Climate Change Minister James Shaw rang the NZX bell in Wellington to mark the start of the first ever auction of carbon credits under the Emissions Trading Scheme.

By noon that day, some 40 participants had submitted bids for 11 million credits and a total of 4.75 million were auctioned off at a price of $36 per unit.

To just about anyone who isn’t one of those 40 market participants, that may have sounded like a bunch of gibberish. Despite being one of New Zealand’s most important tools for reducing emissions, the Emissions Trading Scheme (ETS) is horribly complex and poorly understood.

Given that it is likely to play an increasingly prominent role in the effort to combat climate change – expected to be solely responsible for a 15 percent decrease in emissions by 2035 – and be subject to a correspondingly larger degree of public attention, Newsroom has written this explainer to help our readers understand what the ETS is and how it works.

The basics

In some countries, emissions trading schemes are called cap-and-trade schemes, and that might be a better name. The rough idea is that a certain number of carbon credits – in our ETS, they’re called New Zealand Units (NZUs) – are available to trade between polluters. For every tonne of emissions that a polluter releases in a year, they have to surrender a carbon credit back to the government.

Capping the total number of credits in the system caps the allowable amount of emissions in any given year. If there are too few credits for the expected emissions, the price of each credit will rise according to the basic rules of supply and demand, and polluters will decide whether they want to fork out the cash for a credit or whether it would be more economical to stop emitting (via decarbonising the polluting processes or closing up shop). 

Who’s included?

Polluters required to surrender NZUs for their emissions are as high in the production chain as possible. For example, while you and I driving our cars are responsible for greenhouse gas emissions, were are not required to purchase carbon credits or surrender them to the government. Instead, the companies that import petrol to New Zealand are responsible under the ETS – although they pass the cost on to consumers.

Under current regulations, every sector of the economy except for agriculture is counted in the ETS. Agriculture is scheduled to enter the scheme (or face some other form of carbon price) in 2025 at the latest, and a review of the sector’s progress towards pricing is scheduled for next year.

However, it hasn’t always been this way. Initially, only forestry was part of the ETS. The rest of the economy was scheduled to enter in a staged manner, but this was delayed when National neutered the scheme in 2009. Eventually, the waste, energy (including transport) and industry sectors did enter the ETS, but agriculture’s entry date was postponed indefinitely by National.

How do polluters get units?

There are five ways a given participant might acquire NZUs. The first is via the auction mechanism which debuted last Wednesday, March 17. 

In quarterly auctions, the Government will offer a set number of units for sale – currently 4.75 million per auction. There’s a price floor (currently $20) and an effective ceiling, which would see millions more credits released during an auction if the threshold (currently $50) is crossed, to reduce the price. Over the course of three hours on an auction day, participants submit online bids, which are then ranked in order from highest to lowest. The first 4.75 million units worth of bids are successful and all successful bids are paid at the final clearing price, the price of the lowest successful bid.

Just days ahead of the first auction, the Government also changed the law to enable Shaw to set a methodology to determine a secret reserve price, without which the market was subject to manipulation.

Wednesday’s auction saw 408 bids from 40 participants seeking, in total, 11,626,500 NZUs. As the clearing price of $36 fell well below the effective ceiling price (called the cost containment reserve), just 4.75 million units were actually auctioned off to 30 successful bidders.

The second way that emitters can obtain NZUs is via free allocation. Certain ETS participants receive a free allocation of up to 90 percent of their expected emissions in NZUs from the Government. This is to ensure that these participants are not disadvantaged when exporting products and competing with companies in jurisdictions without a carbon price. In the worst case scenario, being subject to the full brunt of the ETS could see emitters close up shop in New Zealand and a new, dirtier emitter start up somewhere without a carbon price.

These select businesses, known as emissions intensive and trade exposed (EITE) entities, receive millions of free units from the Government every year. A 2019 Stuff analysis found just four companies – the Tiwai Point aluminium smelter, the Glenbrook steel mill, Methanex and Fletcher Building’s cement arm – receive three quarters of free allocation. Reforms to the ETS in 2020 that introduced auctioning also began to phase out these free units, but at a glacial rate of 1 percent a year for the next decade, then 2 percent a year through the 2030s and 3 percent a year until 2050.

Moreover, if agriculture enters the ETS, it too is likely to receive a free allocation of up to 95 percent.

The third option for buying units is to purchase them on the secondary market. Any company that owns NZUs can sell them to another participant at an agreed-upon price. This is meant to be the main mechanism of the ETS, as the laws of supply and demand will see scant units rise in price on the secondary market. Indeed, the carbon price has risen dramatically since the 2020 reforms from around $25 per NZU to just shy of $40 today.

Fourthly, anyone can receive NZUs if they can prove they have sequestered a corresponding amount of CO2 from the atmosphere. These largely applies to big forestry operators who can “create” NZUs as their trees suck up carbon and then sell those NZUs on the secondary market for a profit. When they cut down their plantation forests, however, these companies will have to surrender some units back to the government for the carbon the decaying trees will release.

Forestry companies aren’t the only entities that can receive NZUs through sequestration, however. There is a role for other landowners will significant forest stocks, like farmers, to receive some NZUs for their sequestration. This could help offset the cost of agriculture entering the ETS.

If we’re getting real technical, some experts say only NZUs earned from sequestration are true “carbon credits”, because they represent a real offset or reduction in emissions. NZUs obtained by other methods represent allowable emissions but not a decline in greenhouse gases.

Finally, emitters can also purchase units from the government at a fixed price, which has long been $25. The availability of an unlimited supply of units at a certain price has meant that the price on the secondary market flatlined at $25 for the better part of a decade. The 2020 reforms, however, indicated that the fixed price option would be eliminated in May of this year. It was also increased to $35, which partially prompted the recent spike in the price of carbon.

What is the ETS cap?

For the bulk of its existence, New Zealand’s ETS has been a cap-and-trade scheme without a cap. The fixed price option allowed unlimited units to flow into the market, which meant there was never a cap on emissions. In essence, the ETS was a complex and piecemeal carbon tax of $25 per tonne on certain emitting activities.

The 2020 reforms, however, set a harder cap in place. Now, the number of allowable NZUs is based on emissions budgets for successive five-year periods. These budgets are recommended by the Climate Change Commission – which delivered its first draft recommendations in January – and adopted by the Government.

For example, the Commission’s draft budget for the period 2026 to 2030 is 290.2 million tonnes. That means 58.04 million tonnes would be available under the ETS in each year of that period. Some of these would be given away to emitters in the form of free allocations. Others might be cancelled entirely for sectors that aren’t subject to the ETS – so, for example, just over half of the current provisional budget for 2021 is disregarded because agriculture is not yet in the ETS.

The remainder will be auctioned off at the quarterly ETS auctions. After that, the system is a closed market, in which new units are only introduced through carbon removal activity like planted trees.

Will it make a difference?

A 2019 report on New Zealand’s emissions found that the ETS would have the single greatest impact on emissions of any policy announced to date. However, there is wide agreement among policy-makers, experts and officials (outside of Treasury) that the ETS alone won’t get us to our targets.

While it theoretically could on its own meet our various targets, if the price ceiling was removed and the carbon price was allowed to skyrocket, the non-fiscal impacts of that could be significant. It would involve replacing nearly all of New Zealand’s sheep and beef farms with plantation forestry.

Moreover, such a solution wouldn’t be sustainable – eventually forest ecosystems become saturated with carbon and offer diminishing returns. That means that a strategy relying solely on forestry offsets and not on emissions reductions would see hectare after hectare planted until we ran out of land.

“There is no chance. No chance – zilch – that you’ll do it just with the ETS,” Shaw told Newsroom last year.

“What has previously been described by Treasury as ‘complementary measures’ are actually – you need to do everything. You need to pull every single lever you have.”
– James Shaw, Climate Change Minister

“And I think that’s a significant shift in thinking. If you went back even to the last government frankly, if you went back to the 2000s, the market purists would say, ‘All you need to do is get the price right and change will happen’. Every country where change has actually happened, the emissions price – whether it was an ETS or a carbon tax – has been part of the solution, but often at the margins. In the UK, they think that the ETS played about a 10 percent role,” he said.

“What has previously been described by Treasury as ‘complementary measures’ are actually – you need to do everything. You need to pull every single lever you have.”

The Climate Change Commission came to the same conclusion.

“The Emissions Trading Scheme alone won’t get us to where we need to be. Action is needed across all sectors of the economy,” the Commission wrote in its draft advice.

“Under current policy settings, the scale of afforestation that is expected to occur would in large part be driven by the emissions price in the Emissions Trading Scheme. Wholesale or large conversions of sheep and beef farmland to forestry would impact communities and reduce employment in the immediate area as forestry-related work is likely to be more concentrated in larger rural towns, particularly those involved in processing.”

What’s next for the ETS?

The ETS is now set up to continue with few further modifications, the Government says. The next big change will be the Government’s decision on emissions budgets, which will then filter down to setting the cap on the ETS.

Next year will also see a review of the progress towards pricing agricultural emissions by the Climate Change Commission. Emissions from livestock could be forced into the ETS then, if not enough progress has been made to reduce emissions independently, or more details around how pricing will work in 2025 could be released.

The Commission’s draft advice also offered suggestions for further changes to the carbon market. These included a higher price floor and threshold for the cost containment reserve. As it stands, both the floor and the reserve are set to increase by 2 percent a year. But the Commission wants to see the floor set at $30 immediately and increase by 5 percent a year plus inflation, while the effective ceiling would be upgraded to $70 and increased by 10 percent a year, plus inflation.

“The price corridor they signal should be sufficiently wide to allow price discovery by the market to occur and factor in inflation to prevent the price levels from eroding in real terms,” the Commission wrote.

The draft advice also raised concerns that the ETS over-incentivises forestry offsets and doesn’t do enough to make gross emissions reductions worthwhile.

“Current NZ ETS settings may incentivise more large-scale pine plantations than is desired to meet 2050 targets and could lead to forestry displacing gross emissions reductions,” the Commission found.

“This approach would fail to drive meaningful decarbonisation and instead use up land resources for the purpose of offsetting avoidable emissions. This is not sustainable and would leave the next generation with the task of reducing gross emissions at the same time as they will need to be adapting to escalating climate change impact.”

Marc Daalder is a senior political reporter based in Wellington who covers climate change, health, energy and violent extremism. Twitter/Bluesky: @marcdaalder

Leave a comment