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STANDING COMMITTEE ON ECONOMICS
27/03/2009
Exposure drafts of the legislation to implement the Carbon Pollution Reduction Scheme

CHAIR —Good morning, Mr Curnow. Would you like to make an opening statement?

Mr Curnow —Yes, thank you. I am a partner in the global climate change practice of the international law firm of Baker and McKenzie and I have been specialising in the area of climate change for the last 10 years, having worked on all areas of climate change law, advising on the design and implementation of emissions trading schemes and the establishment of some of the world’s first dedicated carbon funds as well as advising on hundreds of Australian cross-border carbon transactions across mandatory and voluntary markets, including projects under the clean development mechanism as well as many forestry offset projects under Greenhouse Friendly and the New South Wales Greenhouse Gas Abatement Scheme. As someone with this breadth and depth of experience in carbon markets for many years and who had involvement in some of the very first markets, I feel well placed to share with the committee my thoughts and observations on the government’s proposed Carbon Pollution Reduction Scheme and the draft legislation implementing scheme.

In terms of that scheme, I would like to make a few introductory key points. The CPRS is a well-designed cap-and-trade scheme that places Australia on par with the international efforts. The European Union has had an emissions trading scheme in place its 2005. New Zealand has legislation for an ETS in place. Japan is now planning a mandatory scheme. The US has had a number of subnational schemes for a few years, and of course the Obama administration has indicated its intention to put in place a national cap-and-trade scheme. We should not forget that all the larger developing countries also have a number of domestic policies and measures in place to reduce their greenhouse gas emissions, including, for example, renewable energy efficiency targets in countries like India and China as well as hosting CDM projects.

The choice of cap and trade in scheme design is also on par with international efforts. All of these countries are considering cap and trade and not carbon taxes, baseline credit or intensity based targets. This is important because, if Australia were to choose a different scheme design to cap and trade, we would have the same problems as we do with different rail gauges across the country—incompatibility to link, with greater transaction costs, which would ultimately mean greater compliance costs for Australian business.

It is critical that the legislation implementing scheme be passed as soon as possible and without delay. You will no doubt hear and probably have heard from many organisations appearing before the committee that giving certainty to business is critical in ensuring the transition to a low-carbon economy in a way that avoids adjustment shocks and allows Australia to play its part internationally in a least cost way. Having advised many businesses on scheme design, and many of those will be affected as liable entities as well as the market-makers, I can echo these comments. Even some of our clients who do not fully agree with the government’s scheme policy or design are now starting to realise that they still need some policy certainty in order to move ahead with key investment and operating decisions. For this reason, it is important that scheme legislation be passed soon so that the implementation timetable for a July 2010 start can be maintained.

The system of caps and gateways is an innovative way to provide policy certainty to industry and business. The ability to set longer term gateways, up to 10 years after five-yearly caps, is critical in giving industry and business longer term policy certainty to plan and invest for longer term climate change action. But, at the same time, this system gives the government flexibility in setting the emissions levels to take account of Australia’s economic circumstances, what progress is being made internationally to a post-2012 framework as well as what the science tells us in about reductions required to avoid dangerous climate change.

The ability to link internationally under the scheme by bringing in eligible international Kyoto units and over time by allowing Australian units to be sold into overseas markets is also an important aspect of the scheme’s designed. Global warming is an international problem with global causes and consequences. One tonne of CO2 emitted anywhere in the world has the same cumulative effect as another tonne emitted somewhere else. Similarly, one tonne of CO2 reduced anywhere in the world has the same cumulative benefit as another tonne reduced anywhere else in the world. This is why global action is imperative on climate change and imperative in the context of Australian implementing its own scheme. Allowing linking between schemes is the way in which governments and businesses will be able to build up global action and, importantly, this linking of schemes allows the global community and Australia to reduce emissions most efficiently and at least cost. Even though the international negotiations on a post-2012 framework will take the a few more years, global action is proceeding through the growing number of domestic emissions trading schemes and the way that they will increasingly link to each other from the bottom up. This is not just developed countries. Developing countries like South Africa, Mexico and South Korea are considering implementing their own emissions trading schemes to link up globally.

CHAIR —Thank you, Mr Curnow. Following on from that, you were talking about the linkages of schemes internationally. Professor Warwick McKibbin on Wednesday talked about shielding Australia from that international market. He said it might lead to increased volatility in the Australian market. So he proposes a kind of hybrid scheme whereby there would be a central body that would deal with the international markets. Do you think that is a realistic proposition given what you have said?

Mr Curnow —I do not see the need for that sort of body or entity to regulate that. I think the volatility is something that at the moment really goes, if you look at the European scheme, much more to the broader financial environment and the economic environment and I guess to some extent to the issue of scheme design in Europe. A lot of the selling off of permits there really is a result of the allocation process in Europe, where there is allocation on the basis of production,  and mostly freely allocated, and so much so that there is some overallocation because of the decline in economic activity, which has allowed a short-selling of those permits. With respect to the issue around linking, the way the government has proposed to ban exporting for the first five years is really the way in which you would deal with that price volatility, because that puts some downward pressure on price in that, once there is full exporting and importing, to some extent we will be looking to the global price as far as what sets the Australian price. Having a ban on exporting for the first five years would put some downward pressure on that price.

CHAIR —Thank you. You mentioned that the allocation was one of the problems with the European system. Are there any other key problems that you can see in terms of that cap-and-trade system?

Mr Curnow —I think really that was probably a fundamental issue. It explains a lot of the price activity over the last few years in the European scheme. It relates very much to that allocation process. Without a large amount of auctioning—it was probably only up to five per cent in total—there was no real price discovery at the start of the scheme, so I guess for a while that was played out in the markets, which is why we saw some volatility there. The crash that people are aware of a couple of years ago was really the market doing its job. It was reacting to supply and demand. There was oversupply because there was overallocation, so the price dropped. I think a lot of the issues around price in Europe have really gone back to that process of allocation. Bear in mind that that was in the first phase, which was always intended as a pilot phase under the European scheme. Phase 2 of that scheme, which started last year and goes through to 2012, by all accounts will be short, so there will not be overallocation. There has been a lot more scrutiny in the national allocation plans that have been set at the member state levels to make sure that there will not be a repeat of that overallocation.

CHAIR —Do you think the current proposal by the Australian government for allocation is adequate, that it overcomes some of these problems?

Mr Curnow —Yes, I think compared to other schemes, the proposed Australian scheme has a much higher level of auctioning of the total number of units that would be put into the system compared to others. I think that is an important element in terms of allowing early price discovery for the market, particularly in order to build that liquidity and allow the intermediaries and the market-makers to come into that market.

CHAIR —Do you expect a vigorous market in secondary trading to develop in the CPRS?

Mr Curnow —Absolutely. We have seen that already in Europe with the European scheme around the linking of the project based credits from the Kyoto protocol into that scheme and we have seen that across other countries even where there are not formal trading schemes, like in Japan, who are big purchasers of CDM and JI credits globally. The market has responded to that as markets do in terms of setting up the range of derivative products that will build that secondary market as well as I guess the infrastructure. So in Europe, for example, you have trading that is done on a forward basis, over-the-counter trades as well as futures trading, on the various exchanges. Those are obviously growing by the day as that market grows.

CHAIR —I suppose people are now very aware of derivatives and other instruments of secondary markets. Do you see any problems developing in that kind of market?

Mr Curnow —There is discussion about how quickly the secondary market will move to what you might describe as a securitisation of the various carbon credits. A carbon credit is not like any other commodity on which derivatives are based; it does have its differences. That is also why, in linking, compatibility of schemes is important, because it means you avoid that difference across different types of credits, which allows for a much easier flow in a global market. There will be some limitations around achieving that level of securitisation over carbon credits in the secondary market because of the fact that you have different qualitative and quantitative limits placed, to some extent, in different schemes.

Senator BUSHBY —In your opening statement you went through a list of other countries that are also looking at ETSs and the actions that they are taking internationally. But it is fair to say, isn’t it, that the ETSs that each of those countries are looking at are all different to some extent? Most of them are cap and trade.

Mr Curnow —They are cap and trade.

Senator BUSHBY —And within that, there are a lot of variations as to how they are applying it.

Mr Curnow —That is right. The thing to remember is that you will get differences at a domestic level in terms of looking perhaps at what gases are covered, what sectors are covered, how you allocate permits—all of those key scheme design issues. To some extent that is not as important to the linking, because it goes to how within those schemes there may be a surplus or the markets may be long or short, depending how broad they are and how the allocation has been done. The key thing around linking is that there has to be that compatibility in being able to account for the transfer of permits from one system to another, so that you do not get double counting in the system or gaps in the system, from an environmental point of view.

Senator BUSHBY —But the bottom line is that each of those nations that may well consider it will look at their own domestic circumstances, and the political pressures, environmental pressures and economic pressures they may be under, to try and design a cap-and-trade scheme that will work best within their economy but will then plug into the international—

Mr Curnow —Yes.

Senator BUSHBY —Presumably in Australia the government has looked at the issues, and the proposal that we are looking at today is based on Australia’s peculiarities.

Mr Curnow —I cannot speak for the government, but my understanding is that there has been a lot of analysis of other schemes, particularly the European scheme, to learn from how they were set up initially. I think this scheme presents a lot of innovative things and others will learn from Australia—things like the obligation transfer number system. I think that presents a lot of opportunity for other countries who want to have a broad coverage and give flexibility as to where that liability is placed, particularly when you bring in transport. There is also the inclusion of forestry and the whole methodologies around that. So there are a number of innovative aspects here that I think others will learn from.

Senator BUSHBY —So, as you say, there are new measures in this ETS that may not be in other ETSs. But the bottom line is that, in setting up a cap-and-trade scheme, a government has a lot of options. In terms of the design there are a lot of things that a designer can look at and make decisions while still aiming to achieve the desired outcome. There are a lot of things that you can do differently in setting up a cap-and-trade scheme to reach that point.

Mr Curnow —Certainly, there will be differences. But I would argue that, when you analyse the various cap-and-trade schemes put in place, they really will not differ that much. They will differ really only in terms of how broad their coverage is and how you initially allocate the units.

Senator BUSHBY —And the compensation issues.

Mr Curnow —Of course there is compensation, which—

Senator BUSHBY —And how they deal with that as part of the scheme, when looking at the whole scheme and the way it works.

Mr Curnow —Yes.

Senator BUSHBY —So there are a lot of choices they can make. The government has gone for the approach that it has taken. As you note, there are some new measures in there, which in your opinion are good ones, but they could have and could still make other decisions to do some things differently—

Mr Curnow —Absolutely. There is always room to—

Senator BUSHBY —while still delivering an ETS based on a cap-and trade model.

Mr Curnow —That is right. There is probably not a lot that you could add to this scheme that has not probably already been thought of as far as types of design features go. To my mind, the way that you would tinker with this scheme would be more around the existing components, such as allocation, coverage—

Senator BUSHBY —A lot of the evidence that we are receiving from affected stakeholders around the country is on doing those sorts of things differently. That is one of the reasons why we are here. You also stated that it is critical that the legislation be passed without delay—those were your words. Then you went on to say that certainty is needed for business and that even those who do not agree with the need for the scheme are still calling for certainty. Is the certainty that is required the passing of the legislation and the setting up of the frame work so that businesses know exactly what they are going to be dealing with or is it the start date? If the legislation was passed today, and they knew exactly what it was, does it matter whether it is starting in 2010, 2012 or some other time—apart from the environmental concerns?

Mr Curnow —It depends. It would certainly depend on where you sit in terms of your type of business. If you are sitting on refinancing or reinvestment decisions, things are lined up and you have made an assumption that things would start on 1 July 2010 and you have factored in the price and then there is a delay, there is going to be a cost to you. Certainly a number of business that we have spoken to would be in that situation. There are others who are going to have a large liability under the scheme who would want one or two years of extra time to get ready for the scheme as a benefit. Realistic, that partly depends on where you sit as far as your—

Senator BUSHBY —But the bottom line is that what your clients in particular would like to know is the regulatory frame work that they will have to deal with. The sooner that that is in place the better. There are varying considerations as to what impacts the implementation date might have on your clients.

Mr Curnow —Having observed this, my sense is that perhaps in only the last three months there has been a growing consensus around the fact that we need that certainty in terms of the legislation being passed so that there is certainty around the scheme commencing. Then there is some divergence of views as to whether that should be 1 July 2010 or one year later. From a personal perspective and after observing how these markets work, delay in the longer run is just going to lead to higher costs for a lot of businesses. The early start date is there to give industry the full period in which to meet the required target.

Senator BUSHBY —I have one final question on that before I move on to another issue. If the scheme contains some flaws—there are issues with certain businesses or there are issues with the way it might apply—is it better to get that right before you implement it or is the certainty of knowing what they are dealing with more important?

Mr Curnow —It depends what flaws you had in mind. It depends on whether we are talking about details that would probably be the subject of regulation—and a lot of it will be. Bear in mind that a lot of the detail here, not from a macro policy point of view but the more technical aspects, will be laid out in regulation. That makes sense in terms of providing time to work out the technical layer of this scheme. To the extent that there are no fundamental flaw in the broad scheme coverage, you would want that passed because that would give certainty.

Senator BUSHBY —You are in a group within Baker and McKenzie which works on the provision of legal advice on climate change. How long as that been set up?

Mr Curnow —We set up this practice about 10 years ago at a global level.

Senator BUSHBY —How long has it been going in Australia?

Mr Curnow —In Australia, 10 years as well.

Senator BUSHBY —Do you envisage that there will be a great need for business, both large and small, to obtain legal advice around their obligations under the legislation as proposed at the moment?

Mr Curnow —Yes, I think that is right. I say that from current experience. We are certainly advising a range of clients on the draft legislation as well as the scheme more broadly. But you would expect that, mainly because you have a new piece of legislation that is putting in a new regulatory regime. People obviously want to make sure that they understand it, what their obligations are and the broader commercial implications of how you deal with the carbon pass-through—what that means for existing and future contracts and all those sorts of issues.

Senator BUSHBY —This line of questioning is not intended to reflect on you and I. Good on you—if you see an opportunity for business and you take it, that is good. What I am interested in is the obligations that it is going to place on business in addition to the direct costs that will arise as part of an intended consequence of the legislation, to shift people away from emissions intensive activities. There will be a lot of compliance costs and, as you just indicated, all business who are affected will need to understand their legal obligations under this regulatory framework once it is in place. Those obligations will be new and different to what a lot of them are used to.

Mr Curnow —That is right. But I would add that I do not think advice around understanding those would go on indefinitely. I think there would be a period after which you would expect people seeking that advice to understand it. Once you got your reporting systems in place and worked out your liability, I think that could quite quickly be absorbed into an organisation as an internal function which companies did as they do for other areas of compliance or even the trading side of things. Over time you would see the resources built internally, after which the transaction costs around legal advice or whatever would certainly be lower.

Senator BUSHBY —I do not want you to disclose anything protected by legal privilege, but have any of your clients raised issues regarding the timing of this in terms of their competitors in other countries not having to wear the same issues?

Mr Curnow —Yes. A number of clients have raised the issue and a concern around that, to the extent they fall within the category of emissions intensive trade exposed industries. I have noticed in the last few months that that is still a concern and the focus is on the current process of working out the definition activities from the basis of the compensation package as a way to deal with that, as opposed to delaying the scheme indefinitely. That is, I guess, the key issue for them. I think that comes back to your earlier point—

Senator BUSHBY —The lesser of two evils, effectively.

Mr Curnow —Perhaps. I cannot speak for them on that.

Senator XENOPHON —Mr Curnow, you said that you do not want us to go down the path of the old narrow gauge, standard gauge and broad gauge railways, so we need to have a system that meshes. But, as long as there is a basic cap-and-trade framework, there can be variations on a theme, can’t there—as long as there are emissions permits to trade and there is a trading mechanism in place?

Mr Curnow —Yes. As long as you have a fungible, permanent standard. It is all based on one tonne of carbon dioxide equivalent, across the Kyoto gases. That is what that represents. At a very rudimentary level, as well as the infrastructure, that is probably the most you need to transfer between two systems—a way for recording an export of one permit for another, inputting that into another, and finding out what that means for that system. I think, as they start to diverge more, it is likely you will have more technical questions around the way that they link. Also, importantly, there are political limitations; you are perhaps going to see more reluctance by countries to link two schemes which they feel are too different.

Senator XENOPHON —The fungible, the permit, that is the key to it though, isn’t it, if it is a CO2 equivalent?

Mr Curnow —Yes, that is a fundamental, but if you do not have the political support to actually link the schemes then you could still have compatible units.

Senator XENOPHON —Can I ask you about Europe? I think it may have been touched on earlier that the European scheme is now A$25 in the permit price Euro equivalent. The price then plunged to as little as $7 not so long ago. What can we learn from that, and what similarities are there with the Australian scheme so that we will not get that enormous volatility which does not give price certainty for renewables?

Mr Curnow —It has been an interesting thing to watch that price in Europe and the recent drop. If you look at the market fundamentals for Europe, the price should be twice as much, if not three times, according to some analysts.

Senator XENOPHON —What does that mean? You say it is the market fundamentals. Does that mean there is a market failure in terms of that particular scheme?

Mr Curnow —I think you have behaviour in the market there which is going against those fundamentals. I think that is being driven at the moment by the fact that people are using permits as a way to raise cash by selling them off. That really does go against the market fundamentals that you have unlimited banking in the European scheme from phase 2 to phase 3. The Europeans have unilaterally extended their scheme out to 2020 irrespective of what happens internationally. You have a longer-term target with unlimited banking and that really should imply that you would be not selling those off now; you would be holding onto those. The other key thing there is that the market will be short in this phase because the European Commission was much tighter in the allocation of permits through the member states and their national allocation plans. If it is projected to be short, goes up to 2020 and there is unlimited banking, you would expect the price to be a lot higher than it is. I think what has happened is you have people selling off permits as a way of raising cash.

The other issue is that they are able to do that because of the allocation rules of Europe which basically meant that for a temporary shutdown you do not have to surrender those credits or those permits; only for permanent shutdowns. So for two weeks if there is less economic activity and output, I guess, that is freeing up permits of some liable entities, who are then able to sell those off. That increase in sale and supply in the system has led to that price dropping.

Senator CAMERON —Both Senator Bushby and Senator Xenophon have put certain positions to you. Has anything that may have arisen from those positions changed your view that the CPRS is well designed and on par with international developments?

Mr Curnow —My view is that it is well designed, particularly because it has some very innovative features as I mentioned. From the work I do in various markets, I think, it is certainly on par. Of course we have not seen what the US has in mind as their potential cap-and-trade scheme, but my understanding is that there are already going to be discussions between the Australian government and the US government to look at what they might learn from our scheme.

Senator CAMERON —One of those innovative initiatives is the clean development mechanism. There has been some criticism that we should not be buying emission reductions offshore. What is your view on that?

Mr Curnow —My view is that you want full linking and that will take a few years because we are in a process of other countries setting up their own domestic schemes. You obviously have full linking at the sovereign state level between Kyoto parties, those who are parties to the protocol, but at the domestic emissions trading level we do not have the full linking, which I would view as important over time. The reason for that is that it opens up the opportunity to achieve the lowest cost abatement, wherever that might be achieved globally, given that it has the same impact wherever that is undertaken.

The CDM in that context is really what was at the core of including that originally under Kyoto—it allowed emissions activities to be undertaken in developing countries, where I guess the cost of abatement is less than developed countries, and developed countries could use those units towards their compliance targets. So in that context I think the linking of the ability to bring CERs into the Australian scheme is important. It also of course allows Australian companies to connect to those projects in offering services and technologies that we might have in those projects. I think the other important thing about the CDM is that at the moment that is the key way in which developing countries are engaged on climate change—that is the way that they are learning how you reduce emissions, how you report those emissions and how you account for those emissions. I think it has been a way to actually focus them around taking domestic action.

So I think, in all of those contexts, including CERs in the Australian scheme is important. There has been some criticism about that potentially meaning that Australia could achieve its entire target with offshore permits. I think in reality that would never happen for a number of reasons. We are only one buyer in the global market for CERs and while at the moment the price in Europe has dropped I think it will go back up in the next couple of years. So the ability to bring in CERs will always be a function of what the global price for that is compared to the Australian price. The other reality is that, being a project based mechanism, you do not necessarily have certainty of delivery—the output from those projects may vary and so the number of CERs actually generated may be different to what people imagine it is at the moment. There was a figure quoted at one point of 1.6 billion CERs. That is what is in the pipeline not what has been issued at the moment, so that is what is coming down the pipeline. Most of that has already been forward sold—mostly to European and Japanese buyers—so the probability of Australia getting all of those CERs and bringing them in to meet our entire compliance obligation I think is highly unlikely.

Senator CAMERON —How would you deal with the criticism that we are going too far ahead of everyone else, that this is not the right economic climate and that no-one else is doing anything like what we are doing? You raised the issue of China and India actually taking emissions abatement steps. Could you give me a flavour for how you feel about that?

Mr Curnow —I think it is fair to say that the Australian scheme would be the most comprehensive emissions trading scheme—mainly really because of its coverage more than anything else. I think every scheme that comes along after another will to some extent be more comprehensive because people will learn from what others have been doing. Certainly the coverage of the Australian scheme, as far as domestic schemes go, is broader than others. But Australia is not really ahead of where other countries are at or will soon be at in terms of putting in a domestic emissions trading scheme. I think the other thing to remember is that very few countries are looking at putting in domestic schemes which they are then going to quarantine from the global market. So a sense of linking those is what we are seeing in those places.

In terms of China, India and the like, certainly there are no broad national schemes in China or India as far as baseline and credit or cap and trade or sectoral or anything like that goes, but obviously that is one of the areas for discussion internationally—potentially having sectoral targets for countries like China and India. I think the notion that developing countries are not doing anything is just incorrect. If you go to China, you will see that obviously they have a lot to do in terms of reducing their emissions—but they have a mandatory renewable energy target of 20 per cent by 2015, I think it is; they have energy efficiency targets; and they have a whole range of measures around reducing emissions which, while not at a national cap level, are policies and measures that are being implemented. We see that across a number of those countries.

Senator CAMERON —Are you aware of the work of Frontier Economics and Danny Price in terms of the baseline and credit approach of emissions intensity?

Mr Curnow —Not in any detail. I am aware of baseline and credit schemes, having worked on New South Wales greenhouse gas projects, and of course the CDM is a baseline and credit scheme. It is in itself a baseline and credit scheme which brings credits into a cap-and-trade system.

Senator CAMERON —Can you advise us what you think would be the lost opportunities if we do not move quickly on this scheme?

Mr Curnow —I think a failure to have the legislation passed, and I guess not having certainty in terms of what the policy position is going to be, would have a large impact on current investment decisions—and not even just in terms of long-term competitiveness but also existing investment decisions that impact within the country. You are going to have potential significant losses there. You have probably already heard about the fact that in the electricity market there is no forward pricing beyond 2012-2013 because people are unsure about what the price is going to be. Delay in that context obviously means that you are going to get significant issues in the electricity sector. That is just one example. So I think delay really leaves all sorts of industries from all sides—whether they be trade exposed or strongly affected through to the market makers and the financial intermediaries, those who are actually going to be financing these projects—in a position where they are really not sure how they go about making their investment decisions. So I think there is a significant cost there the longer that is delayed.

CHAIR —Thank you.

Proceedings suspended from 10.02 am to 10.16 am