Thursday, 21 May 2015

Linking to credible sellers - de-linking ambition and ETS prices

By Suzi Kerr and Judd Ormsby, Motu Economic and Public Policy Research

In our last post we showed how even an emission reduction target of 5 per cent below 1990 levels could require a GHG price in excess of NZ$250 by 2030 if the New Zealand Emissions Trading Scheme (NZ ETS) were New Zealand’s only significant climate policy (However, the global price required to limit global warming to 2 degrees could be as low as NZ$60 by 2030[1]. This is because the global least cost approach to limiting atmospheric concentrations of CO2 equivalent gases to 450 ppm – roughly the level that achieves a 2 degree target – requires about 66 per cent of (discounted) abatement effort out to 2100 to occur in developing countries (Edmonds et al. 2007).

Linking is not a substitute for domestic emission reductions but allows us to do even more for the global effort and helps manage the uncertainty around short-term mitigation potential within New Zealand that could stop us taking ambitious short term targets.

We could choose to link our ETS to a poorer country with low-cost mitigation options), a credible cap, and a reliable monitoring regime. This could be done either through a government-to-government transfer or directly through an ETS. This would enable us to pay for real mitigation to occur where it is cheaper – and of course the environment doesn't care where mitigation occurs.

So, if we link our ETS at the 5 per cent below 1990 emissions target to a lower-priced international scheme, what might happen? (Five per cent may not seem like much, but the logic would be the same for a much more ambitious target.  We’re sticking with 5 per cent in our modelling for comparability.)

The figure below shows our simple model’s results when we link our ETS to a $100 carbon price in 2025 (and announce our plans today). The price drop occurs immediately.  Why? Because people plan ahead. Anticipating a future price drop, participants use up their banked New Zealand unit faster, knowing they will have access to cheaper units in the future. Using up the bank faster means firms emit more and emissions prices are lower.

Figure 1: Linking to a $100 price in 2025

What about if we link to a price lower than NZ$100? In a blog post last year, Luke Harrington and Catherine Leining discussed research that suggested the social cost of carbon (which in an efficient world would be the emissions price) could be much lower. What would happen if we link to a NZ$40 price?

Figure 2: Linking to a $40 price in 2025

In Figure 2 you can see that, as well as the initial price drop, the price drops again in 2025 when the link activates. This occurs because the bank runs out. Figure 3 shows the path of the bank when we link to a $40 dollar price. If firms could use post-2025 units for compliance before 2025 they would, but they are not allowed to.

Figure 3: The path of the bank when we link to a $40 price in 2025

Linking to credible schemes with lower prices would allow New Zealand to meet its targets without a very high carbon price. With this knowledge we might decide to take on more ambitious targets. But there is a limit to how much a future link can decrease current prices. The sooner we can link to a low price, the more we can drive down current prices and, potentially, contribute even more real reductions to the global effort.

If we could link immediately, our decision on the target would have few implications for NZ ETS prices, beyond a certain level of ambition and depending on the price we link to. We would be international buyers and our price would depend on the cost of mitigation in the country we link to.  Additional ambition would have no implications for the ETS price and, through it, on competitiveness of exports and the costs of goods like electricity and petrol; it would be solely a question of global ethics. How much is New Zealand willing to contribute?

A proposed link 10 years away is a highly uncertain thing; the proposed Australian-EU link comes to mind. This uncertainty would dampen any price response to an announcement about a future link.  If the cap were viewed as certain and the link uncertain, ETS prices would be higher than they need to be.  Firms would hold back units in the bank in case the link doesn’t happen.

Smart policy wouldn’t just wait for international linkages to come to us through some form of post-Kyoto agreement. Instead New Zealand should actively seek out linkages with other countries, particularly developing countries like our Pacific neighbours.

In the long-term we will need to do much better than 5 per cent below 1990 levels.  Globally we need to achieve zero net carbon emissions so New Zealand needs to transition to zero net emissions too. We’ve discussed examples of complementary measures that should also be considered previously.

If you are interested in more details about how our model works, be sure to check out our last post.

[1] Ministry for the Environment’s discussion document, page 13.

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