The kindest view you could have of the emissions trading scheme, what's left of it, is that it is a brutally pruned seedling barely surviving in frozen ground.

Just how much damage the Government's refusal to limit New Zealand emitters' ability to meet their obligations with ultra-cheap imported carbon has done to the scheme is apparent in the 2012 numbers released by the Ministry for the Environment on Tuesday.

Last year, 26.9 million units were surrendered to the Government by participants in the ETS, a whopping 64 per cent increase on 2011's tally of 16.4 million.

Actual emissions of greenhouse gases did not jump 64 per cent, of course.


Emissions from the energy and industrial sector did rise, probably reflecting low inflows into the hydro lakes early in the year, which required more gas and coal to be burned in thermal power stations. Emissions from liquid fossil fuels were flat.

The big increase, however, was in the forestry sector, which accounted for 82 per cent of the increase in units surrendered.

Some of that was deforestation, where a forest is harvested and the landowner then switches to another land use and is deemed to have emitted the carbon stored in the trees.

The collapse in carbon prices meant that the deforestation liability no longer provided much of a barrier to exit from forestry.

Or to put it another way, the incentive to replant that carbon pricing was supposed to provide has pretty much disappeared. Incentives matter.

The other driver of the increase in units surrendered by the forest sector represents "Kyoto" forest owners - those whose forests were planted since 1989 on land not previously forested - opting out of the ETS.

When that happens they have to repay the Government the same number of units it has previously allotted to them for the carbon removed from the atmosphere and stored in their trees (since 2008 anyway).

The incentive to do that is good old-fashioned arbitrage. The units the Government allotted to forest owners, and to trade-exposed industrial emitters, are New Zealand units, only good within the New Zealand ETS.


But the scheme allows those with obligations under the scheme to surrender other sorts of unit instead of NZUs, including certified emission reduction units (CERs), emission reduction units (ERUs) or removal units (RMUs) issued offshore under the Kyoto Protocol.

The trouble is that because way too many of these things have been issued, and because the European ETS, much the most liquid carbon market, limits the extent to which European emitters can use them to meet their obligations, they are a glut on the market.

ERUs, in particular, which are issued mainly by Russia and other eastern European governments, have traded for as little as a few cents a tonne.

No wonder, then, that last year 95 per cent of the units surrendered under the New Zealand ETS, where no such restriction applies, were imported, 70 per cent of them ERUs. In 2011 71 per cent of the significantly smaller number of units surrendered were imported.

As an aside, allowing such an overwhelming majority of the units surrendered to be sourced offshore is hardly consistent with Kyoto's principle of supplementarity - that reliance on international carbon trading must be supplementary to domestic action to reduce emissions.

In any case untrammelled access to international Kyoto markets has allowed some forest owners to sell their NZUs when the price was $20, subsequently replace them with cheap ERUs, use the latter to square accounts with the Government and pocket the profit.

Others may have decided to hold on to their NZUs but filled their boots with enough cheap imported carbon to meet their obligations so that any future recovery in the price of NZUs, which do not have a use-by date, is all upside.

Of the 26.9 million units surrendered last year 9.2 million were from the forestry sector.

"Who can blame them?" says Lizzie Chambers, principal of Carbon Match, a carbon trading facility.

"It's been a torrid, unpredictable tale with a lot of complexity, compliance cost and very little change on the ground thus far."

But a corner may have been turned. Recent weeks have seen NZUs move from the $2 level to around $4.70.

That is not high enough to drive any significant reduction in emissions, she says, but it is a step in the right direction.

Nigel Brunel of carbon brokers OMF Financial says: "We are now seeing a spread of buyers enter the market and the price action suggests this market has the impetus to go higher. Most of the sellers have been small forest owners selling some stock, some of whom are exiting the ETS, and speculators who bought at lower levels letting some go."

It may be the market starting to adjust to the fact that going forward emitters' ability to use cheap imported units for compliance purposes will be limited.

The Government has yet to decide on the rules for carrying over Kyoto units for use beyond the end of 2012. But the upper limit will be 15 million tonnes.

In addition, by refusing to undertake commitments under the Kyoto Protocol for the 2013 to 2020 period, the Government has shut New Zealand out of the Kyoto markets from 2015 on.

So demand for NZUs, which have been largely crowded out of the domestic carbon market, ought to increase.

Just as well, because there are millions of them out there as the ETS has been running for more than three years.

The big uncertainty is how many will ever be available for sale.

Kyoto forest owners in the ETS may well opt to keep them in the bottom drawer as they will need them to cover the emissions they are accountable for when they harvest their trees.

Another potential source of liquidity in the market, linkage with an Australia ETS, is looking pretty unlikely with the election of a Coalition Government committed to scrapping carbon pricing.

So officials of the Ministry for the Environment are working on an auctioning system to provide an additional supply of NZUs to the market. In light of all this uncertainty that is an unenviable task.

Meanwhile, deforestation continues, at a rate of around 5000ha a year - small by comparison with the "chainsaw massacre" years which preceded the start of Kyoto's first commitment period in 2008.

But the 5000ha figure may understate the rate of deforestation.

Landowners have four years after harvest to replant and avoid a deforestation liability. In the meantime they get the benefit of the doubt, unless it is obvious that a land use change is under way.

The ministry's report has afforestation exceeding deforestation in 2010, 2011 and most of all in 2012. But its estimate for this year has a net contraction in the size of the plantation forest estate - exactly the opposite of what we need.

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