Climate Change & Emissions Trading

10 Oct 2011

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Crystal Ball Gazing the Future of the NZ ETS

“Doing New Zealand’s Fair Share” is the title and focus of the New Zealand Emissions Trading Scheme Review Panel Final Report, released last month. In this FYI Elisabeth Welson and Joanna Lim comment on highlights from the report, and attempt to crystal ball gaze as to what the recommendations might mean for participants and others acquiring and disposing of units.

The Panel has endorsed the New Zealand Emissions Trading Scheme (NZ ETS) as a key part of New Zealand doing “its fair share” and responded to concerns by submitters that New Zealand should not move too far ahead of international competitors on climate change. At the same time, it has provided evidence to support a view that New Zealand is neither in front nor behind its competitors, but rather is “keeping up and doing its fair share”.

In all, the Panel has outlined 61 recommendations. Of these, the recommendations likely to have the most impact on participants and others acquiring and disposing units include:

• Extending the transition measures (including continuation of a price-cap, allocations to emissions intensive trade exposed industries and the one-for-two obligations).
• Excluding CERs with questionable environmental integrity.
• A continued focus on the importance of international linking.
• A number of practical changes for forestry – the Panel recommended that a hard headed assessment with possible unilateral change may be required, with the caution that it may not be desirable to diverge from international rules (see further our companion FYI focussing on the agriculture and forestry sectors.
• The agriculture sector entering the NZ ETS in 2015 as planned, but with the point of obligation at the farm gate, transition measures and a continued focus on research into mitigation measures. Statements from Climate Change Minister Nick Smith suggest, however, the Government may be leaving the door open on agriculture, at least for the moment. For further detail on agriculture, again see our companion FYI focussing on the agriculture and forestry sectors.

Looking into the future, in the current “climate” it seems likely many of these recommendations will find favour if the present Government is returned after the election with the appropriate majority. Participants and traders will need to consider how these recommended changes affect their strategic planning for trading in units, particularly in relation to the number of units that will be required for surrender in the NZ ETS, the types of units that will be acceptable and available for trading, and the convertibility of NZUs for export.

Transition Measures should be Extended

Participants in the ETS and traders may need to consider reworking their trading strategies to anticipate the real potential that the number of units required for surrender under the NZ ETS will be lower than expected in the period from 2013 to the end of 2015.

The Panel recommends that the existing transition measures, originally set to expire at the end of 2012, are phased out more slowly “to strike the right balance between managing short-term competitiveness concerns and providing long term certainty”.

The transition recommendations include:

• Extending the one unit for two tonnes of CO2 surrender measure for participants so that it scales up to a full surrender obligation progressively from 2013 to 2015, and extending similar transition measures to additional sectors as they enter the NZ ETS - see the table (replicated from the Final Report) below:
• 

Table: Recommended levels of surrender obligation for different sectors
 

• Increasing the price cap from NZ$25 to NZ$30 (and then progressively increasing it by $5 per year) for new and existing sectors – while issuing a strongly worded caution to participants not to use the price cap as a proxy for their carbon costs in their retail pricing.
• Examining the potential inclusion of additional eligible emission sources in NZU allocation assessments.[1]
• Examining the potential for inclusion of an allocation cap on the free allocation of NZUs in the next ETS review. This is partly to respond to concerns that activities such as the production of lignite have the potential to produce emissions significantly beyond the level of New Zealand’s emission targets, but yet may be eligible for allocations of units. The lack of a cap is seen as something that might also make it more difficult to link to other schemes, including Australia’s scheme, because of the uncertainty about the number of units that might be generated in the NZ ETS.

CERs with Questionable Environmental Integrity be Excluded

To enhance the environmental integrity of the NZ ETS, the Panel suggested urgent consideration be given to the eligibility of some CERs - particularly where some CERs have dubious environmental benefits (such as CERs arising from HFC gas abatement).

The Government has since released a discussion document  proposing to exclude CERs generated from HFC-23 and N2O gas destruction projects. These CERs are reported to comprise approximately 67% of all CERs issued to date. A timely exclusion of these CERs would mitigate the risk of a global oversupply of these units from impacting on the price in the NZ ETS. The international trend is to exclude these CERs (the EU has recently banned them starting from 2013, and the Australian scheme will also exclude them). 

The proposal is that Participants will be prevented from surrendering affected CERs not already held in the New Zealand Emission Unit Register once new regulations take effect. This could also exclude CERs to be transferred into the NZ Emission Unit Register at a later date under existing forward contracts.  Participants and traders should consider immediately reviewing their carbon trading strategies to take into account these likely changes.

The discussion document invites submission on the proposal and sets out 11 specific consultation questions. Participants and traders may wish to consider making submissions, in particular on:

• any forward contracts and the need for or desirability of exemptions;
• the timing of any exclusion (from 1 January 2012, or 1 January 2013);
• who has responsibility for checking the provenance of CERs (the participant or the Government) and any practical concerns relating to identifying this and identifying when affected CERs entered the NZEUR; and
• whether an exemption should be available for affected forward contracts maturing after the date of exclusion.

These CER exclusions have the potential to open opportunities for sellers of NZUs, particularly if all NZUs (not just forestry NZUs) become convertible to AAUs as the Panel has proposed. 

The Future of International Trading

Those participating in the NZ ETS will be well aware of the need to take into account the uncertainty about the future of international units in the short term when making trading decisions. The Panel has now officially recognised what we have all suspected for some time: there is unlikely to be a successor to Kyoto in place by the end of 2012.  

In the Panel’s view, this lacuna is likely to subsist only in the short term. The Panel fully expects New Zealand to face obligations under a binding international carbon agreement in the medium to long term (and these obligations may potentially be a step-up on the current emission reduction obligations under the Kyoto Protocol). There is also no doubt that the NZ ETS will continue to be important in New Zealand’s contribution to the international response to climate change, even if there is no specific international agreement to follow on from Kyoto immediately.

The Panel recommends that the Government continues to engage in the development of international carbon markets generally, particularly noting that alignment with the future Australian scheme could be desirable (see our Q&A for more details) – but with the caveat that the NZ ETS should not be bound to the features of any particular scheme.

On the basis that there is no short-term replacement for the Kyoto Protocol, care needs to be taken in purchasing Kyoto units (including AAUs, RMUs, CERs and ERUs) for settlement beyond 2012, as their value cannot be determined. Purchasers of forestry NZUs should also take care if they are intending to convert these to AAUs for export beyond 2012, as it is not known if there will be AAUs available for this purpose.

The Panel recommends various practical changes to the NZ ETS that diverge from the current international rules, particularly in the treatment of forestry[2] - see our companion FYI focussing on the agriculture and forestry sectors. While the Panel recommends that the Government adopt a “hard-headed assessment” of the Panel’s recommended changes to domestic rules with a view to improving the rules for New Zealand forestry, it is also cognisant of the potential risk of diverging from international agreements and causing additional costs to be imposed on participants and the Government under future international agreements.

The ban on export of non-forestry NZUs should be lifted, in the Panel’s view, as soon as the price cap is removed (or as soon as the price cap becomes redundant because it well exceeds the market price). This is to enhance exposure to the international carbon market which is beneficial to New Zealand because it creates a more efficient scheme than one that is closed. While those receiving allocations of NZUs will undoubtedly be pleased at the prospect of unlimited access to international carbon markets, this is still predicated on international agreement – and that, as discussed above, is still largely up in the air.

Crystal Ball Gazing

The NZ ETS has always suffered from uncertainty due to the politics that surround climate change.  The Panel’s report provides some useful guidance on where the NZ ETS is going. Perhaps the strongest message is that fundamentally the NZ ETS is here to stay, although we will not see any changes pre-election.  Undoubtedly there will be some fine-tuning to come, but exactly what will depend on the post election make up of Parliament.

We expect participants will be carefully scrutinising the detail of the Panel’s recommendations and monitoring next steps. Pending more certainty on how the NZ ETS might look going forward, the prudent approach will be a cautious one for decisions beyond 2012. 

Authors

Joanna Lim

Senior Associate - Corporate & Commercial

DDI: +64 3 365 0958

Mobile: +64 21 359 407

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Craig Nelson

Senior Associate - Corporate & Commercial

DDI: +64 9 977 5185

Mobile: +64 21 918 309

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