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Stationary Energy and Industrial Process Component of the New Zealand Emissions Trading Scheme - Technical Advisory Group Final Report

• Summary
• SEIP TAG final report and recommendations
• Annex I: Members of the SEIP TAG
• Annex II: Terms of Reference
• Annex III: Summary of Allocation Process
• Annex IV: TAG SEIP Methodologies (Regulations) sub-group
• List of tables

Summary

I. General

Role of the Stationary Energy and Industrial Processes Technical Advisory Group

The Stationary Energy and Industrial Processes Technical Advisory Group (SEIP TAG) was established in December 2007 to provide guidance and advice on technical design elements of the stationary energy and industrial process (SEIP) emissions components of the New Zealand Emissions Trading Scheme (NZ ETS). The SEIP TAG comprises 16 experts, including three government officials and 13 industry experts (see Annex I membership list).

The key task of the SEIP TAG is to provide advice to the Government on options for a transitional and partial offsetting of NZ ETS-related costs as a result of emissions from the SEIP sectors.

Some clarification is warranted as to what is meant by ‘transitional and partial offsetting of NZ ETS-related costs’ and related terminology such as ‘free allocation’ in this context. One of the key principles underlying the NZ ETS legislation is that emitters face the full cost of their emissions. Participant firms face this full cost through the obligation to surrender New Zealand Units (NZUs) for every tonne of their associated emissions.

Most New Zealand firms will face increased costs of production under the NZ ETS, either because they are required to surrender NZUs to cover their emissions or because they face higher energy and fuel costs. Many firms will be able to pass a portion of these costs down the supply chain to their customers. However, many firms, typically those in trade-exposed sectors, will be unable to pass on the bulk of these costs. To reduce the impacts on firms unable to pass these costs on, two options for partially offsetting these costs during a transition period were considered by the Government in its Framework Document of 2007. The first option was an allocation of NZUs free of charge, the second was a progressive obligation on emitters. Both of these options and related design issues were referred to the SEIP TAG for further evaluation.

Specific issues related to this task are:

1. defining and evaluating different options for the allocation of units or other assistance
2. as part of the above, defining thresholds (size and scope) for assistance, rules for entry, trade exposure tests, recognition of early action etc
3. advising on specific issues about partially offsetting the costs of electricity – specifically, how to assess the impacts of emission costs on electricity costs.

The Terms of Reference of the SEIP TAG (see Annex II) did not extend to design features of the NZ ETS that are specifically addressed as provisions in the draft legislation (now the Climate Change Response (Emissions Trading) Amendment Act 2008, hereafter referred to as the Act), for example the definition of emission obligation, the fixed allocation pool for the SEIP sectors, or the phase out of allocation from 2019 to 2029.

General Caveats

• Participation in the SEIP TAG is in no way indicative of support by members of the SEIP TAG for the design features of the NZ ETS laid out in the Act.
• Members of the SEIP TAG have participated as technical experts rather than as representatives of their firms or industry organisations. The respective organisations to which the members belong reserve the right to challenge or disagree with the recommendations put forward by the SEIP TAG.
• Recommendations supported by government officials on the SEIP TAG do not necessarily reflect government policy.
• The allocation options considered by the SEIP TAG are methodologies to allocate units within a pool fixed at 90 per cent of eligible firms’ emissions in 2005 (as set out in the Act). The fact that industry members have deliberated on allocation methodologies within this context should not be interpreted as being indicative of their support for the framework prescribed in the legislation. In fact, a number of industry members of the SEIP TAG strongly believe that it is not possible to develop a plan that prevents leakage and economic regrets within a pool fixed at 90 per cent of eligible firms’ emissions in 2005, and that this would be further exacerbated if a new entrant reserve, and/or intensity-based allocation is provided within the fixed pool.

Summary and recommendations

The SEIP TAG has generally worked to try and reach consensus on recommendations reflecting the views of the group. However, for some recommendations members have reserved the right to express an industry, officials or a minority view (a minority view can be expressed by as few as one TAG member). The wording of the recommendations reflects the degree of consensus, for example:

• “the SEIP TAG recommends” indicates a recommendation supported by all members of the SEIP TAG
• “the majority of SEIP TAG recommends” indicates a majority of SEIP TAG members favour the recommendation – a minority view may also be expressed
• “industry members of the SEIP TAG recommend” indicates a recommendation supported by industry members of the SEIP TAG
  “officials on the SEIP TAG recommend” indicates a recommendation supported by government officials on the SEIP TAG.

Organisation of the work/structure of this report

The SEIP TAG met on 12 occasions during a period from December 2007 to September 2008. The SEIP TAG set up a number of sub-groups which met separately from the full SEIP TAG to progress specific issues in more detail.

The above tasks essentially fell into two categories; firstly, those work streams relevant to the preparation of a draft allocation plan and, secondly, methodologies relevant to the drafting of regulations. This report addresses each of these issues in Sections II and Section III respectively.

Work on areas relevant to the preparation of a draft allocation plan is further split up into a series of work streams. These were:

• data requirements
• eligibility
• allocation sub-group
• sub-group on electricity market price effects
• progressive obligation.

The work stream on data requirements addressed issues relevant to all the allocation work streams.

Section II – Issues Relevant to the Preparation of an Allocation Plan

Table 1 outlines the decision tree framework adopted by the SEIP TAG for working through the various issues relevant to the preparation of an allocation plan.

Table 1 Decision tree framework – issues relevant to the preparation of a draft allocation plan

SEIP TAG work relevant to allocation
Issue	Task of the SEIP TAG	Recommendations
A. Why should costs be offset in the SEIP sectors?	Clarify the rationale for offsetting costs
B. How should costs be offset?	Consider whether economic regrets should be avoided by a transitional allocation of emission units or a progressive obligation.	Recommendation 1
C. Who should be eligible for an allocation of units?	1. Define trade exposure Consider what tests/thresholds should be used to determine whether impacts are material enough to warrant assistance. Determine whether a test should be on the basis of impact on cost, profit or revenue. Evaluate whether multiple thresholds (categories of trade exposure) are warranted. Consider how the point of eligibility should be defined. Define any other thresholds Determine rationale for and nature of de-minimus threshold or tests. Determine rationale for and nature of automatic threshold.	Recommendations 2–12
D. How should we allocate units?	Develop criteria and apply them to different allocation methodologies. Consider how new entrants and growth by incumbents should be addressed. Consider what rules should be applied to firms that close. Consider what rules should apply to firms that move location within New Zealand.	Recommendation numbers 13–18
E. How should we address electricity price impacts?	Review previous modelling work on this issue, identify and undertake additional modelling if required. Define the electricity price impact in a carbon-constrained world. Determine a rationale of how to calculate the price impact for period 2010–2012. Determine a rationale of how to determine the cost of an NZU. Determine the factor (tCO2 equivalent/MWh) that will be applied to eligible firms who are exposed to the electricity price impact.	Recommendation number 19

A. Rationale for cost offsetting

As a starting point in its work, the SEIP TAG discussed the underlying rationale for partially offsetting NZ ETS-related costs. The SEIP TAG considered the discussion included in the Framework Document, which focussed on economic regrets; it also considered a wider set of issues relating to protection against emissions leakage.

The SEIP TAG agreed that the primary purpose of any cost-offsetting measures (eg, allocation of units) is the avoidance of economic regrets.

The majority of the SEIP TAG agreed that the focus of any cost-offsetting measures should be on trade-exposed firms ie, those firms producing goods that are sold at prices set in international markets where  it is unlikely that emission regulations are affecting prices. It is these firms who face international competition who could, if faced with significant NZ ETS -related costs, be forced to reduce output and, in some cases, close plants.

However, some industry members are of the view that this definition of economic regrets and its focus on firms producing goods that are sold at prices set in international markets is too narrow and that there may be other circumstances where compensation for stranded assets resulting from the introduction of the NZ ETS is warranted.

B. How NZ ETS related costs should be offset?

Two broad options were considered as the method for providing assistance to firms facing increased costs: (1) a progressive obligation and (2) a transitional allocation of emission units.

A progressive obligation introduces a requirement for selected participants in the NZ ETS to surrender emission units at a rate that starts at less than one NZU for one tonne of
CO₂ equivalentquivalent emissions but that builds up to a one for one requirement over time.

The SEIP TAG concluded that a progressive obligation would not adequately target trade-exposed firms. Specifically, targeting the progressive obligation at trade-exposed firms was considered to be more difficult to administer in an NZ ETS employing an upstream point of obligation. As a consequence the SEIP TAG recommended no further work on this option.

In summary, a transitional allocation of units was identified as the preferred method for providing assistance to firms facing increased costs under the NZ ETS. Consequently, the remainder of the report focuses on key design decisions around an allocation model.

C. Who should be eligible for an allocation of units?

The SEIP TAG identified a number of steps to work through in defining who is eligible to receive units. Some criteria or tests are needed in order to determine the entities that are eligible for an allocation of units. The necessary components of a test or criteria should be shaped by the rationale for allocation, and as stated above, this is to reduce the likelihood of economic regrets. The SEIP TAG agreed that a two step process would be needed to determine eligibility:

1. Defining which entities are trade exposed, and
2. Identifying a ‘materiality threshold’ at which point the cost impacts of the NZ ETS are expected to be significant.

Defining a point of eligibility

In order to determine eligibility, a first requirement is to define whether the basis for determining eligibility is defined at the firm, product, or process level, or specific components of these. The SEIP TAG considered this issue and noted that:

• it is products that are trade exposed as it is the product’s characteristics, rather than the plant’s or firm’s, which determine whether it can be traded internationally and whether New Zealand firms can pass on costs from increased prices
• it is production processes that have emissions and result in emission costs
• individual firms can have more than one process and produce more than one product; defining eligibility at a firm level can lead to an allocation of units for products that would not be defined as eligible if produced by a firm with a different structure.

Based on the above, the SEIP TAG decided that the point of eligibility should be based on measuring the emissions associated with the process of turning specified raw materials into a trade-exposed product or products.

Defining beginning and end points of eligible processes

The above definition (of the point of eligibility) needs additional specificity around the beginning and end points of eligible processes. This is needed in order to define the total number of emission units in the pool used for allocation, and to estimate the number of units that will be allocated to individual entities.

The arguments for splitting the eligibility consideration into smaller distinct processes (a narrow definition) are that this enables the removal of allocations on closure of a process, and this minimises the number of units that would be allocated. If the thresholds are ‘right’, this would be consistent with the objective of avoiding economic regrets at least cost. The argument for a wider definition is that it provides greater assurance against leakage through greater generosity of allocation whereby a greater proportion of cost increases are offset.

The balance of views comes down to whether there is a perceived greater risk of getting the definition boundary wrong such that leakage might occur with economic regret, or of the Government allocating more allowances than it needed to, at a potential cost to taxpayers. During the SEIP TAG’s deliberations, industry members supported a wide definition whereas officials on the SEIP TAG supported use of narrower definition.

Defining trade exposure

The SEIP TAG defined trade exposure as:

“Firms that are subject to international competition in export markets and/or from imports (or the threat of imports), and the prices they receive for their goods and services do not reflect the cost of emissions”.

Therefore, a product is trade exposed if the costs of production increase in New Zealand because of the NZ ETS, but the cost increase cannot be passed on because the price is set by plants in another country that do not face the same cost increases. There are two elements that need to be examined:

• whether the product is traded between different countries and thus under competition from goods produced elsewhere
• whether the product price currently includes a cost of emissions.

Given the openness of the New Zealand economy and the fact that New Zealand is largely a price taker in respect of the goods it produces, the SEIP TAG concluded that the vast majority of New Zealand products could be considered to be trade exposed to some degree.

Setting a materiality threshold

In addition to being trade exposed, the other component of the eligibility test put forward by the SEIP TAG is that the production process faces a material increase in costs. There are a number of ways by which this can be defined; all of which are trying to measure the size of the cost increase relative to some other factor. This is essentially an emissions intensity measure and possible factors considered by the SEIP TAG included:

• costs
• profits
• revenue.

The SEIP TAG concluded that costs were the preferred measure. The costs to be included in a cost intensity test need to be defined, and, specifically, whether they will include raw material costs.

Notwithstanding the above, industry members of the SEIP TAG were concerned that a cost-based intensity measure might not identify all vulnerable plants. Specifically, it would not discriminate between:

• a firm operating in a low margin industry with a low-cost intensity but which would be significantly trade exposed and
• a firm operating in a high margin industry with a high-cost intensity but which would not be significantly trade exposed.

Specifying the level where a cost intensity threshold should be set is a difficult task. Specifically, it is not possible to define a level of cost increase that is sufficiently high to result in an economic regret, nor an intensity that would result in such an impact. Thus simplifying approaches must be adopted. The SEIP TAG considered a number of options for achieving this.

None of the approaches considered are ideal. In terms of the setting of a threshold, the SEIP TAG recommends that ideally both materiality and equity (around the margin of the threshold) be taken into account. The most important of these is materiality (as measured by the level of emissions intensity of costs). In addition, the SEIP TAG recommends that if robust data is available, decision-makers should seek to use any discontinuities in the series of emissions intensities when deciding on specific threshold(s). Placing thresholds around discontinuity points in the series is likely to reduce inequities caused by the creation of thresholds.

Once a threshold is defined, the process can lead either to the definition within an allocation plan of the product/processes that are eligible for allocation or just to the definition of the methodology that would be used to define those that are eligible.

Single or multiple thresholds

The SEIP TAG considered the merits of adopting more than one materiality threshold to create separate tiers of eligibility. The tiers could be used to define processes that were eligible for different rates of allocation eg, those with higher emissions intensities might be eligible for a higher level or rate of allocation.

There are clear pros and cons associated with using one, or more than one, threshold for determining eligibility. Within the context of a fixed pool of allocation, using more than one threshold means that some firms’ contributions to the pool are allocated to other firms simply on the basis of relative emissions intensity. On the one hand those firms that are ‘losing’ a slice of transitional assistance may consider they have been treated inequitably. On the other hand, the use of more than one threshold would allow greater targeting of the pool to available allocation. Further, it would be likely to reduce the level of inequity caused around the margins of firms receiving transitional assistance and those not receiving transitional assistance.

Implementing the materiality threshold

Implementing the materiality threshold test requires a decision on who is made eligible and specifically whether there is a tag-along clause in which, for any given industry, if one plant or process is defined as eligible, all other plants in that industry are defined as eligible.

Base years for determining eligibility

Comparison of any individual industrial process with the threshold will need to be undertaken for a specified time period. This needs to be recent, as it needs to reflect actual vulnerability to costs, and historical, to avoid disincentives to intensity improvement. The SEIP TAG recommends that an average intensity over a recent historical period be used. More specifically, the SEIP TAG recommends that the average intensity between 2005 and 2007 inclusive is used. It is recommended that firms have a choice of financial or calendar year.

Thresholds to limit transaction costs

The SEIP TAG discussed two other possible thresholds that could be used to limit transaction costs in the process of defining eligibility. Both are based on absolute levels of emissions as opposed to emission intensity. They are:

• an upper threshold that was used to identify the most exposed firms. All plants that were trade exposed and with emissions above the absolute emissions threshold would be eligible and would not need to pass the intensity threshold
• a lower, de minimus, threshold that would make ineligible any plant that had emissions less than that threshold. This would be used to isolate emission sources which were never conceived as being the subject of an allocation.

The SEIP TAG considered that the upper threshold could send unfortunate signals through providing automatic allocations to the highest emitters. It also believed that the emphasis in designing an allocation plan was on making the process of being tested for eligibility via the intensity threshold as simple as possible.

There were some concerns raised over the use of a de minimus threshold because of the potential impacts on small and medium-sized industries (SMEs). There was a suggestion that an alternative approach could use a financial barrier eg, an application fee that might (or might not) be reimbursed if the applicant was later deemed to be eligible. It was noted by the SEIP TAG that the 50,000-tonne threshold discussed in the Framework Document is considerably higher than would be adopted were a de minimus threshold to be introduced.

D. How do we allocate?

Choice of allocation methodologies

The SEIP TAG considered a number of options for defining the number of units that should be allocated to eligible processes. The key issues included:

• the use of historical or updated data
• whether allocations should be made to new entrants.

Five options were identified, as set out in Table 2.

Table 2 Allocation options

	Emissions-based	Output-based
Initial basis	1(a) Historical emissions A percentage of emissions in an historical year(s).	2(a) Historical output A percentage of output in an historical year(s) times an agreed benchmark emissions factor.
New entrant reserve	1(b) Historical emissions + new entrant reserve As above, plus a separate new entrant reserve.	2(b) Historical output + new entrant reserve As above, plus a separate new entrant reserve.
With updating		2(c) Updated output A percentage of output in a recent year times an agreed benchmark emissions factor.

Option 1(a) and 1(b) (historical emissions) are frequently referred to as grandparenting. Option 2(c), an updated output methodology, is sometimes referred to as an intensity-based allocation within a cap.

The allocation options considered by the SEIP TAG are methodologies to allocate units within a pool fixed at 90 per cent of eligible firms’ emissions in 2005 (as set out in the Act). The fact that industry members have deliberated on allocation methodologies within this context should not be interpreted as being indicative of their support for the framework prescribed in the legislation.

At the outset, the SEIP TAG identified a number of criteria for evaluating the various allocation methodologies. These included assessing the extent to which a methodology:

• gives incentive to efficient emission reductions
• gives incentive to efficient improvement
• avoids or minimises leakage
• rewards early action
• provides certainty for those eligible to receive an allocation of units
• minimises administrative costs.

An additional principle, which was often raised in the SEIP TAG’s discussions, was the concept that ‘you take out what you put in’ ie, there should be a strong correlation between what an eligible firm contributes to the fixed pool of units (based on their emissions in 2005) and what they receive in the form of an allocation of units.

Officials on the SEIP TAG abstained from making recommendations on allocation methodologies at this stage.

In summary, the criterion of most importance to a majority of industry members of the SEIP TAG in considering the merits of the various allocation methodologies was the need to provide a high level of certainty for recipients as to the number of units they will receive on a year-to-year basis. Strongly related to this is the concept that what a participant receives in the form of an allocation of units should closely correspond to what they put in. While many of the industry SEIP TAG members voiced support for an intensity-based methodology and a new entrant reserve if unconstrained by a fixed pool, they did not consider that such approaches were workable with this constraint.

These views led a majority of industry members to conclude that a methodology based on historical emissions (grandparenting) is preferred over the other options. It was also the major reason why a new entrant reserve was not recommended if it is to be taken out of the fixed pool.

Base year(s) for allocation

The SEIP TAG considered a period of base years prior to, and post, 2005 (2005 being the year which determines the size of the pool according to the Act).

Special circumstances

The SEIP TAG recognises that some individual recipients may be adversely affected by constraining the years that may be chosen. In special circumstances, where an individual recipient can demonstrate that these years do not reflect business-as-usual emission levels because of a reduced capacity while upgrading, alternative criteria may be used to determine the level of allocation.

Plant replacement

Discussion focussed on the specific issue of closure of an old plant by a firm and the opening of another plant, by the same firm, at a different site.

Closure rules

Closure rules are very important in terms of influencing decisions at the margin. The Act states that the entity that is eligible for an allocation of units loses this eligibility on closure. However, defining closure is not necessarily straightforward, nor is it so that economic regrets only occur at closure.

E. How do we address electricity price impacts?

The SEIP TAG identified a number of issues for consideration in working through the electricity price impact of the introduction of the NZ ETS. It was agreed that:

• eligibility was defined under the same criteria as direct emissions
• analysis of the price impact would be completed using different methodologies to determine the most appropriate method for the allocation period of concern (2010–2012)
• a transparent price curve for the NZU will be needed for the electricity price impact to be converted into an allocation of units to eligible firms.

Section III – SEIP Emissions Calculation Methodologies

The Methodologies (Regulations) sub-group was tasked with developing methodologies for the activities related to the:
SEIP sectors, Schedule 3, Part 3 and 4
opt-in for stationary energy, Schedule 4, Part 4
other removal activities, Schedule 4, Part 2, Sub-part 1.

The sub-group, after reviewing the provisions of the draft Bill, has systematically examined each activity listed under the stationary energy, industrial processes and opt-in sections.

With respect to the other removal activities (in Schedule 4, Part 2 of the Act), the methodologies sub-group agreed that it was not appropriate to develop methodologies for each potential removal activity as the list could be large and the Act did not list activities but rather set out criteria that must be met. Therefore, the methodologies sub-group agreed that a process should be developed, and the other removal regulations should detail the process a participant must follow in order to verify they are carrying out a removal activity and to verify the total emissions sequestered either permanently or exported. Officials are currently undertaking work to establish an appropriate process and will consult on the draft regulations in mid-2009.

Treatment of particular issues outside of the Terms of Reference of the SEIP TAG

The following issues were raised in the SEIP TAG but not discussed in detail as they pertain to specific design features of the legislation and are therefore outside of the group’s Terms of Reference.

Some industry members expressed concern that firms who purchase industrial heat or steam, including that from cogeneration plants (as a substitute for the direct use of coal or gas), are precluded from receiving an allocation of NZUs.

Some industry members expressed concern that liquid fossil fuels used in the SEIP sectors do not receive an allocation of NZUs.

Officials note that these issues have been raised in submissions to the Select Committee and are specifically addressed in pages 31–33 of the departmental report.

 

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Last updated: 15 September 2008

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