Understanding the New Zealand Emissions Trading Scheme

By James Adams

Several lengthy documents on New Zealand’s response to climate change have been published this year. For example, the Ministry for the Environment (“MfE”) sought public feedback on the design of a Zero Carbon Act in June this year. 14,500 submissions were received, suggesting that there is substantial public interest in this policy area.  

The Productivity Commission have also released a report on New Zealand’s climate change challenge. The brevity of its title – “Low emissions economy” – is somewhat incongruous given the report’s massive length: it stretches to 620 pages and contains 78 recommendations.

This article focuses on a third document, and one that has attracted substantially less attention. Weighing in at a mere 87 pages, it is a discussion document for proposed changes to the Emissions Trading Scheme (“ETS”). In contrast to the Zero Carbon Act, which will set targets for reducing New Zealand’s greenhouse gas emissions, the ETS is the primary tool for meeting our goals. This article presents a brief history of how this troubled scheme came to be, how it works (or doesn’t), and how to fix it. So if you care about climate change and you don’t know your NZUs from your FPOs, read on.

 

How we got into this mess, part one

There was evidently enough concern about our warming world in 1988 to warrant setting up the Intergovernmental Panel on Climate Change (the “IPCC”). This was followed by the United Nations Framework Convention on Climate Change (“UNFCC”) in 1992 and the Kyoto Protocol in 1997. Although New Zealand was a proponent of each of these agreements on the world stage, there was little domestic action on the matter until the new millennium.

The Clark Government’s first action on climate change was to ratify the Kyoto Protocol. Along with 36 other industrialised nations, we were classified as an Annex B signatory, which meant that we would have to reduce our greenhouse gas emissions relative to our emissions in the year 1990. Urgency was still lacking, however, as we were under no obligation to start until 2008.

Like a student writing an essay, the Clark Government was not quick to get started on designing a domestic emissions reduction scheme. Although the evidence was mounting that we were not on track to meet our commitments, plans for a carbon tax were abandoned in late 2005. The bright people in Environment House were then asked to design an Emissions Trading Scheme instead, which was only just ready in time. Barely two month before the polls opened for the 2008 election, Labour, the Greens and NZ First voted to support the Climate Change Response (Emissions Trading) Amendment Act 2008. The ETS was born, and none too soon.

How an ETS works

To explain what the ETS is, it might help to first describe what it is not. The ETS is not a carbon tax, despite occasional ill-informed claims to the contrary. A carbon tax would impose a charge on any individual, organisation or business whose activities produce greenhouse gas emissions. It could be made more or less complicated, of course: different types of emissions could be charged at different rates, and different types of emitters (for example, households) could be exempt from the tax, with the understanding that businesses would probably pass their costs onto consumers. But the essence is the same:the more greenhouse gas you produce, the more you pay to the government.

That is not how the ETS works. Instead, the government issues a specific number of New Zealand Units, or NZUs. Each NZU is essentially a license to emit one tonne of carbon dioxide – or an equivalent amount of a different type of greenhouse gas. If you are a part of the scheme and you emit ten tonnes of carbon dioxide or equivalent (“CO2e”) each year, then you must surrender to the government ten NZUs annually. NZUs are given to entities whose activities absorb greenhouse gases, which mostly means forestry.

The idea is that emitters will purchase NZUs off absorbers, providing an incentive for emitters to reduce their emissions and a stream of income which absorbers can use to plant more trees.

How we got into this mess, part two

Labour’s original plan was to include the whole economy, starting with forestry in 2008 and expanding incrementally, with agriculture being the last to join, in 2013. That said, some industries would be treated with kid gloves: any ‘trade exposed’ sector would, for the time being, be given 90% of its required NZUs for free, and agriculture would get 90% of the NZUs it would have needed in 2005.

Yet these defects paled in comparison to the scheme’s fatal flaw: there were few limits on the international units that could be surrendered in place of NZUs. More specifically, forestry businesses in Ukraine could get their government to recognise that, by planting some trees (that quite possibly would have been planted regardless), they should be issued an international equivalent of the NZU. These international units were plentiful in supply, cheap to purchase, and verging on fraudulent: it was generally very difficult to tell quite where they had come from. Nonetheless, the New Zealand government would accept them in place of NZUs.

Labour’s ETS was immediately reviewed by National after the 2008 General Election. Their initial changes, the Climate Change (Moderated Emissions Reduction) Act 2009, did nothing to prevent the influx of international units. Instead, they merely increased the support available to industries by linking the number of free NZUs that companies would be given to the emissions intensity of their operations. Other businesses would benefit from a ‘two for one’ system through which they would only have to submit half the number of units. Agriculture’s entry to the scheme was postponed indefinitely.

As predicted, this gutted the scheme. Because New Zealand emitters could buy cheap units from overseas, there was no demand for NZUs. Similarly, there were no incentives for businesses to reduce their greenhouse gas emissions. Further changes in 2012 merely extended the ‘two for one’ system and made a series of other minor tweaks.

In fairness to the previous government, they eventually came to the realisation that the system needed some fairly radical change. This process began by putting a stop to the reliance on cheap, low-integrity international units, and so the ETS became ‘domestic-only’ in 2015. Cabinet also asked MfE to look into other changes that could be made to the scheme, and it is those changes that are being consulted on at the moment.

A new approach

The changes that MfE propose are numerous and substantive. First, the discussion document details a new system for distributing NZUs, via a regular auction. People who currently buy and sell NZUs will likely have strong opinions on the format of these auctions, their frequency, and who is allowed to participate in them. No doubt it is important to get this right, but proposals of this sort are a matter for those who will be directly affected by the processes.

Second, there is the matter of the remaining loopholes and support measures for sectors that previous governments wanted to protect. MfE appear to be supportive of ending or phasing out each of these anomalies, with the exception of the special treatment for agriculture. This will mean that businesses will no longer be able to avoid paying for their emissions that result from burning coal, as was previously possible. The industrial allocation, through which trade-exposed emissions-intensive industries only had to pay for 90% of their emissions, will be wound down, and the only question is when this will begin, and how fast it should proceed. The original ETS legislation proposed starting in 2010 and winding down 1% a year, but given that we have prevaricated for almost a decade, the phase out will need to be steeper than this.

Lessons learned?

In two other areas, however, New Zealanders have reason to be concerned about MfE’s proposals. It is suggested that we should start to allow international units back into the market – even though it was the proliferation of low-quality international units that undermined the ETS through to 2015. This time, however, we are told that the government will limit the number of international units that can be surrendered in place of NZUs, and that only international units that meet “high standards of environmental integrity” will be accepted.

The rationale for this change is that, given it makes no difference as far as the climate is concerned whether a tonne of carbon dioxide is emitted in New Zealand or Ukraine, the total cost of responding to the threat of climate change is reduced if businesses in New Zealand (for whom it would be costly to reduce their emissions) can pay for businesses overseas to mitigate our continued pollution. In theory, this is no different from the carbon offsetting options that many airlines now offer: because it would be a hassle for you give up flying, you can pay for Air New Zealand to plant some trees for you, which soak up your emissions and salve your conscience.

With both carbon offsetting and letting international units back into the ETS, there is a risk that people will opt for the cheapest option, overlooking concerns about integrity. This can be mitigated by setting rules as to which types of international unit the government will accept in place of NZUs, although this adds some complexity to the scheme and therefore a small additional compliance cost for businesses. Another option is to have an entity buy international units on New Zealand’s behalf, which could auction off an equivalent number of NZUs. The logical entity is the Climate Change Commission, but this would mean that an unelected body would have a considerable influence on the government’s financial position and its climate change policy. Alternatively, the government could buy and sell international units itself, but this risks the matter of international units becoming an unpredictable and political hot potato.

Finally, the ETS discussion document is critical of both price floors and ceilings in the market for NZUs. The previous government operated a price ceiling to protect emitters from overly onerous obligations under the ETS. Formally known as the Fixed Price Option (“FPO”), emitters could buy an unlimited number of NZUs at $25 each, regardless of the market price. This was rarely used because the market price stayed lower than this. However, so long as the price stays so low, the ETS will be utterly ineffective at convincing anyone to reduce their emissions, just as charging five cents per plastic bag at the supermarket would be unlikely to change many people’s behaviour.

The obvious way around this is to abolish the FPO, which MfE propose, and impose a price floor – a minimum price below which it would be illegal to buy or sell NZUs. MfE are not keen on this option, writing that price floors are interventionist, administratively complex, with potentially significant negative fiscal impacts.” There is some truth to this: the ETS relies on foresters selling NZUs to emitters, and it would be hard to enforce a minimum price in such an informal market. Instead, MfE have designed a complicated system of releasing more or fewer NZUs in response to the market price crossing various trigger prices. Feedback is being sought on whether this system should be included in legislation, or whether there should be an element of discretion, and in what circumstances.

Conclusion

Much has changed in the climate policy in New Zealand. Previously, there was little public consultation on emissions trading legislation and even less ambition to reform the scheme in any meaningful way. When given the opportunity to speak before the Select Committee considering the Climate Change Response (Emissions Trading and Other Matters) Bill in 2012, submitters relied on emotive appeals, calling on the government to care about the future of our planet. Today, there is no need to remind legislators about the urgency or importance of climate change. Instead, we are being asked what we think about complex proposals contained in lengthy documents. The trade-offs today are between democratic control and administrative predictability, rather than between a livable planet for future generations and whatever the alternative was.

Yet the battle is not yet won. Although MfE’s proposed changes to the ETS are another sign that we are getting back on track, there is a risk that we get so bogged down in the detail that we lose sight of the bigger picture. From its inception onwards, the ETS has been characterised both by unwarranted faith in the artificial market for NZUs, and in the bureaucratic complexity of the scheme. The proposed changes are radical in contrast to what has come before but the questionable essence of the scheme remains.  

Featured image source: http://www.chicagotribune.com/news/nationworld/science/ct-climate-change-report-20171030-story.html

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