Unravelling the new world of carbon trading

The first commitment period of the Kyoto Protocol kicked in this year and also signalled the start of New Zealand’s obligations under the arrangement. Energy specialist CHRIS TAYLOR* explains what it all means, and compares the Government’s ETS with the EU-ETS.

Over the next five years, our net greenhouse gas emissions must remain, on average, consistent with our 1990 level of emissions. This equates to approximately 309.5 million units (or tonnes of greenhouse gas emissions converted to carbon dioxide equivalents) between 2008 and 2012, inclusive.

However, the Government’s latest estimates suggest that we will fail to meet this target by approximately 45.5 million units. In the absence of any targeted action, it would need to acquire sufficient credits to cover this deficit from international markets.

The Government’s Emissions Trading Scheme (ETS) is the core price-based mechanism designed to introduce the cost of carbon into the economy. It anticipates that, by devolving the responsibility for and cost of reducing emissions directly to businesses through the ETS, the country will be able to reduce the deficit, potentially by 20 million units. This reduction is primarily driven by reduced levels of deforestation, while over the longer term it is expected that businesses and individuals will respond to price signals.

What does all this mean for the energy sector in New Zealand?

Liquid fossil fuels

Firstly, the liquid fossil fuels (read transport fuels) sector is due to enter the ETS on 1 January 2009. All liquid fossil fuels will be covered, except international aviation and marine. This sector has also experienced the highest level of growth in emissions since 1990. The obligation to surrender credits will rest with large fuel suppliers, who will have to acquire credits for the carbon content of the fuel that they sell. In certain limited circumstances, there are opt-in provisions that will allow jet fuel users to take on the obligation to surrender credits. There will be no free allocation of credits to fuel suppliers. 

The Government anticipates that the impact of the introduction of the ETS on the level of emissions from the liquid fuels sector will be minimal. The main reason for this is that fuel demand is relatively unresponsive to price. Interestingly, New Zealand is taking the lead in targeting transport fuels; currently the EU-ETS does not cover the transport sector. 

Stationary energy

The treatment of emissions from the stationary energy sector is significantly different than it is in the EU, particularly in respect of electricity generation. The New Zealand Government’s approach is to place the obligation to surrender credits ‘upstream’ – that is, on firms that import or extract coal, natural gas, or geothermal resources. That said, it is currently considering carve-outs to large downstream firms that wish to manage the obligations associated with their own emissions. In addition, the Government is promoting the continued development of renewable electricity generation through a proposed moratorium on fossil fuel generation over the next 10 years.

One of the Government’s agreed principles is that no assistance will be provided to firms whose profits will be largely unaffected by their participation in the ETS. Conceptually, if the increased costs can be passed through to consumers, then why should the company receive an allocation?

This is different from the EU-ETS, where free allocations are provided to electricity generation companies who, as a result, only need to acquire credits for any ‘uncovered’ emissions. These are generally a very small proportion of their output. However, this has led to windfall profits being generated by some electricity generators, as wholesale electricity prices were raised to reflect the full cost of carbon emissions, but free allocations were received to cover the cost impact on the generators.

Sources of credits

To meet their obligations, fuel suppliers and electricity generators will need to source credits that are acceptable under the ETS. This includes the domestic trading unit (a New Zealand Unit or NZU); or a Kyoto Compliant Unit, such as an Assigned Amount Unit (AAU), Certified Emission Reduction (CER) from an emission reduction project in a developing project, or an Emission Reduction Unit (ERU) from an emission reduction project in a developed country.

The decision as to what ‘unit’ to buy will be dependent upon price and availability. Initially, the domestic supply of credits will be limited to those that may come to market from pre-1990 forests and potentially some post-1989 forests, although the quantum of these is yet unknown. Similarly, credits allocated gratis to businesses at risk will be give out at the start of 2010, providing a small period for the liquid fuels sector to acquire and surrender them to meet its 2009 obligations (by 30 April 2010). The stationary energy sector will need to surrender its first year’s credits by 30 April 2011.

Demand will exceed local supply – the shortfall will come from international markets. At this stage, the most likely source of such credits is expected to be CERs, although the potential for cheap ‘hot air’ AAUs has not been ruled out. The Government’s current proposal is that there will be no restriction placed on the volume of credits that can be brought into the ETS, although there will be limited restrictions placed on the types. These mainly focus on credits arising from nuclear projects and CERs from forestry projects, while other potentially contentious CERs, generated from HFC-23 projects, for example, can still be utilised.

The shortfall will lead to domestic prices trending toward the international price of emissions, consistent with the Government’s desired objective that New Zealand faces the international price of carbon. CERs are currently closely linked to the price of an EUA (European Union Allowance – the unit of trade in the EU-ETS), generally trading at a discount of 20 percent to 25 percent to an EUA. At the time of writing, EUAs are trading at around €20, and CERs at €15, equivalent to $28. This is higher than the Government’s initial indicative range of $15/tonne to $25/tonne, which always appeared very conservative.

Already, companies that will face obligations under the ETS are in the market acquiring credits to meet their anticipated requirements. This provides them with an opportunity to potentially secure favourably priced credits prior to an exchange-traded market commencing operation.

Getting prepared

New Zealand is now accruing obligations under the Kyoto Protocol. The fossil fuels and stationary energy sectors are relatively early participants in the Government’s ETS. As a result, those businesses with obligations under the scheme need to have well defined carbon management strategies in order to understand what their obligations under the ETS are likely to be, what their opportunities for emission reduction are, and ensure they have a strategy for acquiring credits to meet their residual obligations.

It is important that businesses start addressing these issues now, so as to be able to meet their obligations in the most cost-effective manner.

* Chris Taylor is a partner at Price Waterhouse Coopers, specialising in energy and climate change services.