For a better price cap

New Zealand's ETS has a price cap. It needs a better one.

When the carbon price hits $50, the government releases more units into the system. Some of those units are ones that are already within the cap. The government reduces the number of units auctioned each year within the cap to account for stockpiled older units it expects to be redeemed that year. If those stockpiled units fail to be redeemed and are instead held, there will be price pressure. So the government then auctions more units. And again - this is still within the cap. If the stockpile isn't run down this year, there will be more stockpile left next year, and we'd then expect fewer units auctioned by the Crown to account for that. 

After that runs out, the government can release more units - units that are over the cap. These over-cap units don't actually break the cap as they are backed: each unit released must be backed by an equivalent emission reduction elsewhere. 

But that does introduce risk to the Crown - it has to come up with ways of backing those units. 

The government has signaled that it won't change the price cap this year. If we hit the cap, nobody quite knows what the government would do to back units. 

Last year, we suggested tying the NZ price cap explicitly to prices in the European market so that, at worst, hitting the cap could mean buying credits there to back units released here. A better approach could instead have the government ask the Climate Commission to assess which ETS are robust, then take a weighted average of prices across those systems as constituting the NZ price cap. The price cap would move around but that's okay. If people needed to, they could hedge against European prices on European markets; a weighted average based on volumes will mostly follow Europe anyway. But the government could then just buy credits in whichever market is currently cheapest to back units at the cap. That would mean it would make gains rather than losses when hitting the cap. Right now, they'd lose a lot if they had to go to Europe to buy credits to back units - prices there are about double what they are here.

My column this week went through the case:

The Government could use that surplus to reduce global emissions even more quickly by buying more units. Or it could rebate more money back to households to offset the equity effects of higher ETS prices.

But perhaps more importantly, an explicit link to international prices, combined with securing permission to purchase credits elsewhere, brings credibility to the price cap. The price cap is not credible if the Government is promising to lose a lot of money by using it. A non-credible price cap encourages buying credits at $50 in the expectation that the Government will increase the cap rather than continue losing money.

The Government needs to update the price cap before the next ETS auction. Rather than choose some new price level, like $70 or $100, it should set the cap to follow international carbon prices. It would make for a better, and more durable, path to net zero.

Minister Shaw has since ruled out updating the cap this year. It's defensible: there are also credibility risks in changing the settings hastily. And prices here have risen more quickly than anyone expected. 

But it's still worth building that better cap, and updating to it when possible.