Legislation introduced last week to reform the emissions trading scheme has the benefit of a decade of experience in how to get it wrong.
The ETS made it into the statute books in the last few weeks of the previous Labour Government's ninth year in power, only to spend almost all of the National Government's nine years in office rendered totally ineffectual.
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That was thanks to emitters being allowed untrammelled access to cheap and environmentally worthless international units created under now-defunct Kyoto Protocol mechanisms.
It was a cap-and-trade scheme without a cap, and the resulting collapse in carbon prices left forest owners who were looking to sell into the market badly let down.
A flood of international units is no longer a problem, at least for the time being. Instead, more recently the scheme has been undermined by a price ceiling provision which allows emitters to meet their obligations by paying the Government $25 a tonne in cash rather than buying New Zealand units on the market and surrendering them.
While that delivered the Government a cash windfall of more than $400 million last year and potentially even more this year, it has muted the price signal from the market. It has also has meant millions of extra units have been left in circulation — an asset for those who hold them and a liability for the Crown.
In light of these and other failures, the Climate Change Response (Emissions Trading Reform) Amendment Bill introduced last week makes some major changes to the ETS.
Crucially, it seeks to ensure that it is a cap-and-trade scheme with an actual cap on emissions — one which will keep dropping in line with the five-year carbon budgets that the partner legislation, known to its admirers as the Zero Carbon Bill, will set up.
If and when international units become available again — and a lot of work remains to be done internationally under the Paris Agreement to ensure a credible mechanism for ensuring their environmental integrity — imports of them will count towards the cap. So will NZ units the Government either auctions or allocates to those who earn them (eligible forest owners) or who need them (emissions-intensive, trade-exposed firms).
The environmental integrity of any imported carbon credits is essential. The ETS is like a bird sanctuary which at last is predator-free. It would be a shame to open the gates to rats and stoats again.
In any case, the Zero Carbon Bill, as reported back by the environment select committee last week, now includes a provision that the national carbon budgets must be met as far as possible through domestic action — whether that is emission reductions or removals (by trees). Offshore mitigation can be used if there has been a significant change of circumstances that changes the basis on which the relevant carbon budget was arrived at and affects the ability to meet the budget domestically.
Another line of defence against the risk of repeating the ETS price collapse is a provision enabling a price floor, through a reserve price on auctioned units. This, the Government says, would help protect the value of forestry investments.
As for upside price risk, the ETS reform bill would replace the $25 price ceiling, which market prices are now bumping up against, with a "cost containment reserve" of units available to be auctioned if a trigger price is reached.
This is intended to provide a kind of safety valve. The reasoning is that carbon prices absolutely need to rise — a lot — to incentivise the investments needed to rein in emissions. But destabilising price spikes risk undermining support for the scheme, so some form of guard rail is warranted.
It cannot be the equivalent of just printing money, however. Importantly, the bill provides that units auctioned from the cost containment reserve have to be backed, as soon as practicable, by real reductions in net emissions. Put another way, to the extent that this is an exercise in borrowing against future carbon budgets, it will have to be repaid.
Inevitably, much of the bill relates to forestry. Physically, there is no way New Zealand can meet its medium-term commitment under the Paris Agreement, or the mid-century target to be set by the Zero Carbon Bill, without the carbon sucked out of the atmosphere by the trees in an expanded forest estate.
Economically, for that to happen there need to be financial incentives to plant those trees. The challenge is getting right how far and how fast that expansion of forested land goes. There is an opportunity cost to seeing more and more of the country covered by pine trees.
Too generous a regime risks front-loading afforestation, reducing the pressure on emitters to undertake the investment they need to make to reduce emissions, and — as there is only a finite amount of land suitable for this use — pre-empting the use of this mechanism in the future when it might be really valuable.
Too miserly or unpredictable a regime, on the other hand, risks a continuation of the recent pattern of little or no increase in the forest estate to obviate the continued increase in gross emissions.
The legislation introduces a measure advocated for some time called "averaging accounting".
At present, for forests planted since 1989 on land not previously forested, units can be claimed for all the carbon those trees sequester as they grow, right until they are harvested, when the carbon is deemed to be emitted and an equivalent number of units has to be surrendered to the Government. This imparts a lot of volatility of volumes, and with it price risk.
Under the averaging approach, forest owners will earn units until their forest has reached an age equivalent to its long-term average level for carbon storage. Provided the forest is replanted upon harvest, averaging looks through or disregards both the increased sequestration beyond that average level and the subsequent deemed emissions upon harvest.
"This will be administratively simpler and will increase the number of units forest owners can trade at low risk, encouraging them to plant new forests," the Government says.
But this innovation will not be available to post-1989 forests registered before January 1 this year — something the Forest Owners Association can be expected to protest when the bill comes before the select committee.