On Wednesday September 1, The Government lost control of the ETS to speculators. This has big implications and challenges for the path ahead.
The September 1 2021 auction of carbon credits within the Government’s Emission Trading System (ETS) has brought considerable embarrassment to the Government. Quite simply, the Government was outgunned by institutional investors and could not cap the price to the supposedly guaranteed maximum of $50 per NZU.
The ETS is a Government construct, within which the Government supposedly holds all the cards. The Government makes the rules and it also plays the game.
At this latest quarterly auction, there were supposed to be 4.75 million NZUs up for sale, with these available for purchase by companies needing to meet their carbon liabilities. However, there was also nothing to stop other companies that had no carbon liabilities from purchasing the units as a financial hedge.
Prior to the start of the year, the Government set the rules for 2021. These included that units at the four quarterly auctions would be available for sale at no less than $20 each and no more than $50.
The Government had two weapons to defend its stated rules. If all units could not be sold for at least $20 each, then some would be withheld. Conversely, if the price threatened to go above $50, then the Government had a war chest of another seven million units, euphemistically called a ‘cost containment reserve’ available to be used across the four auctions.
What the Government had never identified was that if institutional investors wanted to play the game in a big way, then the seven-million-unit war chest might not be enough. And hence they were badly caught out. In essence, the war chest was a shield, but one which they hoped would not have to be used.
The reality is that the Government had to use all of its war chest, thereby auctioning 11.75 million units rather than the 4.75 million that it intended. Even then it was only able to hold the price to $53.85 instead of the supposed maximum of $50.
The fundamental principle of the ETS is that the supply of units is meant to decrease over time, with this causing the price to gradually rise and thereby influence emission behaviour. Having to put another seven million units into the market has blown that strategy, at least for the meantime.
Somehow the Government will need to claw those units back over coming years, or else its Paris commitments will start to look very sick. And how is it going to now manage the next auction on 1 December?
Minister Shaw has previously stated that he cannot by law increase the $50 maximum within this current calendar year. Does that mean that something similar will occur at the next auction?
One thing for sure is that under current settings the institutional investors will be back for another go. Will Minister Shaw have to replenish the war chest and release even more units?
According to economic theory, hedge funds can serve a purpose by providing liquidity to a market and thereby dampen volatility. But the game changes when speculators, typically comprising institutional investors but also individuals, sense an opportunity to make a financial killing and thereby reshape the overall market.
There is no suggestion that the institutional investors in this case acted as an organised collective. Rather, they each saw an opportunity created the Government’s actions to play a game of buy, hold and then sell some time in the future.
The key event setting up the opportunity to make some big money occurred on 18 August when James Shaw in his role as Climate Change Minister advised that the minimum auction price for a NZU would rise to $39.32 by 2026, and the maximum price would rise to $110.15.
These announcements removed much of the speculative risk and increased the potential for windfall profits. Also, the underlying message was clear that the Government was going to use the ETS to drive behaviours. It was all on!
The institutional investors would have quickly realised that as long as they could afford to hold the units for several years, then it was a low-risk operation. At worst, they would lose around 20 percent of their investment, with this being highly unlikely, and there were very good prospects of doubling their money.
NZUs can be bought and sold on the secondary market at any time. By close of business on Wednesday 1September, the day of the auction, the price had already risen on that market to $59. The futures price for 2026 had risen to $67.62. So any speculator could immediately guarantee a profit of almost $14 per unit by now taking out a contract to sell today’s purchased units in 2026.
A realistic estimate is that genuine buyers needing units to cancel their emission liabilities would have soaked up most of the proposed 4.75 million units. That suggests that the speculators have probably purchased about seven million units, which eventually they will put back into the market.
In cash terms, the Government has also done rather well. Purchasers will have to pay around $625 million to the Government in coming days for those purchases. But from the Government’s perspective, that was not the fundamental purpose of the ETS. In contrast, what the Government has accidentally created is an emission trading scheme where prices are fundamentally determined by speculators.
Minister Shaw must now be squirming at the way he has lost control of the ETS steering levers. There will be serious discussions in coming weeks between the Minister and his officials as to how the Government can get back control of the levers.
The importance of these matters is that the ETS has the potential to bring about the greatest land-use changes, both intended and unintended, that New Zealand has seen in the last 100 years. Let there be no doubt, carbon forestry based on current prices is much more profitable than sheep and beef. It is also highly likely that permanent forests will be more profitable than production forests.
It would be nice to think that the Government did at least have control over the levers.