CPRS White Paper: Coal issues

Introduction

The coal mining industry will be affected both directly and indirectly by the Federal Government’s proposals for an emissions trading scheme. In particular, members of the industry will face:

• a liability to purchase numbers of emissions permits both to account for their own direct emissions of greenhouse gases and as a ‘proxy’ for the emissions of smaller-scale users of coal for combustion (Direct Carbon Costs), and
• additional costs arising from the fact that upstream suppliers of goods and services which serve as inputs to the industry’s operations (for example, electricity, liquid fuels and machinery) will themselves pass on to the industry a proportion of their additional carbon costs (Upstream Carbon Costs).

In almost all cases the government expects that the coal industry (like every other industry) will wish to, and will be able to, pass through those increased costs to its customers. However, the government has expressly ruled out providing any specific legal assistance to enable such pass-through.

This briefing note explores the issues that will arise in these circumstances, particularly in the context of existing relatively long-term supply agreements. In our experience, many such agreements either fail to address the issue at all or address it in a way which will not enable relatively complete (or any) pass-through of Direct Carbon Costs and Upstream Carbon Costs.

Some necessary background on relevant design features of the emissions trading scheme proposed for Australia is provided first.

Background and assumptions

The design of the scheme

The current Federal Government was elected with a commitment to introduce, in 2010, an Australia-wide emissions trading scheme as a vehicle for reducing Australia’s emissions of greenhouse gases. On 16 July 2008, the government formally expressed a set of ‘preferred positions’ in relation to the design of such a scheme with the release of its Green Paper on the Carbon Pollution Reduction Scheme (Green Paper). The government has announced that it will release, by the end of 2008, a settled policy position in relation to these matters in the form of a White Paper.

This briefing note proceeds on the assumption that all relevant design features of the emissions trading scheme will conform with the government’s ‘preferred positions’ as set out in the Green Paper.

The Green Paper proposes the establishment, in 2010, of a comprehensive cap-and-trade emissions trading scheme to be known as the Carbon Pollution Reduction Scheme (CPRS). The CPRS will cover virtually all sectors of the economy which are implicated in the emission or the removal within Australia of greenhouse gases, with the temporary exception of agriculture and the permanent exception of deforestation. Relevantly, the CPRS will cover coal mining, electricity generation, transport and industrial processes.

A party that is covered by the CPRS will be liable to surrender, in each year, an amount of emissions permits equivalent to its total emissions in that year of greenhouse gases, including carbon dioxide and methane. A covered party which does not surrender sufficient emissions permits to cover its emission will be liable to a penalty. A party will be able to acquire emissions permits either directly from the government at a quarterly public auction, or by way of trade with other holders of emissions permits. (Some covered parties will be allocated a proportion of emissions permits free of charge. The Green Paper does not propose that mining of coal for sale in the domestic market will fall into this category.)

A single emissions permit will authorise its holder to emit one tonne of ‘carbon dioxide equivalent’. This amounts to one tonne of carbon dioxide or the amount of any of the other five covered greenhouse gases that has been judged by the science to have an equivalent global warming potential. For example, methane has a carbon dioxide equivalence of 21, so that a covered party will need to hold 21 emissions permits in order to emit one tonne of methane. (A table setting out the covered greenhouse gases and their carbon dioxide equivalence is given in the schedule to this briefing note.)

The number of emissions permits in circulation will be equivalent to the government-determined ‘cap’ on greenhouse gases, and will thus have a scarcity value: this is the ‘carbon price’ signal which the scheme is intended to generate. The government has stated that it will announce the cap operative in the first five years of the scheme, together with an indicative ‘trajectory’ or range of caps for a further 10 years, by the end of 2008.

In place of emissions permits, a liable party may be able to surrender an equivalent amount of international instruments such as those generated by the Kyoto Protocol’s Clean Development Mechanism. The Green Paper foreshadows that there will be restrictions on the number and types of international instruments that will be available for use in the CPRS, but for the most part does not give details. In this briefing note, references to acquiring or surrendering emissions permits should be read to include acquiring or surrendering such international instruments as will be eligible for use in the CPRS.

Emissions trading is not a carbon tax

It is important to appreciate that a cap-and-trade emissions trading scheme like the CPRS is not equivalent to a carbon tax. Indeed, the two mechanisms operate in opposite ways:

• with a carbon tax, the government directly sets the carbon price and expects thereby to have an indirect effect on the quantity of greenhouse gas emissions, but
• with a cap-and-trade emissions trading scheme, the government directly sets the maximum permissible quantity of emissions and expects thereby to have an indirect effect on the carbon price.

Under a carbon tax, one would expect that the carbon price would stay fixed for relatively long periods but the quantity of emitted greenhouse gases would fluctuate. Under a cap-and-trade emissions trading scheme like the CPRS, one can expect that the quantity of greenhouse gases allowed to be emitted will stay fixed for relatively long periods (such as five years) but the carbon price will fluctuate in response to a range of market influences, including the government cap itself, expectations about the future trajectory of that cap, the extent of existing and anticipated compliance with the cap, speculation and trading in derivative instruments, international developments, and so forth. This means that the amount of carbon cost that will need to be passed through pursuant to supply agreements is likely to be a fluctuating quantity over the life of that agreement.

What will comprise coal miners’ carbon costs?

Under the CPRS, the operations of a coal miner will attract liability for the surrender of emissions permits in respect of the following emissions:

• the coal miner’s direct emissions of greenhouse gases as a result of its mining operations, provided that these amount to at least 25,000 tonnes of carbon dioxide equivalent per year: these will principally be fugitive emissions of carbon dioxide and methane, and
• in a role as a proxy for the emissions of small-scale domestic users of the coal produced by the coal miner’s operations (where ‘small scale’ means that each user’s emissions will be less than 25,000 tonnes of carbon-dioxide equivalent).

Together, these will constitute the coal miner’s Direct Carbon Costs.

Significantly, a coal miner’s operations will not attract liability for the emissions produced by coal-fuelled electricity generators which emit 25,000 tonnes or more of carbon dioxide equivalent. Rather, those generators will themselves attract the liability to surrender permits for those emissions.

As mentioned above, a coal miner will also be faced with possibly significant Upstream Carbon Costs. These will certainly include greater costs of electricity, petroleum products and locally manufactured machinery, but are likely to include increased costs of many other business inputs as well.

The obligation to act as a proxy for the emissions of smaller-scale emitters, as referred to in the second point in the paragraph above, will apply not only to coal miners but also to distributors, washeries, and producers of coke and coal by-products. The Green Paper does not address how the proxy role will be apportioned between these sectors.

Who will be liable to purchase permits for a coal mine’s emissions?

The Green Paper proposes that liability under the CPRS will be aligned with liability under the existing (but recent) National Greenhouse and Energy Reporting System.

The effect will be that the controlling corporation of a corporate group, where either the controlling corporation itself or a member of its group has ‘operational control’ over a covered facility or activity, will be liable to surrender (and therefore to purchase) emissions permits. A controlling corporation is defined to be a corporation which is not a subsidiary of any other corporation registered in Australia (where ‘subsidiary’ is defined as in the Corporations Act 2001 (Cth)).

This may be significant in agreements where provision is made for carbon-cost pass-through, but only in relation to the carbon costs of the entity which is the supplier under the agreement. Where that entity is not also the controlling corporation of the relevant group, those carbon costs will not be captured by the provision.

Existing contracts and carbon-cost pass-through

We have reviewed a number of existing agreements, and have assisted in drafting new agreements, in relation to provisions for carbon-cost pass-through.

In our experience, many of those provisions in existing agreements (particularly agreements drafted before the early 2000s) will be ineffective for passing through either Direct Carbon Costs or Upstream Carbon Costs. Examples of agreements with provisions which we believe will be ineffective in whole or in part include the following types:

• Agreements which make no express provision for carbon-cost pass-through and which do not have provisions governing imposts or change of law which are sufficiently widely framed to cover such costs. In these types of agreements, it is difficult even to argue that the parties had carbon costs in contemplation in negotiating the agreement.
• Agreements which include provision for the pass-through of ‘carbon taxes’ without further definition of that expression. As noted above, a cap-and-trade emissions trading scheme is not a carbon tax. Furthermore, and despite continued use in some circles of the expression ‘carbon tax’ to describe the proposals for Australia, the difference between the two concepts has been clear in this country since at least the mid to late 1990s, and has been recognised internationally since the early 1970s. Accordingly, there is a serious question whether such provisions will allow for the pass-through of Direct Carbon Costs stemming from the purchase of emissions permits. It is quite clear that such provisions will not, in most cases, allow for the pass-through of Upstream Carbon Costs.
• Agreements which include provision for the pass-through of ‘carbon taxes’ where that expression is defined, but not in a way that is appropriate to capture either Direct Carbon Costs or Upstream Carbon Costs.
• Agreements which make otherwise effective provision for the pass-through of carbon costs, but only those incurred directly by one of the contracting parties. As mentioned above, current proposals are for the controlling corporation of the relevant corporate group to be the point of liability under the CPRS.
• Agreements which make effective provision for the pass-through of Direct Carbon Costs but not of Upstream Carbon Costs.
• Agreements which effectively define both Direct Carbon Costs and Upstream Carbon Costs but which provide no or insufficient machinery for claiming those costs. Issues that will arise in this regard include the proper apportionment of a supplier’s total carbon costs to a specific supply agreement, the fair and reasonable identification of Upstream Carbon Costs (as opposed to operating costs which have increased for other reasons), the apportionment of those costs to the agreement, and a procedure for resolving the disputes that almost inevitably will arise when a claim for pass-through of substantial costs (especially Upstream Carbon Costs) is made.

The examples above are representative, but do not exhaust the range of issues that can arise in relation to carbon-cost pass-through under long-term supply agreements.

Next steps

We recommend that coal miners:

• review existing supply agreements which have a term that will or is likely to extend into 2010 and beyond for the presence and likely effectiveness of any carbon-cost pass-through clauses
• include appropriately framed carbon-cost pass-through provisions in all future supply agreements, and
• also review existing agreements, and proposed new agreements, where the coal miner is a recipient of goods or services under the agreement, with a view to resisting the pass-through of carbon costs.

Schedule

Greenhouse gases to be covered by the CPRS

More information

For information regarding possible implications for your business, contact