For taxpayers, arbitraged carbon credits are not money in the bank

Aug 16, 2016

Largely as a result of three years of arbitrage between foreign and domestic units as New Zealand de-linked its Emissions Trading Scheme (ETS) from international carbon markets, the New Zealand government was liable for 140 million banked carbon credits as of July 2015 (with a domestic value today of about $2.5 billion).

“If the government had shut the door quickly on foreign Kyoto units in 2013 and launched auctioning instead, it would have offered better value to taxpayers as well as to the climate,” said Suzi Kerr, Senior Fellow at Motu Economic and Public Policy Research.

These credits (also known as New Zealand Units or NZUs) belong to industrial and forestry organisations and can be surrendered to meet their greenhouse gas obligations under the ETS.

“In essence, because of arbitrage, ETS participants now hold an excessive number of units that the government is required to accept against future emissions,” said Dr Kerr. “The private NZU bank is implicitly a liability on the government’s balance sheet. The units represent future emissions whose cost will be borne by the government rather than emitters.”

This issue drives home the importance of how we think about linking in the future, as does yesterday’s release of the Morgan Foundation’s investigation into New Zealand’s past use of foreign Kyoto units.

“The government should allow New Zealand mitigation to be substituted by mitigation abroad only when foreign reductions are credible. We want value for New Zealanders’ money.”

“A key lesson in all of this is that New Zealand’s emissions trading market is responding to price signals as it is meant to. When those price signals are wrong, they create negative outcomes where least cost means least effectiveness. When the price signals are right, they can support efficient low-emission transformation. When conditions change, the price signals also need to change, quickly.” said Dr Kerr.

When the Emissions Trading Scheme was set up in this country, New Zealand was linked to the Kyoto market. From 2008 to 2011, non-forestry sectors couldn’t sell NZUs overseas and NZU prices were around $20, which was below Kyoto prices.

From June 2011, Kyoto prices began to fall and NZ ETS participants started buying some international units so NZU prices were roughly equivalent to Kyoto prices. In November 2012, the government announced that it would not proceed with the second commitment period of the Kyoto Protocol, and this raised the domestic value of NZUs relative to Kyoto units. However, overseas Kyoto units remained acceptable for surrender in the NZ ETS until 31 May 2015.

“In this gap between announcement and implementation of delinking, there was a considerable amount of arbitrage between NZUs and international units – the government gave out valuable NZUs that can be used for the long term but accepted extremely cheap foreign units with a limited lifespan,” said Dr Kerr. “You could think of it as extra unintentional free allocation for industry and foresters.”

“The long period of price divergence has led to a large privately held bank that is a liability to the New Zealand government in the post-Paris world. It also reduces the government’s ability to raise revenue by auctioning NZUs,” said Dr Kerr.

Dr Kerr’s work with colleague Judd Ormsby has shown that if New Zealand had stopped allowing cheap international units to be used in place of NZUs when it was announced we were leaving the Kyoto Protocol, then government would probably have started auctioning NZUs, and raising revenue, already.

“We’ve given away our cake so now we can’t eat it.”

The NZUs in ‘the bank’ equate to nearly twice this country’s projected 2015 net emissions of 67.9 million tonnes of greenhouse gases.

“On the positive side, our work shows even a small, nascent, and relatively illiquid market such as New Zealand’s reacts rationally now to anticipated future market conditions,” said Dr Kerr. “This suggests that if we announce limits on future supply in our ETS, it will immediately send the right price signals, and private-sector effort will be directed toward reducing emissions. Economic conditions will support, not hinder, companies that want to do the right thing.”

The recent academic paper by Dr Kerr and Judd Ormsby outlines this issue in more depth: “The New Zealand Emissions Trading Scheme de-link from Kyoto: Impacts of banking and prices.”