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Part 3. Sensitivity Tests

Scenario 7

As in Scenario 6 with an international allowance of 30 Mt5 instead of 50 Mt of CO2e.

The difference of 20 Mt in allowances has a significant impact, with both welfare measures showing a marked decline. Private consumption falls by 3.5% compared to 2.2% in Scenario 6. Real GDP in world prices declines by 2.3% compared to 1.5% in Scenario 6.

Overall we infer that the number of emission units assigned to New Zealand is an important parameter in determining the costs to the country of participating in global agreements to reduce GHG emissions. (Note that this does not imply that New Zealand should not participate in such agreements, as we have not considered the potential costs of non-participation such as being subjected to tariffs in export markets.)

Scenario 8

As in Scenario 6 with absorption of the carbon charge in profits by three emissions intensive industries exposed to international competition.

Previous scenarios have all been based on the standard competitive economic model where industries endeavour to pass cost increases onto domestic and foreign consumers, with the final incidence depending on elasticities of demand and supply, and general equilibrium effects. At the level of industry aggregation with which we are working, no demand elasticities are infinite and no product is a perfect substitute for any other product. Thus no industry disappears if a carbon charge is imposed, in the same way that no industry disappeared from New Zealand when industry-specific ACC levies were introduced. Of course some parts of some industries do close. Parts of the clothing industry could no longer compete when tariff protection was reduced, but other parts of the industry have prospered and now produce goods with much higher value-added.

A carbon price may reduce the production of milksolids (or more likely the rate of increase in the production of milksolids as some conversions become uneconomic), but the loss is likely to be manifested in less income from basic commodity exports than in less income from value-added exports. Higher domestic cement prices may encourage some importing of cement at the margin, but there are other aspects of the New Zealand product such as location, delivery times and certainty of supply which mean that not all buyers of cement will switch to importing if cement pries rise by 5%.

Another feature of the competitive model is that industries cannot earn super-normal profits, or indeed earn sub-normal profits. Thus an industry cannot absorb a carbon charge in the form of lower profits. In the long term this would cause the industry to contract, but in the short term an industry may well absorb some costs provided revenue covers variable costs.

We examine this situation in Scenario 8, where three industries; Oil Refining, Non-Metallic Mineral Products (cement) and Basic Metals (steel and aluminium) are assumed to be able to absorb the price of carbon in the form of a lower rate of return. In effect we tell the model that in the BAU the risk premiums for these industries were too high and would fall under a carbon price – a somewhat ironic simulation methodology. Note with regard to Oil Refining only the carbon price related to refining is absorbed, not the entire incremental charge at the pump. This preserves competitiveness with imported refined product.

As shown in Table 3 the only macroeconomic impact is a slightly lower fall in GDP measured at world prices; 1.4% compared to 1.5% in Scenario 6. This comes about because the real exchange rate does not need to fall as much to maintain balance of payments equilibrium (although the difference is less than 0.05%), as competitiveness in three key industries is maintained by absorption of the carbon price. 6

As shown in Table 4, Oil Refining still incurs a substantial reduction in demand because of higher petrol and diesel prices faced by the consumer. Cement output still declines relative to BAU, but only by a third of the amount that occurs in Scenario 6. In contrast Basic Metals output rises above the BAU level. Quite a large proportion of its output is sold to other industries such as Fabricated Metal Products, which is more competitive in Scenario 9 (relative to BAU) because of the lower real exchange rate. Of course this effect occurs in Scenario 6 as well, but is swamped by the loss of competitiveness of Basic Metals.

The expansion of these emission-intensive industries relative to Scenario 6 means that the reduction in emissions in Scenario 8 is somewhat less than in Scenario 6; 12.6% compared to 13.2%. The better position of these industries comes partly at the expense of agriculture, emissions from which fall by fractionally more in Scenario 8.

Scenario 9

As in Scenario 6 with international trade prices reflecting international action to reduce GHG emissions.

The above scenarios are all based on the premise that countries that compete, or could potentially compete with New Zealand’s exports on world markets do not impose some form of significant carbon pricing. Similarly for countries that compete with New Zealand goods on the domestic market. This placed some New Zealand firms at a disadvantage.

In this scenario we set competitors’ prices for dairy products, meat products, base metals (aluminium and steel), oil products and cement to change by the same amount that the prices of goods from New Zealand industries change in Scenario 6. 7

While the prevention of a decline in international competitiveness might be expected to increase total exports, in fact they are unchanged from Scenario 6. Exports of dairy and meat products certainly show a marked improvement on Scenario 6, but other exporters such as forestry processors perform worse than in Scenario 2. Tourism exports (not shown) rise by 3.4% in Scenario 6, but fall by 0.6% in Scenario 9. As in Scenario 8 with a fixed supply of factor inputs, the improved position of some industries comes at the expense of others.

Of course there is still a macroeconomic gain due to the lift of 2.6% in the terms of trade. Private consumption falls by 1.4% compared to 2.2% in Scenario 6. Gross domestic product measured in world prices is almost back to the BAU level. The relative welfare gain would have been somewhat greater were it not for the higher emissions in Scenario 9, necessitating another $400m of emission rights to be bought on the international market.

5 This would represent a path that would have emissions at 50% of 1990 levels by 2025.

6 Price changes in Oil Refining, Non-Metallic Mineral Products (cement) and Basic Metals relative to BAU are -0.1%. 0.0% and 0.0% respectively.

7 To simplify the modelling, only sectors with particularly high emissions were included.

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