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GRANT ANDERSON*
On 2 December 2009, the Senate voted for the second time to reject the federal government’s Carbon Pollution Reduction Scheme Bill 2009 (Cth) (the ‘CPRS Bill’). This rejection, which followed the negotiation of amendments with the Opposition to secure the passage of the CPRS Bill, came when the Opposition split over support for the CPRS Bill and ended up adopting an anti-emissions trading scheme platform. While the Bill (with the amendments) was reintroduced into Parliament in February 2010, the federal government chose not to proceed with it and subsequently announced that it would defer consideration of an Australian emissions trading scheme until 2012.
It is now more evident than ever that the complexity inherent in an emissions trading scheme, and the economic consequences of imposing a carbon price that will manifest itself in price increases for emissions-intensive and energy-intensive goods and services (including electricity, gas and transport fuel), mean that an emissions trading scheme is highly unlikely to be passed into law without bipartisan support. The deferral, and possible demise, of the government’s proposed Carbon Pollution Reduction Scheme (the ‘CPRS’) is unfortunate because it deprives Australia of an important policy tool that could assist in transitioning Australia from a high carbon economy to a lower carbon economy. The advantage of an emissions trading scheme (or a carbon tax) where it applies across the economy is that it minimises economic inefficiencies through leaving it to the market to determine the most cost-efficient manner in which to secure the reduction in greenhouse gas emissions that is necessary to meet a particular cap on those emissions. The alternative of directly regulating greenhouse gas emissions (for example, through mandating emissions levels for specified activities) is likely to see higher cost emissions reductions achieved at the expense of lower cost abatement alternatives.
Nonetheless, this article proceeds on the, perhaps incorrect, assumption that an Australian emissions trading scheme will ultimately be introduced, and that the scheme will be similar to the scheme that is contemplated by the CPRS Bill.[1]
The CPRS is a cap and trade scheme. The cap component consists of the government setting by regulation the aggregate number of tonnes of carbon dioxide equivalent of greenhouse gases[2] that may be emitted each year by activities that are covered by the CPRS[3] and issuing (either by auction or administrative allocation) carbon permits, called Australian emissions units (‘AEUs’), equivalent to that number of tonnes. Each year liable entities are required to surrender that number of AEUs that corresponds to their greenhouse gas emissions, failing which they must both pay a monetary penalty[4] and make good the deficit in AEUs as part of their surrender obligations for the following year.[5]
The trade component is the mechanism whereby those liable entities that value AEUs most (that is, that generate the highest returns from emitting greenhouse gases) acquire the AEUs they require to cover their emissions. A trade in AEUs develops because the emissions cap for a year is less than business-as-usual emissions, resulting in the demand for AEUs exceeding their supply. It is this which puts a price on carbon and results in those who value AEUs most purchasing them, while those who value AEUs less modify their activities so as to reduce their emissions (for example, by reducing the output of their emissions producing activities or by introducing lower emissions technologies and practices).
This is a simplified description of the operation of the CPRS because, under the CPRS Bill, AEUs will be able to be borrowed and banked — that is, AEUs issued in respect of a year that precedes or comes after a particular year will be able to be used to acquit an entity’s CPRS liability for that particular year. In addition, under the CPRS Bill, emissions liabilities will be able to be satisfied not just by surrendering AEUs but also by surrendering emissions reductions that are created both domestically and internationally (for example, from forest sequestration). However, it is sufficient to set the context for this article, the purpose of which is to examine an issue that is not likely to attract much political debate, but that is nevertheless of significant practical importance. This is the issue of the pass through of costs incurred under a scheme such as the CPRS.
Broadly speaking, two groups of entities attract liability under the CPRS Bill: direct emitters of greenhouse gases and upstream fossil fuel suppliers. As a general rule, where a facility produces direct (scope 1) emissions of 25 000 tCO2-epa or more, the entity that has operational control over that facility[6] (or, where that entity has an Australian holding company, that holding company) will be required to surrender AEUs to cover those emissions.[7] Conversely, upstream fossil fuel suppliers will be required to surrender AEUs to cover the greenhouse gas emissions embodied in their fuels irrespective of the amount of those embodied emissions.[8] These liability provisions will result in the CPRS imposing direct liability on around only 1 000 entities, but it will have an economic impact that is far wider than its impact on these entities because the resultant carbon price will increase the prices of energy-intensive and emissions-intensive goods and services, such as petrol, electricity, gas, transport, aluminium, cement, glass, iron and steel, which are widely used throughout the economy.
For the CPRS to have its intended effect of transforming the Australian economy from a high to a lower carbon-intensive economy, it is critical that liability under the CPRS is imposed on the entity that is in the best position to manage that liability and to pass on the costs associated with it to those who buy the output of the relevant activity. Contracts drafted following the introduction of a scheme such as the CPRS can be structured so as to deal with the allocation of CPRS costs, and this article sets out a number of considerations that need to be taken into account in drafting the relevant provisions. However, contracts that are negotiated before the introduction of a CPRS-type scheme might not provide for the allocation of CPRS costs, at least in unambiguous terms. While the federal government has ruled out legislating for the pass through of CPRS costs, it has included in the CPRS Bill some statutory mechanisms that are designed to facilitate the pass through of those costs under existing (as well as future) contracts. It is to these mechanisms, and the limitations inherent in them, that this article first turns.
The CPRS Bill contains two statutory transfer mechanisms that enable the transfer of CPRS liabilities: the liability transfer certificate (‘LTC’) mechanism and the obligation transfer number (‘OTN’) mechanism. The LTC mechanism can be utilised to transfer liability for direct emissions within a corporate group or to the financial controller of the emitting facility, while the OTN mechanism can be utilised to transfer liability for embodied greenhouse gas emissions from upstream fossil fuel suppliers to downstream entities in the fossil fuel supply chain. Both of these mechanisms are discussed below.
Liability for the direct emissions of a facility is imposed on the entity that has ‘operational control’ over the facility or, where that entity has a ‘controlling corporation’, on the controlling corporation of that entity. For these purposes, and as is the case for the associated reporting scheme that is implemented under the National Greenhouse and Energy Reporting Act 2007 (Cth) (the ‘NGER Act’), the ‘controlling corporation’ of an entity will generally be the ultimate Australian-incorporated holding company of the entity,[9] and an entity will have ‘operational control’ over a facility where it has the authority to introduce and implement operating, health and safety, or environmental policies for the facility.[10] Because it is conceivable that more than one entity might have this authority, it is provided that the entity which has the ‘greatest authority’ to introduce and implement operating and environmental policies for the facility will have operational control over the facility.[11] The question of which entity has operational control over a facility where the authority to introduce and implement operating, health and safety, and environmental policies is shared between entities is likely to arise where, for example, a facility owner contracts out the operation of the facility to a third party.
By way of digression it is noted that the application of the concept of operational control to unincorporated joint ventures raises some complexities. Because the CPRS Bill (and NGER Act) only contemplate that one entity can have operational control over a facility,[12] in circumstances where an unincorporated joint venture (as opposed to the joint venture operator, if any) has the (greatest) authority to introduce and implement the relevant policies, it is provided that the joint venturers must nominate one of their number as the entity that is to be taken to have operational control over the facility.[13] However, as a practical matter, securing agreement on the nominated entity will often not be an easy task; the nominated entity (or its controlling corporation) will thereby assume 100 per cent of the CPRS liability associated with the facility’s emissions and will be reliant on its fellow joint venturers to provide it with either funds or AEUs to meet their share of this liability — that is, the nominated entity will bear the statutory liability and will be exposed to the credit risk or contractual default risk of its fellow joint venturers. In the face of these quite genuine difficulties, the federal government has sought to drive joint venturers towards reaching agreement on the appointment of a nominated entity by using a rather blunt instrument. Under the legislation, a failure to nominate an entity for this purpose will expose all the joint venturers to a civil penalty[14] and will result in each of the joint venturers (or their controlling corporations) bearing an equal share of the joint venture’s CPRS liability.[15] Apart from the issue of the civil penalty, this would result in a sharing of CPRS liability that may be considerably out of proportion to the participants’ joint venture interests — in particular, those participants that have a lesser joint venture interest will bear a disproportionate share of the CPRS liability associated with the joint venture’s activities. A more preferable outcome in the case of unincorporated joint ventures, where operational control over the joint venture’s activities is not vested in another entity, would be for the CPRS liability associated with the emissions of those activities to be imposed directly on the individual joint venturers in proportion to their joint venture interests as at a particular point in time (for example, as at the end of the previous reporting year).
It is against this background that the LTC mechanism enables:
(a) the controlling corporation of an entity with operational control over a facility to transfer liability for the facility’s emissions to another member of the controlling corporation’s corporate group;[16] and
(b) an entity with operational control over a facility (or its controlling corporation, if any) to transfer liability for the facility’s emissions to an entity that is not a member of the same corporate group as the first-mentioned entity where financial control over the facility rests with the second-mentioned entity.[17]
In both cases, this transfer of liability occurs by virtue of the Australian Climate Change Regulatory Authority (‘ACCRA’) issuing the transferee with an LTC. As a consequence of being issued with an LTC, the LTC holder will assume liability for the greenhouse gas emissions emitted by the relevant facility during each financial year (or part thereof) for which it holds the LTC, but only if the quantity of those greenhouse gas emissions exceeds the (proportionately pro‑rated) 25 000 tCO2-e threshold.[18] An LTC is facility-specific and cannot be transferred.[19] However, once issued, an LTC remains in force until it is surrendered by the LTC holder or cancelled by the ACCRA.[20] The ACCRA must cancel an LTC if (among other things) the LTC holder ceases to meet the eligibility requirements for an LTC (see above), the LTC holder fails to pay any unit shortfall penalty imposed on it in respect of the facility within 30 days after the due date,[21] or the LTC holder suffers an insolvency-related event.[22] The surrender or cancellation of an LTC will result in CPRS liability in respect of the facility reverting to the entity that would have had that liability in the absence of the LTC.
The objective of the LTC mechanism is to enable CPRS liabilities to be transferred to those entities that are best placed to manage them. As stated above, there are two circumstances in which the LTC mechanism can be used. These are discussed below.
The need for a mechanism to transfer the CPRS liability associated with a facility’s emissions within a corporate group arises because the CPRS Bill imposes that liability on the controlling corporation of the group. The issue in this regard is that the controlling corporation will often not be the entity that enters into contracts for the sale of the emitting facility’s output. Instead, the contracting entity is more likely to be the subsidiary of the controlling corporation that has operational control over the facility. As such, any cost pass through provisions in these contracts (at least where they were negotiated prior to the introduction of the CPRS) is likely to be confined to costs imposed on the subsidiary, and so will not extend to the costs imposed on the subsidiary’s controlling corporation in discharging its CPRS liabilities.
The purpose of the intra-group LTC mechanism is to overcome this problem by allowing the controlling corporation to transfer its CPRS liability for the facility to the subsidiary and therefore render the costs associated with discharging that liability as costs of the subsidiary. Unfortunately, the LTC mechanism, as structured in the CPRS Bill, is unlikely to achieve its objective of enabling the subsidiary to pass through those costs to the counterparty under an existing (pre-CPRS) contract. The reason for this is that one of the most common forms of cost pass through provisions is a change in law clause, and change in law clauses typically only apply to costs that are incurred ‘as a result’ of a change in law. While there is no doubt that the introduction of the CPRS will constitute a change in law, the transfer of CPRS liability from a controlling corporation to its subsidiary entails a voluntary assumption of liability by the subsidiary. Specifically, it entails the subsidiary applying (with the controlling corporation’s written consent) to the ACCRA for an LTC for the facility.[23] By voluntarily applying for an LTC, and thereby taking a transfer of its controlling corporation’s CPRS liability for the facility, the subsidiary will not be incurring the associated costs of satisfying the CPRS liability ‘as a result’ of a change in law but, instead, ‘as a result of’ its voluntary action in applying for an LTC.
Even in contracts that are negotiated after the CPRS comes into operation (so that a change in law clause will not be triggered), any cost pass through clause will need to be carefully drafted to encompass costs that are voluntarily incurred by the subsidiary under the LTC mechanism if it is indeed intended that CPRS-related costs should be passed through to the contract counterparty.
While these issues could be overcome by imposing the CPRS liability for a facility’s emissions directly on the group member that has operational control over the facility, an alternative approach that is more consistent with the framework of the CPRS Bill would be to require a subsidiary that has operational control over a facility to apply for an LTC unless its controlling corporation agrees otherwise. This would result in the imposition of a legal obligation on the subsidiary, which would trigger the operation of a change in law clause in any contracts the subsidiary may have for the sale of the output of the facility. It would also avoid the need for new contracts with such subsidiaries to be drafted with cost pass through provisions that extend to the costs incurred under the CPRS Bill by those subsidiaries’ holding companies or that extend to costs that are voluntarily incurred by the subsidiary.
In order to qualify for the issue of an LTC, the subsidiary must satisfy the ACCRA that it has, and is likely to continue to have, the capacity, access to information and financial resources necessary to comply with the CPRS obligations and national greenhouse and energy reporting scheme reporting obligations that will thereby be imposed on it.[24] Moreover, if the ACCRA issues an LTC for the facility, then the controlling corporation is taken to have given a statutory guarantee for the payment of any unit shortfall penalty imposed on the LTC holder (and any associated late payment penalty).[25] These safeguards should be sufficient to support the primary liability being imposed on the subsidiary as they effectively require the controlling corporation to stand behind the subsidiary’s obligations much as the controlling corporation would need to do where CPRS liability is imposed directly on it.
A further issue with the intra-group liability transfer mechanism contained in the CPRS Bill arises where a subsidiary is not a wholly-owned subsidiary (for example, as in the case of an incorporated joint venture). In these circumstances, the minority shareholders may have little incentive to agree to the subsidiary voluntarily assuming a liability that would otherwise be entirely borne by the controlling corporation of the group to which the majority shareholder belongs. There is therefore the possibility that, if the minority shareholders have a veto right, they will block an application by the subsidiary for an LTC. This would result in the majority shareholder’s controlling corporation bearing 100 per cent of the liability associated with the facility’s emissions. However, there is no reason why a partially-owned subsidiary should not bear this liability: it is the subsidiary which undertakes the emitting activities and which is in the best position to manage those emissions (for example, by investing in emissions abatement technology) or to pass on those costs (for example, by including appropriate cost pass through clauses in its contracts). Again, this points to the desirability of CPRS liability being directly imposed on the subsidiary as described above.
There are a number of circumstances in which operational and financial control over a facility will be vested in unrelated entities (for example, where a mine owner contracts out the operation of its mine to an independent third party operator). This is significant from a policy perspective because the entity with financial control might have the greatest influence over the facility’s emissions — for instance, because it makes decisions regarding the technology used in and the capital expenditure on the facility, both of which may impact on the facility’s emissions profile. In this case there is an argument that CPRS liability for a facility should be imposed on the entity that has financial control over the facility, so as to incentivise it to manage those emissions.
It is to address this situation that the CPRS Bill permits an entity that has financial control over a facility, and that wishes to assume liability for the facility’s emissions, to apply (with the written consent of the entity that has operational control over the facility or, if applicable, that entity’s holding corporation) to the ACCRA for an LTC for the facility.[26]
For these purposes, an entity will have ‘financial control’ over a facility if:[27]
(a) it (together with any other relevant parties) has entered into a contract with the entity that has operational control of the facility (the ‘operator’) under which the operator operates the facility on behalf of that entity (and those other relevant parties);
(b) it is able to control the trading or financial relationships of the operator in relation to the facility;
(c) it is a member of a joint venture or partnership and, as such, its share of the economic benefits from the facility is at least as great as that of the other joint venturers or partners; or
(d) it is able to direct or sell the output of the facility.
Regulations may also specify other circumstances in which an entity has financial control over a facility.
On the basis of the above criteria it is possible that there could be more than one entity with financial control over the facility, for example, as in the case of the members of an unincorporated joint venture who have equal joint venture interests. This may lead to some confusion and argument as to the entity that is entitled to apply for an LTC. In any event, the entity with financial control over a facility might be reluctant to assume the associated CPRS liability where it cannot pass the costs of that liability through to the facility’s customers (for example, as where the sale contracts are with the operator or, even if they are with the financial controller, where those sale contracts do not contain a satisfactory cost pass through provision). Finally, one of the most obvious scenarios of where financial control over a facility might vest in a party other than the operator is where the facility is owned by an unincorporated joint venture but is operated by an independent operator. However, in this scenario it is unclear why just one member of that joint venture would choose to take on 100 per cent of the CPRS liability relating to the facility’s emissions.
As previously mentioned, the CPRS Bill imposes liability on upstream fossil fuel suppliers for the greenhouse gas emissions that are embodied in the fuel they supply. The reason for this is to enable broad scheme coverage of emissions from the combustion of fossil fuel. Imposing liability on upstream suppliers (rather than direct emitters) in these circumstances means that the CPRS-related obligations are imposed on a relatively small number of entities, thereby reducing the costs of compliance with the scheme. However, this separation of the point of obligation from the point of emission means that upstream fossil fuel suppliers will have little incentive to manage their carbon price exposure, at least to the extent they are able to pass the carbon cost through to the purchasers of their fossil fuel. It also means that the CPRS liability is imposed on an entity that is unable to directly manage that liability through modifying the use of the fossil fuel, and that upstream fossil fuel suppliers will potentially incur considerable costs in acquiring the AEUs required to cover the combustion-related emissions of downstream entities.
The OTN mechanism provides a means for upstream fossil fuel suppliers to transfer their CPRS liability to downstream purchasers who are in a better position (and have an incentive) to manage that liability. Under this mechanism, liability for emissions attributable to fossil fuels is transferred from the fossil fuel supplier to a purchaser when the purchaser quotes its OTN to the supplier in respect of the supply of that fossil fuel, and the fossil fuel supplier is then only liable for the emissions attributable to fossil fuels that it supplies other than under an OTN. Because they assume the associated CPRS liability, entities that purchase fossil fuels under an OTN should ensure that they only pay a carbon-exclusive price for the relevant fuels.
Broadly speaking, an upstream fossil fuel supplier is required to surrender AEUs to cover the potential greenhouse gas emissions embodied in its fuel where (among other things):
(a) the supplier supplies imported liquid petroleum fuel and import duty is payable on that fuel by the supplier;[28]
(b) the supplier supplies liquid petroleum fuel that is manufactured or produced in Australia and excise duty is payable on that fuel by the supplier;[29]
(c) the fuel is untransformed fossil fuel other than liquid petroleum fuel (for example, coal, liquid petroleum gas, coal seam methane, or natural gas that has not been created from liquefied or compressed natural gas) and the supplier undertakes the first supply of that fuel in Australia (for example, where the supplier produces that fuel in Australia or imports it);[30]
(d) the supplier supplies natural gas that is provided to it out of a prescribed wholesale gas market (such as the Victorian wholesale gas market);[31] or
(e) the fuel is transformed fossil fuel (for example, brown coal briquettes, coal-based char, coke oven coke, or liquefied or compressed natural gas) and the supplier undertakes that transformation and supplies that transformed fuel.[32]
However, where an OTN is quoted in connection with the purchase of that fuel, the upstream fossil fuel supplier’s CPRS liability is effectively passed to the fuel purchaser and will ‘crystallise’ on the purchaser if:
(a) the purchaser resupplies the fuel to a person who does not quote an OTN;[33] or
(b) the purchaser applies that fuel to its own use (including following its transformation into another kind of fuel) and thereby emits greenhouse gases.[34]
Conversely the purchaser will be able to transfer its assumed CPRS liability if it resupplies the fuel to a person who in turn quotes an OTN to the purchaser.
An OTN may be obtained on application to the ACCRA or may be unilaterally issued by the ACCRA.[35] Depending on the circumstances, the purchaser of fossil fuel may be required to quote an OTN — for instance, as where it purchases coal for use in a facility under its operational control and that facility produces at least 25 000 tCO2-epa of greenhouse gas emissions from the combustion of coal.[36] In other circumstances the purchaser has the option of quoting an OTN[37] (for example, where the purchaser uses liquid petroleum fuel as a feedstock), but the supplier is not obliged to accept that OTN.[38] This means that, in the latter case, a purchaser that wishes to take a transfer of the CPRS liability associated with its fossil fuel purchases can be precluded from doing so by the supplier. This seems to be contrary to the object of enabling the transfer of CPRS liability to the entity that has the most incentive and ability to manage that liability.
Under the CPRS Bill, a fossil fuel purchaser that holds an OTN may:
(a) make a ‘one-off’ quotation of the OTN to the supplier of that fuel in relation to a particular supply of the fuel (for example, where the contract is for the supply of a single delivery of coal); or
(b) make a ‘standing quotation’ of the OTN to the supplier of that fuel in relation to a class of supplies of the fuel (for example, where the contract is for the supply of multiple deliveries of coal or the supply natural gas, or where the supply is under multiple contracts).[39]
The OTN mechanism raises a number of issues for fossil fuel suppliers and purchasers. For example, a special purpose procurement company that purchases the entire fossil fuel requirements of its corporate group may not be able to require that fuel to be sold to it under an OTN, as the facilities in which that fuel is combusted will not be under its operational control but instead will be under the operational control of other members of its corporate group. This would preclude the purchasing group from taking a transfer of the associated CPRS liabilities and managing them itself. Conversely, on the supplier side, a fossil fuel supplier will need to institute a procedure for checking the OTN register before supplying fuel to persons who quote an OTN. This is because, if a supplier supplies fuel to a person where the OTN quoted by that person is not shown on the OTN register as that person’s OTN, the supplier (as well as the purchaser) will be liable to a penalty.[40] Moreover, contracts for the supply of fossil fuel will need to address supplies made under an OTN by, for example, requiring the purchaser to quote and maintain an OTN and providing for the fuel price to include a carbon cost component where an OTN ceases to apply in respect of a supply during the contract term.
It is not uncommon for contracts for the supply of goods or services to contain a provision for adjusting the price of those goods or services where a new ‘tax’ is imposed or where there is a change in the rate of an existing ‘tax’. Although the CPRS Bill contemplates the possibility of payments for AEUs purchased at auction constituting a tax, it is fairly clear that the CPRS does not in fact impose a tax:[41] a liable entity that pays for AEUs at an auction receives something of value in return (an AEU),[42] and does not need to purchase its AEUs at auctions in any event (it can purchase them on the secondary market instead). Moreover, a tax generally has the primary purpose of raising revenue,[43] whereas it could be argued that the sums raised through auctioning AEUs under the CPRS are designed primarily not to raise revenue but to operate as a disincentive to the emission of greenhouse gases. Finally, while the CPRS Bill requires the surrender of AEUs to meet emissions liabilities (which may be characterised as the compulsory exaction of something of value), the surrender of those AEUs does not contribute to government revenue because the AEUs are cancelled on their surrender.[44] Accordingly, a ‘change in tax’ clause will not operate to pass through to a purchaser the costs imposed on a supplier as a result of any liability the supplier may incur under the CPRS Bill to surrender AEUs to cover the greenhouse gas emissions of any activities undertaken by it for the purpose of producing the goods or services the subject of the contract.
However, change in tax clauses also often extend to levies and charges. A ‘levy’ is akin to a ‘tax’ in that it is ‘imposed’ on the liable entity, albeit usually in order to raise funds for a specific purpose.[45] For similar reasons to those given above, it would be unlikely that the cost of purchasing AEUs (whether at an auction or on the secondary market) would be regarded as a ‘levy’. Conversely, a ‘charge’ can connote an amount that is payable (voluntarily or involuntarily) for the supply of goods, services or some right or benefit.[46] Indeed, the CPRS Bill refers to the amount paid for AEUs at auctions of those AEUs as a ‘charge’.[47] It is therefore conceivable that a pass through clause which refers to ‘charges’ could operate to pass through to the purchaser under a supply contract the supplier’s cost of purchasing AEUs at an auction. However, this would be an unusual outcome for two reasons. First, on such a construction, the clause would not operate to pass through the supplier’s cost of purchasing AEUs on the secondary market (that is, other than at an auction). Second, the clause would not operate to pass through the supplier’s costs of purchasing eligible Kyoto units, which can be surrendered instead of AEUs to acquit liabilities under the CPRS Bill. Ultimately, the operation and scope of any pass through clause is a question of construing that clause in the context of the particular contract and having regard to the intention of the parties at the time the contract was entered into.
It is also not uncommon for contracts for the supply of goods or services to contain a provision for adjusting the price of those goods or services where an additional cost is imposed on the supplier as a result of a ‘change in law’. The introduction of the CPRS will constitute a change in law. However, change in law clauses are often predicated on the assumption that the cost consequences of a change in law can be fairly accurately estimated up front and then translated into an increase in the per unit price of the goods or services. This assumption does not hold for the CPRS for at least two reasons. First, the price of AEUs is likely to fluctuate, with the actual price paid by a liable entity depending on whether the AEUs are purchased on the spot or forward market, are purchased at auction or are accessed under the transitional price cap.[48] The effective price of these AEUs will also depend upon the supplier’s carbon price hedging strategy. In short, it will be very difficult to estimate accurately the carbon cost associated with producing the goods or services supplied over the term of the contract, and this will be increasingly problematic the longer the unexpired term of the contract. Second, while a liable entity may simply decide to purchase AEUs to cover its business-as-usual greenhouse gas emissions, it may be more cost effective for the liable entity to invest in technology or process changes that reduce the greenhouse gas emissions resulting from its activities. In other words, the liable entity has an alternative option for addressing its CPRS liabilities, and this alternative option will typically entail a capital investment that should be spread over the life of the technology or process change and allocated equitably among all purchasers of the supplier’s goods or services. This optionality is unlikely to be accommodated in a standard change in law clause.
Even where a contract does contain a cost pass through provision that is drafted in such a way as to capture the costs imposed by the CPRS in respect of goods or services supplied under the contract, that provision may be limited to costs which are imposed on the supplier. As outlined above, such a provision would not capture costs that are imposed on another entity (such as the supplier’s controlling corporation, which is typically the entity that is primarily liable under the CPRS Bill for the direct emissions of its group’s activities) and might not extend to costs which are voluntarily assumed by the supplier (as where the CPRS liability is transferred to the supplier using the LTC mechanism or a voluntary OTN).
The issues discussed above mean that contracts which have been negotiated before the introduction of a CPRS-type scheme might not permit the pass through by the supplier to the purchaser of costs associated with any CPRS liability that is imposed in respect of the goods or services supplied under the contract. Equally, at least some of these issues are also relevant when drafting a new contract where the parties are agreed that it is appropriate for CPRS-related costs to be passed through under that contract. In this latter case, the precise type of pass through clause required will depend on the nature of the goods or services being supplied, and whether the supplier (or its controlling corporation) is directly liable under the CPRS Bill or is only indirectly affected by the CPRS because the CPRS increases the cost of energy-intensive or emissions-intensive inputs that the supplier uses to produce the goods or services which it sells. Some considerations that are relevant to the drafting of a carbon cost pass through clause are discussed below.
Where a supply contract is with a party that is (or whose controlling corporation is) liable for the greenhouse gas emissions of the facility that produces the goods or services that are being supplied, or where a supply contract is for the supply of fossil fuels (so that the supplier is liable for the greenhouse gas emissions embodied in those fuels), a key issue will be to incentivise the supplier to minimise the costs associated with its CPRS liability. This can take the form of a provision that requires the supplier to use all reasonable endeavours to minimise those costs in accordance with good industry practice, or that limits the carbon costs that may be passed through to the purchaser to those costs that would be incurred by a reasonable and prudent supplier in the same position as the actual supplier. However, a more sophisticated approach is to tie the costs that may be passed through to a benchmark emissions intensity: if the emissions intensity of the supplier’s activities is higher than the benchmark, then the supplier is only entitled to pass through a proportion of the costs associated with its CPRS liability. Conversely, if the emissions intensity of the supplier’s activities is lower than the benchmark, then the supplier is entitled to pass through not just the costs associated with its CPRS liability but also a premium that represents a sharing of the saved costs between the supplier and the purchaser. Of course, the challenge here is to identify an appropriate benchmark emissions intensity, and this will not always be some ‘industry average’ (for example, the benchmark intensity for electricity supplied from a coal-fired power station is likely to be calculated by reference to the emissions intensity of other coal-fired power stations rather than by reference to an average emissions intensity that includes the emissions intensity of renewable energy and gas-fired power stations).
In addition, where the costs that are to be passed through are the costs of purchasing AEUs to cover the CPRS liability, a supplier can be incentivised to minimise those costs by a provision which deems the cost of the AEUs (for cost pass through purposes) to be an average price rather than the price actually paid for them by the supplier. Because the price of AEUs purchased on the spot market is likely to be quite volatile, the use of a carbon price that is averaged over a period of time or the use of a forward price will encourage the supplier to mitigate its carbon price risk by hedging and so reducing the cost of the AEUs that it purchases. Moreover, where it is more cost effective for the supplier to invest in technology or process changes to reduce the greenhouse gas emissions associated with producing the goods or services, the supplier can be encouraged to do so by providing that the purchaser will pay an amount not exceeding its allocation of the CPRS costs that are avoided through that investment.
In either case, an important issue that needs to be addressed is the allocation of CPRS-related costs to the particular supply contract. It will often be the case that a supplier will sell its goods or services to a range of purchasers or that the supplier (or its group) will produce a variety of goods or services that attract CPRS liability. A purchaser will wish to ensure that the CPRS-related costs that are allocated to its contract are allocated on an equitable basis, with all purchasers of similar goods or services from the same supplier bearing those costs based on the volume of goods or services they purchase and the term of their contracts. A purchaser will equally wish to ensure that the costs which are allocated to the production of goods or services of the type supplied to it are a fair proportion of the costs attributable to all activities of the supplier’s group (for example, that it is not fixed with only high cost AEUs). This issue assumes some significance where the supplier’s group is entitled to an administrative allocation of AEUs (that is, the group receives those AEUs for free), as where the group undertakes emissions-intensive trade-exposed activities or coal-fired electricity generation. One way of achieving this is to deem the carbon price (for cost pass through purposes) to be the average cost of all AEUs purchased or acquired by the supplier’s group over a specified period of time. Where a supplier seeks to reduce its CPRS liability by installing new technology or undertaking process changes, similar issues of cost allocation arise, with it being necessary to spread that cost over the life of the technology or process change and over all supplies of the relevant goods or services.
An alternative is for the purchaser to undertake to purchase, and transfer to the supplier, sufficient AEUs to acquit the CPRS liability referable to its contract. The benefit of this approach is that it is left to the purchaser to manage its exposure to the price of AEUs. A failure to provide the requisite number of AEUs would lead to the purchaser being required to compensate the supplier for any penalty payable by the supplier and to make good the deficit in AEUs.
Whichever approach is adopted, it may be prudent to include in the supply contract a provision for the supplier’s carbon-related costs or greenhouse gas emissions to be audited or independently verified so that the purchaser has some comfort that the costs it bears are appropriate.
As stated above, the CPRS will impact upon a range of entities that are not directly liable under it because it will increase the price of the energy-intensive and emissions-intensive inputs that those entities use to produce goods or services. Most change in law clauses will not allow these increased costs to be passed through to the purchaser of those goods or services because the increase results not from the imposition of a new legal obligation on the supplier but from the imposition of a new legal obligation on a party upstream from the supplier. In any event, a change in law clause will be of no assistance when the contract is entered into after the CPRS has come into operation.
In order to pass through these ‘indirect’ costs, the pass through clause will need to provide for the identification of the carbon component of the supplier’s input prices. This can be quite a challenge where that carbon component is not separately identified to the supplier. A possible approach is to index the price of the goods or services to an average AEU price, with the degree of indexation taking into account the proportion of the supplier’s input costs that are attributable to carbon costs. This will incentivise the supplier to review its supply chain to ensure that its own suppliers are minimising their carbon intensity.
It is important that a carbon pass through provision is not considered in isolation from the other provisions in the contract. For example, where carbon costs can be passed through both under a change in law clause and a carbon pass through clause, it will be desirable to make it clear that the change in law clause does not operate in respect of CPRS-related costs. Equally, where the contract price is indexed to CPI then, because the CPI will reflect the impact of the carbon price that is established under the CPRS, it will be desirable to avoid the supplier being compensated for its carbon costs both under a carbon pass through clause and as a result of a price increase that may be attributable to carbon costs being included in the CPI.
If Australia adopts an emissions trading scheme similar to that proposed in the CPRS Bill, the sellers and buyers of energy-intensive and emissions-intensive goods and services will need to review their existing contracts to determine whether and, if so, to what extent, they permit the seller to pass through to the buyer the CPRS-related costs associated with those goods and services. Moreover, in negotiating new contracts for the supply of such goods or services, the parties will need to consider whether CPRS-related costs are to be passed through and, if so, the appropriate form of pass through provision to adopt. Indeed, even now it would be prudent to review existing contracts that are likely to extend beyond the time an emissions trading scheme may be introduced to determine how CPRS-related costs are treated under them. It would be equally sensible to negotiate new contracts with a view to considering how they should provide for the pass through of costs related to an emissions trading scheme. This is because, although the federal government has deferred the introduction of its previously proposed emissions trading scheme, it is not inconceivable that such a scheme will be brought into operation in the foreseeable future.
[1] This article was written before the 2010 introduction of the amended version of the Carbon Pollution Reduction Scheme Bill 2009 (Cth). However, the provisions of the 2009 Bill that are relevant to this article (and that are referenced in this article) are substantially unchanged in the 2010 Bill.
[2] The relevant greenhouse gases are the six Kyoto Protocol gases: carbon dioxide, methane, nitrous oxide, sulphur hexafluroride, and specified hydrofluorocarbons and perfluorocarbons.
[3] These activities include the production of stationary energy (eg, electricity generated by combusting fossil fuels), transport, fugitive emissions (eg, from coal mining), industrial processes (eg, manufacturing, minerals processing, and chemical and metal production) and waste treatment (eg, solid landfills and waste water treatment).
[4] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 133–6.
[5] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 142.
[6] A ‘facility’ is ‘an activity, or a series of activities (including ancillary activities), that involve the production of greenhouse gas emissions, the production… or consumption of energy’: Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 5; National Greenhouse and Energy Reporting Act 2007 (Cth) s 9.
[7] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 17(1)(a)(i), (b)(i), (3), (4), 18(1)(a)(i), (b)(i), (3), (4). See also the corresponding provisions in the CPRS Bill where the facility is a landfill facility (although a 10 000 tCO2-epa threshold may apply in respect of landfill facilities in certain circumstances): Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 20(13), 21(13).
[8] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 31–9.
[9] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 5; National Greenhouse and Energy Reporting Act 2007 (Cth) s 7.
[10] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 5; National Greenhouse and Energy Reporting Act 2007 (Cth) s 11.
[11] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 5; National Greenhouse and Energy Reporting Act 2007 (Cth) as it is to be amended by the Carbon Pollution Reduction Scheme (Consequential Amendments) Bill 2009 (Cth) new s 11A (see sch 1 s 172).
[12] National Greenhouse and Energy Reporting Act 2007 (Cth) s 11(3); Carbon Pollution Reduction Scheme (Consequential Amendments) Bill 2009 (Cth) sch 1 s 169.
[13] Carbon Pollution Reduction Scheme (Consequential Amendments) Bill 2009 (Cth) new s 11B(1)–11B(5) (see sch 1 s 172).
[14] Carbon Pollution Reduction Scheme (Consequential Amendments) Bill 2009 (Cth) new s 11B(2) (see sch 1 s 172).
[15] Carbon Pollution Reduction Scheme (Consequential Amendments) Bill 2009 (Cth) new s 11B(6), 11B(7) (see sch 1 s 172).
[16] Carbon Pollution Reduction Scheme (Consequential Amendments) Bill 2009 (Cth) pt 3 div 6 sub-div A. See also Carbon Pollution Reduction Scheme (Consequential Amendments) Bill 2009 (Cth) ss 17(6), 18(6), 19, 20(7), 21(7), 22.
[17] Carbon Pollution Reduction Scheme Bill 2009 (Cth) pt 3 div 6 sub-div B. See also Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 17(6), 18(6), 19, 20(7), 21(7), 22.
[18] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 19(1), (4), (5), 22(1), (4), (5).
[19] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 80.
[20] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 77(3), 78, 79.
[21] A unit shortfall penalty is payable where the LTC holder fails to surrender the number of AEUs (or eligible Kyoto units) that is required to cover the facility’s emissions during a financial year: Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 133.
[22] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 79.
[23] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 70(2), (3)(c)(i).
[24] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 72(3)(b); National Greenhouse and Energy Reporting Act 2007 (Cth) as it is to be amended by the Carbon Pollution Reduction Scheme (Consequential Amendments) Bill 2009 (Cth) new s 22E (see sch 1 s 181).
[25] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 138.
[26] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 74(2), (2A). The consent of the applicant’s controlling corporation (if any) is also required: Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 74(3).
[27] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 81.
[28] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 31.
[29] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 32.
[30] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 33.
[31] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 33A.
[32] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 35.
[33] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 37.
[34] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 38, 39. See also Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 17, 18, 19.
[35] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 41–5.
[36] See Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 52. See also Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 53–5.
[37] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 56–64AA.
[38] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 64A(3), 64B(3), 66.
[39] See Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 51, and the provisions regarding what constitutes a supply and when a supply is made: Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 5, 5A, 6. The manner in which an OTN is to be quoted is specified in Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 51A, 51B.
[40] Carbon Pollution Reduction Scheme Bill 2009 (Cth) ss 68(1), (3), (5), 327(4)(a)–(b), (5).
[41] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 91. See also Carbon Pollution Reduction Scheme (Charges-General) Bill 2009 (Cth); Explanatory Memorandum, Carbon Pollution Reduction Scheme (Charges-General) Bill 2009 (Cth) [1.6]; Carbon Pollution Reduction Scheme (Charges-Excise) Bill 2009 (Cth); Explanatory Memorandum, Carbon Pollution Reduction Scheme (Charges-Excise) Bill 2009 (Cth) [1.6]; Carbon Pollution Reduction Scheme (Charges-Customs) Bill 2009 (Cth); Explanatory Memorandum, Carbon Pollution Reduction Scheme (Charges-Customs) Bill 2009 (Cth) [1.6].
[42] See Air Caledonie International v The Commonwealth [1988] HCA 61; (1988) 165 CLR 462, 466–7.
[43] See Ha v State of New South Wales [1997] HCA 34; (1997) 189 CLR 465, 491; Airservices Australia v Canadian Airlines (1999) 202 CLR 133, 177.
[44] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 129(10).
[45] See Australian Tape Manufacturers Association Ltd v Commonwealth (1993) 176 CLR 480.
[46] See 112 Acland Street Pty Ltd v ANZ Banking Group Ltd [2002] VSCA 95; (2002) 4 VR 372.
[47] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 90.
[48] Carbon Pollution Reduction Scheme Bill 2009 (Cth) s 89.
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URL: http://www.austlii.edu.au/au/journals/MonashULawRw/2010/13.html