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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

6. Emissions Trading

An emissions trading scheme requires a group of emitters to hold tradable units or allowances to match some or all of their greenhouse gas emissions over a defined period. Emitters can either reduce their own emissions or trade allowances to meet their obligations. While there are a number of types of emissions trading schemes, two principal options analysed in this paper are the cap and trade and baseline and credit models. The difference between the two is that the cap and trade model uses an absolute framework, in that allowances must be surrendered to the authorities for every tonne (or other unit of quantity) of emissions produced, while the baseline and credit trading model uses a relative framework, where only deviations from an emissions baseline must be accounted for.

Emissions trading schemes are particularly suited to sectors in which emissions can be estimated and reported accurately at low cost, which have a reasonable number of emitters and in which the transaction costs of covering those emitters are not unreasonably high. The stationary energy sector and industrial processes sector generally fulfil these requirements and have been the main target for these kinds of measures internationally. However, emissions trading could potentially be applied in other sectors, such as transport, waste, agriculture and forestry. The government’s climate change work programmes on transport, agriculture, land-use change and forestry will give further consideration to any issues specific to the inclusion of these sectors in a broad emissions trading regime.

A third option is to allow for trading of cross-sectoral offset credits, either as a stand-alone model or along with either cap and trade or baseline and credit models. Alternatively, any emissions above a specified level could be required to be compensated for with offset credits, which would in turn be tradable.

An emissions trading system recognises that the cost of abating greenhouse gas emissions differs across different entities and provides opportunities to reduce the total cost of emission reductions by allowing them to be made where it is cheapest to do so.

Emissions trading can offer more flexible settings than a greenhouse gas charge and is likely to be more effective in encouraging emission reductions in areas where it is most cost-effective. However, costs of establishing a broad emissions trading regime may be higher than for a greenhouse gas charge.

6.1 Trading models: cap and trade, baseline and credit, and offset trading

This section outlines in general terms features of three emission trading approaches. In practice, any chosen trading scheme may have a mix of features (eg, a cap and trade scheme with a sectoral offsets component).

A more detailed assessment of the relative merits of these different models in the context of the energy sector is provided in the government discussion paper Transitional Measures: Options to move towards low emissions electricity and stationary energy supply and to facilitate a transition to greenhouse gas pricing in future. [This paper has been released by the Ministry of Economic Development as part of its consultation on the draft New Zealand Energy Strategy, and is available at: www.med.govt.nz].

Cap and trade

The main feature of a cap and trade scheme is that a fixed ceiling or cap is set for a certain type of emissions (international examples are CO₂ and NO_x) over a set period of time in combination with tradable emission allowances. A cap and trade scheme is in effect a regulation with a market component. The allowances are initially allocated in some way (eg, based on historical emissions, auctioned or purchased at a fixed price), typically among existing sources. Each source covered by the programme must hold allowances to cover its emissions, and is free to buy and sell from other sources.

Essential elements of a cap and trade scheme are:

• emissions are capped at some level in each period

• allowances to emit greenhouse gases are issued for each period

• there is a penalty for non compliance.

Key design issues include:

• point of coverage

• threshold for entry

• use of offsets or other flexibility mechanisms

• method of allocation of allowances.

Under a standard cap and trade design, an overall emissions cap is applied to a group of emitters and tradable emission allowances equal to the cap are issued into the market (eg, through gratis allocation or auction). To comply with the scheme, emitters must surrender allowances equal to their total emissions. An absolute cap provides some level of certainty about the volume of emission allowances available in the market. The relative supply of emission allowances, and the demand for them, determines their market value.

Baseline and credit

In baseline and credit schemes, individual emitters are assigned an emissions baseline which represents a schedule of allowable emissions over time. These can be defined on an absolute or an intensity basis.

Emitters are exempt from carrying a liability for their emissions up to a baseline level, which has to be less than actual emissions to have a substantial effect. If the scheme is based on absolute emissions, it is no different from a cap and trade scheme with grandparented allowances. The only allowances likely to be traded are associated with deviations from the initial allocation.

Baseline and credit schemes start to differ from cap and trade schemes when they are designed on the basis of emission intensity: sources must buy additional allowances when their emissions rate per unit of activity (energy input or output of energy or product) exceeds the baseline level. The system allows emitters to increase their total emissions without being required to buy more allowances, as long as the emissions are the result of increased activity rather than a change in the emissions intensity of the production.

For the purposes of this discussion paper, baseline and credit schemes are taken to operate on an intensity basis, with an emitter’s baseline expressed in terms of tonnes of emissions per unit of production. An emitter can increase its production and its absolute emissions without being required to provide allowances, as long as the amount of emissions per unit of production remains below the baseline.

A major distinction between baseline and credit schemes and cap and trade schemes is the timing of provision of allowances to participants. While the intensity baseline is determined in advance for baseline and credit schemes, the actual amount of production and the emission intensity of that production is not known until the end of the year (or other period used). Consequently, emitters do not know the extent of their liabilities or benefits until the end of the period, when emission allowances are allocated. With cap and trade schemes, the amount of the cap is known in advance irrespective of production levels, so allowances can be allocated with certainty at the start of the period.

The treatment of firm closures and new entrants could be simpler under a baseline and credit model because a cap and trade system requires a proportion of the cap to be set aside for unknown new entrants. Similarly, a cap and trade system could create perverse incentives to keep inefficient plants running at low output, should there be a policy to prevent the sale of allowances from closed plants by withdrawing allowances. A baseline and credit system does not require a new entrant reserve and, on closure, a firm would not receive any benefit of allowances to trade because entitlement to allowances might depend on continued operation.

Trading of cross-sectoral offsets

The term offsets is used to describe a reduction or removal of greenhouse gas emissions that counterbalances emissions elsewhere in the economy. In the context of this paper, offsets can be activities that are funded by emitters in one sector to reduce or sequester emissions in other sectors such as agriculture or forestry. The government’s discussion paper Transitional Measures (referenced earlier) also looks at the option of trading cross-sectoral offsets, but in the narrower context of using offset trading to meet emission obligations in the stationary energy sector.

Activities that generate offset credits tend to be in the form of projects: an activity at an identifiable location that is individually managed and accounted for. The possibility of implementing project measures is being considered both by the draft NZES, for the stationary energy sector, and more generally by the climate change work programme on “the need for and future shape of, cross-sectoral incentive programmes such as the Projects to Reduce Emissions programme”. For the purposes of this paper, the distinction between project schemes and offset trading is that offset credits are used in conjunction with a system of emissions trading that creates obligations for emitters in a particular sector or sectors.

There are a number of ways to trade in offset credits. One is to design a trading scheme, such as cap and trade or baseline and credit, and allow for offset credits to enter this market. This is a common feature of emissions trading schemes and effectively means certain types of offset credits have the same value as an emissions allowance.

In general allowing for offset credits as part of a domestic trading scheme will improve both the cost effectiveness and (more contentiously) the environmental effectiveness of the scheme. Allowing for offset credits broadens the scope of a domestic trading scheme, which reduces compliance costs for the sector facing the cap and, in theory, leaves net emissions unaltered. Trading in offset credits can also help to encourage emission reductions from sectors that are not as well suited to a cap and trade regime.

Concerns about allowing for offsets credits as part of a trading scheme are that they will weaken the incentive for emission reductions with the capped sector itself. However most concerns about the use of offsets are linked to concerns about whether the activities for which the credit is given are in fact creating real emission reductions (or removals in the case of sequestration projects).

A second option would be to create a market that trades solely in offsets by requiring some or all of the greenhouse gas emissions from a sector to be met solely by offsets from a particular sector or sectors.

6.2 Implementation issues

In addition to selection of a trading model, key issues to consider for implementing an emission trading system include:

Coverage of the scheme and points of obligation

The larger a trading scheme, the greater the opportunities to seek out least-cost emission reductions. However, larger systems are also more administratively complex, which can increase transaction costs. Some sectors may be better suited to emissions trading than others.

Within trading sectors, the “points of obligation” for surrendering emission allowances to cover emissions can be defined at the level of the upstream source of an emitting product (at points of production or supply of fossil fuels), at the level of the downstream emitter or user of a product, or at points in between. Using upstream points of obligation is the easiest approach to administer, as it involves the fewest parties.

In the longer term, it is likely to make sense to apply either upstream points of obligation or a combination of upstream and downstream points of obligation in different sectors, depending on factors such as administrative and compliance costs and the relative mitigation incentives created at different points of obligation. One consideration is the extent to which cost-effective behaviour to reduce emissions is influenced by direct obligations to surrender emission allowances versus price signals passed down through the supply chain. For example, if the government were to consider a limited trading scheme for large direct emitters in the electricity generation and industrial sectors before 2012, it could be feasible to apply a downstream point of obligation as only a limited set of consumers of most fuels or other emitting inputs would be subject to the scheme. In large trading systems, applying downstream points of obligation becomes increasingly complex to administer.

Competitiveness-at-risk/international leakage

The same basic decisions about an acceptable level of cost to impose on businesses and issues of international competitiveness and leakage can arise under emission trading regimes as under a greenhouse gas charge regime. However, emissions trading also offers benefits such as increased flexibility in compliance and opportunities for least-cost mitigation. The overall stringency of the cap, methods of allocating emission allowances (such as gratis allocation or auctioning of allowances, or use of a fixed price), the stringency of non-compliance penalties, price control (safety valve) mechanisms and wider market linkages can reduce the cost of the system to emitters and limit the risk of international leakage of emissions.

Using linkages/safety valves

At some level, an emissions trading scheme requires an overall cap to achieve the desired environmental outcome. However, such a cap can potentially be set at an international level, and does not need to be further defined at a national or sectoral level. For example, in the case of Annex I countries that have ratified the Kyoto Protocol, an international emissions cap is defined as the total number of assigned amount units allocated for 2008 to 2012.

For firms within the cap, emissions trading is intended to enable access to least-cost mitigation opportunities. This objective is most likely to be achieved where there are many diverse sources of allowances, the supply of allowances exceeds demand, transaction costs are not prohibitive, and pricing is transparent. In market situations where demand for allowances exceeds supply, the acquisition of allowances is mandatory or there are limited suppliers, the market price for allowances is likely to be set either by the marginal cost of mitigation or the non-compliance penalty – whichever is lower.

Under those conditions, sellers will inflate the sale price of allowances relative to the actual cost of mitigation. The result will be that least-cost mitigation opportunities in the economy will be funded, but the financial benefits will accrue to suppliers, and buyers may not realise substantial cost savings relative to the marginal cost of abatement.

New Zealand could consider setting its own absolute cap on a national or sectoral basis for a domestic emissions trading system. This approach would create an incentive for resources to move to lower-emission uses within the economy, which is one of the objectives of a trading system. However, it could place a cost constraint on production by limiting emitters’ access to least-cost mitigation opportunities outside of the cap.[This depends on whether reducing emissions domestically is cheaper than reducing overseas emissions.] It could also constrain the liquidity of the domestic emissions trading market, given the small size of the New Zealand economy and the limited number of large direct emitters.

To avoid these issues, New Zealand could design a more flexible national or sectoral emissions trading scheme. One option would be to link a domestic trading scheme to the Kyoto emissions trading market (through trading of assigned amount units, emission reduction units from joint implementation projects or certified emission reductions from clean development mechanism projects). A second option would be to link a domestic trading scheme to other countries’ emissions trading schemes, such as the European Union Emissions Trading System. A third option would be to build in other safety valve measures such as the use of project-based allowances/offsets, linkages to other sectoral climate change programmes, or price protection (such as making allowances available for purchase at a set price or setting a relatively low financial penalty for non-compliance). These options could be designed to preserve the environmental integrity of the trading system while enabling greater market liquidity and reducing the costs of compliance.

Method of allocation of allowances

A number of methods could be used to make an initial allocation of allowances to participants in an emission trading scheme, including:

• gratis allocation of allowances to emitters. This could be done on a number of bases, including: grandparenting allowances to existing emitters on the basis of historic emissions, or providing allowances to emitters on the basis of projected emissions

• providing allowances to participants in a particular industry up to a benchmarked level of emission performance

• auctioning

• hybrid gratis allocation/auction regime

• a requirement to purchase emission allowances, such as project-based allowances or offsets.

Auctioning emission allowances offers some important benefits over gratis allocation. It is considered more economically efficient. Under a pure auction, emitters would simply purchase allowances to cover their emissions liability – the government would not determine which emitters would have preferential access to allowances, and on what basis gratis allowances would be awarded. There would be no need to separately consider crediting for early action to reduce emissions – top performers would be rewarded automatically by needing to purchase fewer allowances than poor performers. Auctioning would generate revenue that could be recycled back into the economy so that the measure became revenue neutral for the Crown.

The concept of gratis allocation of emission allowances is ingrained in the Kyoto Protocol in the allocation of assigned amount units to Annex I countries. Gratis allocation of allowances can mitigate the adjustment cost of assuming emission reduction obligations under a trading regime, and address competitiveness-at-risk impacts from exposing firms to a price on greenhouse gas emissions before their international competitors. It can also be a powerful tool for engaging emitters to participate in emissions trading.

However, as demonstrated by the European Union Emissions Trading System, gratis allocation processes can be complex and time consuming to design and implement. Allocated allowances have a market value and constitute an asset to emitting firms. Gratis allocation can introduce significant market distortions. Surrendering allowances to cover emissions has an opportunity cost, so emitting firms that receive gratis allowances may still choose to pass the full price of their emissions on to consumers. Gratis allocation schemes may help reduce the burden of adjustment costs of emissions pricing on producers, but not on consumers. The complexities involved when using grandparenting or other methods of gratis allocation may make it necessary or desirable to determine the allocation of emission allowances well before the trading scheme begins.

An important consideration in the design of allocation schemes is allowance allocation on the basis of absolute emissions versus emissions intensity. Allowance allocation on the basis of absolute emissions involves some underlying assumption about the level of production, whereas allowance allocation on an intensity basis enables the allocation to adjust automatically to fluctuations in production. If an emissions cap is designed on an absolute basis but allowance allocation is done on an intensity basis, some mechanism will be needed to translate the absolute cap into an intensity metric. Allowance allocation on an absolute basis drives decision making around marginal increases in production, while allowance allocation on an intensity basis influences decisions on the average cost of production.

Market entry and exit issues

Under some methods of allocation of emission allowances (particularly where emissions are grandparented to emitters on the basis of historic emissions), new entrants to an industry may face barriers while existing parties may receive windfall gains. For example, making allowances available to existing participants but not new entrants will create a potentially prohibitive cost disadvantage for new entrants, which will have to buy allowances to match their emissions. One solution would be to set aside a reserve that could be allocated to new entrants on the basis of a reasonable level of emissions for their projected production. In the case of grandparenting on the basis of historic emissions, existing participants leaving the New Zealand market could also receive windfall gains as they would no longer have emissions from production and their allocation of units would be available for sale. To the extent that this production was displaced to other countries outside the trading system, the environmental value of these allowances would be negated by increased emissions in other countries. A possible response would be to require the return of allocated allowances to the government when a plant was closed down. Alternatively, a dynamic baseline under a baseline and credit system could potentially solve these issues.

Compliance, banking and borrowing mechanisms

The environmental integrity and market effectiveness of an emissions trading scheme must be enforced through a compliance regime. Firms could fail to comply by emitting more than their allowance holdings or by failing to meet their monitoring and reporting requirements. Non-compliance penalties could take many forms, including monetary fines, a requirement to purchase and surrender additional allowances, the assignment of a more stringent target in future compliance periods or restricted trading access in future periods.

Enabling banking of emission allowances and borrowing of allowances from future periods could create some flexibility in compliance. Under a banking mechanism, firms with excess emission allowances relative to their emissions over a given compliance period could retain those allowances for use in future periods. This would give firms an incentive to over perform against their current target. Under a borrowing mechanism, firms could borrow allowances from their future allocation in order to meet their allowance requirements in the current period. These mechanisms could become complex if the basis for trading of emission allowances was expected to change substantially over time.

The design of the compliance, banking and borrowing mechanisms could play an important role in influencing the market price of emission allowances. The mechanisms could also affect market liquidity and be important considerations in ensuring linked emissions trading schemes were compatible.