Aligning NZ ETS settings with Domestic Budgets and the NDC (Part 2 of a 3-part series)

This is part two of a three part series on aligning NZ ETS supply settings with both New Zealand’s domestic emissions budgets and its NDC. This article focuses mostly on the requirements of the Climate Change Response Act with regard to making ETS settings, and looks at options for meeting those requirements.

Part 3 will analyse some number for the quantity of ETS units that could already be seen as inconsistent with the NDC, two years (2021 and 2022) into the ten-year NDC period. It will also summarise what I think the Climate Change Commission needs to tell the government in its advice on ETS settings in relation to the NDC, and what the options are for the government are in responding.

1. New Zealand’s NDC

In part 1 of this series I explained New Zealand’s NDC, and what it would take to achieve it. If you didn't read this already I suggest you do so, as the Article below will likely be hard work without it. But in summary:?

? For each year in the 2021-2030 NDC period, domestic emissions that are above levels consistent with the NDC need to be balanced by extra reductions in another country, paid for by New Zealand. The cross-hatched area in the graph below shows the volume that would need to be balanced internationally if domestic emissions are at the level of the proposed domestic budgets (blue line).?

? The structures of the Paris Agreement set up an expectation that this is done on an ongoing basis, not at the end of the period. The NDC is not an issue for later: it is an issue for every year from 2021 to 2030.

? New Zealand will be expected to show in each biennial progress report to the UNFCCC (starting in 2024) how it is tracking toward meeting its NDC target.

FIGURE 1: Domestic emissions above levels consistent with the NDC budget need to be balanced by international reductions.

Note that the need for future international purchases at this level is not inevitable: every effort should be made to bend the curve for domestic emissions downward so that the domestic budgets are over-achieved, reducing the need for international purchase.

2. The Emissions Trading Scheme authorises emissions in the sectors it covers

Emissions Trading Schemes (ETS) are unlike many other climate change policies in one very important respect: rather than only being a policy to reduce emissions, they set an allowed level of emissions for the covered sectors, by issuing a controlled quantity of allowances/units. If ETS unit supply is set in line with New Zealand’s emissions targets, then the ETS can help deliver those targets. The Ministry for the Environment website summarises this nicely:?

New Zealand's ETS currently covers all emissions in energy, industry and transport, some waste emissions, and allows unlimited use of forestry removals. Agricultural methane and nitrous oxide emissions are currently not covered by the ETS, but are scheduled to enter in 2025 unless alternative pricing arrangements are put in place.

3. What does the Climate Change Response Act say about the purpose of the ETS?

The Climate Change Response Act is the legislation governing the ETS. The Act's purpose section in relation to the ETS (Section 3(1)(b)) is to:

?That is, the domestic and international targets have equal status: the purpose of the ETS is to “assist” in achieving both targets. This equal attention to domestic and international targets is mirrored in the subsequent section of Act (30GC) that specifies what the Minister must do when setting unit limits (i.e. the number of allowances/units issued each year) and price controls. That section says:?

Again, settings need to be in accordance with both the domestic budgets and the NDC.?However there are exceptions: the Minister has flexibility to consider other matters, and if justified by these, the ETS settings do not need to “strictly accord” with the budgets or NDC.?

?I’m not a lawyer, but to me “not strictly accord with” means that there is important and necessary operational wiggle-room for the ETS settings to be different from the targets by a modest amount at the margin: this is important because exact matching isn’t necessarily possible. However I don’t see that this wording would allow the ETS settings to be entirely inconsistent with achieving either the Budgets or the NDC. For completeness, the matters the Minister must consider in setting unit supply volumes are:?

?I note that international obligations are mentioned in this list of matters, while domestic targets are not. That suggests to me that if there is a tension between the two, there’s certainly no reason to assume that aligning settings with the domestic budgets should take priority.

4. What decisions will be made in 2022 on ETS unit supply?

For each calendar year the ETS operates, the Minister sets an “overall limit” for ETS allowances, which is the sum units available by auction, those allocated for free to emissions-intensive companies, and approved overseas units. Approved overseas units are those issued in other countries that are allowed to be brought into the NZ registry and used toward NZ ETS obligations. There are currently no approved overseas units.

ETS unit supply and price control settings are made five years in advance, so that participants can plan to meet tightening future constraints. That means that decisions made in 2022 will cover the period 2023-27. This will entail:?

- adding 2027 values;

- reviewing the settings for 2025 and 2026 and changing these if justified;

- reviewing 2023 and 2024 settings, and making changes if justified. Settings for these two years immediately ahead would normally be fixed, but this year special circumstances apply that trigger a review: new domestic budgets, a revised NDC, and the cost containment reserve was triggered.??

There will also be other decisions relating to price settings, the cost containment reserve, and phase-out rates of free allocation that I won’t discuss here.

Ahead of the Minister making these decisions each year, the Climate Change Commission provides advice. This year the Commission intends to provide its ETS advice mid-year, then after that the government will consult on proposed ETS settings for 2023-2027, with decisions taken before the end of the year (to be in place for 2023).

5. What does it mean for ETS unit limits to be “in accordance with the emissions budget and the nationally determined contribution” ?

To me, two concepts are key in providing direction on aligning ETS supply with both domestic budgets and the NDC:

1. to achieve the NDC, domestic emissions that are above levels consistent with the NDC each year (and up to the level of the domestic budgets) need to be balanced by extra reductions made in another country.?

2. in the sectors covered the ETS, the ETS unit supply decisions authorise a level of domestic emissions (through issuing a quantity of allowances)

Therefore if ETS unit supply decisions are to be in accordance with both the domestic emissions budget and the NDC, then the government will need to be clear about what level of emissions is consistent with the NDC each year in sectors covered by the ETS, and how it intends to balance domestic emissions above that level with international purchases.

So in my view, the first step in aligning ETS settings with domestic budgets and the NDC is to consider what level of emissions is actually consistent with the NDC in the sectors covered by the ETS. This is not as simple as it might sound and will require decisions from the government: do they see the NDC “effort” (i.e. the need to internationally balance excess domestic emissions) being entirely within sectors covered by the ETS, or should some of the effort be associated with agricultural emissions? In what shares? As long as agricultural emissions remain outside the ETS this is an important question because it will determine, for sectors that are covered by the ETS, what level of domestic emissions can be seen as consistent with the NDC.?

The figure below sketches two examples (perhaps at extreme ends of a continuum) of the level of emissions that might be consistent with the NDC in the sectors covered by the ETS. [this ignores complications like stockpile reduction for now]

Example 1: All NDC effort is associated with sectors currently covered by the ETS (shown by dashed red line). This means that agricultural emissions (outside the ETS) are only expected to achieve the reductions needed to meet the domestic budgets, but nothing further. The “gap” between the NDC and domestic emissions then falls entirely to the ETS sectors.

Example 2: 50% of NDC effort is associated with sectors currently covered by the ETS (dotted red line). This effectively assumes that the government attributes half of the extra reductions needed to meet the NDC to the agriculture sector. These could be achieved by extra emission reductions in agriculture, or the government or agriculture sector purchasing offshore units to balance the excess. This would clearly ease the load on sectors currently covered by the ETS to meet the NDC.

In each example, as in Figure 1 above, it is the area between the red (NDC) line and the blue (Budgets) line that represents excess domestic emissions in ETS sectors that need to be balanced internationally. Clearly, the quantity that needs to be balanced depends on government decisions about how they see NDC effort distributed between sectors.

The second step is to consider the actual mechanics for “balancing excess domestic emissions with international reductions”, and whether and how this would affect domestic ETS settings. There are two broad approaches the government could take:

? Approach 1, following the mechanism spelled out in the Climate Change Response Act, would be for the government to approve specific overseas units for use in the NZ ETS. For ETS settings to be in accordance with domestic budgets and the NDC, the quantity of NZUs supplied (auctioned + freely allocated) would need to be reduced to NDC-consistent levels, and there would need to be a limit on use of overseas units so that total domestic emissions authorised (the “overall limit”) don’t exceed the domestic budgets.?This would result in lower ETS auction revenue for the government than currently forecast (as some auctioning is replaced by overseas units), but ETS participants would cover the cost of purchases to meet the NDC.

? Approach 2 would be for the government to purchase and cancel international units independently of the ETS (but still for the purpose of balancing extra emissions in ETS-covered sectors). For ETS settings to be in accordance with both domestic budgets and the NDC, the government would need to distinguish the quantity of annual NZU supply that is consistent with the NDC, and the quantity of NZUs (up to the level of the domestic budgets) that need to be matched by offshore units. In this approach ETS auction revenue is preserved, but there is a separate cost to the government of purchasing international units to meet the NDC.

6. How has the government been making ETS unit supply settings over the past two years??

For settings made in 2020 and 2021 (for 2021-25 and 2022-26), the government made ETS settings using a provisional approach, which references only a domestic “provisional emissions budget” and not the NDC. For example, the regulatory impact statement for the 2021 ETS settings explains:?

?That is, the current process acknowledges that there is a legal requirement to align with the NDC, but the actual practice is to only use the domestic budgets in making ETS settings. I have heard a number of explanations (some reasonable) for this as an interim approach:?

? Ahead of the Commission’s advice, it was unknown how deep the cuts proposed through the domestic emissions budgets would be: it was unclear what (if any) the gap would be to the NDC, so it would be difficult/premature to put numbers to an NDC gap.

? The previous NDC was expected to be revised, so locking in NDC-related parameters would have been premature.

? The government had not taken decisions yet on how to manage the NDC.

? There were no “approved overseas units”, so the NDC can't be incorporated.

Whatever the merits of that provisional approach, for this year's decisions we are in a different situation: both emissions budgets and the revised NDC will be in place, so the “gap” to be managed is now clear. Going forward, I don’t think it is acceptable to continue to ignore the NDC when making ETS unit supply settings.?Doing so makes an implicit assumption that the NDC will somehow be sorted out elsewhere, later. It means that the ETS settings in and of themselves are clearly not consistent with the NDC, as they unconditionally allow emissions in excess of NDC-consistent levels.?It implies that if there is a question of whether to prioritise meeting the domestic budgets or the NDC via ETS settings, we should forget about the NDC. I don’t see support for that view in the legislation.

7. But but but… the government hasn’t taken decisions yet on how to manage the NDC… and offshore units valid for NDCs aren’t available yet (or at least haven’t yet been approved by the government yet)… what does all that mean for ETS settings being in accordance with the Budgets and NDC *now*??

Even ahead of the government taking full decisions on its NDC approach, and ahead of units being available/contracted for purchase, there are things they can and should do to align ETS settings with the NDC. The options for the government (and the Commission advising them) look something like this, in increasing level of how seriously the NDC is taken:?

1. Be transparent about what annual quantity of domestic emissions the ETS is authorising in excess of NDC-consistent levels, that will need to be covered by international purchases later. This is a start, but to me this just quantifies how mis-aligned current settings are: it is not enough to meet the legal requirement to actually be “in accordance with” the NDC.

2. For each year’s ETS settings, the government is transparent about the level of international purchase needed to square up that year’s NDC accounts and announces a credible plan to balance excess emissions that have already happened and a plan to meet future international purchase obligations that result from this year’s ETS settings decisions. That is, in making ETS settings out to 2027, the government should look at the excess domestic emissions over the 2023-27 time period that will need to be internationally backed. To me, one absolute key to the credibility of such a plan is having financial budget set aside to cover the cost of these international purchases. At the moment this considerable cost (potentially $1B per year) is not formally included in the Crown Accounts.?

3. If the government cannot credibly promise to “make good later”, another option would be to limit ETS unit supply to only NDC-consistent levels until such a time as the government does have credible plans/purchase contracts/financial budget in place. This would provide greater certainty that ETS settings are consistent with the NDC. Note that this does NOT mean that domestic emissions need to be cut any more than would otherwise have occurred: there is a massive stockpile of banked ETS allowances that could bridge the unit supply gap for a couple of years until international arrangements are in place. This would essentially bring forward the gradual “stockpile drawdown” of 5.4Mt/year currently foreseen over the whole decade to instead occur in the next couple of years.??

I imagine that the government would argue that the third option would be too damaging to “the proper functioning of the emissions trading scheme”, because a sudden and un-signalled withdrawal of auction units would be difficult for participants to manage. But on the other hand, ETS function is currently hobbled by the large stockpile of banked allowances, and a faster drawdown would allow the system to work better more quickly. If a halt to auctioning is discarded, then falls on the government to make the second option work: transparently identifying the annual NDC shortfall, and having a credible plan and financial budget to make good on the gap.?

While this means there's work to do, the good news is that it’s still only April, so the government has until the second half of this year to come up with this framework ahead of consulting on ETS settings.

8. Summary:

? The Climate Change Response Act requires ETS supply to be “in accordance with” the NDC as well as with the domestic emissions budget.

? However to date, only domestic emissions budgets have been used as a reference for making ETS supply decisions.

? Even ahead of full decisions being taken on NDC management, and ahead of international units being available to purchase, ETS supply settings could still be in accordance with the NDC if there is

o Transparent reporting of the annual quantity of ETS units issued each year that will require balancing by international units to meet the NDC.

o A credible plan to acquire those units.

o Financial budget set aside to pay for them.?

Alternatively, the government could reduce ETS auction volume to NDC-consistent levels until international arrangements are in place.