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5 How Emission Units are Allocated

This chapter focuses on how the Crown will allocate emission units into NZ ETS, including:

  • the context and rationale for providing assistance to firms through free allocation
  • sectoral considerations regarding to whom to give assistance, how much assistance to give, and for how long to give assistance
  • the government’s agreed allocation principles
  • the government’s in principle decisions on which sectors will receive free allocation when they enter the scheme, and at what level

5.1 Context

Each year the total number of emission units the government makes available must be allocated to the ETS market. The method used to make that allocation is an important factor in ensuring that the market works efficiently, that the cost burden of the ETS is shared fairly across the different parties (taxpayers, consumers, firms and industry sectors), and that the ETS is kept as administratively simple as possible.

The simplest method of allocation is to offer the units for sale by auction. However, if applied for all units from implementation, this would create a significant financial shock to those ETS participants that could not readily pass on the cost of those units to their customers. For this reason, free assistance (often in the form of free allocation)35 is typically provided to participants to make the adjustment to an emissions trading scheme.

The arguments for continuing free allocation beyond a transition period are less strong. Free allocation involves sometimes difficult value judgements (such as whether to gift units to new start-up businesses as well as to established businesses). In addition, auctioning units generates revenue for the government, which can then be used to offset taxpayer liabilities under international agreements, to support households in making the shift to lower-emission lifestyles or otherwise assist the economy. For these reasons, auctioning is generally the favoured long-term allocation method.

One of the key principles underlying the ETS is that emitters face the full cost of their emissions. When this is achieved, it creates incentives to identify the widest range of emission reductions and to undertake all emission reductions that can be achieved for less than the price of emission units. Firms face this full cost through the obligation to surrender units regardless of whether they buy them or receive a level of free allocation. Allocation methods can be used to reduce some of the impacts of the introduction of the ETS, without changing the fundamental incentives to limit emissions across all opportunities.

The box below presents the government’s rationale for providing some level of free allocation to firms under the NZ ETS as a transitional measure.

Box 4: Why provide assistance to firms?

It appears likely that New Zealand will be operating in a world that is more, rather than less, carbon-constrained in the future. In introducing an ETS, the government is seeking to develop a tool that fully integrates the cost of emissions into the cost-structures of the economy and thereby supports the transformation of the New Zealand economy so that it can operate effectively and efficiently in such a world. New Zealand firms need to prepare for a world in which activities that increase or reduce emissions have a direct financial consequence.

Most New Zealand firms will face some increased costs of production under an ETS due to facing higher energy and fuel prices or (for a smaller number of firms) being required to surrender NZUs to cover their emissions. Many will be able to pass a portion of these costs down the supply chain to their customers (thus providing a demand-side behavioural incentive to reduce emissions). However, some will not be able to pass the bulk of these costs on, resulting in profit impacts for shareholders and (potentially) some loss of competitiveness. The term “stranded assets” is sometimes used in this context.

A further reason for providing assistance to business relates to concepts of competitiveness-at-risk for trade-exposed firms. This relates to the possibility that firms may close or reduce New Zealand production due to the imposition of a price on emissions.

The government considers it unhelpful to frame discussion on assistance issues in terms of competitiveness-at-risk considerations, because the concepts are poorly defined and the impacts often overstated. There are many factors that influence firms’ profitability and competitiveness. Emissions pricing would be just one of them, and its impact would be difficult to distinguish from those factors that managers and shareholders must (currently) routinely address. (This issue was discussed at length in the Stern Review, see section 2.2.)

It is in New Zealand’s interests to ensure that our business environment encourages growth in areas of the economy that maximise New Zealand’s economic advantages and take into account the carbon footprint of specific activities. Having said this, the loss of production would be of concern for three reasons:

(1) The risk of ‘regrets’

There could be long-term regrets associated with firms closing or substantially reducing production levels.

A key situation in which regrets might arise is when the countries that New Zealand competes with have not yet joined the international regime, but are expected to join within the next decade or so. It is not likely to be in New Zealand’s interests to allow significant loss of production (and, in particular, significant loss of capacity) to occur as a result of competition with firms in such countries if New Zealand firms would be expected to be able to effectively compete with them once they have been brought under the international regime, and that is expected to occur relatively soon. In seeking engagement on this issue, the government wishes to focus particularly on this concept of avoiding long-term regrets, rather than on competitiveness-at-risk issues more generally.

(2) Concentrated job losses

Firm closures or reductions in production are likely to lead to job losses. Although current employment rates are high, and workers would be expected to find work again, the government is concerned about the possibility of significant job losses in some regions that may unduly disrupt regional economies or require significant numbers of people to move to find new jobs. This can have substantial adverse impacts on local communities, and the impacts will be greater than those associated with the same number of job losses distributed widely across the country.

(3) Reputational issues for New Zealand

The rapid introduction of an ETS that affects production costs for emissions-intensive plants can lead to significant reductions in the value of capital stocks, not anticipated at the time of investment. Other countries have sought to protect these values in the transition to an emissions trading regime, and a failure for New Zealand to follow suit could have an adverse impact on investment risk. There is an argument for protecting capital value, at least for some time.

(4) The issue of carbon leakage

One of the challenges from an international climate change viewpoint is the issue of carbon leakage36.

From an economic viewpoint, New Zealand’s climate change challenge is to maximise its economic performance within an ongoing carbon constraint. From an environmental viewpoint, the major way in which New Zealand can contribute to ameliorating the challenge that climate change poses is through encouraging effective international action, not through avoiding carbon leakage.

It is possible that some production that occurs in New Zealand will relocate to other countries as a result of the introduction of the ETS. Although some carbon leakage could result, this would be small from a global viewpoint. It can be argued that it would e unwise for New Zealand to attempt to address leakage concerns through ETS design as this would risk increasing the overall economic cost New Zealand faces to meet its international obligations but fail to secure any significant global environmental gain. Ultimately, the only effective solution to carbon leakage concerns is to improve the design of international agreements.

5.2 Allocation considerations

The primary decisions in designing any assistance package are to whom to give assistance, how much assistance to give, and for how long to give assistance. There is also an important decision to be made about the mechanism through which the assistance is provided. Each of these is addressed below.

5.2.1 To whom?

Different sectors have specific characteristics that determine whether free allocation of some units is justified. Electricity and liquid fossil fuels

Electricity generators and liquid fossil fuel providers are not likely to suffer major (negative) impacts on their profitability through the introduction of an ETS. They are likely to pass on any extra costs imposed by an ETS to consumers down the supply chain, regardless of the level of free allocation. Consequently, there is little justification for these sectors to receive any free allocation. Industrial production

In contrast, some participants in the industrial production sectors may not be able to pass on additional costs imposed by an ETS. Firms that have high emissions levels and that undertake emissions-intensive activities might argue that an ETS jeopardises their competitiveness. Nevertheless, the international literature suggests that competitiveness-at-risk concerns can often be exaggerated.37 There are a range of factors that influence whether firms relocate their operations, including:

  • the importance of location to market access

  • the role of sunk capital in location decisions

  • the role of a skilled and stable workforce in location decisions

  • loyalty to a country (or region).

Despite these reservations, it is likely that a number of emissions-intensive plants located in New Zealand have some vulnerability to an emissions price, and that this justifies some degree of free allocation. Forestry and agriculture

The government believes that for participants in the forestry sector (pre-1990 forests), the additional obligation imposed by an ETS may justify some form of free allocation. The government also believes that some level of free allocation may be appropriate for the agricultural sector. Here, free allocation would need to be directed as far as possible to farmers, who could be affected by the ETS through higher prices for fertiliser inputs, lower prices for outputs and reduced land values. Further detail on the government’s proposals for free allocation to individual sectors is addressed in the next chapter.

Box 5: Allocation decisions in the EU ETS

The European Union’s Emissions Trading Scheme (EU ETS) is the cornerstone of the EU’s strategy for addressing climate change. When the scheme started in 2005 it was the world’s first international trading system for CO2 emissions. It operates on an absolute-basis as opposed to an intensity-basis and covers over 10,000 installations in the energy and industrial sectors that are collectively responsible for close to half of Europe’s emissions of CO2.

Allocation decisions are made by member states (eg, the United Kingdom, Sweden and Italy) in the form of national allocation plans (NAPs) in line with criteria set by European framework legislation and subject to final approval by the European Commission. The NAPs set out the total quantity of European allowances (EUAs) in each member state for each period. The amount of allowances allocated must be consistent with each member state’s Kyoto target. These allocation plans also set out how allowances will be allocated to individual installations. In addition, the extent to which member states plan to purchase Kyoto emission units internationally and the amount of CERs and ERUs that operators can use for compliance purposes must be stated in the NAPs.

The EU ETS was set up to have a number of phases. Phase 1 is from 2005–2007; Phase 2 is from 2008–2012. The allocation process for Phase 1 has been widely acknowledged as being beset by problems such as significant over allocation by several member states (mainly due to poor data) and inconsistencies in treatment of sectors between states. To some extent it was the political intent that Phase 1 would be a learning phase. Nevertheless, the fact that the allocation decisions in Phase 1 allowed emissions from some of these sectors to rise during 2005–2007 has been widely criticised by environmental groups. Prices for EUAs were consequently very volatile in Phase 1 and are close to zero in 2007, the third and final year of Phase 1.

There has also been a lot of debate in the EU about the method of allocation. The EU ETS rules allow for predominantly free allocation (gifting) based on historical emissions, with a provision for member states to a sell up to 5 per cent of allowances in Phase 1 and up to 10 per cent in Phase 2. The initial phase of the EU ETS coincided with high energy prices and widespread public concern about windfall profits accruing to electricity utilities as a result of the free allocation of allowances. Note that the allocation rules do not compensate electricity users for electricity price increases.

National allocation plans for Phase 2 of the EU ETS are now being approved by the European Commission. In general, guidelines for the plans have tightened considerably to ensure greater consistency of treatment by member states and less generous allocation levels. The European Commission’s initial guidelines – ahead of the revelation of the significant over-allocation in Phase 1 – sought an overall downward adjustment of emission budgets by approximately 6 per cent compared with the Phase 1 cap.

Now that the majority of national allocation plans for Phase 2 have been assessed by the European Commission, it is estimated that the Phase 2 cap will be reduced by over 12 per cent compared with the Phase 1 cap and that EU ETS sectors will have to reduce their emissions by about 6.5 per cent compared with 2005 emission levels. Gradually, more member states are making use of auctioning.

Two member states with very high emissions levels, Germany and the United Kingdom, have decided to auction up to 8 per cent and 7 per cent, respectively, of the 10 per cent maximum allowed. Greater confidence by market participants in the allocation process and the tightening of allocation levels has led to a relatively stable forward (2008) price for EUAs to date, at approximately $NZ30.

An interesting contrast in the European context is the situation of Norway, which is not a member state. Effectively, Norway is adopting the broad set of EU ETS rules (ie, joining the EU ETS) with the exception of adopting the EU ETS rules that limit the proportion of allowances that can be auctioned.

The Norwegian Government settled on providing allowances equal to 30 per cent of emissions in an historical period (1998–2001 average) and providing no allowances to the oil industry. Relevant also is the Norwegian decision to base allocation on a relatively dated historical period (1998–2001), thus reducing the incentives for firms to position themselves for a relatively generous free allocation.

5.2.2 How much?

There is no easy way to determine how much assistance to provide. Having said this, the government does not propose to protect all firms from facing cost increases, or to protect the economy from the costs of meeting its Kyoto (and future international) obligations. There are financial constraints on the total level of assistance the government can provide under the NZ ETS. Any assistance paid for by government comes at an opportunity cost and implies less revenues available elsewhere in the economy.38

In order to maintain the effectiveness of the ETS, a significant number of firms must face the cost of their emissions at the margin. The levels of free allocation should minimise the extent to which the effectiveness of the ETS is undermined, and any broader economic distortions that result.

5.2.3 For how long?

Over time, it is preferable to move the level of free allocation towards zero. This would improve the overall economic efficiency (assuming effective revenue recycling) and administrative simplicity of the scheme, and it provides revenue that can be used for various purposes, including assisting consumers to respond to the impact of an emissions price.39 Moving towards zero free allocation also diminishes the inequities that can arise between sectors, and between individual firms within sectors (it is not possible to design an allocation approach that avoids all perceptions of inequities). The government’s intent is to remove all free allocation progressively between 2013 and 2025.40

An issue arises if there were to be a time-gap between successive international agreements during this timeframe. At this stage, the government’s preference is to continue the rate of decline (regardless of the lack of an international agreement). This would provide business with some certainty for planning purposes and recognise the importance of an adjustment to an economy that incorporates the full price of emissions.41

5.2.4 Firm entry and exit

The government also needs to make decisions on the treatment of firms that enter and exit the New Zealand market.

If firms are gifted units based on historical emission rates, new firms entering the market will not receive units. However, this is not as inequitable as it might appear. Incumbent producers will not receive any increase in allocation if they expand their output, and should not; to do so would subsidise output. This means that new entrants and incumbents will compete on an even footing when looking to grow production.

Potentially, high levels of gifted units create some level of bias against new entrants into a market. This is a complex issue. Assuming that both new and incumbent producers of a product have to fully fund increases in emissions, providing levels of free units does not provide a cash advantage to incumbents. However, there is a balance sheet benefit that is not available to new entrants. In the short run, it is possible that this effect could stifle innovation somewhat (ie, high levels of free allocation could delay more efficient technologies being employed).42 This is unlikely to be a long-lived effect, especially given the intent to reduce levels of free allocation over time.

For the ETS to be fully effective, it is desirable that firms considering entry and existing firms considering expansion take account of the full costs of their action, including the cost of their greenhouse gas emissions (GHG). The government’s initial preference therefore is that no emission units be given to firms entering the New Zealand market in order to ensure they are treated on an equal basis to existing firms looking to grow their levels of output.

The handling of the exit of firms can also be problematic. Firms are less likely to close if doing so will lead them to lose their eligibility to receive units.43 Economic efficiency suggests that stopping closure is undesirable as plant closure may be an efficient response; it may be the source of low-cost emission reductions. But plant closures can come at the risk of long-term regrets as noted above (there is an interaction between firm closure rules and the way in which assistance is provided – this is discussed below). On balance, the government’s preference is to stop assistance where firms cease operation in New Zealand.44

5.2.5 Through what mechanism – free allocation or progressive obligation?

The government has two broad options available for providing assistance to firms within the ETS. The first is to gift emission units to those firms expected to be most heavily affected by the introduction of the scheme. This option is referred to as “free allocation”. The number of units given to each firm could be determined, for example, with regard to their emissions in a recent year (such as 2005). To maintain strong incentives to reduce emissions, the level of units given to each firm over time would ideally not be adjusted to reflect changes in their emissions or output levels. The units that are gifted will have considerable value. The firms that receive them (which will not necessarily be those with an obligation to report emissions and surrender units) will be able to sell them, or if they have obligations, use them to help meet those obligations.

The second option is for the government to limit the extent of the obligation on firms to surrender units to cover their emissions. This option is referred to as a “progressive obligation”. Under this option, the obligation to surrender NZUs to cover emissions would initially be reduced. Instead of a full obligation to surrender one NZU for every tonne of emissions, businesses would initially only be required to surrender one unit for every, say, five tonnes of emissions. Over time, this obligation would be steadily increased to the full obligation. This progressive obligation approach would directly reduce the costs faced by firms.

There are clear trade-offs between the free allocation and progressive obligation approaches. A free allocation approach would:

  • provide a stronger economic signal to reduce emissions (both on the demand and supply sides) because firms are exposed to the full cost of emissions as soon as they enter the scheme

  • not be as vulnerable to policy changes in terms of incentives on firms to reduce emissions, given that the full cost signal is in place

  • more accurately provide support to firms for whom there may be regrets if closure were to occur

  • limit the fiscal exposure for government

However, a free allocation approach would:

  • be significantly more complex administratively

  • arguably, not deal with new entrants as well as a progressive obligation approach in terms of possible competitiveness risks

  • not lead to any assistance (within the ETS) being given to households or businesses that fail to meet whatever eligibility criteria are put in place

Under the progressive obligation approach the advantages and disadvantages are reversed. This approach is most suited to parts of the economy in which defining which firms to target is problematic, and where it is more important to influence long-term investment decisions than short-term decisions. If a progressive obligation were to be used, it would be most suitable in the stationary energy and industrial processes sectors. This is because there is relatively little growth in emissions forecast from stationary energy and industrial processes, and therefore signals to effectively influence long-term investment decisions are critical, while strong signals to reduce emissions in the short term are less important. This approach could also be an option to consider for the agricultural sector.

The strength of this price signal would also depend on the period over which the progressive obligation was set. For example, if a progressive obligation for stationary energy became a full obligation within three years, electricity prices could begin to adjust upward within a short timeframe. If the progressive obligation is applied over a period of 15 years (as the government is proposing if any progressive obligation is to be used), prices could adjust more gradually, but the reward to invest in low-emissions technologies would be less.

5.3 Allocation principles

As part of the long-term core design of the NZ ETS, the government has decided in principle that it will allocate NZUs into the market through a combination of sales (most likely auction) and free allocation (gifting). The government has also agreed in principle that the level and duration of free allocation will be considered against the following underlying principles.

i The government will attempt to maintain broad equity of treatment between and within sectors.

Decisions to give high levels of assistance to particular sectors are likely to come at the expense of reduced levels of generosity elsewhere. While an equitable sharing of the cost of the ETS will not always be straightforward to define, significantly inequitable treatment of particular firms or sectors would undermine the government’s broader objectives.

ii The government will seek to avoid long-term regrets in designing and implementing short-run policies.

The transformation of New Zealand to a lower-carbon economy will take a period of time. Short-term decisions that have the potential to undermine this longer-term objective should be avoided.

iii The government will make the transition more manageable by being relatively generous in the first commitment period (CP1), from 2008 to 2012.

The evolution of New Zealand to an increasingly low-carbon economy will take sustained effort. The long-term efficacy and sustainability of the ETS is therefore paramount. Relatively generous initial levels of assistance are recommended in recognition of the fact that businesses will need time to lower their emissions, and that relatively broad support will be needed to implement an effective and high-quality ETS.

iv The government will not provide assistance to firms whose profits will be largely unaffected by the introduction of an ETS.

Many firms, especially those selling their products and services domestically, will be able to pass on a significant portion of the costs they face under the ETS to their customers. The impact on the profits of these firms will be limited. Consequently, there is no strong reason for providing a level of assistance to them.

The practical effect of not providing assistance to firms whose profits will largely be unaffected is that there would be no free allocation provided to fossil fuel providers or to electricity generators. In these areas, it is anticipated that the costs associated with the purchase of emission units are likely to be passed through the supply chain to consumers regardless of any level of free allocation of emissions units.

v The government will favour assistance via gifting units (“free allocation”) as opposed to a progressive obligation, but will leave open the possibility of using a progressive obligation in some sectors.

The government has a general preference for using free allocation as the primary assistance tool as this preserves the signal to reduce emissions. Having said this, the use of a progressive obligation for the stationary energy and industrial process sectors, and also in the agriculture sector, is not ruled out and will be subject to the engagement process.

vi The government will move to zero assistance over time for overall economic efficiency, equity and administrative reasons.

The government has considerable flexibility in setting its post-2012 assistance policies. An ultimate move to zero assistance is clearly preferred for efficiency (assuming effective revenue recycling), equity and administrative reasons. Moving to zero levels of assistance also avoids the inequities that can arise between sectors that are, and are not, receiving assistance (eg, agriculture versus fisheries). Also, where the free allocation approach is used, inequities may arise within sectors between those firms that receive units because they were in operation before the scheme started, and those firms that entered the market afterwards.

The government has decided in principle to move toward a zero level of free allocation by 2025, with a linear rate of decline from 2013 to 2025. As this transition occurs, the government would expect to make emission units available to participants in a NZ ETS through regular auctions. This would provide revenue for government (that could be recycled elsewhere into the economy).

Further to this, a series of guiding statements have also been identified to assist decisions on allocation. These are that the government will:

i not pursue strategies for meeting New Zealand’s commitments in the first Kyoto commitment period (CP1) of 2008–2012 that will make it harder for the country to meet its obligations in future commitment periods

ii favour approaches that enhance economic efficiency

iii favour approaches that minimise administrative costs and complexities

iv not allocate more units that it has available in the long term.

In terms of transitioning to the inclusion of all sectors being included in the NZ ETS, subject to de minimus considerations, the following additional interim objective has been identified.

By the beginning of 2013, all major sectors of the New Zealand economy are exposed to the international price of emissions, at the margin of all operations.

This would be modified if a progressive obligation approach were to be used. Further to this, two guiding statements that cover timing of entry and assistance to business in the 2008–2012 first commitment period (CP1) are that the government will:

i leave open the option of purchasing units internationally (to meet the cost of emissions it remains responsible for or to fund levels of free allocation) so long as the overall fiscal impact of the ETS is kept broadly neutral

ii decide when to introduce sectors into a NZ ETS on the basis of technical readiness, and broader social and economic considerations.

5.3.1 In-principle decision on levels of assistance through free allocation

The government has made a number of in-principle decisions, based on the principles set out above as well as efficiency, equity, and administrative ease objectives, regarding the total level of free allocation of emission units as a form of assistance to business:45

  • in the forestry sector, free allocation will be provided such that the Crown assumes a total liability (taking the cost of the provision of the de minimus thresholds into account) for deforestation emissions as follows:

    • from 2008 to 2012, 21 Mt CO2-e for plantation forest, plus a relatively small allocation set aside for forest weed control (eg, wilding pines)
    • from 2013, an additional 34 Mt CO2-e for plantation forest
  • the agricultural sector will be provided with a free allocation pool equal to 90 per cent of 2005 emissions when it is brought into the ETS

  • the pool of units for eligible industrial producers will be based on 90 per cent of 2005 emissions from those eligible industrial producers

  • indirect emissions associated with the consumption of electricity, as well as direct emissions from stationary energy and direct emissions from non-energy industrial processes will be included in the concept of emissions from industrial producers46

  • starting from 2013, when agriculture is brought into the ETS, the free allocation pools for industrial producers and agriculture will decrease on a linear basis so as to phase out assistance completely in 202547

  • new sources that begin emitting during the period of the free allocation will not have any access to the pool of free allocations

  • firms that cease trading will not retain any free allocation

  • no free allocation will be provided to the upstream points of obligation in the liquid fossil fuel and stationary energy sectors, electricity generators, or landfill operators.

  • the agricultural sector will be provided with a free allocation pool equal to 90 per cent of 2005 emissions when it is brought into the ETS

  • the pool of units for eligible industrial producers will be based on 90 per cent of 2005 emissions from those eligible industrial producers

  • indirect emissions associated with the consumption of electricity, as well as direct emissions from stationary energy and direct emissions from non-energy industrial processes will be included in the concept of emissions from industrial producers46

  • starting from 2013, when agriculture is brought into the ETS, the free allocation pools for industrial producers and agriculture will decrease on a linear basis so as to phase out assistance completely in 202547

  • new sources that begin emitting during the period of the free allocation will not have any access to the pool of free allocations

  • firms that cease trading will not retain any free allocation

  • no free allocation will be provided to the upstream points of obligation in the liquid fossil fuel and stationary energy sectors, electricity generators, or landfill operators.

Box 6: How will the proposed assistance policies contribute to the government’s objectives?

As noted, the government’s assistance policies are motivated by a desire to spread the costs of the ETS equitably, as well as:

  • avoiding significant reductions in output, or firm closure, that lead to economic ‘regrets’

  • avoiding particularly large or concentrated job losses

  • avoiding damage to New Zealand’s reputation as a good place to do business.

This text box explains how the free allocation of NZUs will help to achieve these objectives.

Economic theory suggests that the free allocation of emission units (as opposed to auctioning) will typically not affect firms’ decisions on levels of production. This is because even where NZUs are gifted to firms, they will have considerable value, and as a result, firms that receive NZUs for free would still be expected to take the cost of emissions into account, and to sell their NZUs and reduce output where that is the more profitable option.48

On the surface, this would appear to suggest that the free allocation of units may be no better than auctioning at achieving the government’s objectives around avoiding economic regrets and large or concentrated job losses. The incentives would be the same under either approach.

However, the government considers that important elements in the design of its allocation proposals mean that its assistance package, while not perfect, will be effective at helping to prevent these outcomes. For example, the intention to stop any free allocation to firms that cease production altogether is particularly important. Firms will be discouraged from stopping production under the proposed package, because doing so would cause them to lose their eligibility to participate in future NZU free allocation rounds.

It should also be noted that disputes exist over how consistent the behaviour of firms is with economic theory on the impact of free allocation. Emerging evidence from the EU ETS suggests that the level of free allocation does have an effect on the levels on production decisions of firms.49 However, the issues are complex and firms respond both to the impact on production costs (the cost of producing another unit of output which includes an emissions price) and profits (specifically the change in access to or cost of capital in the form of retained earnings or access to debt and equity, and this will differ between free allocation and allocation via sales). There may also be a timing and awareness issue involved in this particular case.

Lastly, the government’s analysis of different options for providing assistance to firms concluded that they also involve difficulties.50 The two major alternatives to free allocation – an “intensity-based” approach to obligations and targeted exemptions – require a move away from a finite quantitative target for emissions (see section 4.5.2 for more information on an intensity-based approach).

Indications are that New Zealand will be operating in a world that is more, rather than less, carbon-constrained in the future even though the exact manner in which international agreements will reflect that carbon constraint is not known. Given this, it is the government’s intention to transition the New Zealand economy to a point where emissions are taken into account, alongside other factors such as labour costs, in production decisions. Allowing growth in emissions to occur that does not factor in the cost of emissions is inconsistent with this approach.

At a more practical level, any move away from an approach that provides an effective overall control over emissions would need to be tightly targeted in order to avoid undermining the effectiveness of the scheme as a whole. Robust, objective approaches for determining to whom to target this assistance are very difficult to develop. As a result, there is a risk that these alternative approaches could lead to boundary issues, with pressures to increase the numbers of firms or sectors receiving special treatment over time.51

Once firms are operating under an intensity-based approach – or if firms have an exemption from the ETS entirely – it is also likely to prove difficult to successfully transfer them back to the wider, absolute approach. Depending on the exact nature of the policy arrangement, firms would either have an incentive to grow their emissions in order to receive a higher level of free allocation when they entered the wider, absolute approach, or would face a substantial shift downwards in their level of obligation when they entered the wider, absolute approach.

5.3.8 Inter- and intra-sectoral equity considerations for providing assistance

Considerations of inter- and intra-sector equity have been prominent in the assessment of different models for providing assistance to different sectors of the economy. (Within sector assistance issues are discussed in further detail in the next chapter.)

In terms of inter-sector equity, government has agreed in principle that the same approach should be used to calculate the total level of assistance that is provided to eligible firms in the industrial sector and agriculture (ie, 90 per cent of 2005 emission levels) when they enter the ETS.

Assessing a comparable level of assistance to provide for deforestation is complicated because deforestation emissions are different in nature from agricultural or industrial emissions. The historical average deforestation rate for the 10 years prior to the announcement of the deforestation cap is estimated to have been between 1.9 per cent and 3.8 per cent of the harvested area.

An allocation for deforestation to landowners of 55 million units represents a deforestation rate of slightly over 5 per cent of all pre-1990 exotic forests. As such, an allocation of 55 million units is regarded as generous.

Discussions with European officials have suggested that intra-sector equity can be as important as inter-sector equity. This document has outlined a possible approach to be used to determine assistance at a firm level within the industrial sector that operates within the total envelope of assistance outlined above.52

Options for intra-sectoral allocation within the agricultural sector are in the early stages of development, as there are many issues to work through prior to determining the appropriate model for distributing any assistance provided to the agricultural sector.

There are various levels of argument within this space. For example, different agricultural sub-sectors (eg, dairy vis-à-vis sheep) have grown at different rates since 1990. A question that may well arise is around the extent to which differential growth rates in emissions should be reflected in the distribution of assistance within these sub-sectors. Further, it is important not to lose sight of interactions with other policy goals such as maintaining competitive markets for product supply.

None of these approaches is perfect and there are many different lenses with which to view inter- and intra-sectoral equity issues. It is simply not possible to develop an assistance policy that is viewed as totally “equitable” by all parties.

As an example, while it is proposed that eligible industrial producers be provided with assistance to mitigate electricity price increases (which is not the case in the EU ETS), the government does not propose to provide any assistance for increases in the cost of liquid fossil fuels. Although the price increases for liquid fossil fuels are likely to be less than half that of wholesale electricity on a percentage basis, there are some firms that are more exposed to increases in the price of liquid fossil fuels than others. Such firms may therefore argue that the current design of the assistance package is ‘inequitable’.

5.4 Summary

Allocation of units within the NZ ETS will be an important area for stakeholder engagement. These discussions will need to find a balance between the competing objectives of efficiency, equity and administrative ease. It is a complex area of design and all approaches have weaknesses.

The allocation package set out in this section has the advantage of being relatively simple at the high level53. It has a strong focus on inter-sector equity and is generous (for firms that cannot pass through costs) at first, both for equity reasons and to reduce the chance of long-term regrets. While generous at first, it ensures that some contribution is made by all sectors reflecting the importance of equity between producers and consumers.

A key element of the allocation package is to put in place robust price signals to reduce emissions. For that reason, over time the government will ensure a (well-signalled) phase-out of free allocation in the interests of economic efficiency and administrative ease.

35 Two forms of assistance are identified in this section of the paper – through the provision of free allocation or through a progressive obligation. Unless specified otherwise, this section of the paper is drafted assuming that assistance is provided in the form of free allocation.

36  Leakage arguments relate to the possibility that a reduction in New Zealand’s (say) agricultural production may be offset by higher production in other countries where agricultural gases do not incur any emission charge. In this case, it is possible that total global agricultural greenhouse gas emissions would not change.

37 There is a significant body of literature in this are, although this tends to be focused on the industrial sector. One source, the Stern Review (Stern Review, The Economics of Climate Change) noted that “the empirical evidence on trade and location decisions, however, suggests that only a small number of the worst affected sectors have internationally mobile plant and processes”.

38 There are also equity considerations between consumers and producers that are relevant. In particular, consumers have no ability to pass on costs so, from an equity viewpoint, it can be argued that producers should bear some costs, even if these cannot be passed on.

39 International evidence suggests that as long as these increased auction revenues are used effectively, the full phasing out of all assistance can provide considerable economic benefit. OECD Information Paper COM/ENV/EPOC/IEA/SLT(2002)5. Towards International Emissions Trading: Design Implications for Linkages.

40 Note that some levels of free allocation could be maintained indefinitely without seriously undermining the efficacy of an ETS.

41 Such an approach would also be consistent with a one-off approach to allocation.

42 This is only an issue where new entrants are competing with New Zealand firms in a market with limited demand. Free allocation to existing firms does not change the fundamental economics of entry, which are based on costs of production, including an emissions price, versus the value of output.

43 In some trading schemes, free allocation is maintained after firm exit in order to avoid dis-incentivising plant closure, as that can be part of the least-cost response.

44 One potential problem with stopping assistance on firm closure is that firms, especially in the industrial sector, may continue to operate a plant at a low level in order to continue to receive units. It is unclear how significant this possibility is. In many cases, industrial processes cannot easily be substantially scaled down from existing levels and remain in operation.

45 Discussion of allocation of this assistance within sectors is covered in the next chapter.

46 The basis for allocation for electricity consumption will be one that compensates firms for the cost impact. It therefore needs to be based on the emissions from marginal generation rather than average generation.

47 For industry, this would mean receiving the same level of assistance in the years 2010, 2011, 2012 and 2013. Following this, the level of assistance provided would decline every year. The planned review of the ETS provides an opportunity to adjust this decision somewhat once the “shape” of future international agreements becomes clear.

46 The basis for allocation for electricity consumption will be one that compensates firms for the cost impact. It therefore needs to be based on the emissions from marginal generation rather than average generation.

47 For industry, this would mean receiving the same level of assistance in the years 2010, 2011, 2012 and 2013. Following this, the level of assistance provided would decline every year. The planned review of the ETS provides an opportunity to adjust this decision somewhat once the “shape” of future international agreements becomes clear.

48  There is an opportunity cost associated with surrendering an allowance. If a plant had not produced the extra unit of output, it could have sold the allowance.

49 The Carbon Trust argued that firms “having secured compliance without taking any action, they have had no need to think about opportunities for abatement”. Allocation and Competitiveness in the EU Emissions Trading Scheme, Options for Phase II and beyond, Carbon Trust, June 2006.

50 Options to address risks around regrets exist outside ETS design. The two most commonly discussed, often in a European context, are the possibility of border tax adjustments, or the possibility of sectoral agreement for particular industries. This paper does not discuss these other than to note the existence of these possible approaches.

51 It may also require a revisiting of rules around firm entry – from an equity viewpoint.

52 The government will be engaging with the Negotiated Greenhouse Agreement firms on allocation issues.

53  Although more complex options for determining total allocation levels are available, it is not clear that the benefits of more sophisticated approaches outweigh the costs.