Climate Change Leadership Forum, Cluster B, Meeting 7 Minutes

May 22, 2008, 1-5pm

1. Modelling

Adolf Stroombergen (Infometrics) presented his review of NZIER’s report “The impact of the proposed Emissions Trading Scheme on new Zealand’s economy, April 2008.”

The primary difference between the NZIER and Infometrics’ own work is that NZIER’s modelling put NZ Pays at less cost to the economy than an ETS. Adolf’s view is that NZIER’s methodology, analysis and conclusions are sound. He set out four explanations for their finding:  reduction in aggregate investment under ETS; strong agricultural contraction under ETS; taxes are not explicitly modelled, and foreign investment falls under ETS.

The discussion focussed on investment which NZIER and Infometrics identified as the key difference. Infometrics assumed that aggregate investment would not decrease under an ETS; NZIER assume it would due to lower rates of return expressed in NZ prices. While to business participants it seemed intuitive that the ETS would lower investment (and, anecdotally, some investors are already making decisions to divert capital in response to likely carbon charges), this ignores offsetting effects in other sectors as a result of lower taxes, exchange rate adjustments and reduced domestic competition from high emitters. Internationally, empirical studies are unable to clearly model the drivers of investment so this is not a question with a clear answer.

Adolf compared the introduction of a carbon cost to the introduction of ACC levies, which did not obviously change overall investment. There is no obvious way to resolve the issue ahead of the system’s implementation, though both NZIER and Infometrics agree that system uncertainty is likely to lower aggregate investment.

NZIER were asked whether their model is hypersensitive to impacts on profitability, especially in agriculture. This could explain large predicted losses in the agriculture sector. NZIER noted that land use modelling at Motu has also predicted big effects in the agricultural sector. [On checking after the meeting Motu did find large predicted impacts of an emissions charge on profitability (which depends in part on high current debt levels because agriculture is currently profitable so that land prices are high). However if the intent of the question was to ask whether agricultural production is hypersensitive to a carbon charge, then the NZIER model is orders of magnitude more responsive than Motu’s.]

NZIER noted that the NZ Pays strawman obscured what they considered to be the primary finding of their modelling: that the ETS discriminates against export sectors in a macroeconomic CGE sense. They believe there will be unnecessary cost on the NZ economy if trade exposed sectors are not given sufficient support and that we need to be careful about risks in the short term.

If we accept the NZIER result, we also need to accept that high emitting sectors including agriculture are currently over-taxed relative to other sectors and that we need to change the structure of our tax system, independent of the ETS. To model this type of tax shift we would really want a model that explicitly models the NZ tax system. Peter Weir pointed out that most agricultural profits are received as capital and are therefore untaxed.

Neither model has technological change responding to a carbon price. The authors both set aside this option due to a lack of information about the projected relationship, though each includes emission reductions for average technological advancement (through energy substitution and other mitigation). A consultant for Emissions Trading Group noted that a lack of technological responsiveness to a carbon price is key for the ETS. The system should encourage mitigation and technological change, otherwise paying for NZ’s obligation through general taxes would be equally effective  – differing only to the extent that different types and rates of taxes cause different amounts of deadweight loss. It was noted that technological change cannot explain differences between the two models, since both treat the issue similarly. However, by not including technological responsiveness to a carbon price both the NZIER and Infometrics models will tend to under-estimate the benefits of the ETS relative to a situation where there is not an ETS. In addition, neither model includes rewards for carbon sequestration from forestry, which could have a similar effect.

The policy implications of this discussion are difficult.  Overall, the NZIER model adds another scenario to the set of scenarios based on different assumptions.  The CGE modelling can tell us how the economy behaves under different assumptions but cannot tell us which set of assumptions is most likely.  The case studies commissioned by Cluster B will hopefully complement the macroeconomic modelling with bottom up information.

2. Economic regrets

Suzi Kerr (Motu) presented a paper (co-authored with Andrew Coleman, also of Motu) titled ‘Economic Regrets’. The paper had been circulated with the minutes from the previous meeting, as well as in the agenda.

The assumed objective of the allocation policy is to minimise economic regrets from leakage.

She presented the following flow diagram.

Text description of figure

The flow diagram outlines the circumstances under which a firm might require protection by asking the following series of questions:

Would a firm maintain production with a global agreement?
No – Do not protect.
Yes – Do long-term firm benefits from maintaining or building firm-specific capital justify maintaining production despite lower short-term returns?
Yes – Do not need to protect
No – Does the cost of providing protection to the firm (cost of raising taxes) exceed the social losses if production falls? The social losses are primarily a stream of wage premia to those who would work in the firm in the short and long term.
Yes – Social regrets do not justify protection despite leakage
No – Policies to protect production of at-risk products would provide potential value.

If there are multiplier effects from investment then the social benefits go beyond benefits to wage earners.

Fletcher Building clarified that the ETS will not ‘close’ their business, but it will affect where they source resources to maximise returns to shareholders.  Fletcher Building will stop manufacturing cement when it is cheaper to import. The discussion in the paper in terms of a firm staying or going is intended to simplify the paper; the same considerations apply to regrets from firms lowering production.

Greenpeace questioned whether subsidies should be only offered to firms. Other options would be to provide credit to workers and communities, invest in substitutes or nationalise the firm. However if the purpose of subsidy is to cause the production to stay in NZ, paying the firm is the only option to do this (though nationalising could do this too).

Fletcher Building queried the use of ‘protection’ and ‘subsidy’ as terms in the debate. They believe they are asking for a level playing field – efficient industry should not be subject to unbalanced overseas competition. However it is costly to level the playing field, particularly given that border tax adjustments (BTA) are not an option at present. An official from Emissions Trading Group stated that the last time BTA was considered at the CCLF, it did not get much support because it conflicted with NZ’s strategic trade approach. In addition, our major trade competitors are not non-Annex 1 (though Forestry is an exception here, and Agriculture is a complicated case given that the EU and US are unlikely to ever include agriculture in their systems).

Some private sector representatives argued that new investment decisions are also irreversible (when negative) so subject to the same regrets as contraction in production.  Thus they argued that new investments should be treated symmetrically.

3. Leakage case studies

The meeting updated delegates on progress towards leakage case studies. These are now underway in accordance with the terms of reference discussed at earlier meetings.

Fletcher Building outlined their reasons for taking part in the case study process. They believe the resulting microeconomic analysis will be a useful complement for existing macroeconomic modelling. They also expect it to aid their own understanding of expected liabilities with a carbon charge, which may aid planning. It was noted that Fletcher Building’s experience might be useful for other companies getting to grips with the system.

CRA, a consultancy employed to carry out a case study, outlined progress. Their work provides estimates of likely emission increases if the case study operations were to move offshore. They plan to be able to model the competing costs of importing once relevant data is available.

Comments on the existing work included the following:

  • Include wages as well as employment numbers affected in order to assess social losses, and a measure of annual investment.  What is likely to happen to workers?
  • Include current total emissions, as well as projected emission increases from moving production offshore so that the impacts of environmental leakage can be assessed.
  • We want to be able to show how sensitive the decision to produce domestically is to a matrix of carbon prices, oil prices and exchange rates.
  • Leakage to Australia is a very real issue because it can occur across plants within one firm. A company could feasibly supply the domestic market from NZ and the overseas market from Australia.
  • Another key issue is the reversibility of any movements in production or investment decisions.  If decisions can easily be reversed there are unlikely to be regrets even if there is short-term leakage. Some of the changes anticipated in the CRA case study were argued to be irreversible.

NZIER discussed their experience working on a separate leakage case study. In the context of this discussion it was asked whether it would be possible to include the price of oil in the analysis, i.e. what are the sensitivities between carbon prices and oil prices for those considering moving all or part of their production offshore.

Another key issue was the treatment of sunk costs.  The group’s feeling was that the analysis should consider forward looking decisions based on current assets rather than requiring adequate rates of return on existing assets.

The meeting discussed which components of this work will be most useful to the wider forum. The most interesting question is what firms are likely to do and why, and Suzi Kerr asked for the contractors to include their intuitions on this (and those of the people they are in contact with). Dave Brash suggested that the next report to the forum will be generic for the moment. We have a range of studies, which are likely to show quite varied results. The report should discuss why there is a value to participants, and indicate when we plan to have the full results.

Because the final results will not be available in time for the CCLF, we agreed to hold a separate meeting to discuss the findings on June 4th so that any preliminary conclusions can be passed to the select committee on June 5th.  A focus for this short-term group could be to consider the employment / social and environmental costs of the scenarios identified in the completed case studies.

We recognise that this will be too tight a deadline for full analysis and discussion and will continue that after June 5th as a useful input to the TAGs and for later reviews of free allocation. 

4. SEIP TAG

An Emissions Trading Group provided an update from the SEIP TAG.

The Eligibility sub-group is working on criteria to determine who would be eligible to receive a free allocation of units. It is looking at a two-step procedure to determining eligibility, the first being a test of trade exposure and the second a test of materiality.  The sub-group now intends to further develop and test proposed criteria using real data.  A major issue that has been raised during discussion of the sub group’s work in the TAG is the impact of different eligibility criteria (and tests) on small and medium size businesses.

The Allocation sub-group is in the early stage of evaluating different allocation options. Generally two allocation options are being considered with variations - the first a ‘grandparenting’ method based on historical emissions; the second an output/intensity based method.  Both methods are to apply within a ‘cap’ – or an overall limit on units that can be freely allocated.  And both methods need to address the question of new entrants, such as by a ‘new entrant reserve’. The ability to road-test these allocation options using reliable data is a key issue for the TAG.  The possibility of a progressive obligation is not recommended by the TAG.

A key issue to be addressed is how the choice of allocation methodology impacts on the choice of eligibility criteria and vice versa. For example an output/intensity based allocation methodology may be best suited to a product/sector level eligibility test.

The TAG also has concerns that the constraints contained in Section 70 of the ETS Bill, limit the methods that might otherwise be available for free allocation.  The 90% of 2005 emissions is a particular example, in that the options for an intensity based allocation are severely compromised by that cap.  Another example would be consideration of a new entrant reserve. 

The issue of a fixed total cap on free allocation can be discussed within Cluster B but not the SEIP TAG.  Suzi Kerr has been invited to a combined Eligibility / Allocation TAG sub-group meeting on 27 May.  At this meeting, the work being carried out by the TAG can be further clarified, and Cluster B can then identify further work projects that would inform decision-making on these aspects of free allocation to the industrial sector.

5. Next steps

Potential roles for Cluster B going forward are the following:

  • Further analysis of ‘leakage case studies’.
  • Reassessment of the appropriate overall level of free allocation.
  • Analysis of the appropriate phaseout of free allocation and the structure of reviews.
  • Analysis of the relationship between allocation methodologies used and the phaseout/review.

There may also be a role for Cluster B to consider the issue of sector agreements as a threat to equity in the ETS. This issue is under consideration in a number of TAGs, but would benefit from Cluster B’s wider mandate