Tackling Climate Change with an Emissions Trading Scheme

Over the past few months it has become clear that many people do not fully understand how emissions trading works in New Zealand. To help explain how the New Zealand Emissions Trading Scheme (ETS) works, Motu Economic and Public Policy Research has released seven short videos answering questions asked by students relating to climate change and the ETS. You can also watch the full compilation here.

What is emission trading?

Limits emissions.
Lets the market find the price.
Drives behaviour change.

An emissions trading system (ETS) enforces an emission reduction target and increases the cost of high emitting activities driving investment and behavioural change. The government issues a limited number of emission units, which are allowances to emit greenhouse gases. Every tonne of emissions has to be matched by an emission unit. The number of emission units limit the amount of greenhouse gases emitted into the atmosphere and gives them a market value, the emissions price. This encourages New Zealanders to figure out where emissions can be reduced at the lowest cost. The number of units issued shrinks over time, allowing New Zealand to gradually transition to a low-emission economy.

How does emissions trading affect me?

Regulated firms
pay the price and pass it on,
so we emit less.

A relatively small number of regulated participants are required to surrender units in the ETS. For example, in the energy sector (covering production of electricity and heat as well as transport), ETS participants are firms that produce or import fossil fuels. The participants pass on the cost of those units to the businesses they sell their fossil fuels to, who then pass the cost on to consumers who use the fuels and actually create the emissions. This price signal encourages us to consume less high-emission products, it makes low-emission choices more attractive and drives us to change our behaviour. We don’t need to understand the ETS to respond. When the government starts to auction units, the revenue will go to the government and can be returned to the economy in different ways – such as reducing other taxes or issuing rebates; providing transitional support to vulnerable households, businesses or communities; or funding special projects.

We've had emissions trading for a while, why are emissions still going up?

Prices were too low.
No more. Price is rising, now
reductions begin.

Low ETS prices did not force companies nor consumers to change their behaviour, so emissions kept going up. The ETS price was very low and as long as the price for high-emission activities did not rise, firms did not need to reduce their emission levels. Furthermore, there was uncertainty about future emission limits and prices, so companies they did not change their investment patterns. New Zealanders did not experience any increase in costs for these high-emission activities and therefore did not change their consumption patterns either, so emissions kept going up. However, as emissions prices have increased in the last two years, firms are increasingly encouraged to reduce their emissions.

Can the emissions trading scheme be fixed?

It isn’t broken.
Brave politicians just need
to constrain units.

The ETS market functions well now, but participants need to know for certain that the future domestic supply of units will decline as New Zealand moves toward a low-emissions economy. This requires limiting both the number of units that are auctioned and freely allocated by the government, and the number of overseas units that can be used in the system (if that becomes possible in the future). The ETS is currently cut off completely from overseas units. New Zealand can’t keep outsourcing all of our emission reductions; under the Paris Agreement, all countries need to stop pumping emissions into the atmosphere.

What can we do about dodgy carbon credits?

Dodgy credits stopped.
Setting limits will send good
price signals at home.

The ETS was originally designed so that New Zealand could adopt the international price on emissions. We did this because emission reductions help the climate in the same way wherever they take place, and globally it makes sense to achieve the most reductions possible for every dollar of investment. However, we found that international units weren’t from real emission reductions and as the international price collapsed, it was more attractive for New Zealanders to buy cheap, low-quality overseas units than reduce our own emissions. Our ETS has not accepted overseas units since mid-2015 and they are not currently traded in our market. The Paris Agreement offers a fresh start, with a new framework for emissions trading between countries. We must ensure that any overseas units used by New Zealand will produce the same benefit to the atmosphere as making emission reductions at home in New Zealand. By applying quality controls and quantity limits on overseas units used in the ETS, we can send the right kind of price signals that will help New Zealanders reduce emissions, while helping developing countries start their own low emission transitions.

Is the emissions trading scheme enough?

Enforce the limit,
encourage policy change,
emissions will fall.

If the limit on emissions in the ETS is enforced, emissions will go down. However, we also need other policies that will make it easier for producers and consumers to respond effectively to price signals; otherwise the price for emission units could get very high. Emission reduction policies are also needed for sectors outside of the ETS, like biological emissions from agriculture. Emission pricing is an important part, but not the only part, of an effective strategy for reducing emissions in New Zealand.

Emissions trading vs carbon tax: which is better?

ETS is here.
Now we know how to fix it,
don’t change instruments.

A carbon tax and an ETS have a similar effect, but use different mechanisms. If well designed, they both can encourage behaviour change, generate government revenue which can be returned to the economy, ensure rigorous regulatory compliance, and cover the same emissions from the same emitters. New Zealand already has a functional ETS, and if we make some straightforward changes we can establish an effective price relatively quickly. We don’t have to change instruments to change the tune.