The biggest risk to New Zealand’s Emissions Trading Scheme isn’t technical issues in how the scheme is run or in its accounting. The biggest risk instead is politics. Government has worried that, as the binding cap on the ETS drives emissions down as the cap tightens, rising carbon prices will bring political backlash.
Fear of rising ETS prices has sparked all manner of ineffective climate policies intended to prevent ETS prices from rising.
But Budget 2021 brought some hope of a more durable solution. The government announced that revenues from the ETS will be ring-fenced.
That makes a carbon dividend possible. The government could take the money it collects when it sells carbon credits and give every household an annual dividend payment.
A carbon dividend would reverse most of the politics around rising ETS prices. Rather than hurting vulnerable families whenever they pay for power or petrol, rising carbon prices would mean larger annual payments going to every household.
It would be a big deal, if we could get it.
New Zealand’s Emissions Trading Scheme has a binding cap. Within the covered sector, which is basically everything except for agriculture and international travel, net emissions cannot exceed the ETS’s cap.
Every tonne of greenhouse gas emitted must be matched by one New Zealand Unit (NZU), a permit which gives its holder the right to emit one tonne of CO2 or another greenhouse gas adjusted for its warming potential. The number of NZUs that the government auctions or gives away, plus a few holdover units from earlier versions of the system, forms the cap.
As New Zealand moves toward net zero, the number of units sold by the government will decline. Emitting more than that amount requires that someone else, somewhere in the system, sequesters carbon – most typically by planting trees.
The government earns money when it sells NZU at auction. The government’s expected earnings at auction will be increasing – at least for a while. Eventually, the decline in the number of units sold will outweigh the increasing price of each unit sold.
And all of it had been set to go straight into the government’s consolidated accounts, rather than being hypothecated, or ring-fenced, for other purposes.
Substantial increases in carbon prices are very likely as New Zealand progresses toward net zero. Until recently, the ETS seemed mainly to be a way of getting people used to the idea of carbon prices; there was no real cap on emissions. But changes to the system last year brought a firm and binding cap. ETS prices have roughly doubled over the past few years as the system strengthened.
So far, carbon price increases have not generated any great political backlash, nor have they caused any substantial hardship, despite nearly quadrupling since 2016. The wonderful thing about price-based mechanisms, like the ETS, is that everyone in the system has strong incentive to find all of the easiest ways to reduce emissions.
At a carbon price of $20 per tonne, businesses look for changes in process and equipment that cost no more than $20 per tonne to achieve. Now that the price is $36.50 per tonne and forecast to rise further, more changes become cost-effective.
Until relatively recently, carbon emissions came with no cost to the emitter at all. That meant there were many opportunities for reducing carbon emissions at very little cost. But as the cap tightens, further reductions in emissions become more difficult – the low-hanging fruit is picked first. And carbon prices will rise.
The fear of rising carbon prices poses a political problem for climate change policy. If carbon prices double again - as has happened in Europe and Britain since November – the effects of those prices on heating, petrol, and energy will become more obvious. And they may land most heavily on poorer communities driving less efficient vehicles and with homes that are harder to heat.
And so government has worried that political support for the ETS, and for net zero, may be fragile. Support for net zero is easier when the policy does not put a substantial dent in households’ budgets.
Government has tried to ease that political pressure by pursuing a raft of climate policy interventions that do far less good, per dollar spent, than government could do by simply relying on the ETS. The government always has the option to reduce the cap more quickly, or to buy up existing ETS credits without using them. The cost-per-tonne of those measures is simply the ETS price.
The government can, right now, cut a tonne of emissions very simply and cost-effectively. It only needs to buy an NZU at auction and shred it so nobody can use it. The cost of doing that currently is $36.50 per tonne. But the government is pursuing measures costing hundreds or thousands of dollars per tonne: early replacement of boilers in schools, regulatory interventions in process heat, and electric vehicle promotion.
None of these measures can affect New Zealand’s net emissions. It is strictly impossible. Transport and process heat are all included in the Emissions Trading Scheme. If a factory or fuel company bids for fewer NZU at the next auction, that just means the next highest bidder gets those units instead. Net emissions are unchanged. Reducing the cap more quickly, or buying and retiring NZU, is far more effective.
But the government will expect that different people bear the costs of emission reductions achieved through regulatory measures.
Rising ETS prices hit everyone, transparently. Regulatory costs are opaque. So governments can wind up preferring regulatory interventions that are far less effective than simply working through the ETS, because of those political costs.
And that, finally, brings us back to ring-fencing the ETS revenues and the potential for a carbon dividend.
The government has been worried about rising ETS prices because of the potential for political fallout. The government will earn a lot of money through ETS auction as the cap tightens, but a lot of vulnerable families will be left paying the bill. It would be inequitable and would build political fragility.
But the government now has a choice. Starting next year, the government will ring-fence the money it earns when it auctions NZU. It hasn’t announced what it will do with the money, but it could use it to implement a carbon dividend.
A carbon dividend is simple. It takes the money that the government earns when it sells NZU and gives it back to Kiwi households. The Citizens’ Climate Lobby’s submission to the Climate Change Commission in March included analysis by Infometrics economist Adolf Stroombergen. Stroombergen ran the numbers and estimated that, in time, every adult in the country could be paid $1100 per year as carbon dividend, with half as much provided as dividend to children under the age of 18. The average dividend per household would be about $2400.
The transfer provided through a carbon dividend would be highly progressive. Richer households spend more money in everything, and carbon is embedded in everything. At a carbon price of $400 per tonne, Stroombergen estimated that the poorest fifth of households, in total, would pay less than $100 million in total on ETS charges for petrol and diesel, while receiving almost $800 million back as dividend.
And the policy can be strengthened further.
The government is 51% owner of New Zealand’s major power generators. If power prices increase because coal or gas burners at Huntley need to turn on, the government could take any of the higher dividends it receives from the generators and put them into the carbon dividend.
And rather than paying a dividend at the end of the year based on realised ETS revenues, the government could pay the dividend at the start of the year based on forecast ETS revenues. The subsequent year’s dividend could wash up the effects of any errors in forecasting.
That way, households would have the cash in advance to deal with rising ETS prices, and to assist in their own transitions to lower carbon footprints.
Just imagine the change in the politics around rising carbon prices, under a carbon dividend. Instead of facing pressure because of rising prices, the Minister could take credit for larger dividends provided to every household in the country. If the transfer through the dividend were not progressive enough, the government could provide a higher dividend for those with Community Services Cards.
Rising energy prices can make life difficult for any government. But if Ministers can point to a carbon dividend that for most households, especially those on lower incomes, is greater than the extra cost of energy, the ETS and the government which stands behind it will be safe.
Until this year’s budget, a carbon dividend could not be done. ETS revenues simply went into the government’s general pot, and Treasury maintained firm opposition to ring-fencing those revenues. That barrier has now been surmounted.
The government may be tempted to turn those ETS revenues into a slush fund for climate-related pet projects for Ministers. But pet projects in funding insulation, or home heating conversions, or electric vehicles, or anything else, cannot affect net emissions.
The only way to bring down net emissions, within the covered sector, is to bring down the cap more quickly. And the only way to bring the cap down more quickly is by removing the political obstacle to rising carbon prices.
A carbon dividend would help lock in New Zealand’s path to net zero, if the government is serious about getting there.