Bindingness and the ETS

The Commission's final report came out today. It has a series of recommendations that cannot do much to affect net emissions when they run up against the binding cap on net emissions in the Emissions Trading Scheme.

So the Commission decides to claim that the cap is really non-binding. 

Concern was raised by several submitters that the NZ ETS has a 'neutralising effect' on emissions reductions achieved by other policies. They cited that in an ETS with a fixed emissions cap (limit on total emissions), every tonne not emitted by one party will be available for someone else to emit.

The NZ ETS, however, does not have a fixed cap. This is partly the legacy of how the NZ ETS was run in the past, which has led to over 130 million units banked in participant accounts. This represents significant oversupply beyond what is likely needed for annual demand and hedging purposes.

The lack of a fixed cap is partly by design - recent reforms have implemented price measures to either withhold or release units, to put a brake on the emissions price from going above or below certain levels. These reforms reflect the political context in which the NZ ETS operates, where policy makers are concerned not just about efficiency but also about where costs fall. 

This is not unusual. Every functioning ETS in the world today contains market stability mechanisms that alter the number of units available depending on the market price or other factors. This means that ETSs are hybrid instruments, with safety valves to manage price or adjust the cap in response to economic changes - given the inherent uncertainty in setting a cap based on forecast emissions.

The recent NZ ETS reforms also implemented a flexible, five-year rolling cap. Emissions reductions that are expected to be achieved through other policies can be factored in when the cap is set. 

The cap can be adjusted over time to reflect actual emissions reductions achieved through other measures, or reductions to emissions not covered by the NZ ETS. This is important in Aotearoa, as significant emissions are not covered by the NZ ETS, such as agricultural emissions and emissions and removals by some forests.

The combination of oversupply, price measures and a flexible cap in the NZ ETS mean that it will not necessarily guarantee a specific emissions outcome. It also means that the NZ ETS can be managed in conjunction with other policies so that emissions reductions or removals from other policies are not a wasted effort (see Chapter 19: The direction of policy for Aotearoa of the 2021 Supporting Evidence for more information). 

The Commission is wrong about the implications of legacy units, and wrong about how the ability to re-jig future limits makes it desirable to pursue complementary policies.

Let's take them in order.

The Commission is right that people stockpiled carbon units when the price was cheap against a time when prices were expected to be higher. And the Commission is right that more units would be released if ETS prices hit the cap. 

But the setting of the cap is sensitive to those. Here's how the Ministry for the Environment explains it. The website is dated April 2021, so I doubt it's changed since. 

Calculating NZUs available at NZ ETS auctions

The overall limits are reached by following a series of steps to determine the total number of NZUs that will be available for sale at NZ ETS auctions.

We start with the total volume of the emissions budget, then:

1. Forecast emissions from outside of the scheme are removed to calculate the NZ ETS overall limt.
2. Any required technical or forestry-related adjustments are made.
3. An agreed volume of units is removed to drive stockpile reduction.
4. The number of units projected to be freely allocated, or provided through negotiated greenhouse gas agreements are removed.
5. A limit is set on international units
6. The remaining volume is available to auction.

Point 3 says how they deal with the accumulated stockpile. They reduce the number of units created for sale into the system by the government so that more units are sold from those stockpiles. The expected sales from the stockpile are in the cap. If, in any given year, the number of sales from stockpile are higher than expected, they must consequently and necessarily be lower than otherwise expected in some other year. And future iterations of the cap would then come with revised expectations about flow from that stockpile. It does not plausibly affect Net Zero 2050 unless those with the units expect to do best by holding those units until 2050 and selling lots of them at that point. 

And if government is worried about that threat, they could presumably legislate a use-by time fuse on the stockpiled units such that they would no longer be accepted for meeting surrender obligations after 2040. 

The right comparison for the stockpiled unit volume isn't annual emissions, but total net emissions over the path to 2050. That path has to include release of fewer units by the Crown, offsetting the emissions that come from the stockpile. That's it. The cap continues to bind. Figure 1 from MfE makes it really abundantly clear. Look at the picture. It's split into two halves. One half is the uncovered sector, that still needs to face emission prices - agriculture. The other half is covered by the cap. On which side of the line is the grey pie slice titled, helpfully, "stockpile reduction volume"?

Again, this is MfE's explainer on how the cap is set, dated April 2021. Free industrial allocations? They're in the cap. Stockpile reductions? They're in the cap too. Neither of them makes the cap non-binding. Because they're part of the cap. 

Next, the price cap. Yes, the ETS has a price cap. But that does not affect the bindingness of the ETS's cap on net emissions. Rather, it introduces fiscal risk for the Crown. 

Why? 

Look at how the thing works, again as detailed by MfE, again from a page dated April 2021. 

The cost containment reserve

The cost containment reserve is a reserve of NZUs which are available for sale only if a trigger price is reached in the auction. Making these extra NZUs available at auction eases demand for emissions units.

The effectiveness of the cost containment reserve in dampening the overall NZU auction price is dependent on the volume of units available and the demand for them.

Cost containment reserve units need to be backed by the Government

If any NZUs are sold from the cost containment reserve, causing the emissions budget to be exceeded, then the NZUs need to be backed by the Government. This means the Government would need to procure equivalent emissions reductions, for example by purchasing international units or funding activities that reduce emissions domestically.

So if we hit the price cap and the government releases one more NZU, the government must simultaneously find a way of avoiding a tonne of emissions. Allowing one more unit while reducing one more unit means net zero relative to the existing cap. 

It does not affect the bindingness of the cap. It cannot, unless you think that the government will renege on its obligation to back units. 

If buying credits in Europe is the most tractable way of backing an NZU, and European prices are higher than the NZ ETS price, then the Crown has potentially substantial liability. That liability increases the political risk that a future government might renege. 

But there's a simple solution. 

Update the cap so that instead of tracking $50 plus 2% per year, it just anchors in the European price. Whatever the European price happens to be at time of auction is the price cap at that auction. If the price cap gets hit, the government could just use the money it gets by selling those extra units to buy European ones and shred them to back the NZU released. Simple. Effective. Obvious. 

Finally, what about the Commission's view that the effects of complementary measures can be considered when setting the subsequent years' caps? 

It's true, but misses the point. 

The government can reduce the cap more quickly, with or without implementing complementary measures. 

If the government is *very* lucky, its regulatory solution is one that wouldn't have been found by ETS participants - perhaps there was an underlying real market failure that was getting in the way. In that case, the regulatory measure could be easily justified on a standard CBA laying out the intervention logic and the costs and benefits. 

If the government is *only* lucky, its regulatory measures will replicate the least-cost solutions that would have been found by simply reducing the cap without taking those regulatory measures.

But if the government is *not* lucky, it will find interventions that cost more than the going ETS price. It could have done better by reducing the cap more quickly - without also implementing measures like EV subsidies or petrol vehicle bans. 

So the problem isn't then that the the government can't offset things by lowering the cap more quickly, it's that the measures taken have a high hurdle to pass if we want to know that we're doing the most good possible. Because if it costs the country a billion dollars to reduce emissions through some regulatory measure costing twice the current ETS price, the government could instead have cut the cap by (roughly) twice as much for no greater cost to the country as a whole. Don't we want to be able to cut the cap faster rather than slower?

The way that caps are set isn't secret. The Climate Commission has to have known that stockpiled units don't make the cap nonbinding except in the most meaningless of ways - in any particular year, you'll get overs and unders around the path to net zero. It simply doesn't matter. And it also doesn't make complementary policies more desirable.