New Zealand's Emissions Trading Scheme - how will it work and what are the implications for business?

New mechanisms to combat climate change mean the cost of carbon has now become a commercial reality for New Zealand business. This article reviews the Government's recently outlined Emissions Trading Scheme which although will only directly impact on a relatively small number of entities, will have economy-wide repercussions.

In September this year, the Government announced the framework for a domestic emissions trading scheme in New Zealand. The scheme will be a "cap and trade" system which covers all greenhouse gases (CO2, CH4, N2O, HFCs, PFCs and SF6) and will eventually include all major sectors (i.e. forestry, transport, stationary energy, industrial processes, agriculture and waste). Participants in the scheme (discussed below) will have an obligation to hold and surrender emission units that match the emissions levels for which they are responsible. It is intended that the scheme be economy-wide by 2013, and although the scheme will only directly impact a small number of entities, it will have economy-wide repercussions.

The objective of the scheme is to operate as a "least cost" option for reducing emissions. Those that can reduce their emissions most cost-effectively will benefit by earning or being given emission units which they can sell on to those who will have more difficulty reducing emissions. In many cases, the cost of greenhouse gas emissions will ultimately be shared by consumers as participants in many sectors are likely to pass on the cost of compliance.

HOW WILL THE EMISSIONS TRADING SCHEME WORK?

Participants

The New Zealand Emissions Trading Scheme (NZ ETS) will include three types of participants:

1. Businesses who will be "points of obligation", will be required to surrender emission units, and whose participation in the NZ ETS will be mandatory.

2. Those that receive freely allocated emission units or receive emission units for eligible afforestation.

3. Those that participate in trading activities to take advantage of the market opportunities that may arise.

Units and allocation

Allocation of NZUs will be through a combination of gifting and auctioning of units, depending on how different sectors and participants will be affected by the introduction of the NZ ETS and whether they can pass costs through to consumers (as discussed below). The Government has decided to freely allocate units initially in those sectors that will have difficulty passing on the cost of compliance. Sectors such as fossil fuel providers and electricity generators who can pass on cost increases to consumers will have to purchase credits to meet their obligations.

Given that the Government has stated that each New Zealand emission unit (NZU) will be backed by a Kyoto Unit, the total number of NZUs available is likely to be capped at an amount equivalent to New Zealand's global cap on emissions set under the Kyoto Protocol.

Staged entry into the scheme

The forestry sector will be the first sector to enter the NZ ETS, with obligations beginning on 1 January 2008. However the first compliance period (the period for which emissions obligations and emissions will be measured) will not end until 31 December 2009. From 1 January 2009 the liquid fossil fuels sector (mainly transport) will have obligations and the compliance period will end on 31 December 2009, coinciding with compliance for forestry. It is the Government's intention that these first two sectors in the NZ ETS will trade between themselves (especially given that some forest owners will have an excess of units if they have received a free allocation of NZUs and have no immediate intention to deforest).

Entry of other sectors into the scheme is as follows:

Stationary energy (including coal, natural gas and geothermal)	1 January 2010
Industrial process (non-energy) emissions	1 January 2010
Agriculture (includes farming and horticulture)	1 January 2013
Waste	1 January 2013

THE REALITY NOW FOR BUSINESS

While details of the scheme are still being digested, there are some clear key implications arising that could impact your business.

Business with "obligations"

Under the scheme, certain businesses will carry specific obligations. The Government has yet to confirm which entities will have what is known as "points of obligation" but when identified these businesses will have an obligation to surrender NZUs, to cover their direct emissions or emissions associated with their product. We do know that for economic efficiency reasons, a point of obligation will generally be an entity at the upstream point of the sector (e.g. fuel companies as compared to motorists). It is anticipated that there will be just over 200 points of obligation in total (plus any foresters who opt in to the scheme) - a relatively small number who will be obliged to participate in the NZ ETS.

These businesses with obligations can expect to be allocated NZUs. The Government has indicated that in many sectors it will freely allocate NZUs to them. However, where an entity with obligations under the scheme is capable of passing on the cost of carbon, such as electricity generators and fuel companies, then the Government will not freely allocate NZUs to them as it would result in their having a windfall gain. The Government has applied the principle that where carbon costs can be passed through or on, NZUs will be auctioned rather than freely given.

The wider business impact

While many businesses will have no obligations under the NZ ETS, the scheme's financial ramifications go beyond those with specific obligations. The cost of carbon arising from the NZ ETS will affect all businesses as the costs flow down and through the economy. For example, we may expect to see an increase in transport and energy costs, and in the costs of products arising from industrial processes.

The costs for a business with NZ ETS obligations will depend on the extent to which it is able to reduce or offset its emissions, so reducing the cost of having to hold NZUs. Entities which try to straight pass on the entire cost of NZUs, which they are originally required to hold, may face resistance from their customers. Consumers will no doubt want to know whether the business or organisation could have reasonably mitigated their unavoidable carbon costs in other ways rather than passing them on.

Credits grow on post-1989 trees

The Government has made a stark change in its position on the forestry sector. No longer will the Government be refusing to part with carbon credits associated with post-1989 forests but instead will now freely allocate NZUs for an increase in carbon stocks after 2008 to foresters who own post-1989 forests and who opt to join the NZ ETS. Providing credits to foresters will contribute significantly to the trading volume and liquidity of the NZ ETS. The Government has also specifically ensured that the timing of including the forestry and transport sectors into the NZ ETS is aimed to encourage trading between the two.

Although opting into the NZ ETS may result in a post-1989 forest owner making a significant financial gain, there will be liabilities associated with being a "point of obligation" in the forestry sector, in particular when it comes to deforestation or decreases in carbon stocks caused by fire or storm damage etc. Foresters will need to consider the scale of their activities and their long-term plans when considering the benefits and implications of being a point of obligation in the NZ ETS, particularly in comparison to benefits arising from opting into the Afforestation Grant Scheme. This scheme encourages forest plantings by people who do not want to join NZ ETS. The Government would retain the credits and liabilities of these forests, but landowners would receive a grant for the initial planting of unforested land.

Wide market carbon trading

Businesses without obligations under the NZ ETS can choose to join the trading of NZUs. Our experience with the European Union emissions trading scheme suggests that there would be wide market participation in New Zealand. We expect to see traders such as banks, entities with offset projects, and potential points of obligation such as electricity generators, enter the market relatively early on to capitalise on the opportunities including:

• pot ential points of obligation acquiring NZUs during the early stages of the scheme in order to hold NZUs for future surrender obligations - for example, if they consider the price for NZUs will rise over time as it did in the EU; and

• businesses who carry t he passed on cost of carbon and who will be looking to profit through their trading activities to offset those costs.

We have already seen significant interest from foreign players in acquiring emissions units from offset projects in New Zealand and expect that they will also be interested in acquiring NZUs (backed by Kyoto-compliant units) through the NZ ETS. The Government envisages that the NZ ETS will be able to link internationally with other emissions trading schemes.

Growing investment in offset projects

A significant amount of investment by New Zealand entities is expected to be generated in carbon offset projects, including renewable energy resources such as wind farms and landfill gas projects, or projects to capture or reduce carbon emissions. Although the NZ ETS will act as the primary incentive to invest in these projects, incentives also arise under the Government's Sustainable Land Management and Climate Change Plan of Action. The recently released New Zealand Energy Strategy provides for contestable funds to support deployment of marine-based electricity generation and low carbon technologies, and further incentives are also anticipated under the soon to be released National Energy Efficiency and Conservation Strategy.

We also expect to see New Zealand entities with obligations under the NZ ETS investing in offset projects or acquiring Kyoto-compliant units arising from offset projects overseas to help meet their surrender obligations.

Similarly businesses to whom the costs of carbon are passed are likely to look to do the same in order to make a profit by trading units to offset those costs.

Is carbon neutrality still a worthwhile investment?

For some entities the new scheme may mean that the incentive to become certified carbon neutral falls away. Those meeting the direct or indirect costs of carbon arising from the NZ ETS and also paying for non Kyoto-compliant units in order to be certified carbon neutral, will in effect be paying twice for its carbon footprint. Where this is the case, those businesses will need to consider carefully the benefits of being certified carbon neutral against the increased financial costs they are facing. For some entities, such as those battling against the concept of food miles, certified carbon neutrality may make financial sense, but for others it may simply be a financial drain.

Detailed information on the Government's climate change solutions and the impending NZ ETS can be found at www.climatechange.govt.nz.

Update Since this article was written, the Climate Change (Emissions Trading and Renewable Preference) Bill was tabled in Parliament on 4 December. Part 1 of the bill amends the Climate Change Response Act 2002 to introduce the NZETS. Climate Change Practice Bell Gully is advising the Government on legal issues involved in the design and implementation of the NZ ETS. In 2000 we advised the Government on the potential legal framework for an emissions trading scheme, and its drafting of the emissions trading aspects of the Climate Change Response Act. Bell Gully has also been advising business over the last decade on climate change matters, including advising on New Zealand's first transaction on the Chicago Climate Exchange, the sale of emissions units from New Zealand projects under the Kyoto Protocol, offset projects including wind farms and contracts dealing with the passing of carbon costs in the energy sector. For more information, contact practice group leader Simon Watt

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