Decarbonising will be New Zealand’s biggest mission over the next 30 years. Whether we get it right is crucial to our economy and the planet. Marc Daalder takes a look at the arguments that we’re over-thinking our response and that just one policy is needed to reach net zero emissions.

ANALYSIS: When the Climate Change Commission’s draft advice landed in late January, it offered up a raft of ambitious policies to reduce emissions: Stop importing fossil fuel vehicles from as early as 2030, ban new connections to the natural gas grid from 2025, subsidise electric vehicles, set a renewable energy target, regulate emissions from farms.

In response, the Opposition said that only one policy is needed to reduce emissions sufficiently: The Emissions Trading Scheme (ETS).

What is the ETS? Newsroom’s Emissions Trading Scheme explainer

The country’s carbon market covers all parts of the economy other than agriculture and caps the amount these sectors can emit in a given year. By releasing a limited number of carbon credits or New Zealand Units (NZUs) into the market, the ETS puts a price on carbon. As the cap is lowered and emissions are made to fall, that price will rise.

On the face of it, once agriculture is included in the scheme, the ETS could be the sole tool needed for reducing emissions. But is it that simple?

A bit of history

To understand the issues at play, we’ll need to know the history of the scheme.

Legislation establishing the ETS was passed just prior to the 2008 election. Labour’s ETS would have progressively introduced industries, beginning with forestry in 2008 and ending with the primary sector in 2013. A set number of units would be auctioned, vulnerable industries would receive an additional allocation of free credits (to be phased out from 2019) and emitters would otherwise be forced to reduce emissions, offset emissions themselves or purchase offsets from the international, Kyoto-era carbon market.

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When National came to power after the 2008 election, it gutted the ETS. Entry of agriculture was delayed indefinitely, as was any cap. Instead, an infinite number of NZUs were available for purchase from the Government, at a price of $25 per unit – and each unit was now worth two tonnes of emissions.

This was no longer a cap-and-trade scheme, but a very low carbon tax of $12.50 a tonne that wasn’t indexed to inflation and applied to less than half of the country’s emissions.

In 2010, the ETS was responsible for abating 703,000 tonnes via incentivising afforestation and blocking deforestation. That fell to 513,000 tonnes in 2015, before rising to nearly two million in 2017. 

In legislation introduced in late 2019 and passed in mid-2020, the Government attempted to undo its predecessor’s amendments. Agriculture is now slated to face some sort of emissions price by 2025, with a backstop of entering the ETS if required. The fixed price option has been abolished, leaving only three ways for units to enter the market: Government allocations (currently being phased out), the generation of carbon credits through sequestration, and quarterly government auctions. By limiting the number of units to be auctioned and the number of units it allocates, the Government has placed an effective cap on emissions from sectors covered by the scheme.

That cap will be set in relation to the emissions budgets that the Government adopts, which are likely to closely resemble the recommended budgets provided by the Climate Change Commission in its final advice.

The waterbed effect

Since the reforms came into effect, the carbon price has surged after languishing below $30 a unit for 12 years. On the day the commission released its final advice, June 9, the market price for an NZU cracked the $40 mark for the first time ever.

However, the more significant impact of the reforms has been that addition of a hard cap on emissions covered by the ETS. Prior to this cap, emissions had continued to rise and climate policies were needed to drive them back down. Now, however, some contend that most additional climate policies won’t lead to additional emissions reductions.

Take the feebate scheme as an example. The Government says it will reduce emissions by 9.2 million tonnes over the course of the next three decades.

The Opposition has cried foul, saying that any emissions avoided in the transport sector as a result of the policy to incentivise electric vehicle uptake and make high-emitting vehicles more expensive would simply be available within the cap for another emitter instead.

“The current policy of the feebate scheme is an example of types of policies that the commission had recommended in their report which actually do not lower emissions at all,” says Stuart Smith, National’s climate change spokesperson.

National Party climate change spokesperson Stuart Smith. Photo: Lynn Grieveson

This is called the waterbed effect. Pushing down on emissions in one sector covered by the cap, via an additional policy, redistributes the ability to emit to other sectors within the ETS. At most, the theory goes, such policies serve only to reduce the carbon price by reducing demand for NZUs. That could be seen as subsidising emitters within the ETS, without any effect on overall emissions.

At the same time, no one holds that there is no need for complementary policies. 

“I think there will be times when policies will need to be introduced to deal with particular issues of equity,” Smith says. And his colleague, Michael Woodhouse, has said the party supports incentives for EVs.

“The argument is not that you just only do ETS and never do anything else,” Matt Burgess, a senior economist at the New Zealand Initiative think tank, told Newsroom. Burgess and the NZI’s chief economist Eric Crampton have been outspoken over the need to think more carefully about climate policy in light of the ETS cap.

“You make the case for doing other things policy-by-policy, taking into account the ETS, so that policies have the opportunity to add value. They can add value if there’s a market failure that means the ETS isn’t working as well as it could.”

Market failures?

The disagreement here is partially one of scope. While most agree that the ETS has a major potential to reduce emissions and almost everyone agrees that some additional policies are still needed, the point of difference relates to the amount and scale of complementary work needed and the reasons why. (Everyone also agrees that the ETS will do little to reduce biogenic methane and agricultural emissions, which are not covered by the scheme). 

“I think at the end of the day we’re all pragmatists and the real debate to be had is around when a complementary policy is appropriate and on what grounds it should be appropriate and to what extent cost-effectiveness should dominate over other considerations,” David Hall, a senior researcher in politics at AUT’s The Policy Observatory, told Newsroom.

Advocates of greater government intervention say there are many market failures or barriers to decarbonising that the ETS might not affect.

“You need a mix of tools and you need the right combination of tools to achieve this transformation, rather than just minimal cost optimisation,” says Ivan Diaz-Rainey, an associate professor in finance at the University of Otago and the leader of the university’s Climate and Energy Finance Group.

The feebate scheme could be one of those.

“The Clean Car Discount and the ETS work in a complementary manner,” Climate Change Minister James Shaw insists.

Climate Change Minister James Shaw. Photo: Lynn Grieveson

“The barrier and the reason why New Zealand is lagging behind other developed countries in terms of the uptake of electric vehicles and low emission vehicles is because, in our market, New Zealanders buy their cars, we don’t lease them, and we tend to buy vehicles that are very cheap up front but with high running costs. An EV is the other way around – it’s expensive to buy up-front and then cheap running costs.

“The ETS affects the price of petrol, so it drives up the running cost, but it doesn’t do anything to affect the up-front cost of the vehicle, which is one of the main barriers of uptake. The ETS sends a price signal that an internal combustion engine vehicle is expensive to run and that improves even further the economics of the operating costs of an EV. But it doesn’t solve the barrier to uptake, which is the up-front costs of the vehicle and the Clean Car Discount does that. That sends a price signal in a different and, in fact, the most important part of the purchasing decision.”

“I think carbon prices have a role. But these are people that just see the real world like economic models.”
– Ivan Diaz-Rainey, University of Otago

This argument rankles Crampton, who says this isn’t a market failure by any means.

“EVs having a higher capital cost than petrol vehicles isn’t a market failure by any economist’s definition of the term,” he says.

“If you go to any car dealership’s website, they will offer you financing terms. Credit markets exist in these. They turn the up-front capital costs into a monthly payment. That monthly payment will be higher than a petrol vehicle, but you’ll be paying less in fuel costs.”

Consumer choices

Market failure or not, EV subsidy advocates respond, clearly more needs to be done to incentivise uptake. The Climate Change Commission estimates that next year, the whole-of-life costs of an EV will fall below that of an internal combustion engine (ICE) vehicle. That’s not expected to lead to a sudden surge in purchases of clean cars, however.

Neither is the fact that petrol prices are likely to rise alongside the carbon price (which currently makes up 10 cents in every litre) and reducing demand. By 2035, the commission found, the price of petrol could be up 30 cents. Someone buying a new car today could still well be driving that ICE in 14 years’ time and they probably aren’t thinking about what the price of an NZU will be in a decade.

However, Crampton says consumers are smart enough to make the right decision if they’re fully informed.

“The Climate Commission pointed to potential information failures that people might not appreciate the ongoing running costs of petrol vehicles compared to EVs. Well, if that’s the case, there’s a really simple solution for that,” he says.

“We already have stickers on car windows that advertise their annual running costs. It would be easy to update those stickers saying, here’s the annual running cost in five years when we expect the ETS price to be, what, $80? Here’s your expected path on running costs, make your decision.”

A man fills a ute with diesel. Photo: Lynn Grieveson

Diaz-Rainey thinks that takes an overly optimistic view of consumers’ decision-making.

“That’s just nonsense really. I did a lot of work on choosing policy tools. You can assume firms generally make reasonably rational decisions. But individuals? We can barely understand interest rates on a loan agreement,” he says.

“Consumers, actually if you ask them – and we did this with focus groups for [European energy mogul] E.ON – they want people to take the bad choices away. We heard this repeatedly in focus groups. Take the bad choices away and just leave reasonable choices. Within that, provide good information and provide incentives.”

The real world is just more complicated than that, Diaz-Rainey says.

“Their position comes from a fairly market fundamentalist perspective. That would be my view of it. And I’m a markets guy and I believe in markets. I think carbon prices have a role. But these are people that just see the real world like economic models.”

This is another key point of disagreement. Where advocates of the ETS think the simplicity of the scheme is its beauty, complementary policy supporters say that simplicity doesn’t fit into the real world.

Back to the cap

That aside, none of this disagreement on pricing grapples with the reality of the ETS cap. Even if consumers are making the “wrong” decision and buying inefficient ICEs, Crampton says, that won’t affect the overall level of net emissions. Because emissions are capped at a certain level, other abatement opportunities will have to arise.

“You’re literally paying 10, 20, 50 times more for each tonne. Or cutting 2 percent of the emissions per dollar by insisting that emissions need to come down over here rather than over there. It guarantees failure to get to net zero. It’s too hard a target not to be systematic about it.”
– Matt Burgess, NZ Initiative

The Climate Change Commission has a way around this. In a Zoom webinar recorded shortly after the release of the commission’s draft advice, commissioner Catherine Leining (who helped design the ETS all the way back in 2007) suggested that the ETS cap could be moved down in subsequent years to take into account the effect of complementary measures. This helps avoid the waterbed effect.

If the feebate scheme is expected to reduce emissions by 9.2 million tonnes over the next three decades, starting with (as an example) 100,000 tonnes in 2022, then the ETS cap in 2022 could just be lowered by 100,000 tonnes. Although the cap is set in line with the emissions budgets, it can be adjusted from year-to-year as needed, simply by auctioning fewer credits into the market.

Moreover, the commission has set its budgets based on what emission reductions are achievable at this stage. If complementary policies make greater reductions achievable in the near future (because there are now more EVs in the country, or it is easier to cycle to work in Auckland, or coal-fired generators at Huntly have shut down), it can revise its future budgets downwards.

Huntly power station. Photo: Lynn Grieveson

Shaw tells Newsroom he expected this latter mechanism would be the most common way the Government avoids the waterbed effect. But he didn’t rule out lowering the ETS cap from year to year in the event of a major change. If a significant industrial polluter were to suddenly shut up shop, the Government has the option of auctioning fewer credits into the market the next year to account for that, he says.

However, the number of credits in the market would likely be significantly reduced either way, because most big industrials in New Zealand receive as much as 90 percent of their credits as a free allocation from the Government. The disappearance of an emitter of that scale would mean these credits would no longer be freely released into the market, bringing the cap down almost automatically, Shaw says.

In response to all this, Crampton has a simple question. Instead of reducing the ETS cap to account for the impacts of complementary measures, why not just reduce the cap without an additional policy?

“The Government can always just reduce the cap faster anyways without having those policies. If a policy is cost-effective – like, if there is some real market failure underlying things, then it should be able to stack up and show that it reduces emissions at a lower cost than just working through the ETS, then that’d be fine. But otherwise just reducing the cap and letting people adjust to the prices finds the lowest-cost ways of adapting,” he says.

Instead, Burgess is concerned that the commission has entirely abandoned a least-cost approach to reducing emissions.

“This unwillingness to let the chips fall where they may according to what’s most effective and insist that we have to cut emissions in this particular sector actually has a really big penalty with it that I don’t think’s really been understood,” he says.

“You’re literally paying 10, 20, 50 times more for each tonne. Or cutting 2 percent of the emissions per dollar by insisting that emissions need to come down over here rather than over there. It guarantees failure to get to net zero. It’s too hard a target not to be systematic about it.”

And ACT Party leader David Seymour had a different issue with this proposal: He doesn’t believe the cap should be set by the commission’s proposed budgets, but rather in line with actual emissions reductions achieved by our trading partners. He’s quick to clarify that he doesn’t want the cap to be based on the emission reduction targets set by trading partners like the United Kingdom or European Union (who have pledged far greater cuts than New Zealand) but rather on the cuts they actually accomplish.

“All my life, since Kyoto, countries have been setting bold targets that they haven’t reached,” he says.

Meanwhile, Smith lands on the same point as the New Zealand Initiative, when speaking to Newsroom.

“A far more efficient way of dealing with this would be to say, ‘We want to lower emissions by 9.2 million tonnes that we hadn’t planned on, so we’re going to take those certificates out’.”

Stranded assets

To this, advocates of complementary policies say they have other benefits as well, like avoiding stranded assets. New Zealand’s slow uptake of electric vehicles and (soon-to-be-rectified) lack of a vehicle emissions standard could expose us to greater transition costs in the future, feebate defenders say.

A Nissan Leaf charges up. Photo: Lynn Grieveson

Every new ICE bought today is likely to still be on the road in 2035. And under current policies, the Climate Change Commission says, more than half of newly-purchased cars will be ICEs until 2035. Given the average age of a light passenger vehicle is more than 14 years right now, that means tens of thousands of fossil fuel vehicles imported in 2035 could still be driving right up to 2050.

That either locks in emissions, making it more difficult to reach net zero by 2050, or turns hundreds of thousands of fossil fuel vehicles into stranded assets. The commission’s preferred pathway goes some length to avoiding this, with EVs making up half of imports by 2028 due to subsidies and the possibility of a total ban on imports of fossil fuel vehicles by 2035. In other words, by increasing the number of EVs in New Zealand now, even if the carbon price wouldn’t incentivise this on its own, the Government could be ensuring we aren’t stuck with an expensive and dirty fleet that we need to rapidly decarbonise in the 2030s and 2040s.

“I’m a big believer in getting the ETS settings to do the work and the ETS has not been allowed to do its job in most of the 13 years that it’s been in operation.”
– James Shaw, Climate Change Minister

This philosophy comes through elsewhere in the commission’s advice as well. It offers up as one option the possibility of banning new connections to the natural gas grid – this too would make sure that people don’t install expensive gas infrastructure with the hopes of low running costs, which turns out to be an uneconomic decision as gas prices rise 52 percent in two decades.

The ETS also doesn’t get new infrastructure built that allows people to mode-shift, because those sorts of decisions are outside of consumers’ hands.

“The ETS doesn’t build light rail, doesn’t build cycleways, it doesn’t build any of those options. You’ve got to do that in your infrastructure spend so people actually have the choice of mode switch,” Shaw says.

Managing impacts

Finally, there’s a major third reason for complementary policy that almost everyone agrees on – although, again, there’s still a question of scale. That’s managing the impacts of a high carbon price, both in terms of equity and from a social or political perspective.

The commission is explicit in its advice that there is a way to meet New Zealand’s net zero target through, essentially, the ETS alone. With no new policies and a $50 carbon price, net zero is accomplishable through massive planting of exotic forestry, often on land currently used for sheep and beef farming, and with gross long-lived emissions only falling by half a million tonnes. However, this would not be a “sustainable” net zero – by 2065, net emissions would creep back above zero if planting doesn’t continue.

That’s because forestry offsets alone are not a long-term solution to climate change. And such a strategy would be likely to set off major political backlash. Already, the encroachment of plantation forestry on marginal farmland has sparked a movement calling itself 50 Shades of Green, with farmers angered by the desolation such actions have left behind in rural areas and the environmental impact of industrial-scale tree harvesting.

Farmers rally against pine plantations in November 2019. Photo: Lynn Grieveson

But the truth is such an approach is an economical reaction to a high carbon price. Nearly 75 million tonnes of greenhouse gases could be abated through converting sheep and beef farms to exotic forestry, at a cost of $15 per tonne of emissions. So long as the carbon price sits above $15 a tonne, therefore, it’s a no-brainer in purely economic terms.

However, the backlash from the primary sector has meant there’s a political consensus that this isn’t a workable approach. Smith and Seymour both say they expected local government to restrict plantation forestry and that such a move would be important if we really went all-in on the ETS.

Were that to happen, the carbon price would have to rise because cheaper abatement options would have been ruled out. This, in turn, spawns equity issues.

Low-income people, who spend more of their earnings on power and transport, for example, will see their weekly spending rise by nearly twice as much as high-income households, in percentage terms. That’s according to a consultation document from the latest round of ETS reforms, which found a $100 a tonne carbon price would increase the weekly spend of low-income households by 1.3 percent while raising the weekly spend of the highest income households by just 0.5 percent.

Complementary policies could intentionally invoke the waterbed effect by redistributing who pays for the emissions reduced within the ETS cap.

By subsidising home insulation improvements for low-income households, for example, the Government could use taxpayer funds to reduce emissions. Someone else within the ETS could still emit instead, but the Government will have lowered the energy used by those households and therefore helped buffer them against the increased cost of power or gas.

Indeed, much of climate and ETS policy to-date has revolved around managing the impact of a high carbon price, which could be politically damaging to those in power. But without a high price, the ETS has struggled to actually accomplish anything – until the imposition of a cap.

A carbon dividend

Here again, Crampton thinks there’s a simpler solution to these equity issues: a carbon dividend. He and Burgess argue that the money raised by the ETS auctions should be redistributed to households. That could be evenly spread across the country or weighted more towards poorer households or those most likely to face the disproportionate impacts of a higher carbon price.

“You forecast how much money the Government’s going to get, send everyone a cheque at the start of the year saying: ‘We want you to start funding your own transition. We don’t know what’s best for you. Maybe it’s getting an EV, maybe it’s putting better insulation in your house, maybe it’s a million other things that we can’t see’,” Crampton says.

Smith and Seymour told Newsroom they were open to the idea of a carbon dividend. And Shaw pointed out that the Government had announced at this year’s Budget that it will begin to hypothecate the revenue from the ETS for climate-specific policy. He says a carbon dividend was one of the options on the table, but that no decision had been made yet.

That Budget announcement revealed the Government expected to get about $3 billion over the next five years from ETS auctions. Split evenly, that would be about $120 per person per year – maybe not quite enough to fund a transition of the scale Crampton has in mind. But Crampton also wants to see the Government dedicate its own dividends from its 51 percent share in the country’s power generators to this redistributive project,  if a high carbon price feeds back into higher dividends, which would bump up the amount in the pot – as would a higher carbon price in the first place.

Pine plantation in the Remutakas. Photo: Brian Stocks/Flickr

As with the overall reliance on the ETS, however, detractors say the simplicity of this policy could be its greatest weakness.

“The thing about Eric and the New Zealand Initiative is that they take an extremely purist approach. Actually, the world demonstrably just doesn’t work that way,” Shaw says.

Diaz-Rainey says: “It seems theoretically very, very appealing. In a very clean and idealised world, that seems very appealing, but I just don’t see it happening.”

And Diaz-Rainey also says it’s hard to escape the sense that some of those arguing against complementary measures are in fact just advocating for delay.

“Those that are arguing that a carbon price is enough, then if the carbon price went really high they say this is socially inequitable. If you take that to its logical conclusion, they’re not really after transition.”

Both National and ACT did vote against putting a cap on the ETS in 2020 and now argue that that cap is all that’s needed to reduce emissions.

Regardless of what strategy New Zealand ends up taking, everyone agrees this is an important conversation to be happening. It’s certainly more useful than a debate over who should or should not be driving utes or EVs.

For more than a decade, the ETS has served as little more than a subsidy for forestry offsets and a gentle tax on carbon. Now beefed up with a single cap and stripped of a fixed price purchase option, the scheme should affect the way we think about climate policy.

“I’m a big believer in getting the ETS settings to do the work and the ETS has not been allowed to do its job in most of the 13 years that it’s been in operation, but you do need a policy mix to be able to get to where you’re going to get to,” Shaw says.

Crampton says: “Because it’s fairly recent, folks haven’t really wrapped their heads around it or incorporated it as much into their thinking.”

That needs to change.

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

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