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General Equilibrium Analysis of Options for Meeting New Zealand’s International Emissions Obligations

Summary

Part 1. The Kyoto First Commitment Period

Scenario 1

Scenario 2

Scenario 3

Part 2. Beyond Kyoto CP1 - 2025

Part 3. Sensitivity Tests

Scenario 2

An emissions trading scheme with a carbon charge of $25/tonne, government purchases units for excess emissions from offshore, financed by higher personal income tax if permit revenue is insufficient. Methane and nitrous oxide are exempt. Free allocation, in most cases equal to 90% of approximate 2005 emissions, applies to the following industries:

• Dairy processing
• Pulp and paper
• Industrial chemicals (fertilizer and hydrogen)
• Non-metallic mineral products (cement and lime)
• Basic metals (iron and steel)
• Oil refining

Analogously, the following industries are also 90% compensated for higher electricity prices:

• Dairy processing
• Wood processing
• Pulp and paper (thermo-mechanical pulping)
• Basic metals (aluminium)

With the exclusion of agricultural non-CO2 emissions from the ETS during the first commitment period, our analysis suggests that any potential loss in asset values is negligible, although industry aggregation in the model may understate such loss. In contrast, the potential loss of international competitiveness is not negligible (under no assistance).

Hence in our modelling we treat free allocation as an output subsidy, albeit limited to the equivalent of 90% of 2005 emissions in most cases – see box.

Table 1 shows that the carbon charge reduces CO2 emissions by 5.9% or 2.3 Mt. Thus the cost of units to be bought offshore is about $170m. And with a rising marginal cost of abatement, it is cheaper to undertake some abatement domestically than purchasing units from offshore. This represents a gain from an emissions trading scheme over Scenario 1. Might the gain be higher without free allocation?

Free allocation of emission rights may be thought of as some of the proceeds of auctioned rights being recycled back to industry. Other options for recycling include lower income tax rates and subsidies for growing trees or undertaking research into carbon sequestration. We have not undertaken a full analysis of recycling options, but we consider the welfare effects of recycling via free allocation against the option of recycling via lower income taxes.

Firstly, as noted above, the most important factor determining the welfare effects of a price on carbon is the cost of any emission units that New Zealand collectively may have to purchase offshore. An ETS means that more emission reduction occurs domestically and thus fewer allowances are required to be purchased from abroad. The next most important factor is that producers and consumes face the correct set of relative prices at the margin. Free allocation need not compromise these factors.

Most recycling options then will be a second order issue in terms of the welfare effects of an ETS. Without free allocation households incur a loss in purchasing power because of the lower New Zealand dollar brought about by the increased demand for foreign exchange – to pay for the offshore emission permits.

With free allocation the exchange rate effect is smaller because exports are maintained at a higher level, as free allocation helps to preserve competitiveness. Acting against this, however, is that households must forego some of the tax reductions that would be available if all emission rights were auctioned.

Our analysis shows that these effects are largely offsetting. That is, the loss in private consumption from an ETS is not particularly sensitive to some free allocation of emission rights. However, the model does not fully consider all relevant factors:

1. It ignores the transactions costs of free allocation.
2. Household taxes are modelled as simple average tax rates by household income quintile. Thus the full deadweight loss from progressive income taxation is not fully captured, especially with invariant total employment.
3. Free allocation that is too generous could provide windfall profits to overseas shareholders.

Accordingly, we would expect that over time the welfare cost of the ETS would be reduced if free allocation of emission rights is phased out, other things equal.

Note also that irrespective of the recycling mechanism, the relative welfare gain that is associated with the introduction of an ETS (Scenario 2 v Scenario 1) is likely to be under-estimated somewhat as the model does not include the effect of reductions in emissions from activities not included in the model, such as deforestation.

A domestic carbon price does not decimate the tradable sector. For a given balance of payments constraint (as occurs here) anything that impedes the international competitiveness of the economy will in the long run be offset to at least some extent by an adjustment of the real exchange rate, either in the form of lower domestic prices or a devaluation of the nominal exchange rate.

As shown in Table 2 only Oil Refining and to a lesser extent Non-metallic Mineral Products incur falls in output. (Electricity is not a traded industry.) Underlying these reductions are increases in output prices of 0.7% and 0.4% respectively. It is unlikely that such increases endanger the overall viability of these industries. Note that for Oil Refining free allocation covers its own direct emissions from the refining process, but not the emissions produced when the refined fuels are combusted in vehicle engines. Thus its lower output is a direct result of less consumer demand for liquid fuels.

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