Background
5. Emissions trading is developing as one of the primary means of combating human induced climate change around the world.
6. NZX argue that provision of a trading platform has the potential to benefit not only its operator but also the government and New Zealand as a whole, by furthering the government's sustainability and economic transformation agenda. For example, it could:
- demonstrate international leadership in sustainability;
- provide protection and enhancement of New Zealand's green brand, including brand leverage for participating New Zealand companies; and
- increase liquidity in the New Zealand emissions market through international trade.
7. Officials therefore consider it important to consider the regulatory environment to ensure that there are no legal or commercial impediments to prevent a person from attempting to establish a platform in New Zealand.
8. Officials have been mindful in analysing the regulatory framework in this area of the undesirability of legislating for one type of trading platform or for one type of market participant only. On this basis, the proposals in this paper are not NZX specific, but would apply to any participant who sought to provide such a platform in New Zealand.
Emissions trading
9. There are two types of markets for the trading of emissions units internationally:
- Mandatory schemes: Markets that arise from a government requirement to participate in an emissions trading scheme such as the scheme proposed in New Zealand, or currently in the European Union; or
- Voluntary schemes: Markets that arise as participants voluntarily create an emissions trading scheme to satisfy an environmental requirement or to meet consumer preference or wider sustainability preferences. For example, the Landcare Carbon Zero scheme.
Types of units
10. Government has decided in-principle to introduce an economy wide, internationally linked emissions trading scheme (NZ ETS) and is currently engaging with stakeholders over the detail of the proposed scheme [CBC Min (07) 19/2 refers].
11. For the purposes of this paper, it is important to distinguish between:
- Emissions units that are registered on the NZ ETS register that is currently being developed ("NZ ETS units");
- Emissions units that are not registered on the NZ ETS register ("non-NZ ETS units") and therefore operate in voluntary or "grey" markets;
- Both NZ ETS units and non-NZ ETS units ("emissions units").
12. NZ ETS units include Kyoto protocol units, NZUs and in the future may, by a linking mechanism, include units from overseas emissions trading schemes.
13. Non-NZ ETS units are comprised of both units that do not derive from any government regulated ETS ("voluntary market units") and units that form part of an overseas emissions trading scheme but that have not yet been linked to the NZ ETS. Once units from an overseas emissions trading scheme is accepted for linking with the NZ ETS, it will be able to be registered on the NZ ETS register and will then become a "NZ ETS unit").
14. Only NZ ETS units may be used under the NZ ETS in satisfaction of a participant's obligation (imposed by the NZ ETS legislation) to surrender units to the Crown on emitting greenhouse gases. No other units are valid for surrender. Nevertheless, voluntary market units are currently being traded by persons who, for example, want to claim "carbon neutrality". Although these units are not valid to off-set a government-imposed liability, the market still sees them as valuable commodities. It is not clear at this stage, how the voluntary market will respond to the introduction of the formal NZ ETS.
Types of trading
15. The trade of emissions units can occur through a variety of methods, such as through bilateral contracts, brokers, or an emissions trading platform.
16. Some private sector entities have indicated plans to explore the establishment of emissions registers and/or trading platforms, including NZX, M-Co and Trade-me for the trade of both NZUs and voluntary emissions units. It is important to consider the nature of the market (ie the product being bought and sold) separately from the potential market platform through which trades occur. With respect to the NZETS, Ministers have already agreed that participants should be able to weigh the transaction costs associated with a particular method of trading against their desire to manage risks, and therefore the government has chosen not to prescribe the means by which the market trades emissions units. Over time, it is expected that trade will gravitate toward the market that has the greatest liquidity.
17. Overseas experience has shown that a large proportion of emissions trading has occurred in the form of futures contracts. Therefore, it is important to ensure that New Zealand's regulatory environment for futures exchanges allows for emissions trading.
Suitability of current law to emissions trading
18. There are currently no legal impediments to trade in emissions units or to establishment of a trading platform for emissions units. That is, the commercial opportunities for New Zealand firms to engage in emissions trading will arise regardless of any further law reform.
19. There are, however, legal impediments in relation to the conducting of a market or exchange for trading in futures contracts in emissions units. These are discussed below.
20. There are also certain practical or commercial problems in relation to attracting international and other participants to participate in a regional emissions trading platform, especially in relation to futures contracts. Many of these relate to the fact that New Zealand law relating to clearing and settlement systems and futures exchanges does not currently meet the standards set by the Bank for International Settlements and International Organisation of Securities Commissions (BIS-IOSCO).
21. The regulatory framework governing trade of emissions units on a registered exchange under New Zealand's securities law is conceptually no different to the approach taken for the trade of any other "commodity". It is important to note that many of the proposals in this paper do not relate solely to emissions trading, but rather reform the law relating to clearing and settlement systems and futures exchanges more generally. These reforms will help facilitate efficient trading of emissions units, but, apart from providing that emissions units are "commodities" in respect of which futures may be traded, are not essential to permit trading in emissions units or the establishment of an emissions trading platform.
NZX TZ1 Proposal
22. NZX has requested legislative amendments that would make it feasible for them to establish a futures trading platform and settlement and clearing functions. The legislative amendments sought would also enable other participants to provided these functions should they see commercial opportunity. NZX is requesting these amendments in order to facilitate a commercial imperative of establishing a regional emissions trading platform 'TZ1'. Their central argument is that the trading of units through a regulated futures exchange and clearing house that meets the expectations of international participants will bring a degree of rigour and confidence to a domestic emissions trading scheme, and represent a significant business opportunity for positioning New Zealand as a regional emissions trading hub.
23. NZX currently has an online register system 'FASTER' Fully Automated Screen Trading and Electronic Registration which provides clearing and settlement functions. This system was originally built in 1988 based on the international best practice standards of the time. Although the system has been subject to ongoing development it is no longer able to meet current international best practice standards.
24. The FASTER system has a high level of built in dependency risk and the market is fully dependent on third parties to facilitate and provide some of the conditions which allow trading and settlement to occur. The third parties act as counterparties in the market and record a risk equal to their daily deposit into FASTER.
25. Currently settlement transactions may be unwound in the event of insolvency should a participant fail and notification not be made to NZX such that the participant continues to trade after it is insolvent. Also as each existing counterparty represents a point of risk it is apparent that there exists multiple point of risks (the more points of risk that exist the greater the possibility of that point of risk failing). These points of risk are out of the control of the exchange which in turn cannot give the highest assurance that the market will stay open in the event of a point of risk failure. There also exists a greater physical risk in the current system compared to NZX's proposed model such as outages, telecommunications failures and other failures can occur at each point of risk.
26. This level of risk is seen as a structural flaw as it creates many points of susceptibility than exist in the self contained central counter party (CCP) proposal. Current IOSCO standards recommend reducing points of risk and failure in national markets and making them as secure as possible.
27. The NZX TZ1 proposal eliminates the markets vulnerability as identified above by establishing a CCP and improves the markets integrity and enhances New Zealand's reputation for international investment.
28. In order to make it commercially viable to implement the CCP infrastructure adequate capital backing is required in the form of cash and synthetic capital (used to manage participants risk positions). The supply of synthetic capital is dependent on NZX receiving a satisfactory rating from an international capital market risk rating agency. The rating agency will judge the proposed system on the robustness of the clearing house and the regulatory environment in which it operates.
29. Officials believe that legislative changes as outlined in this paper are necessary to reform New Zealand's regulation of clearing and settlement systems. The proposed legislative amendments would enable NZX (or any other entity) to have a facility of international standing that is more likely to attract international participation than a system based on current legislation.
Proposed timing
30. NZX believe the proposed amendments are necessary to ensure the proposed futures trading platform meets international best practice as recommended by the Bank of International Settlements (BIS) and the International Organisation of Securities Commissions (IOSCO) and thus gains international credibility. Further they believe this credibility will make the platform attractive to potential investors.
31. NZX plan to launch their emissions trading platform in mid 2008 (expected May 2008) and would prefer to have the necessary legislative amendments in place by then (or alternatively at least progressing through parliament so that it can be passed before the end of the current parliamentary term), in order to provide their platform with the international credibility that comes with the regulation of trading functions. Officials expect legislation to be drafted by the end of 2007 for introduction to Parliament in February 2008.
32. The proposed amendments would apply generically to any exchange seeking to operate authorised futures trading or entity seeking to operate a regulated clearing and settlement system. The amendments would therefore not give NZX a legislated monopoly over emissions trading, futures trading or clearing and settlement functions.
Current law regulating futures exchanges and clearing and settlement systems
33. There are some practical difficulties which arise out of the current law regulating futures exchanges and clearing and settlement systems which mean that it is difficult for a person to establish an efficient and robust trading platform for futures contracts for any commodity (including emissions units). These problems include:
- A perception that the New Zealand regulatory environment does not conform with international best practice, as reflected in the recommendations of IOSCO. This has an impact on the ability to attract domestic and international participants to New Zealand markets.
- Different regulatory treatment of securities exchanges and futures exchanges, and the compliance costs associated with needing to seek regulatory approval twice.
- Current regulation of clearing and settlement systems was developed with a different focus (ie focused on the payments system rather than the underlying securities/commodities market), before the IOSCO recommendations were made and includes no formal monitoring and enforcement role for the securities market regulator.
34. Current legislation regarding clearing and settlement systems focuses on the integrity of the payment system, rather than managing the risk of non-delivery of the commodity or security being traded. This means that current New Zealand law does not provide sufficient certainty for participants regarding finality of a futures contract cleared and settled through the existing regulatory framework.
35. While it is possible under current New Zealand law to establish a clearing and settlement system associated with a securities or futures exchange, at a practical level the current law does not sufficiently promote confidence for potential customers regarding the regulatory environment. Therefore, in order to encourage the creation of a futures exchange capable of trading emissions units, it is necessary to reform New Zealand legislation.
36. The proposed amendments in this paper have been identified by officials to fall into three categories these are:
- rationalising the regulatory framework for securities and futures exchanges – these are desirable from a policy perspective to provide for simpler administration of the regime, but are not legally necessary to allow establishment of a futures exchange or clearing and settlement system;
- amendments so that the New Zealand regime for clearing and settlement systems better conforms with IOSCO recommendations – these are considered commercially necessary to give the platform international credibility and thus make it more attractive to potential international participants; and
- technical amendments in response to the emergence of emissions units in New Zealand (both NZ ETS units and non-NZ ETS units), and the way they fit into New Zealand's current regulatory environment.
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