'Borrowing' is commonly denoted as the use of compliance instruments from future vintage years for current compliance.
Such an option enhances compliance flexibility, cost-effectiveness and foster carbon price stability. However, borrowing provides an incentive to delay mitigation actions and thereby potentially weakens future targets.
Restrictions on borrowing under California emission trading program
Under the California emission trading program allowances issued for a future year cannot be used for surrender in an earlier compliance period.
To fulfil compliance obligation, a compliance instrument must be issued from an allowance budget year within or before the year for which an annual compliance obligation is calculated or the last year of a compliance period for which a triennial compliance obligation is calculated, unless:
- the allowance was purchased from the Allowance Price Containment Reserve; or
- the allowance is used to satisfy an excess emissions obligation.
This approach is adopted to prevent the threat of so-called 'cascading borrowing.' This situation occurs when entities are able to use future allowances for current compliance, and it creates a growing shortage of instruments in later compliance periods.
Restrictions on borrowing were considered necessary under the California cap-and-trade scheme, given that allowances will be issued for vintage years through 2020 at the beginning of the program. In some cases, such as allowances sold at the advance auction, allowances from future vintage years can be purchased and held, but not used for surrender.
If borrowing were allowed, the California legislators argue, the added supply would reduce current market prices for instruments. This would lead to a reduction in the level of direct emissions reductions, as well as a greater surrender of instruments compared with a scenario of no borrowing. In turn, this would lead to a smaller supply of instruments in future compliance periods, leading to an even greater reliance on borrowing. Ultimately, either the borrowing would lead to the cap being violated or covered entities having to make drastic reductions in a short period of time.
Borrowing under the Australia emission trading program
Under the Australia emission trading program limited borrowing is introduced – i.e. there is limited capacity to surrender carbon units which are of the following vintage year. The purpose of limited borrowing is to allow liable entities to shift the timing of their emissions and abatement activities to reduce their costs. This construction is also intended to have the effect of smoothing the unit price over time.
Considering borrowing under the Australia cap-and-trade the fundamental distinction must be made between rules for flexible charge years and fixed charge years.
During the fixed charge years (i.e. financial years beginning on 1 July 2012, 1 July 2013 and 1 July 2014) borrowing is not allowed. Thus, in the fixed charge period, a carbon unit cannot be surrendered unless it has a vintage year of that financial year. Consequently, a liable entity cannot surrender a carbon unit of a later vintage to meet its obligations for a fixed charge year.
Special rule is envisioned for carbon units with a vintage year that is a fixed charge year that are issued free of charge under Parts 7 and 8 of the Clean Energy Act 2011 (relating respectively to Jobs and Competitiveness Program and coal-fired electricity generation), which can only be surrendered for the eligible financial year corresponding to their vintage year and, if not surrendered, will be cancelled at the end of 1 February of the next financial year.
In the flexible charge years (i.e. financial years later than fixed charge years as indicated above) carbon units of the current, later or the immediately preceding vintage years may be surrendered, but there is a limit on the number of ‘borrowed’ units (that is, units of the next vintage year) which can be used for surrender. The said limit consists in the rule that if surrendered carbon units representing more than 5 per cent of the emissions number are ‘borrowed’, then the excess number of units over the 5 per cent is not regarded as surrendered for the relevant financial year when calculating the unit shortfall and is instead treated as surrendered at the next surrender date. In addition, ‘borrowed’ units can only be surrendered within a specified period when the entity’s emissions number is known.
Borrowing under the EU ETS
Within a certain trading period borrowing is allowed. This means that for instance 2011 EUAs can be used for surrender for emissions from 2010.
This process is also technically facilitated by the timelines for:
- allowances allocation - by 28 February of each year, the competent authorities issue the quantity of allowances that are to be allocated for that year, and
- allowances surrender – this must be done by 30 April each year and relates to a number of allowances equal to the total (verified) emissions during the preceding calendar year.
Inter-period borrowing, however, is not allowed and, as a consequence, EUAs sold in early auctions starting in 2012 will be barred from compliance use in the second trading period.
As appears from this short overview, there exist no common approach to the institution of borrowing in the above cap-and-trade schemes. Each of the above legislations elaborated its own specific rules and constructions, which differ drastically from the most liberal approach like EU ETS, through the moderate one (flexible charge years of the Australian cap-and-trade), to virtually restricted borrowing (with two very limited exceptions) in the California program.