Carbon farmers need to understand the ETS

The price of carbon is determined by Government. There lies the risk for carbon farming. 

Two recent articles of mine have explored the economics of carbon farming on land that is currently farmed for sheep and beef.  Those articles showed that, if financial returns are what matters, then at current carbon prices the development of permanent forests for carbon credits provides significantly higher returns than sheep and beef.

My focus there was on the close to three million hectares of North Island farmed hill country, but a similar situation exists in considerable parts of the South Island. One big exception is the Canterbury Plains, where history shows that shallow soils plus norwest wind storms wreak periodic havoc to forestry operations.

Those findings on the apparent economics of forestry lead to a series of other questions. First, how reliable is this carbon market? Second, what are all the other important things apart from simple economics that need to be considered?

In this article I am only considering the first question, which relates to the price of carbon. Even then it is only a beginners’ guide. The other matters apart from simple economics will still have to wait.

The New Zealand Emission Trading Scheme (ETS) is what is known as a ‘cap and trade’ system.   That means that the Government allocates a set number of emission units which manufacturing industries must purchase from the Government to offset their own emissions. These units are sold by public auction managed by the Environmental Protection Agency.

The ETS is based on units of carbon dioxide. In common usage, these units are typically called ‘carbon units’ but the calculations are undertaken as carbon dioxide equivalents. So here I will use the common usage, but for biologists and chemists who might try to calculate these things, be aware that the numbers actually relate to carbon dioxide equivalents and not mineral carbon.

The price of the units at any time is determined according to the price where the supply and demand for credits is in balance. Companies that miss out on purchasing units must then trade with other companies that have credits for sale. Within this framework, finance companies also play a profit-driven hedging game of buying and selling units.

The idea is that over time there is a declining number of units allocated under the cap by the Government. This leads to an ongoing increase in the price to a point where some industries become unprofitable and either cease or reduce their emitting activities. In broad terms, the allocations are supposed to decline by one percent each year in the current decade, then two percent per annum in the 2030s and three percent per annum in the 2040s.

Consumers are also part of the ETS but only indirectly. For example, all of us, including farmers, are paying a carbon tax on purchased fuel.  A litre of petrol once burned releases about 2.4 kg of carbon dioxide, which here we are simply calling ‘carbon’. With carbon now selling for very close to $50 per tonne, that means that the carbon tax on a litre of petrol is approximately 12 cents.

Most industries are emitting industries but the big exception is forestry which sequesters carbon. In many situations this can be sold.

Note that the forest has to be growing. Accordingly, forests that were existing in 1989 are considered to be baseline forests and no credits are available. Forests planted post 1989 can be registered at any time in the ETS and credits claimed thereafter, but only for the post-registration growth.

Currently, New Zealand has about 700,000 hectares of post 1989 forests of which about 333,000 hectares have been registered in the ETS.  Why the remainder has not been registered is in itself a complex story.  That story will need to remain for another time. My focus here is limited to land that has remained in farmland since at least 1989 and is still in that state.

New Zealand’s total gross emissions are of the order of 82 million units of carbon per year. From a national perspective, New Zealand sequesters about 27 million units of carbon from its post 1989 forests and this reduces the net headline number of emissions that New Zealand reports internationally to around 55 million units.  However, many of these forests were planted in the early 1990s and will soon be milled. The carbon benefits from these forests are about to reduce.

Last year, there were only 6.9 million units of credits allocated to registered forests.   This highlights how our national situation does not necessarily align with what is happening within the ETS.

Currently, methane and nitrous oxide resulting from agricultural activities are not included in the ETS. In time that may change. However, there are strong arguments that there are better ways to deal with the relatively short-lived methane that ruminants produce rather than to include them in the ETS.

Nitrous oxide produced by farming activities receives much less publicity than methane. However, as a long-lived gas, the long-term implications are considerable. There is a logic that nitrous oxide should come into the ETS. I expect this will be an increasing area of debate.

Agriculture is not the only sector of the economy that has major emissions that lie outside of the ETS. Many companies that the Government considers would be at risk from international competitors if they were included in the ETS, currently receive free allocations.

In 2019, the latest year for available statistics, these free allocations totalled 8.3 million NZUs spread across 85 different companies. At the current price of $50, these 85 companies are benefitting each year from this largesse by more than $400 million.

The biggest beneficiaries of this system, with their 2019 free allocations shown in brackets, are NZ Aluminium Smelters (1,697,437 NZUs), NZ Steel (2,118,983 NZUs), Methanex NZ (1,318,490 NZUs) and Fletchers Concrete (689,425 NZUs).  Based on a current carbon price of $50, then these four big firms are in aggregate benefitting by more than $290 million.

It is remarkable how, compared to the populist chatter about agricultural emissions, these big business exemptions get little publicity.  These free allocations are supposed to reduce by one percent each year.

At this point I return to the key question facing any farmer who is considering carbon farming: how reliable is the price of carbon? In doing so, I emphasise that this is a beginners’ guide.

Currently, the Government has a policy that the carbon price will not be allowed to drop below $20, and with this minimum rising at two percent per annum, broadly in line with inflation. Similarly, there is a maximum price set initially at $50, with this maximum also rising at two percent per annum. The Government can ensure this occurs by adjusting the number of NZUs it supplies to the market.

In contrast, the New Zealand Climate Commission has argued that the price should be allowed to rise faster.  Their thinking will have been influenced by the reality that $50 per tonne is insufficient to make a big change in either consumer or corporate behaviours if New Zealand is to meet its Paris commitments.

As just one example, at this point I go back to the topic of petrol prices where, as previously indicated, a carbon price of $50 translates to a petrol tax of approximately 12 cents per litre.  Quite simply, a carbon tax of 12 cents per litre is insufficient to change behaviours in any big way.

So, the Government is caught between a rock and a hard place.  If it holds carbon prices to $50 but with an adjustment for inflation, then behaviours across the broader economy will not change and New Zealand will not meet its Paris commitments. New Zealand would then need to implement authoritarian regulatory systems as to what people can and cannot do.

Conversely, if the Government allows prices to rise well above $50 then there will be an even bigger incentive for sheep and beef land to be converted to forestry.

According to a recent webinar I attended, presented by an ETS specialist from the New Zealand Forest Service (part of the Ministry of Primary industries), forestry is expected to contribute about 25 million NZUs per annum in 2050. That has to come from either first rotation forests or new permanent forests. By my calculations, that will require another million hectares of pasture land to go into new forestry.

The bottom line is that farmers have to make their own judgements as to whether carbon prices will rise or fall. It all depends on how the Government manages the cap.  In other words, it all depends on Government policy and politics.

My judgment is that the long-run price of carbon is more likely to rise rather than fall. But it is in the lap of the Government.

UPDATE: Coincidentally, within hours of this post being uploaded, the Government increased the minimum auction price for carbon from $20 currently in 2021  to $31 in 2022 and $39.32  in 2026.  The maximum price has been increased from $50 currently to $70 in 2022,  and $110.15 in 2026.   The increase in the minimum price is remarkable in terms of how it underpins the minimum returns from carbon farming. The increase in the maximum price is equally remarkable in terms of potential profits.