Australia’s carbon markets will soon have a new asset category: the Safeguard Mechanism Credit unit (SMC). Under the reformed Safeguard Mechanism which took effect on 1 July 2023, these new units will come onto the market from as early as January 2025. Limits on emissions from industrial facilities will be tightened and this will increase demand for Australia’s other carbon unit, the Australian Carbon Credit Unit (ACCU).
To what extent the Safeguard Mechanism is effective and cost efficient in achieving the emissions reduction targets will be influenced, at least to some degree, by the income tax consequences of the emissions unit transactions in relation to both SMCs and ACCUs. These rules are the focus of this article but first a high-level overview of the reforms is provided.
An enhanced Safeguard Mechanism
The reformed Safeguard Mechanism is one of several Australian Government policy initiatives designed to support the more ambitious climate action commitments under the Paris Agreement. Australia’s updated National Determined Contribution represents an additional 15% emissions reduction by 2030 over the previous commitment.
The reforms will set annually declining emissions limits (referred to as baselines) for the approximately 215 large industrial facilities covered by the scheme, which each emit more than 100,000 tonnes of carbon dioxide equivalent (CO2-e) annually. Together, these facilities emit about 28% of Australia’s total emissions and so government measures to meaningfully reduce these emissions is critical.
Under the reformed scheme, a facility that emits less than its annual baseline will be issued with SMCs that each represent one tonne of CO2-e. SMCs are tradeable intangible personal property that can be sold on market or retained (banked).
Covered facilities that exceed their baseline must surrender emissions units to cover the excess. In addition to SMCs, facilities may surrender ACCUs to meet this liability, thereby increasing the demand (and price) for this alternative class of carbon units.
As recognised by the World Bank, baseline and credit systems such as the reformed Safeguard Mechanism are a type of emissions trading scheme, in contradistinction to the cap-and-trade model that was the basis for Australia’s short-lived Carbon Pricing Mechanism.
The income tax overlay
When the Carbon Farming Initiative (under which ACCUs are issued) and the Carbon Pricing Mechanism were established more than a decade ago, the Federal Government took the opportunity to create a discrete set of tax provisions applicable to emissions units by way of Division 420 of the Income Tax Assessment Act 1997. These rules have now also been extended to SMCs.
During the development stage, it was recognised that emissions units could be held for different purposes, which could give rise to different tax outcomes, an outcome seen as undesirable. The rules in Division 420 operate to the exclusion of other potential income tax mechanisms, such as the capital gains tax, and thereby produce uniformity in tax treatment across unit holders. It was also determined at that time that GST would not apply to emissions unit transactions, and this treatment has now been extended to SMCs.
The rules of Division 420 take many features from the tax rules that apply to inventory (trading stock). The so-called ‘rolling balance method’ has the effect that the cost incurred to purchase an emissions unit does not immediately produce a tax expense.
If the unit is surrendered to meet a compliance obligation, the cost is then recognised as an expense. If the unit is sold on market, the original cost and proceeds together produce a profit or loss amount that is recognised for tax purposes at that point. Holders of emissions units have the option to revalue units to market value at year end but this can result in the taxation of unrealised gains, making it unlikely to be attractive to many holders.
This rolling balance method applies uniformly to both ACCUs and SMCs that are acquired on market. However, variations arise in relation to emissions units that have been issued to holders by the Clean Energy Regulator.
Treatment of ACCUs
To appreciate the operation of the tax rules it may be helpful to outline the operation of the ACCU scheme.
Broadly, in order to participate in the ACCU scheme, the carbon abatement or sequestration activity must fall within the terms of an approved method and the project must be registered. Based on reports lodged with the Clean Energy Regulator, the volume of carbon emissions avoided or stored is determined and this is recognised through the issue of one ACCU for each tonne of CO2-e. Through realising the value in the ACCUs, the project can produce an income stream. This can occur via the government auction process or on the secondary market.
The government committed significant funds to the purchase of ACCUs by way of the Emissions Reduction Fund. A reverse auction system ensures that the lowest cost abatement and sequestration activities are identified and funded. A project proponent can bid to sell a specified quantity of ACCUs at specified intervals to the Clean Energy Regulator. The Regulator accepts bids from lowest cost upwards, thereby creating carbon abatement contracts. In more recent years the nature of the agreements has changed to ‘optional delivery’ contracts, in effect granting put options to project proponents. As of March 2023, $2.7 billion has been committed under these contracts.
The effect of the tax rules in Division 420 is to include the value of the ACCUs in assessable income in the year that they are issued to the project proponent. Where ACCUs are issued and banked, the value at the time of issue is included in income for that year by way of deeming that value to be the cost of the units that is the picked up by the rolling balance. Where ACCUs are issued and sold within the year, either to meet a carbon abatement contract or on the secondary market, the proceeds are taxable income. So, in either case, the value of the ACCUs issued is taxable as income, akin to a government grant or subsidy.
This tax treatment was varied with effect from 1 July 2023 for eligible primary producers, being individuals carrying on a primary production business on their own behalf, or through a partnership or a trust. ACCUs issued to eligible primary producers are now afforded deferral. The value of ACCUs is now only taxable if and when they are sold, and that income is now categorised as primary production income for accessing certain other concessional tax regimes.
Treatment of SMCs
The tax rules were separately amended to incorporate SMCs. Although the Explanatory Memorandum to the amendments suggested that the ‘same tax treatment’ was to be provided for SMCs as applied to other emissions units, the way that SMCs have been incorporated into Division 420 has a different effect in a significant way.
Like ACCUs, SMCs are issued by virtue of the operation of the regulations rather than being purchased from the government. The rolling balance method applies to SMCs but, unlike ACCUs, the tax rules do not include the value of SMCs in income in the year of issue. Rather, the proceeds are treated as income if and when the SMC is sold.
Since there would be little if any costs associated with the issue of the SMCs and there is no rule (like that applying to ACCUs) to deem the cost equal to the market value on issue, SMCs will be carried at little or nil cost. This, coupled with the realisation basis available under Division 420, creates a lock-in effect, like that seen in relation to the capital gains tax. If an SMC is issued to a Safeguard Facility, banked and later surrendered to meet an emissions obligation, there will be no income tax consequences: no income is derived, nor expense incurred.
Potential unintended consequences
Given the different tax treatment of ‘free’ ACCUs and SMCs, as well as different carrying costs of SMCs depending on the circumstances in which they were acquired, Safeguard Facilities will need to weigh up the varying tax consequences of unit surrender and will not be neutral as to the different types and sub-categories of units.
Given the nil or minimal cost attached to issued SMCs, a Safeguard Facility may prefer to bank these units to meet future liabilities, rather than crystalise a taxable gain upon sale. This may limit the volume of SMCs on the secondary market and shift demand to ACCUs. The interaction of these two markets will no doubt be watched with interest.
Excellent, well written article.