Part 3: Aligning NZ’s ETS/Budgets/NDC… numbers & consequences

This is the final part of a three-part series on aligning ETS supply settings with New Zealand’s domestic emissions budgets and NDC. Part 1 explained New Zealand’s NDC, and what needs to be done to achieve it. Part 2 looked at the requirements of the Climate Change Response Act for making ETS settings, and options for meeting those requirements. This article will look at some numbers, and summarise what I think the Climate Change Commission and government need to do later this year in recommending and making ETS settings.

Show me the numbers!

The scenarios I show here are to illustrate the concept not to provide exact numbers/precise tonnes. ?I’ve had to pull from different public datasets so there will be inconsistencies, and I’ve made a number of assumptions (detailed at the end of the article). Different assumptions/approaches would give different numbers, in particular the government’s choices around NDC management.

The figure below shows scenarios for ETS units supply for the time period 2023-27, for which the government will make ETS settings this year. In the figure you’ll see for each year:

·????????Free allocation of units to emissions-intensive industries (green), which I’ve shown as unchanged from that in last year’s consultation on ETS settings. Less free allocation than this would allow more auctioning.

·????????A quantity of units withheld from auctioning to encourage use of the large stockpile of banked allowances in the NZ ETS (yellow), unchanged from the current 5.4Mt/yr.

·????????Auctioned units authorising emissions at levels consistent with the NDC (orange) and auctioned units that authorise emissions above NDC-consistent levels (grey). The grey quantity would need to be internationally backed or replaced by approved overseas units.

The figure shows two scenarios: in (a) on the left, all the effort to meet the NDC (& hence all need for international balancing of emissions above NDC-consistent levels) is assumed to occur in sectors covered by the ETS, while in (b) on the right, around half of the NDC effort is associated with the agriculture sector. Naturally, NDC-consistent emissions in ETS sectors can be higher in (b) where some of the NDC effort is picked up by (or on behalf of) the agriculture sector.

Scenarios (a) and (b) are both consistent with the domestic emissions budgets, because total unit supply (including the assumed use of stockpile) is equal to domestic emissions levels consistent with the domestic budgets (blue line).

For these assumptions, over the five years 2023-27 around 60% of all auctioned ETS units in (a), and 30% of auctioned units in (b) would need to be internationally backed or replaced by overseas units. Putting it another way, up to twice as many units would be auctioned than is consistent with the NDC: clearly inconsistent with the NDC unless the international backing is done.

In the previous article, I discussed the fact that international units that can be counted toward the NDC are not yet available (or at least not yet contracted), so the government is not in a position yet to do this international backing and/or replacement with overseas units in the ETS. I suggested two interim approaches to keep ETS settings on track with the NDC nonetheless:

1.??????Keep ETS auctioning at planned levels for now, and do the international purchase later. To implement this, the government would need to track how many emissions are being allowed each year (i.e. how many units have been auctioned) above NDC-consistent levels out to 2027, make financial provision to cover these internationally, and have a credible plan to make the purchases. I would note that the cost of meeting the NDC is not currently reflected in the Crown accounts (hoping to see improvement in this in Budget 2022!) For scale, if it takes until 2025 before any international purchasing/overseas units were to happen, the government could already have a backlog of 30-40Mt to cover (17-20Mt for 2021-22, and 13-20Mt for 2023-24 by my quick estimate), in addition to having to purchase to cover emissions above NDC-consistent levels (or allow overseas units into the ETS) every year from 2025 onwards.

2.??????Reduce the level of auctioning to NDC-consistent levels until international market arrangements are put in place. This would mean that ETS companies are reliant on use of banked stockpile units in the interim. I have sketched this scenario below: although auctioning is reduced temporarily, domestic emissions can continue, covered by increased use of banked stockpile units, and auctioning increases later (or overseas units are allowed into the ETS) so that the total unit supply over the NDC period to 2030 is unchanged. This would impact on the functioning of the ETS in the short term, but would give more certainty over achievement of the NDC.

Climate Change Commission advice & government decisions in 2022

The Climate Change Commission does not have a specific statutory role to advise the government on how to manage New Zealand’s NDC. As such the Commission may take a view that it shouldn’t pre-empt government decisions on NDC strategy, and as a result may not be willing to quantity the level of emissions in ETS sectors that is/isn’t consistent with the NDC – leaving the NDC management questions for the government.

However this does not mean that the Commission can ignore the NDC: it must still make recommendations to the government that it views as being in accordance with the emissions budgets and the NDC. Recommending ETS settings based only on the domestic budgets could result in units being auctioned at around twice the level consistent with the NDC, or around 30-50Mt extra over the 2023-27 period. Without international balancing, that is not consistent with the NDC. It would also be giving ETS participants a false impression of the market’s future: we know now that overseas units and/or international balancing will be needed, and that should be signalled to the market.

My guess is that the Commission might recommend a process (rather than specific numbers), and highlight the set of decisions that the government needs to take. As part of this, it could go further and provide an example calculation to illustrate that process. And it could also provide advice on which of the interim approaches I’ve suggested above (or another) it views as best meeting the requirements of the legislation until international arrangements are in place.

The government has work to do. To make ETS settings consistent the requirements in the Act it will need to make some basic decisions on NDC management: including the “trajectory” for tracking progress, how effort is seen as being shared between sectors, what level of domestic over-achievement will be targeted in the period to 2027, and how the cost-containment reserve and stockpile use interface with NDC achievement. ?The ETS price settings (not discussed in these articles) might also logically be made in reference to international purchase prices. ?

This year’s ETS settings run through to 2027: this is 70% of the way through the NDC budget period. It’s simply not credible to push this out another year and pretend that 2023-27 settings could be made without reference to the NDC. ??

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Post-script 1: What about the cost containment reserve?

In my view the annual cost containment reserve volume should be set much lower than the current 7Mt/yr, because it CCR should be seen as an emergency reserve that kicks in only if it is much more expensive for ETS participants to get from a BAU path to the Budgets pathway than anticipated. The average difference in emissions between the BAU and Budgets pathway in ETS-covered sectors for the 2021-2030 period is around 5MT/annum, so allowing more than 5Mt/annum in the CCR is actually providing enough extra units to allow emissions to be <above> BAU levels if the CCR were triggered each year. ETS settings should be requiring below-BAU change, so only a fraction of the 5Mt should be in the CCR (e.g. something like 1-2Mt/yr). At that level, if the CCR were triggered it would mean less drawdown of the stockpile in that year, but not no drawdown. In the figures I’ve presented above, you can think of the “stockpile drawdown” area as actually being “stockpile drawdown and/or CCR”, as long as the CCR volume is small. The international backing being carried out in these scenarios allows for 5.4Mt/yr of stockpile drawdown being backed – some of this could equivalently be CCR volume being backed.

Post-script 2: What if emissions are above the level of the domestic budgets?

ETS participants are free to emit more than is consistent with the domestic budgets and NDC (i.e. above the blue line in the graphs), and comply with their ETS obligations by using banked units to cover the excess emissions. Their only obligation in the ETS is to surrender one unit for every tonne of emissions. This creates a mis-match: use of banked units counts toward ETS obligations, but does not count toward the Budget or NDC (which are assessed based on actual emissions/removals over the time period). If emissions in ETS sectors are higher than the budget levels, the government would need to purchase <further> international units to cover this further excess in order to meet the NDC. Whether this would also be seen as meeting the Budgets is an open question – the Commission has recommended no use of offshore units toward the Budgets (i.e. that domestic emissions should not be above the blue line). Whether the government would allow itself more flexibility will presumably be announced as part of the Emissions Reduction Plan in May.

In terms of paying for any extra excess there is a helpful coincidence: the stockpile of banked ETS units is currently treated as a liability in the Crown accounts, so if companies emit more and surrender more banked units, this (perhaps perversely) has a positive impact on the Crown’s balance sheet. That could then offset the cost of the extra international purchasing needed to meet the NDC.

Post-script 3: Assumptions & Data Sources

Assumptions:

• Agricultural methane and nitrous oxide remain outside the ETS, only to simplify the picture shown for the ETS sectors. I also assume that agricultural emissions are reduced in line with the Climate Change Commission’s “demonstration path”, which was used to recommend domestic budgets. Assuming this rate of reduction actually allows for slightly more emissions within the ETS than at present, because the current ETS methodology assumes agricultural emissions continue at <projected> levels.
• Free allocation continues at previously-calculated rates. The government has signalled intention to tighten up free allocation and has already reduced allocation to the Tiwai Point aluminium smelter, so we should expect to see these numbers go down when this year’s proposed ETS settings come out. Lower free allocation would allow more auctioning.
• Continuing to reduce auction volume by an average of 5.4Mt/yr from 2023 to 2030, to encourage use of the stockpile of banked allowances. I have not tried to specifically calculate the “right” level of drawdown – again, this is an illustrative assumption. The ETS will not function properly until the stockpile is reduced, so I see stockpile draw-down as a key element of ETS settings, and one that should not be traded off against e.g. use of the cost containment reserve.
• I have used the sum of agricultural methane and nitrous oxide as a rough estimate of total net emissions “outside” the ETS. In reality there are other emissions outside the ETS (some waste, synthetic gases) but also some forestry removals not in the ETS. At present, these other emissions and removals come close to matching each other (within ~<0.5Mt/yr) so ignoring these works ok in making a rough estimate of emissions covered by the ETS.

Data sources:

·????????The Ministry for the Environment’s projections for total gross and net (target accounting) emissions. https://environment.govt.nz/what-government-is-doing/areas-of-work/climate-change/emissions-reduction-targets/new-zealands-projected-greenhouse-gas-emissions-to-2050/

·????????The “forestry adjusted demonstration pathway” from the data tables released alongside the NDC announcement https://environment.govt.nz/what-government-is-doing/areas-of-work/climate-change/nationally-determined-contribution/ , for projections of removals in the domestic pathway used to calculate the domestic emissions budgets, and for the 2005 gross emissions figure that was used to calculate the NDC.

·????????The Climate Change Commission’s final advice dataset https://ccc-production-media.s3.ap-southeast-2.amazonaws.com/public/Inaia-tonu-nei-a-low-emissions-future-for-Aotearoa/Modelling-files/Scenarios-dataset-2021-final-advice.xlsx for more detailed projections by sector and gas. These are in AR4 GWPs, but I converted agricultural methane and nitrous oxide to AR5 GWPs in the estimate of emissions “outside” the ETS.

·????????MfE’s 2021 consultation on ETS settings https://consult.environment.govt.nz/comms/proposed-nz-ets-changes2021/ , for numbers on free allocation, and for information on emissions inside/outside the ETS. I did not use the inside/outside numbers directly, but as a cross-check of my estimate of agricultural CH4+N20 being roughly the same as total net emissions outside the ETS.

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