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Chapter 14 Caps for the carbon pricing mechanism

The Authority is required to make recommendations for caps under the carbon pricing mechanism. The Authority acknowledges that the Government intends to repeal the carbon price and replace it with a Direct Action Plan to reduce Australia’s emissions.

Caps under the carbon pricing mechanism limit emissions from electricity generation, direct combustion, landfills, wastewater, industrial processes and fugitive emissions. These emissions represent more than half of Australia’s total emissions.

Chapter 14 sets out caps consistent with the 15 and 25 per cent target options being considered by the Authority. The recommended caps take account of estimated emissions from sources outside caps, uncertainty in emissions estimates, free allocation of emission units and limits on the use of international units.

The Clean Energy Act 2011 (Cth) requires the Authority to make recommendations for caps under the carbon pricing mechanism. This legislated requirement persists even though the Government intends to replace the carbon pricing mechanism with its Direct Action Plan. Chapter 14 sets out the Authority’s approach to calculating caps that are consistent with either a 15 or 25 per cent target in 2020. It discusses:

  • the carbon pricing mechanism and the role of caps;
  • considerations in estimating the budget available for caps; and
  • the year-by-year shape of caps.

It presents calculations and draft recommendations for annual caps corresponding to the two 2020 target options identified in Part C of this Report – a 15 and 25 per cent reduction relative to 2000 levels. Further details, including calculation methodologies and data, are set out in Appendix E.

14.1 The carbon pricing mechanism and the role of caps

The carbon pricing mechanism was established under the Clean Energy Act and covers more than half of Australia’s emissions. Entities in covered sectors pay the carbon price if they emit at least 25 kilotonnes of carbon dioxide equivalent (kt CO2-e) annually. The remaining uncovered sectors are subject to an equivalent carbon price, or do not face a carbon price (Table 14.1).

Table 14.1 Coverage of the carbon pricing mechanism

Carbon pricing mechanism Equivalent carbon price No carbon price2
Emissions above the annual 25 kt CO2-e threshold from:
  • electricity generation
  • direct combustion1
  • industrial processes
  • waste deposited since July 2012
  • fugitive emissions
Transport fuels used for:
  • domestic aviation
  • marine transport
  • rail transport
  • business in off-road transport
  • non-transport business uses
Synthetic greenhouse gases
Emissions from:
  • agriculture
  • land use, land use change and forestry
  • fugitive emissions from decommissioned mines
  • conventional road transport
  • entities in sectors covered by the carbon pricing mechanism which fall below the 25 kt CO2-e threshold

Notes: (1) Direct combustion excludes diesel, which is covered by the equivalent carbon price (unless opted in).
(2) Some sources are eligible to create offsets under the Carbon Farming Initiative (CFI).

Under the existing legislation, the carbon pricing mechanism has a three-year fixed-price period from 1 July 2012 to 30 June 2015. When the fixed-price period ends, the legislation provides for annual caps on emissions covered by the carbon pricing mechanism (‘covered emissions’). The gap between the trajectory and cap allows room in the emissions budget for emissions from sources outside the carbon pricing mechanism (‘uncovered emissions’) (Figure 14.1).

The cap determines the total number of Australian carbon units for a particular year to be issued by the Government. These units would be provided to entities as a free allocation or sold at auction, generating Government revenue.

Figure 14.1: The relationship between the trajectory, cap and emissions

This figure shows the illustrative relationship between the trajectory, cap and emissions over time. The trajectory is a downward sloping line illustrating Australia’s indicative year-by-year national emissions pathway to its target. The area underneath the trajectory is equal to the national budget and comprises of covered and uncovered emissions. The cap is the limit on covered emissions. The cap is lower than the trajectory.Uncovered emissions fill the gap between the cap and the trajectory.

Source: Climate Change Authority

If emissions covered by the carbon pricing mechanism exceed the caps, liable entities could purchase international units or domestic offsets to make up the difference. Approved international units could be surrendered to meet up to 50 per cent of an entity’s carbon liability. At present, approved international units include European Union Allowances (EUAs) and Kyoto units (units generated under the Kyoto Protocol). A sub-limit of 12.5 per cent applies to Kyoto units. Domestic offsets include Australian Carbon Credit Units (ACCUs) under the CFI.

Under the Clean Energy Act, the Authority must recommend five years of caps, taking account of:

  • voluntary action to reduce Australia’s greenhouse gas emissions;
  • estimates of greenhouse gas emissions that are not covered by the Clean Energy Act;
  • the extent (if any) of non-compliance with the Clean Energy Act and the associated provisions;
  • the extent (if any) to which liable entities have failed to surrender sufficient units to avoid liability for unit shortfall charge; and
  • any acquisitions, or proposed acquisitions, by the Commonwealth of eligible international emissions units.

The current legislation requires the Minister responsible for climate change to take the Authority’s advice and recommendations into consideration when setting caps, and to announce caps five years in advance.

In the event that regulations setting the caps are not made or disallowed, the Clean Energy Act provides for default caps. The first annual default cap equals total emissions covered by the carbon pricing mechanism in 2012–13, less 38 million tonnes of carbon dioxide equivalent (Mt CO2-e). Following this, for each year that regulations were not made, the annual cap would be 12 Mt less than the previous compliance year (Figure 14.2).

Default caps were originally designed to be broadly consistent with the unconditional 5 per cent target. Since then, the 2000 base year emissions have been revised up, and projections for covered emissions for 2012–13 have been revised down. Based on the Authority’s current assessment, default caps are now broadly consistent with a 15 per cent target in 2020.

Figure 14.2: Default cap arrangements under the carbon pricing mechanism

This illustrative bar chart shows the default caps arrangements from 2015-16 to 2019-20. The first annual default cap, in 2015–16, is 38 million tonnes less than total emissions from sources covered by the carbon pricing mechanism in 2012–13. For each subsequent year, the default annual cap is 12 million tonnes less than the previous compliance year.

Source: Climate Change Authority

14.2 Overview of the Authority’s approach to caps

The Authority will recommend annual caps that are consistent with its recommended 2020 national emissions budget (Box 14.1).

To this end, the Authority must first determine how much of the budget to reserve for emissions from the fixed-price period and uncovered emissions from the flexible-price period. The remainder of the budget is available for caps, and can be distributed across the flexible-price period to 2020. This approach gives confidence that Australia’s total emissions will stay within its 2020 budget.

Box 14.1: Framework for calculating caps

In determining the number of units available for caps, the Authority has applied the following approach:

Emissions allowance for caps = National emissions budget (2013–20) minus aggregate emissions from the fixed-price period minus uncovered emissions in the flexible-price period minus adjustment for Global Warming Potentials (GWPs) minus adjustment for voluntary action

The figure shows a stylised breakdown of the national emissions budget from 2013 to 2020 to illustrate the Authority’s approach for determining the number of units available for caps. An adjustment for voluntary action, fixed price period emissions, uncovered emissions and an adjustment for Global Warming Potentials are depicted below the downward sloping trajectory. The emissions allowance for caps is the gap between the trajectory, emissions and adjustments.

Note: The area under the trajectory is equal to the national emissions budget (2013–20).
Source: Climate Change Authority

The Authority has used its best estimate of uncovered sector emissions, assuming existing legislation, to calculate caps. That is, the share of the budget allocated to uncovered sector emissions will be determined by a projection of what those emissions will actually be.

An alternative approach, suggested by the Business Council of Australia, is to set caps based on a proportional share of emissions, arguing that this would ‘avoid a disproportionate shifting of the abatement burden onto covered sectors’ (Issues Paper submission, p. 3).

The Authority does not propose to adopt this approach because:

  • encouraging equal shares of emission reductions across sectors is the wrong goal – it would not promote efficiency, because different sectors have different emissions reduction costs;
  • it relies on estimates of business-as-usual emissions. Many emissions reduction policies have been in place for years, and have changed Australia’s economy and emissions in permanent ways. As a result, business as usual becomes an increasingly abstract concept over time; and
  • it would not give a high likelihood of Australia meeting its national emissions budget. If the approach required uncovered sectors to deliver a certain amount of emission reductions, but no policies were in place to ensure that happened, Australia would breach its budget.

This does not mean that the Authority considers that uncovered sectors have no role in meeting the national emissions budget, or that existing policies in uncovered sectors are ideal. The overall policy mix should be reviewed regularly and policies in uncovered sectors should aim to deliver an equivalent incentive to reduce emissions as the covered sectors face.

Even so, the Authority does not consider that its approach would impose a disproportionate burden on covered sectors. Uncovered sectors already contribute to reducing Australia’s emissions. For example, between 1990 and 2012 emissions from the land sector (an uncovered sector) fell by 85 per cent, while emissions from electricity (a covered sector) increased by 53 per cent (see discussion in Chapter 12). Further, as discussed in Chapter 10, the level of the cap is not expected to affect the level of the carbon price (the burden that matters to firms) because of links to international carbon markets. As a result, the level of the cap would be unlikely to materially affect the burden faced by the covered sectors. The most significant impact is, instead, on Government revenue – providing the Government with a good incentive over time to ensure that appropriate policies apply to all sectors.

14.3 Estimating emissions outside the caps

To estimate emissions outside the caps, the Authority must consider:

  1. Fixed-price period emissions for the whole economy.
  2. Uncovered emissions during the flexible-price period, taking into account:
    • emissions that do not face the carbon price;
    • emissions that are subject to the equivalent carbon price; and
    • emissions associated with non-compliance and payment of the shortfall charge.
  1. Voluntary action and other adjustments.

The Authority has used the economic modelling discussed in Chapter 10 and Appendix C to estimate emissions. The medium scenario represents the best estimate of global and national economic activity. It therefore provides the best estimate of emissions, and has been used as the basis for calculating caps. Other scenarios have been used to test whether the resulting caps are robust across a range of possible future carbon market conditions. The Authority will monitor new emissions data and projections, and the implications for this analysis, and reflect relevant developments in its Final Report.

14.3.1 Whole-of-economy emissions during the fixed-price period

The Authority must estimate the whole-of-economy emissions that are likely to occur under the fixed-price period, since none of these emissions are covered by the caps. These emissions are subtracted from emissions available for caps. Based on the modelling, the Authority estimates fixed-price emissions to be 1 784 Mt CO2-e.

14.3.2 Uncovered emissions during the flexible-price period

The Authority must estimate the emissions from sources not covered by the carbon pricing mechanism. As illustrated in Table 14.1, some uncovered emissions do not face a carbon price at all; others face the equivalent carbon price.

The proposed treatment of these emissions in calculating caps is discussed below.

Emissions that do not face a carbon price

As set out in Table 14.1, a number of sectors do not face a carbon price. The Authority has made a best estimate of emissions from these sectors, then added estimated CFI credits and ‘below threshold’ emissions.

  • The CFI is a carbon offset scheme. CFI projects reduce uncovered emissions, but allow for an equivalent increase in covered emissions through the generation and use of ACCUs. To avoid double counting, the Authority needs to add the credited emissions reductions back to uncovered emissions.
  • Facilities in sectors covered by the carbon pricing mechanism that emit less than the 25 kt CO2-e threshold do not face a liability; these are referred to as ‘below threshold’ emissions and fall outside the caps. Below threshold emissions are difficult to estimate because many of those facilities are not required to report their emissions. The Authority has estimated below threshold emission by comparing covered emissions estimated from the national inventory with emissions that are liable under the carbon pricing mechanism.

Emissions subject to an equivalent carbon price

As set out in Table 14.1, some liquid fuel use for the transport sector and synthetic greenhouse gases are subject to the equivalent carbon price. The Authority has made a best estimate of emissions from these sectors, deducting estimated ‘opt-in’ emissions.

‘Opt-in’ arrangements allow large end users of fuel to voluntarily take on direct liability under the carbon pricing mechanism rather than face the equivalent carbon price. When entities choose to opt in, their emissions move from outside to inside the caps. This, in turn, makes more of the national emissions budget available for caps. Opting in during the fixed-price period allows liable entities to pay a lower carbon price on average over the year (as they can defer payment of their carbon cost to the end of the financial year rather than pay the equivalent carbon price each month). These benefits diminish in the flexible-price period; however, companies that opt in have greater flexibility to manage their carbon liability.

The Authority considers that entities that have already opted in are likely to remain within the carbon pricing mechanism. Some additional entities might opt in in the future, particularly very large fuel users. The Authority has made a best estimate on this basis.

Emissions subject to non-compliance and the shortfall charge

The Authority has considered whether to make an allowance for non-compliance or payment of the shortfall charge – that is, for emissions that should have been covered by the cap but were not. Under the carbon pricing mechanism, liable entities are required to surrender an eligible unit, or pay the shortfall charge, for every tonne they emit. If they choose to pay the shortfall charge or simply do not comply, they would not surrender emission units and those emissions would be outside the cap.

The legislation creates strong incentives for liable entities to comply and surrender eligible units. For example, the unit shortfall charge is double the benchmark average auction price for Australian carbon units during the particular compliance year, making it unlikely that entities would choose to pay the shortfall charge. Non-compliance is also unlikely as legal penalties apply and the rate of compliance for similar legislation has been close to 100 per cent. As a result, most liable entities would be likely to surrender emissions units. The Authority will therefore assume emissions associated with non-compliance and payment of the unit shortfall charge are zero when recommending caps to 2020.

Calculating uncovered emissions

Considering all these factors, the Authority estimates uncovered emissions during the flexible-price period to 2020 to be 1 379 Mt CO2-e.

14.3.3 Voluntary action and other adjustments

The Authority has considered:

  • accounting discrepancies between the carbon pricing mechanism, the CFI and the national greenhouse gas inventory;
  • voluntary action – accounting for GreenPower and the voluntary cancellation of renewable energy certificates;
  • Government purchase of international units; and
  • carryover from the Kyoto Protocol first commitment period.

Accounting discrepancies – changes in global warming potentials

The emissions reporting system used for the carbon pricing mechanism and the CFI is currently based on global warming potentials (GWPs) used in the first commitment period of the Kyoto Protocol. The international community has agreed to update GWP values for targets in the second commitment period; however; the accounting system used in the carbon pricing mechanism and the CFI will not be revised until 2017–18. As a result, there will not be a one-for-one relationship between the carbon pricing mechanism and CFI and the national emissions budget for the first two years of the flexible-price period.

The Authority has made its best estimate of this discrepancy and will deduct 16 Mt CO2-e from the budget available for caps.

Voluntary action – accounting for GreenPower and the voluntary cancellation of renewable energy certificates

As outlined in Section 8.7, the Authority considers three types of voluntary action should be recognised as additional to the national target – voluntary cancellation of domestic emissions units, GreenPower purchases and the voluntary cancellation of renewable energy certificates (RECs) under the Renewable Energy Target.

Only GreenPower purchases and the voluntary cancellation of RECs need to be considered when calculating caps. Voluntary cancellation of domestic units reduces caps directly; in contrast, GreenPower purchases and the voluntary cancellation of RECs reduce emissions from electricity generation, which is covered by the caps.

The Authority has made a best estimate of GreenPower purchases and voluntary REC cancellations over the period, and will deduct 16 Mt CO2-e from the budget available for caps.

Government purchase of international units

While the carbon pricing mechanism allows liable entities to buy and use certain international units, the Government could also purchase international units directly.

At this time, the Government does not have any plans to purchase international units under the carbon pricing mechanism. One reason direct purchase might be considered would be to loosen the caps required to meet any given target, and increase the number of Australian carbon units available for auction. This could reduce the cost of achieving any given target (for example, the Government could buy low-cost Kyoto units and sell additional Australian carbon units at a higher price). For strong targets, this could also reduce the risk that the 50 per cent limit on international units becomes binding.

As discussed in Section 14.5 below, Government purchase of international units provides a way to reduce the cost of achieving a 25 per cent target, and reduce the risk that the limit on international units would become binding.

As a result, the Authority has based its recommendations for caps for a 15 per cent target assuming no Government purchase of international units, and has based its recommendations for caps for a 25 per cent target assuming Government purchase of a total of 75 Mt CO2-e of international units to supplement caps for the period to 2020.

Carryover – the first commitment period under the Kyoto Protocol

As outlined in Section 8.7, carryover from the first commitment period of the Kyoto Protocol could be used to strengthen the 2020 target by 3 percentage points. On current estimates, this would shift the national trajectory down and reduce the national emissions budget for 2013–2020 by 91 Mt CO2-e. This would be directly offset by the carryover, which would then be available for caps. To illustrate the effect of adding the carryover, caps for an 18 per cent target would be broadly the same as those presented here for a 15 per cent target.

14.4 Managing uncertainty in emissions estimates

All estimates in the previous section are based on projected future levels of emissions. Actual emissions will inevitably be higher or lower than these estimates. If actual emissions are higher than estimated, Australia’s emissions could exceed the national budget to 2020. If actual emissions are lower, Australia would more than meet its budget to 2020, and the surplus units could be carried over and used after 2020.

The Authority’s objective is to recommend caps to meet the 2020 budget. Therefore, the Authority’s primary concern is whether actual emissions would be higher than estimated. If there was a material risk that uncovered emissions would be higher, the Authority could incorporate a buffer to guard against the risk. This approach had some support among stakeholders.

In the past, national emissions projections have tended to be too high rather than too low. For example, the Authority found that emissions projections for the first commitment period of the Kyoto Protocol overestimated emissions from uncovered sectors by 13 per cent on average. Further, future emission drivers are reasonably well understood and represented in models used. This suggests uncovered emissions are unlikely to be higher than estimated in the Authority’s modelling.

Emissions trends could vary if policies affecting uncovered emissions change; however, the Authority has made a best estimate based on existing legislative settings.

On balance, given the history of overestimation, the Authority considers there is no need to create an emissions buffer.

14.5 Year-by-year shape of caps

After estimating the proportion of the 2020 budget available for caps, the Authority needs to consider the year-by-year pathway or ‘shape’ of caps.

The Authority considers that, in general, the shape of caps should follow the slope of the trajectory on a year-by-year basis (Figure 14.3). This is a straightforward and predictable approach that clearly aligns caps with national emission reduction goals.

Figure 14.3: Shape of caps – releasing carbon units in line with the trajectory

This stylised figure shows what annual caps look like when following the downward sloping trajectory over the time period 2012-13 to 2019-20. Fixed price emissions are shown between 2012-13 and 2014-15 and uncovered sector emissions from 2015-16 to 2019-20. Annual emissions caps fill the gap between the trajectory and uncovered sector emissions. The annual emissions caps decrease in line with the trajectory.

Source: Climate Change Authority

Still, as stakeholders including the Australian Industry Group noted, it may be appropriate to change the shape when:

  • caps are insufficient to accommodate the free allocation and early auction of Australian carbon units; or
  • caps are at a level that could affect the carbon price, due to limits on international units.

14.5.1 Ensuring sufficient units are available for free allocation and early auction

To ensure consistency with the design of the carbon pricing mechanism, caps should be large enough to accommodate the allocation of free carbon units under the Jobs and Competiveness Program and the Energy Security Fund; and the scheduled early auction of carbon units. Where caps based on the slope of the trajectory are not sufficient to cover these allocations, the Authority will redistribute units across the period.

For a 25 per cent target, reshaping is required to accommodate free allocation and early auction. Units have been redistributed to ensure at least five million units are available beyond these minimum requirements, and to ensure the total number of units across the period remains the same. No reshaping is required for a 15 per cent target.

14.5.2 Ensuring sufficient units are available to minimise the impact on the carbon price

The Authority identified two potential ways in which caps could influence the level of the carbon price, which could be addressed through shaping caps.

First, caps affect whether the 12.5 per cent sublimit on Kyoto units is binding. Liable entities can meet up to 12.5 per cent of their liability under the carbon pricing mechanism with units created under the Kyoto Protocol (Kyoto units). Kyoto units are currently trading at prices well below European prices. If liable entities are unsure whether they need to use the full 12.5 per cent allowance, the carbon price in Australia could be volatile, fluctuating between the Kyoto unit price and the European price. This could be avoided by shaping caps to ensure the sublimit was binding in every year.

The Authority’s analysis indicates the Kyoto sublimit would be binding in all years under a 15 and 25 per cent target, so there is no need to reshape caps.

Second, caps affect whether the overall 50 per cent limit on international units is binding. This limit applies until 2020. If domestic units are in short supply, and the 50 per cent limit becomes binding, the price of domestic units would need to rise above the European price. Caps could be shaped across the period to minimise the risk that the 50 per cent limit would bind in any year.

The Authority’s analysis indicates the 50 per cent import limit would not bind for a 15 per cent target, so there is no need to reshape caps.

For a 25 per cent target, the analysis shows the 50 per cent import limit does bind in the later years. However, this cannot be corrected through reshaping caps, as there are insufficient units available across the period to 2020. The budget available for caps is 814 Mt CO2-e, less than half the projected emissions from liable entities. Carbon offsets under the CFI would not be sufficient to cover the shortfall. If international carbon prices were lower, the shortfall would be even greater. As a result, the domestic carbon price would need to increase above the European price to drive additional emissions reductions within the domestic economy, leading to higher compliance costs for liable entities, and higher cost impacts on consumers.

The budget available for caps could be increased if the Government purchased some international units directly (as discussed in Section 14.3.3). This could reduce the cost of meeting the 25 per cent target, as the Government could purchase international units, increase the number of Australian carbon units available to auction and minimise the risk that the 50 per cent import limit was binding. The Authority’s analysis indicates Government purchase of 75 million units would be sufficient to minimise the risk, even if international carbon prices remained low. The budgetary cost of purchasing these units would be offset by the additional revenue raised. The caps recommended in the next section for a 25 per cent target assume 75 Mt CO2-e is added to the budget available for caps.

14.6 Recommended caps for 15 and 25 per cent targets

Taking into account the issues discussed in this Chapter, caps are recommended for the five years from 2015–16 to 2019–20. Table 14.2 outlines the 2020 budget that is available for caps for a 15 and 25 per cent target.

Table 14.2: Budget available for caps

  15 per cent target 25 per cent target
National budget (2013–2020) 4 314 4 010
Fixed-price period-emissions (2013–2015) -1 784 -1 784
Uncovered emissions (2016–2020) -1 379 -1 379
Global Warming Potentials adjustment -16 -16
Voluntary action (GreenPower and voluntary cancellation of renewable energy certificates) -16 -16
Government purchase of international units 0 75
Available for caps 1 119 889

Note: All figures in Mt CO2-e. Totals may not sum due to rounding. Uncovered emissions include CFI estimates.
Source: Climate Change Authority, based on The Treasury and DIICCSRTE 2013 data and GreenPower 2013

Draft recommendation

R.7 That the level of carbon pollution caps for each of the first five years of the flexible price period under the carbon pricing mechanism be:

  If Australia adopts a
15 per cent target (Mt CO2-e)
If Australia adopts a
25 per cent target (Mt CO2-e)
2015–16 234 193
2016–17 229 178
2017–18 224 182
2018–19 219 171
2019–20 214 165