Annex 4: Trade-exposure and emissions-intensity tests
Trade-exposure test
Demonstrating trade exposure on the basis of quantitative tests is extremely difficult. The key issue here is that any cost increase in New Zealand because of the NZ ETS cannot be passed on because the price is set by plants in another country that do not face the same cost increase. There are thus two elements that need to be examined:
- whether the output is traded between different countries, and so it is likely that prices will be set outside of New Zealand
- whether the output price currently includes the cost of emissions – this would be the case where the price was set in countries that regulated greenhouse gas emissions, but it might also be the case where new investments are being made on the basis of anticipated future pricing of emissions.
The question of whether an output is traded is relatively simple to answer, although it should be noted that the extent of trade to and from New Zealand is not always a measure of whether a price is set internationally. For example, an output could be manufactured entirely in New Zealand for the domestic market, with no exports, but the New Zealand price is set on the basis of international benchmarks because there is the potential for imports to compete with domestically produced goods. The relevant question is therefore more about whether international trade is possible than whether it is currently occurring to or from New Zealand.
The current inclusion of emission costs in a commodity price is far less clear, especially where there is the potential for investment decisions to be made on the assumption of future pricing.
In theory, prices in competitive markets will be set by the marginal costs of production of the marginal producer(s).1 However, the marginal producer – either the actual plant or its country of location – is often not identifiable in practice. So if some other countries – but not all – introduce emission policies that affect production costs, it may not be possible to identify whether prices are being influenced by these emission policies.2
Detailed analysis of price setting for individual commodities is complex and ultimately may not yield useful results. Also, it is a field of analysis in which the Government has much less information than the industry that is being assessed. Simpler criteria are needed.
Measuring quantities produced in different countries is one approach (eg, New Zealand production as a proportion of the world total, or the proportion of the total produced in non-Annex 1 parties), but this does not really address the issue of where the marginal (price-setting) producer is.
In addition, prices might be starting to incorporate a market expectation of future emissions regulation. For example, investment in electricity-intensive industry might be occurring in countries where marginal electricity generation is from renewable sources, because this is where electricity costs over the long run are expected to be lowest given an anticipated future carbon price. Under these circumstances, production costs and commodity prices would be starting to incorporate an emissions price.
Given these complexities and uncertainties, under the New Zealand track all activities will be assumed to be trade exposed unless they are very obviously not. Therefore, activities which cannot receive allocation because of the trade exposure test are those where:
- the activity is electricity generation
- there is no international trade of the output across oceans, or it is not economically viable to import or export the output of the activity.
This is different from the Australian test for trade exposure, and may lead to additional activities being included in New Zealand that do not meet the more restrictive trade exposure requirements in Australia.
Emissions intensity test
Emissions intensity is a measure of the extent to which the increase in costs as a result of the NZ ETS will have a material impact on the firm and its activities. Ultimately, what affects a firm’s decision to maintain production will be the extent to which marginal revenues exceed marginal costs (this affects how much it produces) and whether its profit exceeds its costs of capital (this affects whether it will remain in business).
A marginal cost test requires very detailed knowledge about an individual firm or industry and is thought to be too complex for an eligibility test. Arguably there is greater concern over a firm staying in business than in maintaining levels of production per se. Thus the emphasis should be on the test of whether there will be a significant impact on profits.
This leaves two questions:
- What is the right metric for defining emissions intensity?
- What are the right thresholds?
Metrics
If the concern is about plant closure, then the target is to define a level above which the cost of emission units would reduce company profits (on average) to less than the ongoing cost of capital (or all capital costs for new plants). A threshold defined as a percentage of profit (eg, as EBITDA)3 may be a reasonable approach, although the problem here is that it might simply lead to the inclusion of plants and industries that are relatively unprofitable, rather than being particularly emissions intensive, and would also be a difficult test to apply in practice.
Alternative approaches examined have been:
- value added
- revenue
- costs.
A value-added test has similarities to profits: it is the contribution the firm makes to the wealth of the economy, and the simplest way to understand it is as pre-tax profit plus payments to workers; this quantity is also equal to revenue less the costs of bought-in goods and services. Properly defined, value added is a wider concept than this because some of the bought-in goods and services have value added themselves, and in estimating the GDP contributions of a sector (eg, in input-output tables), these contributions are added using multipliers estimated for specific inputs to specific sectors. However, a value-added test would tend to focus assistance on those activities that are vulnerable to a range of cost increases rather than those for which the cost of emissions in particular is significant. A value-added test also requires decisions about which costs can legitimately be subtracted from revenue. The Government would be at a disadvantage in making these judgements.
An analysis of data in Statistics New Zealand’s Annual Enterprise Survey suggests there is a statistically significant relationship between profit, value added, revenue and costs. It suggests that any of these indicators could be used to produce a measure of intensity. The simplest to collect and verify is revenue, and this is the test that has been included in the Act for use on the New Zealand track.
The Act contains two emissions intensity thresholds:
- a moderately emissions-intensive activity emits between 800 tonnes of CO2-e per 1 million New Zealand dollars of revenue and 1600 tonnes of CO2-e per $1 million of revenue
- a highly emissions-intensive activity emits more than 1600 tonnes of CO2-e per 1 million New Zealand dollars of revenue.
The amount of assistance an eligible activity receives depends on which of these thresholds it passes. Eligible activities that are moderately emissions intensive will initially receive assistance at the rate of 60 per cent of the relevant allocative baseline. Eligible activities that are highly emissions intensive will initially receive assistance at the rate of 90 per cent of the relevant allocative baseline.
1 That is, if we assume that market demand is met by all the plants in the world supplying in price order, the most expensive plant that is supplying some of the market demand is the marginal producer.
2 Note that these might include non-price measures (eg, technical standards).
3 Earnings Before Interest Tax and Depreciation of Assets.
