Evolving Australian carbon markets

Carbon markets, in various forms, have remained an enduring feature of Australian carbon policy in an environment of considerable uncertainty. Through previous greenhouse gas mitigation policies, the underlying infrastructure of carbon markets in Australian has become well-developed. This includes the greenhouse gas monitoring and reporting systems, along with a range of carbon offset methodologies. The underlying infrastructure appears to form a robust basis on which future policies will be developed, and will continue to shape the evolution of Australian carbon markets. In this context, recent developments in Australian carbon markets may provide useful guidance to the likely evolution of Australian carbon markets in the future.

Demand for carbon credits in Australia

Under current policy settings, the 203 most significant industrial GHG emitters (facilities which emit more than 100,000 tonnes of CO₂-equivalent a year) are required to keep their emissions under defined baselines. Those that exceed their baselines must surrender an equivalent number of carbon offsets (those that do not exceed their baseline do not get any form of credit). These offsets must be Australian Carbon Credit Units (ACCUs) generated from projects carried out in Australia according to a range of Government-defined methodologies. In its first year of operation (the 12 months to June 30, 2017) these facilities emitted 131.3 Mt of CO₂-e, but only a few exceeded their baselines, by a total of 448,097^[1]. This means broader market demand for Australian carbon offsets for compliance purposes is relatively low, and on current policy settings is unlikely to increase.

There were also 140,000 Australian compliance offsets voluntarily cancelled in the year to June 2018, which is small compared to national emissions of 534 Mt (though much voluntary activity involves retiring international credits such as Gold Standard carbon credits).

The primary source of current carbon demand is the Emissions Reduction Fund (ERF) in which AUD$2.55 billion^[2] is being spent to purchase domestic carbon offsets. Much of this has been in the form of contracts to provide carbon offsets, typically over seven to ten years, which recognises that carbon projects often generate offsets over a number of years, and incur many of their costs upfront. In the absence of other sources of demand, a long-term contract is required to make the investment viable.

The Emissions Reduction Fund has used a series of reverse auctions to secure contracts for the provision of carbon offsets^[3]. These auctions used a discriminatory-price format, in which successful bidders receive the price they specify. Each auction has an undisclosed reserve price, and the Government retains some discretion over how many bids which come in under the reserve price are accepted. Auctions are run at irregular intervals with no pre-specified budget. The first was in April 2015; the eighth and most recent was in December 2018.

The first auction in April 2015 contracted 47 Mt of carbon from 107 projects^[4] at an average price of AUD$13.95/t. The second auction contracted a similar volume (45 Mt) at a lower average price ($12.25/t); in the third auction, the price fell to $10.23/t (Figure 1). This fall in prices suggests that the auctions were succeeding in maintaining a competitive environment. It was also clear that the carbon tax price of AUD$23/t from the previous Government was no longer anchoring price expectations. The volume of carbon and number of projects also declined, suggesting declining participation, perhaps due to the low prices seen in some of the auctions. More recently prices are trending higher (Figure 2).

Supply of carbon credits in Australia

The supply of carbon credits, particularly ACCUs, has focussed around projects participating in the ERF. Supplying participants in the ERF may be divided among projects which focus on bio-sequestration of carbon in soils and vegetation, and projects which focus on emission abatement (i.e. destruction of methane gas from landfill). Within these, 10 broad types of methodology may be identified with three bio-sequestration methods (forest regeneration, soil carbon and reforestation) and 7 emissions abatement methods (avoided deforestation, landfill gas, savanna fire management, energy efficiency, waste management, agricultural practice change and coal gas). Over time, the mix of contracted project types has evolved (Figure 3), where emissions abatement projects strongly dominated the initial auction round, bio-sequestration has dominated all subsequent rounds. In particular, bio-sequestration projects applying native forest regeneration methods have become the most significant source of carbon in later rounds and now represents almost half of all ERF contracted carbon (Figure 4).

The prevalence of forest regeneration and avoided deforestation projects suggests a preference for projects with low upfront costs. Unlike reforestation, these methods do not require active tree planting which can cost around $3,000/ha^[5]. Avoided deforestation can have the added benefit of generating carbon offsets quickly as there is no need to wait for trees to grow. For native forest regeneration, the main activity is generally the exclusion of livestock, which suppress tree growth. The main cost is foregone revenue from grazing animals. Capital investment is minimal, though additional fencing may sometimes be required. While carbon sequestration projects have permanence requirements, landholders do have the option to reverse a project if they return the equivalent number of carbon offsets (though there are additional penalties for exiting Emissions Reductions Fund contracts).

Contracts awarded in the auctions run for a maximum of ten years. Most bio-sequestration (projects will continue to generate offsets for longer than ten years due to the time taken for trees to reach their maximum size, but generating income from this will depend on future demand for carbon offsets. The majority of the $2.55 billion allocated to the auctions has now been allocated, and on current policy settings, there is little broader market demand. Foregone option values for the land on which biological sequestration projects occur is a major component of the costs of carbon such projects. It is therefore perhaps not surprising that many land sector participants are seeking to develop sequestration projects that require little capital and are potentially reversible at some point in the future.

There has been reasonable uptake of soil carbon sequestration projects, though this represents a small fraction of its overall potential. These soil carbon sequestration contracts have been put together by aggregators, bringing together a large number of smaller projects across different parcels of land in an attempt to minimise transaction costs. This means that individual projects appear quite large in the data (Figure 5), although individual elements of such projects may be small. None have yet proceeded to the stage of delivering any carbon offsets to the Government (Figure 6). The success, or otherwise, of these projects represents a significant source of uncertainty for Australian carbon markets. Soil carbon sequestration could be a significant source of offsets, though the transaction costs will be high. While Australian farms are relatively large, the attainable quantities of soil carbon per hectare tend to be much lower than elsewhere.

Reforestation has the potential to contribute many millions of tonnes of carbon offsets per year over several decades to Australia’s national GHG mitigation efforts. It can also bring significant environmental co-benefits such as biodiversity protection and improved water quality, although it can reduce downstream water availability, a significant problem in some parts of Australia. Despite this potential, reforestation has so far played only a modest role in generating carbon offsets with 22 projects contracted for an average of 150,037 tonnes (Figure 5) representing just 2% of the volume contracted through the auctions (Figure 4). Reforestation projects typically incur large upfront costs (to prepare the land and establish new trees) and a significant loss of option value for landholders. Returns are highly variable across the landscape, and there can be opposition to displacing agricultural production. Many stakeholders value the environmental co-benefits that come from reforestation, but this requires biodiverse plantings which sequester less carbon than monocultures.

The capture and destruction of methane from landfill waste disposal sites is the third most significant methodology by volume. These projects are capital intensive but have the added benefit of generating power through burning the captured methane. Landfill gas projects were particularly prominent in the first auction as many had been planned and prepared under previous carbon policies. There has been some contention about the aditionality of landfill gas projects, as many already attract payments through renewable energy incentive schemes^[6]. Perhaps unsurpisingly, landfill gas projects have delivered the largest proportion of contacted offsets among other methods (Figure 6).

The other major source of GHG abatement offsets in the Australian market is savanna fire management. Wildfires are common in Australia, particularly the tropical savannas across the north. These fires emit substantial quantities of GHGs, and not just from the combustion of carbon in the vegetation. Nitrous oxide and methane emitted from fires contribute 1-3% of accountable national emissions, depending on annual fire activity. Vast areas of northern Australia burn each year in late dry season wildfires which can be managed through prescribed burning^[7]. In Australia’s tropical savannas, fire management involves strategic controlled burns early in the dry season to reduce the risk of major fires occurring in the late dry season. The resulting reduced frequency and severity of fires can reduce GHG emissions against a business-as-usual scenario.

Savanna projects typically involve re-establishing traditional Aboriginal fire management regimes, which provide economic and social benefits for Indigenous Australians on their traditional lands. So far 57 of these projects have been contracted through the Emissions Reduction Fund auctions (Figure 5), covering much of the northernmost areas of Australia. This corresponds to the areas previously identified as having the greatest economic potential^[8]. This method could be applied further south, although the benefits would be less as rainfall, and hence fire frequency, are lower, so there is less scope to reduce fires. In addition to avoiding direct GHG emissions from fires, a change to the methodology means that these projects will in the future have the potential to also generate offsets from enhanced biomass in the vegetation which results from decreased fire frequency.

The performance of this methodology does vary seasonally, as offsets are based on actual fire frequency rather than modelled projections. However, many of these projects have been running for a number of years and are progressing well. Overall, savanna fire management projects have already delivered 19% of their contracted commitments (Figure 6), suggesting that it will be a dependable source of offsets into the future.

Energy contributes over 80% of Australia’s national GHG emissions but represents just a small part of the carbon offsets market (though there is a separate program mandating a national renewable energy target). There are a range of methodologies rewarding improved energy efficiency, which contributed a total of 17 projects, mostly in the earlier auctions (Figure 4). There have also been small numbers of projects around waste streams and fugitive GHGs from coal mines. Other agricultural projects have mostly been based on the capture and combustion of methane from piggery waste. These tend to be relatively small individual projects but are cost-effective as they also generate energy^[9]. Cattle (through enteric methane) are responsible for the majority of Australia’s agricultural emissions, but to date, only a single project has targeted these emissions, despite there being a number of available methodologies.

Emerging trends in the Australian carbon market

Within these 10 broad types of methods for generating Australian carbon offsets there are currently 37 specific methodologies, although the market has consolidated around a much smaller number. Many methods have never been applied. This has resulted in a rather concentrated market which is heavily exposed to biological sequestration, particularly low upfront cost forest regeneration projects. It is somewhat puzzling that energy efficiency methodologies have not been more widely adopted, given the scale of energy-related emissions. It is possible that the decline in prices over the first three auctions pushed such schemes out of the market. Indeed there was a notable decline in the diversity of methodologies contracted over the eight auctions to date.

There is also evidence of geographical concentration. The forest regeneration projects which make up around half the current market are concentrated across a reasonably contiguous region of northern New South Wales (centred around the semi-arid region of Cobar) and southern Queensland. This is likely to reflect relatively low returns from grazing in these regions, and perhaps the diffusion of the method through landholder social networks. However, this also subjects them to correlated environmental risks such as drought (and associated fires), which would have a large flow-on impact on the broader market.

In principle, this consolidation should reflect the market identifying and pursuing the lowest cost carbon opportunities. However, the dominance of a single large buyer (the Emissions Reduction Fund), which is focussed solely on the lowest cost carbon rather than building a diversified portfolio may cause the market to become sub-optimally concentrated. Another factor will be the role of a small number of carbon market professionals who play a key role in project development, providing advice and in many cases taking stakes in projects. The legislative requirements of the carbon offset scheme, and the complex nature of GHG emissions and sequestration make project development a complicated and time-consuming process.

A large proportion of projects involve three or four specialist advisory companies who have the expertise and experience necessary to navigate the system. As these individuals and firms build their experience they inevitably come to specialise in particular methodologies; indeed it is necessary for them to do so in order to realise economies of scale. This introduces an element of path dependency to the market, and with future market opportunities currently limited there is little incentive to incur the costs required to diversify into additional methodologies. However it should also be noted that these professionals also act as a (privately funded) extension and salesforce for the carbon market; without them, participation by landholders would likely be far lower.

These are strange times for carbon markets globally, and Australia is no exception. Public investment has created a surge in carbon offset projects, but these have become heavily concentrated in a small number of methodologies, which limits the resilience of the market to environmental or economic shocks. Despite widespread positive intentions, there is little demand from compliance buyers, and uncertainty over future international carbon trading frameworks is inhibiting investment. Market-based solutions offer the most efficient means of achieving a policy goal such as reducing GHG emissions. However, efficient markets require a supportive institutional environment. Investment in carbon offset projects is a risky business given the likelihood (or certainty) of future policy changes. Domestic policy has changed repeatedly, and international frameworks for carbon trading are yet to be finalised, which is inhibiting the development of carbon markets, and the ability of firms to make longer-term plans based on market signals. Those emitters looking to the market to meet current or future compliance liabilities will find limited opportunities, which may prompt some to find in-house opportunities rather than relying on markets to find the lowest cost solutions.

By Dr Andrew Reeson and Dr Todd Sanderson.

 

[1] www.cleanenergyregulator.gov.au/NGER/National%20greenhouse%20and%20energy%20reporting%20data/ safeguard-facility-reported-emissions/safeguard-facility-emissions-2016-17

[2] As of January 2019 2.55bn Australian dollars is equivalent to 1.6bn Euros

[3] The authors provided advice (not all of which was followed!) on the initial design and later review of these auctions.

[4] These figures exclude projects which were initially awarded contracts but have been discontinued.

[5] Polglase, P. J., et al. (2013). Potential for forest carbon plantings to offset greenhouse emissions in Australia: economics and constraints to implementation. Climatic Change 121, 161-175.

[6] Burke, P.J., (2016). Undermined by adverse selection: Australia’s direct action abatement subsidies. Economic Papers: A journal of applied economics and policy, 35(3), 216-229.

[7] Note these northern fires are quite different to the less regular but more destructive and dangerous fires in southern Australia (which are generally the ones to make the news)

[8] Heckbert, S., et al. (2012). Spatially explicit benefit-cost analysis of fire management for greenhouse gas abatement. Austral Ecology, 37(6), 724–732.

[9] Hertle, C. (2008). Assessment of Methane Capture and Use from the Intensive Livestock Industry. Rural Industries Research and Development Corporation (RIRDC), Australia.