15 April 2016

New Zealand Steel and the unethical two-for-one - free emission units and arbitrage profits from cheap Russian units

The Godfather In this post there is still a gratuitous image of Marlon Brandon as the Godfather but the post is about one of NZ's biggest companies; New Zealand Steel. They just opposed the possible ending of the supposedly temporary "two-tonnes-for-one-unit" deal. That's a bit rich when their idea of the ideal "two-for" is to receive millions of emission units for free under the New Zealand Emissions Trading Scheme industrial allocation provisions and yet buy millions of the dubious international Russian units (ERUs) and make windfall arbitrage profits.

Well, back on 17 March we had New Zealand Steel whining to Radio NZ that the NZ emissions trading scheme review would lead to higher carbon costs which would make their business less viable

Chief Executive Andrew Garey told Radio New Zealand

"the removal of the 2 for 1 provison for big carbon dioxide emitters will undermine the viability of the business"

What is this two for one deal? On page 12 of the NZETS review discussion document, it states;

"The one-for-two surrender obligation allows participants from the liquid fossil fuels, industrial processes, stationary energy and waste sectors to surrender one unit for every two tonnes of emissions (ie, a 50 per cent surrender obligation)."

However, Garey has his facts wrong in assuming the loss of the two-for-one deal will increase his NZETS liability. On page 13 of the NZETS review discussion document, it states;

"It should be noted that if the one-for-two surrender obligation is removed, the amount of free allocation provided to emissions-intensive and trade-exposed activities will automatically be increased to correspond with the increased surrender obligation."

So New Zealand Steel will have to surrender twice as many units. But its free allocation of units will double. One bit of corporate welfare in the NZETS is removed and another takes its place! Talk about the NZETS as an insurance policy for big emitters that protects them from any incentive to reduce emissions!

I could respond by saying I sympathise with Mr Garey. I mean, really, who does understand the NZETS? However in his interview with Radio NZ he goes on to indicate that if the NZETS is toughened up, then his parent company, Bluescope Steel, may just decide to close the Glenbrook Steel Mill. Nice steel mill you got. Shame if something happens to it. That is just typical arrogant big business behaviour. So I have no sympathy for Mr Garey.

There are some obvious questions to try to answer with actual emission unit data from the New Zealand Emission Unit Register, which records legal title for all valid carbon credits/emissions units in the New Zealand. How many units were NZ Steel given for free under the industry allocation plans? What were NZ Steel's NZETS-liable greenhouse gas emissions from processing steel from iron sands? Were they allocated more units than they had to surrender? Did they also make arbitrage trades in any of the dubious Russian or Ukrainian emission units?

We know that New Zealand Steel has been receiving free allocations of emission units as the allocations are listed on the Ministry for the Environment's web page Industrial allocation decisions.

Another MfE web page Eligible industrial activities tells us the formula for the unit allocation is (LA × ∑ (PDCT × AB)) ÷ 2.

The level of assistance (LA) for New Zealand Steel is 90%. There are four products (PDCT) each with it's own allocative baseline (AB). The products and allocative baselines are 3.2613 units for each tonne of iron or steel, 0.119 units for each tonne of cast carbon steel, 0.28 units for each tonne of vanadium-bearing steel and 0.163 units for each tonne of flat hot-rolled carbon steel.

That page is just repeating what is in Regulation 23 and the Schedule Prescribed emissions intensity and allocative baselines of the Climate Change (Eligible Industrial Activities) Regulations 2010.

I have already compiled a Google sheet of all units allocated to emitters from 2010 to 2014. It was compiled from the year by year Industrial allocation decisions

We add a 'filter' to the Google sheet on the top row of the column headers and set the filter on the 'Applicants.Name' column header to 'NZ Steel'.

This tells us that New Zealand Steel Development Limited (account holder NZ-1903) received these free NZ units.

2010 494,704
2011 989,304
2012 1,003,730
2013 1,029,352
2014 1,073,489

Or a total of 4,590,579 units over the five years. NZ Steel received more units than any other industry. More than smelter operator New Zealand Aluminium Smelters Limited. I know this as back in 2012 I made a pie chart of the 2011 free unit allocation data. That showed that of the 3.472 million units allocated to industry in 2011, 90% went to thirteen NZ companies. Here is that pie chart.

Now I want data on the greenhouse gas emissions from processing steel from iron sands. The New Zealand's Greenhouse Gas Inventory 1990–2013 reports the greenhouse gas emissions from steel production from iron sands in tonnes of CO2-e. New Zealand Steel is the only iron sands processor so these are New Zealand Steel's emissions. The emissions are;

2010 1,646,890
2011 1,736,250
2012 1,718,930
2013 1,747,500

(There is no total for 2014 as we won't see the next greenhouse gas inventory for the 2014 year until later this year)

I want to compare the number of emissions surrendered with the number of units given as free allocation. Ideally, I would have the number of units actually surrendered by New Zeland Steel each year. In a transparent system we would know that, would we not? Unfortunately, the NZETS is not transparent and the units surrendered are not available to the public.

In 2013, I asked the Environmental Protection Authority (EPA) under the Official Information Act for the numbers of units surrendered by New Zealand Steel and some other companies. The EPA refused my request on the grounds that the Climate Change Response Act trumped the Official Information Act. In May 2014, after a delay of a year, the Ombudsmens Office agreed with the EPA. So much for transparency.

So I have to estimate the unit surrender obligation. I keep in mind the two-for-one deal. So my annual estimate of the number of units New Zealand Steel is required to surrender under the NZETS is half of the actual emissions (one unit covers two tonnes). Also NZETS surrender obligations started on 1 July 2010. So 2010 was a half year for free allocation and unit surrenders. So I take half of the 2010 actual emissions.

My data now looks like this

                            2010      2011      2012      2013      2014
Greenhouse gas emissions     823,445 1,736,250 1,718,930 1,747,500        NA
NZETS surrender  obligations 411,722   868,125   859,465   873,750        NA
Free allocations of units    494,704   989,304 1,003,730 1,029,352 1,073,489

Lets make a chart. I think a bar chart will be a suitable choice. The colour scheme is lightest pink for actual emissions, mid-pink for my estimate of the units surrendered (emissions x 50%) and purple for the free allocation of units. The purple bars (free units) are noticeably larger than the surrender estimates. It appears that New Zealand Steel are consistently being allocated more free units than they need to surrender to match their direct emissions.

In summary, in the years 2010 to 2103, the actual number of units given to New Zealand Steel exceeded the estimated number to be surrendered by 82,982, 121,179, 144,265 and 155,602.

Does the free allocation of units include compensation for any other carbon-intensive energy inputs I have not taken into account? In principle, yes, as the original September 2007 Framework for a New Zealand Emissions Trading Scheme document makes this statement about free allocation to emitters;

"indirect emissions associated with the consumption of electricity, as well as direct emissions from stationary energy and direct emissions from non-energy industrial processes will be included in the concept of emissions from industrial producers".

Also the New Zealand Aluminium Smelter free allocation included an undisclosed quantum of units for the fictional coal content of electricity inherent in their energy supply from Lake Manapouri. Yes, I know that last sentence seems to make no sense at all. You really need to read the linked blog post!

The Heavy Industry Energy Demand Update Report (by Covec, Feb 2009) provides estimates of the carbon dioxide emissions from each energy input (except electricity) used by New Zealand Steel.

The Covec report estimates that in 2008 the coal emissions were 1,615,100 tonnes (93%), the natural gas emissions were 106,200 tonnes (6%), the coke emissions were 18,100 tonnes (1%) and the diesel emissions were 3,800 tonnes (0.22%). Adding up to 1,743,200 tonnes of direct emissions. Covec don't calculate the emissions content of the 426 GWh of grid electricity used in 2008.

The estimated natural gas emissions at about 100,000 tonnes per annum almost adds up to the 'surplus' allocated units which are between 120 thousand to 155 thousand tonnes annually. So its arguably plausible that part of the free allocation of units is to compensate New Zealand Steel for the increase in the cost of natural gas caused by the NZETS.

Except that there is no evidence that the price of natural gas or electricity or coal has increased because of the NZETS. And we have known that since 2011.

Covec's 2011 report 'Impacts of the NZ ETS: Actual vs Expected Effects' prepared for the 2011 ETS Review Panel could not find any increases in electricity, natural gas or coal prices caused by the NZETS.

Officials supporting the 2012 Finance and Expenditure Select Committee queried the five major electricity generating companies about NZETS costs flowing through into wholesale electricity prices. Their reply was;

"costs being passed through directly from the NZETS are not visible or distinguishable due to the wholesale market pricing mechanism and these costs are not directly passed through due to competition factors".

As the New Zealand Emissions Trading Scheme evaluation report 2016 states on page 38;

The prices of emission units have been too low to affect business costs either for participants or those who receive costs passed down from participants.

So from 2010 to 2014 New Zealand Steel consistently received a free allocation of emission units that materially exceeded their estimated liability to surrender units to match actual emissions. The surplus units were not needed to compensate for increased energy costs caused by the NZETS as the NZETS did not cause any energy costs to increase. The free unit allocation was and is simply a transfer of wealth to New Zealand Steel in the form of a tradable right or voucher (unit) that is highly liquid.

So New Zealand Steel, the emitter receiving the most free units in the NZETS, has faced no NZETS-related carbon price at the margin or in any sense. Instead of acting as a carbon price at the margin, the free unit industrial allocation regime in conjunction with the lack of energy cost pass-through has acted as an insurance policy or hedge contract - protecting New Zealand Steel from the carbon price!

This is the embodiment of fundamentally flawed design in the NZETS and it is symptomatic of the National Government's unethical approach of rewriting the NZETS to suit the whims of big business. It's also symptomatic of the earlier big business campaign to pressure the Labour Government to drop a carbon tax and move to the inherently less transparent NZETS.

You would think that this case study into New Zealand Steel could not get worse. However, it does get worse. From 2013 to 2015 New Zealand Steel engaged in arbitrage profiteering using the most dubious international emission units, the Emission Reduction Units.

To see if New Zealand Steel has owned any Emission Reduction Units, we go to another Google sheet Kyoto Unit Holdings by Account 2008 - 2014 which compiles data from the EPA Emission Unit Register. We add a 'filter' to the Google sheet on the top row for 'NZ Steel Limited' in the 'Account.Holder' column of the Google sheet of New Zealand Steel's emission reduction units.

We find that New Zealand Steel Limited did own some Emission Reduction Units.

2013 1,022,527
2014 1,001,714

I have amended the bar chart and added the Emission Reduction Units owned by New Zealand Steel as extra orange bars. It is interesting to note that the number of ERUs is fairly close to the number of free NZUs. Both were more or less 1 million for 2013 and 2014.

We have fairly persuasive evidence that New Zealand Steel was consistently allocated more free units than it needed to surrender for its actual emissions. Therefore New Zealand Steel never needed to buy any extra emissions units to surrender under the NZETS. Yet New Zealand Steel owned about a million Emission Reduction Units at the end of both 2013 and 2014

So if New Zealand Steel always had more than enough free units to meet it's obligation to surrender units under the NZETS, why would it also buy international units? There is only one plausible answer. It is to make an arbitrage profit.

Why am I so sure New Zealand Steel carried out arbitrage trades with its NZUs and surrendered cheap dubious ERUs rather than the free gifted NZUs for 2013 and 2014? It's the maths.

Data from the Emissions Unit Register, NZEUR Holding & Transaction Summary, which I have summed into another Google sheet, tells us that the total numbers of NZUs surrendered by all emitters were 732,667 in 2013 and 576,470 in 2014.

As those numbers (for the whole of the NZETS) are less than New Zealand Steel's estimated surrender obligations, it is mathematically impossible for New Zealand Steel to have met those surrender obligations without having used ERUs.

Here is a hypothetical example of what New Zealand Steel might have done.

According to a Carbon Forest Services webpage that tracks emission unit prices, on 11 October 2013, New Zealand units (NZUs) (the same type of units allocated to New Zealand Steel) had a market price of $4.20 each. On the same day the Russian or Ukrainian Emission Reduction Units had a market price of 35 cents each. One NZU was worth 12 times as much as an ERU.

If New Zealand Steel had purchased 1 million ERUs on 11 October 2013 at 35 cents each or $350,000, it could then surrender 873,750 of them to the Government to match it's 2013 emissions. Based on that 'if', New Zealand Steel would then be in a position to sell all the 1,029,352 New Zealand units of the 2013 allocation at $4.20 each for a possible value of $4,323,278. The hypothetical profit would be $3,973,278.

That is just one possibility based on NZU and ERU prices on one date. I suggest you browse over to the Carbon Forest Services New Zealand Unit & Emission Reduction unit chart and hover over the chart to see the differences between ERU and NZU prices from early 2013 to 2015. Even when NZUs hit a historic low price of $1.60 in February 2013, they were still 9 times more valuable than ERUs. Choose your own combination of price difference and possible profit from buying ERUs and selling NZUs.

It's not just me saying that this is unethical profiteering. Here are statements from forest consultant Ollie Belton, Herald Economics Editor Brian Fallow and Green MP Kennedy Graham.

Carbon forest consultant Ollie Belton said this;

"..trade exposed industries that were gifted up to 90% of their surrender obligations were able to meet all their obligations with the super cheap ERUs and bank the gifted NZUs. Since 2012, NZUs have had much higher market value than ERUs, generally more than five times as high, hence the arbitrage opportunity. Never have polluters had it so good. They have made hundreds of millions in arbitrage profits."

Brian Fallow of the Herald described the arbitrage trades as corporate welfare.

"This is where the corporate welfare comes in. The ETS is designed to ensure that large emissions-intensive trade-exposed operations like the Tiwai Point smelter or the Glenbrook steel mill are only exposed to a carbon price at the margin - and a pretty narrow margin at that...But the collapse in international carbon prices has presented the smokestack sector with an arbitrage opportunity too.
They have been able to hoard their NZUs, in the expectation they will be more valuable in the future, and meet their obligations in the meantime with cheap imported Kyoto units instead".
.

Kennedy Graham placed it on the record at Parliament that he regarded the arbitrage trades as morally reprehensible.

"Emission-intensive, trade-exposed entities, which include aluminium, iron, steel, cement, whey, wood, and paper, are free to bank profits from the emissions trading scheme — cash for pollution. They receive free allocations of New Zealand Units as compensation for any energy price rises brought about by the emissions trading scheme...
These industries are also required to surrender units to clear liabilities. This is dependent on calculations based on their emissions profile. They can surrender New Zealand Units or Kyoto Units, such as emission reduction units and certified emission reduction units. These overseas units are valued between 10c and 40c.
They are engaging in the arbitrage by receiving free New Zealand Units from the Government, then selling them at market prices of $3 to $4, then buying cheaper overseas units such as the certified emission reduction units and emission reduction units for anything from 10c to 40c to surrender back to the Government.
They bank the profit. In some cases, this is in addition to existing tax-paid subsidies running into the tens of millions of dollars. Let me acknowledge that these activities are entirely legally, but they are morally reprehensible and they reflect Government stupidity and cynicism of the highest order".

Conclusion

New Zealand Steel really have achieved the ultimate emission trading scheme "two-fer". The NZETS's free allocation regime over allocates them more emission units than they need to surrender for their emissions and the availability of the imported international units gave them the opportunity to make windfall arbitrage profits. So instead of a carbon price there were unearned windfall profits.

I agree completely with Ollie Belton, Brian Fallow and Kennedy Graham that such arbitrage profiteering is morally reprehensible corporate welfare. Yes, the polluters have never had it so good. It seems that the more free units you give a company, the more it abuses the privilege of having an emissions trading scheme. This is just one example of how deeply unethical conduct in New Zealand Emissions Trading Scheme has been. The whole scheme is now so morally tainted it has no valid ethical basis to continue. The New Zealand Emissions Trading Scheme should be simply abandoned.

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