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    The implications of Australia's new carbon emissions target for bond investors

    The implications of Australia's new carbon emissions target for bond investors

    17 October 2022 Fixed income, Responsible investment

    New higher carbon emission reduction targets for Australia pose risks and opportunities for institutional investors.

    Key Points

    • Australia’s new national emissions target for 2030 requires a rapid increase in renewable energy capacity
    • Replacing fossil fuel revenues with green alternatives will be technically challenging and requires sustained, large-scale public and private investment
    • The scale of investment required means it is likely to be part funded by green bonds
    • Australia’s economy will retain its deep structural dependence on fossil fuels for many years, increasing the risk of asset stranding and long-term credit risks

    In September, legally binding emissions reduction targets for 2030 and 2050 were set by Australia’s House of Representatives as part of a Climate Change Bill. This provides overarching legislation to implement Australia’s net-zero commitments and codifies its targets under the Paris Agreement in national law.

    The 2030 target is a 43% reduction on the 2005 baseline across all greenhouse gases. To deliver this, the government has set an annual budget of emissions from 2020 to 2030.

    The cornerstone of the 2030 emissions target is Labor’s national goal to increase the renewable share of grid generation from around one third today to 82% by 2030. Emissions will also need to be reduced from new and existing industrial facilities.

    Whilst there is formal consensus on the net-zero targets across both of Australia’s major political parties, the Liberal party, now in opposition, has refused to back the new bill and has announced that it will create its own policy package over the coming parliament – it has previously objected to placing a carbon tax on high-emitting companies.

    The Climate Change Bill does not immediately impose new obligations on companies, but it will be followed by sector-based reforms and targets. There are also proposed reforms to the Safeguard Mechanism which places an obligation on Australia's largest greenhouse emitters to keep net emissions below a set limit. This is a key part of reaching the 2030 target, as while the previous government’s analysis showed Australia on track for a 30% reduction in 2005 emissions levels by 2030, this reduction was driven overwhelmingly by decarbonisation in the power sector and offset by a 9% projected increase in emissions from the industrial sector. A key hurdle is that most of Australia’s existing large industrial sites are in excess of 20 years old, so costs of adaptation may be significant, and the risks of stranded assets will increase.


    Private capital wanted to meet targets

    Electricity offers the most immediate opportunities for delivering cost-effective emissions reductions in line with the government’s plan (see Figure 1). This stems from high fossil fuel intensity generation today and the strong economic viability of solar and wind projects in many regions. Central to the government’s plans for decarbonising electricity is an AU$20bn investment to increase renewable capacity and community-level battery storage projects. This is part of the wider ‘Powering Australia’ plan that aims to spur AU$76bn of public and private investment in electricity, industry and agricultural decarbonisation.


    Figure 1: Emissions by sectors, 1990 to 2022


    Source: Department of Climate Change, Energy, the Environment and Water


    Buildout of this infrastructure will require sustained capital investment, with opportunities for fixed income investors given the reliance on debt, as well as public finance to deliver the plan. Regulators are expected to support private sector investment in these projects through guarantees and other incentives. The states of New South Wales and Victoria have already begun issuing green bonds in pursuit of an aggressive target of a 50% reduction in emissions by 2030.

    These policy signals will likely add weight to investor momentum on decarbonisation. Major domestic power producer AGL Energy Ltd plans to invest up to AUD$20bn on renewable energy capacity by 2036 and under pressure from activist investors it is to bring forward coal phase out by a decade.

    The scale of capital investment required also points to strong growth prospects for the green and sustainable bond market in Australia. Issuance of Australian green bonds in 2022 has already more than doubled on the previous year, according to Bloomberg. Whilst Australian dollar denominated green, or impact bonds represent a very small share of the US$1.9 trillion sector (around 1.5 percent), a growing volume of issuers in ‘high impact’ mining and energy sectors have brought such instruments to market locally.

    The investible universe of green and impact-focused bonds looks set to continue to diversify and to see strong growth in the coming years as a result of such supportive policies.


    The burden on industrials

    To align with the 2030 target, the Safeguard Mechanism is transitioning to a ‘baseline and credit’ model from July 2023, with aggressive emission reductions required. Currently the Safeguard applies to 215 industrial facilities emitting over 100,000 tonnes of CO2e per year, with facilities having the option to buy or sell Australian Carbon Credit Units (ACCUs) for emissions above or below the baseline. To date, lenient rules have led to an increase in emissions from facilities under the scheme, but this looks set to change with the requirement for an aggregate 30-40% fall in emissions over the 2023-30 period. This is likely to lead to the private sector becoming the largest buyer of ACCUs for the first time. This will be technically difficult for many facilities to achieve given the age and carbon intensity of those falling under the scheme, and the cost of ACCUs looks set to surge as a result.

    However, the proposals do not yet equate to a ‘fair share’ reduction in industrial emissions in line with the revised national target (which itself is not aligned with the Paris Agreement 1.5C trajectory). This increases the front-loaded burden of emissions reduction on the power sector as well as the risk of a rapid regulatory tightening over the course of this parliament to fully align the Safeguard with a Paris Agreement trajectory.


    The risk to Australia's credit rating

    Australia remains an outlier amongst developed nations in terms of emissions, ranking eighth highest in the world in terms of GDP per capita and first for coal power emissions per capita. Whilst the strong credit profile of Australia helps mitigate the influence of activist investors, the country has come under increasing pressure to evidence progress on decarbonisation. Modelling work by the previous Morrison government pointed to increases in the cost of government debt by 100-300 basis points by 2050 in the absence of a low-carbon transition, whilst analysis by FTSE Russell identified a risk of sovereign default by 2050 under a disorderly transition scenario.

    Insight’s own scenario analysis using Network for Greening the Financial System (NGFS) outputs points to the potential for climate-driven inflationary shocks out to 2050. This could necessitate central bank interest rate responses under current policies and a divergent net zero scenario (see Figure 2). In such a disorderly scenario, countries rapidly adopt different low-carbon policies, with negative impacts on fossil fuel exporters. By contrast, inflationary pressures under a net zero 2050 scenario are likely to be more muted, and the central bank policy response similarly moderate.


    Figure 2: Australia – central bank intervention rate under transition scenarios


    Source: Insight Investment, NGFS, NiGEM


    In addition, Australia's balance of payments has become increasingly reliant on the export of raw materials from the natural resources sector, which helped push the current account into surplus in 2019 due to high prices for coal and iron ore. Coal has historically been a major contributor to national and state government budgets and economies – in 2018/19, the value of Australia’s metallurgical and thermal coal exports was around AUD$70bn, with Queensland’s earnings from coal mining royalties representing around 8% of budget revenues alone.

    Demand for coal is forecast to fall across the globe by the International Energy Agency (IEA), including in Australia's main export markets in Asia (see Figure 3). Demand for thermal coal is increasingly being replaced by renewable energy and gas for power generation, and emerging low-carbon steel production technologies poses a long-term threat to metallurgical coal demand.


    Figure 3: Global and domestic coal demand could fall rapidly


    Source: IEA, Grattan Institute


    Liquified natural gas sales is another growing source of revenue for Australia due to high prices and is the country’s second-largest source of emissions, however long-term production is likely to concentrate in lower-cost operating environments such as Qatar, according to the IEA.

    On the positive side, Australia is increasingly leading the way in green hydrogen demonstration projects, and is expected to play a major role in future exports given the abundance of low-cost domestic renewable energy. A number of Australian ports are also making investments in pilot projects in anticipation of growing export opportunities in the future. Similar opportunities are emerging in the battery metals supply chain, with copper and lithium demand expected to see strong growth to 2030 as a result of Australia’s strong share of the overall global supply.


    The scale of the challenge

    Energy transition presents major challenges to Australia’s export and industrial model. Analysis by the Net Zero Australia project has estimated that to replace the value of coal and gas exports with clean energy exports such as green hydrogen, green ammonia and renewable energy, electricity generation in 2050 would need to expand by as much as 15 times today’s levels at a cost of hundreds of billions of dollars. Major, long-term focused investments will be needed in renewable energy generation, electricity transmission infrastructure and hydrogen supply chains, and in particular sensitivity to transition concerns are needed. This points to strong growth prospects for the domestic green bond market and low-carbon finance.

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