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International linkages in carbon markets: what does this mean for New Zealand?

08 June 2008

International tradability of carbon credits is one of the key features of emission trading scheme design. Linking the NZ ETS to the global carbon markets (estimated to be valued at US$64 billion in 2007) provides New Zealand firms with sources of additional credits for meeting obligations under the NZ ETS, as well as alignment with international prices. It does however expose New Zealand firms to the complexities of the global carbon market, and to price drivers that are not directly related to activities in New Zealand.

One of the keys to understanding the global market for carbon credits is recognising that there is, currently, no single universally recognised form of carbon credit. Instead, the global market for carbon credits comprises a number of forms of carbon credit commodities, each with differing sources, uses, and, ultimately, price. In these circumstances, it is important to know exactly what type of carbon credit commodity is being traded.

The Kyoto Protocol itself establishes a number of carbon credit commodities. Assigned Amount Units (AAUs) are allowances given to countries that have binding commitments under the Kyoto Protocol. AAUs are in effect an allowance to emit one tonne of CO2 equivalent. Parties with insufficient AAUs to cover their emissions must acquire additional Kyoto Protocol credits to cover the shortfall in their free allocation of AAUs. A country can use AAUs acquired from other countries or other forms of Kyoto Protocol credits, principally Certified Emission Reductions (CERs, which are off-set credits generated from emission reduction projects in developing countries) and Emission Reduction Units (ERUs, which are off-set credits generated from emission reduction projects in developed countries).

The European Emissions Trading Scheme (EU ETS) has established a credit known as the European Allowance (EUA). This is the primary carbon commodity traded as part of the EU ETS.

The proposed NZ ETS will create a further new carbon commodity, known as a New Zealand Unit (NZU). While NZUs can be used to meet obligations under the NZ ETS, they cannot be used in the European or other overseas emissions trading schemes, nor by countries to meet Kyoto Protocol obligations.

Finally, there are a number of “voluntary” carbon credits that are being traded, both within New Zealand and in overseas markets. They are typically used by firms wanting to voluntarily off-set their carbon footprint, and cannot be used to meet obligations under statutory schemes such as the NZ ETS and the EU ETS.

Trading in each of these various carbon credit commodities does not occur in isolation. One of the key features of international linkages is the ability to use credits from one scheme to meet obligations under another scheme – that is, there is a degree of fungibility of credits. For example, as currently proposed, participants in the NZ ETS will be entitled to meet their obligations by surrendering to the Government not only NZUs but also unlimited numbers of AAUs, CERs and ERUs (other than from nuclear projects). However they will not be able to use EUAs from the European scheme.

This does not mean that EUAs hold no relevance for participants in the NZ ETS. There is likely to be a shortage of NZUs within the NZ ETS, and with limited numbers of additional NZUs being generated from forestry activities in the short term it will be necessary for New Zealand firms to look overseas for sources of Kyoto Protocol credits that can be used to meet obligations under the NZ ETS. By far the most plentiful and accessible form of Kyoto Protocol credit is the CER. However New Zealand firms looking to purchase additional carbon credits to meet their NZ ETS obligations will need to compete with European participants in the EU ETS, who are able to use CERs to meet obligations under the EU ETS and are the major source of demand for CERs. Foreign governments and other international buyers will also compete for these CERs.

Furthermore, the interlinking nature of the markets for Kyoto Protocol credits and EUAs create a pricing dynamic that impacts on the price for CERs, and will be felt by firms and consumers in New Zealand.

Weather and energy markets in Europe have a large effect on EUA prices, as power sector emissions cover about 60% of the total emissions that fall within the scope of the EU ETS. As electricity demand (and price) rises, prices for EUAs to cover emissions from increased generation activities also rise. Because CERs can be used to meet EU ETS obligations, there has been generally increasing demand pressure for CERs.

However recent decisions by the European Commission (potentially limiting the entry into the EU ETS of additional CERs post-2012) have weakened longer-term demand for CERs, raising uncertainties about the future supply of CERs from new emission reduction projects in developing countries which have relied on steady European demand for CERs as a commercial basis for investment in new emission reduction projects.

If New Zealand moves to link the NZ ETS with a future Australian ETS, it is possible that NZUs will be accepted within the Australian scheme, and, any new Australian carbon credit commodity could be accepted within the NZ ETS. While this would provide a further source of credits for NZ ETS purposes, New Zealand participants will also face increased competition for credits from participants in an emissions trading scheme in a country with an emissions profile dominated by thermal electricity generation.

So, international linkages will expose New Zealand firms to pricing drivers that are not directly related to activities in New Zealand. This is in many ways unremarkable (New Zealand will always be subject to the whims of the global oil market), and will be necessary if the long-term objective is to create a global market for a universally fungible carbon commodity. In the meantime, for New Zealand firms looking to source additional credits to meet obligations under the NZ ETS, understanding the price impact of international linkages will be important for assessing the future impact of emissions trading obligations.

Footnote

  1. State and Trends of the Carbon Market 2008, World Bank, May 2008

This article is the first of a two-part series. The next issue of Boardroom will deal with accessing global carbon markets.

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