NZ ETS and manageable costs

by Suzi Kerr, Senior Fellow at Motu Economic and Public Policy Research Trust

In my last post I examined what we need to consider in setting an NZ ETS price consistent with an efficient long-term transition (at least in expectation). Given that price, are there any reasons to protect some sectors from the full price?

If we have chosen an NZ ETS price (or price corridor) we expect will lead to the most efficient adjustment path for the New Zealand economy, what arguments could there be to treat some sectors more leniently by, for example, extending a partial unit surrender obligation?

Arguments for special treatment could include:

• Reducing impact on GDP – NZIER modelling commissioned for this consultation process (based on specifications provided by the Ministry for the Environment) considers this, but in a very limited way. It is a static model so does not allow gradual adjustment or technological change. They simply consider three NZ ETS price levels (NZ$10, 25 and 50) none of which are likely to be high enough to achieve New Zealand’s Intended Nationally Determined Contribution (INDC) for 2030 through domestic action (see previous reports by Infometrics, and Landcare Research). They do not model the cost to the country of any effects on our ability to meet our international target (INDC) or the costs of transitioning too slowly (or too quickly) to a low-emissions economy. If these were included, the impact on GDP would almost certainly be positive. Even with these limitations, however, the GDP impact is estimated by NZIER to be small. New Zealand has previously experienced ETS prices above NZ$20 without obvious effects on GDP.
• Learning about operation of the NZ ETS and mitigation options – This was an important argument for a gradual transition (though not necessarily through a partial obligation) when the system was first created but now seems a weak argument given that the system started in 2008.
• Alignment with existing contracts – When the NZ ETS was first established, some companies had existing long-term contracts that did not take an emission price into account and potentially faced heavy losses.  Eight years on, we might expect that companies should have built emission price and liability variability into their contracts, especially as the partial obligation was initially introduced as a temporary measure that would end in 2012.  
• Reducing risk of leakage – The size of these risks is highly uncertain, the loss to New Zealand if some production does gradually move is unclear, and in any case leakage risk is separately addressed with output-based free allocation to trade-exposed producers.
• Moderating distributional effects - Emissions costs are already passing through to consumers in most sectors. If there are concerns about impacts on households, those are probably most efficiently addressed directly through the tax-benefit system.

Arguments against special treatment could include:

• Obscuring the signal about the long-term transition to low emissions – With an extension of a partial obligation, sectors may expect ongoing special treatment and this could distort long-term investment decisions.
• Reducing short-term mitigation – A low effective price reduces the incentive for short-term emission reductions that have long-term climate change consequences.
• Raising the cost of meeting New Zealand’s international commitment – New Zealand still needs to meet its international commitments. If responsibility for this mitigation shifts from the NZ ETS to the government, it is likely to cost more. 
• Inequitable distributional effects - The partial obligation places higher costs on taxpayers and creates a cost differential between emitters from forestry and those in other sectors.

A note on forestry:  To date, a full surrender obligation has always applied to the forestry sector and there continues to be no basis for applying a partial obligation to the forestry sector. When the partial obligation (where entities surrendered only one unit for each two tonnes of emissions, often referred to as ‘one for two’) was introduced, most foresters were receiving credits so were pleased to benefit from receiving the full price. In addition, they could not have paid a different liability than they received in credit without perverse incentives. The few forest owners who were deforesting at the time (along with all other pre-1990 forest owners) received some compensation through free allocation.   The forestry sector is now moving toward a mix of sequestration credits and harvest liability as post-1989 forests mature and allocation of compensation is complete.

Is a gradual transition to a full unit obligation warranted? 

Managing adjustment to a changing NZ ETS price is not an issue that is specific to the movement to full surrender obligations. With a highly uncertain supply of NZUs in the medium term, movement from partial to full surrender is only one of many things that will drive price (and the effective price companies face when partial obligation is taken into account). The broader question of NZ ETS price management will be discussed in the second round of the consultation (and a later blog). The only transitional issue that may be relevant here is having a smooth and predictable administrative process for changing the obligation. Low-emission investment benefits from stronger ETS market confidence. This in turn can be supported by advance notice of changes and, more generally, predictable evolution of policy.