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4.2.2 Assessment of current carbon tax and NGAs

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4.2.2 Assessment of current carbon tax and NGAs

Summary

This section assesses the current carbon tax and NGA regime against the following criteria:

  • environmental impact
  • economic efficiency
  • economic and social impact
  • sustainability and flexibility
  • feasibility.

It concludes:

  • the emissions-mitigation impact of the regime appears to be modest due to the relatively narrow coverage of the carbon tax, the general inelasticity of energy use in the short term (coupled with the relatively low price impact at the announced tax rate), the high proportion of renewable energy in New Zealand’s electricity supply (and hence the reduced impact of electricity conservation on emissions levels), and the limited exposure of NGA firms to an emissions price
  • the 2005 ABARE general equilibrium modelling showed that a global emissions price of $NZ13 per tonne of CO2e would reduce New Zealand’s GDP by 0.04% in 2010. This represents the best available estimate of the macroeconomic impact of the announced carbon tax. This impact is considered moderate
  • the carbon tax exemptions applied to the agricultural sector and NGA firms create unequal incentives across the economy to reduce emissions and are therefore a significant source of inefficiency. These firms will not face the same incentives to develop or invest in improved business practices and technologies to reduce emissions as those paying the tax. This will affect New Zealand’s ability to achieve abatement in the medium and long term at lowest cost
  • establishing a price-based measure that is sustainable over the medium term (10 to 20 years) brings a number of advantages including reinforcing the price signal sent by the measure, improving regulatory and investment certainty, and avoiding transition costs. Due to the limited anticipated emissions reductions and economic efficiency issues outlined, it is considered the carbon tax/NGA regime is unlikely to be sustainable over such a period.

The objective of the carbon tax is to encourage the reduction of greenhouse gas emissions in New Zealand at least cost, while assisting the New Zealand economy to prepare for a carbon-constrained future. The tax will increase the cost of emission-causing activities so that it better reflects the environmental costs they impose on society. [An example of a Pigouvian tax.] Ideally, a tax will apply a uniform incentive on all emitters across the economy, thereby using the market to encourage uptake of lowest-cost emissions-abatement opportunities.

NGA policy aims to protect the international competitiveness of New Zealand firms by exempting them from the carbon tax in exchange for requiring them to move towards world’s best practice in emissions management.

This section will assess the current carbon tax/NGA regime against the following criteria:

  • environmental impact
  • economic efficiency
  • economic and social impact
  • sustainability and flexibility
  • feasibility.

Environmental impact

New Zealand’s climate change policies can have both a direct and indirect impact on global environmental outcomes. Direct impacts will be very small. As New Zealand’s contribution to global emissions is 0.2%, the impact of any change to New Zealand’s emissions on the global climate is insignificant. The substantive environmental benefits of New Zealand’s climate change policies are more likely to relate to indirect effects, including encouraging other countries to take action to reduce emissions, creating knowledge on good policy design and demonstrating the feasibility of price-based measures. These “international influence” effects are very difficult to attribute.

Despite this, it is considered that emissions-reduction potential is the most appropriate measure of the environmental impact of New Zealand’s carbon tax/NGA regime. Reducing emissions is a key objective of any carbon tax and international influence could be based on the level of domestic emissions abatement New Zealand achieves.

Expected emissions reductions from the carbon tax

Under announced policy, the tax will apply to New Zealand’s carbon dioxide, methane and nitrous oxide emissions from:

  • fossil fuel-based energy supply and use
  • industrial process emissions
  • fugitive energy emissions.

It will also include perfluorocarbons (PFCs) that result from industrial processes (excluding refrigerants). It will not apply to:

  • methane or nitrous oxide emissions from agriculture
  • synthetic gases (other than non-refrigerant PFCs) from process emissions
  • methane from the waste sector.

Agricultural emissions make up approximately half of New Zealand’s emissions profile (see Section 3.1). The latter two sources make up a very small proportion of New Zealand’s total emissions.

Firms that are assessed as competitiveness-at-risk can gain an exemption or refund of the carbon tax via NGA policy. Many of New Zealand’s high-energy-intensity firms have applied for an NGA, and further applications can be received on a continuous basis. It is estimated that up to 40% of emissions subject to the carbon tax will receive an exemption through NGAs (although these firms will still be faced with an incentive to manage emissions at world’s-best-practice levels).

Excluding NGA firms and agricultural emissions, it is estimated that the carbon tax will apply to approximately 30% to 35% of New Zealand’s total emissions profile. This restricted coverage has a significant impact on the ability of the tax to achieve emissions reductions.

The key emissions activities exposed to the tax (excluding those activities likely to receive exemptions) will be transport and electricity generation. Transport activities facing the tax include all fossil fuel-based land transport, domestic aviation and domestic shipping, and account for approximately 20% of New Zealand’s total emissions. Transport demand is typically unresponsive to minor changes in price in the short term. The MED SADEM model (Supply and Demand Energy Model), which projects medium-term responses in New Zealand’s energy market, uses demand elasticity factors [These elasticity factors are derived from historical observation of the relationship between price and demand movement in New Zealand. However, they only estimate the impact of marginal price changes around the current price. Demand elasticity may increase as the price increases, so larger changes in price may have a greater effect.] of -0.13 for petrol and -0.09 for diesel; ie, a 13% and 9% reduction in demand for a 100% increase in price.

International studies of transport demand responsiveness show similarly low elasticity factors: Bohi (1981) estimated a demand elasticity factor of -0.2 for petrol in the United States in the short run, but a long-run elasticity of -0.7. Greater long-term responsiveness arises from the ability to shift fuel types, change the overall vehicle stock, and improve fuel efficiencies through technology development.

A $15 per tonne of CO2e carbon tax is estimated to increase the price of a litre of petrol by 3.5 cents and the price of a litre of diesel by 4 cents (IRD, 2005). These price movements are within the bounds of standard market fluctuations in the price of transport fuels. Given typically inelastic demand for transport fuels, and the low price impact expected, dramatic reductions in transport energy use (and consequently emissions) are not expected. A considerably higher price increase might achieve more significant emissions reductions, especially in the longer term, although economic impacts of substantially increasing the cost of transport fuels are likely to be severe.

Electricity generation accounts for approximately 8% of New Zealand’s total emissions. Reduced electricity use does not translate proportionally into reduced thermal emissions, given that 60% to 75% of New Zealand’s generation is based on renewable, non-emitting sources. [In the longer term, emissions savings from reduced electricity demand will be dependent on the marginal new generation; ie, the new generation plant that will be delayed as a result of less demand. MED modelling suggests this will be mainly renewable in the short term (up to 10 years out) and coal thereafter.] Assuming most large industrial electricity users negotiate NGAs, residential electricity users and small and medium businesses will be the main electricity users facing the carbon tax.

The impact of the tax on electricity prices is estimated to be modest at approximately 1 cent per kWh (IRD, 2005) compared with the current residential price of electricity of around 17 cents per kWh. Like transport, demand for electricity tends to be relatively inelastic. The SADEM model uses a price elasticity factor of -0.15 for residential energy use (90% of which is electricity) and an even lower elasticity for industrial and commercial energy use. Cross price elasticities of a shift from electricity to various alternative fuels in the industrial and commercial sector range between -0.1 and -0.42.

Bohi (1981) estimated a short-run demand elasticity of -0.2 and a long-run demand elasticity of -0.7 for electricity use in the United States. Again, the long run brings the opportunity to respond through purchasing decisions (such as buying more efficient appliances) and technology development. Given the low estimated impact of the carbon tax on electricity prices, however, resulting electricity demand reduction (on those sectors it applies to) is not expected to be significant.

The carbon tax will also affect decisions on the operation of and investment in generation, as it will make carbon-intensive forms of generation relatively more expensive. The SADEM model projects that a large amount of gas generation will displace coal generation (at Huntly Power Station) in the period to 2010 as a result of a $15 per tonne of CO2e tax, although the impact will reduce after this date as gas from New Zealand fields becomes increasingly expensive. Modelling of impacts is discussed in more detail below.

Industrial processing accounts for approximately 5% of New Zealand’s total emissions and consists principally of emissions from the manufacture of steel, aluminium, urea, cement, lime and hydrogen, as well as oil and gas extraction. Industrial-process emissions are within the scope of the tax, although it is anticipated that most major sources of industrial-process emissions will be covered by NGAs and will therefore receive rebates or exemptions. Under the NGAs, these firms will still face incentives to manage their emissions at world’s-best-practice levels.

Expected emissions reductions from NGA policy

In exchange for full or partial relief from the carbon tax, NGAs require firms to achieve world’s best practice in emissions management by 2012. The agreements require firms to pay (in cash or emission units) for excess emissions if world’s-best-practice targets are not achieved, and the Crown to transfer emission units to firms if additional emissions reductions occur (an example of a baseline-credit approach). Most NGA emissions targets are based on emissions intensity [Emissions intensity is measured by the number of tonnes of CO2e emitted per unit of production or output.], however, so gross emissions from NGA firms may still increase without penalty if the business is expanding its output. The use of an emissions-intensity metric for NGAs therefore places no constraint on growth in industrial production, but reduces the emissions increase associated with such growth.

Emissions intensity targets contrast with New Zealand’s Kyoto Protocol obligations, which are based on aggregate emissions. A number of NGA firms are expected to expand production in the period to 2012, which may make it more costly for New Zealand to meet its CP1 obligations.

NGA negotiations to date indicate improvements in emissions intensity achieved through compliance with the agreements will be in the order of 7% or less from 2004 to 2012. If NGA firms fail to make the intensity improvements required, they will be obliged to pay the carbon tax or transfer carbon credits [NGA firms have the option to purchase international carbon credits to meet their NGA obligations; however, overseas investments in carbon credits will not reduce New Zealand’s domestic emissions in the longer term.] to cover the excess emissions. In incorporating the impact of NGAs in SADEM modelling, MED estimates that NGAs will result in NGA firms reducing emissions by between 2% and 4% from business-as-usual from 2008 onwards.

In some cases, NGA firms already operate close to world’s best practice in emissions management, as their energy intensity gives them a strong business incentive to use energy efficiently. For the most energy-intensive industrial sectors, given the existing importance of minimising energy costs and the relatively slow rate of technology change, projections of world’s-best-practice emissions intensity tend to reflect gradual improvement rather than dramatic step changes. NGA target pathways tend to mirror this expected trend of gradual improvement.

Information from early applicants suggests that a significant level of investment may still be required to bridge even a small gap between current performance and world’s best practice. Emissions-reductions benefits of such investment would be expected to endure post-2012.

Experience during negotiations has indicated the NGA process may be of value in raising awareness of the importance of emissions mitigation and energy efficiency among senior management at many of New Zealand’s biggest emitting firms. Over a number of years, this can catalyse a valuable “attitude change” among influential business people, although quantifying resulting emissions reductions is not possible.

Quantitative projection of emissions reductions

MED’s SADEM model [The SADEM model has recently been audited as part of an overall review of New Zealand’s emissions projections for CP1. The audit found the SADEM model gives a reasonable overall depiction of the specifics of the New Zealand energy sector and is an appropriate tool for projecting energy-related CO2emissions over CP1. However, a risk was noted that future emissions forecasts from the SADEM model may change where work is planned to more accurately capture the energy demand arising from the transport sector.] projects that a $15 per tonne of CO2e carbon tax (with exemptions applied to steel and aluminium production and forestry processing) coupled with NGAs [Emissions reductions resulting from NGAs are based on independent assumptions that are then incorporated into the model.] will decrease business-as-usual emissions by:

  • 0.92Mt CO2e per annum in the energy (non-transport) sector by 2020 (0.90Mt CO2e resulting from the carbon tax and 0.02Mt CO2e resulting from NGAs). This equates to a 4% reduction on business-as-usual energy (non-transport) emissions. Despite the carbon tax/NGA regime, overall emissions from this sector are still projected to grow by 17% between 2005 and 2020
  • 0.14Mt CO2e per annum in the transport sector by 2020 (all resulting from the carbon tax). This equates to a 1% reduction on business-as-usual transport emissions. Despite the carbon tax/NGA regime, overall emissions from this sector are still projected to grow by 36% between 2005 and 2020
  • 0.08Mt CO2e per annum in the industrial processes and fugitive emissions sectors (all resulting from NGAs). This equates to a 2% reduction on business-as-usual industrial process and fugitive emissions. Despite the carbon tax/NGA regime, overall emissions from this sector are still projected to grow by 7% between 2005 and 2020.

Assumptions of the SADEM model are set out below.

  2005 2010 2015 2020
GDP (billion 2004 $NZ) 149.1 171.5 190.7 210.8
Oil Price (2004 $US/bbl) 50.00 50.00 46.66 43.33
Coal Price (2004 $NZ/GJ) 3.75 3.75 3.75 3.75
Exchange Rate ($NZ/$US) .690 .600 .600 .600
Gas Discoveries (PJ/Year) 60 60 60 60
Population (million) 4.08 4.22 4.35 4.48

The overall impact of the carbon tax/NGA regime is therefore projected to be a 1.14Mt CO2e reduction on business-as-usual emissions by 2020. This equates to 2.48% of energy emissions and 1.25% of total New Zealand greenhouse gas emissions in 2020. [Based on projections of total emissions in the draft New Zealand 4th National Communication under the UNFCCC (2005).] A 1.25% reduction on business-as-usual emissions is considered to be modest, particularly given the carbon tax/NGA regime is the centrepiece of New Zealand’s climate change policy package.

The modest impact is likely to be a result of the coverage of the tax, the inelasticity of demand of covered sectors, and the high proportion of renewable energy in New Zealand’s electricity supply (and hence the reduced impact of electricity conservation on emissions levels). The use of emissions-intensity targets is also considered to limit the exposure of NGA firms to an emissions price.

Short-term (through to the end of CP1) emissions savings resulting from the carbon tax/NGA regime are likely to be greater than medium-term (to 2020) savings. The carbon tax yields its greatest impact through changes to electricity generation. It is expected that the tax will result in the displacement of coal generation with gas generation through to 2010. As New Zealand gas reserves are run down and the price of gas increases, this impact is expected to diminish.

Using the mid-point of 2010, the carbon tax/NGA regime is projected to achieve emissions reductions of 13.45Mt CO2e across the five years of CP1. At an emission unit price of $NZ8.56 (as used to estimate New Zealand’s potential CP1 liability in the Crown accounts), this reduction would save New Zealand purchasing an additional $115 million worth of units to meet its CP1 obligations.

A higher tax rate would be likely to encourage a greater level of emissions reductions, particularly if rate increases were signalled well in advance and over a reasonably long timeframe. However, an increase in the tax rate will be accompanied by a corresponding increase in economic and social costs, and ultimately, the ability of the tax to achieve emissions reductions in its current form is limited by its relatively narrow coverage (taking account of NGA exemptions).

There is some support for New Zealand’s relatively low projected emissions reductions in international ex-post studies of the impact of carbon taxes. Bruvoll and Larsen (2002) examine the effect of carbon taxes introduced in Norway between 1991 and 1999. A range of tax rates were applied across different fuels and activities (including petrol, gas and coal), although several industries with relatively high emissions were exempt. Minus exemptions, the carbon taxes covered about 64% of total carbon dioxide emissions in Norway. The average rate applied was $US21 per tonne of CO2 (approximately $NZ30 per tonne of CO2). Despite the high rate, the estimated effect of carbon taxes on national carbon dioxide emissions was a reduction of 2.3% over this period. This relatively small effect was thought to relate to the extensive tax exemptions and relatively inelastic demand in the sectors where the tax was implemented.

Conclusion

Overall emissions reductions from the carbon tax/NGA regime look to be modest, at a 1.25% decrease on business-as-usual emissions by 2020. The modest impact is considered to result from relatively narrow coverage, the general inelasticity of energy use in the short term (coupled with the relatively low price impact at the announced tax rate), the high proportion of renewable energy in New Zealand’s electricity supply (and hence the reduced impact of electricity conservation on emissions levels), and the limited exposure of NGA firms to an emissions price.

The tax is projected to result in some significant displacement of coal with gas in electricity generation through to 2010, although this effect diminishes as the price of New Zealand gas increases. Estimated emissions reductions as a result of the carbon tax/NGA regime are 13.45Mt CO2e over CP1.

Ultimately, the ability of the tax to achieve emissions reductions in its announced form is considered limited, as the tax applies only to around a third of total New Zealand emissions (taking account of NGA exemptions).

Economic efficiency

In the context of climate change policy, an efficient price-based measure would mean:

  • emitters have an equal incentive to find and apply the lowest-cost methods for reducing their emissions [From a global efficiency viewpoint, New Zealand should incentivise emissions reductions up to the international price of carbon.]
  • all emitters have the same incentives to use all potential methods of reducing emissions (The Treasury, 1997).

Essentially, an efficient price-based measure would incentivise the least-cost emissions-reduction opportunities across the whole economy.

Breadth of coverage

The characteristics of New Zealand’s particular tax regime will have a significant impact on its overall efficiency. As an efficient tax would provide all emitters with an equal incentive to find and apply the lowest-cost emissions reductions, breadth of coverage is an important consideration. Granting exemptions to a tax often implies that some firms could decrease emissions at lower marginal cost than others, yet are not required to do so (Sin and Kerr, 2005).

International experience supports this view. A review of partial carbon tax exemptions currently applied to industrial energy users in Sweden, Denmark and Norway found that they have serious implications for the theoretical efficiency advantages of using carbon taxes to reduce carbon emissions, and may be expected to increase the overall macroeconomic cost at which reductions are achieved (Ekins and Barker, 2001). Pizer et al (2005) find that applying substantial exemptions (including to industry) to an economy-wide cap-and-trade programme in the United States may double the costs at which abatement is achieved.

Sin and Kerr (2005) agree that, in general, exemptions cause inefficiencies but note the exception is where firms operate purely in a competitive international market and are unable to absorb or pass on any extra costs. Imposing costs on them will result in production and emissions simply moving offshore, which is a wholly undesirable outcome from a national-benefit perspective.

In CP1, exempting businesses from the tax (thereby foregoing potential emissions reductions) will result in the Government purchasing more (or selling fewer) permits on the international market. The Government has to recover these expenses through general taxation, which causes distortions in the economy. Conversely, a broadly based tax could result in significant revenue recycling through tax cuts in other areas, which could give New Zealand firms competitive advantage over their international competitors (Sin and Kerr, 2005).

In recognition of the limited opportunities to reduce emissions in the agricultural sector, methane and nitrous oxide emissions from farming have been excluded from coverage of the carbon tax in New Zealand. Agricultural emitters therefore will not face the same incentive to reduce emissions as those subject to the tax.

In the short run, this may not have a substantial impact, as there are thought to be few opportunities for low-cost abatement of agricultural emissions [Firms do tend to underestimate their potential opportunities for abatement before they face a price, however. Getting people to identify and exploit these opportunities is one of the main reasons for using a price-based measure.] (see Section 4.7). But in the long run, the agricultural sector will be subject to a lesser incentive than those sectors facing the tax to invent, innovate and invest in emissions-reducing technologies [Sinn and Kerr (2005) argue that, in relation to New Zealand, most new “clean” technologies are developed overseas and adopted by domestic firms. Consequently, incentives to invest may generally be more important than invention and innovation. However, New Zealand does engage in research and innovation in niche sectors. In the agriculture sector, for example, New Zealand may be as well placed as any to develop emission-reducing technologies.]. Under the announced carbon tax, we therefore cannot be sure that the least-cost opportunities for abatement will be adopted in the medium and long-term. Given that the exemption applied to agriculture accounts for around half of New Zealand’s total emissions, this is potentially a significant distortion and may increase the overall costs at which abatement is achieved.

Furthermore, firms that successfully negotiate an NGA will receive an exemption or rebate of the carbon tax. NGAs require firms to meet world’s-best-practice targets in emissions management and provide incentives to achieve (and exceed) their target. However, as NGA incentives apply to marginal emissions around a world’s-best-practice target (which is based on emissions intensity rather than total emissions) the incentive is not equivalent to that faced by non-exempt sectors.

As with agriculture, in the short term, this may not have a significant effect on emissions reduction if it is assumed that NGA firms have relatively few low-cost abatement opportunities available to them. However, NGA firms will not be faced with the same incentive to invest in emissions-reducing technologies and seek out new ways of reducing emissions, which will affect the ability of the regime to achieve abatement at lowest cost in the medium and long-term.

Ekins and Speck (1999) studied the use of negotiated agreements applied to tax-exempt firms in the manufacturing sector in various European countries and found that, while better than nothing, these agreements did not send the signal to consumers and producers of the need for fundamental restructuring that would result from price increases under a price-based measure.

NGA policy

By providing for applications for and negotiation of tax exemptions on an individual basis, NGA policy can create incentives for strategic behaviour and lobbying. This reduces overall productivity and can make it challenging for the Crown to establish appropriate emissions targets and relief levels for NGA firms. NGA policy aims to reduce this risk through a robust eligibility procedure and through recent changes to the NGA process that allow for emission target pathways to be set formulaically, using an independent world’s best-practice study, rather than through negotiations. However, some degree of strategic behaviour is inevitable and will result in efficiency losses.

Sin and Kerr (2005) also note that, due to the transaction costs of negotiating agreements, small firms are less likely to receive NGAs. This is inequitable and may shift production from small firms without NGAs to large firms with them at no environmental gain.

Conclusion

The announced carbon tax creates unequal incentives across the economy to reduce emissions, due to the exclusion of agriculture and NGA firms (although NGA firms will still face an incentive on marginal emissions around their target pathway). While this is not likely to have a significant detrimental impact immediately, given the relatively few current opportunities for abatement in these sectors, it does affect the incentive faced by agriculture and NGA firms to invest in capital and develop new and improved business practices to reduce emissions in the future. This is likely to impact on the cost at which emissions abatement is achieved in the medium and long term.

Economic and social impact

This section will assess:

  • macroeconomic impacts of the carbon tax
  • competitiveness benefits of NGA policy
  • trade implications of NGA policy
  • sectoral and social impacts of the carbon tax
  • compliance and transaction costs of the carbon tax/NGA regime.
Macroeconomic Impacts

Macroeconomic impacts of an emissions price in New Zealand can be estimated using a general equilibrium model. The 2005 Australian Bureau of Agricultural and Resource Economics (ABARE) general equilibrium modelling (discussed in detail in Section 4.9) included a scenario where:

  • a global emissions price of $NZ13 per tonne of CO2e would be faced by all Annex I countries, excluding the United States and Australia
  • the emissions price would be applied to all sectors excluding agriculture, both internationally and in New Zealand
  • New Zealand would need to abate (or purchase emissions units for) 7.7Mt CO2e per annum during CP1 to meet its emissions target.

This scenario presents the closest approximation to New Zealand’s current circumstances, including the announced carbon tax, of the scenarios modelled by ABARE. While no exemption from the emissions price was applied to emissions-intensive New Zealand firms under the scenario (as is occurring under NGA policy), international competitiveness risks are mitigated by the broad application of an emissions price among developed countries. The scenario did not assume revenue recycling of carbon tax revenue, which, can assist in reducing adverse economic impacts.

The modelling projected that a global emissions price of $NZ13 per tonne of CO2e would reduce New Zealand’s GDP by 0.04% in 2010. [This is in comparison to the ABARE reference scenario where no climate change policies are implemented internationally.] Based on 2010 GDP of $171.5 billion (in 2004 $NZ; as assumed by MED’s SADEM model), this equates to an impact of $69 million per year. The GDP impact results primarily from changes in output and trade in various energy-intensive sectors.

Iron and steel (-4.4%) and primary aluminium production (-4.3%) were projected to experience the greatest output reductions. Iron and steel exports were projected to decrease by 9.6% and primary aluminium exports were projected to decrease by 4.3%. The impact on agricultural production was very small, given the exemption applied to agricultural emissions.

There is a variety of limitations associated with general equilibrium modelling. These limitations are outlined in detail in Section 4.9. In particular, the model assumes that structural adjustment within the economy is costless and takes place in a steady manner. In reality, it is known that this is not the case. In terms of timing, a review of the ABARE model stated that a “new long-run equilibrium industry configuration could take 10 to 20 years to complete, with many downside adjustments occurring faster than many upside adjustments” (Grimes, 2002). Effectively, this means that the costs in 2010 may be greater than those outlined in the results presented. Modelling results therefore need to be interpreted with caution. Nevertheless, the macroeconomic impact derived by the model presents the best estimate available of the anticipated impact of the announced carbon tax.

In 2001, Hoerner and Bosquet (2001) reviewed ex-ante modelling undertaken in a number of European countries of the economic impacts of various types of carbon and energy taxes. Although the coverage and rates of these taxes vary, this collation of results presents a useful comparison with New Zealand’s modelled GDP impact. Based on 44 studies containing 104 distinct simulations, the impacts of environmental tax reform on GDP were shown to range from -5.0 % to +2.5 %.

The projected macroeconomic impact of a $13 per tonne of CO2e global emissions price of a 0.04% reduction in GDP appears moderate for an environmental tax, based on the review of European taxes. However, it should be noted that a large proportion of the European modelling studies made assumptions around recycling tax revenue, influencing the range of modelling results. Revenue recycling will reduce the adverse economic impacts (or increase the positive impacts) of an environmental tax on the economy.

Given the difficulties in examining the economy-wide impacts of a set of individually negotiated emissions-reduction agreements, no attempts have been made to assess the macroeconomic costs of NGA policy.

Fiscally, a carbon tax of $15 per tonne of CO2e is expected to raise approximately $600 million (GST-inclusive) per annum (± $50 million), while approximately $240 million (GST-inclusive) per annum (± $50 million) will be needed to give firms with NGAs relief from the tax.

A separate assessment at the time carbon tax policy was finalised found that the Consumers Price Index is likely to increase when the tax comes into force, mainly through retail petrol and electricity prices (about 0.1 percentage points due to the petrol rise and 0.1 to 0.25 percentage points due to the electricity price rise).

Competitiveness benefits of NGA policy

As noted in Section 4.2.1, the imposition of a carbon tax could result in “emissions leakage” in cases where New Zealand firms compete against foreign firms that are subject to less stringent climate change measures. In the case of internationally traded commodities, if New Zealand were to constrain its industrial production to reduce domestic emissions, and this production was displaced to other countries with less-stringent climate policies, then global emissions would actually increase despite the apparent reduction in New Zealand’s national emissions inventory.

It is considered that a carbon tax of $15 per tonne of CO2e presents a real risk of emissions leakage in New Zealand. NGA policy aims to address the issue of emissions leakage by providing competitiveness-at-risk firms with relief from the tax in exchange for meeting world’s-best-practice targets in emissions management.

[withheld under OIA s6(a), s9(2)(d), s9(2)(j)]

These firms represent a significant proportion of New Zealand’s industrial sector. [The industrial sector (excluding mining activities) produced approximately 25% of New Zealand’s GDP in 1998 (EECA, 2000).] Data are not currently available on the expected collective contribution of NGA firms to New Zealand’s GDP during CP1.

Some competitiveness issues may still arise as a result of the requirement under NGAs for firms to move to world’s best practice in emissions management by 2012 and the consequential effect this adjustment will have on marginal costs of production. However, these issues are not as severe as they would be if exemptions were not granted.

Under current NGA policy, the Government must conduct an initial net national benefit assessment of entering into an NGA as a pre-condition to each eligibility decision. This net national benefit assessment is revisited prior to signing the final NGA. The net national benefit assessment comprises objective and subjective elements. The objective element focuses primarily on the net cost to the Government of granting carbon tax relief versus the total economic contribution of the applicant. The objective element is then rebalanced by consideration of subjective factors such as regional and investment benefits versus economic efficiency distortions (POL Min (03) 8/8). Therefore, the Government must conclude that each NGA generates a net national benefit before entering into an agreement.

In the context of New Zealand’s goals for economic growth (including increasing New Zealand’s per capita GDP to the top half of the OECD), reduced economic production among NGA firms would be undesirable, especially where there is no associated environmental benefit. Provided international efforts to apply stringent emissions-reduction incentives remain fragmented, it would be in New Zealand’s best interests for any application of a domestic price signal at a level that would threaten firms’ international competitiveness to be accompanied by some form of relief for international competitiveness-at-risk firms.

 

[withheld under OIA s6(a), s9(2)(j)]

[withheld under OIA s6(a), s9(2)(j)]

Sectoral and social impacts

As exemptions will be applied to agriculture and most large industrial firms through NGA policy, the carbon tax will be predominantly borne by small and medium businesses and domestic energy users.

In a survey of SMEs undertaken by PricewaterhouseCoopers (2004), there was a moderate level of concern among firms about the impact of the carbon tax. Those who expressed the strongest concerns were firms for whom exports were a significant part of sales and those who competed against imports. Both groups were particularly concerned about competing with non-Kyoto countries such as Australia and the United States. Companies that almost exclusively supplied domestic markets were relatively unconcerned.

The majority of SMEs (over 90%) are small firms that are not energy intensive and for whom the effects of a carbon tax will be small. Most will absorb the additional cost or pass it on. [Detailed data on the specific impacts of the tax are difficult to obtain, but estimates provided by a consultant for the New Zealand Vegetable Growers Federation show that for a Franklin farmer growing arable crops, energy (diesel plus electricity) accounts for 6.3% of total operating costs, and a carbon tax (at $25 per tonne of CO2e) would increase this by 0.7%.] A minority of larger firms may be adversely affected by a carbon tax because they spend a significant proportion of their operating costs on energy, cannot easily pass on cost increases, face limited options for improved energy efficiency, and would require major capital investment to take up these options. Typically, these firms include foundries, chemical manufacturers, tyre makers, wood processors, food processors, metal coaters, fertiliser manufacturers, and glasshouse crop growers.

The impact of a carbon tax and the response of these larger firms will vary. Some are capable of immediate improvements in energy efficiency that could mitigate the effects of a carbon tax in the short term. Others are already energy efficient and face limited and often expensive alternatives in the short term, for example, switching to alternative fuels (eg, from coal to gas or biomass). For some energy-intensive firms, particularly those that compete in export markets or against foreign imports, impacts are therefore likely to be more significant.

The Government has developed policies to assist with adjustment to the carbon tax for energy-intensive businesses that lack the resources to go through an NGA process. Policy measures include grants to assist with energy-efficiency investments and support for demonstration projects in energy-intensive industries. Information on improving business energy efficiency to reduce the impact of the carbon tax is also available on the Ministry for the Environment’s website.

For domestic energy users, the total effect on households is likely to be approximately $4 per week (IRD, 2005). The 4 cents per litre increase in the price of transport fuel and 1 cent per kWh increase in the price of residential electricity are within the bounds of standard market price movements for both these services and are not anticipated to have significant adverse effects.

Creedy and Sleeman (2004) found that the distributional effect of a carbon tax on households is somewhat ambiguous. Households with relatively low total expenditure were found to spend a proportionately greater amount of their income on carbon-intensive commodities such as petrol and domestic fuel and power. However, substantial price increases are also anticipated in several commodity groups on which households with relatively high total expenditure spend proportionately more. Therefore, for a majority of household types, a carbon tax proves to be neither strictly progressive nor regressive. [Portions of the low-income group most vulnerable to increases in prices will receive some degree of compensation, as benefits and superannuation are adjusted to the Consumers Price Index and Family Support will be indexed to increases in the Consumers Price Index from 2008.]

Kerr (2001) assessed t he likely distributional effects in New Zealand of a carbon tax on petrol. The costs of a petrol tax were thought to fall almost completely on consumers, as a result of New Zealand’s relatively competitive market for petrol. Using Statistics New Zealand’s Household Expenditure Survey, it was found that a petrol tax would have slightly regressive impacts but might affect middle-income people most. This was especially true when adjustments for household size were made. This result, while based on limited analysis, was thought to be consistent with more detailed international studies.

In general, most sectors facing the carbon tax will not be significantly adversely affected by it. Energy-intensive businesses that are not of sufficient size or are not sufficiently affected to negotiate an NGA, are likely to experience more significant impacts, although a set of policy measures has been adopted to ease the transition for these firms. The impact on households is projected to be low and will not vary significantly with income levels, although analysis of the distributional effects of a carbon tax on petrol indicates middle-income groups could be those most affected.

Compliance and transaction costs

The carbon tax will impose some administration and compliance costs on firms. In designing implementation details of the tax, the Government has aimed to minimise these costs by applying the tax upstream in the supply chain (therefore reducing the number of firms facing these costs) and, where possible, administering the tax via existing systems such as those for collecting excise duty, GST and the Energy Resources Levy.

Firms liable to pay the tax directly and NGA firms will be required to file regular returns to Inland Revenue. Other firms claiming rebates of the tax will do so in relation to one or more tax periods but will not have to file regular returns. Return filing will generally be electronic. A minimum threshold of $2,000 worth of emissions a year, calculated as if the charge were being applied, is proposed for applying the carbon tax to any taxpayer. In general, it is considered that administration and compliance costs associated with the carbon tax will not be onerous.

The process of applying for and negotiating NGAs can be time consuming and complex, and stakeholders have reported that these transaction costs act as a barrier to entry for some firms. The process has also been costly for both the firm and the Crown – the cost to the Crown of negotiating individual NGAs has been between $100,000 and $200,000.

In early 2005, the NGA policy was reviewed and the process was modified to reduce the time and cost involved. Key changes included the use of an automated procedure to calculate a firm’s emissions target pathway, rather than this being a matter for negotiation between the Crown and the firm; the development of a streamlined process to determine the “world’s-best-practice” level of emissions intensity; and the increased use of standardised text for NGAs. Early indications are that the NGA review changes will considerably simplify and speed up the NGA process.

Conclusion

It is anticipated that the macroeconomic effect of the carbon tax will be small but negative. The 2005 ABARE general equilibrium modelling projected the impact of a $NZ13 per tonne of CO2e global emissions price on the New Zealand economy. The assumptions under this scenario present the closest approximation to New Zealand’s current circumstances, including the announced carbon tax. However, due to limitations with equilibrium modelling, caution is warranted in interpreting the results.

The scenario projected that New Zealand’s GDP would decrease by 0.04% in 2010 [This is in comparison to the ABARE reference scenario where no climate change policies are implemented internationally.] as the economy undergoes some restructuring. This equates to an impact of $69 million in 2010. The iron and steel and primary aluminium industries were projected to sustain the greatest sectoral impacts. Under the announced policy package, these sectors are likely to receive exemptions from the carbon tax under NGA policy.

A review of modelling exercises that assessed the impact of various energy and emissions taxes on European economies showed a range of anticipated economic impacts from -5.0% to +2.5% of GDP. In the context of this range, the impact of an emissions price on New Zealand as projected by ABARE appears moderate.

Under the current policy package, NGA policy plays an important role in protecting New Zealand’s international competitiveness. At the announced carbon tax rate, there is a real threat of economic and emissions leakage from New Zealand if NGA firms are not exempt. In the interests of New Zealand’s goals for economic growth, any domestic emissions price set at a rate, and in a context, that would threaten New Zealand’s international competitiveness should be accompanied by some form of relief for competitiveness-at-risk firms.

Those sectors facing the carbon tax will not be significantly adversely affected by it. Energy-intensive businesses that are not of sufficient size or are not sufficiently affected to negotiate an NGA, are likely to experience more significant impacts, although a set of policy measures has been adopted to ease the transition for these firms. The impact on households is projected to be low and will not vary significantly with income levels, although analysis of the distributional effects of a carbon tax on petrol indicates middle-income groups could be those most affected.

Compliance costs from the carbon tax are not thought to be overly onerous. Transaction costs are faced by the Crown and the applicant firm under NGA policy, although these costs are reducing significantly as a result of recent changes to the negotiation process.

Sustainability and flexibility

Importance of sustainability

Establishing a price-based climate change measure that is sustainable over 10 to 20 years has a number of advantages:

  • stability reinforces the signal sent by a price-based measure that emissions will be part of the economy in the future, and therefore may promote effectiveness of the instrument
  • stability gives investment certainty to firms on the price measures they will be operating under (many firms are making investment decisions that will last for 20 to 30 years)
  • it avoids the cost of transitioning between regimes; eg, the Government and firms spend time and resources assessing how one regime will work, only to repeat the process with a new regime.

The adopted measure should allow for adjustment to meet more stringent or less stringent New Zealand emissions targets that might eventuate under any future international framework. If intended as a basis from which to move to a different regime, a clear transition path should be set out to ensure this transition can and will occur.

Sustainability of carbon tax/NGA regime

A number of factors impact on the sustainability of the current regime:

  • policy decisions on the application and rate of the announced carbon tax and the existence of NGA policy extend only until 2012. Firms therefore face uncertainty in terms of the climate change policies they will be subject to in the medium term. Under uncertainty, firms will be less likely to make appropriate decisions in relation to their carbon intensity, impacting on the effectiveness of the tax. Some NGA firms have identified this as a significant concern, given the long-term nature of their capital investments
  • furthermore, the Government has indicated that the carbon tax may not be its preferred long-term price mechanism. The Cabinet paper setting design details of the announced carbon tax notes that, in a situation with a well-functioning international permit market, an emissions trading regime would almost certainly be more efficient than a carbon tax. In announcing the carbon tax, the Government reserved the right to move to a trading regime should the circumstances make it appropriate
  • under the current regime, agriculture and NGA firms are exempt from the carbon tax. While few near-term emissions-reduction opportunities may be available for these sectors, in the medium-to-long term (assuming the current policy remains), these sectors will have a lesser incentive to invest in new capital and develop new business processes or products that reduce greenhouse gas emissions than those sectors subject to the carbon tax. As a result, lowest-cost options to reduce emissions across the economy may not be adopted. It also creates equity issues, as small New Zealand businesses and households continue to pay for their emissions while large industrial users and agriculture firms continue to be exempt
  • the current carbon tax/NGA regime would not have New Zealand well placed to significantly increase emissions reductions to meet specific quantified targets should this be required under a future international framework or as a result of more specific scientific information becoming available on the emissions reductions required to stabilise the climate. As the tax applies only to around a third of New Zealand emissions, a ramp-up of the rate would be unlikely to achieve significant emissions reductions unless it was to a level that would create significant costs on the sectors it covered.

A number of aspects of NGA policy make it unsuitable as an ongoing solution to international competitiveness issues, should they continue for a further 10 to 20 years:

  • the NGA process to date has involved significant time and resource costs for both the Crown and applicant firms. Despite the fact that the process has been recently streamlined, repeating this process on a regular (say, five-yearly) basis for each individual firm (potentially in addition to receiving intermittent re-applications from firms found ineligible) would seem to be a high ongoing transaction cost. A continuation of the current carbon tax/NGA regime in the medium term could also see a general increase in NGA applications as smaller firms find the relief offered to be worth the transaction costs
  • renegotiating NGAs may lead to strategic behaviour and lobbying by NGA firms, which would inhibit investment and abatement in the meantime. For example, firms may elect to defer investment in more energy-efficient capital until after future target pathways have been negotiated (although this may be addressed through recent changes to the process for setting target pathways). Strategic behaviour and lobbying lead to losses in productivity
  • NGA targets are currently based on emissions intensity. A number of NGA firms are expected to increase overall production through to 2012, allowing for an increase in their absolute level of emissions. This has ramifications in moving to a possible environment where New Zealand is required to achieve more stringent emissions reductions.

It is therefore considered the current regime is unlikely to be sustainable over a period of 10 to 20 years.

Flexibility of carbon tax/NGA regime as a basis for transitioning to an alternative regime

The suitability of the current regime as a basis for moving to emissions trading will be influenced by the characteristics and rules of the trading regime (which itself may depend on matters such as linking rules established by the European Union for the European Union Greenhouse Gas Emission Trading Scheme). Points of obligation for emissions trading could remain the same as for the carbon tax – firms would simply be required to remit emission permits to the Government rather than issuing payment. Provided the carbon tax was adjusted to follow the international price of carbon, the cost to emissions-inducing activities of a tax and an emissions trading scheme (linked to the international market) would be approximately equivalent.

In moving to a new regime, pressure may be applied by firms currently granted exemptions for continued relief (particularly while equivalent overseas firms do not face similar measures). Under a trading scheme, this would likely involve the “grandparenting” of emissions units to NGA firms, perhaps based on their level of production at that time. Given that the current tax is applied upstream but exemptions (in the form of NGAs) are applied downstream, the current regime would most likely lead to a similarly structured trading regime (ie, a “mixed” emissions trading regime rather than a “pure” regime).

In practice, once the carbon tax/NGA regime has been established in New Zealand (with the associated policy development, legislative and political processes, including the process of negotiating NGAs) it seems likely it will remain in place for some time, at least through CP1; ie, heavy transaction costs in designing and implementing the current regime may lead to some inertia. The fact that a transition path to a future regime is currently not well defined may further exacerbate this.

Conclusion

Establishing a price-based measure that is sustainable over the medium term brings a number of advantages including reinforcing the price signal sent by the measure, improving regulatory and investment certainty, and avoiding transition costs.

The announced carbon tax would not have New Zealand well placed to significantly increase emissions reductions should this be required in the future, due to the exemptions applied to the agriculture sector and NGA firms. Furthermore, the NGA process may create ongoing transaction costs for the Crown and for firms, and may lead to strategic gaming behaviour. The Review concludes that the carbon tax as announced, and the NGA policy, are unlikely to be sustainable over the medium term.

Feasibility

A carbon tax applied to upstream sources of emissions (mainly producers and importers), and excluding the agriculture sector, is thought to be manageable to administer. Many administration details have been worked through as part of the policy development process, including identification of government agencies responsible for administering the tax. A number of complex implementation issues exist:

  • applying emission factors to different streams of gas
  • taxing fugitive gas and coal seam gas emissions
  • taxing geothermal energy emissions
  • taxing domestic aviation fuel
  • applying the tax to existing stockpiles of coal or gas.

Consultation with stakeholders on many of these issues has been carried out and practical solutions have been identified or are being developed. These issues are likely to be present for any price-based measure.

Initial negotiations of NGAs were time consuming and costly for both the Crown and the firm, although the streamlined process established following the NGA review will significantly cut down the time and resources required. Also, officials (and consultants) have developed their expertise at processing NGAs, which assists in running a quick and effective process. Overall, NGA policy does take time and resources to implement, although experience has shown that the process is certainly feasible and will probably only improve. If NGA policy were to be continued beyond 2012, greater feasibility issues may be encountered as a result of the ongoing negotiations required.

Conclusion

The carbon tax would be manageable to administer. The NGA process can be long and costly but is feasible in the short term and appears to be improving. The NGA policy is unlikely to be sustainable over the medium term – say, beyond 2012.

Overall conclusion

Likely emissions mitigation as a result of the carbon tax/NGA regime would be modest, due to relatively narrow coverage, the general inelasticity of energy use in the short term (coupled with the relatively low price impact at the announced tax rate), the high proportion of renewable energy in New Zealand’s electricity supply (and hence the reduced impact of electricity conservation on emissions levels), and the limited exposure of NGA firms to an emissions price.

MED’s SADEM model projects that a $15 per tonne of CO2e carbon tax, coupled with NGAs, will achieve a 1.14Mt CO2e reduction in annual emissions from business-as-usual by 2020. This amounts to 1.25% of anticipated total New Zealand emissions at this time.

During CP1, a total reduction of 13.45Mt CO2e is projected over five years. At a price of $NZ8.56 (as used to estimate New Zealand’s potential CP1 liability in the Crown accounts) for emission units, this reduction would save New Zealand purchasing an additional $115 million worth of units to meet its CP1 obligations. [Assuming a price of $NZ8.56 and a net CP1 deficit of 36Mt CO2e, New Zealand would still need to purchase $308 million worth of units, despite these additional reductions.]

It is anticipated that the macroeconomic effect of the carbon tax will be reasonably moderate. The 2005 ABARE general equilibrium modelling projected the impact of a $NZ13 per tonne of CO2e global emissions price on the New Zealand economy. The assumptions under this scenario present the closest approximation to New Zealand’s current circumstances, including the announced carbon tax. The scenario projected that New Zealand’s GDP would decrease by 0.04% in 2010 [This is in comparison to the ABARE reference scenario where no climate change policies are implemented internationally.] as the economy undergoes some restructuring, an impact of $69 million. This impact is considered moderate for an environmental tax, although due to a range of limitations associated with equilibrium modelling, caution is warranted in interpreting the modelling results. [In particular, a review of the ABARE model (Grimes, 2002) stated that a “new long-run equilibrium industry configuration could take 10 to 20 years to complete with many downside adjustments occurring faster than many upside adjustments”. Effectively this means that the costs in 2010 may be greater than those outlined in the results presented.]

The carbon tax exemptions applied to the agriculture sector and NGA firms create unequal incentives across the economy to reduce emissions and are therefore a significant source of inefficiency. While this is not likely to have a significant detrimental impact immediately (given the relatively few current opportunities for abatement in these sectors), it does affect the incentive faced by agriculture and NGA firms to develop and invest in new and improved business practices and technologies to reduce emissions in the future. This will affect New Zealand’s ability to achieve abatement in the medium and long term at lowest cost.

Establishing a price-based measure that is sustainable over the medium term (10 to 20 years) brings a number of advantages including reinforcing the price signal sent by the measure, improving regulatory and investment certainty, and avoiding transition costs. Due to the limited anticipated emissions reductions and economic efficiency issues outlined above, the carbon tax/NGA regime is unlikely to be sustainable over such a period.