Friday, 22 April 2016

Finding the best cure for a "hot air" hangover

By Catherine Leining, Policy Fellow at Motu Economic and Public Policy Research

When it was introduced in 2008, the New Zealand Emissions Trading Scheme (NZ ETS) pioneered many design features. Among these was replacing the conventional ETS cap on emission units and constraint on offset credits with an unconstrained buy-and-sell linkage to the global cap set by the Kyoto Protocol. This gave participants the option to increase their own emissions while contributing to global mitigation by buying overseas Kyoto units if that was the most efficient outcome.  The history of why this policy choice was made and how it has impacted on the system’s outcomes alongside other design features and historical events is detailed in Motu’s new working paper entitled Lessons Learned from the New Zealand Emissions Trading Scheme.

A substantive report published this week from the Morgan Foundation (Climate Cheats) has brought fresh public attention to a longstanding and well-known problem: the use of “hot air” Emission Reduction Units (ERUs) to meet NZ ETS obligations as well as New Zealand’s Kyoto target over 2008-2012 (CP1). These units were legal tender by international agreement but most resulted from weak targets and economic downturn rather than “additional” mitigation investment. (For more background on this issue, see my earlier post.) Their use in the NZ ETS has contributed to a large participant-held bank of NZUs and a large government-held surplus of Assigned Amount Units (AAUs). The report recommends that the government:
  1. Cancel the NZ AAU surplus (as a proxy for cancelling ERUs) rather than applying it to help meet New Zealand’s future target(s); 
  2. “Burn” the NZ ETS bank by removing the one-for-two unit obligation and freezing industrial free allocation for a year; and 
  3. Block future imports of units until their environmental integrity can be assured. 
The third recommendation is excellent and essential to the sound operation of the NZ ETS in the future.  The flow of imported units has already been stopped by New Zealand’s exit from the Kyoto market in mid-2015.  Any future linking arrangements must have environmental credibility and New Zealand can be proactive in designing approaches to ensure this outcome.

The other two recommendations could have unfair outcomes and undermine market confidence in government rule making – a key requirement for future low-emission investment. As Suzi Kerr and I reported in our initial NZ ETS Review submission, there is merit to restoring a one-for-one unit obligation in all sectors with advance notice.  There is also merit to phasing out industrial free allocation when the risk of emission leakage is no longer significant.  Compensating for past unit import rules is not the appropriate rationale for either of these changes.

A more effective remedy to past use of “hot air” ERUs which both supports mitigation and maintains fairness and market confidence is for New Zealand to deepen its mitigation targets and implement an ambitious cap in the NZ ETS.

It’s true that the government could have produced a better environmental outcome in CP1 by banning “hot air” ERUs from the NZ ETS and channeling New Zealand mitigation investment to produce long-term mitigation dividends rather than short-term profits to countries with inflated targets.  It’s also true that more NZ ETS participants could have chosen not to buy “hot air” ERUs.  The facts remain that:
  • ERUs were internationally accepted units backed by Kyoto targets and many governments used them to help meet their targets for CP1.  
  • NZ ETS participants also surrendered Certified Emission Reductions (CERs) that had variable quality.
  • NZ ETS participants purchased Kyoto units and banked NZUs to different degrees and for a variety of reasons, in adherence with the system's rules.
  • New Zealand’s AAU surplus was the cumulative product of many complex domestic policy decisions, sector actions, economic conditions and international mitigation ambition. 

It is not clear to me whether the government’s decision to carry forward surplus AAUs conforms with agreed Kyoto Protocol rules which it has pledged to uphold. Setting negotiation politics aside, banking emission units should be encouraged, both domestically and internationally.  Banking encourages emitters to over-comply with targets, provides flexibility, improves ETS liquidity, and reduces emission price volatility. Both the government and NZ ETS participants are carrying forward a substantial emission liability for future harvesting, and banking units is in New Zealand’s strategic interest for managing that liability efficiently over time.  Cancelling the NZ AAU surplus would come at taxpayer expense, rather than at the expense of those who bought weak units.  Confiscating banked NZUs, or cancelling industrial free allocation as a proxy for doing so, would not be fair to NZ ETS participants and would seriously undermine both the system’s operation and participants’ trust in government rule making.

The outcome we need is an effective transition to a low-emission economy. We can’t regain the lost mitigation opportunities of the past by imposing potentially unfair and distorting measures on today’s NZ ETS participants and taxpayers.  Instead, we can take social responsibility for past decisions, acknowledge the flexibility gained from banking, and increase the ambition of our mitigation targets supported by an effective NZ ETS cap and sound linkages to other markets.

History shows us that an ETS is only as strong as its weakest link, and seemingly cheap options can come at a cost.  In this case, it may not work well to pay it back but there are good options to pay it forward.


  1. Agree with the need to increase ambition/stringency of NZ ETS settings, but a few quibbles with this post:

    - Yes, many governments used low-integrity ERUs but as the Morgan Foundation’s report shows NZ was by far the worst offender. Moreover, justifying environmentally harmful decisions (using fake ERUs) on the basis that “other governments did it too” is a logical fallacy.

    - “There is also merit to phasing out industrial free allocation when the risk of emission leakage is no longer significant.” To start with, the new global agreement is comprehensive (or as close to it as we will get). There is nowhere left to leak to. Even if there was, I recall someone once said that trying to address leakage through NZ ETS design “would risk increasing the overall economic cost New Zealand faces to meet its international obligations but fail to secure any significant global environmental gain”. The justification for subsidising CO2 pollution is just as poor as the argument for subsidising milk, car or steel output in NZ: It is not in our economic interest to shield emitters from the cost of pollution for any length of time. We are close to two decades from the time NZ govts signalled a clear intent to pursue carbon pricing as a preferred approach. How many decades do big emitters need for a transition? How many decades do we have left for drastic CO2 reductions to occur?

    - The 2 for 1 subsidy was never justified by any evidence or analysis. It was introduced as a temporary measure in the context of a global economic crisis (which actually impacted NZ to a relatively small degree). Any serious market participant has been aware this design feature was a political sop that could be pulled immediately. Removing it should not be portrayed as something that needs to be broken softly to market participants. It was an unjustified emergency measure.

    1. Thank you very much for your comments.

      Regarding your first point: I agree with you completely that the rationale "everybody else is doing it" is not useful for the climate system and NZ certainly could have done much better from that perspective. I am not using that to justify the emission value of NZ's choice, but it does reinforce the legality of NZ's choice under the Kyoto Protocol.

      Regarding your assertion around "worst offender": According to the MF report, NZ used the most ERUs by proportion but Germany and the UK had larger absolute numbers of ERUs and many other countries also used them. Using a relatively smaller proportion of ERUs would not have improved the justification for NZ's choice (or that by other countries who sold or bought weak ERUs). Every tonne matters.

      Regarding your assertion of "fake units": ERUs were the outcome of a weak agreement but were not "fake" units because they were backed by national targets as a safeguard against projects lacking integrity. Some were of better quality than others (e.g. those associated with green investment schemes).

      Regarding your second point: The Paris Agreement is an important step forward, but given the variability in countries' target form (absolute versus intensity, sectoral versus economy wide), target ambition and domestic policies, it does not yet eliminate the potential for emission leakage which would cancel out emission reductions in NZ. You raise important considerations for the phase-out of industrial free allocation.

      Regarding your third point: Policy uncertainty is a major deterrent to low-emission investment. As a matter of principle, changes to NZ ETS rules should be signalled in advance where possible to protect market operation. Given reporting is done on an annual basis, it would make sense for the change in obligation to be applied from the beginning of a reporting year. In the submission which Suzi Kerr and I made to the ETS Review, we stated we could see no reason why the change should be delayed beyond January 2017.

      As a reminder, the next round of submissions on the NZ ETS is due on 30 April 2016. I encourage you to share your views with the government. Cheers!