Phase Out of Assistance: Briefing for the Climate Change Leadership Forum

Prepared by the Emissions Trading Group
Date: 9 April 2008

Climate Change Leadership Forum report number: 11

Executive Summary

Attached is the paper went to Cluster B for discussion at their meeting on Monday 7 April. The paper incorporates their comments and feedback.

Background

At the Cluster B meeting of 15 February and the Climate Change Leadership Forum meeting on 21 February papers on phase out options were considered. Further work was commissioned on a possible alternative option.

This paper looks at the objective of a phase-out approach, develops the possible alternative option further and then considers what the pros and cons of this option are. This paper is designed to generate further discussion.

Objective of phase-out

Any options for phasing-out of free allocation need to align with the objective(s) for the provision of free allocation and with the resulting allocation plan. Allocation could cover a variety of objectives; prominent amongst those are reducing adjustment costs, addressing equity concerns and maintaining New Zealand's reputation as a sound country to invest in by compensating for stranded assets, and minimising economic leakage and economic regrets.

Clarity about the objective for free allocation is critically important for selection the appropriate phase out approach. The phase out of free allocation over time is mainly relevant in the situation where the objective of free allocation is economic regrets. It is not relevant where the objective is compensating for stranded assets. And by addressing economic regrets, adjustments costs will also be reduced.

Economic regrets concerns the risk production shifting overseas when there is an expectation that this production would be viable in the medium term once the next international agreement is known. Avoiding economic regrets is a time-limited concept. It should be tied to avoiding decisions that would be regretted once it is clear what the next international agreement is.

However, it is not about protecting industry from the behaviour of other countries in response to that international agreement (competitiveness at risk). It is inevitable that imposing a cost of emissions will accelerate some decisions that result in relocating manufacturing/production overseas. Simply striving for prevention of all economic leakage could result in subsidies for industries that may not have a long-term future in (a low carbon) New Zealand.

While a key objective for the phase out of free allocation has been expressed as economic regrets, it is worth noting that this is concept can be considered a sub-set of environmental leakage and through addressing economic regrets the phase out of free allocation will also address an element of environmental leakage.

Environmental leakage arguments have two facets. Firstly, if emissions that are currently occurring in New Zealand transfer to a country that does not have Kyoto Protocol quantified commitments (the Kyoto “bubble”), then global emissions will increase (other things being equal). Secondly, it may be that production of certain products is more carbon efficient in New Zealand than elsewhere. As such from a long-term global carbon efficiency viewpoint, avoiding leakage is desirable because it will minimise, in the long-run, the global cost of meeting emission reduction targets.

However, continuing to allocate free emission units to private entities to avoid all environmental leakage involves New Zealand taking on an additional environmental responsibility (over and above its Kyoto commitments) at economic cost to the country. Further to this, leakage must (ultimately) be dealt with through improved international agreements – and it can be argued that New Zealand should focus its efforts on improving those international agreements.

It is for these reasons that the relevant objective of any phase out approach can be considered to be avoiding economic leakage. The key issue to consider in the development of phase out approaches is the cost to the taxpayer of providing free allocation in relation to the cost of any economic regrets. The costs relating to economic regrets are generally one-off (resulting from the shift in production) and should fall over time as more countries come within international agreements.

Analysis of a possible alternative option

Description of option

The possible alternative option is:

  • Free allocation of 90% of 2005 continues until 2018;
  • Move to zero free allocation in 2030;
  • Review every five years;
  • Clear review criteria and process.

See bullet list above for details of line graph.

As noted above it would be useful to provide more certainty on the criteria and process for these reviews. This could be achieved by having a separate review clause in the bill in regard to the phase out of free allocation. This would build on the relevant criteria and process already in the Bill.

The relevant review criteria in the Bill include:

  • The emissions pricing policies of New Zealand’s major trading partners; and
  • The implications of any future international obligations with respect to its emissions and removals that New Zealand had undertaken.

These criteria might not be the right criteria and could be clarified.

Possible criteria for the review of the phase out approach include:

  • Fairness between business sectors, taxpayers and consumers;
  • The number of countries facing binding emissions targets and the extent to which these countries are New Zealand’s competitors for imports and exports;
  • The implications of any future international obligations on New Zealand’s emissions target;
  • Significant changes in emissions mitigation technology; and
  • Other ways available for addressing economic regrets.

With regards to certainty on the process the bill currently sets out the timing, timeframe, responsibility, consultation requirements, issues for consideration and publication of these reviews. Further certainty could be provided by expanding the description of who must be consulted and how.

It is also recommended that further certainty on the outcome of any review also be provided for. Additional certainty could be achieved by specifying the features of phase out that can be amended as a result of any review. For example, through specifying that free allocation of 90% of 2005 cannot continue beyond a certain period and that the end date for free allocation must be no later than a specified date. This also sends a clear signal that an ultimate objective is for New Zealand firms to be facing the full price of carbon and that the reviews are not intended to move away from this objective. Another specification would be that the government will not allocate more units than it receives under any post-Kyoto obligation.

Impact of the alternative option on hypothetical firms

Previous analysis has been undertaken to compare the impact of different phase out options with the option outlined in the bill. This analysis was based on a hypothetical firm that emits 1,000,000 tonnes per annum (static) and makes a profit of $100 million per annum before emissions trading is introduced. The Emissions Trading Group compared the impact that different phase-out options could have on the net present value and profits of that firm.

It is proposed that more realistic model firms be used to analyse the impact that the preferred phase out option would have. Cluster B will be requested to provide some test cases for this analysis. The information required for each test case includes:

  • Emissions;
  • Current profit;
  • Average asset life;
  • The timeframe over which the firm seeks to recover capital investments.

Benefits and costs/risks of the alternative option

The possible benefits and costs/risks of this option are in comparison to the phase out option (base option) in the Bill.

The benefits of this option are:

  • Ensures that phase out can be refined based on the next international obligation (assuming there is one);
  • Ensures the number of countries facing binding emissions targets and the extent to which these countries are New Zealand’s competitors for imports and exports are taken into account in the review;
  • Provides further time for the New Zealand economy to adjust;
  • Allows additional time for businesses to adjust while still facing the marginal price of emissions.

The costs/risks of the option are:

  • In the long-run it is in New Zealand’s overall economic interest to move to zero free allocation (assuming efficient revenue recycling); however, this option further delays the achievement of this;
  • There is a risk that, if any future international obligation is set at more than 16% lower than our current cap, extending the phase out until 2018 would have a fiscal cost to the Crown. The extension of the phase out therefore is likely to result in the allocation packages beyond 2012 being percentage based rather than absolute figures;
  • The longer that free allocation is provided the less units the Crown has to auction and therefore to use for tax reductions or spending purposes (extending the phase out by five years would cost the Crown around $1.3 billion in lost revenue [This is based on the current phase out proposal which would see the free allocation reduced by 1/12th each year. Based on an estimated 49 million units allocated for free this means that each year an additional 4 million units would be retained by the Crown. Over five years this adds up to 61 million units. At a carbon price of $21.17 these units are valued at $1.3 billion.]) – this represents a transfer from taxpayers to firms;
  • Firms that are receiving free allocation for long periods of time could be perceived by consumers as avoiding their environmental obligations which might create a consumer back-lash;
  • It creates a risk that firms will focus on the review process rather than making the necessary structural adjustments;
  • Depending on the original allocation plan, free allocation might become less relevant over time (this is particularly an issue if the original allocation plan is based on historic emissions).