What ‘should’ the ETS price be?

by Suzi Kerr, Senior Fellow at Motu Economic and Public Policy Research Trust

The government is seeking input on whether all sectors in the New Zealand Emissions Trading System (NZ ETS) should move to full surrender obligations (i.e. all sectors must surrender one unit for each tonne of emissions) and how to manage the costs of moving to full surrender obligations. To address these questions, we need to consider what current NZ ETS price would be consistent with an efficient long term transition (at least in expectation) to a low-emission economy, and what is likely to happen to the NZ ETS price if full surrender is implemented.   

This blog follows on from Catherine Leining’s, which set the wider context for these decisions.

What ‘should’ the ETS price be?

The fundamental purpose of an ETS is to constrain emissions and hence set an emissions price path that facilitates a gradual, cost-effective transition to a low emissions economy. This is a long-term objective and the investments and behavioural changes that will drive the transition are long term, so the system has to be thought of over a long period – not just in terms of current issues.

For a cost-effective transition, emission units should be fully bankable with no risk of confiscation. Banking brings forward emission reductions, improves liquidity, reduces price volatility, and creates a long-term constituency for a strong ETS. If units are bankable (and there is a positive bank, as there is in New Zealand), then price is determined by long-term supply, not short-term. If the NZ ETS is later linked to a larger ETS (or other source of international units), then that larger system will set (or at least affect) the NZ ETS price once the link begins.  Linking will also heavily affect the New Zealand price as soon as a link is anticipated. An earlier blog explored some of these effects.

Prices are driven by expectations about long-term supply and demand. Long-term supply in the ETS is set by governments both through and in response to New Zealand’s international targets. Long-term supply also depends on:

• decisions around the desired rate of domestic decarbonisation and the short run balance between domestic action and funding credible mitigation action abroad,
• whether ETS participants or the government purchase international units, and
• decisions on reduction targets for sectors covered by the ETS relative to uncovered sectors (currently dominated by agriculture).

Supply is currently highly uncertain even over the next few years (e.g. to 2020) because the government has neither outlined aims for emission prices or domestic emissions (reduction) nor given signals about how many units might be auctioned. Options to link our ETS internationally are highly uncertain.

Long-term demand is also uncertain because it depends on economic activity and mitigation costs, but these are no different than forecasts that affect any other product. In the short term, demand is also critically dependent on the government’s decision on whether and how quickly the non-forestry sectors move to a full surrender obligation.

To decide on an appropriate current NZ ETS price we need to think about what price is required to meet NZ goals for both reaching net zero emissions in the long term, but also the total amount of emissions between now and then – the path of reduction. Answering this analytically would require us to predict economic activity, technology change and uptake, responsiveness to emissions prices, and effects of non-price policies. The price required also depends on how we might contribute to mitigation in other countries – and how NZ takes credit for that, allowing temporarily higher domestic emissions. Estimating an appropriate emission price is thus complex and ultimately is a question of judgement not modelling.

One way to think about this price is the ‘social cost of carbon’ which estimates the climate damages from emissions. In a 2013 study a central estimate was US$37 per metric tonne of CO2 (US$11 – 109 in 2015) rising to US$26 - 220 in 2050. These estimates and even the fundamental approach to generating them are contentious. Key uncertainties are the rate at which countries implement policies to reduce emissions and the rate of clean technology change and uptake as well as the impacts of climate change and the ability of humans and natural systems ability to adapt to them. An alternative way to think about price is to consider prices in other jurisdictions such as California, Quebec and the European Union.

New Zealand needs to make its own local judgement and then make investment and policy decisions expecting that ‘best’ price is above a minimum level, but also take into account the possibility that it may be much higher in future.

What is likely to happen to the NZ ETS price if full surrender is implemented?

Simplistically, if full surrender is implemented the effective price paid by non-forestry sectors will double because they need to buy two units where they previously bought one (for activities that are eligible to receive it, free allocation for each unit of output also doubles). In addition, because demand has doubled from these sectors the price can be expected to rise, assuming supply remains the same. Working against this, more mitigation should occur in response to the higher price.

However, the actual effects on price are impossible to estimate in the absence of clear information on medium-term supply. To the extent that a decision to move to full surrender obligations signals a higher level of NZ ETS ambition by government, the impact on price may be higher than would occur only through the changes in demand. It will depend heavily on the effect of the decision on market expectations. Recent NZU price rises seem likely to reflect gradually shifting perceptions of the government’s ambition and hence limits on future supply.

In my next blog post I will look into two more central questions:

• Are there reasons to protect some sectors against the full price?
• Is a gradual transition to a full obligation warranted?