Emissions trading scheme – is it here to stay?

New Zealand's emissions trading scheme is now on hold while a complete review of its features is carried out under the new National Party Government. In this article, senior associate Kate Radka summarises the key features of the emissions trading scheme which will be the subject of that review.

At the end of September 2008, on one of the last sitting days in Parliament, the Labour Party traded amendments to the Climate Change (Emissions Trading) Bill (involving seven Supplementary Order Papers) to gain sufficient support from the Gree n Party and New Zealand First to pass the Climate Change (Emissions Trading) Bill.

The main purpose of the Climate Change (Emissions Trading) Act was to introduce an economy-wide, all gases, emissions trading scheme. While the Act that was passed maintained the main overall features from the first draft of the Bill, there were a number of key aspects amended, refined and more clearly defined. However, almost as soon as businesses obtained some certainty as to the likelihood of their compliance obligations, New Zealand has had a change in government and the New Zealand carbon market is again in a state of disarray.

In securing ACT's support to form a government, National has agreed to suspend the emissions trading scheme set up under the Act while it carries out a complete review of the features of the scheme, and considers alternatives to an emissions trading scheme. A review of the features of the scheme should not come as a complete surprise to businesses. National was vocal about its concerns over the speed with which Labour was implementing the emissions trading scheme, and throughout its pre-election campaigning proposed to amend features of the emissions trading scheme within its first nine months in power. The Rt. Hon. Nick Smith, now Minister for Climate Change and Minister for the Environment, has suggested that the proposed review will not significantly delay National's original intention of having an emissions trading scheme in place, albeit in an altered state, around September 2009.

However, with the scope of the Select Committee review yet to be finalised and with Prime Minister John Key's recent comments about the possibility of a carbon tax replacing an emissions trading scheme, businesses face another nine months of uncertainty while the country's Kyoto obligations continue to apply. Foresters in particular will be concerned as to whether there will still be retrospective obligations back to 1 January 2008 given the relative uncertainty as to whether an alternative form of the proposed scheme or a new carbon tax will be the compliance regime in place from the end of 2009.

In this update we provide a summary of the key features of the New Zealand emissions trading scheme (ETS) that was passed, which will be the subject of the Select Committee review to be carried out.

The scheme's key features

With a lot of the detail of the ETS expected to be covered in future regulations, the Act itself primarily sets out the mechanics of the ETS, including:

• clarifying the activities that give rise to mandatory obligations and the right to participate under the ETS;
• in the context of specific business activities, who will or could be a participant in the ETS;
• details of a participant's obligations to measure and report emissions and to surrender emission units to account for the reported emissions, as well as the penalties for failing to comply with obligations;
• the basis on which units will either be allocated without charge, or sold, to participants by public tender; and
• which units may be surrendered for compliance purposes.

Staggered sector entry

Entry of the relevant business sectors into the scheme is staggered under the Act. The forestry sector is to have retrospective obligations from 1 January 2008.

Stationary energy and most industrial processes would follow from 1 January 2010.

The liquid fossil fuels sector was to enter a year earlier from 1 January 2009. However, Labour announced a policy change earlier this year, given the rising cost of fuel, to delay the entry of this sector. The liquid fossil fuels would now enter from 1 January 2011 under the current wording of the Act.

Agriculture, waste, and industrial processes involving SF6, HFCs and PFCs would be the last sectors to enter, from 1 January 2013.

Some coastal shipping and fishing (where vessels hold fuel purchased off-shore and travel through New Zealand's coastal waters) would also be included in the ETS, if an Order in Council were to be passed.

Inclusion of forestry

Under the current form of the Act, pre-1990 forestry owners would receive a one-off allocation of New Zealand Units (NZUs), with compliance obligations for deforestation. The number of NZUs each forestry owner would receive would depend on whether the land is the subject of a Crown forest licence and Treaty negotiations, or how long the current owner has held the land.

Post-1989 forestry owners generally could have chosen whether to:

• opt into the ETS and receive NZUs for net carbon stock increases, with the right to harvest but incurring compliance obligations for any net carbon stock decrease; or
• enter into a covenant not to harvest or deforest for 99 years under the Permanent Forest Sink Initiative (an initiative sitting alongside the proposed ETS), and thereby be awarded Assigned Amount Units (AAUs) for carbon sequestration (the relevant legislation required for the continued application of the PFSI scheme has not been mentioned throughout the initial reports of reviews and suspension of the current emissions trading scheme, and therefore we have no reason to believe at this time that PFSI has been suspended); or
• choose to do neither, in which case the forestry owner would have no liabilities for harvesting or deforesting, but will also have no opportunity to receive NZUs or AAUs for any carbon sequestration occurring on their land.

Any NZUs or AAUs allocated or awarded to forestry owners would not be temporary in nature (unlike forestry units from Kyoto clean development mechanism projects). Such units are currently to have the same features as non-forestry NZUs/AAUs and are available for trading and for compliance use on the same basis.

Allocation and auctioning of units

The primary unit of trade for the ETS under the Act is an NZU. Each NZU would be backed by a Kyoto-compliant unit, primarily an AAU. The responsible Minister would allocate NZUs without charge to the forestry and agricultural sectors, as well as to trade-exposed entities (although only for the proportion of their production which is trade exposed), with a phase-out of free allocation for agriculture and trade-exposed businesses expected to start in 2018. The Minister would also allocate NZUs free of charge to fishing operators in New Zealand for three years in 2011, 2012 and 2013, to soften the impact of increased fuel costs these operators will face following the introduction of the liquid fossil fuels sector into the ETS. It was Labour's policy that all free allocation would be stopped by 2030. If National were to retain an ETS then it may choose to extend the period of free allocation (at least in part) beyond 2030.

In other sectors, where the cost of carbon is expected to be passed through, ultimately to the consumer, from an upstream participant, there would be no free allocation. Instead, NZUs or other compliance units would simply need to be sourced by participants with compliance obligations, with the slight possibility of the government selling some NZUs to such participants (although this is unlikely to be the case for as long as the Crown remains in a projected deficit position for the end of 2012 under Kyoto).

Types of allowances permitted for trading

NZUs, Certified Emission Reduction Units (CERs) – except CERs from nuclear projects and a special type of CER called lCERs from forestry projects in developing countries, Removal Units, Emission Reduction Units and AAUs (originating from New Zealand, including under its Projects to Reduce Emissions Scheme and PFSI) would be accepted for compliance purposes under the ETS as it currently stands. tCERs (also, like lCERs, originating from forestry projects in developing countries) would be permitted to be surrendered for compliance purposes with the Minister's consent. We do not expect a significant amount of trading in tCERs in New Zealand.

Imported AAUs (i.e. those AAUs which originate from another country) would not be accepted for compliance purposes under the ETS as currently drafted in the Act, unless the features of the imported AAU fit within the criteria set out in regulations (which have not yet been released). This distinction was driven by the Green Party and focused on ensuring that only imported AAUs with environmental integrity be permitted to be surrendered for compliance purposes under the ETS. With the detailed criteria yet to be released and with the possibility of National widening the scope of AAUs that could be purchased under an ETS (should an ETS be retained), this has and is likely to continue to hamper the early trading of imported AAUs by participants who are wary as to whether an ETS will be retained or not, and if so if the imported AAUs they are seeking to buy would later be permitted to be surrendered.

The restriction brought about by the Greens on the use of imported AAUs for compliance under the ETS would significantly reduce the pool of available units – not to mention potentially cheaper units – for participants to purchase in an already short market. It is possible the "environmental integrity" restriction would drive the price of NZUs and New Zealand originating AAUs to track closer to secondary CERs than it would have otherwise. Some companies have been seeking to mitigate their future trading costs by entering into early trades, despite the "environmental integrity" uncertainties that existed under the ETS, for "green" imported AAUs such as Green Investment Scheme AAUs (GIS AAUs). Increased early trading in PFSI AAUs, and forestry NZUs, was also likely following the passing of the Act, but trading in units that are unable to be subsequently sold into other compliance markets such as the EU ETS is likely to slow down until the outcome of the review is known and participants have some certainty as to whether a carbon tax or ETS will be the Government's compliance mechanism of choice.

International trading

International trading is recognised and permitted by the current wording of the Act. That said, the Minister retains the discretion to restrict the types of units (such as the restrictions on imported AAUs) that may be traded internationally, may enter the ETS, and that may be used for compliance purposes. NZUs may be traded internationally, in which case they would be converted into AAUs by the Minister. Subject to the requirement not to breach the compliance period reserve (a mechanism to ensure New Zealand retains sufficient AAUs to be able to meet its own Kyoto obligations), there is no restriction under the current form of the Act on the number of units that may be traded internationally.

Future international linking with other emissions trading schemes is foreshadowed by the inclusion of "approved overseas units" as a type of unit that may be surrendered for compliance purposes.

International linkage

New Zealand's Registry was linked to the International Transaction Log (ITL) earlier this year. That linkage has already caught the interest of traders, with an account-holder in the New Zealand Registry receiving the first units transferred country-to-country – from Switzerland to New Zealand – through the ITL. (Those units were then bought by Bell Gully for its purposes in the first New Zealand transaction on the Registry).

Rules for the operation of the carbon market

Trading would be available to anyone eligible to open a holding account with the Registry (which includes people residing overseas who meet the eligibility requirements), not just participants.

Of particular interest to those in the financial sector are the rules relating to the operation of the carbon market. The Act attempts to preserve flexibility for parties to trade NZUs in any manner they choose. This could be via over-the-counter trading, trading on a regulated exchange, such as NZX's TZ1 exchange, or trading through an internet-based platform.

Innovation Fund

The current Act implements a contestable Innovation Fund comprising 150,000 carbon credits (worth potentially $7.5 million at today's prices) a year from 2010 to 2012, which may be accessed by certain entities in the industrial sector, including trade-exposed businesses, and the stationary energy sector, to help drive the uptake of innovative technology that will significantly reduce or have the potential to significantly reduce industrial emissions.

For many eligible companies, the receipt of units from the Innovation Fund would be a driver for implementing innovative technology resulting in real emission reductions for both that company and at a national level. However, for businesses who made significant investments to take early action to reduce their emissions, the financial assistance their competitors may get from the Innovation Fund to take similar action may appear inequitable (if it is significant).

Assistance for households

If National retains the policy change required by the Greens and New Zealand First, then households will be receiving a one-off electricity rebate in 2010 to assist with higher energy prices, and may receive assistance with insulation and energy-efficiency, from a $1 billion fund established for that purpose.

The introduction of the ETS initially provided a level of certainty for those with compliance obligations. Even then, however, businesses were awaiting the detail of the operation of the ETS in the form of regulations which had not yet been released. While this dampened the extent of initial trading, those entities with potentially large compliance obligations were to a large extent still progressing early trades to secure sufficient units at favourable prices in order to minimise their financial exposure in future compliance years. While we would not be surprised to see such behaviour continue despite the uncertainty as to whether an ETS will be retained and if so in what form, we expect that any early trading will largely be limited to CERs and ERUs. This is because those Kyoto-compliant units could still be on-sold internationally if New Zealand buyers found they no longer had compliance obligations following the review of the ETS.

* Bell Gully's climate change team is available to advise in detail on the ETS and its implications, on carbon trading in general, and to assist with submissions to the Government during the proposed Review. We recommend that business make submissions on the review of the ETS, not least given the extent to which business lobbying has been demonstrably successful in achieving change to date.

For further information, please contact your usual Bell Gully adviser or:

Simon Watt
Partner

Kate Radka
Senior Associate

David Craig
Partner

Garry Downs
Partner

Ian Gault
Partner

Willy Sussman
Partner

Clive Taylor
Partner

Marija Batistich
Senior Associate

Enquiries and information

For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.