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Decision 5: The New Zealand ETS

The in-principle decisions are the NZ ETS will have major implications for how the world price is transferred through the New Zealand economy. Some activities, such as liquid fuels, will be exposed to the full cost of carbon, at the world price, for every tonne of emissions from 2009. Others, such as agriculture and industry, receive some level of free allocation, and therefore only have to pay for emissions beyond this level. The decision around when sectors are covered under the ETS, and how much free allocation they receive, going forward, will dictate how the costs of meeting the New Zealand cap are shared amongst emitters/consumers and government/taxpayers.

Outcome C: Cost to emitters

The costs faced by emitters will be driven by the amount of permits which they receive for free, their abatement costs, and the world price. The impact of free allocation is relatively straightforward, with the number of permits times the world price simply being a wealth transfer to the emitter. Abatement costs, relative to the world price, will determine the quantity of emissions for each sector which are exposed to the world price, and therefore the amount of emission reductions which they can reduce at less than this price. To illustrate how abatements costs and the world price affect the decisions of firms to reduce emissions, and the impact on costs, it is helpful to use a simple example within agriculture.

In the agriculture sector, it is widely agreed that there are few low-cost abatement opportunities. There are some opportunities which currently exist for reducing nitrous oxide through nitrogen inhibitors, and at a higher price some sort of substitution to other forms of land-use may be possible. However, there may be even greater potential at even higher prices for a new technology to become financially viable which reduces methane from animals. To illustrate how an individual farmer may choose to reduce emissions (assuming some sort of incentive is devolved to the farm level), a hypothetical abatement cost curve has been developed in figure 13 – defined by the line AE. As with other abatement curves there is a given level of abatement available for each activity (x axis), at a given price (y axis).

Figure 13: Indicative abatement cost curve for agriculture 29

See figure at its full size

In the example above, with a world price of around $NZ30, the agriculture sector as a whole will simply have to pay this price for every tonne of emissions above what it receives free allocation for (there are no emission reducing opportunities below this world price). However, if the price were to move to the upper limit of the likely range (around $NZ55) there would be 30MT of emission reductions. The gains to NNW would be the producer surplus - area of triangle ABC. If the price moved to around $NZ85, there would be some land-switching and the methane reducing technology may become financially viable – resulting in reductions of about 80MT and gains to NNW of area ADE. While there is currently little evidence around abatement costs, and many will only be known once the price of carbon is signalled to emitters, it is clear that gains to NNW can be made by passing on some of the costs to emitters30.

As discussed, it is however important that in passing the costs onto emitters, the result is a reduction in net emissions, rather than simply shifting those emissions to countries who do not have their emissions capped. If the overall global emission reducing strategy is attempting to reduce emissions in all countries below BAU, it is necessary that any leakage affects are included in any judgment of the effectiveness of policy.

Outcome D: Government’s fiscal position

The second important outcome, when considering impacts on NNW, is how the Government’s fiscal position is affected by decisions on a New Zealand cap and allocation within the ETS, and how any revenue generated is recycled back into the economy.

Assuming that the in-principle decisions within the ETS relating to allocation are finalised in the current form, the responsibility that the scheme places on domestic emitters is around a 50% reduction below 1990 emissions between 2013 and 2020, and a 70% reduction below 1990 levels by 2020. Figure 14 illustrates that if the Government where to sign up to 1990 levels over this period, there would be approximately 200MT of surplus credits which it could sell on the international market at the world price31.

Figure 14: Indicative domestic emissions and Government surplus.

See figure at its full size.

(From bottom of 2013-20 columns up) green: agriculture; blue and black stripes: industrial processes; red: liquid fuels; blue: stationary energy; brown: deforestation; grey: waste.

With the range or reductions required for developed countries as a whole being somewhere between 10 and 40% reduction below 1990 levels, it is very likely that the Government will be in a position of surplus credits between 2013 and 2020, unlike in commitment period one (CP1) where a significant deficit is forecast. The magnitude of this surplus will in part be due to emission reductions that occur through the world price being higher than domestic abatement opportunities (as discussed in the previous outcome), and also by what level of responsibility the Government signs up to. For example, if a 10% reduction below 1990 levels was negotiated, from figure 14 it can be derived that about 160MT of credits would be surplus – which at $NZ30/tonne, would equate to about $5 billion of extra Government revenue during 2013-2020.

Outcome E: International trade

The third key outcome, which will impact on NNW, is how supply and demand for New Zealand exports is affected by decisions around the rules and participation. For example the impacts of rules around the inclusion of avoided deforestation on prices of timber, will have some flow on effects for our timber exports32. Another example, which has been recently illustrated, is how demand for abatement opportunities within the liquid fuel sector have put pressure on fertile land to produce bio-fuels, which in turn increases the costs of feed-stocks and therefore world agricultural commodity prices. Take for example the increased demand for biofuels in the United States, which in 2006 resulted in more than a third of the total US maize crop being processed for biofuels (nearly 50% increase on 2005), and a near doubling in the price of maize. Maize is a key component of feedstock for non-pastoral farming, and while it is impossible to determine precisely how much affect the increased price has had on agricultural commodity prices, it is fair to say that some of the recent $2billion dollar increase to the dairy farmers’ payout was due to the increased demand for biofuels in the United States. Given New Zealand’s exports are dominated by the land-based, primary production, sector, our export industry will benefit from rules that result in the inflation of prices of primary commodities.

The competitiveness of our export sector will also be affected by whether countries with competing firms accept any responsibility for emissions, and if they pass this on to these emitters. This issue is closely related to leakage, as simply putting a price on activities in New Zealand which are highly mobile may result in those activities shifting offshore, with potentially an increase in emissions. To address both competitiveness and leakage issues, the Annex 1 countries should promote the introduction of sectoral targets within developing countries for industries such steel, aluminium, cement etc. While a cap on emissions would be ultimately desirable, introducing a price directly into these sectors would result in the world price for these commodities reflecting the cost of carbon, which would ensure the competitiveness of New Zealand firms is not harmed. The same case would hold for agriculture emissions, although the chance of any sectoral target in this area would seem small – given that many of the producers are small scale farmers, unlike the large multinational industrial firms33.

Another important consideration is how New Zealand’s domestic caps, or potentially even actual domestic emission, affect our clean green brand, and flow on effects for international trade. Recent work by the New Zealand Institute has questioned the current value of this brand, with evidence that there have only been small shifts in consumer preferences for low-carbon products. However, with public awareness growing, it is likely that in the future consumers will probably pay a greater premium for imports with low-embedded carbon, or from countries who are taking responsibility for emissions. Some people, therefore, argue that exporters may benefit from New Zealand differentiating itself from other international participants, and taking on board unilaterally tougher targets, or prioritising domestic emission reductions. This may also have some potential spill-over effects, in terms of developing and distributing low-carbon technologies.

Given the complex nature of these relationships, and potentially large gain in terms of trade for New Zealand, it would be useful to undertake future modelling analysis, potentially working alongside trade modellers, to identify the likely impact of rules on commodity prices, and the affects of domestic emission reductions and targets on New Zealand’s export brand, and the flow on impacts to NNW.

29 As with other curves, the actual costs are unknown, and some argue that the co-benefits of some of the mitigation activities (i.e. biodiversity and flood prevention from planting trees, or nutrient reduction in rivers from the use of nitrogen inhibitors) actually make some of the mitigation opportunities reasonably cost-effective.

30 This assumes that the permits which are available to Government as identical to those available to business, and that the transaction cost differences are negligible

31 There are a range of assumptions in this model around growth in emissions, and that there is no auctioning of Crown AAUs. It is however a reasonable estimate of a likely surplus, given the current decisions around allocation within the ETS. This assumption around allocation within the ETS is however likely to change, with pressure from industry to increase the level of free allocation. This will result in a smaller surplus for Government

32 Some preliminary work my MAF has estimated that the gains to halting illegal logging (which is in part linked to avoided deforestation) are potentially worth around $200million per annum.

33 It is however important that simply waiting for sectors in other countries to face a price on carbon before introducing a price in New Zealand would not be equitable in terms of global emission reducing strategy. Furthermore, by introducing a price in New Zealand before overseas competitors may result in emission reducing technology being developed that can be exported to the competing firms in developing countries in the future.

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