NZU investors are now driving the price of carbon as they play the market
As I write this in late January 2022, the carbon price in the open market is $75, with this measured per tonne of carbon dioxide equivalent (CO2e). That is an increase of just over 10 percent since the last auction of units by the Government less than two months ago in December 2021. It is also 95 percent higher than the price of carbon this time last year.
The most recent 10 percent increase may not sound much. But the fact that the market price has now breached $70 is significant. It means that there is a developing consensus among players in the carbon market that, at the next auction on 16 March, the Government’s seven million NZU cost-containment reserve for all of 2022 will be exhausted.
If the reserve is exhausted in March, it is likely to be onwards and upwards from there for the carbon price, with three further auctions in 2022 unconstrained by any cost-containment reserve.
To understand what is likely to happen and the implications thereof, it is necessary to understand something about the Emission Trading Scheme (ETS). It is also necessary to understand something about new direct investors in New Zealand Units (NZUs) and the effects these people are having.
The ETS is where demand and supply for NZUs come together to determine the price of carbon.
Within the ETS, the demand for NZUs has, at least until recently, been determined primarily by the greenhouse gas emissions (GHGs) of commercial entities. All commercial emitters of carbon dioxide, including farmers, are caught by the ETS. However, agriculture emissions for methane and nitrous oxide are currently excluded.
There is also a very generous supply of free units given by the Government to those industries assessed to be trade exposed. The four big entities in this category are the aluminium smelter, NZ Steel, Methanex and Fletchers.
There are also more than 80 smaller companies who get these benefits. Even rose growers can claim they are trade exposed and get some free units.
On the supply side, in addition to approximately eight million free units of carbon, there will be four auctions in 2022, each of 4.825 million units, plus an overall seven million units initially held back in the cost-containment reserve. This cost containment reserve will be triggered if and when the auction price reaches $70. This supply of auction units come from the Government, with the auction earnings becoming Government revenue.
The potential supply of units is also increased by allocations, both current and historical, for carbon sequestration activities. The store of these units in private hands is now more than 150 million units with a market value of more than 11 billion dollars.
The Government has stopped publishing the proportion of these units that are held by foresters. This is probably because the distinction between forest companies and the new category of investors has become blurred.
Some of the genuine foresters are holding units because they will have a carbon liability if they harvest their forests, rather than converting to permanent forests. The rest of the units are held by financial people who sit at computers in their offices.
Nearly all unit owners, both foresters and investors, are holding on tight to their units. This is because they think the carbon price is going to increase further. And as long as they think that way, then they will continue to hold the units and the price will indeed increase.
But that is not the full story. As well as holding their existing units, the investors are buying additional units.
At the start of this article, I used the term ‘players in the carbon market’. This was purposeful, and reflects the emergence during 2021 of these finance professionals who are now ‘playing the market’.
What caused the change?
Prior to 2021, there was essentially a fixed price at which emitters could buy NZUs from the Government. That all changed with the fixed price system being replaced in 2021 by an auction system, with the price quickly taking off.
The Government thought they could control the price with a cost-containment reserve of units. The flaw in that thinking was that the Government and its officials did not figure out that investors would buy the units as a new form of currency that was much better than a term deposit at the bank and with much less risk than bitcoin.
This was why I wrote an article last September where I said that the Government had lost control of the ETS.
Currently, the number of units that the Government plans to supply at auction over the next few years is based on the premise that the stockpile of units will decrease as investors cash in on the price. But as long as the ‘players’ think the price will increase, then these investors will continue to suck units out of the market and into the storehouse.
The number of players has been increasing rapidly. Anyone can buy these units through entities listed on the NZX.
I am also aware that some of New Zealand’s biggest companies are playing the game. Indeed, they increasingly have analysts whose primary role is to figure out how to play the game on behalf of their corporate owners.
I know about these people because some of them have contacted me to see whether I know something they don’t know. These are smart people, and apart from knowing a little more about the forestry aspect than most of them do, there is nothing much that I know that they don’t know. The only difference is that I am talking in public and they are not.
Quite simply, with the NZ dollar reducing in value with inflation, with housing prices topping out, and with share prices slipping, carbon looks an attractive investment. Hence, it is investor behaviours, either investing directly in carbon farming or more simply just buying up NZUs, that are driving the price of carbon.
So what about that forestry aspect?
Last September I was doing some forestry versus sheep and beef calculations using a carbon price of $50. Even at those prices, a permanent (non-harvested) exotic forest stacked up as superior to sheep and beef in most situations. At current prices of $75, the forestry option looks even better.
The Climate Commission has said that the carbon price needs to be around $140 by 2030 and $250 by 2050. This is supposedly what is required to drag the rest of New Zealand away from fossil fuels. At those prices, there is nothing other than dairy on the very best land and kiwifruit on specific land types that can compete with long-term forests.
As for harvested timber, I consider it doubtful as to whether New Zealand needs new forests for that purpose. There are already about 1.3 million hectares of pre-1990 forests that are on their second and third rotations. If simple economics is what counts, then permanent exotic forestry is where the money now lies.
There are of course caveats on everything. The ETS has been constructed by Government and it is the Government that sets the rules. There are rumours that the rules will indeed change in the coming months to put a dampener on conversion of pastoral land to carbon farming.
However, changing the rules could still leave carbon farming as very profitable and that is what many of the investors are betting on. Right now, there is no doubt that it is carbon farming that is driving North Island hill-country land prices in particular.
Carbon farming ‘rules of the game’ have to be long term given that forestry investments are long term. Accordingly, all political parties need to quickly get on with the job of sorting out their own long-term policies.
In the meantime, big decisions have to be made by those owners of post-1989 forests who are not enrolled in the ETS. There are about 350,000 hectares of forest, much of it farm forestry, in this category.
Anyone considering doing this needs to get everything in place before the end of 2022 so as to obtain credits for the period of 2018-2022. There are delays in the registration process and it cannot be left any longer.
I have been an advocate that owners of these forests should register them, claim the credits, and hang on to them until the dust settles. Obtaining and holding the 2018-2022 credits is fundamental to retaining the option to never harvest these forests. However, not everyone is tuned into this new way of thinking.
My one overarching conclusion is that everything to do with climate-change issues is going to be tumultuous. There will be no smooth sailing.