For two weeks now, New Zealand Unit (NZU) prices have stabilised at just below the ETS price cap of $50. This morning, NZUs are trading for $48.12.
It is possible that the price of NZUs on secondary markets will rise above the $50 cap. Were that to happen, it will be advance warning that the ETS price cap could be breached at the next NZU auction.
The ETS price cap only applies to the government’s auctions of NZUs. However, there nothing to prevent NZUs trading above $50 cap on secondary markets. The price of NZUs is simply the product of supply and demand. The price cap in auctions affects secondary markets because traders will not pay more than $50 for NZUs if they believe they can buy from the government at no more than $50 in the next auction.
Which is why an NZU price above $50 would be significant. It would be the market’s assessment that NZUs will not be available for $50 at the next auction. In other words, the clearing price at the next auction is expected to be above $50 and the price cap will be breached.
The government gives effect to the price cap in auctions by releasing extra NZUs from a reserve called the Cost Containment Reserve (CCR). The release of reserve units is triggered if the “interim clearing price” for the auction equals or exceeds the price cap.
If the CCR is triggered, the government will offer to sell 7 million NZUs from the reserve for $50 a piece. The release of these units defends the price cap.
But there are only a limited number of units to defend the cap. Once reserve units are exhausted, there will be no more to defend the cap. The clearing price for the auction will be free to rise above $50.
Although the government will offer to sell reserve units for $50, my understanding of the auction rules is that the government could end up receiving more than $50 for those units if there is sufficient demand.
Regulations provide a step-by-step procedure for working out the clearing price of ETS auctions.
An “interim clearing price” for an auction is calculated by filling offers to buy units in order from the highest price to lowest. The interim price is the price of the last buy offer that is partly or wholly filled.
If the interim price is equal to or above the “trigger price” – the $50 price cap – then the government will offer to sell reserve units at $50 a piece.
The market operator then continues down the list of buy offers until either all offers to buy at or above $50 are filled, or the CCR is exhausted. The final clearing price is the price of the last partly- or wholly-filled buy offer.
The final clearing price is the fair value of the units. All buyers pay the clearing price, rather than the price they offered.
There is nothing to prevent the final clearing price being more than $50, even with the release of the additional units from the reserve, if there is sufficient demand. Which is how the government could end up receiving more than $50 for reserve units even with a price cap of $50.
I have emailed the market operator to check my understanding of the rules is correct.
It is right that the government receives fair value for its reserve units. The alternative, a rule that forces the government to receive only $50 for reserve units no matter what, that would bring the risk of a speculative attack against the ETS – the opportunity to pay only $50 for units whose fair value is north of that amount.
Incidentally, a rough extrapolation of the price trend for NZUs over the last 12 months suggests we will reach an NZU price of $60 some time in February 2022. Yes, the CCR gets in the way by releasing more units. But a) the CCR is already priced in, and b) only 1.7 million units in the CCR are additional (the rest are in this year’s emissions budget but held back).