NZ ETS unit limits and price control settings for 2025–2029

Overview

This report is our annual advice to Government on the settings of the New Zealand Emissions Trading Scheme (NZ ETS). It focuses on two areas: adjustments to limits on the number of units in the scheme, and to the auction price control settings. Our advice is based on analysis of the system, its operating environment and its impacts; this also raises urgent policy questions.

The NZ ETS is a key policy tool for reducing the country’s greenhouse gas emissions. He Pou a Rangi Climate Change Commission has an annual task to check the scheme’s settings and advise any adjustments needed to keep the NZ ETS on track to support Aotearoa New Zealand’s targets for emissions reduction. Our assessment also considers the impact of emissions pricing.

This year we recommend a significant reduction of auction volumes and flag pressing concerns affecting the ongoing effectiveness of the NZ ETS. These are presented in the context of intensifying climate change impacts at home and across the world, reflecting our consistent identification that urgent Government action is required to broaden, strengthen and accelerate efforts to meet Aotearoa New Zealand’s climate change objectives.

This executive summary is an overview of the key elements of our 2024 advice on the scheme’s settings. It recognises the keen interest across Aotearoa New Zealand in understanding how the Government’s climate change response tools are working, and what improvements might be needed to support the country to make the transition to a thriving, low emissions economy.

Introduction

Why the NZ ETS matters for the transition to a low emissions economy

The NZ ETS is a key tool in the Government’s strategy to reduce greenhouse gas emissions and transition to a thriving, low emissions economy. The scheme operates alongside other government climate policy.

The NZ ETS is a market mechanism created by government to encourage choices that move away from activities that create greenhouse gas emissions, such as burning fossil fuels. It creates an ‘emissions price’ by limiting the volume of greenhouse gases allowed; in the NZ ETS this covers all sectors except agriculture. This ‘cap’ on emissions reduces over time, in line with emissions reduction targets.

The targets the scheme is designed to match up with are the Government’s five-year emissions budgets (which are the stepping-stones to the 2050 target), and Aotearoa New Zealand’s current Nationally Determined Contribution (NDC) – the country’s international commitment to reduce emissions.

However, the history and design of the NZ ETS, as well as uncertain Government climate policy, create challenges for aligning the scheme to those targets. It is now well into the 2021–2030 NDC period, but the plan for meeting the NDC and the role of the NZ ETS in that are still unclear.

The past 18 months have been eventful for the NZ ETS. The emissions price has moved sharply up and down in response to policy announcements and the four declined auctions held in 2023, where bids at the auctions did not meet minimum requirements so no units were sold. i

The 2023 auction outcomes are not a failure but rather the result of the system operating as designed. They are, however, a demonstration of low market confidence and also reflect the large amount of units already in the market.

Over recent years, the cash proceeds from NZ ETS auctions have been a source of income to Government. The reliability of this income is uncertain. Selling units by auction is unlikely to generate steady funds in coming years, because the number of units auctioned is already set to decline in line with targets, and because the auction unit levels is the only setting that Government can adjust to keep permitted emissions in line with the country’s targets.

Our approach

In line with our role to provide independent, evidence-based advice to the Government we have analysed the latest data, considered the issues the Act requires us to address, and drawn on insights and evidence from engagement with iwi/Māori and stakeholders.

Our check of the NZ ETS settings uses a system approach, recognising that each setting interacts with other aspects of the scheme to affect the market.

This means our recommendations need to be read as a package. They include information about how the different parts of the scheme link up, to help the Government avoid unintended consequences as it makes decisions.

Our approach recognises that future reductions in greenhouse gases may not happen exactly as predicted. We treat the emissions budgets and the 2050 target as ceilings on emissions, rather than “bullseye” targets.

In our advice to Government the Commission considers the Crown–Māori relationship, te ao Māori, and specific effects on iwi/Māori. Our analysis and engagement with communities shows this will support faster emissions reduction and help achieve an equitable transition for the benefit of all New Zealanders – as set out in our December 2023 advice to Government on its next emissions reduction plan. ii These considerations are mandated in the Climate Change Response Act 2002.

The matters considered in this year’s advice on NZ ETS settings include the wide variety of approaches taken by iwi/Māori entities to their decision-making about forestry management and their NZ ETS units.

This reflects the overall point, also made in our December 2023 advice on the second emissions reduction plan, that iwi/Māori interaction with the NZ ETS is affected by the specific characteristics and historical circumstances of land owned by Māori.  iii

 Decisions connected with managing land owned by Māori collective owners, including about using New Zealand Units (NZUs) from forests, are often subject to protracted administrative steps and can be strongly influenced by the need to weigh up a range of competing priorities, tikanga values, and kaitiaki obligations including taonga tuku iho.

The diversity of viewpoints we have heard on iwi/Māori perspectives on the NZ ETS indicate a careful and collaborative approach is necessary, including regarding co-design and related aspects under Te Tiriti/The Treaty (see also Part 2: Iwi/Māori perspectives on the NZ ETS).

The impacts of emissions prices on iwi/Māori connects with our consideration of impacts across the economy, as detailed in Part 4: Price control settings. This reflects the need to ensure the transition to a low emissions economy is both ambitious and achievable. Our analysis has shown a fair, inclusive and equitable transition will endure, because that kind of transition would anticipate and manage how decisions affect different groups of people around the country. iv

Many households and businesses will be able to take up options that involve lower levels of greenhouse gases (such as changing how they travel or move goods, or heat buildings), meaning emissions pricing will impact them less and less over time. Impacts of emissions pricing, however, are not felt evenly across communities. Some households are unable to afford low emissions options, some do not have access to them. This is particularly relevant now, as higher inflation over the past two years has caused more people to struggle with the cost of living. Our recent advice on policy options for the Government’s next emissions reduction plan recommends continued use of targeted support for people less able to cope with the impacts of emissions pricing, rather than delaying climate action. v

What we heard through engagement

Effective engagement is an important part of the Commission’s process for developing advice.

For this advice we heard from mandated iwi/Māori representatives, companies, industry associations, market intermediaries including trading houses, and individual experts or consultants specialising in the NZ ETS.

We also drew on insights from past NZ ETS engagements, and engagements undertaken for other Commission work. An important input in the last 12 months was the public consultation and engagement that informed our December 2023 advice for the Government’s second emissions reduction plan.

The key themes arising from engagement were:

• Our NZ ETS settings analysis is sound: 
  Our methodology and recommendations were generally considered to be appropriate.
• Uncertainty about rules and policy is undermining confidence in the NZ ETS:
  This was consistent feedback across almost all engagements. The feedback highlighted Government decisions about price control settings and the (now stopped) review of the role of forestry in the NZ ETS in particular as discouraging investment in decarbonisation and forestry.
• Feedback that forest planting is not likely to continue at rates seen in past years:
  There was consistent feedback that recent high rates of forest planting were unlikely to continue in the immediate future due to policy uncertainty and other unfavourable conditions, with little planting planned for 2025.
• More information on the NZ ETS market would be beneficial: 
  Some participants noted key information for understanding supply and demand was held by the Government but not available to the market; some also hoped that planned NZ ETS market governance reforms would improve market information.
• Iwi/Māori perspectives on the NZ ETS: 
  As outlined above, representatives of iwi/Māori entitites provided diverse views reflecting interest but difficulty in navigating forestry elements of the NZ ETS.

The feedback is reported in more detail in Part 2: Current state and role of the NZ ETS.

Critical issues for the settings updates

Dealing with surplus units already in the NZ ETS market

For the NZ ETS to work well to support emissions reductions, the units available for use in the scheme need to decline in line with the Government’s declining emissions budgets. This is to encourage a drop in the greenhouse gas emissions covered by the NZ ETS, at the rate that will achieve the 2050 target and the domestic emissions part of the NDC.

Over many years, the number of units in the market has grown significantly, built up over time from a variety of sources. Some of the units in the market are necessary for the smooth operation of the NZ ETS, but there is an excess share that presents a high risk to the achievement of the emissions budgets. We refer to these excess units as ‘the surplus’.

The Commission last estimated the surplus in mid- 2022. Our recent analysis shows the estimated surplus has grown from 49 million units to 68 million units at the end of September 2023. The greatest contribution in that period came from a large increase in units allocated to forests registered in the NZ ETS. Figure 1 shows the combined total of surplus units, industrial free allocation units, and units set to be auctioned under the current NZ ETS settings regulations. The graph makes clear the units available exceed the level of allowed emissions from NZ ETS sectors under the NZ ETS emissions cap. The graph does not include the additional 93 million units currently held in private accounts that are not considered surplus.

Currently there is only one way to correct the excess number of units. That is by reducing the volume made available in government auctions. Based on our estimate of the increase in the surplus this year, we are recommending unit limit levels that reduce auction volumes significantly – see Part 3 Unit limits: Step 1.

The Commission’s recommendations on unit limits are based on the same methodology as previous NZ ETS settings advice.7 This year, we have judged it is appropriate to recommend changes to the first two years of unit limit settings – we consider there are circumstances that satisfy the criteria for doing this. Adjusting from 2025 supports the scheme to align with existing emissions budgets.

Figure 1: Our assessment of allowed emissions from NZ ETS sectors compared to units in the market over 2024–2030 (before adjustment)

It avoids the need for drastic reductions from 2027 that would be needed if the settings remained unchanged for 2025–2026, and allows room for further reductions later if the surplus is larger than estimated, or if it grows in the future. This recognises that factors influencing the surplus estimate are dynamic. vii

Other factors have also contributed smaller changes to the recommended auction volumes. These include an update to the overall emissions volume (the ‘emissions cap’) available to the NZ ETS due to methodological updates to the government’s Greenhouse Gas Inventory (GHG Inventory). These methodological updates are refinements to emissions calculations that bring estimated emissions down because of better data and information, rather than because of actions that reduce emissions – this is explained in detail in Part 3 Unit limits: Step 1.

Our recommendation also reflects a technical adjustment related to liquid fossil fuel emissions (as in our previous advice), an updated forecast of industrial free allocation, and refinements to more accurately reflect the NZ ETS’s coverage of synthetic greenhouse gases. Together these combine to give the proposed auction volumes that are set out in the Recommendations section.

Reliability of cash proceeds from NZ ETS auctions
Adjusting units in the scheme to align to targets – by reducing the volume of units available at auction – highlights the unreliability of income for government from the NZ ETS. This was already a reality, given the planned decline in auction volumes in line with emissions targets; this is currently expected to reach zero in the mid-2030s, at which point there will be no further units to auction. The current increase in the surplus, which leads us to recommend sharper adjustment to auction volumes, makes this unpredictability more acute.

Opportunities to bring unit limits down to support further emissions reductions

The Commission has identified opportunities to use the NZ ETS together with other emissions reduction policies to make the most of domestic emission reduction opportunities. This could help reduce the need to fund emissions reductions in other countries to meet the NDC – see also points about the NDC in the Clarifying the plan to achieve the country’s Nationally Determined Contribution section below.

Unit limits in the NZ ETS could be adjusted to reflect sizeable changes in emissions that result from other emissions reduction policies – where these are not already reflected in the related emissions budget. These are where there is a material shift in emissions by NZ ETS participants, and the reduction in unit limits could be made without increasing pressure on others in the scheme. One of several such examples is the action by NZ Steel in partnership with the Government to introduce an electric arc furnace to replace coal as a fuel for part of its manufacturing at Glenbrook Steel Mill. This is expected to reduce that company’s greenhouse gas emissions by 0.8Mt annually from 2027, which will be a permanent reduction to its demand for units in the NZ ETS (this shift away from coal will halve their use of units). The electric arc furnace was not anticipated in the Commission’s scenario pathway analysis in our 2021 advice on emissions budgets, unlike other emissions reduction projects funded by the Government Investment in Decarbonising Industry (GIDI) Fund.

The Government does not currently have policy on how the NZ ETS should be managed in these circumstances. It has the option to reduce the NZ ETS cap to lock in the reductions from other emissions reduction policies or investments. If the Government chooses not to adjust the cap, this would leave more units available and lower costs for other participants. Both options are available to the Government, but they have different consequences for the NZ ETS settings.

The option of reducing the emissions cap when step changes in emissions are achieved through other policies could increase certainty that domestic emissions budgets will be met, and make it easier to also meet the NDC by reducing reliance on offshore emissions reductions.

In the absence of policy direction, the Commission has deferred making a recommendation to tighten the NZ ETS cap this year to reflect the change in expected demand from emissions reduction policies outside the scheme. We are instead flagging this as an urgent policy issue requiring Government decisions, which could include setting out a framework for how the NZ ETS and complementary emissions reduction policies should interact.

Price controls are fit-for-purpose

We have assessed there is no need to change the NZ ETS price controls – the cost containment reserve and the auction reserve price – beyond an adjustment for expected inflation. The ‘price corridor’ that the auction price controls establish remains fit-for-purpose in combination with the unit limits.

Our analysis of price controls included an assessment of impacts of potential emissions prices – as covered in Our approach above.

Key issues requiring Government policy decisions

The NZ ETS is most effective at encouraging changes to lower emissions options if the scheme is operating as part of a cohesive suite of climate policies.

There are ongoing gaps in Government policy that affect the NZ ETS and create uncertainty for market participants. These issues are not the focus of the recommendations in this advice, but we raise them as they undermine the ability of the NZ ETS unit limits and price control settings to serve their purpose. If these issues remain unresolved, it will become increasingly difficult to accord the settings with emissions reduction targets in future. There is opportunity for the Government to address those issues in its next five-year plan for reducing greenhouse gas emissions (due December 2024).

This summary of the key policy issues provides an overview of the most important matters, as set out in Part 2 Current state and role of the NZ ETS.

Decisions needed on goals for gross emissions and carbon removals

The Government has not specified goals for the levels of gross emissions (reducing greenhouse gases where they are produced) or for the levels of carbon dioxide removed through forestry. Clarity from the Government on the levels sought, and the role of

the NZ ETS in achieving them, would support action to meet the emissions budgets and the net zero component of the 2050 target.

As part of our advice on the direction of policy for the second emissions reduction plan, the Commission recommended the Government commit to specific levels of gross emissions levels for the second and third emissions budgets, and provide indicative levels of gross greenhouse gas emissions and carbon dioxide removals out to 2050 and beyond, to guide policy decisions.

Structural improvements to encourage decarbonisation and forests

The NZ ETS is a key tool for meeting emissions budgets and the 2050 target but there are structural issues that prevent the scheme from achieving those goals in a stable way over time.

Addressing these structural issues will bring uncertainty, while solutions are worked out. However, not dealing with these issues risks greater uncertainty and poor outcomes for Aotearoa New Zealand, as the NZ ETS will be limited in its ability to support emissions reductions in line with targets and the overall transition to a low emissions economy.

• The NZ ETS risks initially encouraging increases in forest area at the expense of reductions of emissions at their source. This is a result of the way the scheme rewards carbon dioxide removals by forests, which is usually lower cost than reducing emissions at source.
• From the mid-2030s, the NZ ETS will not continue to incentivise all the forests needed to achieve the 2050 target level of net zero long-lived gas emissions. This is because a significant proportion of the country’s long-lived gases (namely nitrous oxide from agriculture) is not covered by the NZ ETS, which means there is currently no incentive to plant forests to compensate for those emissions.

In our advice on the second emissions reduction plan, the Commission recommended that lasting incentives for forests be provided through to and beyond 2050.

Our other key recommendation was that Government amend the NZ ETS to separate the incentives for gross emissions reductions from those applying to forests.

If the Government chooses not to pursue this approach, it will need to clarify how gross emissions reductions will be made in other ways, such as strengthening other climate policies. This will be essential to decarbonise the economy.

For both issues, our recommendations emphasised that these changes must be developed in partnership with iwi/Māori under Te Tiriti o Waitangi/The Treaty of Waitangi. When considering emissions pricing incentives, the unique characteristics and historical circumstances of land owned by Māori must be taken into account.

Clarifying the plan to achieve the country’s Nationally Determined Contribution

There are significant challenges involved in meeting Aotearoa New Zealand’s current NDC target: to reduce net emissions by 50% below gross 2005 levels by 2030. Earlier analysis by the Commission shows that significant offshore mitigation (emissions reductions achieved in other countries) is likely required.

The Government urgently needs to confirm how the country will achieve the current NDC by 2030.

The Government developed a high-level NDC strategy in 2023. viii That document includes a principle of prioritising domestic action to reduce emissions, which in turn has potential to reduce reliance on offshore mitigation. However, it is not clear how this principle will be put into practice and what the role of the NZ ETS will be in achieving the NDC strategy.

There is significant uncertainty about the role of the scheme and the potential future impact of overseas units on the price of units.

If Government makes its NDC plan and policy clearer, it will help clarify the respective roles of the NZ ETS and other policies to help speed up emissions reductions in this country, and potentially reduce the need to pay for mitigation in other countries to deliver increasingly ambitious NDCs under the Paris Agreement.

For at least the first NDC (2021-2030), emissions reductions from other countries will be needed. The Government could fund these directly, or the NZ ETS could be used to help bring these in if participants were able to directly purchase and surrender international units. Before deciding to help re-open the NZ ETS to international units, the Government would need to consider the implications for equity and the proper functioning of the NZ ETS, particularly in terms of preserving the ability of the NZ ETS to continue to encourage domestic emissions reductions.

There are related issues for the effective operation of the NZ ETS, in particular, to develop unit limits and price control settings that fit well with other climate policies and accord to the NDC as required in legislation. This is an increasingly urgent issue the closer it gets to the NDC 2030 target. It needs to be a priority for the Government.

Recommendations