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4.2.4 Alternatives – a New Zealand emissions trading scheme Introduction

RELEASED UNDER THE OFFICIAL INFORMATION ACT

4.2 Price-based measures

4.2.4 Alternatives – a New Zealand emissions trading scheme

Introduction

One price-based measure that is worthy of serious consideration for New Zealand is to introduce an emissions trading scheme.

The key advantage of an emissions trading scheme is that, in theory, it allows New Zealand to meet its Kyoto (and beyond) targets in a way that minimises the costs to the economy and to society as a whole. An emissions trading scheme would provide clear incentives for reductions in emissions to occur where the cost of that emission reduction is lowest.

There is a range of difficulties associated with emissions trading schemes and these difficulties should not be under-estimated. This section examines the theory behind such schemes, analyses generic and industry-specific issues related to the possible introduction of a New Zealand emissions trading scheme (NZ ETS), and draws conclusions on an appropriate way forward.

Potential benefits of an emissions trading scheme

Under an emissions trading scheme, firms where emissions reductions are relatively easy and cheap to achieve would have a strong incentive to achieve these reductions (and reap the benefits of the sale of any associated emission permits). Firms for which emissions reductions are more costly to achieve would be likely to purchase emission permits through the emissions trading scheme. Such a firm would have strong incentives to invest in technology or otherwise restructure their operations to reduce their emissions on an ongoing basis. Therefore, emissions reductions would be likely to occur where it is cheapest to do so. An emissions trading scheme is particularly valuable when firms face quite different costs of reducing emissions.

In a discussion paper on emissions trading, the Australian Greenhouse Office (Australian Greenhouse Office, 1999a) states that an emissions trading scheme is often seen as an attractive means of addressing environmental concerns because it:

  • is not prescriptive about how emissions reductions are achieved, or who achieves them, thereby allowing emitters maximum flexibility to allocate available permits to their most valuable uses
  • provides greater certainty that targets will be achieved, because the number of permits on issue can be controlled
  • introduces appropriate price incentives for developing better abatement and monitoring technologies.

Differences between an emissions trading scheme and a taxation-based price measure

The key difference between an emissions trading scheme and a tax-based policy is that a tax policy sets the price of emissions (ie, the tax rate). Within a tax-based policy, therefore, there is no certainty about the volume of emissions to be undertaken. In contrast, under an emissions trading scheme there is the potential to limit the volume of emissions. However, such a limit may not be so easy to achieve in a New Zealand context.

There are other important differences between a taxation system and an emissions trading scheme. One difference is that the price of an emissions trading scheme is likely to change frequently, while changes in tax rates tend to be relatively infrequent. Changes in the price of an emissions trading scheme are perfectly acceptable and reflect a variety of factors such as the availability of technologies to reduce emissions, the demand (or lack of) from firms to increase outputs associated with the production of emissions, the stringency of the cap, and, potentially, the price of emissions on the world market.

Furthermore, although it is possible to agree NGAs with emitting firms, the ability to grandparent emission permits to firms potentially allows more subtlety in policy design than tax exemptions allow. Having said this, an emissions trading scheme is a far more complicated policy than a tax-based policy, so set-up costs, timeframes and difficulties are greater.

What would an emissions trading scheme look like?

There is a variety of options and variants for a domestic emissions trading scheme. A model cap-and-trade scheme is outlined below in a simplified form. It is important to note that the variant of an emissions trading scheme outlined in Box 1 should be viewed as being only indicative of the concept.

The Annex 4 briefly outlines the operations of the European Union Emissions Trading Scheme (EU ETS). This is the most publicised emissions trading scheme related to the Kyoto Protocol. [There are many examples of cap-and-trade schemes. In order to reduce emissions that were causing acid rain, an allowance trading scheme to control sulphur dioxide (SO2) emissions, called the US Acid Rain Programme, was set up in the United States in the 1990s. Closer to home, a cap-and-trade scheme is being introduced by Environment Waikato to control the amount of nitrogen entering Lake Taupo.]

Box 1: High-level Overview of how an Emission Trading Scheme May Work

Step 1

The Government sets a number of [Even though Australia has not ratified the Kyoto Protocol, there is interest at Australian state level in setting up a National Emissions Trading Scheme. This is currently at a background paper stage. If set up, it is proposed to be a cap-and-trade scheme operating on the stationery energy sector (this sector is rapidly growing and contributes approximately 50% of Australia’s total greenhouse gas emissions). It would cover all six greenhouse gases under the Kyoto Protocol. (Cabinet Office, New South Wales Government).] parameters around the scheme:

  • what industries are covered
  • what gases are covered
  • whether to set an overall limit on the number of permits and, if so, what that limit is.

Following these decisions, legislation is passed requiring relevant emissions to be covered by an emission permit.

Step 2

The Government allocates emissions permits to firms and organisations (a permit being the right to emit one tonne of CO2e). The permits can be sold or auctioned to firms, or allocated gratis, or a combination of the two. If revenue is gained from any sales of the emission permits, this is recycled through the economy.

Step 3

The Government keeps a register of permits.

Step 4

Emissions permits will be tradable domestically (and possibly internationally). Trades are maintained in the register.

Step 5

At regular intervals, firms must report on their emissions. This reporting must be accurate and measurable.

Step 6

Following the reporting outlined in step 5, firms or organisations that have emitted CO2e (or have undertaken activities that will result in emissions) [Issues relating to the point of obligation are discussed later.] must surrender permits equivalent to that CO2e to the Government. If the firm does not have sufficient permits, it must pay an appropriate penalty to the Government. [Effectively, that penalty forms an upper limit on prices within the ETS.]

Step 7

At the end of CP1, our emissions across the period will be measured and compared with our emissions permits. The question is not whether we have achieved our emissions target as a country, but whether all of our emissions are covered by emissions permits (if we exceed our emissions target, some of our emissions will need to be covered by international permits). The scenarios are:

  • if all our emissions are covered, nothing further needs to happen
  • if some New Zealand individuals or firms hold permits that do not cover emissions, this is not a problem in itself, just a lost opportunity for them (they could have sold them on the international market)
  • if not all of our emissions are covered, the Government is required to purchase units on the international market to cover them. The Government would pay for this with the penalty money paid by those who did not cover their emissions.

The key feature of such a scheme is that, effectively, decision-making about whether to emit CO2e, and how much CO2e is emitted, is devolved to CO2e-emitting firms and organisations. The decision for firms therefore relates to how much it costs them to reduce their emissions relative to the permit price prevailing in the market discussed in step 4 (and the penalty price for non-compliance outlined in step 6).

Baseline and credit schemes have many similar features to cap-and-trade schemes. They operate by allocating an emissions baseline to firms and then allowing trades to occur between firms if baseline targets are over- or under-achieved. The credits are created after the date at which an emission permit must be retired, so the timing of the operations in the cap-and-trade scheme and in a baseline and credit scheme is different.

As a general rule, cap-and-trade schemes are preferred over baseline and credit schemes. Major reasons for this are:

  • cap-and-trade schemes allow a greater depth in the market, whereas baseline and credit schemes only limit tradable credits to those below the defined baseline
  • cap-and-trade schemes allow various options of allocation of units (eg, grandparenting or auctioning) where a baseline and credit approach effectively grandparents firms’ initial allocations of units.

Furthermore, cap-and-trade schemes are the norm internationally in climate change policy. Relating an NZ ETS with international trading schemes would be easier if the NZ ETS were to be a cap-and-trade scheme as opposed to a baseline and credit scheme.

Could we have a solely domestic emissions trading scheme?

A questions that arises, when considering whether to develop an emissions trading scheme, is whether a NZ ETS could operate without links to an international market. This section argues that this is not sensible and, therefore, does not recommend such a measure. In designing a NZ ETS, an absolutely critical decision is whether there should be a limit on the number of permits within it and, if so, what that limit should be. Having a limit would determine the amount of emissions that New Zealand would permit in the relevant time period. Setting such a limit, however, is likely to be highly problematic.

If the limit were set too low, the price within the NZ ETS would be high (reflecting the difficulty that many New Zealand firms and emitters have in reducing their emissions with existing technology). This might well have a significant, and very unhealthy, effect on those firms – in particular, it might lead to reduced production within these firms.

Alternatively, if the limit on the number of permits to be traded within a NZ ETS were to be too high, there would be few buyers and many sellers in the market. Incentives to reduce carbon emissions would be weak, as the price of purchasing emissions permits would be low (or zero). If this were the case, the goal of an emissions trading scheme of being a policy tool to assist in reducing emissions would not be met.

The current projected balance of units for New Zealand in CP1 is that we will have a deficit of 36.2Mt CO2e. As part of the modelling around our net emissions position, variability around the mean was estimated (95% confidence intervals). In a pessimistic scenario, our net emissions position in CP1 would be a deficit of 62.6Mt CO2e, while in an optimistic scenario, it would be a deficit of 11.3Mt CO2e. When added to New Zealand’s assigned amount units of 307.6Mt CO2e for CP1, our total emissions (less sinks) is estimated to fall within the range of 318.9Mt CO2e to 370.2Mt CO2e.

The variability in these estimates is too high to predict with any confidence the appropriate limit for the number of permits that should be allowed within a NZ ETS. It is therefore recommended that, if there is to be a NZ ETS, there is no limit on the number of permits. Effectively, this implies that it would not be appropriate to set up a NZ ETS with no external links.

One option for New Zealand would be to develop an emissions trading scheme in some sectors of the economy and then seek to expand the coverage to cover all sectors. The energy and transport sectors would be best suited in this regard. Even if an emissions trading scheme were developed covering only the energy and transport sectors, the variability in the net emissions estimates is too high to allow contemplation of a NZ ETS covering only those sectors that is not linked internationally.

This effectively recognises that it is not sensible to explicitly limit the amount of emissions from New Zealand. It does not, however, rule out that New Zealand should pursue domestic policies that will reduce our emissions. (If there were a climate change objective of limiting New Zealand’s net emissions to some agreed amount, a NZ ETS with no (or limited) links to an international market might well be an appropriate policy tool.)

The EU ETS allows only a relatively small proportion of units to enter the system through a linking directive. This essentially ensures that much of the European Union Kyoto target is attained with emissions reductions within Europe. It also means that there is still a limit on the number of emissions permitted within the EU ETS. Such an approach would not reduce the difficulty associated with accurately estimating the size of the carbon market so is not a sensible option for New Zealand.

International linkages for a NZ ETS

The only possible way for New Zealand not to have a pre-determined limit on the amount of emissions allowed within New Zealand through an emissions trading scheme is for players in a NZ ETS to have unlimited access to an international emissions market. Under such a scenario, there would be no limit on the number of emission permits that could be traded internationally.

If there were full links with an international market, it is likely that the trading price of permits in a NZ ETS would match the international price [An international price is an interesting concept. Currently, there are several prices for carbon that apply internationally, depending on what market one is trading on and what “product” one is buying.] in the market New Zealand is trading in. A key difference between such a scenario and a carbon tax would be that the price would adjust regularly, while price adjustments in a tax are irregular.

At present, it is arguable whether there is a sufficiently strong international market in place. A key feature of such a market is that there would be relatively low transaction costs associated with the buying and selling of units for New Zealand firms, and that New Zealand firms could access low-priced emission reduction units from overseas. [Further work could explore the criteria for determining whether, in fact, a sufficient international market has developed.]

It is not necessary to have an international market that covers all countries, or all countries that have ratified the Protocol. Arguably, the conditions outlined above are met through the current world market for JI and CDM. This market is developing rapidly and may well mature into enough of an international market to allow the development of a NZ ETS.

One strategy that New Zealand could pursue is to attempt to join the EU ETS. This is not recommended at this point (although the possibility of a future linking with the EU ETS should not be ruled out). If New Zealand were admitted to the EU ETS, it would effectively mean that New Zealand would take both the policy and the price from the EU ETS (our emissions are very small in the context of the European Union so the New Zealand contribution would be swamped). [The European Union may also have a view on what level of our Kyoto target that should be met within New Zealand.] The effect of this is that New Zealand firms would, if they wished to purchase emission permits, pay approximately €20 per tonne of CO2 (assuming the EU ETS price does not change significantly over time). This is a significantly higher price than the price that New Zealand would pay for emissions-reduction units if it purchased them under the Kyoto flexibility mechanisms (again assuming current prices). [The scope of the EU ETS in terms of types of industry is quite limited and would exclude the bulk of sources of New Zealand’s greenhouse gases.]

A further issue that would need addressing if a NZ ETS were linked to an international market is the quality of the units firms would be permitted to purchase. For example, firms may buy “hot air” from an international market to meet their emission permit responsibilities. If New Zealand as a whole was not prepared to meet our Kyoto obligation through “hot air” credits, clear rules would need to be set about the types of international units that would be permitted to be traded within a NZ ETS.

A hybrid scheme?

This section argues that it is not desirable to develop a NZ ETS at this stage. It does, however, suggest that the development and operation of a NZ ETS is desirable in the longer run if international climate change policy settings continue to be related to quantitative goals. This raises the issue of whether there are intermediate steps that could usefully be employed in the short term.

Sin and Kerr recommended that a hybrid tax/permit scheme could be a good policy option to develop in the short term. Under the Sin and Kerr model (variants on the theme exist), the coverage would be the same as the existing carbon tax design (ie, it would avoid the forestry and agriculture sectors). It would operate as a permit scheme with a trigger price at which firms could buy unlimited numbers of permits from the Government. If the trigger price is reached, the system effectively operates as a tax. When the price is less than the trigger price, it operates as a permit scheme.

Such a system would not add great value over and above a carbon tax in the short term. [There would be related benefits. For example, New Zealand would gain valuable experience and lessons in operating permit schemes.] It would, however, be invaluable as an intermediate step for New Zealand to take if a decision were made to pursue the option of an emissions trading scheme in the future. There would be a marginal cost and effort associated with developing a hybrid scheme as opposed to a carbon tax, but this cost is not considered to be overwhelming.

As with all policy options in this area, there would be design issues to overcome. One particular issue would be ensuring that there was not the ability to arbitrage permits [If permits in a hybrid scheme were tradeable internationally and the international price were higher than the permit price, care must be taken to ensure that it is not possible to buy permits from the government and then sell them at a higher price to international bidders.] if the international price for permits were higher than that in a hybrid scheme. Furthermore, a hybrid scheme might be ineffective if the trigger price were set relatively low, as it would effectively operate as a tax at all times. Therefore, it might prove difficult to implement if the carbon tax were levied at a relatively low rate.

Issues to consider when developing an emissions trading scheme

There is a variety of issues to consider and policy decisions to make if New Zealand develops an emissions trading scheme. This section outlines some of the implicit trade-offs and issues; it does not attempt to reach a conclusion on all these matters.

Allocation of permits

The initial allocation of permits is a key issue associated with setting up an emissions trading scheme.

Options in this area relate to grandparenting the permits (allocating them gratis), or selling the permits through some process (eg, an auction or a fixed-price sale), or a combination of the two.

There are strong efficiency and equity arguments involved. [The setting up of the Individual Transferable Quota system for New Zealand fisheries was an example of a tradable permit scheme that involved a grandparented allocation of the relevant permits.] Typically, efficiency is more likely to be maximised with the sale of permits as the value of the permits will move quickly to their most valued use and the cost of determining the initial allocation is likely to be lower. If the permits are sold, issues of revenue recycling also apply (ie, using revenue gained from the sale of the permits elsewhere in the economy). Each emission permit has a property right associated with it (ie, the ability to emit a unit of CO2e), so there are large wealth transfers involved. On the other hand, equity goals can be advanced through the use of grandparenting emission permits. There is a wealth of literature on the topic; see, eg, Crampton and Kerr (1998), Sin and Kerr (2005), the OECD Environment Directorate and International Energy Agency (2004), the Australian Greenhouse Office (1999b) and the New Zealand Climate Change Programme (2001).

One issue that arises from a decision to grandparent relates to timing. In particular, if a decision were made to grandparent (some or all) permits to those existing in an industry, what date should the grandparenting relate to – eg, to 1990 levels? 2005 levels? 2008 levels? This decision relates to determining the most equitable and effective baseline to use going forward – what baseline can be measured? From what point is it "fair” to base a charge?

Decisions on the allocation of permits also influence the acceptability of an emissions trading scheme from the public’s viewpoint. As a general rule, the more permits are grandparented, the more acceptable an emissions trading scheme will be. Partially for this reason, in the EU ETS, the bulk of permits were grandparented while some were sold.

Determining the appropriate points of obligation

Determining the point of obligation involves determining the businesses and organisations that have the legal obligation to hold emission permits. This need not necessarily be the final emitter of carbon (eg, oil companies may be required to hold permits).

For an emissions trading scheme to be effective, it is important that any price increase can pass through to final consumers of the product (eg, so that the motorist is faced with the cost of the emission permit at the pump). This is known as internalising the cost. The end consumer, in this case the motorist, would face the cost of the permit and would be able to factor that into their travel decisions (eg, whether to travel, what mode of transport to use, what types of vehicles to buy). Furthermore, second-order effects would also be relevant; the price of emissions permits would also be reflected in high fuel-intensity products.

Determining which sectors and gases are included

It is not necessary to have all sectors and greenhouse gases included within any emissions trading scheme. As a general rule and depending on the scope for mitigation, a larger market (both in terms of the number of sectors included and the number of greenhouse gases included) is more likely to operate effectively and achieve climate change goals than a smaller market. Even if all of New Zealand’s major greenhouse gases [Carbon dioxide, methane and nitrous oxide.], and all sectors of our economy were included in a NZ ETS, it still would be a small market by international standards.

Leakage issues

A firm having to purchase permits to maintain or increase production levels would have the option of relocating offshore. This concern applies equally to carbon taxes and emission permit schemes, and is difficult to overcome. These arguments apply across many sectors of the economy, to some extent. See the discussion on NGAs for more detail.

Leakage concerns can be addressed by grandparenting initial allocations to major firms that are in direct competition with firms in overseas countries that are not signed up to Kyoto. This would cover emissions from those firms themselves but not any emissions from inputs to their processes (eg, emission permits contained within any upstream effects). Under such a scenario, firms would also face the costs in terms of the emissions trading scheme associated with expansions in production.

Public and political buy-in

An emissions trading scheme is a complicated policy instrument. It involves the assigning and trading of property rights and the development of an effective market for trading those rights. It is not quick or simple to implement and will operate only if there is a high level of buy-in that it is fair and necessary.

To be successful and lasting, an emissions trading scheme requires a high level of both political and public buy-in to the problem of climate change and the domestic policy chosen (the ETS). Simpler policy mechanisms such as regulatory options, or the imposition of a carbon tax, may be more appropriate in an environment of public and political uncertainty. [To make use of the costs of setting up an ETS, an ETS would ideally be able to be used in more than one Kyoto period.]

Data collection and administrative issues

Effective data collection and administration are critical to sound operation of an emissions trading scheme. Issues, listed in no particular order, include:

  • being able to accurately measure emissions performance and to tie individual firms’ obligations to New Zealand’s overall obligation – an accountability issue. These measurements must be able to be done within acceptable cost ranges
  • ensuring that emission permits are easily tradable with no excessive transaction costs (this may be an issue where small volumes of units are either available for sale or required to be purchased).

The first point applies to both a carbon tax and an emissions trading scheme.

The second point is, however, unique to an emissions trading scheme. Anecdotal evidence suggests that the packages of emission reduction units allocated to firms under the PRE initiative were sometimes too small to easily enable sale of those units to potential purchasers. Similarly, firms may need to purchase or sell small numbers of emissions permits to balance their emissions permits with their emissions. For an emissions trading scheme to be effective, a cost-effective way of doing this is highly desirable. [From this viewpoint, a firm may prefer a tax as opposed to an ETS, as a tax would simply require the payment of the appropriate funds, whereas an ETS would require firms to purchase units and then pass them on to the Government.]

Particular industry-related issues

Outlined below is a very brief overview of how a NZ ETS would affect different sectors of the economy.

Agriculture

Agriculture accounts for approximately half of New Zealand’s net GHG emissions. Ideally, therefore, agriculture would be included in any emissions trading scheme in a New Zealand context.

There are issues to consider relating to:

  • the point of obligation (and whether there is a way of ensuring that the appropriate signals are sent to the decision-makers – the farmers)
  • measurement
  • the grandparenting of obligations.

Point-of-obligation arguments relate to the extent to which the appropriate signals can be sent to the decision-makers (ie, farmers). For an emissions trading scheme to be as effective as possible in an agricultural context, it would take into account on-farm decisions that result in carbon emissions, such as on-farm feeding patterns. The transaction costs associated with measuring this would be prohibitive, however. (For some farm inputs, such as fuel or fertiliser, it may be possible to require firms upstream to hold emission permits; the price could then flow through into on-farm decisions). These measurement issues are considered to be very serious in the context of agricultural emissions.

Industry bodies could be required to hold emission permits relating to livestock numbers. The incentives created by such a scheme may not be entirely productive, as such a measure would create incentives to reduce livestock numbers. Related to this, the agriculture industry might move to fewer but larger animals (with higher GHG emissions per animal) if emission permits were related to the number of animals.

If our agricultural research efforts are successful in identifying technologies that can cost-effectively reduce agricultural emissions, it is important that these are put into practice. If the point of obligation of a NZ ETS were at an industry-body level rather than a farmer level, the means of adoption of new technologies would need to be examined closely. This again relates to measurement issues (eg, could the use of new technologies at a farm level be accurately measured?), and also to point-of-obligation issues.

If there were a decision to grandparent emission permits, say to 2005 levels, then (only) any marginal changes in farming operations would be liable under the emissions trading scheme. [Farmers may argue that such a measure would be equitable, as a decision not to grandparent would penalise them for past decisions. Although there is an equity element implicit in this, the issue is no different from grandparenting obligations to other sectors of the economy. Partial grandparenting (ie, grandparenting 50% of permits) is possible.] Therefore, farmers that decreased their carbon emissions from 2005 levels would have an asset they could sell, while farmers that increased their emissions would face the cost of purchasing the required number of permits. As noted above in the discussion relating to the point of obligation, measuring relatively small changes in agricultural emissions may well be problematic.

Having said this, for significant changes to land-use operations such as conversions from one land use to another (eg, sheep to dairying, forestry to dairying, cropping to livestock production), there is a strong case for the decision-maker to face (at least some of) the related carbon emissions costs. In these situations, the decision to change land use presents the nation as a whole with a reasonably significant carbon saving or cost (depending on the land-use change in question). An emissions trading scheme applied to agriculture would enable such a cost to be faced by farmers, so long as it could be implemented effectively. If an emissions trading scheme were not developed, alternative measures to make decision-makers face some of the carbon-related implications of significant land-use changes could be investigated. This is discussed further below.

Forestry

There are particular challenges and opportunities for an emissions trading scheme as it relates to forestry.

Consistency with Kyoto rules

The Kyoto Protocol contains slightly anomalous rules relating to the difference between forests planted post-1 January 1990 ( Kyoto forests) and forests planted pre-1990 (non-Kyoto forests). For more detail on these, see Section 4.6. This distinction is, to some extent, artificial and may not exist in future commitment periods, making the development of policy in this area particularly problematic.

These rules mean that New Zealand faces the liability associated with the deforestation (felling and not replanting) of non-Kyoto forests but does not face any liability associated with harvesting (felling and replanting) non-Kyoto forests. In contrast, New Zealand faces a liability associated with both the deforestation and harvesting of Kyoto forests. [The liability faced by New Zealand on the harvesting of Kyoto forests is limited to the amount of carbon claimed previously from that forest.] If a non-Kyoto forest is deforested prior to 2008, however, New Zealand does not face any liability associated with the deforestation (although New Zealand is liable for any resulting emissions from agriculture on that land).

Given this difference in rules, and that it is not clear that these rules will extend beyond CP1, New Zealand must determine to what extent this distinction should exist in domestic policy settings. This issue is not necessarily insurmountable, but does require careful thought. One particular behaviour that is worth attempting to avoid is land-swapping, where a non-Kyoto forest is deforested prior to 2008 and a Kyoto forest is created of a similar size. If emission permits were devolved strictly on the basis of Kyoto rules, there would be an incentive for firms to land-swap in this way, even though, from an aggregate carbon viewpoint, land-swapping is more analogous to the harvesting of a non-Kyoto forest.

Dealing with inter-temporal issues – Kyoto forests

An obvious feature of forestry is that it is a long-term investment, with the average rotation of a Pinus radiata forest of between 25 and 30 years. In a simplistic sense, carbon is sequestered from the atmosphere in the period of growth of the trees and released to the atmosphere when the trees are felled. [There is debate around levels of residual soil carbon and also around how to account under the Kyoto rules for carbon that is retained in harvested wood products (ie, not all of the carbon sequestered is immediately released into the atmosphere when a tree is felled).] (If the Kyoto forest is replanted, there is an increase in the stock of carbon in the forest, as sequestration associated with growth from the second rotation covers the loss of carbon from decaying material).

One feature of the long timeframe of forestry investments is that a forestry investment spans several Kyoto commitment periods. If there were an emissions trading scheme in place that included forestry, effectively, the Government would be allocating units to forest growers for the credits associated with carbon sequestration over time. On the harvesting or deforestation of the forest (or loss of the forest through wind or fire damage), the forestry company would be faced with a large liability for the loss of sequestered carbon.

This would involve quite a financial exposure for forestry companies; effectively, forestry owners would be exposed to changes in the price of carbon over time. [It is estimated that if the international price of carbon were to increase at a compounding rate of 6% per year, a devolution of credits (as an ETS including forestry would imply) to the forestry industry would have a strong negative effect on the rates of return for forestry investments.] There would also be an exposure for the taxpayer; if forestry companies did not repay any liability of credits to the Crown on deforestation or harvesting of a Kyoto forest, the taxpayer would pay that liability. Given this, if the Government were to include Kyoto forests in an emissions trading scheme, it would require an appropriate form of bond or insurance from the forest industry (this issue would need to be overcome but may not be particularly problematic; options are available in this area).

The converse of this is that, under current policy settings, the Government is exposed to changes in the price of carbon (with associated upside and downside risk). From a theoretical viewpoint, it would be appropriate for this risk to be devolved to the forestry industry, as this is a cost associated with the industry. For this to occur, the various issues associated with forestry vis-à-vis an emissions trading scheme must be overcome.

Decisions around grandparenting for Kyoto forests are similar to those for agriculture. In the agricultural scenario, an equity issue has been raised around grandparenting emission permits when the land-use decision was taken some time ago. In a forestry context, this translates to an issue of whether it is equitable for a forest owner to gain benefit (at the expense of the taxpayer) from a decision to plant a forest 15 years ago. This has links to arguments around compensation for non-Kyoto forests (see below). To continue the agricultural parallel, if farmers were grandparented emission permits to account for current (or 2008 emissions) then, in a similar vein, only new Kyoto forests would attract an emission permit for any sequestered carbon.

Equity issues relating to non-Kyoto forests

The previous discussion dealt with issues to do with Kyoto forests. A different set of issues is associated with the possibility of an emissions trading scheme including non-Kyoto forests.

Companies have invested in forestry for many years in New Zealand. Inclusion of these forests in a NZ ETS potentially introduces a liability on the deforestation of non-Kyoto forests. This would reduce the option (and financial) value of some land currently planted in forestry.

This raises distributional and equity issues and a strong case for compensation can be made. If compensation were to be payable, a major issue to be considered is how it would be distributed among non-Kyoto forest owners. The development of an adequate and equitable compensation regime is not necessarily simple. For an emissions trading scheme to be effective in relation to non-Kyoto forests, one would want the liability for deforestation to be included in the price faced by the land owner (ie, any compensation payable is paid irrespective of actual decisions on deforestation).

Issues in this area are difficult. If no equitable and reasonable solution could be found, one option available to the Government would be to include only Kyoto forests in a NZ ETS. While this would not be ideal from the viewpoint of land owners facing the correct price signals around land-use decisions, it may prove to be a practical way forward. Such a policy would have large implications for the taxpayer (who would bear the liabilities for the deforestation of non-Kyoto forests).

Other forestry-related issues

There are a range of other issues associated with the possible inclusion of forestry in a NZ ETS. These include:

  • who to devolve the credits and liabilities to – the land owner or the forest owner?
  • how to monitor carbon sequestration efficiently
  • if an emissions trading scheme were to include Kyoto forests, what date would be used to determine which forests were covered? When Kyoto was signed? When Kyoto, or the ETS, came into effect?
  • how to avoid opportunistic and (possibly) distortional behaviour while an emissions trading scheme is being considered/set up
  • how to deal with existing contracts to deforest, assuming non-Kyoto forests are included
  • how best to deal with any associated fiscal issues
  • to what extent any devolution of credits into an emissions trading scheme could, or should, be compulsory (for Kyoto forests). Or should it operate on an opt-in basis only, given that the forest owner will need to repay any emission permits previously gained if there is harvesting, deforestation, or any other loss of carbon from the forest?

These issues are not discussed further in this paper. They would, however, need to be resolved if any future NZ ETS included forestry. It is important to note that work has been done on all of these issues and potential ways forward can be identified.

Under current policies, the Government/taxpayer receives any of the Kyoto benefits and pays all of the liabilities associated with changes in land use. It would be preferable from a land-use perspective if these prices were factored into land holders’ decision-making frameworks, as these are real costs that directly flow from land holders’ decisions. If it could be developed, a NZ ETS is an ideal way of incorporating these prices into land-use decisions.

Energy

The carbon tax, due for introduction in 2007, is intended to include the energy sector. Within the design of the carbon tax, many of the issues implicit in the design of an emissions trading scheme have been worked through. It would appear sensible for the point of obligation to be the same as that proposed in the carbon tax design; ie, producers and importers of fossil fuels and firms that carry out certain industrial activities that produce greenhouse gas emissions would be responsible for holding sufficient emissions permits to cover their activities.

If one wanted to allow for emissions resulting from inputs into major emitting firms (that potentially may relocate offshore), some form of an agreement with that firm would be required. As noted in the section on NGAs, these agreements are problematic.

Transport

The situation with transport is not dissimilar to the situation with energy with regards to a NZ ETS. In particular, using the model of the carbon tax, fuel importers would be responsible for holding sufficient emissions permits to cover their activities. Any costs associated with the purchasing of permits could be passed through to end consumers.

One slight difference between a tax and an emissions trading scheme with regards to transport (and energy) is that it is important that the transaction costs for purchasing or selling relatively small numbers of units are relatively small. If they are not, companies may have a justified preference for a tax, other things being equal.

Summary of issues associated with an emissions trading scheme

The table below summarises major issues associated with a NZ ETS from an industry-by-industry viewpoint.

Table 15 - Summary of Issues, Industry by Industry

Issue Possible Solution
Transport
Firms would need to purchase or sell small numbers of emission permits An effective market with low transaction costs is essential
Agriculture
Existing farmers may argue that it is inequitable to force them to purchase permits, given they have been in agriculture for a significant period and mitigation options are few Possible to grandparent (some or all) permits to existing farmers. This could effectively price carbon into differences in behaviour at the margin
Measuring emissions at farm level is difficult to do cost-effectively Hard to overcome in the short term. Could move to a different point of obligation but may lead to perverse incentives
Leakage issues apply Very difficult to overcome. To some extent marginal, however
Forestry
Would place large liability on non-Kyoto forest owners. Could be viewed as highly inequitable Hard to overcome without some form of grandparenting (or the Government retaining the liability)
Equity issues arise if permits are granted to existing Kyoto forest owners - ie, benefiting people for past-decisions (the flip-side of the previous issue) The Government does not grant permits for existing Kyoto forests. Permits are granted only for new forests
Problem where permits allocated for sequestration are required to be repaid on harvest – leaving large liability for forest owner Require some form of bond or insurance from the forest industry. There would still be exposure to changes in the price of carbon
Energy
Firms would need to purchase or sell small numbers of emission permits An effective market with low transaction costs is essential
Leakage issues apply to large energy users where their production is internationally mobile Could grandparent initial allocation. This would cover emissions from the production of the firm itself but would not provide any relief from ETS costs embedded in energy Relief from the cost of an ETS that is implicit in inputs (to firms) such as electricity could be overcome only by some type of NGA. As noted, these are problematic

Summary

An emissions trading scheme is potentially a very powerful policy instrument. An emissions trading scheme could lead to innovative ways of meeting climate change objectives that would otherwise be very difficult, if not impossible, to achieve. Incentives created under an emissions trading scheme can influence behaviour across all relevant areas of the economy. An emissions trading scheme also has the potential to reduce emissions in a least-cost way. As such, there are strong reasons for New Zealand to pursue the development of an emissions trading scheme.

There are significant implicit complexities, however, and these should not be under-estimated. In particular, for an emissions trading scheme to be effective, there are a number of administrative and transactional issues to overcome. These include:

  • being able to accurately measure emissions performance and tie individual firms’ obligations to New Zealand’s overall obligation
  • ensuring that scheme participants are accountable for their emissions
  • ensuring that emission permits are easily tradable, with no excessive transaction costs.

For an emissions trading scheme to be effective, there would need to be an acceptance that it is here to stay, at least for CP1 but preferably longer. Given this, consistency of policy settings is important, as is a high-level of buy-in, both politically and within the economy. The difficulty of design (and time required for the design) of an emissions trading scheme implies that, ideally, an emissions trading scheme would be used for more than one commitment period.

It would be preferable to include as many New Zealand emitters and major greenhouse gases in a NZ ETS as possible. This would help to ensure that a NZ ETS operates effectively as a market and would provide an incentive for as many players as possible to reduce their emissions where it is cost-effective to do so. Leakage may be a problem, especially if the emissions trading scheme results in a high price for carbon within New Zealand. In the first place, however, it may be preferable to include only some sectors of the economy. There are difficulties associated with including agriculture and forestry. It would be more practical to add these sectors to an existing emissions trading scheme rather than develop a new emissions trading scheme including agriculture and/or forestry.

This said, much of New Zealand’s emission is land-use related, and a NZ ETS would be most effective if it included all types of land-use decisions that have significant climate change implications, such as afforestation and deforestation rates, changes in stock numbers (especially cattle), fertiliser application and use of technology. Forms of grandparenting could potentially be employed to resolve equity issues, although further work is required to ensure that major inequities would not remain. From an agricultural viewpoint, measurement issues are important. Although these issues relating to forestry and agriculture apply to all price-based measures, they are especially important from an emissions trading scheme viewpoint.

At this point, it is arguable whether there is an effective international carbon market for a NZ ETS to link into. Such a market may emerge relatively shortly. A market of this nature is necessary to avoid the highly problematic exercise of setting a limit on total New Zealand emissions. An international emissions market would, ideally, allow New Zealand firms to access low-cost emission permits from overseas at low transaction cost.

Going forward

Although an emissions trading scheme offers significant opportunities for New Zealand, there are a number of issues that need to be overcome before an effective one can be set up. In particular, there is (arguably) not an effective international market for New Zealand to trade within, there is probably not the required level of public and political buy-in to the need for a NZ ETS at this stage, and there is not sufficient stability in international policy settings to warrant the significant effort involved in setting one up.

It is not recommended that New Zealand attempt to develop an emissions trading scheme for CP1. Depending on the nature of any successor to the Kyoto Protocol, New Zealand should seriously consider developing a NZ ETS. [The Kyoto Protocol is essentially a quantitative agreement where total emissions from Annex I countries that have ratified the Protocol is fixed. An ETS is an ideal policy instrument to assist in achieving quantitative goals. If, however, any agreement following the Kyoto Protocol does not include such a quantitative goal, an ETS may not be appropriate.] It is important that any domestic policies developed in the short term are designed to enable a transition to an emissions trading scheme as effectively as possible.

If New Zealand were to make a strategic decision to develop an emissions trading scheme in the future, a logical starting point might well be to develop the energy and transport elements of a carbon tax as some form of hybrid model (this could probably be done at relatively low cost). This may prove difficult if a carbon tax were to be levied at a relatively low rate, but would provide valuable experience in developing and operating emissions trading schemes and would significantly ease any future transition to a NZ ETS.

4.2.5 PRE – assessment and future role

Background

The PRE initiative was established in late 2003 as part of a suite of policies to assist New Zealand in meeting its climate change objectives.

Under PRE, the Crown grants a promise of Kyoto-emission units in exchange for firms delivering verified emissions reductions during CP1 from projects that would otherwise not have been financially viable (ie, the project would not occur without the granting of the units). Firms can trade those units internationally.

To date, there have been two PRE rounds (PRE1 and PRE2) plus the awarding of units to t wo “early” projects. In total, 10.88 million emission units have been allocated under PRE to date.

To assist the Climate Change Policy Review, the Allen Consulting Group has reviewed the performance of the PRE programme. [The vast majority of units awarded under the PRE programme were awarded to electricity projects. Given this, the Allen Consulting Group review focused on electricity projects only.]

This section draws heavily on the Allen Consulting review. It outlines the objectives of PRE, provides an overview of the PRE programme guidelines, summarises the Allen Consulting Group’s key findings and provides some guidance on going forward with PRE.

PRE objectives

The key objective of PRE is to reduce New Zealand’s emission profile in the 2008 to 2012 period. Enhancing New Zealand’s energy security was also identified as a desirable outcome of the first assessment round.

Ancillary benefits are also associated with PRE. These include:

  • “learning by doing” in respect of firms participating in carbon markets
  • “learning by doing” in relation to technologies that are immature in the New Zealand context.

An overview of PRE programme guidelines

The key features of the guidelines for PRE are as follows:

  • the project must take place in New Zealand
  • it must result in a reduction in greenhouse gas emissions over CP1
  • it must be additional to business-as-usual (this key point is discussed later)
  • there must be a contestable process for the selection of successful projects.

The following have been drawn from the Ministry for the Environment’s website and describes the PRE selection and eligibility criteria in more detail. (The reference to the 6 million units at the end of the selection criteria is a reference to the second-project round.)

Eligibility criteria

To be eligible for Projects to Reduce Emissions tender rounds, projects need to:

  • Take place in New Zealand.
  • Result in a reduction over the first commitment period of the Kyoto Protocol (2008 - 2012) in the total greenhouse gas emissions that will be reported by New Zealand in the National Greenhouse Gas Inventory to the United Nations Framework Convention on Climate Change, and consequently have a direct impact on reducing the Crown's liability for emissions in the first commitment period. Greenhouse gases are those listed in the Kyoto Protocol: carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs) and sulphur hexafluoride (SF6).
  • Provide a minimum reduction in emissions of 10,000 tonnes of CO2-equivalent in the first commitment period of the Kyoto Protocol (2008 - 2012).
  • Be additional to "business-as-usual".
  • Result in measurable emissions reductions that would not occur without the project receiving the Projects' incentive. Project proposals will undergo:
    • an investment assessment to confirm that they are additional to "business-as-usual"
    • an environmental assessment to determine the level of emission reduction beyond "business-as-usual".
  • The number of Kyoto Protocol emission units requested by the tenderer must be less than or equal to the tonnes of CO2-equivalent emissions expected to be reduced by the project during the first commitment period of the Kyoto Protocol (2008 - 2012).

Further considerations:

  • Each project proposal must be for a single definable project (although parties can submit more than one proposal).
  • Firms in the process of negotiating an NGA with the Government may participate in Projects with respect to activities that are not within the scope of their NGA application or deemed by the Government to be ineligible for inclusion within the scope of an NGA. Firms with an NGA in place can participate provided that the Projects incentive is not being used to help meet an agreed NGA target.
  • Forest sink activities and projects involving sequestration by land-use change and management activities are not eligible for the Projects tender.

Once a project has been confirmed as being eligible to participate, it will be subjected to a risk assessment to identify the risk of it failing to deliver the expected reduction in emissions. This includes assessing any risks associated with the project owner, the project technology, the project resources, and the project economics.

Selection criteria

In the second tender round, eligible projects were ranked and selected on the following basis:

  • The ratio of the number of emission units requested by the tenderer divided by the tonnes of CO2-equivalent emissions expected to be reduced by the project during the first commitment period of the Kyoto Protocol (2008 -2012).
  • Risk assessment of the project.

Subject to the assessed risk of a project, projects offering the most reduction in emissions in exchange for the least number of emission units requested were ranked highest.

Projects were selected in order of their ranking until the 6 million emission units available in the second tender round had been allocated.

Review of the performance of PRE

The key findings of the review of the performance of PRE are as follows:

  • identifying the projects at the margin (ie, achieving maximum cost-effectiveness) will always be difficult and requires considerable judgement
  • it is likely that PRE is among “best practice” in terms of incorporating mechanisms designed to minimise units being awarded to projects that would have gone ahead anyway
  • [withheld under OIA s9(2)(b)(ii)]
  • choices over increments to New Zealand’s electricity supply are increasingly between competing renewable technologies.

The overall effect of these findings is that, in the view of Allen Consulting, it is likely that emissions reductions associated with PRE have been “achieved at a cost (on average) greater than the Kyoto price”. [There are other benefits associated with the PRE programme. Anecdotal evidence suggests that the PRE initiative has materially assisted in the development and take-up of technologies associated with renewable energy sources in the New Zealand context. Furthermore, the PRE initiative has helped New Zealand gain experience in trading emissions units.]

Each of the itemised findings is discussed below.

1. The difficulty of assessing projects at the margin

The review notes that the challenges faced in the design and application of PRE are significant. These challenges include:

  • needing to estimate the amount of emissions avoided as a result of the project
  • needing to estimate emissions avoided at a future time (ie, 2008 to 2012)
  • ensuring that a disproportionate share of benefits is not captured by those who are most able to misrepresent their true circumstances and “play the system”
  • assessing that the abatement projects involved are indeed in need of Government support if they are to proceed
  • determining the minimum amount of support necessary to enable the project to proceed.
2. PRE being among best practice

The review noted that PRE is among best practice in terms of incorporating mechanisms to avoid the PRE support flowing to projects that would have gone ahead anyway.

In terms of this best practice, the Allen Consulting review identifies three key features:

  • a competitive tendering process provides incentives for project proponents to reveal the lowest number of Kyoto units they would be prepared to accept in order to move ahead with their investment
  • a project analysis, comprising a financial analysis, is carried out on each project proposal. This assesses the financial assumptions and costings associated with each proposal to determine whether the project is, in fact, additional
  • a formal declaration is sought from proponents confirming that projects would not be carried out “… but for the award of a contract for emission units”.

[withheld under OIA s9(2)(b)(ii)]

The Allen Consulting review suggests that there was also likely to be some speculative project component in the projects claimed by PRE. This relates to investors who may not proceed with their projects, as agreed. In this eventuality, Kyoto allowances promised under PRE revert to the Crown at their full value, so there is no loss to the Crown (other than transaction costs).

4. Choices over increments to New Zealand’s electricity supply are increasingly between competing renewable technologies

Partially as a result of:

  • the decisions about the introduction of the carbon tax
  • the increasing cost-effectiveness of renewable electricity technologies
  • the increases in the cost of fossil fuels for electricity generation,

an increasing proportion of New Zealand’s increases in electricity generation has come, and is likely to continue to come, from renewable energy sources. This means that it is increasingly likely that, at this time, new renewable electricity projects (irrespective of whether they are business-as-usual, or additional to business-as-usual) will have only a small effect on electricity generation emissions during CP1.

For this reason, the emission-reducing potential of PRE-supported projects may be less than the assessment implicit in PRE. This finding, in addition to the point about additionality discussed in finding 3, may adversely affect the cost-effectiveness of the PRE programme.

Going forward

In light of the findings that:

  • a high proportion of units allocated under PRE went to electricity projects
  • the bulk of New Zealand’s additional electricity capacity (apart from one new combined-cycle gas turbine station) is likely to come from renewable sources in the immediate future
  • there is doubt about whether the expected CP1 emissions reductions resulting from PRE exceed the emission units allocated under PRE,

the review recommends that the Government not continue with PRE in its present form. [Although this analysis raises questions about the value of PRE, it is proposed that existing PRE contracts be allowed to continue.]

An issue therefore arises about the nature of any PRE programme going forward. Relevant questions include:

  • is the PRE model worth continuing with?
  • if so, what should the scope of any future PRE include? (any non-electricity project? any non-energy project?)
  • how can any future PRE programme fit with other policies such as the carbon tax, or policies arising from the Climate Change Policy Review, in order to avoid “double-incentives”?
  • can the PRE additionality (and related) tests be strengthened to avoid business-as-usual projects being successful in any future PRE rounds?
  • should units (of uncertain value) be allocated to successful firms or is a cash payment more suitable?
The Government’s decision on carbon tax

An important factor in addressing the first three of these issues will be the Government’s decision on the carbon tax. If the Government decides to change current policy on the carbon tax (linked to the international price of carbon, capped at $25 per tonne of CO2e, starting on 1 April 2007 at $15 per tonne), firms’ expectations of future prices (in particular for fossil fuels and electricity), and their assessment of the financial viability of different electricity generation projects and projects that would reduce emissions, are also likely to change. The assessment that the bulk of New Zealand’s additional electricity capacity (apart from the one CCGT) is likely to come from renewable sources in the immediate future [Based on modelling by the Ministry of Economic Development.] may change too, although current modelling suggests that this is unlikely.

Conclusion

Consideration of whether PRE should continue and, if so, in what form should be delayed until the Government has confirmed either current policy or some alternative policy on the carbon tax.

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