ACCUs take a very big tumble

Earlier this year there was much discussion around the skyrocketing demand for carbon credits. In early February the AEC published its own analysis - Carbon Credits: Will they continue to rise? – but just three weeks later the price of Australian Carbon Credit Units (ACCUs) took an extraordinary tumble, losing more than a third of their value in one day.

The tumble was caused by an arcane and innocuous looking statement that the Clean Energy Regulator (CER) released on 4 March, which paves the way for billions of dollars in government carbon contracts to be dishonoured and re-sold into the open market.

In June 2019 another article by the AEC also looked at a CER statement which, on that occasion, halved the value of renewable energy Large Generation Certificates (LGCs). While the AEC welcomed the correction of a previously unreasonable CER position, it also noted how environmental markets are heavily exposed to re-alignments of regulators’ opinions, adding highly inefficient risks into markets that ultimately consumers pay for.

Recent events in ACCU prices re-affirm how important it is for government and regulators to avoid surprising the market. The events also expose the fragility of “direct action” carbon markets. Below takes a closer look at the fluctuations and their implications.

ACCUs were going up and up  

The AEC’s 10 February article discussed how ACCUs, after years of stable trading in the teens of dollars per tonne, had rapidly increased due to a confluence of factors. This included their growing attractiveness as a more trustworthy form of voluntary carbon offset than alternatives, and that a possible change of federal government could make them more valuable in the future.

Figure 1: ACCU price movements

Source: Jarden

Carbon farming contracts

Following the 2013 election, the Abbott government abolished the Gillard government’s “gross” carbon price. A gross scheme requires emitters in covered sectors to buy and surrender certificates against all their emissions.

The gross carbon price was replaced by incoming Minister Hunt’s signature “Direct Action”. This is a “nett” or “additionality” approach, where government pays parties to take actions at the margin, i.e. to abate carbon pollution in a way they would not have done had they not been paid to do so.

Additionality is much more challenging to administer because it can never be proved exactly what would have happened in the absence of the payment. The CER applies very complex additionality proving methodologies before granting an ACCU. To maintain confidence in the unit the methodologies are conservative and are only suited to a narrow group of activities. For example, the carbon price reduced emissions by switching some electricity generation from coal to gas whilst it was in force, but it’s not really possible to do this with a Direct Action approach.

One activity that does fit reasonably well is carbon sequestration in vegetation: principally planting or protecting trees in Australia’s vast areas of marginal agricultural land. At 31 January 2022, the government’s Emissions Reduction Fund (ERF) has operated 13 tenders since 2015, which have been dominated by the land sector.

However, having planted a tree, the carbon is sequestered gradually over decades. As the tree grows, ACCUs are accredited by the CER to the farmer, which it has contracted to sell back to the government at the price agreed in the original tender.

These tenders contracted ACCUs at an average price of about $12.50 per tonne. It was always expected ACCU prices would move around, and the long-term fixed price gave the farmer and government a known cash-flow.

It was however recognised there are physical delivery risks for the farmer. For example, a disease could stunt the trees, meaning they won’t generate the promised ACCUs. The contracts still require the farmer to surrender ACCUs, implying they would have to obtain them from other projects. If prices have increased since the contract was struck, the farmer will be exposed to the difference. This has parallels to the concept of liquidated damages in a construction contract, where, if a building project is delayed, the builder has to compensate the buyer, for, say, renting alternative accommodation.

What caused the market to tank?

If the farmer doesn’t deliver the promised ACCUs to the government at all, they are subject to Buyer’s Market Damages (BMD) of the difference between current ACCU prices and the strike price, compensating the government for having to replace the abatement with other sources. However BMD is capped at the strike price, meaning the farmer misses out on being paid the ACCU price i.e. $12.50 plus it has to pay BMD of $12.50 for a total maximum loss of $25 per promised ACCU.

Until 4 March the market had presumably assumed this circumstance could only arise due to a rare physical non-delivery problem, and that the CER would take legal action against a farmer that tried to exercise it opportunistically. However, the announcement offers a structured exit arrangement allowing the farmer to legally walk away from the government if another buyer is prepared to pay more than double the strike price.

With ACCUs recently trading in the $50’s, this meant that around 130 million ACCUs previously contracted to the government were now at liberty to flood into the general ACCU market for returns that more than compensated the loss of breaking the deal with government. So, the market quickly fell back to around $30, the price considered to be the point that roughly makes the exit worthwhile for most of these historical contracts.

Implications

It seems the seeds of this decision were laid in the original BMD contract clause written in the mid 2010’s. It is possible that the CER may have lost in court had it tried to stop it being used in this way.

Minister Taylor described the turn of events in a positive light and consistent with the government's long-term approach. However, parties who had willingly agreed to enter contracts to perform certain actions for the taxpayer at a fixed price are now legitimately able to walk away from that promise and sell to others at a higher price. It is analogous to a builder reneging on an “off the plan” contract simply because house prices have gone up in the meantime.

A great quantity of abatement contracts that the ERF had entered on behalf of the taxpayer will now not be honoured. At first glance this might look good for the government’s finances as it avoids buying them plus it receives a penalty payment. But assuming it has the same carbon objectives, it will have to now re-enter the market to make up the shortfall and pay more than what it has saved.

It also introduces a new uncertainty into the validity of what was previously a highly regarded carbon abatement unit: the ACCU. When an ACCU is voluntarily surrendered, say through a carbon offset on an airline ticket, the consumer reasonably expects new trees will be planted to offset emissions. Instead, what is happening here is that existing trees, previously contracted to government, are simply being re-allocated to voluntary surrender.

Conclusion

Environmental markets are highly abstract and exist only because of regulation. This means they are extremely vulnerable to arbitrary regulatory decision making. This in turn introduces risk into the market that ultimately increases the cost of addressing climate change.

Decision makers need to recognise this and try to avoid these sorts of surprises. In this case this would have meant clarifying to the market whether an exit pathway existed, long before the price reached a level that made it extremely attractive.

The enormous commercial impact of such surprise decisions is also troubling from a market integrity perspective. Note that ACCU prices had been trending down for several weeks prior to the decision. This could have been due to unrelated factors, but it could also have been affected by some ACCU traders anticipating the decision. A party privy to the decision could have illegally made tremendous profits.

While all environmental markets are exposed to these issues, nett designs seem generally at greater risk. This is because:

• “additionality” makes certificates particularly abstract resulting from complex methodologies that attempt to assess behaviours against a hypothetical counter-factual; and,
• being “nett” means there are much fewer certificates on foot at any time compared to a “gross” arrangement, which in turn implies lower liquidity and greater price volatility.