Improving market governance of the New Zealand Emissions Trading Scheme

Option one: Current reporting obligations (status quo). This includes the collection and recording of activities that are reported to the EPA. The status quo currently provides no visibility on price and value information,  which would be useful for market efficiency and investigating market misconduct.

Option two: Improved transaction reporting. This would involve adding additional reporting fields on:

• price of NZUs or total value of the transaction
• whether the trade is with someone else or between the transactor’s own accounts
• the transactor’s primary reason for holding an account.

Collecting this additional transaction information would provide greater access to useful data.

Option three: Full transaction reporting. This would involve adding additional reporting fields that replicate many prescribed wire transaction reporting obligations in the AML/CFT Act.

Subject to feedback, we recommend progressing with option two: Improved transaction reporting.

• Option two would require all NZU secondary market users to report additional transaction details.
• Option two would assist the regulator to detect fraudulent activity or price manipulation.
• Both options two and three would provide price and value of NZU transactions, which would be visible to the Government. Price or value details can improve price discovery for the wider NZU market.
• Options two and three would require OTC trades to be submitted manually to the NZETR.
• For all options, the individual and commercially sensitive information collected would remain non-public and subject to the NZ ETS confidentiality obligations on regulators.
• Option one does not provide sufficient information to detect misconduct.

The objective of improved transaction reporting is to increase transparency in the market and address information asymmetry currently seen in the NZU market.

Reducing information asymmetry in the NZU market

Information asymmetry occurs when some parties have access to useful market information which, if public, would affect NZU buying and selling decisions.

Information asymmetry is a problem because it can reduce confidence in the NZU market and lead to adverse selection.

Adverse selection occurs when a buyer or seller (Person A) perceives that the other party (Person B) has more useful market information. To compensate:

• an NZU seller may increase the price of their NZUs to offset the risk of uncertainty
• an NZU buyer may reduce the price they are willing to pay for NZUs, to offset the risk of uncertainty
• the incentive to engage in the NZU market is reduced overall, reducing the pool of buyers and sellers.

Ultimately, the price of NZUs is suboptimal because market risk is implicitly incorporated into the price due to market uncertainty. We are seeking ways to improve transparency and confidence in the NZU market.

There are two viable solutions to combat information asymmetry and adverse selection, including:

• bridging the information gap
• increasing monitoring and oversight to protect market users.

In the 2021 consultation,* the Government consulted stakeholders on ‘full transaction reporting’.**

There was a mixed response from stakeholders and many did not support full transaction reporting. Other stakeholders stated they were comfortable with transaction reporting on a confidential basis. These stakeholders generally agreed this information could assist a regulator in preventing market manipulation and fraud.

Option one: Current reporting obligations (status quo)

NZU market users in the NZ ETS already collect and record information on their activities (either on emissions or on the carbon dioxide equivalent removals their activities negate) and provide it to the EPA (or the Ministry for Primary Industries, in the case of forestry activities).

Currently, participants in the NZ ETS are required to:

• apply to open a holding account in the NZETR
• register as a participant
• file an emissions return
• if necessary, surrender, repay, or receive units.

The NZETR records and tracks all emission units used in the NZ ETS. As such, it holds a great deal of data that is useful for the NZU market. At present, the NZETR collects the following information for transactions:

• the parties involved in the trade
• the number of units in the trade
• the time and date of transaction
• who set up the transaction, who authorised it, and how they got their transaction authorisation code.

Option two: Improved transaction reporting

Improved transaction reporting would require the following additional fields to be recorded and tracked in the NZETR for all NZU trades:

• the price of NZUs or total value of the transaction
• whether the trade is with someone else or between the transactor’s own accounts
• the transactor’s primary reason for holding an account.

We propose that improved transaction reporting would apply to all NZU trades, to increase transparency. Collecting this additional transaction information would provide greater access to useful data.

Option three: Full transaction reporting

In 2021, the Government consulted on a proposal to introduce full transaction reporting for NZU transactions, as mentioned above.

This option proposed replicating many prescribed wire transaction reporting obligations in the AML/CFT Regulations,* including:

• transaction details
• transaction details in relation to the originator or beneficiary
• customer details.

The proposed option aligns with the objective for topic 3, in that it satisfies the criteria much better than the status quo for integrity and market efficiency, and better for clarity and transparency.

However, stakeholder feedback did not favour full transaction detail reports.

*See Part 1 of Schedule 2 of the Anti-Money Laundering and Countering Financing of Terrorism (Prescribed Transactions Reporting) Regulations 2016 [New Zealand Legislation website].

Appendix D of this discussion document provides the option and risk analysis tables for topic 3.

Option one, the status quo, does not meet the criteria, nor does it improve the risk of potential lack of transparency in the NZU market. Option one is insufficient to mitigate market risks, as the current transaction reporting does not supply the Government with sufficient information to have oversight and transparency of the market.

Option two, improved transaction reporting, provides the Government with additional information to detect misconduct, which increases the integrity of the NZU market. The collection of this information fills gaps, which is a proportional response to the risks when compared to the proposals in option three. The market information can support the regulator to detect misconduct, and improve price discovery, both of which increase market efficiency.

Improved transaction reporting provides key information relating to OTC trades that contribute to the risk of potential lack of transparency in the market.

Option three, full transaction reporting, is administratively complex compared to the status quo and is not aligned with other financial market reporting. However, it does provide high integrity and market efficiency, albeit at an administrative cost to market users.

Full transaction reporting provides a complete, detailed oversight of OTC trades occurring in the NZU market, which greatly improves the risk of potential lack of transparency in the market.

We currently consider the proposed option aligns with objective for topic 3, in that it satisfies the criteria much better than the status quo for integrity and market efficiency. It also satisfies the criteria better than the status quo for consistency and proportionality and clarity and transparency.

Improved transaction reporting would require manually reporting the additional three fields when completing an NZU transaction over the counter. This will involve completing three additional fields when completing a transaction report via the NZETR.

Alternatively, trading NZUs through the optional centralised exchange would automatically report the NZUs or value of the transaction, volume and unit type on behalf of the buyers and sellers.

The rationale for collecting more transaction information is as follows:

• Recording and tracking the price of NZUs via the NZETR helps create a reliable price signal, if published. This price signal helps inform buying and selling decisions, while minimising the cost impact of the carbon price. Given all transactions are recorded and tracked via the NZETR anyway, including an additional field to collect price and/or value information is among the most cost-effective and low-burden methods to improve transaction reporting.
• With the collection of price information, it is also important to be able to distinguish what is a market transaction with a market price, or a transfer of units between own accounts. In the former case, the price and volume information continue to be a reflection of trading activity in the market.
• Some stakeholder submissions to the 2021 market governance consultation suggested it would be useful to record transaction by stakeholder type (ie, whether the buyer or seller was a forester, financial intermediary, or a participant with surrender obligations under the CCRA). The rationale for this was that there are now more different types of people trading NZUs in the NZU market than at its inception, and some of those traders do not have surrender obligations under the CCRA.

Bridging the information gap by publishing more information

To support efficient markets, relevant and useful market information must be available to help NZU market users understand overall supply and demand conditions in the market.

We consider a method to improve market efficiency further is to support the EPA in publishing (anonymised and in aggregate) some of the useful market information collected.

Markets are efficient when they achieve allocative efficiency and efficient price discovery.

• Allocative efficiency means that the market channels resources, such as NZUs, to their highest value uses, and where emissions are reduced by those best placed to abate, at the best time.
• Efficient price discovery, whether explicit or inferred, means the price of NZUs needs to reflect all available information – including the price at which other buyers and sellers are selling NZUs.

The EPA already publishes a range of NZU market data, such as transaction trends, transactions by volume, emissions units transferred, and privately held units.* We propose that the EPA could also be empowered to publish additional reports, including:

• an end-of-day price for all NZU transactions in the NZETR
• the number of transactions, and the volume bought and sold, between accounts (identified using the ‘with someone else’ field), as distinguishing between the two types of trades helps inform reliable price and volume signals
• the types of NZU market users – which would help identify market sentiment and provide supply and demand indicators relevant to sale and purchase decisions.

In doing so, we would be mindful of privacy and confidentially obligations, so as to not expose the buying and selling activities of NZU traders. Publishing this data would help reduce information asymmetry in the NZU market.

The EPA would continue to oversee NZ ETS reporting, including new information on price, who the trade is between, and the type of stakeholders involved in the transaction. Collecting this additional information supports the EPA in their role of monitoring and providing oversight of trades. This provides additional oversight to guard against the risks of manipulation of the price, insider trading and anti-competitive conduct.