Practical ways to change the ETS – Expert Reaction + Q&A

Practical changes to New Zealand’s Emissions Trading Scheme (ETS) would ensure emitters reduce their greenhouse gases quicker than the current pace, according to a discussion paper released today.

Motu Economic and Public Policy Research based its proposals on a series of working papers and meetings. Research fellow Suzi Kerr told that the ETS had fallen into disarray because New Zealand carbon credit prices were linked to the international market. Since pulling out of the Kyoto Protocol, carbon credit prices had risen but at the same time the country’s emissions were rising too.

The Motu paper proposed several mechanisms in order to improve the scheme, including a price band on units and a fixed short-term cap on the number of units issued for auctioning and free allocation.

The paper and associated material are available on the Motu website.

University of Canterbury’s Professor Euan Mason commented on the Motu paper:

“There is much to commend about this report, but it also makes some recommendations that are inconsistent with rational carbon trading and concepts of greenhouse gas neutrality.  These inconsistencies would undermine the effectiveness of New Zealand’s ETS.

“The report correctly states that New Zealand must reduce its domestic greenhouse gas emissions, that there is a practical way to deliver more predictable long-term price signals and that we need independent review and management of our domestic carbon market.

“However, it is not necessarily true that we need to purchase credits on the international market in order to meet our commitments. A report by me and Justin Morgenroth (2017) for instance, sets out how New Zealand could track towards greenhouse gas neutrality during some years by a relatively modest programme to establish forests on erosion-prone land, and moves towards electric vehicles and improvements in public transport could lead to large reductions in domestic emissions given suitable incentives (see the Royal Society’s report  and Vivid Economic’s report) .

“In addition, we should not grandfather carbon credits for ‘allowed emissions’ or auction credits created artificially by government as suggested in the Motu report.  Such credits represent no environmental gain and are just as fraudulent as “hot air” credits sourced from the Ukraine and Russia.  For credits to confer ‘greenhouse gas neutrality’ the purchased credits have to represent greenhouse gasses extracted from the atmosphere (see an explanation). Grandfathered or auctioned credits represent no environmental gain, do not confer greenhouse neutrality on purchasers, and promote speculative behaviour among carbon traders.  They could rightly be called “thin air” credits because they are created out of thin air.

“If we choose to continue with the ETS then the following policy changes are required in order to reduce risk and stabilise the price of NZUs:

  1. Manage our domestic credit currency
    – Set reduction targets each year that stabilise the NZU price at a level that encourages us to meet international commitments. Emission reduction targets could be set by a small policy group that is protected from interference by government or lobbyists, and charged with keeping the NZU price at a level that would enable New Zealand to meet its international climate change commitments.
    – Plan to gradually reduce our NZU price as the world solves the climate change problem, thereby also reducing long-term liabilities for owners of forests. If this policy was well known then foresters would be more inclined to participate in the ETS.
    Stop giving away “thin air” credits, and require surrenders only for “over target” greenhouse gas emissions. “Thin air” credits have no credibility, and simply add to the NZU currency pool without creating any value. Requiring surrenders only for “over target” emissions would mean less long-term liability for ETS participants and also no inflationary infusions of “thin air” credits into the market.
  2. Apply the ETS equally to all sectors. Not only would this be more equitable and minimise market distortion, it would lessen the load for current participants.
  3. Allow trading only between sequesterers and emitters, so that if you over-pollute you pay someone else to clean up. Speculative investment in NZUs encourages gaming and price fluctuation. and contributes nothing to mitigating climate change. Restrictions on trading would limit speculative behaviour.
  4. Buy back gifted NZUs that were replaced by hot air credits before surrender so that our ETS can begin to work without undue delay. We cannot afford to wait several years for the ETS to work effectively. Buying back the gifted mountain of NZUs stored in our registry would mean that NZU owners would not be out of pocket but the ETS could begin to operate more swiftly.”

The SMC also prepared a Q&A with Dr Ivan Diaz-Rainey, Associate Professor of Finance at the University of Otago, on the ETS.

What do you think the weaknesses are with the Emissions Trading Scheme as it currently stands? What are its strengths?

“No intervention is perfect, the NZ ETS is no exception. It has come in for some stringent criticism from commentators and no doubt the forthcoming review will lead to renewed criticism. But NZ ETS is just a tool and is as strong as its designers allow it to be. The idea that a tax will be some form of magic bullet is naïve – all one has to do is look at tax law to realise that a tax, though maybe simpler, is no easy solution either and would not have the flexibility of an ETS solution.

“We should not forget that a tax was discussed for nearly a decade before we got NZ ETS. The fact that we have an ETS and that it is sending a price signal, albeit a relatively weak one, is positive. The elephant in the room is the asymmetry created by the absence of agriculture in the scheme. I am not sure if NZ ETS is the right vehicle for agriculture but there needs to be policies in place to make sure the whole economy is contributing to the effort to mitigate climate change.”

What key changes do you think would improve the ETS? Is this possible through review, or should we be looking for a new system?

“There are a range of issues under consideration in the review which are all important and have the potential to strengthen NZ ETS not least (1) Demand/supply of units and price management (2) governance – to what degree should there be regulation of carbon markets and those that give advice to, for example, foresters (3) international linking (4) forestry – currently there are issues with mixed incentives, for instance on wild pining.

“With respect to price management, more auctioning will send a stronger price signal and will ensure the government carries less potential financial risk from the Paris agreement – given that the Paris agreement provides hard targets and NZ ETS is an intensity system, there are real financial risks for the government if we do not mitigate enough (they would presumably have to make up any shortfall by buying carbon units from abroad). Also, say a tax policy is used in agriculture, then some form of price management might be needed to ensure NZ ETS does not deviate too far from that tax. This might be done through a Carbon Central bank type organisation. A bit like a central bank does with inflation, the Carbon Central Bank could target a price and intervene around bands in that price. An alternative to all this would be to have a hard cap and coverage to include agriculture, as originally envisioned.

“A related issue is how integrated NZ ETS becomes after 2020 given the painful experience of allowing 100% importation prior to withdrawal from CP2. A clear lesson from that is that some form of importation limitation needs to be imposed if the scheme is going to incentivise domestic mitigation. No national scheme outside NZ ETS has allowed importation of more than 20%. To allow large levels of importation would strike a serious blow to the credibility of the scheme and would influence which established ETS’s internationally (e.g EU ETS) might be willing to link with it. The reality is that meeting the Paris agreement will involve getting carbon leaner domestically, potentially a painful transition but we should not fear it, we should embrace it and see it as part of having a more modern and efficient economy.”

What role do you think the ETS plays, or could play, in New Zealand meeting its obligations under the Paris Agreement?

“It will be central but other policies to support it are needed e.g. something specific for agriculture as mentioned above and perhaps incentives to green transport.”

What do you think needs to happen for New Zealand to meet its Paris obligations?

“Climate policy needs to be de-politicised as much as possible. Again, the example of central bank independence provides a good model. The NZ ETS legislative architecture should be flexible enough to accommodate different regimes in the Beehive. For instance, flexible enough to allow for a Green majority government to alter the levers of NZ ETS so that it has a broadly equivalent effect to a tax i.e. 100% allowance auctioning and price management around a fairly tight band. So the tool is flexible enough to accommodate different political imperatives but the tool in itself is not in question. New Zealand led the way in terms of central bank independence internationally, perhaps it can do so in term of carbon market architecture also.”