Post 2012 options for emissions trading

1. Post 2012 options for emissions trading Climate Change and Energy Emissions Management Forum Brent Layton 15 August 2007

2. Background • The detailed design of an emissions trading scheme determines its: • Effectiveness in addressing greenhouse gas emissions • Impacts on economic activity • Business New Zealand therefore commissioned NZIER: • To review the design and performance of overseas emissions trading schemes • To consider preconditions for emissions trading in New Zealand • To develop a proposed design for a New Zealand scheme

3. Outline • Emissions trading: • What is it • Why use it • How to use it

4. What is emissions trading? • Draft New Zealand Energy Strategy: • “An emissions trading scheme creates a responsibility for a defined group of emitters to hold tradable units or allowances to match some or all of their greenhouse gas emissions over a defined period.” • “Entities subject to the scheme are able to either reduce their own emissions or trade units or allowances to meet their obligations.”

5. What is emissions trading? • Draft New Zealand Energy Strategy: • Signals a preference for the cost of greenhouse gas emissions being reflected in relative prices • Favours the use of economically efficient, price-based measures to reduce emissions at least cost, applied broadly across key sectors of the economy • Points to the transition to and ultimate adoption of emissions trading

6. Why use emissions trading? • Case for intervention – what is the market failure? • Prices don’t fully reflect full costs, including environmental costs such as the effects of greenhouse gas emissions • If greenhouse gases have real economic costs, now or in the future, not including these costs: • Causes high emissions activities (e.g. energy sources, industrial processes) to be under-priced relative to activities producing fewer emissions • Results in higher than optimal level of high emissions activities relative to low emissions activities • Leads to higher than optimal level of emissions and environmental degradation • Even if impacts are uncertain, may still be worth reducing emissions now

7. Why use emissions trading? • What is the appropriate intervention to address this market failure? • Make market prices incorporate the cost of emissions • Enable the market to determine optimal levels of activities (and resulting emissions) accordingly • Emissions trading achieves this (in principle, depending on design): • Allows individual participants greater flexibility to determine their emissions reductions according to their abatement costs and output prices • Allows aggregate reduction in emissions across all participants to be achieved at least total cost

8. Why use emissions trading? • Alternatives: • Non price-based: • Voluntary restraint • Information campaigns (e.g. energy efficiency) • Research funding (technology-push) • Prescribing quantitative restrictions/targets • Price-based: • Subsidising low emissions activities or emissions abatement • Taxing emissions or emissions-producing activities • Emissions trading schemes

9. Why use emissions trading? • Voluntary restraint: • Ensures costs and benefits are weighed up • Adopted only where net benefits to firm (e.g. marketing advantage) • May not meet international emissions reduction obligations

10. Why use emissions trading? • Research funding: • Who pays and who appropriates the benefits • Who decides which research to fund (“picking winners”) • May not meet international emissions reduction obligations

11. Why use emissions trading? • Regulatory restriction: • Example: • Firm allowed to emit five tonnes of carbon dioxide equivalent per year • Not allowed to emit more, even if abatement is very costly or reduction in emissions can be achieved only by cutting output • Alternatively, if abatement is relatively easy and low cost, there is no reward for reducing emissions below allowance • Assumes that regulators have full information to determine optimal levels of emissions, which not only vary by sector, firm and activity, but also change over time with changes in technology and prices

12. Why use emissions trading? • Subsidies: • What is the right level of subsidy to achieve a given level of emissions reduction? • Susceptible to on-going political opportunism around what to subsidise and level of subsidy • Not easy to internationalise market for emissions abatement

13. Why use emissions trading? • “Carbon” taxes: • What is the right level of tax to achieve a given level of emissions reduction? • Difficult to obtain international agreement on tax rates, so not easy to internationalise market for emissions abatement • Open to on-going political opportunism around rates and who pays • Should have lower transaction costs than emissions trading in establishment and operation

14. Why use emissions trading? • Emissionstrading: • Relatively easy to set allowances to achieve a given level of emissions reduction • Potentially open to on-going political opportunism around allowances • Easier to obtain agreement on emission levels than on tax rates, so easier to internationalise market for emissions abatement than an emissions tax • High abatement cost firm can buy additional emissions allowance from low abatement cost firm • Low abatement cost firm can earn reward for reducing emissions below allowance – able to sell surplus allowance

15. Coverage Approach Aggregate cap/target Point of obligation Permit allocation Offsets Trading period duration Banking & borrowing Credit for early action Penalty for non-compliance Competitiveness at risk International linkages Market ownership & governance How – design parameters

16. How – design options • Coverage: • Voluntary or mandatory • Geographical area • Gases • Sectors • Thresholds

17. How – design options • Approach: • Baseline-and-credit – set a baseline level of emissions and award credits for reducing actual emissions below the baseline and debits for exceeding baseline • Cap-and-trade – allocate emissions allowances and require their surrender against actual emissions • What’s the difference?

18. How – design options • Point of obligation – to report emissions and to demonstrate that sufficient allowances are held: • Downstream – where emissions are released • Upstream – where sources of emissions originate • Hybrid

19. How – design options • Permit/entitlement allocation: • How much to whom • Free or by sale/auction • New entrants • Absolute or relative shares • Growing sectors • Life of entitlement • Offsets

20. How – design options • Trading period duration • Banking and borrowing • Credit for early action • Penalty for non-compliance

21. How – design options • Competitiveness at risk • International linkages • Market ownership and governance

22. How – preconditions • Preconditions: • For a successful emissions trading scheme • Of net benefit to New Zealand • Some essential • Some conditional on circumstances • Some, if lacking, can be met through scheme design by including mechanisms to provide necessary components

23. How – preconditions • International agreement and commitment to restrain emissions: • Sufficiently wide coverage of countries • Sufficient certainty about rules and criteria for change over time • Internationally agreed basis for emissions measurement – clearly defined unit for trading • Political and social consensus in New Zealand for emissions restraint and emissions trading

24. How – preconditions • Verifiable emissions measurement processes: • Direct measurement (e.g. end-of-pipe monitoring) • Indirect measurement (e.g. fuel inputs, where highly correlated with consequent emissions) • Estimation (e.g. average emissions rates per unit of input or output, where difficult/costly to monitor actual emissions) • Registry for recording ownership and transfer of entitlements • Trading forum

25. How – proposed design • Coverage: • All six greenhouse gases • Ultimately, all significant emissions sources, including agriculture, excluding household emissions • Expand over time to additional sectors according to analysis of incremental costs and benefits of their inclusion

26. How – proposed design • Emissions entitlements: • Specified relative to output for firms with competitiveness at risk • Based on international peer group-based best practice for larger firms and historical emissions for smaller firms • Allocated free of charge to firms with competitiveness at risk (including agricultural sector) • No allocation to sectors without competitiveness at risk (including electricity generators) – required to buy in auctions or from other entitlement holders

27. How – proposed design • Offsets: • Carbon credits for forestry growth and native bush regeneration • Debits for harvest or destruction to reflect emissions (released in New Zealand) from the harvest/destruction process • Can be offset against replanting credits

28. How – proposed design • Point of obligation: • Some upstream, some downstream, some hybrid according to sector • Trading period duration: • Evergreen 10 year entitlements • Extended every three years • Firms must surrender required entitlements with three months of end of each calendar year

29. How – proposed design • Banking and borrowing: • Both permitted • Borrowing limited to 10% of year’s entitlement and must be repaid at a rate of 1.15 x amount borrowed • Credit for early action: • Some recognition desirable, but how requires further analysis • Penalty: • Monetary penalty for entitlements not delivered within three months of end of calendar year • Required to make up deficit the following year at a rate of 1.15 x deficit

30. How – proposed design • Competitiveness at risk: • Expand scheme to additional sectors only where their inclusion is of net benefit • Either when equivalent emissions obligations are faced by overseas competitors • Mitigate competitiveness effects through free allocation of entitlements, defined relative to output

31. How – proposed design • International linkages: • Credits accepted to meet New Zealand’s international obligations • Tradable, foreign buyers and traders permitted • Market ownership and governance: • Contestable provision of market operation services by private sector • Under rules set by government and with verification by government

32. How – proposed design • Implementation: • Climate change outcome is long-term • Poorly designed emissions trading scheme could have disastrous impacts on New Zealand economy • So focus initially on getting the design “right” (i.e. economically efficient signals and incentives) • We can tighten/loosen constraints over time as knowledge and technology improve