The ETS just broke. This is how to fix it.

Sneaking through the wall-to-wall coverage of Covid this week was news of an Emissions Trading Scheme’s cock-up. Unexpected demand in the quarterly government auction led to carbon busting its $50 price cap and the government having to issue 7 million more units to keep the price from blowing out. The blowout received extensive media coverage including this piece from NBR. Warning: I’m in it.

Why did the blowout happen and how can it be prevented?

The ETS is a useful tool but one that’s hamstrung by politics and is doing too much of the heavy lifting for all our climate change transitions. It also illustrates auction the political realities of climate change action – that the Government is still unwilling to treat all sectors of the economy fairly and face the real cost of carbon. This political timidity can be measured in dollars, as we’ve seen this week.

To understand how it be better we need to return to first principles. The ETS attempts to find the carbon price. That’s what markets do, by balancing demand and supply. So why are they so out of line?

The demand for emissions rights is high because New Zealand has stubborn emitters who won’t or can’t or don’t believe they could reduce emissions, even at high prices. The supply of emissions reductions is tight because we can’t plant that many trees and we didn’t invest anything like enough in mitigation technology ten years ago.

Jez Weston

If the ETS operated freely the price would be politically too high. So it is ham-strung by price caps (but better than 2013 with dodgy overseas units and price hit $1.45). It’s a broken market that punts emissions costs into the future to keep the price capped today.

The government is committed to holding down the price to protect a small number of politically-powerful industries. Hence speculators can take our money. Speculators only take money by finding dysfunctional markets. Political dysfunction is the best kind of market dysfunction and this is an opportunity for speculators to take money from future NZ taxpayers.

I’m personally up 40% since December and I’m not happy about it because none of this directly reduces emissions.

What to do – part 1

So what to do? We can fiddle around with market rules to limit speculation and volatility. We could have defendable price caps, faster-responding price limits, more market friction, and make emission rights limited to year of purchase to avoid banking.

There’s plenty we could do with the market rules but that needs to be thought through carefully. The more complex the market the easier it is to game. For instance, price limits are well-intentioned. Their stated aim is to give companies certainty about future liabilities and to reduce the risks of, for example, a company making a big investment in reducing emissions but then the carbon price falls and that investment doesn’t pay off. That de-risking is a good idea, if and only if the price limits are realistic, meaning that they bracket a reasonable price. That’s not our situation – the price limits are so low that all they are doing is creating opportunities for speculators to make bank.

We should tighten market rules because volatility is bad, but we shouldn’t try to use market rules to change the price. That price should be set by the fundamentals of demand and supply. That’s what we have to do because that’s what reduces emissions.

What to do, part 2

A better approach is to reduce demand for emissions reductions by helping or forcing stubborn emitters to reduce emissions. This means more than just price-based measures, because we are seeing that price elasticity for emissions is very high. If those politically powerful industries cannot reduce emissions then those businesses should not operate. Except that’s not going to happen, because they are “politically powerful industries”, at least until they lose their social licence. Right now, they’re getting preferential treatment: agriculture is half our emissions and still not paying their carbon costs.

What to do, part 3

Finally we need to increase the supply of emissions reductions. We’re rapidly planting pine trees but there are limits on that, both biophysical and political. We need to invest in emissions reduction technologies at a global scale. We need to roll out those technologies as fast as we can, as huge as we can.

That’s why I’m a partner in the Climate VC Fund. Our aim is to accelerate the uptake of emissions-busting technology and businesses. The good news is that many of the technologies we need have been invented – they just need commercialising or scaling. Take the heat storage blocks being commercialised by MGA Thermal, our first investment.

In the case of gnarlier problems, such as agricultural methane, technological solutions might seem elusive. In that case we may need to seek alternatives such as plant-based or lab-based proteins. Whether it’s new tech, existing tech or simply new business models, we have what we need to replace heavy industries. Let’s get on with it.

Dr Jez Weston is a founder and partner in the Climate VC Fund.