The Five A’s of an Effective NZ ETS Review

by Catherine Leining, Motu Economic and Public Policy Research Trust

Public consultation is underway on the government’s 2015/2016 review of the New Zealand Emissions Trading Scheme. The first stage of submissions (due 19 February) focuses on whether non-forestry sectors should face the full unit obligation per tonne (compared to 50% under current rules) and invites comments on the scope of the review. The second (due 30 April) focuses on how the government should manage unit supply, emission prices and exposure to emission costs and invites comments on other issues.

Ministry for the Environment officials have been blunt about the system’s impact to date: “Research for this evaluation, and evidence from the interviews, found no sector other than forestry made emissions reductions over the Kyoto Protocol Commitment Period One (2008-12) (CP1) that were directly caused by NZ ETS obligations.” On the basis of participants' purchases of Kyoto units and some improvement in net forestry emissions, officials concluded that the system has delivered on its two-fold purpose to assist New Zealand in meeting its international climate change obligations and reducing net emissions below business-as-usual levels.

In this case, we are hitting the target but missing the point. Limiting temperature rises below 2 degrees C requires a transition to net zero global emissions by the end of the century, with peaking of global emissions in the near term. So far under the NZ ETS, the short-term emission price has been too low and the long-term emission price too uncertain to support the strategic decarbonisation of New Zealand’s economy.  Both gross and net emissions are projected to rise significantly through 2030 under current settings.

The government’s review would benefit from inviting stakeholder input on five “A’s” essential to reforming the NZ ETS: Ambition, Architecture, Alignment, Acceptance and Agriculture.

Ambition

Strategically, the first step in ETS design is deciding how quickly to decarbonise the domestic economy and establishing a credible long-term trajectory for reducing emissions in capped sectors with acceptable emission prices and system costs. This trajectory should be set in the context of possible sectoral emission reduction pathways which are informed by technical and economic mitigation potential and aligned with other development objectives. Aiming for corridors for ETS emissions and emission prices, with upper and lower boundaries, could guide cap setting and price adjustment by future governments as circumstances change while providing a basic level of certainty for ETS participants and investors.

In the context of rising domestic emissions and being nested within the Kyoto emission cap with access to international credits, New Zealand skipped this step initially during NZ ETS design.  It would serve us to go back and set intended corridors for domestic emissions and emission prices under the NZ ETS with the goal of decarbonising New Zealand’s economy, and translate this into an ETS cap as enabled (but not yet applied) under the 2012 NZ ETS amendments. 

Architecture

An effective ETS architecture will be required to deliver increasingly ambitious mitigation outcomes. A key decision for the government is whether the NZ ETS will operate in the future as a domestic price maker or an international price taker. The NZ ETS was fundamentally conceived as an internationally linked system where the domestic price was set by the Kyoto market, but it was compelled to delink as of June 2015 because the government did not take a Kyoto CP2 target. The government’s consultation document appears predicated on the assumption that it will be feasible and desirable for the NZ ETS to re-link to the international carbon market in the 2020s.  Other jurisdictions with an ETS have chosen to engineer a domestic price with limited or no exposure to international prices. Our future options are open.

Having agreed on the objectives and drivers of domestic carbon prices, the government can then consider whether there are grounds to justify different effective prices for different sectors. In the initial design, all sectors in the NZ ETS were to face the full price of emissions at the margin in order to make efficient investment decisions under growing global carbon constraints. In 2009 (and reinforced in 2012), the government halved the unit obligation for non-forestry sectors with the goal of sheltering them from the full international price in a time of recession. Today’s context necessitates a new architecture for managing unit supply and emission prices in tandem, complemented by strategic allocation and use of auction revenue to manage the distribution of costs. Any decision to apply a partial unit obligation to some sectors should be taken in the context of those other considerations.

Given the large surplus of banked units and the likelihood of other cost containment measures (such as a price cap and free allocation for emissions-intensive, trade-exposed producers), there is a strong case for moving directly into a full unit obligation for all sectors with reasonable advance notice, rather than phasing in a full obligation gradually. This is reinforced by NZIER’s modelling, which shows that switching from a partial to a full unit obligation at $25 per tonne would shave GDP growth by only 0.1% in 2020, equivalent to eight hours’ worth of GDP.

Alignment

The NZ ETS should be aligned strategically in two ways: with other domestic policies and with opportunities for international cooperation on mitigation.  First, it would be useful for the government to engage with stakeholders on how the NZ ETS price signal could interact with other sectoral policies and regulations to achieve desired sector outcomes. The NZ ETS price signal by itself may not be sufficient to drive rapid step changes in low-emission technology and infrastructure in key sectors.

Second, to help in meeting its 2030 emission reduction target, New Zealand faces a strong incentive to align the NZ ETS with international expectations for credibility and ambition, both to facilitate linking to other ETS and to position New Zealand as a better partner for other forms of cooperation on mitigation.  Linking ETS requires harmonisation of key design features affecting unit supply, environmental integrity and price control.  The government's NZ ETS design decisions should preserve options to link. From political and practical standpoints, neither a partial unit obligation nor a weak or absent cap will be appealing to prospective linking partners.

Acceptance

Providing greater certainty over future mitigation policy is a critical enabler of investment in decarbonisation. New Zealand would benefit from both improved and new processes to secure cross-party and public support for ambitious emission reduction pathways and a rising emission price as part of a broader low-carbon development strategy.

Agriculture

In this year’s review, the government will explicitly not address the inclusion of biological emissions from agriculture in the NZ ETS. In 2012, Cabinet agreed to exclude biological emissions from agriculture indefinitely, subject to review in 2015. The government stipulates that its 2012 criteria for inclusion have not been met: “there are technologies available to reduce these emissions; and international competitors are taking sufficient action on their emissions in general.” In the absence of market-ready breakthrough technologies for livestock methane, there is still considerable potential for efficiency improvements, using available technologies and practices, which could be incentivised by an emission price. Nitrous oxide emissions could be considered separately from methane emissions. This issue continues to merit discussion, whether within the scope of this review or in a separate process.

Summary

For the potential environmental, economic and social benefits of the NZ ETS to be realised, changes are needed. These relate not just to its architecture but also to its underlying objectives and its relationship with other policies and the evolving international carbon market. Broadening the scope and timing of the review would help both the government and the New Zealand public to make the most of this consultation opportunity.