Delinking the New Zealand Emissions Trading Scheme from the Kyoto Protocol: comparing theory with practice

By Dominic White, Motu Economic and Public Policy Research

Motu Research had an article published recently in the journal Climate Policy called Delinking the New Zealand Emissions Trading Scheme from the Kyoto Protocol: comparing theory with practice.

Linking emissions trading markets, when the linkages are designed and managed effectively, can have many benefits including improving market quality (i.e. more market liquidity and depth, less price volatility, and lower risk of market manipulation), reducing emissions leakage, increasing administrative efficiency, and supporting least-cost mitigation across the combined systems. Delinking becomes necessary if a link between two or more emissions trading markets does not operate effectively or one government decides to withdraw. How delinking is managed determines the impacts on unit supply and prices for the individual markets.

The New Zealand Emissions Trading Scheme (NZ ETS) presents an opportunity to compare the theory of linked emissions trading with practice. From 2009 until October 2012, New Zealand was linked to the international market under the 1997 Kyoto Protocol and there was no indication that this link would be broken. A series of events starting in late 2012 cast doubt on the future eligibility of Kyoto units in the NZ ETS, made the future of linking in New Zealand uncertain, and may have contributed to price divergence between offshore and domestic units. Our study’s focus was to estimate the impact of two key announcements made by the New Zealand Government on October 17, 2012, and on November 9, 2012, on the prices and types of units surrendered by ETS participants in New Zealand.

As described on the New Zealand Government website, in the October 17 announcement, the government signalled it would consult on the carry-over of Kyoto units after the first commitment period ended on 31 December 2012 and review the eligibility of ‘certain units’ in the NZ ETS. Also described on the New Zealand Government website, in the November 9 announcement, the government announced that it would take its target commitment for 2013–2020 outside the Kyoto Protocol.

To study the effect of these announcements, we used daily price data in a difference-in-differences model over the period 1 January 2011 to 1 January 2016. We also looked at the type of units which were surrendered over this period in New Zealand.

In our analysis, we found evidence that, even with differing pre- and post-time specifications, the government announcement in October 2012 caused prices in the two markets – for New Zealand units (NZUs) and offshore Kyoto units – to decouple. This meant NZUs traded at a premium based on their projected scarcity and in anticipation of the coming delink, NZ ETS participants banked (almost) all their NZUs for future use and used cheap Kyoto units to meet (almost) all their current obligations. This was backed up by the trends in the raw price data and the change in the types of units surrendered over this period. We further found, when examining the raw price data, that the announcement on 9 November 2012 exacerbated the price difference between the markets.

The New Zealand Government’s decision to delay proceeding with delinking after signalling change has had significant and enduring impacts on market operation. Had the New Zealand government delinked the NZ ETS sooner, it could have prevented the arbitrage incentivised by difference in prices between markets and the inflation of the participant-held bank of NZUs. Earlier delinking would have necessitated government auctioning of NZUs, which would have both introduced a cap on unit supply and raised revenue for the government that instead went offshore.

Setting an ETS cap would have required challenging political decisions on domestic mitigation ambition which had been avoided since the system’s inception. Given the large surplus of international units, which New Zealand carried over post-2012, and the uncertainty of international negotiations for the treaty to succeed the Kyoto Protocol, it is impossible to guess how ambitious an NZ ETS cap might have been starting in 2013 or 2014. However, any signal of longer-term unit supply constraints would have helped to guide business decisions on low-emission investment and the government would have been better prepared to regulate for increasing ambition.

The NZ ETS has entered the first Paris Agreement period in 2021 with a large participant bank of NZUs which are not backed by internationally recognized units and will constitute a taxpayer liability under New Zealand’s Nationally Determined Contribution as well as contribute to uncertainty about unit supply and auction revenue in the NZ ETS. On the positive side, reforms to the NZ ETS passed in 2020 have added features enabling the system to help deliver on New Zealand’s international and domestic targets: a domestic cap on unit supply, more effective price control measures, and a quantity limit on participant surrenders of offshore units if they are permitted in the system in the future.

A key insight from the 2012 announcement was it showed policy makers the New Zealand carbon market acts like a well-functioning market and responds appropriately to supply-side signals. A key disadvantage from the protracted time between the announcement in 2012 and the delinking in 2015 was the increased stockpile of NZUs. If the New Zealand Government intends to link the market to overseas markets in the future, it should consider an appropriate delinking strategy before any agreement is made.