Delinking the New Zealand Emissions Trading Scheme from the Kyoto Protocol: comparing theory with practice

Abstract

ABSTRACT The New Zealand Emissions Trading Scheme (NZ ETS) presents an opportunity to compare the theory of linked emissions trading with practice. From 2009 until October 2012 New Zealand was linked to the market under the 1997 Kyoto Protocol and there was no indication that this link would be broken. A series of events starting in late 2012 cast doubt on the future eligibility of Kyoto units in the NZ ETS, made the future of linking in New Zealand uncertain, and may have contributed to price divergence between offshore and domestic units. Delinking was officially confirmed by the New Zealand government in December 2013 to take effect from 31 May 2015. This raises the question of what the effect of delinking and announcements had on the carbon market. To study this effect, we used daily price data in a difference-in-differences model over the period 1 January 2011 to 1 January 2016. From this model, we found evidence that, even with differing pre- and post-time specifications, the government announcements in 2012 caused prices in the two markets – for New Zealand units (NZUs) and Kyoto units – to decouple and NZUs traded at a premium based on their projected scarcity. This is further backed up by the behaviour of the raw price data and the change in the types of units surrendered over this time period. The NZU price reaction to the government announcements (rather than delinking itself) shows strong evidence of a well-functioning market. Key policy insights The NZU price reaction to the delinking announcement shows strong evidence of the New Zealand carbon market reacting in the present to news about the future: a property of any well-functioning market. The long period of price divergence between the New Zealand and Kyoto markets has led to a large privately held bank that is a liability to the New Zealand Government and reduces the government's ability to auction NZUs. If the NZ ETS had delinked earlier from the Kyoto market it could have avoided a protracted period of arbitrage which significantly inflated the NZU bank.