Report recommends changes to New Zealand Emissions Trading Scheme

Summary
Extension of transitional measures
Excluding CERs with questionable environmental integrity
Future of international trading
Comment

Summary

"Doing New Zealand's Fair Share" is the title and focus of the New Zealand Emissions Trading Scheme Review Panel's final report, which was released in September 2011. This update considers the highlights of the report and attempts to predict what the recommendations might mean for participants in the New Zealand Emissions Trading Scheme and other parties that acquire and dispose of units.

The panel has endorsed the New Zealand Emissions Trading Scheme as a key part of New Zealand's contribution to combating climate change, and has responded to concerns by submitters that New Zealand should not move too far ahead of international competitors in its measures. However, the report provides evidence that New Zealand is neither ahead of nor behind its competitors, but is "keeping up and doing its fair share".

The panel has outlined 61 recommendations. The recommendations that are likely to have the greatest impact on acquirers and disposers of units include:

• an extension of the transitional measures (including the continuation of a price cap, allocations to emissions-intensive, trade-exposed industries and the 'one-for-two' obligations);
• the exclusion of certified emission reductions (CERs) with questionable environmental integrity;
• a continued focus on the importance of international linking;
• a number of practical changes for forestry - the panel states that a "hard-headed assessment" of possible unilateral change may be required, while cautioning that it may be undesirable to diverge from international rules; and
• the entry of the agriculture sector into the scheme 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. However, statements from Climate Change Minister Nick Smith suggest that the government is keeping its options open on agriculture, at least for now.

Many of these recommendations are likely to find favour if the present government is returned with an appropriate majority in the November 2011 general election. Participants and traders will need to consider how the recommended changes would affect their strategic planning for trading in units, particularly in relation to:

• the number of units that will be required for surrender in the scheme;
• the types of unit that will be acceptable and available for trading; and
• the convertibility of New Zealand units (NZUs) for export.

Extension of transitional measures

Scheme participants and traders may need to consider reworking their trading strategies to anticipate the possibility that the number of units required for surrender under the scheme will be lower than expected for the period from 2013 to the end of 2015. The panel recommends that the existing transitional measures, which were originally due to expire at the end of 2012, be phased out more slowly "to strike the right balance between managing short-term competitiveness concerns and providing long-term certainty". The recommendations include:

• increasing the price cap from NZ$25 to NZ$30 (and then progressively increasing it by NZ$5 a year) for new and existing sectors, while strongly cautioning participants against using 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 including an allocation cap on the free allocation of NZUs in the next scheme review. This recommendation is partly in response to concerns that activities such as the production of lignite have the potential to produce emissions that are significantly beyond the level of New Zealand's emission targets, but may nonetheless be eligible for allocations of units. The lack of a cap might also make it more difficult to link to other schemes, including Australia's scheme, because of uncertainty about the number of units that could be generated in the New Zealand scheme.

One of the panel's chief recommendations is to extend the measure of one unit surrendered for two tonnes of carbon dioxide emitted so that it scales up to a full surrender obligation from 2013 to 2015 (rather than terminating at the end of 2012), with similar transition measures being extended to additional sectors as they enter the scheme. This plan is set out in the table below.

Excluding CERs with questionable environmental integrity

In order to enhance the scheme's environmental integrity, the panel suggests that urgent consideration be given to the eligibility of some CERs, particularly if they have dubious environmental benefits - for example, CERs arising from hydro-fluorocarbon (HFC) gas abatement.

The government has since released a discussion document that proposes to exclude CERs generated from HFC-23 and nitrous oxide gas destruction projects - these reportedly account for around two-thirds of all CERs issued to date. A timely exclusion of these CERs would mitigate the risk that a global oversupply of these units could affect the price in the New Zealand scheme. The international trend is to exclude these CERs - the European Union recently banned them with effect from 2013 and the Australian scheme will also exclude them.

It is proposed that participants would be prevented from surrendering affected CERs that are 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 Emission Unit Register at a later date under existing forward contracts. Participants and traders should consider immediately reviewing their carbon trading strategies to take these likely changes into account.

The discussion document invites submissions on the proposal by 31 October 2011 and sets out 11 specific consultation questions. Participants and traders may wish to consider making submissions, in particular on:

• forward contracts and the need for, or desirability of, exemptions;
• the timing of any exclusion (from January 1 2012 or January 1 2013);
• the issue of whether the participant or the government is responsible for checking the provenance of CERs, as well as practical concerns relating to identifying provenance and date of entry in the Emission Unit Register; and
• the question of whether an exemption should be available for affected forward contracts that mature after the date of exclusion.

These CER exclusions may create opportunities for sellers of NZUs, particularly if all NZUs (not only forestry NZUs) become convertible to assigned amount units, as the panel has proposed.

Future of international trading

Scheme participants will be aware of the need to take account of the uncertainty about the future of international units in the short term when making trading decisions. The panel has officially recognised what most stakeholders have long suspected: a successor to the Kyoto Protocol is unlikely to be in place by the end of 2012.

In the panel's view, this will be only a short-term gap. The panel fully expects New Zealand to face obligations under a binding international carbon agreement in the medium to long term, and recognises that these obligations may represent a step up from the present emission reduction obligations under the Kyoto Protocol. The scheme will remain an important part of New Zealand's contribution to the international response to climate change, even if no specific international agreement follows Kyoto immediately.

The panel recommends that the government continue to engage in the development of international carbon markets generally, particularly noting that alignment with the future Australian scheme could be desirable, but with the caveat that the New Zealand scheme should not be bound to the features of any particular scheme.

With no replacement in sight for the Kyoto Protocol in the short term, care must be taken in purchasing Kyoto units (including CERs, assigned amount units, removal units and emission reduction units) for settlement beyond 2012, as their value cannot be determined. Purchasers of forestry NZUs should also be cautious if they are intending to convert these to AAUs for export beyond 2012, as it is unclear whether AAUs will be available for this purpose. Removal units also cannot be carried over into any subsequent commitment period.

The panel recommends various practical changes to the scheme that diverge from the existing international rules, particularly in the treatment of forestry (eg, allowing forest offset planting and 'emissions to atmosphere' accounting for carbon). Although the panel recommends a "hard-headed assessment" of the recommended changes to domestic rules, with a view to improving the rules for New Zealand forestry, it is aware 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 panel considers that the ban on the export of non-forestry NZUs should be lifted as soon as the price cap is removed (or as soon as the price cap becomes redundant because it far exceeds the market price). This would enhance exposure to the international carbon market which, in turn, would be beneficial to New Zealand, making the scheme more efficient than a closed scheme. Although those receiving allocations of NZUs will undoubtedly be pleased at the prospect of unlimited access to international carbon markets, this is still predicated on an international agreement that remains largely up in the air.

Comment

The NZ scheme has always suffered from uncertainty due to the political issues that surround climate change. The panel's report provides useful guidance on the direction of the scheme. Perhaps the strongest message is that the scheme is here to stay. The scheme will be fine-tuned, but the exact changes will depend on the post-election composition of Parliament.

Participants will be carefully scrutinising the details of the recommendations and will monitor the next steps. Pending more certainty on how the scheme may look in future, a cautious approach will be appropriate for decisions beyond 2012.

For further information on this topic please contact Elisabeth Welson or Joanna Lim at Simpson Grierson by telephone (+64 4 499 4599), fax (+64 4 472 6986) or email ([email protected] or [email protected]).

Endnotes

(1) Such as liquid fossil fuels (potentially excluding transport uses), fugitive emission of methane, and waste fuels for determining eligibility for free allocation of NZUs for emissions-intensive, trade-exposed industries.