An ETS price is set by the market, but price safeguards can help.
The NZ ETS cap will require a further accessory: a price collar (price ceiling and price floor). In the current policy and market context, there is value in managing both supply and prices under the NZ ETS. No one knows the optimal value for either. While managing emission quantities in line with our emission targets and budgets, we can guard against unacceptable price extremes in both directions.
In December 2018, the government signalled it planned to replace the current fixed-price option (FPO) of NZ$25 per tonne with a volume-limited cost containment reserve (CCR) implemented at auction. However, the FPO will be retained for surrenders due in 2019. The government will investigate potential options for a price floor.[i]
In our preferred approach,[ii] the CCR would be bound by the cap. It would operate using a tiered approach as follows:
If the auction price rose to hit a first trigger price, units would be released from the CCR for auctioning. The auction would continue to set the price.
If the auction price continued to rise and hit a second trigger price, the government would initiate a review of NZ ETS supply and price settings which could either be conducted by, or informed by independent advice from, the Climate Change Commission.
If the CCR volume was exhausted before new unit supply settings were in place, the government would offer an unlimited number of fixed-price units for purchase and immediate surrender by participants. Fixed-price units could not be traded or banked.
As of April 2019, the market price is sitting slightly above NZ$25. The current FPO should be replaced as soon as possible – with advance notice to the market. In the current context, it discourages efficient mitigation, generates windfall gains for participants holding NZUs, and poses serious target and fiscal risks to the government.
For managing downside price risk, we recommend incorporating a reserve price at auction. This is simple to implement and can help avoid very low prices. If private actors were not willing to pay at least the reserve price, the government would stop selling units and the supply to the market would automatically contract. An auction reserve price mechanism would not provide an investment guarantee. Units in the secondary market could still be traded below the auction reserve price. With a reserve price, an ETS auction would respond quickly and predictably to unpredictable events that lower prices. A reserve price would signal the direction of travel for minimum emission prices and build confidence for low-emission investors and innovators. It would also provide greater assurance to government about the minimum level of auction revenue to expect.
As with the cap, the price collar settings should be should be decided and fixed five years in advance, extended by one year each year, and guided by an indicative 10-year trajectory (corridor).
[i] Genter (2018); Ministry for the Environment (2018c)