Why the Safeguard Mechanism supports steep reductions in emissions and steep rises in carbon prices – with a possible sting

Following reforms to the Safeguard Mechanism, many of Australia’s largest emitters are about to start trading in the carbon market for the first time.

In brief:

• Safeguard Mechanism (SGM) reforms will drive significant new emissions reductions, but covered facilities will also require more Australian Carbon Credit Units.
• Prices will rise significantly, with our central estimate seeing prices double to around $80/tCO2e before 2035.
• The market’s changing gear drives significant uncertainties, including more rapid price increases, and so businesses must think differently about carbon offsets.

Australia’s carbon market is about to shift gears.

On 1 July 2023, reforms to the Safeguard Mechanism (SGM) kick in. Around 215 of Australia’s largest industrial facilities are now on a net zero trajectory, with a default obligation to reduce their greenhouse gas emissions by an average of 4.9% each year until at least 2030.

Heavy-emitting facilities that don’t cut their pollution are required to buy either Australian Carbon Credit Units (ACCUs) or Safeguard Mechanism Credits (SMCs) equivalent to the volume of carbon emissions that exceed their cap.

This is not just a carbon credits game. The SGM is set to drive substantial emissions abatement. But decarbonisation can be challenging, costly and complex for businesses, especially those in emissions-intensive sectors. Many facilities will not be able to meet their compliance obligations at reasonable costs without the help of carbon credits to offset some of their emissions.

A steep transition has begun

In 2022, after analysing the global voluntary carbon market, the EY Net Zero Centre forecast a rapid increase in costs of carbon credits. We suggested prices could rise from below USD$20 per tonne in 2022 to as much as USD$150 per tonne in 2035.

We also predicted that governments would impose new and more stringent abatement obligations on businesses – and that this would blur the lines between voluntary and compliance markets for carbon credits.

Since then, the Australian Government has introduced a robust policy framework to drive industrial-scale decarbonisation. Reforms to the SGM were passed with crossbench support and largely endorsed by Australia’s business community.

Around the same time, an independent review of ACCUs confirmed the integrity of Australia’s carbon credit market. The review panel, chaired by Professor Ian Chubb, concluded that the ACCU scheme was “fundamentally well-designed” but could be improved “by applying knowledge gained through implementation or practical experience”. The panel made several recommendations, all of which have been accepted at least in principle by the Australian Government.

We therefore expect the ACCU market to underpin Australia’s carbon policy framework for large industrial emitters until at least 2030, and likely much longer.

The step change in demand for ACCUs from 1 July 2023 is certain to drive new demand.

However, our modelling and analysis finds the new linked SMC and ACCU markets are delicately balanced. Near-term ACCU prices and volumes will thus be very sensitive to the behaviour of SGM facilities and other market participants.

This makes market dynamics and outcomes highly uncertain, including the potential for boom-bust patterns. Key uncertainties for 2030 include the timing and extent of SGM abatement investments, decisions to hold or sell Safeguard Mechanism Credits (SMCs), and entry of new SGM facilities.

In principle, this intrinsic instability could be moderated by a natural evolution of the market, with long-term contracts, for example, providing future price visibility and allowing companies to manage their risk.

In the shorter term, as prices and market volumes increase, our central estimate is that the total value of Australia’s ACCU market will more than triple before 2030.

Delaying abatement by a few years could see prices more than double and hit the price cap before 2035. Similarly, we can expect higher prices if facilities that generate SMCs decide to hold a substantial share of these credits for future use.

Remove the sting by rethinking your strategy

Our call to action is clear. Carbon credits will become more expensive to purchase, and that means all businesses – not just those captured by the SGM – need to start thinking about the future.

The first step is to reassess the role of carbon offsets in your organisation’s decarbonisation strategy. How you use offsets will be determined by the same factors that shape your decarbonisation strategy itself: the exposure of your business and the abatement opportunities within reach. Ask yourself:

1. What is your emissions intensity? Consider your emissions profile now and into the future under different outlooks. How will emissions intensity change over time? What are the key decision points and options? How do your potential emissions profiles compare to those of your peers and competitors, and global leaders in your sector?
2. How immediate are the pressures to act? Understand the underlying drivers of stakeholder attitudes and their implications. Consider the potential pace of change, and possible triggers or tipping points – like further government regulation – that could increase the pressure to act.
3. What is the opportunity space for reducing emissions? Identify the most relevant types and sources of emissions. Consider how well your asset lifecycle aligns with your desired timeframe to reduce emissions and the technology solutions that could help.

There’s a salve to the sting. A well-functioning ACCU market could generate very large volumes of high integrity removals-based credits – and this can help Australia to meet its net zero emissions targets and move from laggard to leader in climate action.

Note: Dr Steve Hatfield-Dodds was a panel member of the Independent Review of Australian Carbon Credit Units in a personal capacity.