation through both houses of Parliament will be much greater. Greater independence in the regulation of the scheme may also lead to more stable market policy, and greater price certainty in the long-term
• The quantum of the initial fixed price is likely to be set at $26 per ton (or around the mid-point of the broader $20 to $30 per ton recommendation). Amidst calls from the Greens for a price in excess of $40 per ton, and calls from business for a price in the area of $10 per ton, it appears that Garnaut's figures will be much closer to the mark. Garnaut takes into account both comparable carbon prices around the world for schemes of similar ambition and research into the theoretical cost of carbon
• It is likely that the MPCCC will implement Garnaut's plans for linking the scheme with offset markets. This includes linking only to domestic land sector offset markets for the first three years, and then linking to international markets upon the transition to a flexible price cap-and-trade scheme. Further, the parameters surrounding the extent to which this linking should occur are likely to be broadly adopted, with limits imposed on the number of offsets that can be used for compliance with the scheme, and for those limits to increase slowly in a linear fashion
• Garnaut's recommended coverage of the scheme is largely the same as the CPRS except for the different arrangements for the inclusion of agriculture in the scheme. Our principal commentary here is to note that there is no certainty that Garnaut's recommendations on the inclusion of agriculture will be adopted given that the scheme will require the votes of two key rural Independent lower house MPs to pass
• The recommendation of compensation to households through taxation reform, increased social security and energy efficiency technologies, is likely to be the principal foundation of the household compensation package. This is not just because of the practicality and responsibility of such measures, but also because such reform has been all but promised already.

There is a long way to go in terms of political wrangling and compromise before the carbon pricing legislation will be passed. As policy begins to crystallise and as more detail is released it becomes apparent that the scheme will be at least as ambitious as the CPRS, but with likely greater independence of market regulation and oversight. Business should start considering options for allocating future carbon liabilities based on expectations of cost and compensation, and start contemplating the hedging of forward carbon liability based on price expectations of around $26 per ton in the short to medium term (and sourcing credits from domestic Kyoto compliant projects). Consideration can also be given to contemplating longer term hedging arrangements based on the likelihood of relatively stable and independently set market parameters.

If your business requires any assistance in planning its strategic response to climate change regulation, please do not hesitate to contact a member of our experienced climate change team.