Current status
In July 2021 the Ministry for the Environment (MfE) published a consultation document, "Designing a governance framework for the New Zealand Emissions Trading Scheme" (the 2021 consultation document). The 2021 consultation document considers at a high level whether, and how, the New Zealand Emissions Trading Scheme (ETS) should be regulated.
On 17 November 2022, MfE published a further consultation document, "Market governance of the New Zealand Emissions Trading Scheme" (the 2022 consultation document). The 2022 consultation document is seeking feedback in relation to treating New Zealand Units (NZUs) as financial products under the Financial Markets Conduct Act 2013 (FMCA), as well as regulating the NZU market through already existing financial markets legislation. This includes regulating financial advice in relation to NZUs, requiring NZU market operators to be licenced as a financial product market operator and the prohibition of insider trading and market manipulation. Submissions on the 2022 consultation document will close on 24 December 2022, with MfE expecting ETS market governance policy decisions to be made in early 2023.
This article summarises the background of the ETS regime, the findings of the 2021 consultation document and the proposals of the 2022 consultation document.
The status quo
The ETS is a scheme designed to reduce greenhouse gas emissions in New Zealand. Broadly speaking, the scheme requires businesses to surrender NZUs to the government in exchange for their emissions. NZUs are initially issued by the government, but they can be bought and sold by businesses who wish to cover existing emissions or offload unused NZUs.
Currently, there is no specific regulatory framework or regulator which governs the ETS market. While the ETS market is subject to commercial legislation of general application (for example, the Commerce Act 1986 may apply in respect of anti-competitive behaviour in the ETS market, and the Fair Trading Act 1986 may prohibit false and misleading advertising by traders of NZUs), the current approach does not protect against all risks in the ETS market.
At the moment, trading is largely conducted over the counter (OTC), with the buyer and seller dealing directly with each other without the use of an exchange. Because OTC trades are negotiated directly between the parties, there is no public record of the trading details or price.
Potential problems with the status quo
The 2021 consultation document identifies seven risks which might arise if the status quo is maintained. These risks are grouped together under three themes (governance of advice, governance of trading, and governance of market conduct). The risks are:
- Under the governance of advice theme:
- users receiving poor, false or misleading advice from NZU advisers (people and organisations who provide ETS users with advice) who do not have to go through any accreditation process
- NZU advisers hiding or disguising conflicts of interest (for example, an adviser may not disclose that they accept commissions for referrals)
- Under the governance of trading theme:
- a lack of transparency, oversight and monitoring in the secondary market. Because information about trades is not made public, traders can hide misconduct or anti-competitive behaviour
- credit and counter-party risk. This is the risk that one of the parties to an NZU trade defaults on their contractual obligations, meaning the trade is unable to be settled
- Under the governance of market conduct theme:
- insider trading and information asymmetry
- manipulation of NZU prices
- money laundering and financing of terrorism.
Other countries have already taken steps to address these risks (for example South Korea's Emissions Trading Scheme requires trades to take place on the Korean Exchange, so that transactions can be monitored). For this reason, the 2021 consultation document suggests the status quo should not be maintained. Instead, it recommends the government take steps to mitigate the risks identified.
Regulatory options
The 2021 consultation document also sets out options the government could pursue to mitigate the risks found in each theme.
The options discussed to address the risks found in the "governance of advice" theme include maintaining the status quo, creating a consumer education campaign (the aim of which would be to educate ETS users about ETS advisers), creating sector guidelines for NZU advisers (which would benchmark an expected level of service from advisers), and creating a code of conduct whilst also requiring the licensing and registration of NZU advisers (the competency of advisers could be assessed on application to hold a license, and the code of conduct would set a benchmark for behaviour).
The options discussed to address risks found in the "governance of trading" theme include maintaining the status quo, encouraging users to voluntarily report transactions to a regulator (which might improve transparency of the market), requiring NZU traders and ETS participants to disclose the total number of NZUs they hold or borrow (which would make the market more transparent and provide information about distribution of market power), and requiring most or all NZU trades to take place on one or more regulated exchanges (this would provide the most information to the public, and a common set of rules could be imposed to ensure users are treated equally and able to buy and sell at a fair market price).
The options discussed to address the risks found in the "governance of market conduct theme" include maintaining the status quo, setting position and purchase limits (which would prevent one user or group from acquiring such a large share of NZUs that they could wield unfair market power), encouraging users to voluntarily report the price of NZUs traded and requiring mandatory full transaction reporting (under which users would have to report a comprehensive list of transaction details to the regulator).
The 2021 consultation document also considers whether a regulatory body should be appointed to oversee the market. Six options are discussed in relation to this. The government could:
- Maintain the status quo
- Appoint a self-regulating industry body. Under this option, one or more members of the industry could assume the responsibility of overseeing the sector. This body could work independently or in concert with government entities
- Appoint an advisory regulator. This would be an independent body with the power to give strategic advice to the government on the ETS
- Appoint a market monitoring regulator. This would have the same powers as above, but the body would also be able to collect information to expose misconduct or provide data to the government
- Appoint a market compliance regulator. This would have the same powers as above, but the body would also be able to investigate and enforce compliance with market rules set in primary legislation or regulations
- Appoint a market design regulator. This would have the same powers as above, but the body would also be able to make market rules.
The 2021 consultation document assesses the advantages and disadvantages of each option. The risk coverage of each option (the ability of each option to adequately address the risks of each theme) is also analysed. Generally speaking, the 2021 consultation document finds that options requiring regulation have the best risk coverage.
As the 2021 consultation document makes clear, there are risks associated with maintaining the status quo. For this reason, it seems likely the government will seek to regulate the emissions market. The question is how far the government will look to go. The 2021 consultation document suggests the government would like to move toward exchange based trading, as well as establish a regulatory body with the power to enforce compliance, but nothing is certain at this point.
Further developments
In November 2022, MfE released the 2022 consultation document, which proposes a number of different changes to the NZU market to improve governance and manage risk. MfE proposes to classify NZUs as a "financial product" (as defined under the FMCA) as a response to shortcomings of the status quo market governance framework. The 2022 consultation document highlights four main market governance topics, these four topics are based on the previous themes that MfE has consulted on. These four topics are as follows:
- Regulating the NZU market based on financial legislation
- Regulating NZU financial advice, transactional and/or custodial services
- Improved transactional reporting
- Applying the AML/CFT Act framework.
For each of the four topics the 2022 consultation paper outlines three different options, including the status quo, and then analyses the options against "five impact criteria" being integrity, minimal complicity and administrative costs, consistency and proportionality, clarity and transparency and market efficiency, with a preferred option then being put forward. Each topic contains a number of engagement questions which MfE is seeking feedback on.
Regulating the NZU market based on financial legislation
There are three options for how the NZU market should be regulated put forward by MfE:
- The first option, the status quo, is continuing to use the limited insider trading provisions in the Crimes Act 1961 with no targeted legislation prohibiting market manipulation or regulating NZU market operators
- The second option is to regulate the NZU market using the FMCA – essentially classifying NZUs as "financial products", which would require NZU market operators to be licenced and that the specific provisions in the FMCA that prohibit insider trading and market manipulation would apply
- The third option is a hybrid of options one and two – essentially use the insider trading provisions of the Crimes Act 1961 as well as creating new provisions, similar to those in the FMCA, that prohibit market manipulation.
MfE suggests that option two is the preferred option as it provides the highest integrity of all the options.
Regulating NZU financial advice, transactional and/or custodial services
There are three options for how the NZU financial advice, transactional and/or custodial services should be treated put forward by MfE:
- The first option, the status quo, is continuing to rely on the existing legislation relating to financial advice. This is currently captured under the Fair Trading Act 1986 (in relation to unfair conduct and practices in trade), the Forests Act 1949 (in relation to parties in the forestry sector), the Financial Service Providers (Registration and Dispute Resolution) Act 2008 and the FMCA (in relation to "financial services" that fall within the FMCA fair-dealing provisions)
- The second option is extending the regulation of financial advice to those persons who give advice in relation to "acquiring, disposing of, or holding NZUs". This would mean that those people who give this advice would need to hold a financial advice provider licence, be registered on the Financial Service Providers Register (FSPR) and comply with all fair dealing provisions under the FMCA, as well as the conduct obligations in part 6 of the FMCA
- The third option is to apply only the wholesale client regulations to advice in relation to NZUs, instead of applying the entirety of the financial advice regulations. This would mean that those persons who give relevant advice in relation to NZUs would not be licenced, but may need to be registered on the FSPR and comply with the fair dealing provisions in the FMCA.
MfE suggests that option two is the preferred option as it best minimises the risk of poor advice and addresses market risks the best of all options.
Improved transaction reporting
There are three options for how transaction reporting should be considered within the NZU market put forward by MfE:
- The first option, the status quo, is to continue with the current reporting obligations. The current reporting obligations currently do not provide for any visibility on price and value information
- The second option is to extend the current reporting obligations to include further information such as the price of NZUs traded or the total value of the transaction, whether trades are between different persons or within a transactor's own accounts and the transactor's reason for holding a NZU trading account
- The third option is to extend the current reporting obligations to include the prescribed wire transaction reporting obligations in the Anti-Money Laundering and Countering Financing of Terrorism Act 2009 (AML/CFT Act), which includes recording transaction details, details in relation to the originator or beneficiary and customer details.
MfE suggests that option two is the preferred option as this option provides the government with sufficient information to identify misconduct without creating too many administrative complexities.
Applying the AML/CFT Act framework
MfE proposes to impose no further AML/CFT obligations on the NZU market. The AML/CFT Act currently already applies to a number of activities in the NZU market, including when people are handling or investing money on behalf of others. As the AML/CFT Act already applies to these forms of financial activities within the NZU market, MfE does not consider it necessary to expand the application of the AML/CFT Act to the NZU market further.
Next steps
Submissions on the 2022 consultation document will close on 24 December 2022. After submissions have closed MfE stated in a media release on 17 November 2022 that New Zealand ETS market governance policy decisions will be made in early 2023.
