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3 The Rationale for Emissions Trading

This chapter covers:

  • why price-based measures can play an important role in reducing New Zealand’s greenhouse gas emissions
  • a general explanation of emissions trading and how it fosters least-cost emission reduction activities
  • the comparative merits of emissions trading and emissions taxes as price-based measures.

As noted above, the government has already developed a range of initiatives to bring about reductions in New Zealand’s emissions relative to the business-as-usual projections. However, significant progress is not likely until our economic system reflects the costs of emissions. It is important that we add a broad price-based measure to the current set of measures to help shape long-term investment decisions that affect our emissions. The question then is what form of price-based measure is most likely to be effective in:

  • bringing about a reduction in our greenhouse gas emissions

  • providing firms with flexibility as to how they manage their emissions obligations

  • supporting our international stance on climate change

  • avoiding harm to our economy during the transition period.

To answer this question it is important first to remind ourselves of what we need a price-based measure to achieve.

3.1 The role of price-based measures in reducing emissions

Under the Kyoto Protocol, starting from January 2008 New Zealand will become liable for the emissions above its quota. As noted, some major sources of emissions are being targeted by other types of intervention. However, the most effective way of influencing a wide range of firms and consumers is via a price-based measure. An effective price-based measure should:

  • redirect resources by creating new market incentives to reduce emissions at least cost, wherever those reductions can be found across the spectrum of economic activity

  • improve the financial return on good environmental practices

  • motivate emitters to invest in their own operations, improve their efficiency and reduce their own emissions as much as possible before looking elsewhere for emission reductions.

There is a risk that a poorly designed price-based measure may have the effect merely of engineering wealth transfers from emitters to taxpayers, from taxpayers to emitters, or from New Zealand to other countries. For that reason it is important to identify the option that can best drive behavioural change across the economy without imposing complex compliance costs or encouraging avoidance behaviour.

3.2 Options for price-based measures: emissions tax or emissions trading?

There are essentially two options for a price-based measure: an emissions tax or an emissions trading scheme. They share a number of fundamental design features:

  • both need to determine “points of obligation”; that is, who is required to pay the tax or to surrender tradable emission units

  • both require systems for measuring, monitoring and verifying emissions levels.

However, they also differ in key respects that have policy significance.

3.2.1 What is emissions trading?

The most common form of emissions trading is the “cap and trade” model. A cap is placed on emissions within the scheme by requiring all emissions to be reported and matched by a tradable emission unit, whose supply is limited. International agreements or national governments determine how many emission units are allocated into the market. Participants that emit greenhouse gases (or supply products that create emissions when used by consumers) either receive the emission units free or purchase them (often via an auction). If their emissions overshoot their allocation of units, they must purchase units from other participants. If they have spare units because they reduce their emissions below their allocation of units, they can sell those to other participants. This is the trading activity.

The Kyoto Protocol is itself built around an ETS, with participating countries having allocations of units (based on their base-year emissions, such as 1990) and being obliged to stay within that allocation or purchase units from other countries.

In an ETS the market sets the price on emission units. This price is passed down the supply chain and flows through the economy, creating an incentive for producers to reduce their emissions and for consumers to reduce their demand for emission-intensive products. For example, the price signal could encourage a business or a homeowner to invest in energy-efficient technology, prompt a landowner to plant trees, or encourage a dairy farmer to capture methane from dairy effluent or make more efficient use of fertiliser.

An effective ETS in the New Zealand context would ideally have the following key characteristics:

  • comprehensiveness: coverage of all major emitting sectors and greenhouse gases over time to promote equity and economic efficiency (this is particularly important in the context of New Zealand’s emissions profile)

  • tradability: international linkages to ensure a liquid market, and to provide a ceiling on the cost of meeting our obligations by enabling New Zealand firms to take advantage of more cost-effective emission reduction opportunities in other countries (rather than requiring all emission units surrendered to relate to reductions that occur domestically)

  • assurance: a high degree of credibility through high standards of monitoring, reporting and verification

  • compliance: a credible penalty regime for non-compliance, including financial penalties, together with make-good provisions that ensure environmental integrity

  • flexibility: adaptability to future changes to New Zealand’s obligations under the international climate change policy framework post-2012.

Maintaining a diverse and plentiful supply of emission reduction opportunities will help to ensure least-cost pricing of emission units in the market. The ETS will also require durable commitment and active engagement by major emitters, the general public, policy makers and political leaders.

3.2.2 How is emissions trading different from an emissions tax?

There are many conceptual and practical similarities between a greenhouse gas emissions trading scheme and a greenhouse gas emissions tax. Both are price-based measures that apply to specified activities that lead to greenhouse gas emissions. Both work by creating financial incentives for individual firms and consumers to reduce emissions. Both provide flexibility by allowing parties that can reduce their emissions more cost effectively to do so more heavily than those that face higher costs. Lastly, both require similar administrative and legislative powers and procedures.

The key conceptual difference between an emissions trading scheme and an emissions tax is that:

  • a tax sets the price emitters have to pay per unit of emissions, and leaves individuals and firms to decide how much to reduce their emissions

  • a trading scheme sets the quantity of emissions, and leaves the market to determine the price of emission units, and therefore the cost per unit of emissions that firms and individuals will face.

In assessing the relative merits of the two types of scheme, the key factors to be taken into account are:

  • the way that uncertainty around key variables within the system affects firms, consumers and the government

  • their ability to fit with the approach taken by other countries and international agreements

  • the ease with which more stringent emissions-reduction targets can be implemented over time

  • the general flexibility created by the measure, both for emitters and for government

  • their acceptability to New Zealand stakeholders and Māori. Uncertainty

In a world where the government knew exactly how firms’ emissions would respond to changes in the price of emissions, the two approaches would lead to identical outcomes. The government could stipulate the overall level of emissions it wanted to occur through the introduction of an ETS, or set an emissions tax at the level that it knew would lead to that desired level of emissions.

In practice, of course, no one knows exactly how a country’s emissions will respond to changes in the price of emissions. Under a tax, there would be uncertainty over the level of emissions that would result in any one year or commitment period. Conversely, an ETS would provide more certainty over the environmental outcome at a global level, but there would be uncertainty over the price of emissions, especially during the initial period when the trading system and the international agreements on emissions levels are evolving. Compatibility with international mechanisms

In the short term, the approach taken in New Zealand needs to be firmly driven by the nature of our international obligations. Any price-based domestic policy measure that does not reflect international emissions prices will result in the government - and ultimately taxpayers - facing the liabilities associated with changes in emission levels and international prices. This is a key advantage of emissions trading schemes (cap and trade, in particular), and is a major reason why, internationally, such schemes are becoming the norm as a primary policy tool to address greenhouse gas emissions.18

Automatic adjustment to the international price is a key reason why the government currently supports the use of an ETS. A tax would provide greater emissions price certainty to emitters, at least in the short term, but it would subject the government and taxpayers to potentially very large fiscal costs if the tax was set too low. Similarly, if the tax was set too high, the economy would face increased costs from having to adjust more quickly than necessary.

Generally, the government sees considerable strategic and economic benefit in taking the same broad approach to reducing emissions as our key trading partners. A New Zealand emissions tax scheme, for example, could not easily be linked with the emissions trading schemes put in place by other countries. In addition, an ETS could create new business opportunities for New Zealand, such as the development of trading infrastructure and new mechanisms for engaging with foreign markets, as well as more generally building New Zealand’s branding as an environmentally responsible nation. Flexibility

An ETS also allows greater flexibility than a tax in a number of ways.

  • Prices adjust automatically in an ETS as international emission prices adjust, whereas tax-based systems tend to be “sticky” in that they can only be increased by an explicit government decision. As noted above, there is also a risk under a tax-based system that the price of emissions in New Zealand would not reflect the international price of emissions, which would increase the cost New Zealand incurs to meet its international obligations.

  • An ETS enables emitters to choose between investing in their own operations and investing in emission reductions elsewhere within New Zealand and internationally.

  • An ETS enables emitters more flexibility in managing credits and liabilities over time (this is particularly important in terms of forest sink credits and liabilities where participants’ strategies for management of future liabilities when forests are harvested will be important).

  • An ETS promotes more equitable access to least-cost emission-reduction opportunities across sectors.

  • An ETS offers design options for addressing equity issues; for example, by adjusting the transitional assistance targeted to each sector according to its circumstances.

  • An ETS provides more flexibility to adapt to changing international and domestic circumstances. Public acceptability

Lastly, consultative feedback from the recent climate change and energy consultation process demonstrated wide - although not universal - support for the introduction of an ETS as the primary means of managing New Zealand’s greenhouse gas emissions responsibilities. From December 2006 through March 2007 the government consulted broadly on a series of climate change and energy policy proposals contained in five discussion papers.19 These included design options for price-based measures to reduce emissions in different sectors. Consultation showed a high level of public, stakeholder and Māori interest in emissions trading, particularly as a long-term instrument for reducing emissions. Conclusion

On the basis of a careful assessment of these factors, and the consultation with stakeholders and Māori on the suite of discussion documents issued in late 2006, the government has concluded that it is in the national interest to implement a broad-based emissions trading scheme as the preferred instrument for emissions pricing.

It is worth noting that if in future there were to be an international shift away from emissions trading schemes, and the New Zealand scheme were to become anomalous, the administrative systems being put in place as part of the NZ ETS could be relatively easily transformed into a tax-based system at a later date.

18 This is evidenced by the Kyoto Protocol, the European Union Emissions Trading Scheme and emissions trading proposals in Australia and in some US states. Emissions trading is also identified as an important tool post-2012 in international discussions.

19 The consultation process included approximately 50 public or multi-sector meetings, workshops and hui, and approximately 100 focused stakeholder meetings. The consultation events took place throughout the country, with over 4,000 people attending. Over 3,000 written submissions were received.