The NZ ETS: Better equipped for the journey – but still unsure of the path

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

Every tramper knows the value of good gear. A well-designed backpack that distributes the weight to the areas of greatest strength can transform the experience of a challenging bushwalk.  

The changes to the New Zealand Emissions Trading Scheme (NZ ETS) announced by the government last month will usefully equip the system for the journey to net-zero domestic emissions. Like a good backpack, they offer a sturdy framework for distributing mitigation responsibilities and costs across the economy. However, we still do not know what route lies ahead, what pace we will set, what provisions will sustain our efforts, and who will carry the heaviest weight.

The government has not altered our path through 2020. What longer-term changes can we expect to see in the NZ ETS?

A better approach to unit supply

Of critical importance is the government’s intention to constrain future unit supply in line with New Zealand’s emission reduction targets. No such constraint applied in the past and an oversupply of low-cost overseas units left no incentive to reduce domestic emissions. This constraint will be achieved in two ways.

First, by 2021 the government will begin auctioning NZUs under an “overall limit” – essentially a cap. This means that auctioning will help fill the NZ ETS supply gap and valuable auction revenue will be generated. To make this happen, the government will need to define an auction limit that supports our targets and manages fiscal risk.

Second, a quantity limit will apply to future purchasing of international units by NZ ETS participants, sending a vital long-term signal. Such purchasing is not possible at present; under the Paris Agreement, transfers of international emission reductions can only be done between governments. A new UN market mechanism could open international emissions trading to private entities but the rules are years away. As discussed in our recent paper, linking ETS markets is not the only – or likely to be the best – way for New Zealand to access international emission reductions. Importantly, any tradable international emission reductions will need to be additional to the seller countries’ Paris targets, not just business as usual, so both their quality and prices should be higher than in the past.

Hopefully these decisions will open the door to more ambitious domestic decarbonisation. The government has reserved its options here, stating that the limit on international units could be “as small or as large as needed” – even up to 100 percent of the target gap.

A higher – and possibly different – price ceiling

Currently participants can meet ETS obligations by paying a fixed price of NZ$25 per tonne. The government now plans to implement an alternative price ceiling – but only after auctioning or international linking is in place. If the price ceiling remains unbound by the auction limit – as is currently legislated – then triggering the price ceiling could send ETS emissions hurtling off the intended path.

While delaying changes to the price ceiling aids participants, it poses a fiscal risk to government. As domestic prices rise toward $25 in anticipation of auction limits, participants could choose to bank NZUs (which will continue to rise in value) and meet their obligations using the fixed-price option instead. This would force the government to compensate by buying more international emission reductions at unpredictable prices.

At this time, the government has chosen not to implement a price floor, which would have served as a price safeguard against over-allocation and guaranteed a minimum return on low-emission investment. California has successfully demonstrated a price floor in its ETS. We looked at options for a price floor at auction in our recent paper and it would be worth reconsidering.

Challenges to balance the emissions budget fairly across the economy

Right now we don’t know how government will distribute the responsibilities and costs for meeting New Zealand’s targets across ETS sectors, non-ETS sectors and taxpayers. Over 2021-2030, the government projects a target emission budget of 594 Mt CO₂eq and a target emission gap of 220 Mt CO₂eq. Under business as usual, the agriculture sector will consume 67% of New Zealand’s target budget. The government plans to freely allocate 123 million units and auction 43 million units in the NZ ETS – but this will cover only 43% of projected gross emissions in the NZ ETS. The government will also need to factor in the target implications of participants’ banked NZUs (projected to total 51 Mt CO₂eq in 2021).  

The Cabinet paper suggests the target gap will be met through some combination of ETS emission reductions, net forestry removals, and purchases of international emission reductions. Future forestry removals are unknown. On one hand, projected harvesting could have less impact on our target under new accounting rules. On the other hand, new planting rates will depend on repairing foresters’ confidence in emission prices. Also unknown are the future availability and prices of international emission reductions.

The government does have further options. It could incentivise the agriculture sector to help lower the mitigation gap – whether biological emissions are outside or inside the NZ ETS. It could also choose to phase out industrial free allocation more quickly. These options would open up more capacity for government auctioning into the ETS market and/or help to reduce purchasing of international emission reductions. They are also critical for New Zealand’s transition to net zero emissions.

More predictable decision making

The government may take until the end of 2018 to make decisions on auction volume, international purchase limits and the price ceiling. It has committed to coordinate future decisions on these issues, announce settings five years in advance and update them on a rolling basis.

While this coordination is useful, our recent paper suggests more strategies for improving policy certainty. First is adding indicative ten-year corridors for future unit supply and price management, providing a 15-year horizon for NZ ETS participants and low-emission investors. Second is enlisting independent technical advice (fitting nicely with current interest in creating an independent Climate Change Commission, as suggested by the Parliamentary Commissioner for the Environment and the Zero Carbon Act movement launched by Generation Zero).  

Policy uncertainty is a powerful deterrent for efficient low-emission investment. The government’s announced changes are crucial to gear up the NZ ETS for the journey to net zero domestic emissions but they don’t yet provide for confidence and speed. Choosing a more ambitious NZ ETS track now could help us to avoid the truly harsh terrain of a rapid economic adjustment to tightening global emission constraints after 2030.