Trading carbon – let the consultation begin

Jim Anderton is one of Parliament’s great survivors. The Agriculture, Forestry and Fisheries Minister claims the Government’s recently released climate change package is the most complicated policy framework he’s ever seen. And Anderton entered Parliament in 1984.

The proposed carbon-trading scheme is complex, ambitious and cautious at the same time and still only faintly drawn. The scheme relies on a great deal of consultation and negotiation yet to come and the Government admits it is hard to predict the directions in which the emissions market may evolve.

In fact although the policy sets out firm targets for carbon neutrality and provides sectors with a clear timeline for inclusion, it still paints an uncertain portrait of where we will be post 2012 when the first round of Kyoto commitments expire.

To a small degree this is adept politics. The phasing in of emission caps means consumers will not begin feeling the impact of price increases until next year’s election is out of the way. But for the most part the policy’s uncertainties reflect the reality that this is a hard issue to tease out and in some cases the best solution is not yet clear.

This is the second paper in a two-part series and is designed to assist you by identifying some of the key features of the Government’s policy.

What’s proposed

  • an emissions trading scheme (NZ ETS) applied to all sectors
  • sectors to be phased in between Jan 1 2008 and 2013
  • participants to have an absolute obligation to surrender one emission unit (NZU) for each tonne of eligible emissions per year

Timetable for phasing in sectors

Commencement​ ​Sector ​Potential points of obligation
1 January 2008​

Forestry​

Land owners​

1 January 2009​

​Liquid fossil fuels(mainly transport)

​Oil companies and users of jet fuel

1 January 2010​

Stationary energy

Industrial process(non-energy) emissions

​Coal importer or miner, gas importer or producer, geothermal electricity generator or direct user, industrial producer that uses oil for combustion, and major users of coal and gas

Producers of steel, aluminium, cement, burnt lime, lime fertiliser, glass, gold and paper
Electricity and refrigeration industry entities that import relevant synthetic gases

1 January 2013​

​Agriculture and waste

​Importers and producers of nitrogenous fertiliser, farmers, sector bodies, enteric fermentation and manure processors and land fills

First impressions

On first impressions the Government appears to have struck a well-judged balance between the competing forces at play here. On the one hand the scheme will reduce New Zealand’s emissions from business-as-usual levels. (Although we will still fall well short of our Kyoto commitments.) On the other it delays the real implementation just long enough to give most sectors fair warning and time to adjust.

Given the level of consultation now required to progress this package, the successes of the forestry and agriculture sectors offer a useful lesson. Both were early mobilisers, opposing government direction in climate change, positing alternative solutions and building constituencies for those alternatives. Other sectors might note the Government has subsequently shifted considerably to accommodate forestry and agriculture, which indicates a willingness to be pragmatic.

In announcing its policy the Government has also lifted the veil on much of its policy development thinking. What this shows is that on some of the very substantial decisions, for example where to set the points of obligation in each sector, the Government has still not firmly made up its mind. The Government states it “holds particularly strong views on the importance of the early introduction of forestry and liquid fossil fuels sectors”. But on almost every other detail it is inviting input from the sectors.

Assessing the market

The Government’s own definition of an effective emissions trading market has five features:

  • a well-defined and enforceable unit of trade
  • a liquid market
  • a transparent regulatory environment
  • good price information for participants
  • low transaction costs

Of those, liquidity and transaction costs are the two most problematic at this stage of the policy roll-out.

How liquid will the market be?

Liquidity is important for establishing a clear price signal upon which businesses can invest in new technologies and new practices necessary to meet the reduced emissions goals set. To achieve liquidity the market needs two things:

  • enough units (NZUs) to trade, and
  • enough traders

The NZ ETS is never going to be big. When it is fully established the Government expects fewer than 200 firms plus foresters to participate.

But the decision to phase in the market, one sector at a time, means in the short term at least there will be both few NZUs and few traders. The decision to freely allocate NZUs to owners of pre-1990 forests will help kick start volume in the market in the short term, as forest owners who have no intention of deforesting their land sell their windfall gain into the market. However, additional NZUs from forestry will only come into the market slowly as trees grow, and then only in small amounts. Further substantial volumes of NZUs will only flow into the market as each sector of the economy is phased into the ETS over the next five years.

Futures trading may emerge on the more sophisticated market platforms, such as the TZ1 market proposed by NZX, helping to signal longer-term price trends. But it will take time for substantial futures trading to emerge due to the lack of detailed information about the ETS and therefore the likely forward pricing of NZUs within the ETS.

Given the relatively weak market forces domestically, the Government accepts that the “primary determinant of the emission unit price will be the nature of the international linkages with the NZ ETS”.

How will NZ ETS link with international markets?

International linkages are vital if the NZ market is to develop depth and liquidity. The Government concedes that without them the NZ market will consist of only a limited number of participants, and create the risk of substantial price volatility.

To avoid this the scheme intends that all NZUs will be backed by Kyoto credits (for the first Kyoto commitment period at least). This means that Kyoto units can be purchased on international markets and used to offset a liability under the NZ ETS (although there are likely to be limits on this). It also means that participants in the NZ ETS will be able to exchange NZUs for Kyoto units through a central registry and sell them offshore.

Practically this means that the price for NZUs will likely mirror the price of Kyoto units on international markets. There are however a number of varieties of Kyoto unit, each with a different price. It is unclear how this lack of uniformity of Kyoto units will impact on the interchangeability with NZUs, and accordingly their price.

It also means the NZ ETS’s "cap" will essentially be set offshore, rather than here at home, in that our cap will be constrained by the number of Kyoto units able to be accessed on international markets. This could potentially weaken any certainty about domestic environmental outcomes. Hence the signal by the Government that there are likely to be limits on “importing” Kyoto units.

Linkage to the international market for Kyoto units also deals with the need for a price cap (also known as a “safety valve”). The Government is confident that the ongoing commitment of key developed countries (to the Kyoto Protocol) and the projected supply of Certified Emission Reductions (CERs) together will provide a sufficiently stable international market so that New Zealand does not need to set its own price cap. However in the absence of a post-2012 international consensus a future government could introduce a price cap.

That the Government should still put so much store in Kyoto remains curious. The US and Australia are staying outside the Protocol, and China, while now endorsing a UN solution, remains resolute in its opposition to any externally imposed restrictions. As yet there is no clear indication of how the international tensions created by Kyoto will be resolved. Talks are scheduled on this in Bali in December.

Are there alternatives for international linkages?

The Government did consider an alternative, whereby it entered direct bilateral carbon trading arrangements with other countries or regions. This would have required a degree of design conformity where none presently exists.

For example, Australia is not a party to the Kyoto Protocol which means bilateral trading between trans-Tasman neighbours could not be in Kyoto units. (The Government is worried this could possibly increase New Zealand’s Kyoto liability.) Also Australia’s trading scheme will not be operational before 2012 and it has opted for intensity-based obligations, where firms are set targets based on energy or emissions efficiency without a cap on total emissions. This contrasts with the absolute obligations favoured by New Zealand. Were Australia to adopt Kyoto (unlikely) the Government says some linkage might be able to occur.

Further, having NZUs backed by Kyoto units may complicate potential bilateral arrangements. New Zealand’s trading scheme is more comprehensive than that of other jurisdictions. It includes forestry and agriculture, which is a first. Also the intention is that NZUs will be able to be banked for use post 2012. The European ETS, for example, does not allow this.

Having conceded the reliance on international linkages, it is possible international cap and trade schemes, such as the European ETS, will not allow interchangeability with NZUs because they consider the design differences too significant to make linkage possible. Similarly it is possible the NZ ETS will not recognise overseas carbon credits.

Such an outcome would naturally have an impact on growth in liquidity, particularly if there is a global trend away from the Kyoto Protocol rules. Already, the Government has signaled a need to review ETS policy settings before 2012.

How fair will the allocation of credits be?

The Government had two options. It could either hand out credits as gifts or auction them off. It has decided to do both. Fossil fuel providers and electricity generators, who can easily pass cost increases through to consumers, will have to purchase credits. For other sectors, if certain criteria are met, there is potential access to free allocation credits, issued annually.

New entrants into the market will not be eligible for free allocations. Firms exiting the market will lose eligibility for free allocation.

From this, there exists the potential for competition to be distorted.

For example Firm A is a new entrant with no free allocations, but in planning for next year needs to anticipate that for every tonne of carbon emitted it must pay (say) $15 for a NZU. Its competitor, Firm B, gets a free allocation every year. It also needs to anticipate a $15 a tonne emitted additional cost, but since every year it gets another free allocation it can afford to lower its prices to $15 below the cost of production because part of its production cost is effectively paid for by the Government. The Government accepts the scheme involves a level of bias against new entrants.

The priority has clearly been to launch the scheme in such a way as to avoid its wider purpose being undermined by scraps with any single sector. So those sectors eligible for free allocation are (except for forestry) potentially able to get “generous” allocations based on 90% of 2005 levels.

The Government admits its allocation proposal has weaknesses and highlights this as another area in which it seeks stakeholder engagement.

Sharing the free NZUs within a sector is clearly going to be a vexed exercise. It seems likely that the push for intra-sectoral equity and the desire to only allocate free units to those whose profits will be affected by the new emissions obligations will lead to considerable political lobbying and positioning. Interestingly the Government’s policy document makes special mention of the complexity of intra-sectoral allocation within the agricultural sector. Options are “in the very early stages of development”, it says.

Also, there is of course the prospect that the early “generous” allocations are merely the thin edge of the wedge; more an introduction than the real deal. The Government intends phasing out the free allocation of units post 2013, cutting in at 8.5% per year.

Farmers enter the scheme the same year and a year after New Zealand’s first round of Kyoto commitments end. By then our level of Kyoto liability will be very clear indeed, data on sector and emissions growth may be more reliable and the ETS itself will be well underway. In the likely event that New Zealand’s reduced emissions are failing to meet targets, will the 90% of 2005 promise still hold firm or will it prove to have been merely a "headline" figure? At the very least agriculture can expect its allocation to vary from the early stages of its inclusion into the scheme.

The Government is pledging to work with the agricultural sector between now and then to reduce emissions (which makes sense), but in the meantime the Government and the sector have to resolve where the points of obligation should fall. The Government has signaled it believes the best option for incentivising behaviour change is to require farm level obligation, although it accepts this is not feasible “in the short term”. Interestingly work on reducing emissions and enhancing sinks, to be rolled out prior to agriculture’s inclusion in the ETS, is focused on the farm.

Will the transaction costs be low?

The scheme can only work if emissions can be measured and reports monitored. International experience tells us this is more difficult than it first appears.

The Government intends to administer the ETS from a central agency. Participants will have an obligation to:

  • calculate their level of emissions using approved methodologies
  • retain sufficient records to verify calculations
  • comply with any directions of the agency

In addition the Government is considering requiring independent third-party verification.

Significantly its preference is for quarterly reporting.

A penalty regime for non-compliance will include fines and publication of the participant’s identity.

In light of all this, compliance is likely to be complicated and costly.

Does the scheme send the right price signals?

This is a significant and complicated shift in emphasis introduced in small steps over time. In its initial stages the price signal will be set by the international price of Kyoto units, in the absence of strong domestic market forces impacting directly on price. The impact of this price signal on the economy however will be faint, due to free allocation of NZUs and the phasing in of sectors. However this may be one of its most essential traits. A policy more rapid or more radical would have failed to attract the much-needed political consensus that now surrounds this scheme.

A soft entry with clear signals will achieve the change in behaviour that is required, but probably not enough of it.

The Government has set some very ambitious targets for carbon neutrality. They will not be met by phase one of this policy alone, which is why the inevitable phase two remains threatening. At that stage the demands on business and the impact on the economy will be more substantial.

However by then the small print regarding how the ETS will work will have been worked through.

The Government is up for consultation on the details now. The papers show clearly that officials have struggled with the complexity of some of the issues still outstanding. The U-turns on forestry and agriculture show ministers are willing to be pragmatic.

The number of active participants in the ETS may be fewer than 200, but the impact of the scheme will be felt throughout the economy. We would advise you to make the most of the opportunities that now exist to influence the future shape of this scheme.

Click here for our climate change team and experience.

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Related topics: Climate change; Emissions trading; Carbon trading; Forestry

 

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