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3. Beyond Kyoto CP1 - 2025

Following the procedure for 2011/12, we prepare a BAU scenario for 2024/25 which acts as a benchmark against which other scenarios can be compared. The same macroeconomic closure rules are adopted. We continue with the previous scenario numbering.

  • Scenario 4 – Replication of Scenario 1 extended to 2025.

  • Scenario 5 – Analogous to Scenario 2, but with methane and nitrous oxides emissions included. No free allocation. (Emissions of methane and nitrous oxide are treated as process emissions, implying that without technological advances, reductions in output are the only way to reduce such emissions. See Scenarios 13 and 14 in this regard.)

  • Scenario 6 – As in Scenario 5 with the carbon price at $100/tonne.

Five sensitivity tests on Scenario 6 are then examined in Section 3.2:

  • Scenario 7 – As in Scenario 6 with a lower international allowance with regard to New Zealand’s emissions.

  • Scenario 8 – As in Scenario 6 with a absorption of the carbon price by emissions intensive exporters.

  • Scenario 9 – As in Scenario 6 with international trade prices reflecting international action to reduce GH emissions.

  • Scenario 135 –as in Scenario 6 with reductions in methane emissions of 10% in dairy, beef and sheep farming, brought about by, for example, breeding for lower emissions.

  • Scenario 14 – as in Scenario 6 with reductions in nitrous oxide emissions of 11% in dairy farming, and 2% in sheep and beef farming, brought about by, for example, the use of nitrogen inhibitors.

3.1 Core Scenarios to 2025

Scenario 4

Government purchases emissions units from offshore, financed by higher personal income tax. The amount involved is $1540m per annum (emissions of 111.6 Mt CO2e less an assumed 50 Mt of international allowances6, at $25/tonne).

Table 3 shows the results. Not surprisingly, with the greater flow of funds offshore the fall in private consumption is much larger than in Scenario 1; 1% compared to 0.2%. The adjustment on the current account is primarily on the export side; exports increase by 1.3% and imports decline by 0.6%, following a 0.8% decline in the real exchange rate to boost competitiveness. The terms of trade fall by 0.6%.

Emissions increase slightly (0.3%) on BAU because of the expansion in exporting industries, which tend to be more carbon intensive than those that sell predominantly to households.

Scenario 5

Uniform carbon charge of $25/tonne on all emissions including methane and nitrous oxide. No free allocation or other concessions.

The carbon price reduces CO2e emissions by 4.0% or 4.7 Mt, comprising a 5.3% fall in CO2 emissions and a 3.0% fall in CH4 and N20 emissions. Thus the cost of units to be bought offshore is lower at about $1400m.

Private consumption declines by 0.7%, notably less than the fall observed in Scenario 4. This outcome contrasts with the 2012 scenarios (Scenarios 1 and 2) where the imposition of a carbon price does not alleviate the reduction in private consumption, although it does affect international purchasing power.

The difference in Scenario 5 of course, is that the carbon price is more widely applied, generating more revenue for government and thus lowering the pressure on income taxes. Indeed incomes tax rates decline by 2.3%. That this does not moderate the fall in private consumption even more is because of the reduction in real wage rates (0.7%) following the rise in prices caused by the carbon price.

Scenario 6

As in Scenario 6 with a carbon price of $100/tonne.

At a price of $100/tonne the cost of purchasing emission permits on the world market is approximately $4700m per annum. It would be considerably more were it not for the larger reduction in emissions, which fall by 13%.

Real private consumption falls by 2.2%, in spite of a significant income tax reduction. At current prices, but allowing for the projected growth in real income between now and 2025, this corresponds to about $800 per person in 2025. The absolute increase in private consumption per capita over the period is projected to be about $12,100, in comparison to the BAU absolute increment of $12,900. In terms of growth rates the figures are 2.4% pa in the BAU and 2.3% pa in Scenario 6. This is shown in the graph below.

Table 3: Macroeconomic Results

 

BAU

Scenario 4

Govt responsible for all emissions.

50 Mt International allowance

Scenario 5

ETS $25/tonne. No free allocation.

50 Mt International allowance

Scenario 6

ETS $100/tonne. No free allocation.

50 Mt International allowance

Scenario 7

As in 6 with 30 Mt International allowance

Scenario 8

As in 6 with lower profit

Scenario 9

As in 6 with higher world prices

Emission units required to be purchased off shore (p.a)

 

61.6Mt

57.0Mt

46.9Mt

66.8Mt

47.6Mt

50.9Mt

Private Consumption

 

-1.0%

-0.7%

-2.2%

-3.5%

-2.2%

-1.4%

Exports

 

1.3%

0.1%

0.1%

1.8%

0.1%

0.1%

Imports

 

-0.6%

-0.8%

-2.8%

-3.5%

-2.8%

-1.7%

GDP in world prices

 

-0.7%

-0.4%

-1.5%

-2.3%

-1.4%

-0.1%

Real wage rate

 

0.2%

-0.7%

-2.7%

-2.4%

-2.6%

-2.5%

Mean household tax rate

 

3.7%

-2.3%

-9.6%

-4.7%

-9.3%

-10.5%

Real exchange rate

 

-0.8%

-0.4%

-1.3%

-2.3%

-1.3%

0.1%

Terms of Trade

 

-0.6%

0.3%

1.3%

0.5%

1.3%

2.6%

CO2 emissions (Gg)

52368

0.2%

-5.3%

-16.4%

-16.3%

-14.6%

-15.4%

Agriculture CH4 & N2O

63513

0.4%

-3.0%

-10.9%

-10.5%

-11.0%

-5.2%

 

115881

0.3%

-4.0%

-13.4%

-13.1%

-12.6%

-9.8%

International transport

4299

1.6%

-5.5%

-18.1%

-16.4%

-13.5%

-16.0%

Emissions by NZ

111582

0.3%

-4.0%

-13.2%

-13.0%

-12.6%

-9.6%

Table 4: Gross Output

Gross Output

BAU

Scenario 4

Govt responsible for all emissions.

50 Mt International allowance

Scenario 5

ETS $25/tonne. No free allocation.

50 Mt International allowance

Scenario 6

ETS $100/tonne. No free allocation.

50 Mt International allowance

Scenario 7

As in 6 with 30 Mt International allowance

Scenario 8

As in 6 with lower profit

Scenario 9

As in 6 with higher world prices

Meat processing

 

0.6%

-3.9%

-14.1%

-13.6%

-14.2%

-4.9%

Dairy processing

 

0.4%

-2.2%

-8.4%

-8.0%

-8.5%

-2.6%

Wood processing

 

0.9%

0.8%

2.6%

3.8%

2.5%

0.6%

Pulp and paper products

 

1.0%

0.7%

2.4%

3.8%

2.2%

0.0%

Oil refining and products

 

-0.4%

-3.6%

-11.7%

-12.1%

-10.5%

-11.3%

Chemicals - industrial

 

0.8%

-0.2%

-1.1%

-0.1%

-1.2%

-2.1%

Non-metallic mineral prod.

 

0.3%

-0.6%

-2.4%

-1.9%

-0.7%

-1.9%

Basic metals

 

1.4%

-1.8%

-7.5%

-5.7%

1.8%

-4.7%

Electricity generation

 

-0.2%

-2.8%

-9.4%

-9.4%

-8.9%

-9.0%

Although the real exchange rate declines, it is not enough to counter the effect of the carbon price on export competitiveness. Hence the adjustment in the external balance is once again dominated by a reduction in imports.

With the carbon price extended to agricultural methane and nitrous oxide emissions, Meat Processing and Dairy Processing both see substantial falls in output relative to BAU. Relative to 2006/07 though, the reductions in implied growth rates are about 0.8% and 0.5% per annum respectively. See Table 4.

Oil Refining output falls by 11.7% as the carbon price now applies to both oil combustion and to emissions released from refining itself. Similarly, with no free allocation Basic Metals output also declines. In contrast the Wood Processing and Pulp & Paper industries see an increase in output. For these industries, which are not particularly emissions intensive in comparison to say Dairy Processing and Basic Metals, the reduction in the real exchange rate outweighs the cost impact of the carbon price. Although not shown in the table, other industries that benefit from a carbon price, in the sense that their gross output is higher than under BAU are Fabricated Metal Products, Machinery & Appliances, Other Manufacturing, and non-traded industries such as Education.

3.2 Sensitivity Tests to 2025

Scenario 7

As in Scenario 6 with an international allowance of 30 Mt7 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.8

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. 9

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.

Scenarios 13 and 14

  • Scenario 13as in Scenario 6 with reductions in methane emissions of 10% in dairy, beef and sheep farming, brought about by, for example, breeding for lower emissions.
  • Scenario 14as in Scenario 6 with reductions in nitrous oxide emissions of 11% in dairy farming, and 2% in sheep and beef farming, brought about by, for example, the use of nitrogen inhibitors.

As mentioned previously, while the model incorporates technological change, it does not respond to the carbon price. We simply do not know enough about how technology might develop in response to a carbon price to be able to specify a robust empirical relationship in the model. We can, however, analyse the effects of some specific estimates about such a relationship. In Scenarios 13 and 14 we explore the effects of two different types of technological change that could lower emissions of methane and nitrous oxides in farming, based on what the Ministry of Agriculture and Forestry consider to be plausible under a carbon price of $100 (or less) per tonne of CO2.

The results are shown in Table 5.

Table 5: Scenarios 13 and 14 Macroeconomic Results

 

BAU

Scenario 6

Scenario 13

Scenario 14

   

ETS

As in 6 with lower CH4

As in 6 with lower N2O

Emission units required to be purchased off shore (p.a)

 

46.8Mt

41.9Mt

44.0Mt

Private Consumption

 

-2.2%

-2.0%

-2.1%

Exports

 

0.1%

-0.1%

0.0%

Imports

 

-2.8%

-2.5%

-2.6%

GDP

 

-0.1%

-0.2%

-0.1%

GDP in world prices

 

-1.5%

-1.3%

-1.4%

Real wage rate

 

-2.7%

-2.6%

-2.6%

Mean household tax rate

 

-9.6%

-8.8%

-9.2%

Real exchange rate

 

-1.3%

-1.1%

-1.2%

Terms of Trade

 

1.3%

1.3%

1.3%

CO2 emissions (Gg)

52368

-16.4%

-16.4%

-16.4%

Agriculture CH4 & N2O

63513

-10.9%

-18.6%

-15.4%

 

115881

-13.4%

-17.6%

-15.9%

International transport

4299

-18.1%

-18.4%

-18.2%

Emissions by NZ

111582

-13.2%

-17.6%

-15.8%

In Scenario 6 the carbon price is estimated to reduce emissions of methane and nitrous oxide by nearly 11%, achieved almost exclusively by reductions in agricultural output. Incorporating two possible technological advances (breeding for lower methane emission and using nitrogen inhibitors) raises this figure to around 19% and 15% respectively. In absolute terms, improved breeding reduces emissions in 2025 by 4.9 Mt (CO2e), with nitrogen inhibitors reducing emissions by 2.8 Mt.

These decrements translate directly into a reduction in the number of emissions units that New Zealand needs to purchase from offshore. In fact it is this effect that is the main driver of the impact on consumer welfare. In Scenario 6, the reduction in private consumption is 2.2% and emission units covering 46.8 Mt need to be bought offshore. The latter falls by 10.5% in Scenario 13 and by 6.0% in Scenario 14. It is not surprising therefore that the reductions in private consumption in Scenarios 13 and 14 are 2.0% and 2.1% respectively.

If the two possible technologies are approximately additive we would expect the decline in private consumption to soften to about 1.9%, from 2.2% in Scenario 6. One might conclude that the results are not sensitive to the types of technological advances that could occur in agriculture. For any single technology this will generally be true, but emissions reductions in the long term depend on securing successive ‘wedges’ of reductions as depicted in MED (2007).10 Some wedges may be small, but can still contribute to a least cost emissions reduction programme.

Text description of figure

This graph shows how cumulative greenhouse gas emissions reductions in all major emitting sectors produce a large decrease in total emissions. Basecase emissions without any interventions are projected to rise to from 26 MtCo2e in 1990 to 55 MtCO2e in 2050. Cumulative reductions from major emitting sectors after the introduction of the emissions trading scheme in 2008 are projected to decrease emissions to around 12 MtCO2e in 2050. The major emitting sectors are as follows: electricity where emissions reductions will come from reduced demand, renewable generation and carbon capture and storage; industry where emissions reductions will come from improvements in efficienncy, fuel switching and renewables and carbon capture and storage; residential commercial; transport where reductions will come from less traffic and a shift in mode of transport, improved vehicle efficiency and new fuels.

3.3 The Cost of Abatement

Drawing together the main scenarios above into Table 6 shows that successively doubling the carbon price from $25 to $50 to $100 does not keep on doubling the reduction in emissions. Dividing the emissions reduction by the carbon price and normalising the ratio with respect to Scenario 5, reveals that the initial doubling of the carbon price produces 94.6% of the initial effect on emissions, while doubling it again produces 83.1% of the initial effect.

Table 6: Changes in Private Consumption & Emissions v Carbon Price

Scenario

Carbon Price

Private Consumption

(% change)

Normalised Effect

CO2 Emissions

(% change)

Normalised Effect

GDP

4

0

-1.0

 

0.3

 

0.2

5

25

-0.7

1.000

-4.0

1.000

0.0

 

50

-1.3

0.948

-7.5

0.946

0.0

6

100

-2.2

0.828

-13.2

0.831

-0.1

7

100

-3.5

 

-13.0

 

0.1

9

100

-1.4

 

-9.6

 

-0.2

The nonlinearity is perhaps not as marked as one would expect, a result of the model being based on smooth production functions.11 However it is not inconceivable that the curvature of the abatement function could switch between concavity and convexity if certain carbon prices lead to break-through technological developments.

Scenario 4 aside, the loss in real private consumption rises in proportion to the change in emissions, not in proportion to the change in the carbon price. If the carbon price produced no reduction in emissions, the losses in private consumption would be greater. That reductions in emissions do occur means that the cost of purchasing emission units offshore does not rise fully in proportion to the carbon price. We may infer therefore that any technological improvements that reduce emissions and that cost less than the carbon price per tonne of emissions foregone (or captured) would have a directly proportional effect on private consumption. Scenarios 13 and 14 demonstrated such an effect.

Real gross domestic product changes little in these scenarios, a consequence of the macroeconomic closure assumptions. Scenario 4, where the government is responsible for all emissions sees a small rise in GDP because export industries are amongst the most productive in the economy. Unfortunately, the increased volume of exports requires a movement down the export demand curves. The associated lower returns cause the observed drop in private consumption. This scenario is allocatively inefficient.

In the graphs below the left most point in each represents Scenario 4 with no carbon price and the government responsible for all emissions. There is no reduction in emissions (a small rise in fact) and a larger loss in private in consumptions than under a $25/tonne price. This is directly attributable to the absence of a price signal – no carbon price means no incentive to reduce emissions, implying the need for more emission units to be purchased from offshore, and so more resources go into exporting at the expense of private consumption.

The red points (circles) represent Scenario 7 where New Zealand has a tighter emissions allowance. Private consumption is significantly lower, but there is little effect on gross emissions – a slightly smaller decline due to the increase in exports.

The green points (squares) represent Scenario 9 where New Zealand suffers no major loss of international competitiveness from subscribing to emissions abatement, as competitor countries adopt similar emission mitigation policies. There is a notable effect on private consumption and on emissions.

The graphs can be used to draw a number of inferences, as shown by the dotted lines. For instance:

  1. Reducing New Zealand’s international allowance by 20 Mt is equivalent to at least doubling the carbon price to $200/tonne as far as the effect on private consumption is concerned (refer Figure 1).
  2. Achieving the same gross reduction in emissions that is obtained with a carbon price of $100 and no action by competitor countries, would require a price of at least $150 if competitor countries also introduce mitigation policies (refer Figure 2).

Figure 1: Private Consumption and the Carbon Price

Figure 2: Emissions and the Carbon Price

 


5 Scenarios 10 and 11 deal with transition costs, presented in Section 4. There is no Scenario 12.

6 The level of allowances that NZ will receive under international agreements is subject to the outcome of future international negotiations. For modelling purposes, this scenario assumes a level that would be broadly consistent with a path that reduces emissions by 50% of 1990 levels by 2050.

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

8 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.

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

10 MED (2007), New Zealand Energy Strategy Low Carbon Energy Scenario.

11 The production functions are continuous and differentiable.