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1. Foreword

2. Executive Summary

3. Introduction

4. Longer-Term Climate Change Policy Development

5. Policy Development on Devolving the Cost of Emissions

6. Emissions Trading

7. Greenhouse Gas Charge

8. Other Regulatory Approaches

9. Emission Reduction Agreements

10. Comparison of Options

11. The Path Forward for Longer-Term Policy Development

12. Glossary

13. Examples of Emissions Trading Systems

Submission Template

5. Policy Development on Devolving the Cost of Emissions

This section addresses a suite of general policy issues relating to the question of how the government should devolve emission reduction and sink management costs and opportunities to producers, consumers and the general taxpayer post-2012. These issues must be considered carefully regardless of which types of implementation measures are selected. The issues include: options for realising least-cost mitigation opportunities; determining emission reduction goals or targets for subsets of emitters; determining the most appropriate way to manage the impacts of climate change measures on the international competitiveness of New Zealand firms; selecting thresholds for determining which firms are subject to specific measures; revenue recycling; and building capacity for strategic emissions management, including measurement, monitoring, reporting, verification and emissions trading.

Some of these general issues may be particularly important in the design of shorter-term policies and measures, and may become less significant over the longer term. For example, competitiveness-at-risk issues for New Zealand firms will ease if the international climate change policy framework produces climate change measures that are comparably stringent across countries. There could be less need to set sectoral or sub-sectoral targets if a price-based measure was applied broadly across the New Zealand economy in place of disparate sectoral mitigation policies. However, other measures, such as revenue recycling, capacity building, and realising least-cost mitigation, are likely to remain important considerations in the design of both shorter- and longer-term policies and measures.

5.1 Realising least-cost mitigation opportunities

Greenhouse gas emissions have a global climate impact. As a result, reductions in emissions (or removals by sinks, such as carbon uptake in biomass) anywhere in the world will have a comparable impact on mitigating climate change. Similarly, it is possible to equate the relative global warming impacts of different greenhouse gases. This enables climate change policy measures to support least-cost emissions reductions wherever they happen, and to maintain the environmental integrity of those emission reductions.

The principle of achieving least-cost emissions mitigation was incorporated into the Kyoto Protocol. The Kyoto Protocol sets country-specific targets for industrialised (Annex I) countries as the basis for an initial allocation of emission allowances (called assigned amount units) during the first commitment period (2008–2012). However, it does not require Annex I countries to meet their emission reduction targets solely through domestic measures. Annex I countries with emission reduction targets can achieve a portion of those targets through three flexibility mechanisms that work across country borders: joint implementation (projects between industrialised countries), the clean development mechanism (projects between industrialised and developing countries), and international emissions trading (the trading of assigned amount units among industrialised countries).

Similarly, the Kyoto Protocol does not constrain Annex I countries from making cost-effective emission reductions in different sectors of their economies and across the sources of the six greenhouse gases included in the Kyoto Protocol. The Kyoto Protocol does place some specific limits on the use of removals by sinks (biomass and soil) in the forestry and agriculture sectors to meet emission targets.

When designing climate change policies, it is important to consider options for least-cost mitigation across sectors and national borders while achieving other environmental and economic objectives. Whether the government pursues emissions trading, greenhouse gas charges, emission reduction agreements or regulatory mechanisms, it may be possible to enable some flexibility in the cost of compliance by applying the following options:

• investing in domestic emission reduction or sequestration activities which have long-term benefits through a cross-sectoral projects mechanism, a centralised fund or another mechanism

• trading emission allowances domestically across different sectors of the economy

• investing in the Kyoto Protocol’s two projects mechanisms (joint implementation and the clean development mechanism) or similar international projects mechanisms

• linking to international emissions trading schemes

• enabling the fully flexible exchange of cash (based on the international price of greenhouse gas emissions or another price set by the government) and emission units to meet emission reduction obligations.

Flexibility mechanisms create opportunities and challenges. The opportunities result from enabling entities with higher-cost emission reduction options to pay those emitters that could reduce their emissions at lower cost. This could help to ensure that the cost to New Zealand firms of reducing their emissions is broadly comparable to the costs faced in other countries.

Challenges result from administering these types of mechanisms and aligning them with the policy’s other environmental and economic objectives. For example, there are additional transaction costs and policy complexities associated with certifying and trading project-based emission reductions. In addition, even if domestic emission reductions were more costly in New Zealand than in other countries, it could still be in the national interest to pursue domestic emission reductions because of other co-benefits, such as economic development, energy security and local environmental gains.

5.2 Determining emission reduction goals/targets for subsets of major emitters

Cabinet has invited Ministers to consider “bold goals or objectives” as part of their ongoing sectoral work programme responsibilities. Such sectoral goals and targets could be defined in qualitative or quantitative terms. They could be expressed in terms of scenarios, policy objectives, technology outcomes, emissions levels or some combination of factors.

If particular measures are targeted to a subset of emitters, they may require specific emission reduction goals or targets. For some kinds of policy measures, it may not be necessary to translate broader policy objectives into quantitative emissions targets for subsets of major emitters. For example, emission reduction targets do not need to be set for subsets of emitters when using a market-based instrument such as emissions trading or a broad greenhouse gas charge. The main feature of these types of measures is devolving liability for emissions directly to the emitters, and then enabling them to choose the most cost-effective response. This response could include reducing their emissions by increasing efficiency, paying a price on their emissions (in the case of an emissions charge), or surrendering any allocated or purchased allowances (in the case of emissions trading). The level of environmental benefit achieved by the system will depend on the level of the price on emissions (in the case of an emissions charge) or the overall cap on the number of emission allowances in the market (in the case of emissions trading).

In the case of emissions trading, an important distinction should be made between setting emission reduction targets and allocating some quota of free emission units or allowances. An emission reduction target implies that an emitter should reduce its emissions to a specific level. A free allocation of emission allowances reduces the cost to the emitter of carrying an emissions liability, but does not imply that the emitter has to reduce its own emissions to meet the level of free allocation.

When using regulatory measures or emission reduction agreements, it may be more important to consider the use of quantitative emission reduction targets or emissions standards for subsets of emitters within the broader context of sectoral or national goals for reducing emissions. However, such targets would have to be imposed in an equitable way across sectors and across emitters, and enable New Zealand to achieve its climate change goals. Setting such targets for subsets of emitters could be a very complex decision-making process.

5.3 Leakage and competitiveness issues

Applying a greenhouse gas price directly to emitters would have both supply- and demand-side impacts across the New Zealand economy. A price could be imposed through an emissions trading system, a greenhouse gas charge or by regulatory measures. It could potentially be applied to all greenhouse gas emissions, specific greenhouse gases or emissions from specific sectors or sources.

For many New Zealand businesses, the increased costs that would be caused by a greenhouse gas emission price could be passed through to their customers or otherwise managed over time. However, this may not be the case for some energy- or emissions-intensive New Zealand firms exposed to international competition from countries with less stringent climate change policies. Those New Zealand firms may not be able to pass emissions-related price increases through to their customers because of competition from countries that did not place an additional emissions-related price on emissions. As a result, the New Zealand firms may lose market share to international competitors. This condition is referred to as competitiveness-at-risk.

There could be a risk of economic and environmental leakage if competitiveness-at-risk firms were exposed to a significant price on all their emissions, at least in the short term. Leakage refers to a shift in production and emissions from New Zealand to other countries. To the extent that reduced production in New Zealand is offset by increased production in other countries, particularly in countries with less stringent environmental standards, there would be no global environmental gain from such displacement and there would be a negative impact on the New Zealand economy. This risk could apply regardless of whether the government used price-based or regulatory measures to reduce the emissions of such firms. However, this risk is also linked to a broad array of factors affecting firms’ international competitiveness, such as currency exchange rates, market fluctuations, labour costs, material costs, productivity and underlying energy prices. Failure by New Zealand firms to adjust to a low-carbon global economy would also damage their international competitiveness in the longer term.

General policy options for managing competitiveness impacts

Within the range of options for price-based policies in the relevant sectors, there are two policy strategies for managing the economic and social costs associated with a business becoming competitiveness-at-risk.

The first policy strategy is prevention. Examples could include: full, partial or transitioning exemption from emission reduction obligations or costs; rebates for costs passed through to at-risk firms; subsidies; border protection; free allocation of emission allowances; and regulatory exemptions. A related approach could be to provide for a gradual increase in the stringency of the measure, potentially resulting in a slowly increasing cost impact. Such an approach is similar to a tightening cap in an emissions trading system with an initial free allocation of emission allowances.

The second policy strategy is providing a safety net to assist with the economic and social adjustment to a lower-emitting economy. Examples could include special unemployment benefits, retraining programmes and relocation assistance.

Examples of preventive strategies include:

• In Denmark from 1996, the carbon tax was set at a lower level for “heavy processes” or energy-intensive sectors, with an additional reduction in exchange for negotiated agreements. Commitments were based on a requirement to carry out energy audits and implement recommendations that met a specified investment criterion.

• In the United Kingdom from 2000, firms and sectors with negotiated agreements have received an 80 percent discount on their Climate Change Levy payments.

• The European Union Emissions Trading System provides a level of gratis allocation of emission allowances to participating sectors based predominantly on historic emission levels.

• Under the previously announced New Zealand policy, firms with Negotiated Greenhouse Agreements were to receive rebates or exemptions covering emissions equivalent to a “world’s best practice” emission rate, and submit or receive emission units for marginal greenhouse gas emissions above or below that level.

Conceptually, managing the competitiveness issue is separate from setting a performance goal or target. In a straightforward cap and trade scheme, in particular, environmental outcomes are determined by setting the emission cap. Any subsequent decision to protect some firms from competitiveness impacts by allocating free allowances to them need not affect the expected environmental outcome. In a charge system, the incentive to mitigate is determined by the charge rate and coverage.

Measures such as exemptions or free allocation can have very significant financial implications for firms and for the economy as a whole. They may create distortions and intra-industry competitiveness issues for the sectors involved. Exempting some emitters from emission reduction obligations effectively shifts their adjustment burden onto other emitters, and may make the economy as a whole less efficient in responding to limits on emissions. Conversely, where some sectors have low-cost technological choices but others do not, universal emission reduction obligations are effectively more costly for some sectors than others. Protecting some firms from emission reduction obligations could increase the overall cost to New Zealand of reducing its emissions. However, in the shorter term, it may be in New Zealand’s broader social and economic interests to mitigate some of the sectoral adjustment effects of introducing an emissions constraint across the economy.

Allocation on the basis of historical emissions may be the simplest approach to compensation for competitiveness-at-risk firms. However, this may be simplistic and risk over-allocation, particularly to firms that may have had high emissions in the past due to low investment in efficiency measures. Allocation in the context of requiring firms to make forward commitments or agreements may reduce these risks. Another option is allocation on the basis of benchmarking for the efficiency of production. All of these options will involve implementation costs for firms and the government.

Considerations for electricity generation

In the New Zealand context, electricity is not an internationally traded commodity and generation firms are not exposed to international competition. In principle, the consideration of competitiveness-at-risk issues does not lead to any case for gratis allocation or charge exemptions for the electricity sector. However, some energy-intensive firms in the industry sector might be put at risk by the impact of a greenhouse gas price passed through in electricity prices, especially if all electricity prices increase as a consequence of a price on emissions from fossil-fuel generation. Comparatively low energy prices have given some energy-intensive manufacturing firms a competitive advantage internationally. Some industrial firms could also potentially be placed at risk by the impact of a greenhouse gas cost on non-electricity energy use and on process emissions.

Generation of electricity in New Zealand is characterised by high levels of renewable energy sources, which is likely to continue to be the case in the future. As a result, the future emissions intensity of New Zealand grid electricity will be low compared to electricity consumed in many major trading partner countries. This reasoning implies a price on emissions from electricity generation would potentially have a low impact, relative to trading partners, on the wholesale price of electricity supplied in New Zealand. However, the size of the impact depends on whether the price on emissions is applied to marginal or absolute emissions and whether the wholesale clearing price of electricity is determined by fossil fuel or renewable generation. As major trading partners incorporate the price of greenhouse gas emissions into their economies, New Zealand’s high proportion of renewable electricity generation may give energy-intensive industries a competitive advantage.

Considerations for the agriculture and land-use change and forestry sectors

These sectors have two types of activity: product processing and land management. The product processing operations are major energy consumers (and to some extent, energy producers), and would have similar interests to those of other manufacturers across the economy. Land management includes a range of activities such as pastoral and arable farming, horticulture, and forestry.

If greenhouse gas pricing were extended across the economy, this could include methane and nitrous oxide from agricultural production. Farmers could lose profit or export market share if they had limited ways of reducing their emissions and could not pass the price increases on to export customers.

If greenhouse gas pricing were extended to land-use change and forestry, forest owners could both face liabilities for conversion of forests to other land use[For example, land uses with a lower net carbon storage value or which emit higher levels of greenhouse gases such as agriculture or residential development.], and attract investment by earning carbon credits in new forest planting. This would alter the relative economics of land use, and in particular have some influence on land-use change from forestry to agriculture.

A range of options is available for moderating the impact of emissions pricing on land management activities:

• A cost on marginal emissions, instead of full emissions, as discussed more generally above. For example, analysis suggests that if emissions were charged at the margin for livestock production, the cost of increasing emissions through increasing stock numbers may be approximately four percent of the gross revenue associated with those increased stock numbers.

• An emissions size threshold to exempt smaller producers from bearing an emissions charge.

• Financial incentives for marginal emission reductions achieved through verified projects. Further analytical work would be needed to ensure that such project-based emission reductions were fully reflected in New Zealand’s national greenhouse gas inventory.

• Agricultural emitters to offset total or marginal emissions by investing in new forest plantings, biofuels, renewable energy or other greenhouse gas-reducing or sink-enhancing activities.

Major considerations in developing the government’s agriculture and forestry work programmes are likely to include exposure to international competition, action by major trading partners, availability of cost-effective mitigation options, responsiveness to pricing mechanisms, measurement and monitoring issues, and administrative complexities. Across all sectors, to the extent that competing firms in other countries also face local or international emissions pricing over time, the risk of leakage will be reduced and eventually disappear.

Considerations for the transport sector

Transport energy consumption in New Zealand accounts for 37 percent of total energy use. Greenhouse gas emissions from transport energy consumption have increased 62 percent since 1990. The Stern Review[Stern, N. et al. (2005) Stern Review: The Economics of Climate Change. Report from H.M. Treasury to the UK Chancellor of the Exchequer. Cambridge: Cambridge University Press. ISBN-10: 0-521-70080-9.] notes about 14 percent of total global greenhouse gas emissions come from transport. If greenhouse gas pricing were extended into the transport sector, the increased costs could impact on the competitiveness of New Zealand products in the international market by increasing total costs of production and distribution.

5.4 Thresholds

A threshold is needed to establish which entities would be covered by a price-based instrument or regulatory mechanism. The definition of the threshold will have important implications for the number of participants, the emissions coverage of the mechanism, the administrative feasibility of implementation, equity among entities above and below the threshold, and economic efficiency. The definition of a threshold would have to include definition of the entity, the scope of its activities or emissions that are covered, and the metric used to determine which emitters are categorised as large emitters and included in the instrument or mechanism.

Considerations for the energy and industrial sectors

In the case of the energy and industrial sectors, the relevant entity to serve as a point of obligation might be a firm as a whole, a business unit or a single site. Officials believe a single site may be the most appropriate entity to use because many New Zealand firms are conglomerates with different types of operations, only some of which would qualify as large direct emitters and be suitable for inclusion in a price-based or regulatory policy measure. However, further work is needed in this area. There will be challenges in developing a clear and enforceable definition that can apply to the full range of corporate structures in the New Zealand industry and energy sectors.

The scope of coverage might include all of the entity’s emissions or be restricted to emissions associated with major processes, excluding items covered by other measures. The metric might be based on a number of measures, such as energy use, direct CO₂ emissions, or energy or emission intensity. A significant issue would be whether to base the participation threshold on absolute emissions or energy use, or on intensity. Including only the largest emitters in a price-based or regulatory mechanism could simplify administration of the mechanism but create domestic sectoral market distortions.

Considerations for the agriculture and land-use change and forestry sectors

When setting thresholds for emitters in the agriculture and forestry sectors, key considerations are which gases and emitting activities to include. Manufacturers or processors in these sectors could be treated similarly to other industrial firms. In the case of land managers, separate thresholds may be needed with regard to methane emissions from ruminant livestock production, nitrous oxide emissions from fertiliser use and livestock excrement, carbon dioxide emissions from land-use conversion, and carbon sequestration from forest planting. Thresholds may need to be further differentiated by type of activity. A key consideration is measurability.

Alternatively, a de-facto collection point at point of processing could be defined. Regulatory rules could be used to control intensity (or measures that ensure adoption of best practice) on each farm. Under this option, the calculation of emissions would be per unit of output based, such as per kilogram of milk solids.

Once the nature of the threshold had been defined, it would be appropriate to set a size threshold. To reduce transaction and administration costs, which could pose a significant barrier to small producers, participation could be limited to major producers. Another option would be to aggregate smaller producers on a regional or sectoral basis, and manage their emissions collectively. Collective management could be accomplished through an industry-level organisation or some kind of government entity. However, careful consideration would be needed regarding the domestic market distortions that could result from setting thresholds in the agriculture and forestry sectors. The design of the threshold should not create perverse incentives for producers to subdivide their operations to avoid the threshold, or to displace emitting activities from operations inside the scheme to those outside the scheme (a form of domestic leakage). In addition, consideration should be given to fair treatment of large and small emitters across all sectors of the economy. These issues will be considered in the further development of the government’s climate change work programmes on agriculture, land-use change and forestry.

Considerations for the transport sector

Price-based (or other) measures could be applied to the transport sector at three levels: individual consumers of transport energy, major transport energy producers or importers, or larger, commercial transport energy consumers. Each level would require a different threshold definition. For example, placing a greenhouse gas charge or emissions trading obligation upstream at the level of fuel production or import may not require a threshold definition if the measure was intended to encourage downstream transport energy consumers to decide whether to absorb or avoid any cost increase. Alternatively, a measure aimed at larger transport energy users would require an entity-level threshold, such as total transport energy consumed. The measure might then need a separate emissions threshold to define the scope of emissions from the entity covered by the measure. Such a measure could enable participating entities to trade or offset their emissions.

This work programme appreciates the difficulty and importance of reducing greenhouse gas emissions from the transport sector. A suite of measures would probably be required: any price-based measure would probably need to be supported by regulatory measures, such as standards and enforcement, as well as changes to urban design and other incentives, such as education and information, to encourage consumer behavioural change and modal choices. The transport climate change work programme is investigating a range of possible measures for reducing greenhouse gas emissions. The treatment of transport-related emissions under broad price-based or other policy measures post-2012 should reflect analysis and decisions made under that work programme.

Considerations for the waste sector

Most emissions of greenhouse gases from the waste sector are from solid waste to landfill or the treatment of waste water. By far the largest source is methane emissions from the anaerobic decomposition of organic matter in landfills. In recent years, these emissions have been progressively declining because of reduced waste volumes and improved landfill management practices. The introduction of the 2005 National Environmental Standard (NES) to control greenhouse gas emissions from landfills is predicted to have a further significant impact on net emissions from the sector. When the NES was introduced, 19 landfills met the one-million-tonne capacity threshold for mandatory landfill gas collection and destruction. The design of a threshold for the solid waste sector should aim to not unfairly penalise those 19 landfills already regulated by the NES.

In contrast, nitrous oxide and methane emissions from industrial, commercial and residential waste water treatment are relatively small and have a much larger number of sources. Direct estimates of emissions are currently not possible for waste water treatment plants. A threshold could be defined on the volume of waste water processed, although varying processing types result in different amounts of emissions for any given volume. The main issue for this sub-sector is the administrative efficiency of any threshold due the range of treatment types, number of plants and measurement of emissions.

5.5 Revenue recycling

Greenhouse gas charges, auctions of emission allowances/units and regulatory penalties can raise substantial revenues that can be returned to the economy in many ways. One option is to link revenue from a greenhouse gas charge or allowance auction to reductions in existing taxes on business or individuals. The economic gain from such tax reductions could partly offset the costs associated with the economy’s adjustment to emissions constraints. Revenue recycling could be designed to offset the impact of higher energy prices on consumers. The funds could also be used to pay for projects which reduce emissions, described as tied revenue. In addition, the funds could be used by the Crown to purchase units to cover any deficit in the first commitment period.

The Minister of Finance announced in the 2005 Budget that revenue from the proposed carbon charge was to have been recycled back to businesses in the form of tax relief. Specific areas targeted were compliance costs, changes to depreciation and fringe benefit tax rules. Underlying this decision was the argument that the options for spending revenue, irrespective of its source, should be judged on their merits alongside other proposals. Any other application of the revenue was considered an increase in the overall tax burden through resulting tax-system efficiency losses. This consideration did not include an assessment of applying carbon tax revenue to purchasing international units to cover a net deficit position over the first commitment period.

Typically, tax reductions are designed to achieve economy-wide or industry-wide benefits, not to offset specific competitiveness impacts. In the case of a greenhouse gas charge or emissions trading scheme, the price burden of competitiveness impacts could be very unevenly distributed, with only a modest burden on most businesses but a substantial burden on a few sectors. General cuts in existing business taxes funded by a greenhouse gas charge or permit auction revenues might not adequately compensate the highly burdened industries. Another way of targeting relief to these industries could be through the mechanism of the charge or trading scheme itself, or through direct payments or exemptions. This was the intention of the Negotiated Greenhouse Agreements policy in the previous climate change policy package, in which rebates were to be provided to eligible firms according to their direct and indirect payment of the tax.

Another option for revenue recycling is to tie the revenue to specific climate change mitigation or adaptation activities, or to relieve consumers who are disproportionately affected by the increased price of energy and other important goods and services. Challenges associated with using the revenue in this way include coping with the variations in funding flows over time, deciding the relative allocation of funding among specified activities and ensuring the efficient use of funding. It could also be argued that providing emitters with money in proportion to their emissions-related burden is ultimately self-defeating, unless the money is applied to reducing emissions.

5.6 Building capacity for strategic emissions management

As longer-term policy measures become more sophisticated and broader in scope, it will be increasingly important to build the capacity of major emitters to meet their emissions reporting obligations and manage their emissions strategically. Major emitters will need to develop the data systems and management tools to measure, monitor, verify and report their emissions. Depending on the design of longer-term measures, major emitters may also need to develop the expertise to participate in emissions trading or offset activities. Building capacity for emissions reporting can also play a vital role in helping firms to understand the sources of their emissions, identify opportunities to reduce emissions and manage their liability for emissions under various policy measures.

This issue will initially be addressed by specific sectoral work programmes, which will aim to support the short-term measures proposed in those sectors. In the longer term, to the extent that a consistent price-based measure might be adopted across sectors and is devolved to emitters, it is likely that new types of measurement, monitoring, verification and reporting will be required for a number of sectors. The chosen approach is likely to be driven by the choice of measures and the administrative complexities and compliance cost of reporting, particularly in sectors with a large number of point-source emitters such as transport. In sectors with a large number of emitters, a top-down approach aimed at collecting emissions data at points of fuel supply may be required rather than a bottom-up approach aimed at individual emitters. A top-down approach is consistent with the general approach currently adopted for compiling New Zealand’s emission reporting under the Kyoto Protocol.

For large direct emitters, measurement, monitoring, verification and reporting of emissions could be vital elements of any long-term measure and are likely to also be important elements of shorter-term measures. Early development of capacity by large emitters to manage these issues will be important in designing and implementing shorter-term measures, and may be necessary to ensure all emitters are treated fairly.