NZ ETS re-design for gross emission reductions (and better land sector outcomes)

There are questions swirling regarding the future treatment of forestry in the New Zealand emissions trading scheme (NZ ETS). This goes beyond the "permanent forests" question currently under consultation, and will eventually impact on how all forestry in the ETS is treated.

The public debate about ETS forestry settings has mostly focused on concerns about ETS prices driving land-use conversion from sheep, beef and dairy farming to exotic pine plantations, and on whether/how biodiverse indigenous reforestation could receive greater incentives than pine. The interests of Māori are also central on this issue, both in terms of respecting the value of previous Treaty settlements involving forestry land, and in not creating new Treaty breaches.

My principal interest is not from the forestry side but comes from the other direction: we need an ETS that drives actual gross emission reductions in energy, transport and industry. These sectors need to get as close to zero emissions as possible. The Climate Change Commission has recommended - and the government has agreed - that ETS design should be changed to drive gross reductions. This would entail changes to the role of forestry in the ETS, but we are yet to see any concrete proposals from the government. The key challenge is how to realign the way forestry (of all kinds) is supported so that it is done "as well as" not "instead of" making a transition away from fossil fuel emissions. There are alternative approaches (some discussed in this piece), but in my current view the best way forward at a high level is:

• forests that receives removal units should still come under the current architecture of the ETS (which is world-leading) to e.g. register forests, do measurement and reporting, set legal obligations, issue units, manage deforestation obligations, provide infrastructure for registries etc.
• However, there should be a change made to who <buys> forestry units. ETS participants should have cap for gross emissions, and no longer purchase/use forestry units. Forestry removals should instead be paid for by the government (which would receive enough increased auction revenue under a gross ETS cap to cover this cost) and/or by other purchasers. Most of the projected forestry removals to 2035 are needed to meet New Zealand's domestic emissions budgets, and any extra can reduce the need for offshore purchases toward New Zealand's current and next NDC. As such, the government could easily commit to being a backstop buyer for all forestry units issued until at least 2035.

This change would address the looming supply/demand imbalance in the ETS, and also means that a different price can be struck for forestry units than the ETS market price. Forest CO2 removal would still be financially rewarded, but at its own appropriate level rather than the ETS price that is intended to drive energy system transformation. The change would also makes it easier to add additional payments that reflect other values beyond only CO2 removal: biodiverse native forests could for example receive an added biodiversity credit. It would allow for better ongoing land-use flexibility, including the potential future need for some forestry to be replaced with bioenergy or food crops.

Background: current NZ ETS design

The NZ ETS puts obligations on emitters in energy, transport, industry and municipal waste. Participants are required each year to surrender one NZ allowance (NZU) for each tonne of emissions they are responsible for. A cap on the quantity of NZUs made available decreases over time (red line in the figure below). Some NZUs are supplied for free to supposedly at-risk industries (grey area), the rest are auctioned (orange), with a few held back to correct current over-supply (purple). However the NZ ETS is unique internationally in that its cap is set for "net" rather than "gross" emissions. This means that companies with ETS obligations are allowed to have emissions above the level of the cap, and count removal of CO2 by forests registered in the ETS to offset them. Gross emissions covered by the ETS (blue line) can therefore be substantially higher than the net emissions cap. [Note: this graph uses the Climate Change Commission's scenario data released alongside their advice on ETS settings. Big thank you to the CCC for proactively providing this!].

The Problem

The NZ ETS establishes a common price for emissions (what emitters pay) and removals (what foresters get paid). However in the New Zealand context, the price incentive needed to drive land-use change to exotic forestry is lower than the price needed to make most emission-reducing investments (like electrification of industrial heat) cost-effective. This means the system ends up favouring increased tree planting instead of reductions in gross emissions. This is seen in the figure above: the rising ETS price is currently driving significant land-use change and a rapidly increasing volume of forestry removals is expected to become available for future purchase.

The Climate Change Commission's projection shown in the Figure above (if current ETS design/settings are maintained) is that by 2035, no auctioned units will be required: enough units will be provided by forestry and free allocation. And beyond 2035 the volume of forestry removals keeps increasing so that by 2040 there is projected to be significantly greater supply of forestry removal units than demand for them in the ETS. This over-supply into the ETS would undermine the ETS price, weakening incentives for gross emission reductions.

Some suggest letting the system self-correct: the price may crash but the net target is still met, albeit with lots of forestry and few gross reductions. I don't see that as a desirable outcome: I agree with the Commission that we need to decarbonise our economy, and a collapsed ETS price will not drive this. [In fact I think we should be going faster than the current Budgets, in line with the IEA's 1.5C-consistent NZE scenario I discussed here .] I also think that more stable signals for land use matter: artificial boom/bust cycles help nobody.

What would it look like to take purchase of forestry units out of the ETS?

Under any policy change, forests that receives removal units should still come under the current architecture of the ETS (which is world-leading) to e.g. register forests, do measurement and reporting, set legal obligations, issue units, manage deforestation obligations, provide infrastructure for registries etc. However, there can and should be a change made to who <buys> the credits.

Gross reductions in fossil fuel emissions are a priority, and should be the main focus of the ETS. In the simplest case, ETS participants would be set a declining cap for gross emissions only, and no longer be allowed to use forestry units. Virtually full decarbonisation of New Zealand's and the world's energy systems is a necessary component of 1.5C-consistent action, as illustrated in the IEA's NZE scenario.

However forestry CO2 removals are still valuable, important and necessary. Most of the expected forestry removals out to 2035 are needed to meet New Zealand's legally-binding emissions budgets set under the Climate Change Response Act, and any extra removals can reduce the need for offshore purchase toward New Zealand's current (2021-30) and next (2031-35) NDC under the Paris Agreement.

But if ETS participants had a gross emissions cap, who would pay for forestry removals? The first point to note is that a gross ETS cap would mean increased auction volume and therefore increased auction proceeds to the government (Figure below). This would generate sufficient cash to pay a carbon value for forestry CO2 removals (at a price lower than the ETS price), and also fund biodiversity incentives. With the need for all of these forestry removals essentially "baked in" to the Budgets to 2035 and New Zealand's Paris Agreement NDC, the government could commit to backstop the purchase of all forestry units until at least 2035.

Longer-term demand for forestry removal units depend on New Zealand's target pathway to 2050 and beyond, whether or not changes are made to the ETS. There are many significant questions: What level of negative emissions do we want after 2050 and who would pay for this? Will agricultural methane eventually need to be offset? What might be the demand for forestry for a future bioeconomy? What about voluntary market or overseas demand? What new competing land uses might there be (bioenergy, food crops)?

Mapping out longer-term scenarios of how demand for forestry removals might unfold is important now, as permanent forests being planted now will still be sequestering carbon in 2050 and 2070. Those making forest carbon investments should be given more visibility of this uncertain future. I want to emphasis that any decision to shift purchase of forestry removal units to outside (rather than inside) the ETS is not the source of uncertainty: The ETS would not have the volume demand for these units from the 2030s in any case.

Challenges and opportunities

Challenges

• Timing. This requires legislative change. Could it realistically be done in time for 2nd budget period (2026-30)?
• Uncertainty: New forestry planting (both indigenous and exotic) is a very important part of New Zealand's climate response: the government will need to provide clarity on the "forestry support" side as well as the ETS changes so the current gold-rush of planting doesn't turn to a complete standstill. How much assurance can be given by clear signalling of direction until actual implementation of legislation?
• There is a 144Mt stockpile of units in the ETS, some held for future forestry obligations. How is this addressed in any change away from ETS-as-buyer?
• What are the Treaty implications - particularly for forest land that was part of existing Treaty settlements, but also for land-use flexibility going forward.
• Deforestation & harvesting - if forestry stays in the ETS for a long time, high ETS prices will deter deforestation and harvesting (for forests operating on a stock-change basis). This risks "saving up" deforestation until settings change.
• How to strike a price for annual purchase of carbon removals outside the ETS, and how to best structure up-front and/or ongoing biodiversity incentives alongside this.

Opportunities

• Separation of forestry and ETS prices/volumes allows for policy in forestry and emitting sectors to be optimised separately, and not fight against one another. For forestry, it allows consideration of what values we want to financially reward, and what level of land-use flexibility we want to maintain. For the ETS emitting sectors, it allows a stronger focus on driving gross emission reductions.
• There is potential to better align forest settings with aspirations of Māori (but also risk of failing to do so).
• Allows for consideration of alternative agricultural emissions offsetting models (e.g. upcoming PCE report)
• It provides the option to reconsider the accounting basis for forestry in our targets, i.e. should <all> forests be counted in NZ's pathway to net-zero, not just the subset currently included in our target accounting framework? This would still be a challenging change to make, but it would be easier if not entangled with ETS settings.

Alternative approaches?

There are many potential other ways to shift the relative incentives for gross emission reductions and increased forestry. Here are a couple of examples - I would hope that when the government eventually releases its proposals it will look across a range of supply and demand options.

• ETS emitters could be allowed to use forestry units for a small percentage of their obligation (with auction volume decreased to accomodate this). Given that there will still be need for forestry beyond this amount for use toward Budgets and the NDC, I see this as only adding unnecessary complexity: the "outside ETS" channel for forestry support still needs to be designed.
• A "two for one" requirement for use of forestry units in the ETS, which would more or less halve the value of forestry units. I don't support this kind of approach as there's a fundamental logic in ETS systems that a tonne is a tonne - if you start using multipliers it gets very hard to match up to targets. In this case, NZ would still count each forestry unit as one tonne toward domestic and international targets (which are measured through the emissions inventory) so there would be a major mis-match with ETS settings that would not be transparent. More fundamentally, there's not particular reason why "half the ETS price" is the right value for forestry removals.

Conclusion

I am increasingly of the view that the ETS shouldn't be in the business of incenvitising forestry at all - the ETS should focus on the elimination of fossil fuel emissions. The "right" level of forestry contribution to New Zealand's climate pathways is a separate question. The carbon and biodiversity values of forests should be rewarded, but in a way that is additional to, not instead of, reducing fossil fuels. This post proposes one possible way forward.