NZ carbon market a work in progress

Oil companies will be among those lining up to buy units. Photo / Martin Sykes

On July 1 something that has always been free, the right to emit carbon dioxide to the atmosphere, starts to cost money.

Under the emissions trading scheme, enacted in the Labour Government's dying days in office and substantially watered down by the National Government last year, the meter starts running next month on emissions from the liquid fossil fuels, stationary energy and industrial processes sectors.

From large corporates to small horticulturists and farm foresters, people have had to get their heads around the arcane world of carbon trading.

The demand side of the market consists of a small number of large companies which are "points of obligation".

They will have to surrender, to the Government, emission units to cover the CO2 emissions from the fossil fuels they sell (in the case of the oil companies) or burn (in the case of electricity generators with plants fired by gas or coal) or which arise from the chemistry of their manufacturing operations (for the likes of cement, steel or aluminium producers).

But only for every other tonne emitted. One of the ways the Government moderated Labour's scheme was to introduce a half obligation as a transitional measure until the end of 2012. The taxpayer will pick up the bill for the other half.

And in fact they don't have to buy any units. They have the option of simply paying the Government $25 a tonne instead, in effect paying a carbon tax. That puts a cap on the price.

In recent months what trading there has been has tended to be in the range of $17 to $19 a tonne.

Companies with large fuel bills can opt to become points of obligation, managing their own carbon price risk rather than paying a carbon-inclusive price for their fuel. Air New Zealand has opted to do this.

Officials estimate that the demand for units over the next 2 years (that is, until the end of the Kyoto Protocol's first, and so far only, commitment period) will be 47 million tonnes.

Just over a third of that will come from the oil companies, and the rest from the smokestack sector - generators and large industrial emitters.

The supply side of the market, by contrast, mainly consists of a large number of small players who receive units called NZUs from the Government.

The great majority will be forest owners, predominantly the owners of "Kyoto" forests - those planted after 1989 on land not previously forested.

The devolution of units to these foresters recognises that their trees, while they grow, absorb CO2 from the atmosphere and so provide an offset to emissions elsewhere. The units are allocated annually.

The flipside is that when the trees are harvested most of that carbon is deemed to be emitted then and there, so those receiving units also accept a liability for the corresponding emissions upon harvest.

A lot of uncertainty surrounds how many NZUs will be available from this source: how many Kyoto foresters will opt in and register for units?

How many of them will sell and how many will put them in the bottom drawer? And of those who want to sell, how many will sell to foreign Governments with Kyoto obligations rather than domestic emitters?

The Government is working on the assumption that two-thirds of Kyoto foresters will opt into the scheme. If so, and together with 16.9 million units to be allocated to the owners of pre-1990 forests, that would represent a potential supply of 76.1 million units - more than enough to meet local demand.

Roger Dickie of the Kyoto Forestry Association believes most Kyoto foresters intend to opt in.

"But they realise they have got time. A lot of them have been thinking that the price is relatively low at the moment so there's no panic," he said.

"But the sceptics are having such a run in New Zealand at the moment that there is probably a percentage of Kyoto forest owners who think they had better get in quick and sell in case [the market] disappears. Just what percentage it would be hard to say, but we have definitely had some investors who sold on that basis."

The Ministry of Agriculture and Forestry reports that it processed more than 300 emission returns from foresters in this year's annual round and transferred 4.4 million NZUs to foresters.

Just over 1 million units have been converted to the form which can be sold offshore. The Norwegian Government is understood to have been a buyer.

Climate Change Minister Nick Smith said it would take some time to see how the market developed.

"But my expectation is that the bulk of the obligations will be met domestically by buying units off New Zealand foresters. I do sense a degree of caution among smaller foresters, of wanting to register and have the units allocated but to then take a watch-and-see approach."

Those on the buy side of the market do not have to surrender units to the Government until May next year.

"I think it is going to take at least a year for the market to settle down," Smith said.

A second source of supply is units allocated to compensate trade-exposed firms, which have to compete in either export or local markets with foreign competitors who do not face a cost of carbon.

Officials estimate 11.7 million units will be allocated over the next 2 years under this element of the scheme.

It is done on an "intensity" basis in two tiers.

Trade-exposed firms whose activities (including the combustion of fuel) involve emissions of 1600 tonnes of CO2 per $1 million of revenue are eligible for free units to cover 90 per cent of those emissions - as compensation in kind. If they are above 800 tonnes but below 1600 they get compensated for 60 per cent.

In practice, given the half obligation and the $25 price cap, it means that a trade-exposed firm whose carbon costs exceed 1 per cent of its revenue will get 60 per cent compensation and those exceeding 2 per cent will get 90 per cent.

"I have yet to have an example from the business community of someone who is significantly affected by the ETS who is not going to receive support," Smith said.

When the policy was announced the Government expected only about 65 firms would qualify for a free allocation under the trade-exposed provisions.

It now appears hundreds will, the ranks swollen in particular by horticultural firms with heated greenhouses.

This is not, however, expected to materially increase the number of units allocated. The horticulture sector as a whole is only expected to qualify for around 90,000 tonnes.

With large numbers of people wanting to sell relatively small quantities of units, the role of aggregators who assemble small parcels into large ones is key.

Commodity broker OM Financial is active in that space. Its carbon expert, Nigel Brunel, said: "We don't take principal positions. We are brokers. Emitters will come and say 'Nigel, we need 50,000 tonnes.' We then go out and find that for them."

OM Financial has a website providing price information.

Westpac has also recently entered the aggregation market. With the balance sheet of a large bank it is able to act as a market maker, buying and selling on its own account.

Smith expects other banks to follow suit but acknowledges a degree of political uncertainty may have led the banks to hold back on investment in this area.

He said that had turned around since the Government made it clear in late April it would not follow the Australian Government's decision to shelve its scheme.

A third potential source of supply to the New Zealand market is units traded in the international Kyoto market.

In particular there are units called CERs which are issued by a United Nations body to emissions-reducing projects in developing countries that meet certain criteria.

That scheme is beset by problems, however, and the World Bank estimates it now takes more than three years for the average project to make its way through he process and be issued its first CERs.

The New Zealand carbon market remains a work in progress. It is a purely over-the-counter market with no exchange and only a handful of intermediaries.

The mechanisms of the market would need to develop significantly to enable it to operate efficiently, Smith said.

"I see the ETS as an incredibly challenging reform. I have been pleasantly surprised how smoothly the implementation has been going to date. It is inevitable there will be a few blips. But there have been far more challenges on the political management side than in getting the mechanics of the scheme operable."