Emissions trading in New Zealand

The recent policy framework put forward for New Zealand's emissions trading scheme (ETS) make it the most ambitious and stringent scheme yet proposed worldwide, but concerns over implementation have sparked fierce debate, finds Roderick Bruce

New Zealand's carbon emissions output is growing at a startling rate. While the country's annual emissions of around 80 million tonnes of carbon dioxide equivalent (Mt CO2e) represent less than 1% of the global total, the country has the 12th highest per capita emissions level globally, due to reliance on private transport and emissions-intensive industries. Emissions from fuel combustion have increased 50% since 1990, significantly higher than the 28% global rate of increase. Emissions from thermal electricity generation more than doubled between 1990 and 2004 due to increased coal use, while emissions from liquid petroleum fuel have risen by 66%, driven by significant growth in the transport sector, according to New Zealand's Ministry for the Environment.

Given that New Zealand has long had an environmentally focused image, an appropriate policy response to high emissions growth is seen as vital. The Labour-led government's September 2007 issuance of a framework for the phased introduction of an ETS to cover all industrial sectors and all greenhouse gases therefore had bipartisan political support. Despite this, the scheme, though still in its infancy, has sparked debate among politicians, stakeholders in industry and financial players, as some say the scheme goes too far while others say it does not go far enough.

Building a structure

The ETS will be phased in gradually, with forestry being the first sector to face compliance, from 2008. Liquid fossil fuels and transport will enter the scheme in 2009, stationary energy (emissions from electricity generation and fuels consumed in the manufacturing, construction and commercial sectors, along with domestic heating) in 2010, and agriculture, waste and all remaining sectors from 2013.

Points of obligation have yet to be fully determined, but despite the "all sectors" label, the government is seeking to limit the number of companies - estimated at around 200 - that will actually face compliance. "The ETS reduces compliance costs by ensuring that the points of obligation are often high in the supply chain," says David Parker, MP for energy and climate change issues. An example of this is the fact that milk-processing cooperative Fonterra, New Zealand's biggest company, will be liable for agricultural emissions rather than individual dairy farmers themselves. The same can be said for transport emissions, for which oil companies will be held responsible, and stationary energy, for which the fuel suppliers will have to comply. Fertiliser companies will be liable for agricultural emissions emanating from their products.

Electricity generators, liquid fossil fuels suppliers and landfill operators will have to comply for the full amount of their emissions, while a free allocation of credits to up to 90% of 2005 emissions will be provided to industrial production firms (particularly those who must compete internationally, such as steel and aluminium producers) and agriculture. Free allocation will be phased out by 2025.

Credits eligible in the NZ ETS will include the domestic New Zealand Unit (NZU), which will be the main unit of trade, equivalent to one tonne of CO2. Each NZU issued by the government will be "backed up" by a Kyoto unit in the NZ Emissions Unit Registry.

To encourage greater liquidity, an unlimited quantity of carbon credits (certified emissions reductions, or CERs) from Clean Development Mechanism (CDM) projects will be allowed, as will emission reduction units (ERUs) from Joint Implementation (JI) projects. Some carbon brokers, such as the carbon credits trading intermediary New Zealand Carbon Exchange (NZCX), already offer the sourcing of international carbon credits for companies in New Zealand, and aggregate credits for domestic emissions reduction projects.

While the concept of an ETS has broad support, some in the business sector have raised considerable concerns about the structure of the scheme and the fast pace at which it is being introduced.

Trading over tax

Debate over pricing carbon began even before the government's ETS announcement in September. In 2002 the government announced plans to introduce a carbon tax, but the policy was held up by domestic politics rather than any debate on its perceived efficacy in reducing emissions. "The word 'tax' basically ended it," says David Skilling, chief executive of the New Zealand Institute, a think-tank. "Although an ETS and a tax have similar economic effects, people made it clear that they didn't want another tax." Carbon trading is seen as more palatable, according to Skilling, as it is more "market friendly" - tradable with a secondary market. "The global attitude seems to be that taxes don't sell and an ETS is a more promising way to succeed," says Skilling.

Energy and climate minister Parker told Energy Risk that the government looked carefully at all the options, including the relative merits of an ETS compared with a tax. "We concluded that trading provides the least-cost and more flexible option," he says. "It allows the price of emissions to change, and with an internationally linked ETS, the price of domestic units (NZUs) would track the international carbon price. It would be difficult to set a tax at the correct level to ensure appropriate emissions reductions."

Not everyone agrees that trading is more effective than tax, though. "We still think that an ETS is a much more difficult and complex way of putting a price on carbon and much more subject to fraud," says Jeanette Fitzsimons, co-leader of New Zealand's Green Party. Fitzsimons feels that trading allows emitters to "buy themselves out of the problem by paying for projects in China".

Setting the pace

The proposed NZ ETS has raised eyebrows for its ambition in two key areas - sector coverage, and the implementation timetable. The major driver behind commencing the ETS in 2008 was allowing it to coincide with the first commitment period of the Kyoto Protocol. As New Zealand is a signatory to the protocol, Kyoto will set the cap for the scheme. Under the treaty, New Zealand must reduce its greenhouse gas emissions to 5.2% below 1990 levels by 2012.

Fitzsimons feels that the scheme's phased implementation "has no sense of urgency", given the relatively long period being allowed for companies to reduce emissions. However, the majority of businesses that will be obliged to comply with the NZ ETS feel that the infrastructure and trading expertise required for compliance is not yet in place, even at the largest companies that should be best-placed for successful trading.

One such company is Genesis Energy, New Zealand's largest thermal generator, which emits 3-6 million tonnes of CO2 per annum. "We've been doing a lot of work because emissions trading and compliance is all very new to us," says Richard Gordon, public affairs manager at Genesis. The company has recently appointed Peter Kimber as carbon strategy manager. He was formerly its wholesale markets manager and is an experienced power trader. "He has been on a study tour to the Chicago Climate Exchange and to an emissions trading conference in New York, and to California. He has been upskilling big time," says Gordon. "He will be recruiting a team of traders and he'll be looking at a number of ways of engaging with the market. He's been speaking with brokers and we've been in negotiations already with one local company with credits to sell."

Gordon admits, however, that while he cannot give exact figures, preparing for compliance is costly and time-consuming. "There is quite a high cost involved and a lot of work to be done," he says. "There are consultants involved, and we must form a carbon-trading strategy and train existing staff. Recruiting new traders will be costly, too."

With the ETS set to make a big impact on large companies, there is concern that smaller, "non-traditional" counterparties who are not already involved in commodity trading will find it particularly hard to adapt.

This is true for the first eligible sector, forestry. "The forestry sector, which is quite a fragmented market, along with smaller stationary energy stakeholders, don't necessarily understand all the detailed requirements and what their obligations are," says Murray Dyer, director with NZCX.

"Given the complexity of an all-sectors, all-gases scheme, once it extends to the whole market there will be a lot of smaller organisations caught up within the ETS that just don't have the resources to be able to handle it easily," says Dyer. "They'll take a while to understand what the issues are when it comes to trading and future obligations."

Climate and energy MP Parker also points out that forestry owners and farmers may decide to get involved voluntarily in trading.

"That's where the broker comes in," says Dyer. "Not only do we put the buyers and sellers together, we assist them through the transaction process as well." Dyer feels that because of a lack of trading expertise, many counterparties will opt for a "pure procurement or risk mitigation approach" to trading, meaning that market liquidity will take some time to develop. One remedy to this is the proposed linkage of the NZ ETS to an Australian carbon trading scheme. "Linking internationally ensures much-needed liquidity in the domestic market," says Parker. "It also helps to ensure that prices on the domestic market are aligned with international prices."

Stuart Frazer of NZCX observes: "For many firms in New Zealand who have trans-Tasman Sea operations, there would also be an opportunity for internal cross-operational trading." Given that Australia's scheme is still in the design stages, details of a proposed link remain vague - but Australia's recent ratification of Kyoto will undoubtedly aid the process.

Though NZCX plans to create an exchange eventually, an exchange-traded spot market is unlikely to emerge in the short term, given that the major sectors involved - forestry, transport and manufacturing - have a relatively low appetite for short-term trading opportunities. "It will be some time before we envisage New Zealand-based market participants trading in environmentally linked financial derivatives," says Dyer. "The majority of participants will likely seek trading assistance - 'the human touch' - from OTC brokers and intermediaries." Investment banks in the region have already expressed interest in offering transaction services, says Dyer, while several firms such as Carbon Market Solutions are setting themselves up in an advisory capacity.

Structural flaws?

A second major characteristic of the NZ ETS is its extensive sectoral coverage. New Zealand's unique emissions profile is the main reason for the ETS's ambitious design. "New Zealand has been more ambitious in trying to design an ETS that covers all sectors and all gases," says Skilling. "Policy has been pushed in that direction because agriculture, which generates 49% of our emissions, is such a large part of our economy." This contrasts with other developed countries, where 12% of emissions on average are from agriculture.

Critics observe, however, that agriculture is only covered by the scheme from 2013, entering with a 90% free allocation of credits of 2005 emissions. "We see that as a major flaw," says Fitzsimons. "An ETS therefore won't drive any reduction on agricultural emissions during the first commitment period. I don't begrudge the agricultural sector profits, it's good for them and New Zealand, but it seems a bit unfair that it should be the one sector protected by the taxpayer," he continues.

In addition, fugitive emissions (methane that escapes during the coal mining process) have been exempted from the ETS. Such emissions have risen 450% since 1990, with more coal mines currently being commissioned. Critics have stated that their exemption is government protectionism of the country's growing coalmining industry. Parker denies this. "Fugitive emissions are difficult to measure and estimate," he says. "Such emissions account for under 1% of New Zealand's greenhouse gas emissions, so this is clearly not about protection of the coal industry."

With much of the detail of the NZ ETS still to be filled in - design for the stationary energy and agricultural sectors will be carried into 2008 and beyond - it seems that the debate over New Zealand's ETS structure will rumble on for the foreseeable future, especially as Fitzsimons states that the hard decisions on the grandfathering of permits (allocation based on historical emissions profiles) will be left until after the next election, expected in November 2008. "This election year lolly-scramble will be highly contentious," she warns.

Genesis Energy's Gordon agrees. "Companies like us will have a chance to comment and put forward submissions to the bipartisan select committee," he says. "There's an opportunity there for some horse trading and some amendments to the scheme. There are still some big issues ahead."