In the ever-evolving legal landscape of New Zealand, where the environment meets economics, the New Zealand Emissions Trading Scheme (NZETS) takes centre stage.
The NZETS is a government strategy aimed at combatting climate change and curbing greenhouse gas emissions. It is a clever market-based approach that puts a price tag on carbon emissions and is intended to incentivise businesses to cut down on polluting activities.
Under the NZETS, the government sets a cap on the total amount of greenhouse gas emissions that can be released by covered sectors (such as energy, industry and forestry). This cap decreases over time, aligning with the country's emission reduction targets and global obligations, such as under the Paris Agreement. Under the Paris Agreement, New Zealand has committed to reducing its greenhouse gas emissions by 30% below 2005 levels by 2030.
While the concept may be simple, the NZETS can be complex and is necessarily an ongoing work in progress. Arguably, in its current form the NZETS is not incentivising emission reductions at the source because it is more cost effective for emitters to simply buy units (to offset) rather than invest in ways to reduce their emissions. Consequently, the government is reviewing the NZETS to make sure it is fit for the job ahead (as explained in our previous article 'Review of the New Zealand Emissions Trading Scheme released').
The outcome of the review is not due to be released for several months and ultimately it will fall to the incoming government to action as it sees fit. Practically, any changes to the NZETS that arise as a result of the review will be subject to further public consultation on the detailed design of any proposals. However, the government has announced that certain changes to NZETS auction controls will take effect in December this year (independently of the outcome of review).
With this background, it is a good time to revisit how NZETS auctions work, take stock of the outcome of the NZETS auctions held this year and discuss the upcoming changes to NZETS auction controls.
The basics of NZETS auctions
The NZETS introduced a special type of currency called a 'New Zealand Unit' (NZU). Each NZU stands for one metric tonne of carbon dioxide or an equal amount of other greenhouse gases.
Participants in the NZETS are subject to specific obligations based on the activities that they carry out. Businesses that carry out captured activities and emit carbon dioxide have legal obligations to surrender NZUs to cover their emissions. To comply, they need to acquire NZUs which are subsequently returned to the government. Emitters can obtain NZUs by purchasing them at government auctions, on the secondary market or by generating their own production of NZUs (for example, by planting forestry).
The government conducts four NZETS auctions per year. The price of NZUs is not fixed - rather, it is dependent on supply and demand (subject to certain regulatory limits and price controls, intended to maintain market stability and prevent excessive price fluctuations).
The government sets these limits and controls five years in advance, but revisits them every year to ensure they align with New Zealand's emissions goals, the Paris Agreement, and the ultimate aim of achieving net-zero emissions by 2050.
Regulatory limits and price controls
Each auction has:
- A unit limit: This is the maximum number of NZUs available for purchase in that auction
- An auction price floor: This is the minimum price for which an NZU can be sold.
All participants in the auction pay the same price for NZUs, called the auction clearing price. The auction clearing price is calculated as follows:
- During the designated bidding timeframe, bids are gathered and arranged in descending order based on offered prices
- Where the demand for NZUs is less than the available supply, the lowest bid price is the auction clearing price
- Where the demand for NZUs meets or exceeds the available supply, the auction clearing price is set at the point at which the demand has met the supply.
However, there are exceptions to the above pricing calculations as follows:
- There is a cost containment reserve price set for each auction which is the price that triggers the release of an additional pool of NZUs to be offered for sale in that auction. Where demand for NZUs exceeds the available supply and the cost containment reserve price is also met, then the clearing price is the price of the last bid above the cost containment reserve price.
- There is also a bespoke reserve price set for each auction which is confidential to the government. If, after the auction closes, the interim auction clearing price is less than the confidential reserve price, the auction is declined and no NZUs are sold. All unsold NZUs are rolled over to the next auction (in the same year only). The purpose of the confidential reserve price is to hinder the sale of NZUs at levels considerably lower than the prevailing prices in the secondary market.
What has happened this year?
Before 2023, there was strong demand for NZUs with the price reaching $88.50 per NZU. However, this year, the carbon market has been extremely unpredictable, with carbon prices fluctuating significantly, dropping to as low as $34 per NZU at one stage.
In 2023, three auctions have already occurred (the most recent in early September), all of which were declined or 'failed' as a result of the confidential reserve price not being met such that no NZUs were sold.
Several factors have contributed to the NZETS market's volatility and the recent failed NZETS auctions, such as:
- The current oversupply of NZUs in the market (ie many emitters have already acquired enough NZUs to cover their emissions)
- The government's announcement that it will review the NZETS which has led to significant market uncertainty with traders hesitant to participate until such time as there is clarity about the future of the NZETS
- The government's rejection in late 2022 of the Climate Change Commission's recommendation that the number of NZUs made available at auction be limited and that the auction price floor be significantly increased. The rationale for the government's decision was that an increase in the price of NZUs would lead to an unacceptable negative flow-down effect to the consumer in the context of the current cost of living crisis. Although the government recently revisited and reversed its earlier decision to ignore the Climate Change Commission's recommendations, it has weakened the NZETS market and left investors feeling uneasy.
While the NZUs from this year's three failed auctions (which total almost 14 million) will be carried over to the final 2023 auction (in December), each previous auction failure makes another more likely. If there are four consecutive failed auctions, the unsold NZUs are cancelled and the auctions will start afresh next year.
Four consecutive failed auctions may result in a short-term win for the fight against climate change as it will reduce the NZU supply and should (logically) eventually push NZU prices up. At the very least, it will chip away at the surplus of NZUs in circulation. However, arguably it is more beneficial in the long run to have a strong and effective NZETS rather than depending on failed auctions to encourage emission reduction behaviours.
In addition, the three failed auctions have resulted in a significant amount of lost revenue for the government. That means less money is available to be contributed towards the Climate Emergency Response Fund which is applied towards addressing the long-term nature of the challenges presented by climate change.
What changes are being made in December?
Whilst there is still some time to go before the outcome of the government's review of the NZETS is announced, and bearing in mind the potential for additional changes that conceivably could result from a change in government following the October election, the incumbent government has already implemented certain modifications to the NZETS auction controls that will come into effect in December this year as follows:
- The NZU limits are reducing - ie there will be less NZUs available for purchase in each auction (intended to drive the use of the current stockpile of NZUs)
- The auction price floor and cost containment reserve price are significantly increasing (intended to mitigate further oversupply)
- The cost containment reserve is being split into two tiers which will establish two different cost containment reserve prices and volumes (intended to prevent market participants trying to hit the cost containment reserve price and instead allow the market to operate in a more sophisticated manner).
Overall, these latest changes have signalled the government's commitment to aligning its decision-making more closely with the Climate Change Commission's recommendations, even in challenging circumstances.
Want to know more?
Businesses interacting with the NZETS should pay careful attention to upcoming changes.