Review of Proposed Settings for the NZ Emissions Trading Scheme. Will it create a functioning ETS?

Topics covered in this article: Sustainability & Climate Change

Mark Harding

Associates

Associate

Phone: +64 7 927 0574 
Email: mharding@clmlaw.co.nz

Bachelor of Law (Hons), Batchelor of Science

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With the release of the proposed settings for the NZ Emissions Trading Scheme (ETS), and Rules for Auctioning (Proposed Settings)[1] we can start to get a better understanding of the specific details for how the overhauled ETS will function.

The Climate Change Response (Emissions Trading Reform) Amendment Bill (Emissions Trading Reform Bill), which is currently awaiting its second reading, restructures the framework of the ETS, however it does not specify the particular settings of the scheme, which will be set through regulations and are set out in the Proposed Settings.

We take a look at the Proposed Settings below and consider whether they are likely to create enough demand to create a functioning ETS and drive investment into greenhouse gas emission reductions.

Who is this for?

This article is relevant for:

  • Covered emitters under the ETS;
  • Forestry companies, farmers and landowners undertaking or potentially interested in forestry offset projects under the ETS;
  • Potential project developers looking at offset projects;
  • Funds and third party financers which may be looking to invest into the carbon market or purchase NZUs.

Why is the ETS important?

The ETS is NZ’s main tool to achieve the 2050 net zero carbon emissions target set out in the new Climate Change Response (Zero Carbon) Amendment Act 2019 (ZCA).

It is important to note this target excludes methane from agriculture and waste sectors which is subject to a separate goal, and a mechanism yet to be determined. 

How does the ETS interface with the ZCA?

Under the ZCA, emission budgets will be set for each five year period to 2050[2] - the volume of emissions which are able to be emitted under each budget will be progressively reduced to provide a step wise transition to net carbon neutral by 2050. These emissions budgets will guide the overall level of the cap on emissions covered by the ETS.  The phases or “periods” in the ETS match up with these emission budget periods under the ZCA, so the emission reductions created by the ETS assist NZ in meeting its climate commitments. 

Emission Periods

The first emissions period under the ETS from 2021 to 2025 is “provisional” (Provisional Period) because it will eventually be superseded by budgets set by the Climate Change Commission (to be established under the ZCA) which are not likely to come in until 2022.

However the Provisional Period is interesting, as it’s the Government’s first attempt at using the overhauled ETS to put forward its preferences in its settings. It is likely that emission budgets for subsequent periods will be adjusted based on the successes and failures of the Provisional Period.  Below we set out a summary of the key Proposed Settings for the Provisional Period

Summary of Proposed Settings for the Provisional Period.

Who is covered? - The “cap”

The “cap” refers to those covered under the ETS.  Emitters covered by the ETS are required to either make emission reductions themselves, or obtain and surrender emission reduction units (NZUs)[3] equivalent to their emissions. 

Only organizations expressly covered under the ETS have emission reduction obligations and will potentially purchase NZUs to meet their compliance obligations.  Currently these include forestry, waste, synthetic gases, industrial processes, liquid fossil fuels (including petrol and diesel suppliers), and stationary energy (such as electricity generation and industrial heating).

Currently the ETS only plans to cover 57%[4] of the Government’s total first emission budget for the Provisional Period.[5]  The most notable (and often discussed) exclusion is agriculture (which accounts for 48.1% of all emissions).[6]

Under the Provisional Period NZUs may be obtained by free allocation, purchased through Government auction, or purchased on the secondary market.  We discuss these options below.

Free allocation

Free allocation refers to the free issuing of NZUs to covered emitters who are considered both emissions intensive and trade exposed. Twenty six of the covered entities under the ETS get free NZUs adding up to approximately 29% of the entire cap[7] (see Fig 1 below).  Currently it is proposed to reduce the free allocation annually from 2021 at a rate of 1% per year until 2030, then at a rate of 2% annually from 2021-2030, and finally at a rate of 3% annually from 2041-2050. 

The effect of the free allocation is that only about 70% of the covered emission reductions under the ETS are required to purchase NZUs, or make any reduction in their own emissions (as 30% of the emissions receive free credits).  This provides a big dampening on potential market demand, especially when coupled with existing stockpiles (discussed further below). 

Figure 1: Remaining NZU auction volume after removal of free allocation

 

Auction volumes

The current fixed price offer for NZUs of $20.00 under the ETS will be phased out and replaced by a Government auction of a limited supply of NZUs (the proposed rules setting out the details for how auctioning will work have also been released and are available here[8]). After removing the portion of NZUs freely allocated (44 million NZUs) the remaining emissions under the ETS for the Provisional Period are 107 million tons. 

The Government proposes to auction a volume of 80 million NZUs over the Provisional Period leaving a shortfall of 27 million tons.  The intention is that the shortfall will be filled by emitters using their existing stockpiles of NZUs and thereby reducing the current stockpile (see below for details on the stockpile).

 

Figure 2: Auction volumes after stockpile adjustment

 

Price controls

Price controls refer to the mechanisms (safety valves) which are built into the ETS to prevent prices either becoming too high or low (referred to as ceiling and floor controls respectively).  The proposed mechanisms for the Provisional Period below may be amended later by the Climate Commission (which should be established by 2021 to provide further advice to the Government).

Ceiling controls: cost containment reserve

The current ceiling mechanism has been a ‘fixed price’ option which allowed participants to purchase NZUs from the Government at a fixed price of $20.00 on demand.

This ‘fixed price’ option will remain until 2021 only (at an increased price of $35.00) and then removed entirely in favour of a ‘cost containment reserve’ as provided for in the Emissions Trading Reform Bill.

The cost containment reserve works by releasing a specified volume of additional NZUs on to the market if a pre-determined “price trigger” is reached during an auction.  The trigger signals the upper extreme of expected and acceptable prices in the ETS, and should therefore be rarely used. The initial proposed “price trigger” for the reserve is $50.00.  In addition, it is noted that the current stockpile of existing NZUs will act as a significant unintended safety valve.

Floor Price: Minimum reserve auction price

Initially there will also be a minimum reserve price for Government auctioned NZUs of $20.00. However, this does not restrict holders of currently existing NZUs from being sold on the secondary market at lower prices.  This is a concern while a large stockpile of NZUs exists.

 

Fig 3 Price control settings under the Provisional Period

 

International credits out for the foreseeable future

Currently the ETS is closed to international credits for the Provisional Period.  International credits are carbon credits created and issued under other carbon certification schemes.  The Clean Development Mechanism under the UNFCCC and Voluntary Carbon Scheme are two large international certification schemes that certify specific emission reduction projects and issue credits to project owners for emission reductions verified under registered certified projects.   There is a possibility this could be revised in the future if the ETS linked up to international markets.

The Stockpile

A large issue with the ETS is the current stockpile with 132 million NZUs currently issued and existing (Stockpile).  The Stockpile is a result of large amounts of international credits that were historically let into the NZETS as well as NZUs which have been issued and not used.  The NZETS was originally designed to work within, and link up to, an international carbon market and accepted international credits created under the Kyoto Protocol.  Many cheap credits were brought into the NZETS and swapped for NZUs especially after international carbon markets crashed up until the NZETS was closed to international credits in June 2015.

To put the Stockpile in perspective, after we take away the “free” allocated permits, the entire cap for Provisional Period is only 107 million tons CO2-e. Therefore starting out there already exists in the market more NZUs than required to be surrendered in the entire Provisional Period.    

Of this Stockpile, 39% (51 million NZUs) are held by forestry participants who are unlikely to sell as credits are likely to be retained to cover both harvesting and to preserve future land use change options’.

The remaining 61% of NZUs (81 million NZUs) are held by non-forestry ETS participants and organizations with no direct surrender obligations and these may be freely traded or used.

The Government’s plan to address the Stockpile is to restrict the number of NZUs available to the market via auctioning, by 27million NZUs over the Provisional Period (See figure 2 above).  The intention is that this will steadily reduce the Stockpile, as covered emitters purchase auctioned NZUs and use already issued NZUs to make up the difference. 

Commentary

Stockpile solution unlikely to reduce oversupply

The difficulty in the Government’s proposed Stockpile solution is it assumes that participants will behave as modelled.  However, it is often very difficult to use models to predict future market behaviour as people and organizations have their own unique circumstances and motivations, and future external market conditions are unpredictable (who saw Covid-19 coming).

Looking at the potential supply and demand volumes, there is certainly a risk of a large oversupply of NZUs on the secondary market for the foreseeable future, which has the potential to create a cloud of uncertainty over the ETS and may dampen investment as a result.

Proposed Settings unlikely to generate demand to drive reductions hoped for

The combination of a cap (which only covers just over half of the total first emissions budget), free credits to supply 30% of these covered emissions, and issues with the current large Stockpile raise concerns for the potential of an oversupply of NZUs and poor demand for NZUs during the Provisional Period. If this is the outcome for the Provisional Period, it will provide little incentive to drive large investment into emission reductions the Government hopes to achieve.

Want to find out more

If you’re interested in finding out more about changes under the NZ ETS and how they may affect you, please contact Mark Harding or another member of the Sustainability and Climate Change Practice team.

 

Latest Update: 28 May 2020



[1] Consultation documents MFE Reforming the NZ Emissions Trading Scheme: Proposed Settings, December 2019 available at https://www.mfe.govt.nz/consultations/nzets-proposed-settings and MFE ‘Reforming the New Zealand Emissions Trading Scheme: Rules for Auctioning – technical consultation document November 2019 available at https://www.mfe.govt.nz/consultations/nzets-rules-for-auctioning.

 

[2] Technically the first period is four years from 2021-2025.

[3] 1 NZU is equal to 1 ton CO2-e (Carbon dioxide equivalent).

[4] 151Mt CO2-e.

[5] The total budget is 354 Mt CO2-e

[6] New Zealand’s Fourth Biennial Report under the United Nations Framework Convention on Climate Change, MFE 2019 at page 17.

[7] Or 44 million tons of CO2-e