Government launches consultation on Emissions Trading Scheme

This week, the Government launched its highly anticipated consultation on proposed changes to the emissions trading scheme (ETS). The consultation relates to two separate but inter-related sets of proposals, and separate discussion documents have been released in relation to each:

• The first discussion document sets out four options for reforming the ETS so as to better incentivise gross emissions reductions, while still incentivising emissions removals from forestry (see our earlier update on this subject here). This relates to concerns that the current ETS design does not incentivise market participants to reduce emissions at source (gross emissions reductions), but rather that it incentivises market participants to meet their obligations under the ETS by purchasing units that have been awarded to foresters for the carbon sequestered by trees (net emissions reductions).
• The second discussion document relates to proposals to redesign the permanent forest category in the ETS.

While the options set out in the two discussion documents are at this stage high-level, and the Government has not indicated what the ultimate policy design will be, all options could have significant consequences for organisations across all sectors. For example, reform of the ETS has the potential to drive gross emissions for reductions initiatives by making it more difficult or expensive for organisations in a range of sectors to rely on NZUs from forestry to meet surrender obligations or to voluntarily offset emissions. On the other hand, the proposals could drastically impact returns for forestry investments (including for some Māori landowners).

Given the high-level and preliminary nature of the options put forward, there remains considerable uncertainty and each of the options are likely to impact prices for NZUs in different ways if implemented. Businesses that interact with the ETS, whether as part of the forestry sector or in the wider economy, must therefore prepare for a further period of policy uncertainty until final decisions are made, which could be some time away given the Government has foreshadowed further consultation on detailed policy design.

Consultation on the discussion documents closes on 11 August 2023. Further details are set out below. If you would like assistance engaging with the consultation process, please get in touch with one of our experts or your usual Russell McVeagh contact.

First discussion document: review of the ETS

The first discussion document sets out four options to encourage greater gross emissions reductions in the ETS, while continuing to support forestry removals. In doing so, it purports to recognise both the important role that forests play in New Zealand's response to climate change, and the challenges associated with widespread exotic afforestation (such as in relation to land-use change and the susceptibility of forests to natural hazards).
 
The options put forward respond to criticism from the Climate Change Commission and elsewhere that the current ETS design incentivises high levels of afforestation given that it is cheaper for market participants to purchase NZUs from forestry to meet surrender obligations than it is to invest in lower-emissions technologies.

The four alternative options proposed by the Government are:

1. Using existing ETS levers to strengthen incentives for net emissions reductions: This option involves the Government reducing the supply of NZUs by using existing levers such as auction volumes, price controls or industrial allocations. The Government considers that this option has limited ability to drive long-term gross emissions reductions unless changes are made to the volume of forestry units available.

2. Creating increased demand for removal activities to increase net emissions reductions. This option involves increasing demand for NZUs by allowing additional entities to purchase them outside of the ETS (eg, the Government or offshore buyers). However, the discussion paper highlights that there is currently no evidence of significant demand from offshore buyers and the effectiveness of this option is expected to be limited.

3. Strengthen incentives for gross emissions reductions by changing the incentives for removals: Under this option, there would be separate prices for emissions reduction activities and removal activities. A lower price would apply to removal activities, making them less financially attractive. This option could be implemented by, for example, imposing restriction on the types of units that ETS participants can surrender, restricting the number of units that can be allocated from removal activities, or restricting the time that removal units can be held (vintaging). The Government expects this option to increase incentives for gross emissions reductions, but notes that it would likely lead to less removal activity in the absence of complementary policies.

4. Creating separate incentives for gross emissions reductions and emissions removals: This option would involve two separate ETSs – one for gross emissions reduction activities and the other for removals. Entities would not be permitted to use units generated from removals to meet surrender obligations. Removal units could be purchased by the Government, emitters, or both. The Government considers that this option would be most likely to drive gross emissions reductions and expects that it would also incentivise removals depending on the price ultimately paid for removal activities. It would, however, require a comprehensive overhaul of the ETS.

In addition, the discussion document highlights a number of ways that the ETS could be amended to support broader environmental outcomes and removal activities, for example, by differentiating between indigenous and exotic forestry in ETS design.

Second discussion document: redesign of the permanent forest category

The Government's proposals to redesign the permanent forest category in the ETS follow consultation last year on proposals to restrict the use of permanent exotic forests in the ETS, which were ultimately scrapped in light of the feedback received. The Government now proposes to take a "cautious approach" the redesign, recognising both the potential environmental and economic risks associated with large-scale transition of land to permanent forestry, and the role that permanent forests can play in supporting Aotearoa New Zealand's carbon sequestration and erosion-related goals.

The Government's proposes a number of options related to three "design choices", summarised below. The discussion document explicitly does not seek feedback on either leaving the permanent forest category or restricting the permanent forest category to indigenous forests only, given the feedback already received on these topics last year.
 

Design choice 1: Which forests should be allowed in the permanent forest category?

Option 1.1 Only transition forests and indigenous forests can enter the permanent forest category.   The Government considers this option would best support the establishment of long-term, indigenous carbon sinks (depending on the viability and treatment under the redesigned permanent forest category of transition forests). On the other hand, the discussion document highlights that transition forests are an emerging forest model and there are uncertainties associated with their long-term impact.

Option 1.2: Exotic forests allowed to enter under limited circumstances – for example, this could include long-lived exotic species, Māori-owned land, or small-scale exotic forests planted on farms.   The Government considers that this would enable higher levels of afforestation than option 1.1, therefore facilitating quicker carbon sequestration and could support Māori aspirations for their land. The discussion document notes, however, that this could lead to a risk that exotic afforestation displaces other productive land use.

Design choice 2: How should transition forests be managed to ensure they transition from exotic to indigenous forest and reduce the financial risks to participants?

Option 2.1: Status quo (no new specific carbon accounting method for transition forests).

Option 2.2: Enable new mandatory specific accounting methods for transition forests in the permanent forest category. The discussion document appears to favour this option, noting that under current settings transition forests will incur significant surrender liabilities under the New Zealand ETS as large exotic species are replaced by indigenous species.

Design choice 3: How should permanent forests be managed?

Option 3.1: Status quo (no additional forest management requirements introduced for forests in the permanent forest category).

Option 3.2: New minimum forest management requirements – specific to the permanent forest category – are introduced for all registered permanent forests (exotic, indigenous, and transition forests).

Option 3.3: New forests management requirements are needed for transition forests.

Interaction with other reforms and reviews

The current consultations interact with a number of other reforms and reviews that the Government currently has underway. In particular:

• Last week the Government announced that decisions have been made to amend the National Environmental Standards for Plantation Forestry (NES-PF). These reforms will empower councils to develop local rules and policies to manage the location of exotic forests, with changes expected to be enacted by October 2023. These changes are part of the Government's overall aim of getting the "right tree in the right place", which the Government is aiming to further advance through changes to the ETS.
• In May of this year, a report was published by the Ministerial Inquiry into land uses associated with the mobilisation of woody debris (including forestry slash) and sediment in Tairāwhiti and Wairoa. The Government anticipates that the proposals in the current consultation documents may assist in meeting the recommendations from the Inquiry. 
• The Government is working on a range of other reforms and reviews that could have consequences for how the ETS operates. This includes work in relation to agricultural pricing, the development of a voluntary carbon market in New Zealand, and the development of a carbon removals strategy.

Market participants should ensure that they are across the full spectrum of developments in this fast-moving area. For example, those with obligations to report on their climate-related risks and opportunities under New Zealand's mandatory climate-related disclosures regime should ensure that risks associated with reforms are appropriately identified, responded to, and disclosed.