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4 Core Design Features continued

4.7 International linkage

4.7.1 Context

Linking to either another country’s trading regime and/or to the global market in Kyoto units is desirable for a number of reasons. An ETS in New Zealand would be a relatively small market with a limited number of participants with unit obligations. Linking internationally ensures much-needed liquidity in the domestic market. It also helps ensure that prices on the domestic market are aligned with international prices.

These factors help to ensure that the NZ ETS aligns with the objective of meeting our Kyoto Protocol and future international obligations at least cost in the long term. Linking also guarantees that the NZ ETS is aligned with global actions to mitigate climate change.

4.7.1.1 Linking internationally

Having ratified the Kyoto Protocol, New Zealand has a number of options available for linking internationally. One option is to allow participants in a NZ ETS to surrender Kyoto units for compliance. Another option is to establish bilateral agreements with other countries to enable respective units of trade to be surrendered in each scheme for compliance. There are also a number of intermediate options between these two ends of the spectrum.

Options for bilateral linking

Direct bilateral linking with an ETS in another country or region implies that the unit of trade in the two different schemes is fully fungible (ie, valid for compliance in each scheme). Bilateral linking requires some degree of conformity between the design features of the respective trading schemes. In effect, both parties have to have confidence in the legitimacy of the other party’s trading unit. Key design issues to enable linking are the core obligation (ie, cap and trade or intensity-based models), sectoral coverage, the unit of trade, the existence of price caps or safety valves, and rules and penalties for non-compliance.

The potential for a direct bilateral agreement between New Zealand and another country or region prior to 2012 is limited. At present, the only existing mandatory regional ETS is the EU ETS. Certain differences in the design between the EU and New Zealand schemes are likely to make direct bilateral linking challenging in the short term. However, officials are working with their counterparts in the EU to assess options in this area.

Australia has also announced plans to introduce a national emissions trading scheme. This is of major interest to New Zealand for linkage given the close economic relationship between the two countries. One impediment to linking is that Australia is not a party to the Kyoto Protocol. This means that trade would not be in Kyoto units, possibly increasing New Zealand’s Kyoto liability if linking were to occur in the first commitment period. This is not an insurmountable barrier, however, because there are options for partial linking between non-Kyoto and Kyoto parties.27

If Australia were to join the Kyoto Protocol, New Zealand might be able to accelerate indirect linkage through the Kyoto mechanisms. However, Australia’s domestic ETS is unlikely to be fully operational before 2012, limiting direct linking opportunities before then. In any event, design features will remain key to whether linking can occur.

Generally speaking, the design features of the NZ ETS will be broadly in line with other existing and proposed emissions trading schemes so as not to restrict future linking opportunities.

Given the limitations on linking bilaterally prior to 2012, it is important to be able to link the NZ ETS to the Kyoto Protocol’s flexibility mechanisms (emissions trading, Joint Implementation and Clean Development Mechanism). Through this linking, the various kinds of Kyoto units28 can be surrendered for compliance by a participant in the NZ ETS in the same way as an NZU.

Potential restrictions on surrendering Kyoto units for compliance

In designing international linkages, there are several technical decisions that the government needs to consider. In particular, the government needs to assess whether to restrict the type or volume of Kyoto units that can be purchased into the NZ ETS. For example, the EU places limits on the number of units that can enter the EU ETS.29 The EU ETS also has restrictions on purchasing units from certain types of projects. Kyoto units (CERs and ERUs) generated from nuclear facilities, for example, are prohibited, as are credits from forestry activities. The EU ETS also has specific guidelines for credits generated from hydro-electric power production projects.

In deciding whether to restrict the type or volume of Kyoto units that can enter a NZ ETS, the government has weighed up issues such as compliance costs (including long-term costs), economic efficiency and flexibility, environmental integrity, equity and the international acceptability of the NZ ETS.

Restricting the volume of Kyoto units may help to encourage domestic abatement relative to international abatement. However, restrictions on volume will increase the costs for participants and for the economy as a whole. Some restrictions on the volume of Kyoto units that can be sold on the international market will occur as a result of restrictions on the Commitment Period Reserve (as discussed in the next section).

Restrictions on the type of Kyoto units may affect the environmental integrity of the scheme. For example, some people have raised concerns about allowing AAUs into the NZ ETS (the EU ETS, for example, specifically excludes trade in AAUs). Arguments against including AAUs are based on concerns about “hot air”, which generally refers to AAUs that were allocated to countries whose emissions at the time were less than in 1990, for example as a result of economic recession during the 1990s and the corresponding sharp decline in their emissions.

Arguments for accepting AAUs are based on lowering compliance costs (linked to the core objective of the NZ ETS) and the argument that AAUs are legitimate units, covered by the Kyoto cap, and therefore should be fully tradable. Countries signing the Kyoto Protocol did so in full knowledge of the implications of these allocation decisions. Removing an AAU reduces the ability of others to emit, and it can also be argued that, to some extent, there is hot air in the inventories of many developed countries.

Units generated by the Kyoto Protocol’s project-based mechanisms - namely the Clean Development Mechanism, which generates CERs, and Joint Implementation, which generates ERUs - are arguably less controversial internationally. However, there are still concerns about the environmental integrity of some of these units associated with different types of projects, in particular:

  • units that are generated by emissions removals from afforestation and reforestation CDM projects (tCERS and lCERs) carry a risk of future liability to the Crown, which does not exist with other units30

  • units generated from HFC-23 projects31 involve significant issues. These issues are currently before the United Nations Framework Convention on Climate Change (UNFCCC) and Montreal Protocol bodies for resolution. If such issues remain outstanding, New Zealand would need to consider excluding them from our Kyoto registry.

4.7.1.2 Managing the Commitment Period Reserve

The Commitment Period Reserve (CPR) is a rule within the Kyoto Protocol designed to prevent parties from overselling in relation to their Kyoto targets. The CPR requires each party with binding targets to hold a minimum number of Kyoto units in its national registry. In New Zealand’s case this means that Kyoto units covering 90 per cent of our assigned amount (under the Kyoto Protocol) must be held in the registry at any point in time throughout the first commitment period (2008-2012). If this limit is reached, the registry would effectively close to outgoing international transfers until more Kyoto units (AAUs, CERs, ERUs or RMUs) were transferred into the registry.

Closure of the registry because of breaching the CPR would self-correct when more units entered the registry. Temporary closure of the registry as a result of breaching the CPR could constrain the ability of participants in Projects to Reduce Emissions, those in Negotiated Greenhouse Agreements and the Permanent Forest Sink Initiative to sell their Kyoto units internationally. These parties can be protected by maintaining a purpose-built buffer within the CPR, and closing the registry to other trades in advance of breaching the actual CPR. This issue is being considered further.

4.7.1.3 Price safeguard mechanisms in the domestic market

Arguments for and against safeguard mechanisms such as ‘price caps’ or ‘price floors’ in ETS design revolve around concerns about the volatility of emission prices and absolute price levels. If the international emissions market were to prove to be particularly volatile, the use of either a price cap or price floor could assist in building confidence in a NZ ETS.

A price cap would limit the emission unit costs faced by New Zealand firms. Different mechanisms could be used to provide a price cap. For example, the government could buy international emission units and sell them to New Zealand firms at the level of the price cap to meet demand. The government would then absorb the cost differential between the international price and the domestic price cap.

A price floor, on the other hand, could be used to help avoid the risk of an unexpected drop in emission unit prices, thereby affecting the viability of investments that were based on higher forecasted emission unit prices. A sudden drop in the price of emission units could occur if there was an oversupply of units in the international market relative to projected demand. One potential mechanism for providing a price floor would be for the government to block further international acquisitions of emission units if the international price fell below the level of the price floor.

Price caps and floors do come with downsides from a policy angle. In particular, the use of price caps and/or price floors:

  • could significantly impede the ability to link the NZ ETS bilaterally to other trading schemes that do not use such mechanisms

  • would require limits on the use of banking provisions (this is particularly important in terms of forestry companies where credits and liabilities occur over a significant period of time, and banking of at least some NZUs is likely to be a serious financial management option for forestry companies)

  • may affect the development of a full range of emissions-related financial products

  • (in the case of a price cap) may act as an impediment to investment in emission-reducing activities.

In the long run, the goal of the NZ ETS is to expose the New Zealand economy to the price of emissions. As such, neither a price cap nor a price floor is desirable as a long-run policy instrument, assuming that the international emissions market continues to operate effectively.

Box 2: Drivers of price in a NZ ETS

The primary determinant of the emission unit price in the New Zealand market will be the nature of the international linkages with the NZ ETS. This means the price of NZUs is likely to be heavily influenced by international price trends. Nevertheless, an element of home bias in the New Zealand market is very possible in light of potential high transaction costs in accessing the international emissions trading market.

Most current trades in Kyoto units are in CERs under the Clean Development Mechanism. There are uncertainties applying on both the supply and demand sides internationally, and these uncertainties seem likely to remain for some time.

The market in the EU ETS is likely to have a higher price (possibly significantly) than prices in a New Zealand market. This is due to EU rules that limit the quantity of Kyoto units that can enter the EU ETS. Given this, while prices in the EU ETS will be one factor in determining the price of CER units, it is not at all clear that Kyoto unit prices will follow the patterns in the EU ETS.

Although it is difficult to predict the price in the NZ ETS market, there is some information available that might be of guidance. The World Bank State and Trends of the Carbon Market 2007 had a wide range of CER prices (USD$6.80–$24.75) with an average price of slightly less than USD$12.00. ERUs were cheaper.

During the first commitment period, the drivers of the international emission unit price will include the availability of project-based units such as CERs and ERUs, the extent to which AAUs enter the market, and the extent to which individual countries choose to meet their Kyoto commitments through the purchasing of Kyoto units.

In the long run, it is hard to predict the directions in which the emissions market may evolve. Prices will depend on the exact nature of future international climate change agreements, and very importantly, the stringency of any future international climate change agreements.

4.7.2 Decisions on international linkage of the NZ ETS

The government has decided in principle that for the first commitment period (2008-2012), the ETS will be linked to the international Kyoto market. Subject to certain restrictions, NZUs will be interchangeable with Kyoto units, and participants will be able to surrender both NZUs and Kyoto units for ETS compliance purposes.

Participants will be able to exchange NZUs for Kyoto units to sell them offshore; however, offshore sales will be subject to constraints imposed by the Kyoto Protocol’s Commitment Period Reserve (CPR). When managing the CPR, preference will be given to participants in Projects to Reduce Emissions, Negotiated Greenhouse Agreements and the Permanent Forest Sink Initiative in order to enable them to sell units internationally.

For the first commitment period, the government will place no restrictions on the type of AAUs that can enter the NZ ETS. However, the ETS will include a power for the government to place restrictions on the type of CERs and ERUs that can be brought into the NZ ETS. The government has already decided to exclude CERs and ERUs relating to nuclear projects from the New Zealand Emission Unit Register, and to prevent individuals from holding lCERs in the Register. The government has also excluded individuals from retiring tCERs for compliance under the Kyoto Protocol. As a result, these units will be unable to be used for NZ ETS compliance purposes. Similarly, if issues around HFC-23 projects remain outstanding, New Zealand would need to consider excluding associated units from its Kyoto registry and therefore the ETS.

In the short term, linkages between the NZ ETS and the emissions trading schemes of other countries will occur indirectly via the international market in Kyoto units, rather than through direct bilateral linkages.

The government has not identified the need to include a price cap or a price floor in the core design of the NZ ETS for the foreseeable future. The ongoing commitment to the Kyoto Protocol of key developed countries, the operation of the EU ETS, and the projected supply of Certified Emission Reductions (CERs)32 are expected to help provide the foundation for a sufficiently stable international market in the Kyoto Protocol’s first commitment period (2008–2012). However, specific work has been commissioned to more fully inform government of possible carbon market developments.

If there were not to be an international agreement after 2012 then the supply of emission units from the international market may well be reduced. In such circumstances, a price cap could potentially be used to create an incentive for emission reductions to occur in New Zealand while not placing excessive cost on the New Zealand economy. Therefore, it is recommended that the legislation include a power to introduce a price cap that could be used if, for example, there is a gap between the Kyoto Protocol first commitment period and later international agreements.

4.8 The quantity of emission units to be issued

4.8.1 Context

The environmental integrity and stringency of a cap and trade scheme depend on the definition of the cap. New Zealand is already part of a global cap-and-trade scheme established under the Kyoto Protocol. For the period from 2008 to 2012, New Zealand will be allocated a fixed number of emission units, and will be able to trade emission units with other countries in the scheme. For this reason, a NZ ETS does not require a separate cap on domestic emissions in addition to the Kyoto cap. The Kyoto cap can be the basis for determining the stringency of the scheme. The approach used under the Kyoto Protocol recognises that all emission reductions have a global benefit, no matter where they occur.

An important distinction in terminology needs to be made between the cap on emissions in a domestic scheme, and limits on the allocation of emission units by the government into the domestic market. If participants in a domestic trading scheme can purchase emission units within an international cap, then there is no hard limit placed on the emissions that occur within the country. However, participants will still face a cost constraint on their emissions if the government limits the number of domestic units that it allocates by gifting.

This approach works as long as there is an international agreement in place with a clear cap. Refer to section 4.13 for discussion about the evolution of the NZ ETS in the context of future international agreements.

4.8.2 Definition of the cap for the NZ ETS

The government has decided in principle that the NZ ETS will operate within the cap on emissions established by the Kyoto Protocol (for the first commitment period) and within whatever cap is established under international agreements post-2012. No further limit will be placed on the emissions that occur within the geographic boundaries of New Zealand. Domestic emissions that exceed New Zealand’s allocation under the Kyoto Protocol (including units issued for removals by forest carbon sinks) must be matched by emission units purchased internationally from within the Kyoto cap on emissions.

The government will limit the number of New Zealand units it allocates for free under the NZ ETS. This will place a cost constraint on emitters and consumers. However, because the NZ ETS will be linked internationally (as described above), thereby allowing the import of additional emission units, there will be no absolute constraint on the emissions that occur domestically in New Zealand.

Box 3: Is the NZ ETS a true cap and trade scheme?

There are different ways to design an emissions trading scheme but all trading schemes require some form of constraint around the total level of emission units available; that is what gives them value and leads to trading.

The classic type of emissions trading scheme is a cap-and-trade arrangement, such as that used for SOX and NOX emissions in the United States. Under this sort of scheme, a government sets a binding, absolute limit on the total level of emissions that can occur in that country (or sometimes state, etc). This binding limit is called the cap.

New Zealand’s ETS is different from this classic type of cap-and-trade scheme in two key ways:

  • First, it operates within an overarching global agreement (the Kyoto Protocol). As the Protocol provides an international cap, an additional cap for the NZ ETS is not required. The global cap will lead to an international price of emissions that will set the price in the market of a NZ ETS.
  • Secondly, under the Kyoto Protocol participants can earn project-based emission units by reducing emissions in developing countries that are signatories but do not have a binding cap. Participants can also earn removal units from eligible land use, land-use change and forestry activities in developed countries. As a result, the cap on emissions for Annex B countries under the Kyoto Protocol does not act as an absolute limit, even at the international level; Annex I countries can collectively emit more than their aggregate cap if they earn units through the Clean Development Mechanism or the use of domestic forest carbon sinks.

4.9 Offsets

4.9.1 Context

An ETS rewards participants for achieving any emission reductions below business as usual. The reward comes in the form of a corresponding reduction in the number of units that the participant is required to surrender at the end of the commitment period, or in a reduction in the emission-related price increases they will face. Participants are also awarded units for removing greenhouse gases from the atmosphere (ie, through new forest plantings). However, an ETS does not incentivise all activities that reduce emissions. For example, the relevant sector may not be covered by the ETS, or the design of the ETS may not be sufficiently detailed to capture the activity.

However, an ETS framework can be augmented by the use of offsets. An offset (ie, a tradable emission unit) could be granted where a person voluntarily undertakes some action that leads to either a reduction of greenhouse gases emitted into the atmosphere, or the removal of greenhouse gases from the atmosphere. In the context of a NZ ETS, an offset mechanism would create an incentive for emission reductions not covered by the ETS. Typically, there would not be a corresponding liability associated with the emission reduction.33 Participants would be awarded NZUs, which they could sell for a profit.

There are two areas where the concept of offsets may be useful:

  • in sectors of the economy not covered by the NZ ETS

  • in sectors inside the NZ ETS where the relevant emission factor system cannot be adapted to provide all of the desirable incentives to reduce emissions.

In relation to the first point, offsets may be a useful transitional measure to consider prior to a sector entering the NZ ETS. They may also be a useful ongoing measure for entities not subject to the scheme (eg, those entities whose emissions are under a de minimus threshold).

In relation to the second point, it is possible that there will be some crudeness of the emission factors that are applied in some sectors. This may particularly be the case for the agricultural sector, where it is likely that participants in the scheme would be at the processor level. In this case, some form of offset could be a useful tool to provide incentives for farmers to take actions to reduce emissions that might not be recognised otherwise.

The second point also relates to the long-term issue of breakthrough technologies that may lead to substantial reductions in emissions (an example is carbon capture and storage, whereby emissions are captured and buried underground or beneath the ocean). While such technologies may be many years away, an ETS should be designed to incorporate their use.

Incorporating offsets in an ETS presents some pitfalls. There is often a complex administration system for offsets, and determining “additionality” can be problematic.34 Furthermore, any reductions leading to the issuance of domestic offsets must also be reflected in New Zealand’s national inventory of greenhouse gas emissions under the UNFCCC to ensure New Zealand gains credit for the reduction at the national level.

The government will engage with stakeholders and Māori on the possibility of including the use of offsets in the NZ ETS. Areas of focus might include which activities could be suitable for offsets, how long an offsets mechanism should operate, and how to minimise the technical and administrative challenges of operating an offsets mechanism.

4.10 Design of the market for NZUs

4.10.1 Context

An effective emissions trading market is fundamental to the scheme’s ability to deliver least-cost emission reductions. Markets rely on competition to perform efficiently, and competition is fostered in markets where:

  • the unit of trade is well defined and enforceable

  • the market is liquid

  • the regulatory environment is transparent

  • participants have good price information

  • transaction costs are low.

4.10.2 Support for the market

There is a role for government to ensure the regulatory environment supports a market with attributes that foster competition.

An emissions trading scheme with strong international linkages can deliver greater liquidity, better price information and lower transaction costs. In the short term, the NZ ETS will be indirectly linked to offshore emissions trading schemes through participants’ use of Kyoto units alongside NZUs to meet compliance obligations (refer to 4.6.2 regarding the exchange of NZUs for Kyoto units for sale offshore).

New Zealand will be a small player relative to others in the international carbon market, and we therefore expect that New Zealand’s participation in emissions trading will have little influence over the price of emissions in international markets.

The sudden fall in the price of emissions in the EU ETS in April 2006 has highlighted that poor-quality or asymmetrical information can have a negative impact on the price of emission units. High levels of information disclosure support well-functioning markets. The government will engage with stakeholders and Māori on the possibility of emission reporting on a quarterly rather than annual basis, with an appropriate level of disclosure, to assist the level of information in the market for emission units.

We expect that over time New Zealand participants will be able to access financial instruments for hedging against price volatility.

It is likely that a large number of trades, particularly initially, will be conducted on a bilateral basis. The government does not intend to prescribe the means by which the market trades emission units. The government is considering the need for amendments to the Securities Markets Act 1988 to enable the operation of registered emissions trading platforms.

The government will engage with stakeholders and Māori on whether the ETS design generally provides a sufficient framework for participants to trade effectively, and what (if any) assistance government could provide to help participants understand and comply with their obligations and build their trading capability.

4.11 NZ ETS registry

4.11.1 Context

Central to the operation of an emissions trading scheme is an electronic register, which can be likened to online banking, and will record NZU holdings, transactions, emissions reporting, and the surrender of units for compliance. NZUs are intangible and cannot exist outside the register, which will create each NZU as a serial number in the registry system.

4.11.2 The New Zealand Emission Unit Register

The New Zealand government has already developed a Kyoto-compliant emission unit register, known as the NZEUR. The government expects to make the NZEUR available to the public in the second half of 2007, but it is restricted to transactions and holdings of Kyoto units only.

The NZEUR was developed in accordance with the Kyoto Protocol, which requires New Zealand to develop an electronic emission unit register accessible via the internet. The NZEUR conforms to technical standards adopted under the Kyoto Protocol to exchange data between national registries and the International Transaction Log (ITL) maintained by the UNFCCC Secretariat. The NZEUR and was established under the Climate Change Response Act 2002 (CCRA). For more information, go to http://www.nzeur.govt.nz/.

4.11.3 Establishing a NZ ETS registry

The government plans to develop a register for the ETS that will provide additional functions not available through the NZEUR (eg, the ability to receive emissions reports and to register NZUs).

The NZ ETS register is not yet under development, but is expected to draw on the design of the NZEUR as far as possible. The two systems will need to be compatible and well linked, and may even operate as one register to reflect the needs of users.

The NZ ETS register will give holders certainty for trading and will facilitate compliance. The government will engage with stakeholders and Māori on what the government can do to facilitate use of the NZ ETS register by participants in the NZ ETS.

4.12 Compliance, enforcement and the administering agency

4.12.1 Context

Compliance and enforcement refer to what is required of participants under an ETS and what happens if participants fail to meet their obligations. These matters are critical for the environmental integrity of an ETS.

The long-term core obligation under the NZ ETS would be that each participant must surrender to the Crown one emission unit for each metric tonne of eligible emissions generated in each compliance period. In order to meet the core obligation, participants will also be required to calculate emissions, retain sufficient records to allow verification of emission calculations, report on emissions resulting from specified activities, and comply with any directions of the administering agency.

4.12.1.1 Self-assessment

The government’s preferred approach to compliance is a “self-assessment” methodology, similar to that used in the New Zealand tax system. The operation of a self-assessment scheme means that participants take actions to meet their obligations under their own volition, and the administering agency verifies participants’ compliance with their obligations via an audit process. The actions taken by participants will be assumed to be in compliance unless subsequently challenged by the administering agency.

While virtually all domestic and international enforcement systems for trading schemes involve self-reporting, different approaches are used to manage the accuracy and truthfulness of reported information. Creating layers of checks should strengthen the integrity of the NZ ETS, but too many layers will increase compliance and enforcement costs.

A strict self-assessment approach is one end of the spectrum; the other end is represented by a scheme, such as used by the EU ETS, which requires participants to register before they are able to engage in emitting activities. Under self-assessment there is only a requirement to report after engaging in the activities during the compliance period.

Other ways of minimising risks of inaccurate or fraudulent reporting include requirements on participants to:

  • have emission reports verified by an independent third party before they are submitted to the administering agency

  • monitor and report their emissions at more regular intervals

  • make emissions information publicly available

  • provide more details in annual reports (or more frequent equivalent reports)

  • have the administering agency (ie, not participants) issue an assessment to participants that accepts emissions as reported during a compliance period.

International examples of approaches generally involve at least some of these requirements. In considering an appropriate compliance and enforcement regime for New Zealand, there is a tension between keeping compliance and administration costs low and ensuring the scheme is acceptable internationally (ie, to enable possible linking with other schemes). The government’s initial preference is to follow a self-assessment approach, but in order to ensure there is comfort with the integrity of the system in the New Zealand market as well as the wider international community, some of the options noted above are being considered further.

The administering agency will need a range of enforcement powers, such as to access land and premises to obtain documents and information. These enforcement powers may only be exercised in relation to matters that relate to a participant’s compliance with their obligations under the NZ ETS.

The administering agency will need to determine the nature and frequency of its verification procedures. One approach would be for it to verify the compliance of every participant over a series of compliance periods. An alternative would be for the administering agency to undertake risk-based targeting. Under this approach, verification would be more frequent for participants at greater risk of non-compliance. The administering agency would also identify verification triggers, such as the submission of an annual report that shows radical and unexpected differences in the level of emissions from previous reports.

4.12.1.2 Compliance monitoring

High-quality emissions monitoring and reporting are essential to assure effective compliance and trading. It is important to consider the costs of compliance to participants and the administration costs of the scheme to the administering agency. Methodologies for monitoring and calculating emissions can be organised into two groups: those that are generic to all participants and those that are specific to participant types (eg, by sector or sub-sector).

To the extent possible, without challenging the integrity of the scheme, monitoring and reporting requirements should take advantage of existing information flow and documentation. Where relevant, the NZ ETS should be consistent with the UNFCCC national inventory reporting guidelines, and with the Kyoto Protocol accounting guidelines. The regime should also refer to and take advantage of relevant and appropriate domestic and international standards and international best practice regarding the calculation of emissions that result from different activities (especially in specialised industries).

In the long term, it is desirable that, where practical and where it does not challenge the integrity of the scheme, there be harmonisation of monitoring and reporting with other emissions trading schemes.

4.12.1.3 Compliance reporting

Compliance with the core obligation should be determined on the basis of reporting of prescribed information such as activities, emission factors, emissions and emission units surrendered. Reporting will need to be at least annual, although there are good reasons for more frequent reporting. In particular, more frequent reporting promotes capability as participants undertake the necessary reporting requirements more often. There are also market efficiency reasons for more frequent reporting: greater information disclosure may support price discovery, leading to a more stable market. Mandatory quarterly reporting is a possibility, and participants could have the option of reporting monthly.

4.12.1.4 Penalties

Participants should face consequences for non-compliance with their obligations. These can include financial penalties, make-good provisions, public disclosure of non-compliance, and criminal sanctions.

Some participants, either due to error or deliberate actions, may fail to comply with their obligations. Non-compliance is unfair to those who do comply and can threaten the environmental integrity of the scheme, so a system of penalties for non-compliance is appropriate. The aim in setting the rate of the penalty for non-compliance is to make the cost of non-compliance higher than the costs of compliance, and to be stringent enough to facilitate international linkages.

The most common options used in trading schemes are a financial penalty or a make-good penalty, or both. The financial penalty could be a fixed dollar amount per tonne, or a multiplier of the price of emission units. The price of emission units may be difficult to identify, especially early in the period, although in time a spot price may become identifiable.

4.12.1.5 Banking and borrowing

Banking allows those participants in an ETS that have emissions below their unit holdings to save surplus emission units for use during a later compliance period. Borrowing is the opposite of this, allowing the use of emission units from a future period for compliance during the current period. Both banking and borrowing provide participants with compliance flexibility and can help smooth out volatility in emission unit prices. However, borrowing may have negative environmental impacts by bringing emissions forward in time, and creates a greater risk of future non-compliance.

4.12.2 Compliance and enforcement under the NZ ETS

The government has made the following in-principle decisions on mechanisms for compliance and enforcement, and the roles of the administrative agency.

4.12.2.1 Participant obligations

In addition to the core obligation to surrender emission units to match emissions in each compliance period, participants will also have an obligation to:

  • calculate their level of emissions using approved methodologies

  • retain sufficient records to allow verification of emission calculations

  • report their level of emissions, and emission units surrendered at the end of each compliance period, to the administering agency

  • comply with any directions of the administering agency.

Participants will be required to calculate their emissions for each compliance period (1 January to 31 December each year), submit an annual report detailing their emissions activities by 31 March of the following year, and surrender the emissions at the date they submit their annual reports.

Where feasible, participants will be required to commence reporting six or 12 months prior to assuming surrender obligations in order to build capacity before incurring binding penalties; failure to comply will not incur penalties. Participants will also be required to monitor their activities in accordance with methodologies specified in law.

The compliance system will be based on the “self-assessment” model like that used in the New Zealand tax system.

4.12.2.2 Administering agency

The role of the administering agency will be to verify compliance, and it will take a risk-based approach to verification. The administering agency will be given the following powers to carry out its functions (subject to change as the compliance regime is refined):

  • access land and premises to obtain documents or information, but not to enter a private dwelling without a warrant issued by a judicial officer

  • remove and copy documents

  • remove and retain documents for inspection

  • require any person to provide information pertaining to participants’ compliance with NZ ETS obligations, either electronically or in writing

  • require any person to attest to the truthfulness of the information furnished by requiring them to sign a statutory declaration, give evidence before the administering agency under oath, and possibly give evidence before a court

  • prescribe forms necessary for the administration of the scheme

  • require the verification of some or all information pertaining to the NZ ETS by an independent third party

  • demand special returns, and make special (including default) determinations of emissions (potentially with the support of technical experts).

The administering agency will not be able to challenge the actions of participants after a certain period. Stakeholder views are sought on an appropriate limitation period.

4.12.2.3 Penalties

A penalties regime will be included in the NZ ETS, involving civil liability for any failure by a participant to meet its obligations, and criminal liability where a participant does so knowingly. Any failure by a participant to meet the core obligation (referred to as a “surrender shortfall”) will result in:

  • a requirement to make up the surrender shortfall within 90 days of a determination by the administering agency that a participant is in breach, at a ratio of 1:1

  • a financial penalty of NZ$30 per tonne of emissions for which emission units have not been surrendered (ie, the surrender shortfall)

  • the publication of the participant’s identity and the nature of the compliance failure.

Where a participant knowingly fails to meet the core obligation, the unit make-up requirement will increase to a ratio of 1:2, the financial penalty will rise to NZ$60 per tonne of emissions, and participants (or their directors, in the case of companies) will face the possibility of criminal conviction. Participants’ failure to meet other obligations will result in a civil penalty of up to $4,000 for the first infringement, $8,000 for the second infringement and $12,000 for the third infringement. Where participants fail to meet these obligations knowingly, they will be subject to criminal penalties, including larger fines, and personal criminal conviction.

A procedure will exist for the administering agency to make a default assessment of the number of emission units that participants must surrender where the participants fail to monitor and/or report their emissions in accordance with their obligations. Where this occurs, participants will be subject to fines for failing to meeting their obligations and liable for the stricter make-up requirements and higher financial penalty. A series of smaller penalties will exist for administrative infringements. Appropriate appeal procedures relating to the decisions of the administering agency will be included in the legislation.

4.12.3 Engagement on verification and reporting

The government will engage with stakeholders and Māori on the following possible checks to help ensure the truthfulness and accuracy of compliance information:

  • independent third-party verification of participants’ annual reports

  • independent third-party verification of information submitted by participants to determine their entitlement to the free allocation of units

  • the ability for participants to seek binding rulings from the administrative agency that their proposed actions to meet their obligations will result in compliance

  • more frequent reporting by participants of their emissions (eg, monthly or quarterly, instead of annually).

The government also wishes to engage with stakeholders and Māori on whether methodologies determining how participants are to calculate and report their emissions should be set out in primary legislation or regulations. The government’s preferred option is to include these methodologies in regulations, because they may need to change as UNFCCC rules are updated. There also needs to be some flexibility for individual participants to seek specific rules that apply to their particular case. Providing for the methodologies in regulations allows for change without Parliament having to pass an amendment to the primary legislation.

4.13 Future evolution

4.13.1 Context

Emissions trading schemes are complex instruments, and the initial operation of any scheme will expose features of the scheme that require refinement. The NZ ETS is no exception and will be an evolving policy instrument. Ongoing refinement of the details of the NZ ETS will be necessary as firms and administrators gain more experience with the scheme. The NZ ETS will also need to evolve to reflect changes in future international arrangements.

To ensure the NZ ETS is operating effectively and is meeting its core objective, it should be reviewed regularly. Any review will need to consider the international setting within which the NZ ETS operates, including the evolution of the UN-based negotiations. The Kyoto Protocol’s first commitment period ends on 31 December 2012. Although negotiations are underway to determine parties’ obligations under future agreements, the scope and nature of these agreements remain uncertain.

It is intended to design the NZ ETS so that it can be adapted to future changes to New Zealand’s obligations under the international climate change policy framework post-2012, and can endure should there be a gap between the end of the first commitment period of the Kyoto Protocol and whatever international agreement is established beyond that point. This is important to help provide some degree of medium- to long-term certainty that there will be a future price of emissions in New Zealand, thus assisting in informing investment decisions.

Should agreement not prove possible in the short term, there is the possibility of a gap between the end of the first commitment period and new international arrangements. This gap could be for a relatively short time, or for a significant period of time. If it appeared that there was unlikely to be an effective international agreement operating for some time post-2012, then pluri-lateral or regional trading schemes may emerge. Under those circumstances, New Zealand may wish to consider developing such trading schemes with, for example, Australia and other countries.

If there was no successor agreement to Kyoto but an international market for emissions continues to operate, the government could continue to issue NZUs at an agreed level and establish domestic rules for the trading of international units meeting sufficient quality standards. Conversely, if there was no successor agreement to Kyoto and no international market for emissions to which New Zealand wishes to link, the government could maintain the ETS by auctioning NZUs, and could use a price cap to mitigate the price risks associated with a domestic-only trading scheme. This would ensure that New Zealand participants in the NZ ETS continued to face a cost of emissions in their business decisions, and to reduce the price uncertainty they faced.

Alternatively, sectoral agreements may emerge for managing emissions (in a way different from that under the Kyoto Protocol) from certain sectors such as cement or aluminium manufacture. These potentially could include the use of intensity-based rather than absolute obligations. Theoretically, the concept of an intensity-based approach could also extend more widely in future international arrangements. If such a scenario were to eventuate, this would be managed under the NZ ETS by changing the nature of the obligation relating to relevant sectors of the economy.

At a more fundamental level, it is possible that the international framework post-2012 could resemble more of a tax than an ETS. If this were the case, and given the objective of meeting New Zealand’s international obligations at least cost in the long run, it would be appropriate to consider whether a tax-based system rather than an ETS were more appropriate. As we have seen, many of the building blocks for developing an ETS are the same as those for developing a tax-based system.

In summary, therefore, it is important (and very possible) to ensure that any NZ ETS is adaptable to future changes in international arrangements.

4.13.2 Regular review

The government has agreed in principle that the legislation for implementing the NZ ETS will include provision for a regular policy review. This review will be concluded no later than nine months before the end of each commitment period (this timing is designed to allow future international agreements to be taken into account). The legislation will also provide for government consultation over the terms of reference for the review.


27 The key task when linking an ETS between non-Kyoto and Kyoto parties is to prevent any net selling of units from the non-Kyoto to the Kyoto party. The EU is actively looking at such a mechanism as part of its proposal to bring emissions from international aviation (not covered by the Kyoto Protocol) into the EU ETS.

28 See section 4.6.

29 Each member state is permitted to decide on the limit for use of CERS and ERUs, which are in turn converted into limits for each installation.

30 A Kyoto party may only retire tCERs and lCERs for compliance with its obligations within the period in which the unit was issued. If a party retires tCERs or lCERs in order to comply with its Kyoto obligations, the units must be replaced by another type of unit in a subsequent commitment period, which is then permanently cancelled (annulled). This replacement requirement arises because of the Kyoto rules for CDM forestry projects (based on concerns about the non-permanence of carbon stored in forest sinks). lCERs must also be replaced if the project for which they were issued fails to meet its requirements (eg, the forest burns down, causing the lCER to be “reversed”).

31 HFC-23 is an extremely potent greenhouse gas. One of the concerns with HFC-23 projects is that they create perverse incentives to increase HFC-22 production (a substitute for HFC-23), which is an ozone-depleting substance regulated under the Montreal Protocol.

32 It is important to note that, although there was significant volatility in the first phase of the EU ETS, the CER market has not been anywhere near as volatile.

33 Forest sinks included in the NZ ETS are not included in this definition of offsets and are not covered by the discussion above.

34 “Additionality” refers to determining whether a project or initiative would or would not have occurred in the absence of the offset mechanism. A project is considered additional if it would not have occurred in the absence of the allocation of the units involved.


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