The government has just launched a consultation on options to reform the New Zealand Emissions Trading Scheme (ETS), to provide stronger incentives for reduction of fossil fuel emissions while also supporting carbon dioxide removal from the atmosphere through forestry. At the same time, it is consulting on redesign of the “permanent forest” category in the ETS. This is a long-read backgrounder on the issues at play.

What is the ETS? How does it currently work?

The ETS is a market which prices greenhouse gas emissions. The higher the cost of emitting, the more incentive there is to make reductions. The ETS covers a little under half of New Zealand’s greenhouse gas emissions, with agricultural methane and nitrous oxide the main exclusions. 

Each year, covered companies are required to surrender one New Zealand Unit (NZU) for every tonne of carbon dioxide (or equivalent) emitted. Over time, the government can steer emissions downward by reducing the number of NZUs made available. NZUs can be traded, which creates a market price and allows emissions reductions to be made where they are most cost effective. Covered companies can obtain NZUs from several sources: 

• Through regular government auctions

• Via free allocation to “energy intensive trade exposed” companies

• From a large “stockpile” of unused NZUs that companies have banked from previous years (when supply was looser)

• By purchasing forestry NZUs which correspond to removal of carbon dioxide (CO2) from the atmosphere as forests grow.

   

The ETS is currently structured to control “net” emissions, that is, reductions in emissions are treated as fully equivalent to removal of CO2 from the atmosphere through forestry. That means that if it is cheaper to do so, emitting companies have the option to purchase and surrender forestry NZUs rather than reduce emissions. In New Zealand the cost to convert marginal farming land to forestry is lower than the cost of many emission reduction options in the energy, transport, and industry sectors: as a result, the current ETS structure encourages substantial land-use change and has less impact on reducing emissions.

[For a more in-depth introduction to the ETS, see Motu’s Guide to the Emissions Trading Scheme (2022 update)]

What are the current rules for forestry in the ETS?

Forests established between 1990 and 2022 that are registered in the ETS earn or surrender NZUs corresponding to their carbon “stock change”, that is, the changing amount of carbon stored in the forest. As forests grow the carbon stock increases, earning NZUs, but if carbon stock is reduced through harvest or conversion of land away from forestry then NZUs must be paid back. From 2023 new ETS forestry rules apply:

• New production forests will earn NZUs only until they reach their long-run average carbon stock (averaged across planting and harvesting cycles). As a result, NZUs are only earned during the growth phase of a first rotation of forestry: there are no NZUs earned on subsequent rotations. As long as trees are replanted there are no harvest liabilities, but NZUs will still have to be paid back if land is converted away from forestry. This new “averaging” approach is intended to simplify participation for foresters.

   

• Forests registered in a new “permanent forest” category can continue to earn NZUs on a stock-change basis. These forests must not be clear-felled for at least 50 years (and units must be paid back if trees are harvested later). Responding to concerns about the potential for plant-and-leave permanent pine forests, the government decided in late 2022 to redesign the permanent category, but to continue to allow exotic forests to register in the meantime.

   

Four issues have motivated consultation on changes to the way forestry is treated in the ETS:

Issue #1: A climate change response dominated by forestry removals (instead of emissions reductions) is not durable 

The ETS was originally set up to control net (rather than gross) emissions to implement New Zealand’s Kyoto Protocol obligations. For 2008-12 New Zealand had a net target in the Kyoto Protocol, and this was mapped directly into domestic policy. The ETS has continued in the same form since then: amendments in 2020 introduced auctioning to the ETS, but did not change its underlying net basis.  

He Pou a Rangi (the Climate Change Commission) has recommended that even with a net target, there should be a stronger focus on gross emissions reductions in the manner that the target is achieved. It found that business as usual would lead to the net target being met primarily through forestry, and that this is not a durable strategy because:

• to maintain net-zero after 2050 would require ever-increasing areas of land to be converted to forestry;

   

• it would leave Aotearoa out of step with the rest of the world which is making technology transition;

   

• it would leave future generations with the task of reducing gross emissions at the same time as they will need to be adapting to escalating climate change impacts; and

   

• there are concerns about the permanence of pine forests, in terms of susceptibility to pests or windfall.

   

Considering all these factors, it recommended “amending the NZ ETS to strengthen the incentive for gross emissions reductions and to manage the amount of exotic forest planting the NZ ETS drives”. 

This consultation provides options responding to that advice.

At the same time, the science has become much clearer that although long-term targets are often framed as “net-zero”, to be consistent with limiting temperature rise to 1.5C emission reductions and forestry removals should not be traded off against one another: both are needed.

The International Energy Agency’s net-zero energy scenario shows that emissions from energy, transport and industry need to reach close to zero globally by 2050, with the small amount of residual emissions captured and permanently stored. There is no offsetting of emissions with forestry removals in this scenario. New Zealand is falling behind on clean technology adoption: for comparison the EU ETS now has a target for 62% gross emission reductions in 2030 (NZ’s proposed settings come nowhere close to this even if gross reductions are prioritised).

Equally, global pathways from the Intergovernmental Panel on Climate Change show that halting deforestation and supporting re-forestation are critical for holding global temperature increase well below 2C (and ideally 1.5C). Countries collectively have net-negative emissions in the second half of this century, with restoration of natural systems and technology-based removals drawing down the previous emissions overshoot. My back-of-the-envelope estimate is that on a per capita basis, New Zealand could need to remove around 20Mt of CO2 annually from 2050 until 2100 as our share of correcting the emissions overshoot (and considering other equity considerations our share would likely be even higher).

In current international debates around use of offsets for fossil fuel emissions, nature-based removals like forestry are increasingly seen as different from truly permanent CO2 removals such as underground storage that converts CO2 to rock. A portion of the CO2 emitted to the atmosphere from fossil fuel combustion stays there for centuries or millennia, so any offsetting of these emissions via removal of CO2 should guarantee that the CO2 stays out of the atmosphere over similar timescales. New Zealand’s ETS currently addresses this through legal obligations on landowners to maintain carbon stocks or pay back units, but this is only as good as future governments’ willingness to enforce those obligations if or when forests are degraded or lost. In overseas debates, more radical solutions are being floated for nature-based solutions, such as blended credits combining nature-based removals with permanent storage, or even allocating units more gradually over the entire storage lifetime (of hundreds of years) rather than up front. 

Issue #2: Under current ETS design, there is a looming mismatch between supply of forestry units and demand from existing ETS buyers

Under current ETS design, the figure below shows the projection made by He Pou a Rangi for gross and net ETS sector emissions in its draft advice on policy for the second budget period. The blue bars show the net emissions in ETS sectors consistent with meeting the legislated emissions budgets out to 2035. The government issues NZUs by auction and free allocation allowing emissions up to that level, while companies can buy and use forestry credits to cover emissions beyond that.

These projections show that the quantity of forestry removals (size of green bars) is expected to increase in the period to 2035 and beyond, with ETS sectors reaching net-zero in 2037. If the ETS maintains a net-zero obligation after that, then other buyers outside the ETS will be needed for some of the forestry units (the green cross-hatched area in Figure 1). That is, ETS emitters would buy forestry NZUs to cover all their emissions, and there would still be a large quantity of forestry NZUs unsold. 

Without change, the scheme is headed for significant supply-demand imbalance, which would likely mean a price fall. That would be bad for emissions reduction incentives, and bad for foresters. On the forestry side it would particularly affect new forests, which take several years to establish before they begin generating significant quantities of NZUs: forests planted from the mid to late-2020’s will be earning the majority of their units after 2035. 

The government’s new modelling in the consultation document suggests that the ETS market will see a falling price path coming, and tree-planting will slow as a result. This reinforces the view that if the NZ ETS is to provide incentives for gross emission reductions and maintain incentives for forestry, the supply-demand imbalance within the system poses a significant challenge.

A point to re-emphasise is that New Zealand will still need a significant volume of forestry removals to achieve emissions budgets, the 2050 target, and to maintain a net-negative position in the second half of this century. The question is, if current ETS emitters won’t be paying for all these units, who will?

Issue #3: The current ETS is much better aligned to support fast-growing plantation pine forests than for slower-growing indigenous reforestation.

He Pou a Rangi recommended greater investment in new and regenerating native forests to deliver a long-term carbon sink, improve biodiversity, soil and water health, and to realise recreational and cultural benefits. New Zealand has a great deal of land that should never have been cleared for farming and could be restored as permanent native forest.

However native forests are slower growing, have high establishment and maintenance costs, and lack a downstream wood industry. These make the commercial investment case for native reforestation challenging. The government’s Emissions Reduction Plan proposed several responses: 

• a review of the yield tables (carbon look up tables) that provide default values for carbon stored in different forest types, and to extend these to greater than 50 years.

• Reducing the cost of native afforestation by working with the nursery sector

• Investigating longer-term options, including supporting Māori-led approaches to native forest establishment

   

These are important actions, but in themselves will not make the ETS a strong driver of native forest planting.The question as to how native forests could be supported better through, or alongside, the ETS is an important motivation for this review.

Issue #4: Rural land-use competition and concerns about environmental impacts of forestry and farming: the “right tree in the right place”

The rapid rise in ETS price since 2019 has led to an increase in farm conversions to forestry. While this is a small share of farmland overall, a concentration in some regions has raised the question as to whether policy settings should be changed to drive the “right tree in the right place”, and whether permanent exotic forests are desirable. Cyclone Gabrielle clearly emphasised the consequences of pastoral agriculture and clear-fell forestry being allowed on highly erosion-prone land. The government is primarily addressing these concerns through the RMA process, allowing greater planning control of which land is unsuitable for clear-fell forestry or for pastoral agriculture, and through standards for forest and land management. 

This ETS consultation should not be seen as a move to limit forestry – it is rather about how to achieve both emissions reductions and maintain support for desired levels and types of forestry. 

Government consultation options: ETS reform

The consultation document stresses that forestry is valuable for climate change response as part of meeting current and future targets. The option of excluding forestry removals from the NZ ETS without an alternative incentive mechanism was dismissed. Four options are presented:

The consultation also asks whether the NZ ETS (or policies linked to the ETS) should be used to strengthen incentives for removals that have broader co-benefits such as indigenous biodiversity, and briefly assesses whether the options above allow this to be done. It also asks whether and how additional removal activities (such as wetland restoration) should receive incentives. 

Government consultation options: Permanent forest category

The separate consultation document on “A redesigned ETS Permanent Forest Category” essentially proposes to limit the permanent category to native forests or to “transition forests” (which start as exotic and transition to native over time) – although it also asks whether exotic forests should be allowed in limited circumstances such as long-lived species, on Māori owned land, small-block forestry on farms or for afforesting highly erosion-prone land. 

One new concept is the suggestion of withholding some units from transition forests until transition has occurred, so that forest owners are not left in the position of having to pay back units when the transition is made to lower carbon-stock native forest. There is a significant emphasis in the consultation on the need for, characteristics of, and enforcement options for forest management plans (for transition forests and/or for all permanent forests receiving credits).

Compass Climate view

We welcome this discussion – it is critical and long overdue. If done well, the review provides an opportunity to update the ETS to drive much deeper emission reductions in energy, transport and industry. It also provides the opportunity to set up a new approach to rewarding the carbon stored by forestry, delivering the long-term carbon sinks that New Zealand will need to 2050 and in the second half of this century for net-negative emissions. 

If done badly, the review will leave us with an ETS that continues trade off these separate but important goals, properly achieving neither. The key policy challenge is how to realign the way forestry is supported so that it is done as well as not instead of making a transition away from fossil fuel emissions.

The options presented by the government are only at a conceptual level, and leave out a lot of key technical and implementation detail. Most importantly, there is no attempt to address what the different options mean for the rights of existing forest owners in the ETS, whose trees have been planted with the current rules in mind. In particular, Māori own around 30% of plantation forestry, and this will increase with future Treaty settlements. The way in which current and future forests are treated is of particular concern to Māori, as are the impacts of ETS prices on vulnerable communities, and the need for rapid emission reductions.  There is also no modelling of how the options would work in practice: this will make it difficult to come to a clear view on the pros and cons of each. 

The document notes that this consultation is only a first step: further work and further consultation will be required after this year’s general election. ETS market participants have been hoping for direction on future settings, but the high-level options in this document do not provide that: depending on the option pursued the long-term price for NZUs could rise or fall, and there may or may not be a different price for forestry NZUs. Until there is resolution, there will be uncertainty in the market so the incoming government should progress decisions, and pass necessary legislation, as a priority.

Based on the high-level information given, option 4 jumps out as having the potential for strong emissions reduction incentives and enabling long-term incentives for forestry removals that do not evaporate when gross emissions reach near-zero (although the double-obligation suggested doesn’t make sense). Separating the treatment of gross emissions and forestry removals has the significant advantage of easily allowing top-up payments for biodiversity or erosion control, or for treating afforestation differently, e.g. as public infrastructure. However it would also be the most significant structural change to the ETS, so would need buy-in and time to implement. The suggestion in He Pou a Rangi’s draft advice on policy for the second budget period of an alternative minimum price for ETS emitters would be a relatively simple measure to keep incentives high for gross emissions reductions in the meantime.    

This policy debate is going to be highly charged, given strong and polarised views in the forestry, agriculture, and fossil fuel emitting sectors. It’s going to be a difficult but very important discussion. But it also provides an opportunity to lift our thinking out of an incrementalist mindset, and look to the horizon: what do we want to have achieved by 2075 or 2100, when our economy is fully decarbonised and when permanent forests being established now will still be in place? If we focus only on the period to 2035, or even 2050, we fall back into incrementalism that has not served us well. 

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Dr Christina Hood is head of Compass Climate, a climate policy and carbon markets consultancy. Compass Climate has undertaken work on forestry-related issues for Pou Take Āhuarangi and for Pure Advantage.

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• Source: https://www.carbonnews.co.nz/story.asp?storyID=27993