Climate Change Leadership Forum reports

• November 2007

Report to the Climate Change Leadership Forum: Draft Document for Discussion

Briefing for the Climate Change Leadership Forum. Prepared by Cluster Group A.
5 November 2007.

I. Introduction and scope

A. Introduction and scope

This paper provides a series of recommendations that the CCLF believe, taken collectively, will result in the most liquid, globally linked and effective scheme possible.

A market is a complex adaptive system. The dynamics of the system encompass the rules and regulations of the market, the number and type of participants, their strategies, the quality and type of information, and infrastructure. It is important to state this up front because, although each of the elements of scheme design are assessed separately in this document (e.g., Unit, Liquidity, Bankability, Tax), and the recommendations are presented separately, these factors are all related.

There are a number of misconceptions around some of these areas – in particular with regard to liquidity. This issue, what it is and why it matters is explained in some detail in the body of the paper.

Working Group A determined that it would initially focus on the issues and opportunities in the key areas of the definition of the Unit, Liquidity and Volatility, Bankability, and Tax. Other issues relating to (measurement, reporting, powers and penalties) will be addressed as information and time permits.

The recommendations below represent a package of actions designed to achieve the highest quality market possible.

B. Goals

The goals of Working Group A are therefore to provide clear, unambiguous recommendations to government on the scheme design and related matters to achieve the following results:

(i) Create a market with the highest degree of liquidity, lowest degree of volatility, and highest quality price signal – as these are the critical drivers of the market, and hence the scheme’s success;

(ii) Preserve or grow the brand of New Zealand and New Zealand Inc. for national benefit; and

(iii) Preserve or grow the set of feasible future real options for both the New Zealand Government and the New Zealand market participants.

C. Approach and timeline

The approach taken was as follows:

(a) Determine critical areas of inquiry for near-term decision making by government;

(b) Determine the key the group was best technically and informationally equipped to answer, and focus on those areas;

(c) Determine an agreed framework for decision making;

(d) Obtain the information required to make confident recommendations under that framework;

(e) Generate draft recommendations; and

(f) Discuss and refine those recommendations with larger CCLF.

The timeline in this area is shorter than that of the overall CCLF. This is because many of the issues are ones that officials are working on in parallel, and will be included in drafting instructions for legislation to be presented before the close of Parliament this year. The timeline is thus as follows:

(a) Present draft recommendations to larger CCLF on 8 November;

(b) Incorporate relevant feedback and any new information from 8 November meeting;

(c) Circulate final paper to entire CCLF as soon as practicable after 8 November for final comment; and

(d) Confirm final paper and make recommendations to government shortly after the second CCLF meeting.

II. Key areas of inquiry

A. The Unit

A. Option and framework – Hot-air AAUs

The most critical inquiry in this area is whether or not “hot-air” AAUs should be included in the scheme. There are four possible approaches that New Zealand could take with respect to hot-air AAUs. These are:

Option 1: The current draft ETS, with AAUs included for all participants;

Option 2: AAUs included; but only to be bought/sold by the Government;

Option 4: AAUs excluded, but with a right to review or triggers for change included; and

Option 3: AAUs excluded.

Unless the New Zealand market is linked to other markets and, critically, other markets are willing to be linked to it, the market will likely be illiquid and prices volatile. Four maximisation criteria were therefore determined. These are:

(a) Impact on liquidity and quality of price formation. The threshold question in this arena is whether or not the inclusion of hot air AAUs would result in diminished real fungibiliy with other global schemes because of an unwillingness to treat units from the New Zealand scheme as “in fact” equivalent (in terms of additionality, etc). The issue, as stated by the International Energy Agency, Paris, 24 October 2007, is that “Free access to all Kyoto mechanisms (including hot-air AAUs) may limit the willingness of other parties to grant New Zealand access to their domestic emissions trading system.”

(b) Impact on brand and global perception of the market. A brand cannot create long-run value for its owners and beneficiaries if it is not authentic. For the brand of the NZETS to be robust and resilient the underlying scheme must therefore be perceived to have positive environmental impact. The test for this criteria was whether our corporates exposed to the compliance or voluntarily imposed procurement demands would be positively or negatively impacted in a revenue and opportunity sense by the brand outcome.

(c) Preserving and creating real options. It was assessed that the most likely route for Australia to take was to become a Kyoto signatory in the near term, or not at all until post 2012. Either way, the scheme design and inclusion of AAUs or not, would be resilient to Australia’s entry to Kyoto. The real option analysis thus becomes predominantly about two specific potential future linkages:

1. Preserving the real option of entering bilateral arrangements with Europe; and
2. Creating a real option to enter a bilateral arrangement with the U.S. (deemed a potentially feasible option because of the inclusion of forestry and agriculture in our scheme, and the importance of those sectors to the U.S.)

(d) Economic impact on New Zealand. This includes:

1. The direct costs and benefits (e.g., dollar impost, liquidity costs, trade and services revenue changes); and
2. Dynamic costs and benefits (i.e., from firm’s future operational, location and investment choices).

B. Assessment

(a) Option 1

The inclusion of hot-air AAUs in the NZETS almost certainly result in the NZU being more a oneway trade in terms of fungibility with Europe and other markets than a two-way trade. What this means is that New Zealand corporates and the Government, with compliance obligations from the NZETS and Kyoto respectively, could utilise the EU market to acquire Kyoto units to meet their compliance obligations. However, the inclusion of hot-air AAUs in the NZETS will mean that the Europeans – and other Kyoto countries that may follow Europe’s lead – will not participate in the New Zealand market on a reciprocal basis.

The NZU would thus be a very low liquidity instrument with local participants disadvantaged on a price basis. The flow-through effects (outlined in more detail in the section on liquidity) would be very harmful. This would have very harmful impact on our long-term cost of compliance and the success of the scheme.

Actual traders, corporates and other market participants were thus firmly, and without dissent, of the view that, if hot-air AAUs were available to purchase, as the purchaser could potentially be buying hot-air AAUs when they acquired NZUs, they would be unwilling to engage in two-way trade and accept NZUs for their own compliance or voluntary purposes.

The current version of the scheme, which includes hot-air AAUs, was determined as unlikely to be successful in achieving any reasonably degree of liquidity, and hence would result in low pricing quality and high volatility. Option 1 thus fails the liquidity criteria.

The private and NGO sectors were firmly of the view that Option 1 would prevent the NZETS, and NZ Inc. more broadly from either capturing any flow through brand benefits, including or gaining or preserving global trade and services revenue. Option 1 also failed the brand test, and was felt to also fail the option preservation test. As Option 1 would also likely result in New Zealand having to “sell-low and buy-high” it is also questionable whether it would actually result in lowest cost.

Cost. A material cost is the cost of illiquidity. The New Zealand market is small and as units are almost certainly going to be short allocated it is critical that we link with other markets. Unless the New Zealand market is linked to other markets and, critically, other markets are willing to be linked to it, the market will be very illiquid. The negative impact on liquidity (and the associated increased costs for New Zealand corporates), and on the brand of New Zealand corporates would have to be assessed against the potentially positive cost impact of cheap hot-air based AAU Kyoto compliance. Moreover, as Option 2 will negatively impact the development of an effective forward market, and thus prevent liquid risk management tools being developed, this is also a real cost to New Zealand.

Thus it is not evident that there are any real measurable direct cost benefits from including the AAUs as an option for the Government only. As there is not sufficient information provided to assess either the direct or indirect economic cost, or evaluate the relative implications of the inclusion of hot-air AAUs, it is the group’s recommendation that unless there is significantly more detailed economic assessment of the direct and indirect costs of a liquid vs an illiquid scheme, and of behavioural and brand benefits, that economic cost not be included as a key criteria in assessing the issue of inclusion of hot-air AAUs.

The recommendation is thus to exclude AAUs from the scheme, and not to recommend Option 1.

With Option 1 eliminated, the other options were tested against the same criteria.

(b) Option 2

Option 2 is the inclusion of AAUs for the Government itself as a “safety valve”. It is assessed under the four criteria.

Liquidity. Market reaction was mixed to the liquidity impacts of Option 2. However, what was unanimous was that the impact would be negative for the effective development for a forward market. Participants will be less willing to commit to a forward position if, in the intervening period between contract agreement and settlement, their risk exposure could be substantially altered by hot-air AAUs entering into the scheme. Specifically, the risk is that participants will not be willing to take the risk that AAUs could become part of the Register, and, upon close-out of a futures contract, there was a chance that the underlying “physical” unit on register was a hot-air AAU.

While this risk exists in the EU ETS and a futures market exists there, the New Zealand market as a price taker (not a price maker for at least the first two years of the ETS) is more at risk from changes in liquidity. Equally, a stable forward price in NZUs will be more resilient to spot energy price movements in Europe, for example.

As outlined later in this paper, the development of a futures market in NZU’s is very important for global participation, for overall levels of liquidity, for the ability of New Zealand corporates to manage and hedge risk, and for environmentally impactful investment to occur and to the actual quality of the spot market price. It is likely that this market will be like the Australia bond market, where spot market pricing is determined with reference to the forward market, rather than the other way around. This should, in its own, provide its own safety valve.

• Brand. The view on whether Option 2 would similarly result in negative branding was more mixed. Traders tended not to have a view. However, some strongly held views were shared by corporates and NGOs. These fell into international and local branding and equity issues.
• International. On a brand-basis, were the Government to actually utilise hot-air AAUs, even if they were to be ring-fenced on the register it would be brand-negative for the scheme internationally. It will create price uncertainty in the forward market, give market signals of being a “self interested option preservation” and create a general perception that the scheme (and therefore the market) is unstable. If the safety valve is a “credible threat”, it will impact negatively on brand. The reaction to the Australian government’s announcement of a safety valve was globally negative, for example.
• Local. If a strong price signal is deemed by the Government to be of benefit in driving changed behaviour, innovation, and, ultimately, a changed footprint, it is unclear why that logic should apply only to the private, and not the public sector. The CCLF does not understand the logic, or the equity, in an approach that would see the Government, (a large contributor to New Zealand’s carbon footprint with its aggregated corporate and state sector footprint) reserving the right to manage its own compliance obligations via utilising hot-air AAUs, while not passing on that ability to the private sector. It was also felt that, as far as incurring cost, the Government should be “in the same boat” as the corporates impacted by the NZETS, rather than “in a different boat”. The same price, behaviour, and other costs and benefits should apply equally across New Zealand, rather than fall disproportionately on one part of it. It was also felt by some that, as in many instances in New Zealand the Government competed with private sector on a business or service provision basis, to exclude part of that on the basis of ownership was to potentially tilt the playing field toward government.

Real options. Regardless of the fact the EU has this approach, it is a larger market, and may well address this issue at a later date. Going second does not give New Zealand the right to follow others’ mistakes when they are recognised as such. With the New Zealand Government being able to unilaterally and at any time, include hot-air AAUs, it is not clear that Option 2 creates or preserves any valuable real bilateral options.

To summarise, for the scheme to result in actual international linkages – essential to liquidity, pricing, and access to global markets on a two way basis for New Zealand, hot-air AAUs (and other similarly ‘tainted’ credits as they may emerge) need to be excluded from any tradable set of units.

The Government utilising no/low-benefit hot-air AAUs for its own “safety valve” benefits only raises significant questions of equity, risks the brand of the scheme, and potentially debases the benefit of the price signal across a large part of the New Zealand economy.

The CCLF believes that hot-air AAUs should thus not be included on a government-only basis as a safety-valve – as to utilise that valve would reverse any liquidity, pricing, brand and access benefits created. As a safety-valve that cannot be utilised has no value, implementing such a policy also has no value.

It is the recommendation of the CCLF that Option 2 not be implemented. If a safety-valve is deemed to be of benefit, then analytically that needs to be broken down into scenarios that need to be managed against. If the scenario government is most concerned about is sudden spikes in global spot prices that impact New Zealand, then the policy focus, and development focus should move to ensuring that conditions are in place for the effective development of a futures market or providing other risk management techniques.

The analysis above is sufficient to indicate that Option 4 (no hot-air AAUs and no “safety-valve”) is preferred to Options 1 and 2. This leaves Option 3.

(c) Option 3

The key to Option 3 being successful is it being credibly different from Option 2. As Option 3 would preserve some potential real option value for New Zealand, and if transparent the requirements to make such change were properly incorporated in legislation, Option 3 will exceed Option 4 on a real options analysis, and perform equally as well on all other criteria. “Free-riding” on EU ETS choices in this area would be an effective, objective and external approach, similarly, if such legislation would incorporate a specific test that the inclusion of hot-air AAUs will need to pass, based on criteria more rigorous than the usual “public interest” test. That would also work.

(d) Recommendation

The recommendation from the CCLF is for Option 3. Hot-air AAUs should be excluded from the NZETS, but the legislation should either a “tag-along” that will incorporate hot-air AAUs if the EC ETS does, or incorporate a right to review should there be a material change in external conditions or the fact base.

B. Liquidity and volatility

A. Context: What is liquidity and why does it matter?

Why does liquidity matter?

“To reap the benefits of emissions trading, deep and liquid markets and well designed rules are important. Broadening the scope of schemes will tend to lower costs and reduce volatility.”
Stern Review: The Economics of Climate Change: Part IV – Policy Responses for Mitigation.

Critically, markets price the level of liquidity and liquidity risk in their trading decisions. Empirical studies find the effects of liquidity on asset prices to be both statistically significant and economically important. It is important to know that illiquidity empirically helps explain the low price of hard-to-trade securities relative to more liquid counterparts with identical cash flows. In the context of carbon, therefore, it is not just product fungibility, but ease-of-trade that it is critical.

What is liquidity?

The level of liquidity is not fixed. It varies according to a series of factors. The goal of NZETS design must be to ensure that the key addressable factors are architected in such a way that, taken together, the design maximises liquidity under any given level of “float” of NZUs.

It is important that we clarify for the broader audience exactly what liquidity is, and what drives it. In particular, there is an assumption implicit in much of the ETG work that liquidity is determined by the physical amount of the instrument that is available for trading (i.e., the “float”). While the float is important, it is by no means the only driver of liquidity. This is clearly illustrated in reference to the impact of the U.S. subprime market on liquidity in the bond and CDO markets. In early 2007 global bond and CDO markets were at record levels of liquidity (as measured by turnover, and by the ability to find a price and transact without delay or price impact). However, with the changed conditions, investor strategies conversed, and an unchanged float of physical assets was held rather than circulated, and liquidity dried up. This shows how the float is a factor, but that a series of other variables are at least as important.

Liquidity also tends to be confused with trading volume. They are highly correlated, but conceptually they are different. A new piece of information might boost the volume of trading (temporarily), but liquidity is about how easy it is to sell a stake at fair value (rather than having to discount to move it). Liquidity is thus a complex concept. Stated simply, liquidity is the ease of trading a security. To measure liquidity, we look to four main measures:

1. Velocity, or turnover of a given float. If the float of NZUs is $1b, for example, and $1.5b is transacted in a given year, the velocity is 150%.
2. Bid-ask spread. Strong buying and selling demand creates a tight bid-ask spread, and is a key indication of the ability to move a position with ease.
3. Depth. At a given price, how deep is the demand and supply of that instrument?
4. Price increments/decrements. Does the price move smoothly in small price increments and decrements, or does it “gap” around (i.e., does a graph of pricing over time look like a line graph or a bar chart?)

It is important to recognise, however, that instruments with lower float are predicted to have more severe search problems and correspondingly higher liquidity premia. The implication for legislation and policy more broadly in the NZETS context is that, with the low float of NZUs, every scheme element possible needs to be designed to ensure that maximum possible liquidity at a given level of float is achieved.

The CCLF below provides analysis and recommendations on legislative and other actions the Government can take to maximise liquidity.

Ultimately, the market’s liquidity will depend on the level of confidence in the integrity and transparency of the scheme, with systems and processes that are simple and efficient. The below factors outlined are all drivers of liquidity, and assessed as part of a system, and recommendations provider.

B. Liquidity drivers – Analysis and recommendations

(a) Information availability and integrity

The diffusion of information in markets is material to liquidity. Market participants – including intermediaries and market makers are attracted to transparent markets with good information flows. There are two main types of information that a market requires to function well. The first is fundamental information. This is information that relates to the underlying drivers of the fundamental value of the traded instrument, today and in the future. The second is transactional and market-based information. This includes information about actual transactions that have occurred, the price and volumes transacted, and the market’s demand and supply for the unit at a given price (known as pre-trade information or “depth”). Together this information set allows traders and various types the ability to form their views of value, and execute according to a variety of strategies.

Fundamental Information. The importance of information of this kind is illustrated by the experience of the EU ETS when the first verified emissions data of installations included in the scheme were published in March 2006. Prices dropped dramatically in response, as it was clear that, for many firms, actual emissions were well below the number of allowances given to them at the start of the scheme. Revealing information on actual emissions regularly through the trading period would help limit this volatility.

Consistent feedback from the global market has been that New Zealand can ensure consistent interest and accurate pricing in the market for NZUs by requiring that all entities with NZETS compliance obligations provide consistent and accurate disclosure of their positions to the market. In particular, regular disclosure as to an entities’ net position against their ETS obligation will help the market understand the fundamentals of demand and supply.

The recommendations in this area are:

1. All emitters with a point of obligation under the ETS be required to provide to the market compliance information on a quarterly basis.
2. This information need only be audited information released on an annual basis.
3. The audit date can differ across emitters so that each entity can manage this audit process with their year end financial audit process. To be clear, the Government should not impose its own calendar on corporates, but follow the example in the Companies Act.

Transactional and Market Information. Most markets around the world that are trusted have as their touchstone the idea of “fair, orderly, and transparent”. While the ideal outcome, from a market and traders perspective is that there is good transparency into both the depth of market demand and supply at any given price, as well as instantaneous information as to transactions that have in fact occurred, to require both of these types of information to be made available would be too costly.

The feedback from both market participants, and corporates, however, is that they see real value (some see it as essential and a not-negotiable) in legislation that requires post-trade transparency for spot market transactions in the NZU. The reasoning is as follows.

There must be an effective “last price” signal provided to the broader market so that any trader (larger or small), or demander or supplier of credits (large or small) can see where the market is at any point in time, and hence make an informed decision as to whether to transact at the price being offered and whether to change their forward looking hedging position or strategy. Where, or how, the transaction occurs is not material, and should not be mandated, but the information is of fundamental public value. This is to ensure both (i) that rorts do not occur where two people are offered the same product at wildly different prices by the same player at the same point in time; and (ii) an overall picture of what the market price, at what volumes is, so traders, suppliers and demanders can execute informed transactional and risk management strategies with the lowest search costs achievable.

There is also a cost to the public and traders if this information is withheld because traders on one side may worry that a potential seller has private information. The more differentially this information is distributed, the greater cost and illiquidity that will result.

Simply put, asymmetric information regarding completed transactions exposes uninformed investors to the risk of being unable to infer information from prices, and this risk is priced. In the New Zealand context, the uninformed players are likely to be either retail, or more likely, offshore. Given the size of the float (i.e., potential level of money to be made) the lower this risk is, the more likely participation is to occur from offshore.

Finally, with a large part of the spot market transactional information available on a post-trade basis, there is a reliable, trusted spot price, from which futures and other risk-management products can develop.

Access to price and volume information is therefore fundamental to liquidity.

The recommendations in this area are:

1. The legislation should require that all trades in NZUs by (or on behalf of) entities with an NZETS compliance obligation, or by financial intermediaries regulated in New Zealand, be reported to an accredited market information release provider.
2. The information to be reported should comprise the volume traded, and the price per unit traded. This information should not be bundled (e.g. if an entity trades 20 tonnes at $20 per tonne, and 10 tonnes at $18 per tonne, each of those trades should be reported separately, as to bundle them would not allow a true market supply and demand curve to be constructed, or to track price movements (e.g., 30 tonnes at $19.30 is a very different information set).
3. This “post-trade” information should be required to be reported to an accredited information provider immediately.
4. To ensure the authenticity of price and volume information released to the market, accredited information providers should receive, but not release, the information as to the nature of the entities transacting. To release this information would be to potentially disclose a trading strategy and hence disadvantage the entity. This is important to reduce search costs for global players (i.e., they have it delivered to them, rather than having to search a specific New Zealand database or access it by request).

Information distributors. Approved information providers should disseminate all the above compliance and price/volume information to the broader market. In the European securities markets, for example, the regulator stipulates what functionality and performance requirements an information vendor must meet to be accredited. A requirement to aggregate compliance information by industry, for example, would be a requirement to receive accreditation. If this information is provided via a web-based application it can be very cheap and very easy. Again, this should be a requirement accreditation that the information provider can make an effective, secure, immediate web based interface available to firms so they can electronically upload standardized information. Not difficult from either end.

The government's role should be to approve infrastructure providers who can compete to provide the information as effectively as possible to the global market, not to undertake that task itself.

The recommendation in this area is:

1. The Government creates guidelines in regulations for approval as an accredited information provider, and manages all information release through such accredited providers.

(b) Number and range of participants

The number of markets participants, and the diversity of strategies they employ, are two of the most important factors in determining the overall level of liquidity.

The recent sub-prime crisis is instructive. What happened there that, almost overnight, a multitude of different investors, who had previously been operating with different strategies – hence the ease of finding both a buyer and a seller at a given price – converged on an identical strategy based on risk minimisation and a flight to cash. This strangled liquidity, which impacted pricing, etc, etc.

Mirroring the above section on Information, there are essentially two types of traders in every market – fundamental traders and flow traders. The fundamental traders (often referred to as “buy and hold” in equities markets), are also known as “liquidity drainers”. This is because these strategies do not result in significant turnover. Once these traders have achieved a position, they tend to sit on it, ride out any news, and wait for their specific strategy to be realised. This behaviour is most easily recognised in retail dominated bond issues. The second type of trader is a flow trader. These traders trade on short term news, and, more critically, short-term changes in price. These traders can also be thought of as “liquidity providers”. In a market such as the NZETS, attracting these players is essential as their participation enhances liquidity.

Ensuring participation in the NZU market from retail investors, financial institutions, corporates, and funds is key. Ensuring that the marginal cost of participating on the New Zealand market is low, and the overall regulatory and infrastructure framework is as globally standard as possible is important to this. This means we should take steps to ensure that no marginal cost of New Zealand regulation is imposed on those who are already supervised by reputable regulators, to encourage institutions from overseas to be continuously in our market on both the demand and the supply side. It is the case that, right now, the global players are sufficiently interested in the New Zealand market, that if this is got right, we could very likely surprise some of the “New Zealand is too small” sceptics with the vibrancy of the market.

The recommendations in this area are:

1. As New Zealand is a marginal destination for global institutions, the regulatory approach to participation in this market, for anyone who wants to trade on licensed markets (as opposed to OTC), or participate directly in any part of the market infrastructure (e.g., exchange platforms, clearing houses, registry), should be based on the European “passport” model. Under this approach, if a participant is approved in their home market to undertake certain activities, they should be allowed to undertake such activities in New Zealand on the basis of being supervised by their home regulator without additional New Zealand-based compliance requirements.
2. The New Zealand Government should actively encourage participation in the New Zealand market by mutual recognition for this market and its infrastructure overseas[For example, the FSA may determine that the electronic extension of market infrastructure (trading, clearing, registry, etc) into the offices of a UK based trader, constitutes setting up an operation there. As such, recognition or exemption may be required. For example, if Barclays Capital in London wanted to transact NZUs on-exchange in New Zealand, and they wanted to do that as a direct participant rather than on an intermediated basis through a New Zealand intermediary, that may be deemed an extension of the New Zealand market into that market, and may require approvals from the FSA. As we are expecting some of the activity, particularly in the forward market to be onexchange, governmental leadership in this would undoubtedly result in increased participation, and hence liquidity.].

(c) Futures market

Liquidity in any spot instrument such as the NZU is significantly enhanced by the existence of a futures market that utilises an identical or similar information set in price formation.

Equally important, from a risk-management (cost) and investment (benefit) perspective, a lack of certainty over the future pricing of the carbon externality will leave a lot of money on the table. We are aware, for example, that certain sequestration projects (some of which could have delivered large benefits) have not proceeded primarily due to lack of a forward price on carbon. These projects would have been Permanent Forest Sinks Initiative projects sequestering carbon on an ongoing basis and thereby having an additional, permanent, measurable and verifiable positive climate impact. They would also have been capable of earning internationally tradeable Kyoto credits. We can confirm that these projects have failed on the grounds that the projected financials of the project could not be upheld without any forward price on New Zealand carbon to which the projected returns could be aligned (i.e. a carbon price that incorporated areas covered by the NZETS and not covered by other schemes, e.g., forestry and agriculture). The people we have spoken with explained that without a trusted, transparent publicly available forward price this project was considered too risky from a financial perspective, and could not therefore proceed. This is a lost opportunity - both in terms of engaging New Zealand companies in domestic sequestration projects and also long term positive climatic impacts for New Zealand.

One other material factor in the specific context of the NZETS as to the importance of the development of a forward market is the fact that the New Zealand scheme is the only Kyoto-based scheme that includes forestry and agriculture. As such, the pricing of forward contracts in other markets that are on a spot carbon reference price that does not contain either of these sectors means that there are not globally viable products available to hedge effectively. To ensure these vital New Zealand business sectors are well serviced in risk management products, a futures market on NZUs must be encouraged to develop.

The recommendation in this area is:

1. Agree that development of a futures market is important, and investigate what other factors have to exist to support the development of a futures market in NZUs in New Zealand and how they are best provided.

(d) Registry and infrastructure

Connectivity to as wide an investor group as possible is critical. The creation of robust institutions, and the collection and provision of reliable information, are important for efficiency. It is clear that a market’s infrastructure is among the most important determinants of this. It is also an important factor affecting the profitability (and hence liquidity) of transactions (e.g., transaction cost, certainty, search costs).

The success of the NZETS will depend on there being an active secondary market (witness the European ETS), which in turn depends the ease, cost and security of trading, clearing and settlement.

A key component of that is the registry. Globally the industry believes that an efficient and secure registry is critical. It enables authenticity of the credits, enables retirement, prevents double selling and manages reporting.

Many emissions registries have appeared, but most do not come from a registry or transactional background. Registry design including the specifications and resulting registries for Kyoto countries and the European ETS have been developed as a short term fix to solve the problem of there needing to be a registry. For example, none seem to have been built to provide an electronic interface so that units can be moved from account to account using instructions produced from an external program (such as approved market participants, exchanges or clearing houses). This lack of foresight means that workarounds have to be made to effect secure trading and settlement. These workarounds both cause increased costs and risks in an active secondary trading environment, and act as a barrier to liquidity developing where there is no active market.

An example of such a registry is the Kyoto registry built for MED. It meets the UN requirements but is limited in its functionality. It complies with what it needs to for Kyoto – but the Kyoto requirements are not designed to encourage liquidity. For example, the MED registry has no electronic external interface (all activity has to be carried out by humans through a web browser); it has no way of temporarily reserving units in an account for settlement purposes; and it has no way of being able to be used for electronic DvP (Delivery versus Payment - the simultaneous, irrevocable exchange of cash and units) which is the global norm on other commodity markets.

If this type of registry is used for the New Zealand ETS then only organisations who have the expertise and resources will be able to offer DvP, by creating a workaround depository system whereby sellers of units transfer the units in advance of settlement to a holding account of the depository organisation. DvP will be effected in the books of the depository and then units transferred from the depository to the buyer's account on the registry. This arrangement will take time, is not ideal and its acceptance by the industry will depend on the quality and financial backing of the depository organisation.

In addition to the “standard” record keeping and ability to track and report movements and balances, the New Zealand ETS registry should be future proofed – it can serve the immediate needs of the ETS today, but will also be able to meet the likely developments in the future including facilitating low transaction cost and highly efficient as secondary trading.

This is particularly important in the Kyoto market because of the "Commitment Period Reserve". The Government (like all Annex 1 countries that undertook Kyoto obligations) is required by the Kyoto Protocol to hold 90% of its cap in its registry at all times. If this limit is reached, the registry will effectively close to outgoing international transfers until more Kyoto units are transferred into the registry. Closure self corrects when more units enter the registry. Preference will be given to certain buyers however trades failing due to registry closure will harm the credibility and liquidity of the market.

While all Kyoto registries have this issue, many governments are not in the position of the New Zealand Government. The New Zealand Government will not only be short its Kyoto compliance, but it will also be delivering Kyoto credits earned through the PRE Scheme and forestry generated NZUs early into the 2008-2012 period. Therefore, the registry may well get near the Commitment Period Reserve on many occasions. The capability for a clearing house to connect and reserve credits prior to transfer will help reduce the risk of settlement failures and consequent liquidity issues.

Another way to utilise the registry to improve liquidity is to bring primary CERs to New Zealand registry and consequently link the NZU market with greater supply of CERs. In particular, there is an opportunity with regard to Asia. This opportunity is as follows:

The CDM Registry won't issue primary CERs (i.e., new credits to the project developer from a developing country project) into any Kyoto register. They will only issue primary CERs where there has been a sale and the host country (i.e., the developed Kyoto Country, e.g., EU, New Zealand, Japan etc.,) of the CER buyer has, written a letter to the CDM Registry to say that it will accept them. This level of UN bureaucracy, it is fair to say, unsettles the primary market and means there is a component of delivery risk in the primary spot market.

This could be critical to primary CER supply to the market here. From the New Zealand Government perspective, as well as improving liquidity and supply, it should also mitigate the concerns around the Kyoto Commitment Period Reserve issue. If the New Zealand Government register was the initial home for many of the Asian, Latin American sourced CERs the New Zealand Government would have no problem with the CPR being breached.

The simple solution is for the project developer effecting a sale / transfer on paper to an entity in the host country, to obtain host country approval for it, and then have the credits on register to sell into the market. However, the only two governments that have indicated that their registry will be “open to foreigners” are the UK and Holland.

The recommendations in this area are:

1. Electronic interface to other systems, such as those operated by participants, banks, exchanges, clearing houses, depositories and other financial institutions, using the well proven international standard messaging protocol (the SWIFT standard 15022) and/or Web services (such as that used to communicate with ITL).
2. Internal functionality to support DvP. DvP is now a standard in the settlement of other financial and commodity products – this will become a standard in compliance market (a proxy for DvP has been developed in the European ETS). DvP can be offered for both transactions that take place on an exchange or that take place OTC.
3. Government must ensure that its registry is open as possible to other entities (including offshore based entities) to hold CERs.
4. The New Zealand Government should allow offshore entities to hold accounts at the New Zealand registry.

C. Government participation and facilitation

The Government has indicated that it has been asked by certain stakeholders to consider potential interventions in the market for NZUs, with the intention of either improving liquidity, or managing price levels. The Government is considering, in particular: purchasing additional Kyoto units on the international market and releasing those into the New Zealand market.

In terms of assisting in liquidity, there are two basic aspects that the Government can look to influence. The size of the float, and the availability and turnover of the float itself.

The CCLF has determined that there are four options available to the Government under the heading of Liquidity.

First, Lending make available the stock of government units in its Kyoto register to the market for trading via lending agreements. Mechanically this would work much like stock lending. In this case the Government would make available certain amounts of its float to liquidity providers (financial intermediaries) on the market, who would trade those units actively on the secondary market with the goal of making a profit. The lending agreement would contain delivery instructions that outlined on what date the Government required a certain amount of physical units to be returned to the register.

If these units were lent to active traders, and if the stipulation behind such lending agreements is that the trading activity is to take place on the New Zealand market, and if the rates agreed are low, then this approach is likely to actively increase trading activity and hence improve liquidity.

Second, seed carbon trading funds. Distinct from making its credits available to the market for trading via lending, this option would see the Government seed carbon trading funds in New Zealand. This approach is to play a leadership role in the establishment of institutions critical to the healthy functioning of the broader market. There is clear precedent for this in the Government's VIF and GIF funds, where the Government will co-invest with approved managers in the venture capital area. This policy framework was established because of a lack of meaningful capital at that end of the capital markets.

This option would see the Government make available a certain amount of money ($250m was suggested as reasonable) for investment into New Zealand domiciled and focused carbon funds. These funds could be focused on generating underlying supply – to improve the float in the market, or on actively trading in the market, or both. It is thought that there are a series of qualified individuals and institutions that would be able to effectively implement profitable strategies in the area of carbon should funding be available. The return structure of such funds should mirror the VIF return structure. The criteria for qualification, however, including the timeframes, should learn and improve from the VIF experience.

Third, establish a market operation function. This is the option outlined in the Government paper where it suggests running auctions in NZUs. The Working Group strongly believes that this would be negative for overall liquidity. If the Government were to act as a market operator, the New Zealand market would likely have some units exchange traded, some traded OTC, and a further set managed via government infrastructure. Rather than consolidating liquidity into a central place (which, in itself, is liquidity improving), this would fragment already low levels of liquidity, and ultimately be liquidity destroying.

Fourth, supplying new credits to the market. This option is focused on increasing the available float of NZUs in the New Zealand market. This would entail the Government utilising its balance sheet in the international markets to acquire NZUs, and then releasing those units into the New Zealand market. In many ways this option is analogous to the RBNZ speculating in the currency markets. Were the Government to undertake this activity, it would need to be prepared for losses as well as returns. As this option, in essence, is about balance sheet utilisation, it is clearly a costbenefit decision for the Government to make.

The recommendations in this area are:

1. The Government enter standard lending arrangements for certain quantities of its Kyoto bank. The Government should work with the private sector to ensure the right institutions are made aware of this facility. The Crown should also outsource the management of the actual lending arrangements. Due to tax reform undertaken last year, such lending will not be a taxable event for the entity that manages such lending on the crown's behalf.
2. The Government should assess developing framework which would seed carbon funds, thus increasing both float of NZUs in the market and their turnover. This should be a short-term priority.
3. The Government should not run an auction process.
4. If the Government deems liquidity provision in the public interest and it believes it is best placed to source Kyoto credits, if it acts in the market, it should do so as a normal market participant, through normal channels. This will have a second order effect of facilitating the development of effective intermediaries.

D. Price controls

The Government has been asked to consider active market controls. While there is obviously a political dimension to this consideration, the CCLF will comment on the impact of price controls on the integrity of the market, likely impact on market participation, and likely overall outcomes on market development and effective operation of the overall market.

The CCLF strongly believes that active control of market prices will be very negative for the development and efficient operations of the market. Key reasons are that such controls will:

• Distort the price signal;
• Reduce or eliminate liquidity at certain price levels (market will become one sided near floors or caps);
• Eliminate the profit incentive from commercial market makers;
• Negatively impact/eliminate the development of a futures market;
• Reduce likelihood of bilateral linking to true market schemes; and
• Create real commercial risk for the Government (depending on the mechanism utilised).

The recommendation in this area is:

1. The Government should not implement any price controls.

E. Bankability

Banking is the ability to carry over unused quotas form one period to another, and the ability to use or purchase quotas from a future period in the current period. This allows trading to take place across commitment periods, as well as across sectors and countries.

As we have identified, to ensure confidence in a stable long-term carbon price, and to realise the full efficiency benefits of any trading scheme, the creation of liquid and efficient markets is essential. A key issue for investor confidence is a commitment to the long-term future of the scheme and predictability in its overall shape and rules. This predictability can be achieved through establishing revision rules for future allocation periods. For instance, governments may announce that future allocations will be contingent on factors such as the price of permits in the preceding period.

ETS units must be able to be banked through the 2012 transition period. The potential issue with this banking arrangement is a potential temporary price dislocation caused, not by any underlying change in the fundamental value of the unit of the environmental impact associated with a tonne of CO2, but dislocation and pricing discontinuities because of the Kyoto transition date and uncertainty around those arrangements. This dislocation was likely to be higher the more closely the NZU price was linked to the EU market price.

Within this framework, banking can be used to create links between different phases of a trading scheme. This can improve flexibility, as well as reduce the risk of price spikes or crashes at the end of trading periods.

The recommendations in this area are:

1. NZETS units must be able to be banked through the 2012 transition period.
2. As the impact of any price volatility in 2012 is most likely to be hardest felt by Agriculture, work should be done on ensuring all proper risk management avenues are explored as an important priority.

F. Tax

(a) Balance date revaluation. It is proposed that New Zealand units held at balance date in any given tax year will be required to be revalued to market value for tax purposes. This is quite different to the tax treatment of other instruments, such as say shares, and the differences may result in inappropriate tax consequences. Moreover, in terms of participation, the cost of managing the complexity of different tax treatments for different types of instruments that are transacted identically, will mean that the risk of technical non-compliance, and the cost of compliance in fact, may be sufficient to prevent participation in the market – with the associated detriment on liquidity that will result from diminished participation.

(b) GST. There are significant difficulties with GST under the proposed system. In particular, when transacting on an exchange, the parties to the transaction will not necessarily be aware whether the other party is resident in New Zealand or registered for GST. This will act as a significant barrier to entry to offshore participation. This has been confirmed with market participants who do not see the proposed arrangement as workable.

The recommendations in this area are:

1. Tax treatment of carbon credits, whether NZUs or other credits held on balance sheet, should be treated in an identical manner to the tax requirements for securities such as shares.
2. NZUs and any other carbon units should be subject to GST at the rate of zero percent.

III. Summary of recommendations

A. The Unit

1. Hot-air AAUs should be excluded from the NZETS, but the legislation should incorporate either a “tag-along” clause that will allow hot-air AAUs into the scheme if the EU ETS does, or a right to review based on a specific test with definitions at a level of specifically higher than the usual “public interest” test.

B. Liquidity and volatility

(a) Fundamental Information

1. All emitters with a point of obligation under the ETS should be required to provide to the market compliance (demand and supply positions) information on a quarterly basis.
2. Audited information need only be released on an annual basis.
3. Each entity can meet any government annual reporting compliance requirements off audited or non-audited information, thus ensuring that each entity can tie their carbon and it into their annual financial audit process.
4. All entities should be required to release that information to government and the broader market via an accredited information provider that can ensure that such information is available globally on a real-time basis. This is important to reduce search costs for global players (i.e., they have it delivered to them, rather than having to search a specific New Zealand database or access it by request).

(b) Transaction Information

1. The legislation should require that all trades in NZUs by (or on behalf of) entities with an NZETS compliance obligation, or by financial intermediaries regulated in New Zealand, be reported to an accredited market information provider.
2. The specific information reported should comprise the volume traded and the price per unit traded. This information should not be bundled (e.g., if an entity trades 20 tonnes at $20 per tonne, and 10 tonnes at $18 per tonne, each of those trades should be reported separately, as to bundle them would not allow a true market supply and demand curve to be constructed, or to track price movements (e.g., 30 tonnes at $19.30 is a very different information set).
3. This post-trade information should be required to be reported immediately to the information provider.
4. To ensure the authenticity of price and volume information released to the market, accredited information providers should receive, but not release, information as to the identity of the entities transacting.
5. The Government should assess developing framework which would seed carbon funds, thus increasing both float of NZUs in the market and their turnover. This should be a short-term priority.
6. The Government should not run an auction process.
7. If the Government deems liquidity provision in the public interest and it believes it is best placed to source Kyoto credits, if it acts in the market, it should do so as a normal market participant, through normal channels. This will have a second order effect of facilitating the development of effective intermediaries.

D. Price controls

1. The Government should not implement any price controls.

E. Bankability

1. NZETS units must be able to be banked through the 2012 transition period.
2. As the impact of any price volatility in 2012 is most likely to be hardest felt by Agriculture, work should be done on ensuring all proper risk management avenues are explored as an important priority.

F. Tax

1. Tax treatment of carbon credits, whether NZUs or other credits held on balance sheet, should be treated in an identical manner to the tax requirements for securities such as shares.
2. NZUs and any other carbon units should be subject to GST at the rate of zero percent.