The Government is rushing to fix a gaping loophole that exposes New Zealand’s carbon market, the Emissions Trading Scheme, to major market manipulation
The Government is exposed to $360 million in financial risk over the next year due to a loophole in the rules governing New Zealand’s carbon market, the Emissions Trading Scheme.
The existence of that hole is a result of an error in the drafting instructions sent to the Parliamentary Counsel Office when the Scheme (ETS) was amended last year, Climate Change Minister James Shaw told Newsroom.
Although Shaw was initially advised that the risk to Crown accounts was low, he said media attention around the loophole meant that advice had changed. Now, the Government has introduced an amendment to Parliament under urgency, set to pass ahead of the first ETS auction on March 17 – at which the Government could lose out on up to $90 million.
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Under the ETS, polluters must surrender one carbon credit – officially called New Zealand Units (NZU) – to the Government for every tonne of emissions they release.
Some industries, like agriculture, are completely exempted from the ETS. Others earn steep discounts, receiving up to 90 percent of their NZUs from the Government free every year. Moreover, until recently NZUs could be bought and sold on the secondary market or bought directly from the Government at $25 per credit.
While the goal of the ETS is to reduce emissions through making it more expensive to pollute, these exemptions have meant it has had a limited impact. With an effective cap of $25 per credit, the carbon price has remained flat for more than a decade. In an effort to put teeth back into the ETS, the Government completely overhauled it last year.
Now, there is a limited supply of credits available for purchase, based on the emissions budgets the Government has set for how much can be emitted over successive five-year blocks. Credits can now only be purchased from the Government at quarterly auctions and the fixed-price option has been eliminated. There is a price floor for the auctions (currently $20) and a reserve of credits ready to be released if the price rises above a certain level ($50) – effectively, a ceiling.
Ahead of the first auction on March 17, the Government has also bumped up the fixed price option to $35 per NZU. In anticipation of more flexibility in the carbon price, second-hand trading has inflated the cost of emitting a tonne of carbon to record-high levels. Currently, an NZU can be purchased for around $39, according to specialist publication Carbon News.
Under the new rules, ETS market participants will submit bids at or above $20. If bids are submitted for more than the 4.75 million units on auction in each of the four auctions this year, the lowest bids are tossed out. Then, the price the successful bidders will pay is the lowest from the bids that were accepted – called the final clearing price.
Confidential reserve price
In March 2020, when considering the ETS overhaul, Cabinet also approved the creation of a confidential reserve price – a secret price floor which only the Government would know the value of, to avoid market manipulation.
In explaining the concept, Shaw compares it to auctioning a house. While you might start bidding at $800,000, there will always be a reserve price (say $875,000) that the bidding must reach or else the sale won’t go through. Only the auctioneer and the seller would know what the price is, however.
In the context of the ETS, the methodology for calculating the confidential reserve price would be set by the Climate Change Minister (in consultation with the Finance Minister) ahead of each auction. If the final clearing price is below the confidential reserve price, the auction is effectively cancelled and no units are sold.
Without the confidential reserve price, the auction could easily be manipulated. If enough participants bid at the price floor of $20, then all 4.75 million units could be sold by the Government for $20 each – and then resold by the bidders on the secondary market for around the current carbon price of $39 per NZU. In other words, the Government could lose out on up to $90 million each auction this year.
A confidential reserve price would reduce this risk, however, because it would almost certainly be set above the price floor of $20 and would therefore incentivise participants to bid high enough to clear what they think the likely reserve price would be.
If Cabinet agreed to the confidential reserve price, why wasn’t it in the ETS legislation passed last year? Shaw told Newsroom that the instructions on how to draft the laws which were sent to the Parliamentary Counsel Office, the arm of Parliament which writes legislation, were missing the instruction to create a confidential reserve price.
“There was essentially an error in the drafting process. Cabinet had actually already signed off on the idea that there would be a confidential reserve price. It was in the original package as a Cabinet decision. But then the way the legislation ended up getting passed is it actually omitted to allow for the creation of a confidential reserve price,” he said.
“I wouldn’t want to put anyone wrong with the specifics but I think there was an omission in the way that the drafting instructions got to PCO. I don’t think PCO made an error in drafting it because they were drafting according to the instructions that they had received, but there was something missing there.”
Cabinet papers and advice published since the error shed little light on how this mistake occurred. Ministry for the Environment (MfE) officials referred to it only as “an issue in the development of the Act”.
After the error was discovered last year, Shaw initially declined to amend the legislation. Officials determined that the issue could be fixed whenever the ETS was next naturally amended.
“There is a risk that without a technical reserve price, the clearing price for an auction may be significantly lower than the prevailing secondary market price. Officials advise me this risk is low, and that auctions are likely to still clear in line with recent secondary market prices,” Shaw reported in September. Plans were drawn up to revisit the issue in Cabinet ahead of the third auction in 2021, meaning any legislation would be unlikely to come into effect before 2022 at the earliest.
Just two months later, however, MfE advised Shaw that the risk was growing.
“The absence of a technical reserve price for NZ ETS auctions poses an increasing risk to the integrity NZ ETS. We seek your agreement to address this risk and take action to enable a technical reserve price prior to the first auction, scheduled for 17 March 2021,” Kate Whitwell, a senior policy analyst at MfE, wrote in a briefing to Shaw on November 12.
“Increasing attention has been given to the lack of a technical reserve price by the media and market commentators, which has greatly increased this risk. It is likely that this public discussion will influence bidder behaviour at auctions and may encourage them to bid at lower prices than they would have otherwise.”
Whitwell said media and political attention on the absence of the reserve price threatened to create a “self-fulfilling prophecy” in which market manipulation would be spurred on by the speculation that market manipulation could occur.
“Market commentators have described the risk as an opportunity to purchase units at prices lower than the secondary market price, sharing this advice with market participants. The more attention that is paid to this issue, the more danger that a “self-fulfilling prophecy” arises because people are encouraged to bid lower in the auction than they otherwise would have done.”
In a paper to Cabinet at the start of December, Shaw outlined the scale of the risk to the Crown’s financial position.
“In financial terms, if the first auction clears significantly below the secondary market price then the difference between the two represents a loss in auction proceeds. For instance, if the secondary market price is $35 then the first auction would be expected to realise approximately $166.25 million. If however, the auction clears significantly below this then the loss could be significant. If the auction cleared at $30 there would be a loss of $23.75 million. If the auction cleared at the price floor (set to $20) then the loss could be $71.25 million,” he wrote.
With a carbon price now $4 higher, that risk is even greater.
Law sent to Parliament under urgency
The amendment to allow the Government to create a confidential reserve price is being passed under urgency. The bill will be in select committee for just a couple of weeks, with a report due back on March 4. The rules will commence on March 15, giving Cabinet time to approve the regulations creating the reserve price (likely that same day) ahead of the March 17 auction.
Scott Simpson, the former climate change spokesperson for the National Party who raised the issue of the Government’s changing position on the risk of auctioning without a reserve price in the House, told Newsroom that National supported the mechanism in principle. “We don’t have any problem with the intent or what’s being achieved or what they’re trying to do.”
However, he had issues with the process the Government had taken and said that if legislation had been introduced to correct the mistake in September, when it was first noticed, parliamentarians would have had more time to consider it.
“It’s not the sort of thing that’s going to bring a government down, but I think there are some process issues about, why the change of positioning? Somebody has obviously decided that the risk is worth proceeding with changing something pretty quickly to get it done. My question is around the process and why it’s being done the way it’s being done, which I personally think is a bit unusual.”
Moreover, he said he wasn’t sure whether the power to set the price should be centralised in the Minister’s office or whether some sort of independent review board or oversight panel might be needed.
“Is the Minister the right person to be setting the reserve? The Minister is effectively setting a secret tax, because the Minister and the Minister alone is setting the reserve price.”
National voted for the first reading of the bill, along with Labour, the Greens and the Māori Party. Only the ACT Party voted against it.