When the government set a binding cap on New Zealand’s net emissions through the Emissions Trading Scheme, it also set a second cap – on prices.
The hope was that that second cap would not really be needed, but it looks like it might become relevant rather sooner than anyone expected.
Hopefully, the government is ready for it.
New Zealand’s ETS includes a price cap. If the price of New Zealand Units (NZU) reaches $50/tonne, the government must release additional units from its Cost Containment Reserve. And ETS prices are now above $47.
How can the price cap be reconciled with a binding cap on net emissions? Units from the Cost Containment Reserve must be ‘backed’: the government has to find, somewhere, emission reductions equivalent to the emissions permitted by those backed units.
As the Ministry for the Environment’s helpful website explains, those emission reductions could be sourced domestically or internationally. Replanting Amazonian rainforests could be an option, if the accounting were sound. Planting trees on Crown land and using those credits at the price cap could perhaps be another option.
When the price cap was set, $50 just happened to match the price of carbon in the European ETS. That is unlikely to be a coincidence.
If worst came to worst and the government found it had no way of backing units cost-effectively domestically, it had an option.
It could, at least in principle, go to Europe, buy credits on the European market, shred them so they could never ever be used, and then use that reserve to back units released here.
Being able to do that would require having a chat with European officials to make sure they would not consider it hostile. Right now, any one of us could privately purchase a European ETS unit and decide not to use it. And it seems unlikely European governments would care. But they might get annoyed about a government buying a few million units without having had a chat about it beforehand.
If that option were real, and if the price cap matched the European price, it would provide a beautiful solution to an important problem. If New Zealand prices ever exceeded European prices, we would risk chasing carbon-intensive industries to places with lower prices. It would cost New Zealand a lot while doing nothing for the environment.
Buying credible international units at the price cap would mean we would be finding more cost-effective ways of reducing global emissions. We could do more for the climate than we could if restricted to options here at home.
But we now have an additional problem. The European carbon price has risen from about $50 to about €50 – or about $100. If the government’s fallback plan for backing units at the price cap was buying units in Europe, they would lose about $50 on every unit.
Last year The Initiative warned that anchoring the price cap at $50 plus 2% per year introduced fiscal risk. If prices in Europe increased faster than prices here, and if the government could not find any better option for backing units, the government could end up buying expensive units in Europe and selling them cheaply here, taking a loss with each unit.
We encouraged tying the price cap explicitly to the European price, rather than to $50.
Alternatively, the government could ask the Commission to test the reliability and credibility of a broader set of international Emissions Trading Schemes – there are dozens of them. New Zealand’s price cap could then be a weighted average of prices in regimes the Commission considered credible.
At the price cap, the government could then back units using the most cost-effective credible international units. If the weighted average price, and our price cap, were $80, but the lowest credible price were $50, the government would have $30 in additional revenue every time it sold a unit using the Cost Containment Reserve.
The government could use that surplus to reduce global emissions even more quickly by buying more units. Or it could rebate more money back to Kiwi households to offset the equity effects of higher ETS prices.
But perhaps more importantly, an explicit link to international prices, combined with securing permission to purchase credits elsewhere, brings credibility to the price cap. The price cap is not credible if the government is promising to lose a lot of money by using it. A non-credible price cap encourages buying credits at $50 in the expectation that the government will increase the cap rather than continue losing money.
The government needs to update the price cap before the next ETS auction. Rather than choose some new price level, like $70 or $100, it should set the cap to follow international carbon prices. It would make for a better, and more durable, path to net zero.