How to make Emissions Trading Scheme bulletproof

Dr Eric Crampton
11 April, 2023

Falling carbon prices have the Finance Minister seeking advice on the Emissions Trading Scheme.

The ETS can and should be bulletproof. Other alternatives risk breaking political support for Net Zero long before the target is reached.

But first, an aide memoire and a bit of problem definition, before we get to a few recommendations.

The Zero Carbon Act’s target of net zero by 2050 enjoyed strong cross-party support. The ETS has been core to New Zealand’s climate response.

Getting to net zero requires steadily reducing the number of New Zealand Units (NZU), the carbon credits issued by the government each year.

The ETS is designed to suit the country’s net emissions target. A tonne of carbon dioxide permanently sequestered from the atmosphere is just as good as a tonne of carbon dioxide that is not emitted – so long as the accounting is right.

Every tonne of greenhouse gas emissions, whether from cars, industrial heat, or power generation, brings the obligation to surrender an NZU to the government. Only biological emissions from animals in agriculture are left out.

If you’re able to sequester a tonne of carbon dioxide, you can get an NZU for doing so. These units do not affect net emissions; one tonne of emissions into the atmosphere is matched with a tonne of emissions pulled from the atmosphere. 

Currently, the government also creates credits out of thin air – the NZU that it auctions and that it allocates to industry each year.

Parliament’s commitment to Net Zero means that, by 2050, every tonne of emissions must be matched by at least one tonne of removals – carbon captured from the air and stored. At that point, carbon captured by trees, or by any number of other technologies that develop and are recognised by the ETS, will be the only source of new credits.

New Zealand’s net emissions, in the covered sector, from now until forever, cannot exceed the number of tonnes allowed by existing ‘from-thin-air’ credits that are still outstanding, plus those the government creates before 2050.

That sets a quantity cap on net emissions, but of an odd sort. The Climate Commission can make recommendations about the number of units that should be issued. But it is impossible to say with certainty how many NZU future governments will issue.

This uncertainty will have contributed to the problems in the first government carbon auction of the year.

In December, Cabinet agreed with Treasury not to follow the Climate Commission’s advice about the ETS price cap.

Because the government has wanted outstanding NZU to be used up, rather than stockpiled, it holds back some units each year rather than putting them up for auction. It hopes that the restriction on quantity encourages prices to increase, drawing stockpiled units onto the market.

But because the government has worried that political support for the ETS will erode if prices rise too much, it releases those reserved units if carbon prices hit a trigger point. Prices can continue to rise beyond the ‘price cap’ on secondary markets, so it isn’t a hard cap on prices.

The Climate Commission had recommended a sharp increase in trigger prices, a much higher minimum price at ETS auction, as well as reductions in the number of units issued. Treasury disagreed, noting potential costs to household budgets if carbon prices rose sharply.

Cabinet seemed swayed by threats to household budgets while inflation runs high and decided against sharp increases in the price cap.

Since then, carbon prices have dropped from around $80/tonne to the $50-$60/tonne range.

Current climate policy sends signals about how many NZU might be issued in the future. If even a Labour government balks at measures that might have carbon prices here approach carbon prices in Europe, will future quantities really be tight enough to justify the prices seen last November? And when interest rates are sharply rising, carbon credits that pay neither interest nor dividends are a lot less attractive as an investment.

That leads us, finally, to a current problem definition. The government is reluctant to let carbon prices rise, because it fears the effects on household budgets. Investors have to read crystal balls to discern longer-term intentions around NZU quantities, because the number of units is not certain. And the price cap mechanism fits awkwardly into the current system. 

Recommendations then become straightforward.

1. Set a Carbon Dividend

Currently, the government uses ETS revenues for industrial subsidies, as well as upgrades to some public buildings. It should stop doing that. If those investments are worthwhile, they should be made by the business that enjoys the benefits, or paid for by the Ministry whose buildings need refurbishing.

The government should instead take every dollar earned when it auctions ETS credits and distribute it to New Zealand households as a carbon dividend. When carbon prices rise, Kiwis would get a larger carbon dividend. At least while the government continues auctioning substantial numbers of credits.

Canada’s carbon dividend results in the vast majority of households getting more back as a carbon dividend than they pay in carbon taxes. Why? The richest households spend more on everything, including goods that contain carbon taxes. So when carbon tax revenues are split equally among Canadians, a small number of rich households pay a lot more than they get back, and everyone else gets more back than they pay in.

A carbon dividend would mean that carbon prices could be allowed to rise.

2. Revise the price cap

Currently, the price cap sets the price at which the government releases a few reserve units onto the market. But any number picked as the price cap will be fraught. A revised price cap could simply track the volume-weighted average price in international carbon markets that the Climate Change Commission determines to be credible.

At the price cap, rather than releasing units from a reserve, the government could buy units on the European market, or on other credible carbon markets, to ‘back’ NZU released at the cap – if no other more cost-effective way of backing credits were available. There would be no need to set a quantity limit on these units. Each one would have to be backed by an offsetting and real emission reduction.

A price cap set this way would reduce the economic risks of rising carbon prices because the New Zealand carbon price would not be able to exceed carbon prices in other countries that take climate change seriously.

3. Set the quantity

Set a fixed number of unbacked ‘from-thin-air’ units that can be issued by the government between now and 2050. Those units, plus currently outstanding ‘from-thin-air’ units, would be the hard and known cap on net emissions.

Cross-party agreement on the quantity would make the system more durable. At the same time, the government could provide a guarantee to buyers of NZU. If a future government issue exceeded the hard quantity on units, NZU holders would be eligible for compensation. Parliaments cannot bind future Parliaments, but they can make some actions more expensive.

With a hard fixed quantity of units set, carbon budgets become far less important – at least for the covered sector.

4. Set clear guidance for the Climate Change Commission to focus on net emissions rather than gross emissions

The Zero Carbon Act set a target of net zero. The Emissions Trading Scheme was designed to reduce net emissions. Part of the problem in December was advice from the Commission aimed at preferring gross emission reductions to net emission reductions. So long as the accounting is right, there is no reason for either to be preferred.

But the accounting has to be right.

A bulletproof ETS

Together, these changes would move us a lot closer to a bulletproof Emissions Trading Scheme. Getting it right matters if New Zealand is to stay the course to Net Zero.

Carbon prices, through the ETS, let each of us – whether as households or as businesses – simply adjust to changing prices as best suits our own circumstances. It helps us find the most cost-effective ways of reducing net emissions, rather than guess at whether a regulation will cost two times or twenty times as much as the going carbon price.

The job is simply too big, and too important, to leave to less-effective alternatives.

I’m not sure this is the advice that Minister Robertson is after. But it is what would work.

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