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Summary

This report draws together the results of general equilibrium modelling undertaken for the Emissions Trading Group since October 2007, previously described in a number of separate papers. The main conclusions from the research are as follows:

  1. Projections of New Zealand’s emissions during the first Commitment Period (CP1) imply that emission units will need to be purchased from offshore to cover about 9Mt of CO2e per annum. At a price of say $25/tonne the implied annual cost is about $225m. Gross domestic product in 2012 is projected to exceed $200 billion, so the impact effect is around 0.1%.

  2. At a carbon price of around $25/tonne there is no significant difference in terms of the impact on the standard of living, between the government purchasing all required emission units from offshore (financed by higher income taxes) without any domestic carbon price, or having an explicit carbon price as part of an emissions trading scheme (ETS). This applies even if major emitters that are exposed to international competition receive some free allocation and if agricultural emissions are exempt.

  3. However, the higher the carbon price the greater the cost of free allocation in terms of both efficient emissions reduction and other uses of permit revenue such as income tax reductions.

  4. By 2025, with a likely higher carbon price and a tighter international emissions obligation, the welfare cost will probably be an order of magnitude greater than during CP1. A range of scenarios suggests that the loss in private consumption in 2025 will be 1-4%, relative to ‘Business as Usual’ (BAU). However, by 2025 consumption per capita is projected to be nearly $13,000 higher than in 2005. In other words we will be slightly worse off relative to BAU, but New Zealand is still wealthier compared to 2005 in all scenarios.

  5. The ETS does not cause the loss in economic welfare. Rather it is a way of addressing the cost of the Kyoto and future international commitments. By 2025, with a higher carbon price, the ETS is a more efficient way of doing this than having no domestic carbon price and the government purchasing from offshore whatever quantity of emissions rights are required, paid for by higher income taxes. Higher energy prices and lower taxes are better than higher taxes.

  6. Important unknowns beyond CP1 are:
    • the size of New Zealand’s international allocation
    • the carbon price
    • whether major trading competitors participate.
  7. Technological change induced by a carbon price is important. Based on two plausible technologies for the reduction of methane and nitrous oxides in agriculture, every 5 Mt of emission units that do not have to be purchased offshore reduces the loss in private consumption by approximately 10%.

  8. Most industries that are projected to have lower output under the ETS than under BAU are nonetheless still likely to grow between now and 2025. Examples are oil refining, electricity production, meat processing and dairy processing. The main exception to this is probably sheep farming.

  9. During the transition to a carbon price and without allowing for any mitigating effects of free allocation, around 50,000 FTE jobs could be at short term risk as part of the one-off economic adjustment cost. This number is small in relation to annual job turnover and in relation to the job losses that occurred during the period of tariff reform in the late 1980s and 1990s.

  10. While in proportionate terms the biggest short term impacts occur in industries such as coal mining, oil and base metals, the largest absolute effects are in wholesale and retail trade, construction and business services. Welfare losses are caused less by diminished activity in carbon intensive industries, than by resources being moved out of private consumption and into exports.

Two conclusions from another Infometrics report are also worth mentioning:

  1. The more stringent the environmental target (especially if this is higher than our international obligation), the less likely we are to achieve high economic growth rates.

  2. Regulations and other measures outside the ETS have the potential to generate large welfare losses because of inconsistent abatement pricing and confusing price signals. The case for non-ETS measures needs to be based on clear demonstration of market failure.

The modelling implicitly assumes that any action or inaction by New Zealand has no effect on how the rest of the world treats New Zealand. For the BAU in particular this may not be a valid counterfactual. For example the EU could impose duties on our exports to Europe if it is perceived that New Zealand is not making an effort to reduce emissions.

A general equilibrium model takes into account the main inter-dependencies in the economy, such as flows of goods from one industry to another and the passing on of changes in costs in one industry into prices and hence the costs of other industries. It is not a macroeconomic forecasting model. For this reason in all scenarios the total amount of employment and investment in the economy is held constant, with pressure in labour and capital markets being absorbed in the prices of these inputs. This ensures that the economy-wide effects of different policies can be attributed to changes in allocative efficiency and changes in international competitiveness, not to changes in the volume of factor inputs.

It is also assumed that New Zealand cannot pay for offshore emission units by borrowing; that is by running a larger current account deficit.

Part 1 of the paper describes the methodology. Part 2 explores a number of policy scenarios for CP1, while Part 3 examines scenarios in 2025. The two main differences between these periods are the amount of emissions to which New Zealand is likely to be entitled, and the exclusion/inclusion of methane and nitrous oxide emissions in an emissions trading scheme. Part 4 looks briefly at the issue of transition or adjustment costs.