Aligning the ETS cap with the Government’s ERP2
strategy
Key messages
1. This briefing seeks your direction on how the second emissions budget should be
allocated between NZ ETS and non-ETS sectors to align with the Government’s climate
strategy. Providing clarity to the market on the minimum level of fixed emissions budgets
that are expected to be covered by the NZ ETS (the NZ ETS cap) is important for
supporting the credibility of the NZ ETS and reducing uncertainty about ETS settings.
2. We seek direction on this issue now as the second emissions reduction plan (ERP2) is
the ideal vehicle and the first opportunity for this Government to publicly signal the
intended NZ ETS cap for the emissions budget two period.
3. Since the introduction of NZ ETS auctions, there has been no explicit direction from
previous governments on how to allocate emissions budgets. The lack of direction has
been a source of uncertainty in the market and the Climate Change Commission has
recommended that this be addressed.
4. In the absence of clear direction, the allocation has been based on the Commission’s
advice and the sector sub-targets from the first emissions reduction plan (ERP1). Under
the current approach, this equates to a NZ ETS cap for emissions budget two of 96Mt
CO-2e (32% of the budget).
5. We recommend the NZ ETS cap be aligned with the Government’s climate strategy as
reflected in the ERP2 suf iciency projections (BRF-5349 refers), equating to a cap of
92Mt CO-2e for emissions budget two. This represents a small reduction from the 96Mt
cap under the existing approach. The reduction is mostly due to a higher share of
emissions budgets being allocated to agriculture than previously, and is consistent with
the Government’s policy for the ETS to be the main tool.1
6. A NZ ETS cap of 92 Mt equates to an emissions budget two share of 212 Mt for non-
ETS sectors (mainly agriculture). This non-ETS share is based on sufficiency projections
that show achievement of the 2030 biogenic methane target is finely balanced, so in
practice the updated ETS cap wil provide no additional constraint on the agricultural
sectors share of the emission budget.
7. We recommend you seek Cabinet agreement to include the intended NZ ETS cap in the
ERP2, and to undertake consultation on it through the 2025 NZ ETS settings process.
This process would provide a clear signal to the market of this Government’s intended
approach in line with your climate strategy, while enabling consultation feedback and the
potential incorporation of any changes that may arise due to the review of the methane
target.
1 This does not necessarily mean 4M fewer NZUs to auction than in regulations. Other changes, such
as updated estimates of the surplus stockpile and industrial allocation forecasts, wil also influence
NZU auction volumes in next year’s ETS settings decisions.
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8. The intended NZ ETS cap based on ERP2 projections would inform future NZ ETS
settings decisions. However, it would not bind regulatory decision-making as NZ ETS
settings decisions must stil meet all legal requirements, including the requirement to be
in accordance with emissions budgets and targets. The projections of ETS and non-ETS
emissions are a required consideration under section 30GC(5)(a).
9. There is an alternative option in which you do not specify a cap but adjust it each year
based on the most recent projections of non-ETS sector emissions for the purposes of
the ETS settings process. This approach would represent a change from past settings
decisions and would reduce certainty for NZ ETS participants, as unit settings would
vary in response to non-ETS sector emissions as well as changes in ETS sectors. In
theory this approach would mean the ETS could compensate for any shortfalls in
agricultural emissions reductions. However, in practice the ability of the ETS to perform
this function is constrained by the large stockpile of units and the relative inelasticity of
ETS sector emissions in the short term. We therefore do not recommend this approach.
10. If no decision is taken through ERP2, the next opportunity to communicate an amended
NZ ETS cap would be during the process for updating 2025 ETS settings. This would
mean the Commission would likely continue to use the existing approach (based on
sector sub targets from ERP1) for its 2025 settings advice which do not reflect this
Government’s climate strategy. This lack of clarity could create uncertainty in the market.
11. Longer term clarity about the ETS cap beyond emissions budget two would increase
market certainty. However, before adjusting the cap for emissions budget three and
beyond, we recommend that you wait until after decisions are made on set ing the
second Nationally Determined Contribution (NDC2) and the biogenic methane target
review, and you have received advice from the Climate Change Commission on
emissions budget four and the 2050 target.
12. The market is likely to respond positively to clarity on how emissions budgets are
allocated to ETS and non-ETS sectors and will see this as a further step in enhancing
market credibility. Whilst the intended small tightening of the cap is unlikely to have any
significant effect on market pricing, we would expect any impact to be positive.
Recommendations
We recommend that you:
a.
Note that providing clarity about this Government’s preferred allocation of emissions
budgets between ETS and non-ETS sectors based on your climate strategy would
support the credibility of the NZ ETS Market
b.
Agree to include a proposal in ERP2 for an NZ ETS cap of 92 Mt for the second
emissions budget with consultation through the 2025 NZ ETS settings process
Yes | No
c. Subject to recommendation b),
agree to including the draft text set out in appendix one in
the ERP2 Cabinet paper and final plan (noting this has been slightly updated from the
text used in the ERP2 documents circulated for ministerial consultation)
Yes | No
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d. Agree to reconsider the NZ ETS cap for allocation for emissions budget three and
beyond following decisions on the next Nationally Determined Contribution and the
biogenic methane target review, and after you have received advice from the Climate
Change Commission on emissions budget four and the 2050 target
Yes | No
e.
Agree to officials informing the Climate Change Commission of Cabinet decisions so that
the allocations can be factored into the Commissions advice
Yes | No
Signatures
Mark Vink
General Manager
Markets Directorate
23 October 2024
Hon Simon WATTS
Minister of Climate Change
Date
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Aligning the ETS cap with the Government’s ERP2
strategy
Purpose
13. This briefing seeks your direction on how the second emissions budget should be
allocated between NZ ETS and non-NZ ETS sectors to align with the Government’s
climate strategy. The briefing focusses on one aspect of the methodology used to
determine NZ ETS settings – specifying the intended proportion of emissions budgets
allocated to NZ ETS sectors (referred to in this advice as the NZ ETS cap2).
Background
14. As originally envisaged, the NZ ETS would have covered all sectors of the economy, in
which case emissions budgets and targets would have determined the cap. New
Zealand Units (NZUs) would have been traded across all sectors of the economy,
allowing those firms and sectors who can most efficiently reduce emissions or increase
removals to do so first. Splitting some sectors out of the NZ ETS means that the
incentives it generates do not apply to the whole economy.
15. For most of its history there was no cap on emissions from NZ ETS sectors; NZUs were
plentiful and ETS prices were low as a result. The reforms that introduced NZ ETS
auctions from 2021 onwards also introduced the need to establish an NZ ETS cap.
Since the introduction of auctioning and the establishment of a cap, NZ ETS prices are
higher than they were and are more effective at incentivising emissions reductions and
removals.
Analysis and advice
The NZ ETS cap is central to providing regulatory predictability to the market
16. The NZ ETS cap is the portion of fixed emissions budgets covered by the NZ ETS. The
NZ ETS cap is combined with other information, notably estimates of the surplus
stockpile of units and forecasts of industrial allocation, to determine auction volumes and
the auction floor price.2 A stable and predictable NZ ETS cap is central for the credibility
of the NZ ETS and provides an important signal to participants that can feed into their
investment decision making.
2 As defined in this briefing, the NZ ETS cap is relevant to step 2 of the settings methodology –
allocating emissions budgets to NZ ETS and non-NZ ETS sectors. The NZ ETS cap differs from the
overall limit on units that is prescribed in regulations. The overal limit on units is a subset of the NZ
ETS cap covering free units issued through industrial allocation, any approved overseas units
(currently none), the number of units sold at auction, and the cost containment reserve. The main
difference between the overall limit and the cap is the portion of the surplus stockpile reduction volume
that exceeds the cost containment reserve.
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17. Since public consultation on the first NZ ETS settings process in 2022, market
participants have been calling for greater regulatory certainty to support their business
planning and investment decision-making. NZ ETS settings consultation this year
received a substantial number of submissions referring to regulatory certainty as a
reason for supporting a particular option. 9(2)(ba)(i)
18. Being clear about the intended NZ ETS cap for ERP2, while supporting regulatory
certainty, is not intended to bind future regulatory decision-making. ETS settings
decisions are made annually within a clear legislative framework, subject to legal
requirements as outlined in section 30GC of the Climate Change Response Act 2002
(the Act). This includes consideration of latest projections of emissions that the ETS
covers and those it does not (section 30GC(5)(a). Providing clarity on the NZ ETS cap
helps set the context within which settings decisions are made. However, ETS settings
decisions must stil meet all legal requirements, including the requirement for ETS
settings to be in accordance with emissions budgets and targets.
The current cap reflects the first emissions reduction plan
19. To date, there has been no explicit direction from the government on how emissions
budgets should be allocated. In the absence of this direction, the Commission uses the
emissions projections from its 2021 advice
Ināia tonu nei: a low emissions future for
Aotearoa and the sector sub-targets established by the previous Government in ERP1 to
calculate the NZ ETS cap.
20. The Commission has repeatedly requested the government provide direction on the NZ
ETS cap so that it can ensure its advice is consistent with the government’s climate
strategy. The previous Government did not explicitly provide that direction, leaving the
use of the Commission’s projections and the sector sub-targets as the default approach
for both the Commission and the Government.
21. Sector sub-targets were established in the first emissions reduction plan as an
accountability tool. They were designed for monitoring progress in individual sectors,
rather than to be used as the basis for NZ ETS settings decisions. You have recently
received advice recommending cancelling the existing provisional sub-targets set by the
previous Government and that other mechanisms should be used to measure progress
towards achieving emissions budgets (BRF-5138 refers).
22. The NZ ETS cap calculated for this year’s NZ ETS settings decisions (based on the
Commissions projections using ERP1 sector sub-targets), was 111 Mt CO-2e for
emissions budget one (39% of the budget), 96Mt CO-2e for emissions budget two
(32%), and 38Mt CO-2e for emissions budget three (16%). The dashed line in Figure 1
shows the NZ ETS cap as used for this year’s NZ ETS settings decisions compared to
most recent ERP2 projections.
The NZ ETS cap determines the share of effort non-ETS sectors are expected to make
towards emissions budgets.
23. Determining the NZ ETS cap then also establishes what portion of emissions budgets
are expected be met by non-ETS sectors (mostly agriculture (~90%) and waste (~5%)).
The non-ETS sector share of emissions budgets was projected to increase from 68% in
emissions budget two to 84% in emissions budget three.
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24. The split gas emissions targets place some constraints on the allocation between ETS
and non-ETS sectors. Almost all biogenic methane emissions are outside of the NZ
ETS, which limits how much the NZ ETS can directly contribute to achieving the 2030
biogenic methane target. The NZ ETS’ main indirect contribution to the methane target is
via afforestation of farmland, which the Government is seeking to constrain via the policy
to limit whole farm conversions to exotic afforestation.
The NZ ETS cap should be calculated based on ERP2 projections to align with the
Government’s climate strategy
25. We recommend that the NZ ETS cap be calculated based on ERP2 projections to
ensure that it is aligned with the Government’s climate strategy as set out in the plan.
Table 1 and Figure 1 show the current allocation between ETS and non-ETS sectors
based on the Government’s climate policies.
26. Using the ERP2 emissions projections would put the NZ ETS cap at 92Mt CO-2e for
emissions budget two. This is 4Mt CO-2e lower than the NZ ETS cap this year, mostly
due to a higher share of emissions budgets allocated to agriculture.3 NZ ETS sectors
would be responsible for most of the net emissions reductions required for emissions
budget two, consistent with the Government’s strategy of a market-led approach
focussed on the NZ ETS.
Table 1 – Projected ETS and non-ETS Sector Emissions in ERP2 (Mt CO-2e)
EB1
EB2
EB3
ERP2 total net emissions
284.0
303.7
252.2
of which
Non-ETS Sectors
173.2
211.8
201.2
ETS Sectors
110.8
91.9
51.0
NZ ETS Sectors from 2024 settings decision
111.1
96.1
38.4
Source: MfE ERP2 final projections (integrated approach)
27. Non-ETS sector emissions are projected to be on track to meet their share of emissions
budget two, and the 2030 biogenic methane target is finely balanced. Therefore the
recommended NZ ETS cap does not constrain the allocation of budgets to non-NZ ETS
sectors any further than required to meet existing legislated targets.
28. Using the ERP2 suf iciency projections to allocate the shares leaves a smal buffer of
1.3Mt unallocated. This buffer can be used within the adaptive management framework
to absorb minor shortfalls.
3 Note, this does not necessarily mean 4M fewer NZUs to auction than in regulations. Other changes,
such as updated estimates of the surplus stockpile and industrial al ocation forecasts, wil also
influence NZU auction volumes in next year’s ETS settings decisions.
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sector emissions. This approach treats emissions inside and outside the NZ ETS as
interchangeable under one overall constraint provided by the fixed emissions budgets.
This would, in theory, have the effect of making the NZ ETS an emissions reduction
backstop for the rest of the economy.
34. This situation would be less predictable for NZ ETS participants, as unit settings would
vary in response to non-ETS sector emissions as well as changes in ETS sectors.
Agricultural emissions are frequently subject to material revisions in the greenhouse gas
inventory, with flow-on effects to agricultural emissions projections. This means non-ETS
sector emission projections can vary considerably from year to year even without any
change to the underlying sector fundamentals and policy settings.
35. Over the past five years, agricultural emissions have, on average, been revised upwards
or downwards by 1.25Mt CO-2e per annum compared to the previous year’s inventory
(and were revised by 1.8Mt CO-2e in the most recent inventory).4 Assuming the
inventory revision persists into the projections, this would translate into 6M NZU swings
in the NZ ETS cap over the settings period. Under normal circumstances, with the first
two years of set ings fixed, these variations would be applied to the final three years of
the settings period.
36. To some extent the consequent volatility in NZ ETS unit settings might be mitigated by
the presence of the large volume of stockpiled units, which would help the market
smooth through some volatility. NZ ETS participants are likely to increase their hedging
positions in response to the volatility. These effects, as well as ETS sector net emissions
being relatively insensitive to short term signals, are likely to reduce the ability of the NZ
ETS to act as the backstop.
37. In addition, as the stockpile reduces and as NZ ETS auction volumes fall, the capacity of
the NZ ETS to act as this backstop wil diminish. Auction volumes are just 2.4M NZUs at
the end of the current set ings period in 2029. Of setting higher non-ETS sector
emissions with fewer auctioned NZUs also has fiscal implications.
38. Per your correspondence with Minister McClay (“Measurement and treatment of reported
emissions” in response to Minister McClay’s letter of 27 March), you have instructed
officials to address the challenges of annual methodological changes in our 2025 work
programme. The outcome of that work could ameliorate some of the challenges noted
above of responding to methodological changes within the constraints of a fixed
emissions budget.
There is an opportunity to strengthen market certainty by explicitly signalling future
caps wil align with the approach in the second emissions reduction plan
39. ERP2 provides an opportunity for the Government to publicly signal its intended
allocation of emission budget two between ETS and non-ETS sectors. Al ocating the
effort between ETS and non-ETS sectors is a key strategic decision for the Government
that should align with its wider climate strategy and other goals.
4 For comparison, inventory revisions for ETS sectors were less than 0.5Mt CO-2e, on average, over
the last five years, and less than 0.2Mt CO-2e this year.
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40. In particular, the allocation of effort has equity implications as it directs where the burden
of net emissions reductions should fall in the economy and in our society. As such, the
allocation is a decision that should be made transparently by the Government.
41. Setting out the intended allocation in ERP2 would provide a clear signal to the market on
the trajectory of the NZ ETS cap in coming years and provide predictability to future
settings decisions. This is closely aligned with the Government’s priority of improving NZ
ETS market credibility, which in turn supports investment decision making.
42. The emissions pricing chapter of ERP2 would be the most suitable mechanism for
communicating the Government’s position on the NZ ETS cap for the emissions budget
two period. Appendix one contains placeholder text for how the position could be
communicated.
43. NZ ETS settings are required to be in accordance with all existing emissions budgets
and nationally determined contribution (NDC) targets. The ERP2 projections show New
Zealand as exceeding emissions budget three (BRF-5349 refers), and therefore these
projections would not be suitable for signalling the NZ ETS cap at this time horizon. Nor
do they include outcomes from the biogenic methane target review or account for the
advice you will receive from the Climate Change Commission on emissions budget four
and the 2050 target. The upcoming decision on setting the second NDC provides an
opportunity to signal the NZ ETS cap for the emissions budget three / NDC2 time
horizon.
What happens if you do nothing
44. If you prefer not to communicate an ETS cap through ERP2, the 2025 NZ ETS settings
consultation is the next opportunity to do so. The main downside of this timing is that the
Commission would not be able to consider it in their next NZ ETS settings advice.
45. 9(2)(g)(i)
Implementation
46. Subject to your decision on this briefing, we recommend that you seek an in-principle
agreement, subject to consultation during the 2025 NZ ETS settings process, to signal
an intended ETS cap in ERP2. This would make clear the Government’s position on the
NZ ETS cap for the second emissions budget period, helping to support certainty to the
market.
47. We recommend that the NZ ETS cap be reviewed as part of the adaptative management
framework for ERP2. This framework wil be developed next year (BRF 5138 refers).
Consultation
48. Of icials from the Ministry for the Environment have worked with Crown Law, Ministry for
Business, Innovation and Employment, Ministry for Primary Industries, and the Treasury
in preparing this report. We have also discussed the recommended approach with our
counterparts at the Commission.
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Appendix One: Draft content for the second emissions
reduction plan and its accompanying Cabinet paper
Draft content for the NZ ETS chapter in the second emissions reduction plan
49. In determining NZ ETS settings each year, one aspect of the methodology is to specify
the proportion of emissions budgets allocated to NZ ETS sectors (the “NZ ETS cap”).
Being clear on how the Government intends to al ocate the emissions budget between
NZ ETS and non-NZ ETS sectors (mostly agriculture) wil provide greater regulatory
certainty to the market, enhancing its credibility and supporting participants to make
investment decisions.
50. For the second emissions budget, the Government proposes to align the NZ ETS cap
with our plan to achieve EB2 as laid out in this document. Specifically, we propose to
allocate 92Mt CO2-e of EB2 to NZ ETS sectors. This reflects the projected emissions of
NZ ETS covered sectors as presented in this plan. We wil consult on this as part of the
NZ ETS settings process in 2025.
51. NZ ETS sectors wil continue to be responsible for most of the net emissions reductions
required to meet EB2, consistent with the Government’s strategy of a market-led
approach focused on the NZ ETS. The allocation to non-NZ ETS sectors is aligned with
achievement of the 2030 biogenic methane target, which current projections indicate we
are on track to meet (optional: refer relevant chapter/section).
52. In addition to public consultation through the 2025 NZ ETS settings process, we wil
review this arrangement as part of the adaptive management framework for the ERP2
(as set out in Chapter 13). This wil help us ensure that our approach to the ETS remains
aligned with achieving emissions budgets.
Draft content for the Cabinet paper for the second emissions reduction plan
53. To ensure the NZ ETS aligns with our market-led approach, I recommend, subject to
consultation through the 2025 NZ ETS settings process, specifying the portion of fixed
emissions budgets that is intended to be covered by the NZ ETS (the NZ ETS cap) in
the second emissions reduction plan. Based on ERP2 projections, this would equate to
an intended NZ ETS cap of 92Mt CO2-e for the second emissions budget. This would
provide certainty and credibility to the market, and support participants in making
investment decisions to decarbonise.
54. Under this approach, NZ ETS sectors wil continue to be responsible for most of the net
emissions reductions required to meet emissions budget two. Non-ETS sector emissions
are projected to be on track to meet their share of emissions budget two, with the 2030
biogenic methane target is finely balanced. I wil review the NZ ETS cap as part of the
adaptive management framework of the ERP2, to ensure that it remains aligned with
achieving emissions budgets.
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