ETS consultation: ‘signal versus noise’ suggests eventual price rise

The unit settings consultation released last week included some unexpected speculation about changing price guardrails in the ETS auctions that has seized market attention.

But the key driver of ETS prices is still unit supply and demand, not auction reserve prices or Cost Containment Reserve (CCR) prices. This is demonstrated by the fact that prices in the ETS during 2023 were consistently above $80/tonne when the auction reserve price was only around $30/tonne.

In that case, the auction reserve price was set far below market prices and had no impact on traded market prices; instead, prices reached new records. Likewise, prices also exceeded CCR prices. This means that the focus of market commentary on the price settings is justified mainly because it was unexpected, not because changing price guard-rails would have any real impact on market pricing.

It looks to me like the discussion of auction reserve pricing was motivated by a desire to avoid future failed auctions but this also ignores market behaviour; the auctions in 2023 all failed because the Confidential Reserve Price (CRP) was not met, which is nothing to do with the reserve price.

Consultation authors don't understand market

If nothing else, the discussion of changing price controls with no supporting rationale for this change, no data and no suggested price to change to, all argue that this section of the consultation was not a serious proposal, and highlights a concerning lack of market understanding by its authors.

Because the Climate Commission recommends that the price settings do not need to be changed, any move to change them would also need to be justified under legislation and this seems an unnecessary expense of political capital for limited or zero gain.

The real story in the consultation is the potential for sweeping updates to unit supply. Because all four auctions in 2023 failed and the first auction of 2024 partially cleared at the reserve price, the way is clear for a reduction of unit supply for all 5 years of the current unit supply period. Usually, the next 2 years are locked-in for price and supply settings, but with the legislative triggers for changes to 2025-2026 settings activated, auction supply for all five years can be changed. 

The Climate Commission’s recommendations are the default for unit supply settings; under legislation, any deviation from the recommendations must be justified by the Minister. This is a high bar, demonstrated by the embarrassing backdown forced on the previous Government by a judicial review which held that the reasons given for not taking the Commission’s advice in 2022 were not justified.

Govt may have to borrow to cover auction shortfall

The Commission’s 2024 advice for dramatically reducing forward auction volumes reflects their view that the ETS has a unit surplus. The recent fall in carbon prices endorses this view; the price collapse and volatility seen in the past few weeks is proof that market traders also see unit oversupply and lack of price competition as key factors.

As the biggest seller of NZUs, the Crown is most exposed to price falls. Treasury has downgraded its projections of Crown revenue in part due to falling carbon prices, and this effect continues to undermine the Crown accounts as we approach the Budget at the end of May. The Government will very likely be forced to borrow to cover the shortfall from the fall in the carbon price which is a direct result of the lack of clarity and unexpected price reduction proposals in their own consultation document.

Despite appearances, prices don’t follow auction reserve or CCR prices; they are driven by supply and demand.

Although the Minister has stated that a ‘strong and stable ETS’ is their goal, the lack of any specific discussion of what that strong and stable ETS looks like has allowed speculative price cascades fuelled by panic selling to shape the market.

Any market that loses 10% of its value in a week, let alone a day, without any real change in market conditions, clearly needs some new settings. This is recognised by the Climate Commission’s recommendations to cut back auction volumes and erode the surplus that is allowing emissions to continue at low cost.

Current settings undermine gross emissions reductions by making pollution cheap, and net emissions by making emissions reductions of uncertain reward. The consultation document makes it clear that following Commission advice on reducing auction volume is the best fit for meeting emissions targets, market function and other criteria. In addition, precedent set by the 2023 judicial review make it clear that any attempt to diverge from that default advice will be challenged and most likely, will be reversed by the courts. 

Reduction in future supply

The market seems to have read the part of the consultation document that covered price settings and speculated about changing them, although to what new value and why is left unsaid, but not read the part that says that reducing future unit supply is the best option for meeting emissions budgets and maintaining market function.

If unit supply is reduced in line with Commission recommendations most of the annual demand will have to be purchased on the secondary market and competition will drive prices higher because it is harder to flush supply out of the registry than it is to buy in bulk at quarterly auctions.

To put that in perspective, the upcoming June 2024 auction will aim to sell about 4 million NZUs in 3 hours, which is about 70% of the total number of NZUs available for next year under the proposed updated settings, and 30% more than the total for the whole of 2029.

Cost to exporters

With the review of our 2050 target and second National Determined Contribution (NDC) due later this year, running an ETS with a unit surplus and prices badly out of step with international prices will stall emissions reductions and, in the case of exporters to the EU, will soon cost the price difference between the NZ carbon price and the EU carbon price (currently about NZ$76/tonne) for emissions. Low carbon prices impact Government revenue in the short term via reduced auction revenue at the same time as international carbon deals to meet our looming Paris target must be funded. 

In short, betting that the auction reserve price is more important than unit supply in the ETS is will only be correct until those unit supply settings are changed. 

Dr Murray McClintock has been involved in forestry in the ETS since 2008. He is the director of carbon projects at Carbon Farm Limited, with a focus on carbon sequestration in indigenous forests.