NZ ETS unit limits and price control settings for 2023–2027

Overview

As the Government rolls out its plans for meeting the country’s emissions reduction goals, Aotearoa New Zealand’s Emissions Trading Scheme (NZ ETS) is in a period of change.

The Government has now committed to its first three emissions reduction budgets, broadly in line with the Commission’s advice, and published its first emissions reduction plan. The plan recognises the need to reduce gross emissions to reach net zero long-lived gas emissions sustainably. It also outlines a range of policies, in addition to the ETS, to help drive down emissions.

With these important steps, confidence in the Government’s commitment to climate action has grown and the price of New Zealand Units (NZUs) has increased significantly. As of the time of writing, the price of an NZU was $76, up from $30 in June 2020.

Our advice on unit limits and price control settings has been developed in line with the intent of the Government’s emissions budgets and emissions reduction plan, and taking into account this shift in the market. It has also been informed by our engagement with a range of market participants, intermediaries, and members of bodies with an interest in the NZ ETS, which has enabled us to test ideas and enhance our understanding of the market.

However, we are providing this advice at a point where the Government has not yet clarified some of its goals for the NZ ETS.

First, it remains unclear how the Government will ensure the NZ ETS is fit to help deliver the outcome of prioritising gross emissions reductions. Without policy change, we expect NZ ETS emissions prices to drive large-scale afforestation, displacing and delaying reductions in gross emissions.

Second, the Government has not yet clarified the role that it expects the NZ ETS to play in meeting its contribution to reducing global emissions under the Paris Agreement, its Nationally Determined Contribution (NDC). The absence of this information creates significant uncertainty for market participants and has been a constraint on our advice. Once this information is available, our advice in future could materially change.

The Government should engage and consult with Iwi/Māori to ensure any decisions made on these issues uphold the principles of the Te Tiriti/The Treaty and avoid compounding historic grievances or unintentionally disadvantaging Iwi/Māori.

We have based our advice on existing data, projections and modelling, and presented our advice to the nearest 0.1 million units. However, this should not be taken as an indication of certainty about the future. Markets are inherently uncertain, and we will update our advice annually as better information becomes available.

Unit limits

The Commission is required to advise the Government on three categories of unit limits for the NZ ETS: a limit on units available by auction; a limit on approved overseas units used; and an overall limit on units. The purpose of these limits is to cap the emissions allowed by the scheme in accordance with Aotearoa New Zealand’s emissions reduction targets – the emissions budgets, the 2050 target and the NDC.

The Commission has followed a seven-step process to develop the unit limits.

Key judgements in setting unit limits

Emissions budgets, the NDC and the 2050 target

We conclude that until approved overseas units are available, the unit limits should be set in line with the Government’s emissions budgets as the stepping stones to the 2050 target and the intended domestic contribution to the NDC. This approach recognises that while approved overseas units remain unavailable, the offshore mitigation required to meet the NDC cannot be delivered by the NZ ETS.

Allocating the emissions budget

We refer to this step as allocating the emissions budget, as it involves determining the share of emissions budget volume that can be used up by emissions that are outside the NZ ETS and what share is therefore available for NZ ETS sectors.

We have concluded that the emissions budget volume should be allocated to NZ ETS and non-NZ ETS sectors based on the emissions reductions implied by the sector sub-targets in the Government’s first emissions reduction plan.

This means that if sectors outside the NZ ETS reduce emissions more than expected, NZ ETS sectors would not be allowed to emit more, and vice-versa. A key reason for this approach is that we now have a specific target for biogenic methane, and 90% of biogenic methane emissions are outside the NZ ETS. Reductions in biogenic methane and reductions in other gases are not substitutable for each other.

Addressing the surplus of banked units

About 144 million NZUs are banked in private accounts [as of 1 June 2022]. Our best estimate of surplus units (the volume of units that present a significant risk to meeting emissions budgets) is 49 million. We propose that auction volumes be reduced consistent with reducing this surplus towards zero by 2030.

There is significant uncertainty in our estimate of the total unit surplus. We intend to take an adaptive management approach, monitoring it over time and potentially adjusting our future advice on unit limits if necessary.

Setting a limit on approved overseas units

The Government will need to secure access to offshore mitigation to achieve the NDC. As there are currently no approved overseas units in the NZ ETS, and no clarity as to when they will be available, we recommend that the limit on approved overseas units should be set to zero.

Proposed auction volumes

Our application of this seven-step process results in the following proposed annual auction volumes:

Price control settings

The price controls in the NZ ETS are the cost containment reserve and the auction reserve price. The purpose of these price controls is to manage the risk of the NZU price at auction being out of line with what is necessary to meet emissions budgets, and to signal the bounds of expected prices in the NZ ETS.

Cost containment reserve

The cost containment reserve is a reserve of NZUs available for sale if the auction clearing price is at or above a specified trigger price.

While the cost containment reserve is intended to be used only rarely, it has been triggered three times in the last six auctions. This implies a major shift in market expectations about future prices over the past year, meaning the cost containment reserve trigger price is now below participants’ future price expectations.

We have concluded that the trigger prices, as well as the structure of the cost containment reserve, should be amended for all five years of 2023 – 2027. Based on the triggering of the cost containment reserve, new analysis of how uncertainties may affect the emissions prices needed to meet emissions budgets, as well as the level and trajectory of international emissions prices, we recommend that the trigger prices increase substantially.

We propose that the cost containment reserve should have two tiers. Two tiers of trigger prices and reserve volumes will help manage the risk of strongly increasing prices if the surplus units remain illiquid, while limiting the fiscal impacts and target risks relative to triggering a single tier cost containment reserve.

Auction reserve price

The auction reserve price is the price below which the Government will not sell units at auction.

Prices have traded well above the auction reserve price since its introduction and current settings are not known to have caused any issues to the functioning of the NZ ETS. However, it is likely the price is currently set too low to adequately address risks around potential market oversupply. We recommend the price be increased to align with the minimum NZU price path compatible with achieving emissions budgets.

Recommendations

Our recommendations for the unit limits and price control settings are:

These figures are rounded to one decimal place and columns may not sum due to rounding.

Impacts of emissions pricing

We have worked with Treasury to update modelling assessing the impacts of higher emission prices on households and the economy. This found that while the magnitude of the impacts appears moderate, they are not insignificant and will result in disproportionate impacts on lower income households and those least able to adjust.

A just transition requires that these domestic distributional impacts and other equity considerations in the transition be managed. The NZ ETS price control settings are not the appropriate tool for doing so, however. These distributional impacts can be best managed if the Government puts in place targeted policies alongside the NZ ETS to support those most disadvantaged and those least able to adjust. 

Whānau Māori, in particular, will be disproportionately affected by higher emissions prices. We reiterate our recommendations from our first advice Ināia Tonu Nei, that the Government should:

• Support a Māori-led approach to understanding and addressing the impacts of the NZ ETS and other climate policies on the Māori economy and Iwi/Māori.

• Work in partnership with Iwi/Māori to advance a Māori-led approach to an equitable transition for Iwi/Māori and the Māori economy.

It is critical that the Government puts in place a suite of complementary policies to deliver on the commitment of a fair, inclusive and equitable transition, and to strengthen the capability of the country to adjust over time, while ensuring strong incentives to transition towards a low emissions economy.