What might the Emission Reduction Plan mean for NZ ETS prices?

This week’s announcement about the New Zealand Government’s first Emission Reduction Plan (ERP) raises questions for participants in New Zealand’s Emissions Trading Scheme (NZ ETS) about the potential impact of these announcements on the price of New Zealand Units (NZUs). Our analysis of the impact has considered both the impact of policies outside of the NZ ETS as well as the outlook for changes to the NZ ETS itself. In addition to the ERP we also need to think about what impact that the funding decisions made through the $4.5 billion Climate Emergency Response Fund (CERF) could be on NZU prices. On balance we find the impact of the ERP and CERF announcements to be neutral for NZU prices in both the short- and long-term, because the bearish outcomes from actions outside of the NZ ETS act to counteract the bullish actions contained in the emissions pricing chapter.

Introduction

On Monday the New Zealand government released its first ERP. The ERP contains a mixture of actions that have been previously announced as well as actions that are being made public for the first time. Many participants in the NZ ETS are likely to be interested in understanding what impact that the ERP might have on the price of NZUs. This article offers a perspective on whether the ERP could be bullish (driving prices higher) or bearish (driving prices lower) for NZUs. Thinking about these price drivers requires consideration of what new information the ERP has provided to market participants about the supply and demand fundamentals for the NZ ETS market.

This article considers the impact of the ERP on NZU prices in two areas:

1. The actions proposed by the ERP outside of the NZ ETS; and
2. The actions proposed by the ERP within the NZ ETS.

The impact of the ERP on NZU prices may also vary across two separate timeframes:

1. What is the short-term impact of the ERP release on NZU prices? The short-term impact on prices will largely be determined by how the contents of the ERP align with the market’s expectations of what was going to be included within it. In the short-term, the impact of the ERP could (for example) still be bullish for NZU prices even if the ERP was filled with actions that are likely to reduce NZU prices in the longer-term. This outcome might occur if market participants had already priced in their expectations that the ERP would contain a strong set of bearish outcomes.
2. What is the long-term impact of the ERP release on NZU prices? The long-term outlook for NZU prices is less about market expectations and more about how the actions outlined in the ERP might impact NZ ETS supply and demand fundamentals. While the impact of these actions might not appear in the NZU price immediately, they can be influential drivers which need to be carefully monitored by market participants.

The actions proposed by the ERP outside of the NZ ETS

To assess the impact of the ERP on NZU prices we need to look at the actions that it proposes both outside and inside of the NZ ETS. We can’t just consider the changes that the ERP proposes to the NZ ETS in isolation. To see why this broader perspective is needed we can look to a couple of policy examples from the ERP:

1. The Clean Car Discount (CCD) should act to keep NZU prices lower than they would otherwise be. This is because it makes purchasing low-emission vehicles cheaper for consumers by subsidising their purchase price. This should help to lower transport emissions, which means that emissions within the NZ ETS will also be lower and the NZU price required to meet the same emissions budgets could be reduced.
2. The establishment of the Centre for Climate Action on Agricultural Emissions could also help to suppress NZU prices. In a similar way to the CCD, if the Centre ‘s work contributes to lowering agricultural emissions then New Zealand’s overall emissions would also be reduced. This will mean that the NZ ETS has less work to do and NZUs could trade at a price below what might previously have been required. This impact on NZU prices is likely to be the case regardless of whether agricultural emissions are eventually included within the NZ ETS or whether they end up in their own pricing scheme.

These two examples help to illustrate that emission reduction policies outside of the NZ ETS can have flow-through effects on the NZ ETS that impact NZU prices. In general, the impact of nearly all the non-ETS emission reduction policies within the ERP will be to lower the NZU price required to meet a certain emissions budget. This is because the more that happens outside of the NZ ETS, the less that the NZ ETS needs to do.

In addition to detailing a wide range of actions outside of the NZ ETS, the Government has announced the first tranche of funding from the Climate Emergency Response Fund (CERF). The CERF has been established with $4.5 billion of revenue that is forecast to be received from the NZ ETS auction platform over the next five years. Of this total, $2.9 billion has now been allocated towards emission reduction efforts. This includes $650 million to the Government Investment in Decarbonising Industry Fund, $600 million to an expanded process heat fund and $330 million towards assisting small and medium sized enterprises to install energy efficient equipment. This money is likely to fund investments that will reduce emissions in the sectors that they are deployed, reducing national emissions, further reducing the amount of work that the NZ ETS needs to do.

On balance, we find both the impact of the ERP and CERF actions outside of the NZ ETS to be bearish for NZU prices. This bearish outlook is mainly driven by the substantial increase in funding that has been directed towards emission reduction efforts. Many of these funding announcements were released for the first time this week and we think that they will put downward pressure on NZU prices in both the short- and long-term.

The actions proposed by the ERP within the NZ ETS

The NZ ETS action included within the ERP with the largest potential impact on NZU price was an agreement to investigate the forestry incentives provided by the NZ ETS. There are a range of stakeholders with concerns that the current design of the NZ ETS provides too strong an incentive for afforestation. The NZ ETS currently incentivises the planting of fast-growth trees which sequester carbon at the highest rate.  This has contributed to an increase in the planting rate for new exotic forests, which is increasingly causing unintended biodiversity issues.  The Climate Change Commission also advised the Government that more attention to this issue was required. We can see evidence of these concerns playing out in a recent Government consultation on the inclusion of exotic forests within the permanent forestry category of the NZ ETS.

If the investigations initiated by the ERP led to a decision that the forestry (or at least exotic forestry) incentives are too strong within the current NZ ETS design, there are several options as to how the scheme could be altered. For example, volume restrictions could be placed on how many forestry units could be issued, and/or how many forestry units could be surrendered for compliance. Some of these options would require at least two different classes of NZUs to be defined (forestry and non-forestry). A further breakdown could see three classes of NZUs created where forestry is broken out into exotic and indigenous sub-categories so that specific incentives can be created for native afforestation. Depending on the choices that are made about the settings within any redesigned NZ ETS, we could see a divergence in price between different classes of NZU, with forestry NZUs priced lower than non-forestry NZUs. Roughly half of the NZUs currently in private accounts within the NZ ETS Register were issued as forestry units.

Overall, we find the impact of these ERP actions on the NZ ETS to be bullish for NZU prices in the long-term. This is because a decision to investigate the NZ ETS settings so that a different balance between gross and net emissions reductions could be achieved could lead to a future restriction on the issuance and/or usage of forestry or exotic forestry units. While this decision within the ERP is in line with recent public discussions about the role of forestry in meeting emission reduction targets, and is line with advice from the Climate Change Commission, it is a new announcement to the market. We caution that changes to the scheme in this area could lead to a differentiation in value between different types of units in the longer-term and not all NZUs might be lifted in price by any changes.  We would also expect the Government to focus on price stability when proposing any alterations to the scheme design to try and reduce any value creation or destruction.

Putting it all together

When we combine the different effects of the ERP, at this early stage we find that the impact of the ERP and CERF announcements are broadly neutral for NZU prices. This is because of the combined impact of the actions described by the ERP both inside and outside of the NZ ETS.

• The actions described by the ERP outside of the NZ ETS are almost all bearish for NZU prices as they help to reduce forecast emissions. Lower forecast emissions means that there is less work needed from the NZ ETS and consequently NZU prices could be lower than they might otherwise have been.
• The most consequential action for the NZ ETS that is described by the ERP is a review of the forestry incentives within the scheme. We judge this to have a bullish overall impact on NZU prices, even though any uplift might be longer-term and not be experienced evenly by all types of NZUs.

While some people might view it as counterintuitive that strong policy announcements from the ERP would act as a bearish force on the NZU price, in many ways stabilising the price of NZUs is a core rationale for having a broad climate change policy suite. This is because higher NZU prices won’t automatically deliver the best social, environmental, and economic outcomes when acting in isolation from other policies. Higher NZU prices shouldn’t therefore become a policy objective by themselves, even though their price may be viewed by many people as a marker for strong climate action.

Strong climate action arises from a wide range of different actors, including consumer choices, investor pressure, changes in financing costs and technological development – all acting alongside government policy. Some important drivers for New Zealand’s emissions include such factors as: the impact of international consumer demand for our agricultural products, the cost trends for batteries/electric vehicles and any methane-inhibiting technologies for ruminant livestock.

A well-designed emissions trading scheme with a clear objective should operate as a balancing point between all these different drivers, having a higher price when other drivers are weaker, and a lower price when the other drivers are more dominant. This week the ERP and the CERF have brought more of these other drivers to the table. NZU prices are therefore an important component of the climate policy puzzle, but not the only tool that we should be relying upon.