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4.8 Moving towards a purchasing strategy

RELEASED UNDER THE OFFICIAL INFORMATION ACT

4.8 Moving towards a purchasing strategy

Summary

This section explores issues the Government would need to consider in developing a purchasing strategy in the context of our net deficit for CP1 and the limited scope for domestic mitigation to close this gap.

It concludes that:

  • New Zealand’s purchasing strategy will be determined by a range of factors, including consideration of the most appropriate objectives, and issues of managing risk, timing and price
  • although there is considerable uncertainty about future supply and demand in the international carbon market, it is very possible that the price of carbon will rise in the future and that there will be considerable volatility in the market
  • to position New Zealand as well as possible to purchase units in the international carbon market, early work on determining our most appropriate purchasing strategy would be extremely useful and valuable.

Recent projections suggest that under current policies, New Zealand is likely to face a significant net deficit under the Protocol for CP1. The limited scope for further domestic mitigation to close this gap without unduly impacting on the Government’s other objectives, including growth, mean that it is sensible to consider the option of purchasing emissions units as part of any overall strategy to meet our Kyoto obligations.

Were the Government at some later stage to move to put in place an emissions trading scheme (see Section 4.2.4) an option under this would be for firms to meet their obligations through the international purchase of units. [For example, under the European Emissions Trading Scheme, private entities can directly purchase via CDM or JI units to meet their obligations.] As this option is not being recommended during CP1, purchases by individual firms are not considered further in this section, although many of the issues raised below would remain relevant. [Depending on the future evolution of any carbon tax, one could consider allowing firms to offset their tax obligations by purchasing units internationally and then surrendering them to the Government.] This section therefore explores issues the Government would need to consider in developing a purchasing strategy.

The flexibility mechanisms

The Kyoto Protocol established a number of flexibility mechanisms that allow Annex I Parties to purchase emissions units from other countries as part of a strategy for meeting their obligations under the Protocol.

These flexibility mechanisms arose from recognition that the cost of reducing greenhouse gases was likely to vary across countries, with different countries facing a different range of options depending on the particular structure of their economy, level of development and the technology in place. The flexibility mechanisms potentially allow the least-cost mitigation options to be taken up at a global scale, reducing the cost of achieving climate change goals.

There are four mechanisms for purchasing emissions units provided under the Kyoto Protocol:

  • International Emissions Trading (IET) – the trade of allowable emissions units, or assigned-amounts units between countries. Where emissions from an Annex I country fall below its assigned level – ie, it has a Kyoto surplus – it may sell the excess units
  • Clean Development Mechanism (CDM) – purchase of projects-based units from a Non-Annex I country
  • Joint Implementation (JI) – purchase of projects-based units from an Annex I country. Generally, the supply of these units is associated with economies in transition. There are two forms of JI – Track I and Track II – distinguished by the nature of their particular arrangements for project approval
  • Removal Units (RMU) – these are issued on the basis of LULUCF activities.

Both the CDM and JI are mechanisms that involve generating emissions reductions as a result of investment in actual projects. [The basic accounting units implicit within the Kyoto Protocol are assigned-amount units (AAUs); removal units (RMUs), which are associated with forest sinks; emission-reduction units (ERUs), which are associated with Track II JI projects; and certified emissions reductions (CERs), which are associated with CDM projects.]

4.8.1 Possible objective guiding a purchasing strategy

There are a variety of objectives that might underpin a purchasing strategy. The particular objective(s) chosen will affect the range of purchase options available, the cost of purchasing units, and the most sensible purchase method. Possible objectives (these are not all mutually exclusive) include:

  • purchasing units at the lowest possible cost in order to meet New Zealand’s specific obligations under Kyoto. This implies no preference between the different types of units available under the Kyoto mechanism or as to which countries/companies/projects they are secured from. In purchasing, the key decision criterion would be price, with the consideration of the quality of units limited to issues of delivery risk
  • purchasing units in a way that the Government can have confidence that the purchase will credibly contribute to the reduction in global greenhouse gas emissions. The use of the international emissions trading mechanism may or may not be consistent with this particular objective. Precisely which units are bought, and from whom, will influence whether this objective is met. The surplus of units that a number of countries are expected to hold in CP1 arose as a result of the emission targets secured in the international negotiation process. A number of countries have, to date, signalled that they will not purchase these units or that they will only undertake purchases where revenues generated are invested in projects that will reduce emissions – so-called green investment schemes
  • leveraging co-benefits from purchase, either in terms of foreign relations objectives or New Zealand business development. For example, the use of CDM may complement New Zealand’s aid strategy, say, by priority being given to purchases from particular countries. Selection criteria for projects under either CDM or JI might include consideration of participation by New Zealand firms in, say, project design or technology provision.

Generally, the more stringent the objectives chosen for a purchasing strategy, the less the available opportunities to purchase and the higher the likely price of units. On the other hand, a purchasing strategy that seeks, to some extent, to go beyond meeting the narrowly defined Kyoto obligation may enhance the public acceptability of purchasing units from overseas.

4.8.2 Factors impinging on the supply and demand for units

The Kyoto market for emission units is still emerging and reasonable uncertainty surrounds how it will evolve over the next few years. This has implications for the likely supply and demand of available units and, therefore, the likely cost of purchasing units. It can also be expected that the market will show some level of volatility. Contributing factors are outlined below:

  • the buying and selling intentions of individual Annex I countries is still emerging. While a number of Annex I countries have already commenced a purchasing programme (eg, the Netherlands ), as the commencement of CP1 approaches, others are evaluating their likely Kyoto position and purchase options. Canada and Japan have signalled an intention to purchase units and are expected to purchase large volumes. Individual member states of the European Union have indicated that they intend to purchase 500 million to 600 million tonnes of CO2 credits for 2008 to 2012 collectively. Similarly, the extent to which Annex I countries with surplus emission units will seek to sell these in CP1 or “bank” them for future period(s) is unclear. A critical factor will be the assessment these countries make about the probability of a post-2012 international framework including binding targets and emissions trading. Further, the extent of any surplus held by these countries will depend, among other things, on the level of growth within these economies
  • uncertainty surrounds whether certain Annex I countries will meet the requirements by 2007, particularly in relation to inventory reporting, and therefore be allowed to participate in emissions trading. Failure to satisfy these requirements would mean that these countries would be able to sell only via the project-based JI track II mechanism
  • the efficiency of arrangements for the supervision of the CDM and JI mechanisms has implications for project supply and cost. Underpinning these mechanisms are governance arrangements designed to ensure that projects are “additional” in the sense that they will lead to a lower level of emissions than would have otherwise occurred, and that these reductions are accurately quantified, monitored and verified. It is expected that the supervisory arrangements for Track II JI projects will be finalised at the forthcoming Montreal meeting of parties to the Protocol. While the CDM arrangements have been in place for a number of years, approval of projects has to date been slow and some projects proponents have found it difficult to demonstrate “additionality”. It is not clear whether this simply reflects start-up factors or will be an ongoing constraint. Standard methodologies are being developed to help streamline project approval. The efficiency of CDM processes has been identified as a key issue at Montreal.

4.8.3 Factors impinging on a purchasing strategy

The characteristics of the projects mechanisms – CDM and JI – have particular implications that need to be taken into account in considering a purchasing strategy:

  • the approval processes associated with CDM and Track II JI processes give rise to specific transaction costs and are time consuming. In regard to CDM, depending on the specific nature of the project, approval can currently take three to ten months (and potentially longer for less conventional projects). The costs associated with project design, validation and verification to meet approval requirements is also significant. In regard to CDM, Det Norske estimate total costs as €275,000 for normal projects and €117,000 for small projects [Source – Presentation to climate change officials. Small-scale projects are defined in three different ways: renewable energy projected with a maximum installed capacity of 15MW, energy-efficiency projects that generate 15Gwh/yr or less, and projects that emit no more than 1,500 tonnes of CO2e.] (other estimates of this are lower)
  • the lead time associated with development and construction. For example, the typical lead time for small-scale renewable-energy projects, energy-efficiency projects and waste-to-energy projects is two years. Large hydro and geothermal projects and fuel switching can take up to five years
  • the need to manage specific country and project risks, with this reflected in specific contractual provisions between the seller and purchaser.

More generally, these factors highlight that emissions units (including those that are not project-based) are not a homogeneous commodity and prices will vary depending on the particular characteristics of the unit in terms of quality, risk and timing. In this sense, it is a misnomer to think in terms of a single international price of units, or that there is an “international carbon market”. [For sake of convenience, the term “international carbon market” is used throughout this report.]

An additional factor that will affect New Zealand’s purchasing strategy is the uncertainty around how many units New Zealand will need to purchase. There is considerable variability around the most likely scenario in our recently calculated net-emissions position. New Zealand’s actual net emissions position for CP1 will not become clear until well into (or even after) the commitment period. This implies that New Zealand may need to stagger its purchases of units over time somewhat.

4.8.4 Purchasing options

There is a variety of options for the Government to purchase emission units:

  • the Government could establish its own carbon purchasing programme. This would involve it going into the market and purchasing units. Units purchased could be AAUs, CERs, ERUs or RMUs [There are various sources of units. For example, the Government could seek to purchase JI or CDM units, or could seek to purchase units allocated to companies under the Projects to Reduce Emissions initiative.]
  • the Government could outsource the purchase of emission units to the private sector
  • the Government could buy into an existing fund such as that run by the World Bank.

Much more detailed assessment would be required about the appropriate balance between these arrangements, in light of the specific objectives of a purchasing strategy agreed by the Government and issues of managing risk, timing and price.

4.8.5 The price of carbon

A key issue that is related to a buying strategy is price. As noted in this section, the more stringent the objectives chosen for a purchasing strategy, the less the available opportunities to purchase, and the higher the likely price of units. The objectives chosen, however, will not be the only determinant of price.

It is not easy to predict future trends in prices for emission units or, more accurately, international carbon prices. There are significant uncertainties about both the demand for, and the supply of, Kyoto-compliant units.

This said, there must be a reasonable chance that the price of carbon will rise in the near future. There is a large possible demand for units, and if major potential buyers such as Canada and Japan enter the market, it is very possible that prices of Kyoto-compliant emission instruments (AAUs, CERs, ERUs and RMUs) will increase, perhaps significantly. It is also possible that there will be significant volatility in prices for emission instruments in the future, given the unstable state of these markets (given these factors, hedging and forward-contracting may well be critical to New Zealand’s success in the market).

In addition to New Zealand’s objectives in the area, and supply and demand in the market, the other determinant of price relates to risk profiles. There are risks associated with projects, ranging from contract risks and project risks to country risks. Depending on whether the associated risks are borne by the buyer or the seller, different price premiums are to be expected. [In a recent survey of potential CDM market players, 82% of Japanese respondents believed that differences in the “quality” of CERs would result in price differences. The same work suggested that respondents are most concerned about the risk that the units would eventually not be acceptable under the CDM. Contract risks, such as the sellers’ credibility, also command a high premium. Asuka and Okimura, 2005. ]

4.8.6 Conclusions

The variety of issues that surround the development of an appropriate and effective purchasing strategy highlight the need for the Government to immediately put in place a work programme, if the option of purchasing units to meet some of our CP1 obligation is to be kept. Early commencement of this work would allow the greatest scope to develop a strategy that met purchasing objectives while managing fiscal risk. Given the considerable uncertainty that surrounds the future price of emission units, it would be sensible to be in a position to purchase at least some units during 2006.

It is therefore recommended that work commence as soon as practicably possible on determining potential buying strategies for New Zealand that reflect New Zealand’s objectives in this area and our risk profile, along with issues of management, timing and price. Especially if international carbon markets prove to be volatile in the future, early agreement of a buying strategy may prove to be extremely useful and valuable.