Sep 2007

Government's long awaited proposals for an emissions trading scheme for New Zealand have finally been unveiled, with the release of "The Framework for a New Zealand Emissions Trading Scheme" policy document on Thursday, 20 September 2007.

The framework document sets out the "in-principle" decisions Government has made about the introduction, objectives and core design of an emission trading scheme for New Zealand.

New Zealand's ratification of the Kyoto Protocol in December 2002 established it as the only country in the Southern Hemisphere with binding obligations to reduce greenhouse gas emissions under Annex 1 of the Protocol. Until now, business has faced uncertainty as to what steps New Zealand would ultimately take to meet its Protocol obligations. Initial policy thinking was based around the introduction of a "carbon tax". Following realisation that, contrary to earlier assessment, New Zealand's net position under the first commitment period of the Kyoto Protocol will be one of significant deficit¹, Government, in June 2005, commissioned a review of all climate change policy responses. The outcome of this review was a preliminary in-principle decision in May 2006 to adopt a policy based around an emissions trading scheme. Since then, New Zealand has been waiting anxiously to see the detail of that policy.

The release of the framework document is the next step towards introduction of such an emissions trading scheme. An ambitious timetable will see legislation in place in 2008, with the scheme applying (for the initial participants, in the forestry sector) from 1 January 2008. The legislative process will provide opportunity for public submissions and discussion over the detail of the emissions trading scheme. However, it appears clear that Government's general policy position is largely settled, and wholesale changes to the scheme outlined in the framework document are unlikely.

In this FYI we outline some of the key aspects of the proposed scheme, examining how it will work and who will be subject to the core obligations. Further publications will follow providing more detailed analysis of topical issues, and examining the impact on a sector by sector basis.

What is the Scheme and how does it work?

The proposed New Zealand Emissions Trading Scheme (NZETS) is designed to:

• reduce New Zealand's net greenhouse gas emissions below business-as-usual levels; and
• assist New Zealand in complying with its international obligations including those under the Kyoto Protocol, in a manner that maintains "economic flexibility, equity and environmental integrity at least cost in the long term".²

It is important to note at the outset that the NZETS does not "replace" the Kyoto Protocol for New Zealand. It exists alongside New Zealand's obligations under the Kyoto Protocol, which must still be met by Government. The NZETS is intended to assist New Zealand in meeting its Kyoto Protocol obligations, both by providing an incentive to reduce greenhouse gas emissions (and thus reduce our net deficit position) and potentially by a partial pass through of costs associated with the remaining deficit position.

The NZETS is a form of "cap and trade" scheme. It does not impose a direct or absolute limit on the level of greenhouse gas emissions, either for New Zealand as a whole or for any given sectors or individuals. The level of emissions will still be determined by the emitters themselves. Instead, the NZETS imposes a core obligation on certain parties to hold, and surrender to Government, a tradable emission instrument called a New Zealand Unit (NZ Unit) for each tonne of carbon dioxide equivalent emissions for which it is responsible.3 Some of these NZ Units will be allocated gratis by Government. The remainder will need to be acquired for value, either by purchase from Government or by trading through a domestic or international market.

The NZETS is designed to create an incentive for parties with the emissions obligations to reduce actual greenhouse gas emissions. This reduction will reduce their costs of complying with the NZETS (or, alternatively, will provide increased benefits from participating in the NZETS).

While there is no direct absolute "cap" on the level of emissions, the end result may well be an indirect cap on emissions. Government has indicated that the number of NZ Units issued will be limited on a basis consistent with our Kyoto Protocol obligations, and each NZ Unit will be comparable to, and backed by, a Kyoto unit. In this way the availability of NZ Units, or of equivalent international units that can be converted to NZ Units may operate to impose a cap indirectly.

Parties who have obligations to hold and surrender NZ Units will be required to make a self-assessment (using approved methodologies) as to the level of emissions that they are responsible for over a specified compliance period. Generally a compliance period will be equivalent to a calendar year, with the exception of the first compliance period for the forestry sector which will be a two year period. There will be obligations to retain records to allow verification of the accuracy of calculations.

Those parties will then be required to report the actual level of emissions that they were responsible for, within a deadline after the end of each compliance period (expected to be 31 March). At the same time they will need to surrender the requisite number of NZ Units relating to those emissions.

To ensure compliance, penalties will be imposed on parties who fail to meet their obligations under the NZETS. Failure to meet the core obligation to surrender sufficient NZ Units will result in a make-good obligation together with financial penalties (of NZ$30 per tonne of emissions that NZ Units were not initially surrendered for) and a "name and shame" penalty. The NZETS envisages criminal penalties for parties (and their directors in the case of companies) who "knowingly" fail to meet their obligations. A policing agency will be established to verify compliance and will have investigative and disclosure requiring powers for this purpose.

Who will be covered by the NZETS

Sectoral coverage
The design of the NZETS reflects the May 2006 in-principle decision that an emissions trading scheme should have the broadest possible coverage – all gases and all sectors. Accordingly, it identifies six major sectors – forestry, liquid fossil fuels, stationary energy, industrial processes, agriculture and waste – and establishes a timetable for bringing each sector within the ambit of the NZETS. The inclusion of agricultural emissions is of particular note, given that sector's responsibility for approximately 49% of New Zealand's greenhouse gas emissions. The framework document envisages that other sectors may, in time, be covered by the NZETS, but does not go into any detail of how such sectors might be identified.

Recognising that immediate application of NZETS obligations to all of these sectors is not desirable, the NZETS proposal is for the six major sectors to be phased in over a period of five years. The timing for entry of the different sectors into the NZETS is summarised in the following table.

Date for entry into NZETS	Sector
1 January 2008	Forestry
1 January 2009	Liquid Fossil Fuels (principally transport)
1 January 2010	Stationary Energy Industrial Processes
1 January 2013	Agriculture Waste and other sectors

Point of obligation
The framework document also identifies the preferred "point of obligation" for each of the sectors covered by the NZETS. While desiring wide coverage, and wanting to create appropriate incentives on emitters to reduce their emissions, Government has recognised that it would not be practical or efficient to impose the core obligation on every individual emitter.

Instead, it has examined the market supply chain for each of the different sectors, to identify a point at which it will be efficient to impose the core obligation. In some cases such as liquid fossil fuels and stationary energy) the identified point of obligation occurs "upstream" of the actual emission. In these cases, the parties on whom the core obligation is imposed will be "responsible" for the emissions that occur further down the market supply chain.

A summary of each of the major sectors and parties subject to the core obligation to hold and surrender NZ Units is set out below.

Forestry
The forestry sector will be the first sector to enter the NZETS. Primarily this is a reflection of the ability of forest owners to bring forward deforestation (to avoid any impact of a delayed application of NZETS to the forestry sector). Government has calculated that a delay of one year could result in 12-24 million tonnes of additional emissions.

The NZETS will distinguish between pre-1990 forests, and post-1989 forests, reflecting the similar distinction made by the Kyoto Protocol.

Pre-1990 exotic forests will automatically be included within NZETS. Government is still considering the application of the NZETS to pre-1990 indigenous forests. The NZETS will cover the emissions produced by the deforestation of relevant forests (although deforestation will not include temporary removal of tree cover by means of harvesting or replanting so long as the forest is ultimately re-established). There will be a de minimus threshold of 50 hectares of forest before the NZETS will apply. There will also be exemptions for minimal deforestation (under 2 hectares in a commitment period) and for deforestation for weed control purposes.

Post-1989 forests will not be automatically included in the NZETS, but may be included voluntarily. Entry of a post-1989 forest into NZETS will mean that that forest is eligible for a credit (in the form of NZ Units) for any increase in its carbon stocks from 2008 (eg through growth or additional replanting), but will also render such forests liable for surrender of NZ Units for any decrease in its carbon stocks from 2008 (eg following harvesting, even if the land is to be replanted).

The NZETS envisages that, in most instances, it will be the landowner who will participate in the NZETS, and will be the party subject to the core obligation. However there will be some ability to transfer the obligation where the landowner does not own or control the forest (eg due to the existence of a forestry right or lease). The ability for forest owners to receive the benefits from afforestation (rather than such benefits being retained by Government for afforestation during 1990-2007, as had previously been proposed) is a significant incentive for post-1989 forest owners to opt to enter the NZETS.

Liquid fossil fuels
The liquid fossil fuels sector relates primarily to transport fuels. NZETS will cover fuels such as petrol, diesel, aviation gasoline, jet fuel, light and heavy fuel oils and naptha. There are some exceptions:

• the NZETS will only cover fuels to the extent that they are used within New Zealand. Fuels that are exported, or used for international aviation or marine transport, will not be covered by the NZETS 
• lubricating oils have been excluded from the NZETS on the basis that the associated administrative complexity significantly outweighs the small amount of  emissions concerned 
• the burning of used oil for energy will be covered under the stationary energy aspect of the NZETS 
• LPG will also be covered under the stationary energy aspect of the NZETS, even where it is used for transport.

The preferred point of obligation for the liquid fossil fuels sector is the oil companies who import and/or uplift fuels from the New Zealand refinery. In the current market this would mean there would only be five participants in the NZETS from the liquid fuels sector – BP, Caltex, Gull, Mobil and Shell. The possibility of an alternative in relation to jet fuel, where the core obligation might instead be imposed on large users of such fuel, is anticipated but not discussed in detail.

Government has confirmed that the NZETS obligations will operate alongside the biofuels sales obligations, which require oil companies to ensure a set proportion of total petrol and diesel sales are made up of biofuels sales.

Stationary energy
The stationary energy sector covers the use of all fuels for electricity generation and for the direct production of power and heat in the industrial, commercial and residential sectors. Primarily this will be fuels such as coal, gas and geothermal fluid. As noted above, it will also cover oil used for combustion for energy, and LPG even where the LPG is actually used in the transport sector. It has also been decided that this sector will cover the use of natural gas in the methanol and urea industries. It will not cover:

• fuels that are exported;
• some fuels used as feedstock in themethanol industry to the extent that the methanol is exported; 
• some fuels used as feedstock in the urea industry;
• "fugitive" emissions of coal seam methane (but it will cover sales of coal seam methane, and the venting and flaring of natural gas);
• emissions subject to carbon capture and storage.

The preferred point of obligation is still to be finalised. The identified options are:

• the upstream suppliers – that is the gas producers or importers, coal-miners or importers, geothermal electricity generators or direct users, and the industrial users of oil for combustion; or
• a combination of upstream suppliers and mid-stream users (such as coal wholesalers and gas distributors and/or major users of coal and gas).

Government has indicated it is keen to receive suggestions on the point of obligation for the stationary energy sector, and will be engaging with stakeholders on this issue.

Industrial processes (non-energy)
The industrial process emissions are primarily those related to the chemical transformation of material from one substance to another – the key processes covered will be the production of steel, aluminium, cement, glass, paper, gold and lime. The loss of inert synthetic gases (hydroflourocarbons, perflourocarbons and sulphur hexafluoride⁴) will also be covered.

The point of obligation will generally be the parties carrying out the relevant industrial process – that is, the producers of steel, aluminium, cement, glass, paper, gold and lime. In relation to the loss of synthetic inert gases, the obligation will be placed on the importers of such gases.

The framework document gives special consideration to the impact of the NZETS on industrial producers, noting that they may be directly and indirectly affected due to a combination of their own direct emissions and to their heavy use of energy. The framework document notes that it may be appropriate for these parties to have direct obligations under NZETS as this may give them a greater level of control over the costs imposed on their businesses. It also recognises the possibility for requirement of transitional assistance measures for some producers (eg. where they are unable to pass costs on and there are competitiveness issues).

Agriculture
Agriculture is the biggest single emitter of greenhouse gases in New Zealand. The major sources of such emissions are synthetic fertiliser use, manure management and livestock. The NZETS has been designed to cover these three sources, as this is consistent with sources that Government is accountable for under its Kyoto Protocol obligations. Other potential sources of agricultural emissions will not be included at this time.

The framework document recognises the administrative inefficiencies that would result if the core obligation was imposed on farmers. In order to avoid this inefficiency, the preferred options for the point of obligation are:

• in relation to synthetic fertilisers, the importers and producers of that fertiliser; and
• in relation to livestock and manure management, the sector processing companies such as meatworks and dairy factories.

The framework document specifically notes that the point of obligation will be the subject to further engagement with the sector.

Waste
The waste sector is the smallest contributor (of the six specially identified sectors) with 2.4% of national greenhouse gas emissions in 2005. Primarily the activities covered by the NZETS will be the emissions arising from solid waste disposal at landfills. At the initial stage emissions created by waste water treatment and solid waste incineration are not to be included.

The delay (until 2013) in introducing waste into the NZETS reflects the potential for enactment of the Waste Minimisation (Solids) Bill. This Bill sets up a funding system to support solid waste minimisation, and one potential funding mechanism is a national levy on waste volumes disposed of at landfills. Although this levy does not directly address greenhouse gas emissions, Government is concerned that it may be inappropriate to apply price measures on the waste sector under both the Bill and the NZETS, where both are designed to encourage improved environmental outcomes.

The point of obligation will be the landfill operators.

Allocation and acquisition of NZ Units

A key issue for those parties that will be subject to the core obligation to hold and surrender NZ Units is how they will obtain those NZ Units. Essentially there will be three ways in which NZ Units can be obtained5:

Free allocation by Government
The NZETS will involve some free allocation of NZ Units where this is considered appropriate, either on a sectoral basis or potentially on a case by case basis in particular areas of sensitivity.

The framework document identifies the current intention that there will be free allocation to:

• the pre-1990 forestry sector, to an extent equivalent to Government's midlevel expectations of emissions from deforestation of such forests (equating to 21.8 million tonnes of emissions during 2008-2012 and an additional 34 million tonnes of emission for the period commencing 2013); 
• the agricultural sector, to the extent of 90% of 2005 emission levels; and
• some participants in the industrial processes sector, depending on the ability to pass-through the costs of NZETS compliance and competitiveness sensitivities.

Such allocation will only apply to existing emissions sources. New entrants and new emission sources are not expected to be eligible for free allocation of NZ Units.

Other sectors are not considered appropriate for the allocation of free NZ Units on the basis that the costs associated with NZETS compliance will be able to be passed on to the end consumer (and the allocation of free units would thus result in a windfall benefit to the parties that would otherwise receive them). The impact on parties (other than industrial processors) who may not be in a position to pass through costs is not considered in detail.

Where free allocation is envisaged, it is intended this will be a temporary measure, with the level of free allocation declining on a linear scale through to zero free allocations in 2025.

Acquisition from Government
The remainder of NZ Units made available by Government will be allocated through sale processes (such as auction). The framework document is relatively light in detail as to:

• the number of NZ Units that might be allocated through sales processes, and the timing of such processes; and
• the likely cost (although given the linkage to international Kyoto emissions units, and the trading ability outlined below, the price is likely to be set by international markets).

Trading
The third source of NZ Units will be the acquisition of those units (or equivalent Kyoto emissions units) through trading on domestic or international markets. As well as providing an opportunity for those who are "short" of NZ Units to meet their core obligations, these trading markets will also allow those with "excess" units (eg. participants in the forestry sector who have been allocated free units and who do not require them to offset deforestation) to sell those units for profit.

Further detail is needed to establish exactly what international units may be acquired in substitution for NZ Units and exactly how these can be used within the NZETS. Until such detail is obtained, there may be a risk involved in acquiring units on the international market in anticipation that they can be used to offset the core obligation in the future.

Next steps

The framework includes a brief overall timeframe for the translation of the policy into law. This would see legislation underpinning the NZETS passed in 2008. It is anticipated that amendment or subsidiary legislation may be required at a later stage for some aspects of the NZETS.

Government is not seeking public submissions on the NZETS policy at present. It will be engaging in workshops with key stakeholders over the month of October 2007. A full public submission and consultation process will occur in 2008 in conjunction with the preparation and introduction of the legislation.

Implications of the NZETS

The release of the framework document does allow potentially affected parties to consider the implications for them, and their potential strategies, in light of a reasonable degree of detail and certainty as to how NZETS will operate.

Such parties will now wish to:

a) work through the actual and potential implications of the NZETS based on the framework and detail that has been released to date;

b) consider their response to the NZETS, in the context of the short term engagement by Government with stakeholders and the subsequent public submission and consultation processes; and

c) develop and/or reconsider their strategy for addressing the implications of the introduction of the NZETS.

For example, parties may wish to consider:

• the extent to which the NZETS is likely to introduce increased cost to their business (or the extent to which it may result in a benefit, such as through the disposal of excess NZ Units); 
• their level of information as to their current (and historic) level of emissions, and their ability to meet reporting and assessment obligations in the future;
• their ability to reduce emissions, and their ability (through such reduction) to reduce the level of cost imposed by the NZETS depending on whether or not they are subject to the core obligation, or whether they are a downstream party to whom costs are passed on; and 
• their ability to pass-through costs that may be imposed upon them; and
• the timing of any acquisition of NZ Units or equivalent tradable units in order to meet any NZETS obligations.

Simpson Grierson will be releasing further publications, and will be holding a number of targeted sessions for clients, to discuss in more detail the implications of the NZETS for various sectors. Details of these sessions will be released shortly. In the interim, if you would like to discuss the NZETS or its implications for you or your business, please contact us.

¹ In conjunction with release of the framework document, Government also released an update of the projected net position for the first commitment period of the Kyoto Protocol, which shows a projected net deficit of 45.5 million emissions units.

² The Framework for a New Zealand Emissions Trading Scheme, page 14

³ The NZETS applies to emissions of all six greenhouses gases covered by the Kyoto Protocol – carbon dioxide, methane, nitrous oxide, hydroflourocarbons, perflourocarbons and sulphur hexafluoride. For the purposes of the NZETS, as for the Kyoto Protocol itself, each of the gases is converted (based on global warming potentials) to a common standard – carbon dioxide equivalent.

⁴ While industrial processes will generally enter the NZETS on 1 January 2010, the application of the NZETS to sulphur hexafluoride emissions will be deferred to 1 January 2013 in recognition of an existing memorandum of understanding between the Crown and major users

⁵ In addition, post 1989 forest owners may earn NZ Units through their entry into NZETS due to carbon stock increase.

This newsletter is produced by Simpson Grierson. It is intended to provide general information in summary form. The contents do not constitute legal advice and should not be relied on as such. Specialist legal advice should be sought in particular matters.