New research documents challenges with industrial free allocation in the NZ ETS

The following press release was issued by Motu on 3 September 2021.  

A new paper from Motu Research documents why the current approach to industrial free allocation under the New Zealand Emissions Trading Scheme (NZ ETS) is outdated, poses high costs to Kiwi taxpayers, could make it harder to meet our 2050 climate change target and raises fairness issues across sectors.  

These issues underpin the government’s current consultation on reform options to industrial free allocation open until 17 September 2021. This paper presents further reform options the government and stakeholders could consider.

In emissions trading systems, emissions units are usually sold at auction or given out for free. Under the NZ ETS, free allocation is currently given to industrial producers who are emissions intensive and trade exposed. Its purpose is to prevent domestic production and associated emissions from shifting offshore to jurisdictions with less ambitious climate change policies and less efficient production. The amount firms receive is a percentage (level of assistance) of the historical average emissions intensity (allocative baseline) for each eligible activity, multiplied by their actual output each year.

Catherine Leining, a Motu Policy Fellow and paper co-author and Benjamin Rontard (paper co-author), say the research points to current NZ ETS shortcomings. 

“The emissions intensity test for eligible firms is based on Australian industrial settings from the early 2000’s and a coal-driven Australian electricity emission factor. A Kiwi-made approach would be more Kiwi-relevant,” said Ms. Leining.

“The trade exposure test presumes a material risk of climate-damaging emissions leakage at any level of import or export competition. That test does not reflect current realities of trade or global climate ambition under the Paris Agreement.

“Allocative baselines are also out of step with evolving industry structures and practices. The levels of assistance are a blunt instrument and activity-specific adjustment is slow.

“The world has changed since Aotearoa’s industrial free allocation policy was first designed. We need an approach better aligning future industrial assistance with the actual risk and cost of emissions leakage — and supporting Aotearoa’s 2050 climate change target,” said Ms. Leining.

The paper reviews possible reforms to industrial free allocation under the NZ ETS, including changing the eligibility criteria or calculation methodology, substituting alternative measures or accepting and managing emissions leakage. But the paper does not recommend specific options. Further research is first needed to evaluate the merits of all options.

Under current policy settings, eligible industrial producers could receive 46 million free NZUs over 2021–2026, worth NZ$2.3 billion at a sample price of NZ$50. The Government has collected evidence of over-allocation in some cases. 

“This is an important time to review if the public and private benefits of maintaining and improving industrial free allocation are worth the cost and complexity, in the evolving context under the Paris Agreement,” said Ms. Leining. 

"Ultimately, any future industrial free allocation should be used to help – not block – the transition to an economy rewarding low-emission innovation. That will require policy adaptable to changing conditions through predictable decision-making principles and processes,” she said. 

Read the full working paper from Motu Research.

The paper presents the views of the authors and not the programme funder or He Pou a Rangi New Zealand Climate Change Commission.

Fast facts on industrial free allocation in the NZ ETS 

1. Under the NZ ETS, eligible emissions-intensive and trade-exposed industrial producers receive output-based free allocation (i.e. the number of free emission units varies with production).
2. The amount of industrial free allocation is calculated as the product of output, an allocative baseline and a level of assistance. Allocative baselines reflect historical industry average emissions intensity for each activity over 2006/07 to 2008/09 for most recipients. Base levels of assistance were set initially at 90 or 60 per cent, depending on if producers are highly or moderately emissions intensive.
3. By default, levels of assistance will reduce linearly by one percentage point each year over 2021–2030, 2 percentage points each year over 2031–2040 and 3 percentage points each year over 2041–2050. Phase-down rates can be reviewed and adjusted by the government in either direction.
4. In 2019, four of 85 eligible companies together accounted for about 70 per cent of total industrial free allocation.
5. Over 2010–2019, 47 million NZUs were freely allocated to eligible industrial recipients. Over 2021–2026, projected industrial free allocation of 46 million units would equate to about 43 per cent of the anticipated auction volume (excluding the cost containment reserve). From 2021, industrial free allocation costs taxpayers foregone auction revenue in return for the benefits of preventing emissions leakage offshore.