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Climate Change Leadership Forum reports

Climate Change Leadership Forum:  Cluster B - Meetings 2 and 3

3 December DRAFT – Cluster participants have not yet provided comments.

November 20, 11.30am – 4.30pm; and November 29, 11.30 – 2.30pm.

Cluster B is a sub-group of the Climate Change Leadership Forum. Its original mandate covers several components of the Government’s proposed Emissions Trading System:

The first meeting of Cluster B addressed each of these issues (Climate Change Leadership Forum Cluster B Meeting Report November 5, 2007).  Discussion at the Climate Change Leadership forum meeting on 8 November led to a focus on economic modelling and allocation issues for the next two meetings of the cluster (November 20 and 29). Minutes were produced from the first of the two meetings – the key points from these are incorporated in this report. The issues covered were:

  1. Economic Modelling – general points
  2. Adjustment
  3. Leakage
  4. Stranded assets
  5. Allocation
  6. Mitigation

This report is not a summary and does not represent a consensus.  It records the major issues raised by different parties (some views may be conflicting) and presents some future directions at the end. 

1. Economic Modelling – general points

We need to instigate relevant economic modelling now if it is to contribute to the ETS structure in 2008. The group agreed to a set of modelling principles. These are to:

At a more macro level, it would be desirable to set up a long term, larger economic modelling funding pool with governance structure that can make decisions on particular research priorities rather than contracting each piece of research separately. This would have advantages in that it would minimise transaction costs, enable and encourage investment by researchers, lower hourly researcher rates and allow New Zealand to build/recruit new research capacity.

Peer reviews should comment on the strength of methodology and analysis and on how well justified any interpretation of results is.

We should ensure that the ETS generates a database that will be useful for evaluation once the system is running. The LEED and IBULDD datasets at Statistics will be central to analysis of the effects of the system. The ETS data should be able to link to these datasets as well as to others.  A limited number of people currently have the skills to work with these datasets.

1.1 Issues

Concerns were raised about whether firms can maintain confidentiality yet provide sufficient information for accurate modelling. This is an issue particularly for sectors with few firms. A balance is required here, since incomplete information will limit the value of any analysis.

Members of the group were also concerned that existing modelling is at a higher level than that needed for individuals to make decisions. In the agriculture sector, for example, modelling based on a percentage of cash flow or individual farm profitability would be desirable. It was noted however that GE modelling has the advantage of linking the effect of one firm’s closure to the whole economy.

A similar point was noted regarding regional effects. Group members noted that some labour markets will be less able to absorb changes brought on by the ETS. The modelling needs to explore these potential differences.

Unknowns in other policy areas, particularly forestry and biofuel, restrict modelling.

1.2 Forthcoming modelling

In addition to the GE modelling commissioned from Infometrics, the group acknowledged existing modelling by MAF and MfE, due for release in early 2008. This model generates abatement cost curves for the agriculture sector. Options for abatement include nitrification uptake, feed pads, and high sugar grasses. Energy efficiency is not covered. Assumptions are made about efficiency and rate of uptake.

Landcare Research has been conducting work on carbon footprinting and carbon neutrality.

Motu note: A workshop in October collated information on other relevant New Zealand economic modelling capacity, by a wide range of research groups. See: www.motu.org.nz for details.

2. Adjustment

Where and for whom are adjustment costs likely to be large, and how large?

Factors and issues mentioned during the discussion include:

New modelling should explore all of these factors to be most effective.

Modelling - Next Steps

It was agreed that a study of high-level adjustment costs would be useful.  This would focus on effects on regions and workers. The proposed methodology was to first rerun the general equilibrium model with full price impacts (i.e. no free allocation) to identify likely structural shifts.  These results would be annotated with key reasons why these shifts may be different to what the model predicts (e.g. industry is one firm only).  Second, these structural shift results would be translated into impacts on employment by region and occupational group.  Third, the raw structural shifts and employment impacts would be compared with actual shifts during the reform period (e.g. 1985 – 1990) to give an indication of the scale of likely adjustment costs. 

The likely impacts of the employment shocks identified could also be assessed using other existing research. 

3. Leakage

What would be the economic (adjustment and dynamic effects on industry development) and environmental effects of leakage?

What products are likely to be affected significantly by leakage? 

Leakage is where New Zealand producers reduce production (and emissions) in response to the ETS, while overseas producers then increase production to address the market gap.

In general, it was felt that there is a lack of clarity in what the Emissions Trading System is trying to achieve regarding leakage. It was felt that we need to think long term – beyond the current Kyoto rules. The key economic issue in leakage seemed to be a conflict between adjustment costs and lost long term opportunities if leakage is allowed versus easier compliance and lower cost to taxpayers if leakage is allowed. We need to get a better idea of the scale of these different impacts. 

The conversation returned frequently to the example of leakage in the wood-processing sector. Threats from the ETS to New Zealand’s forestry industry may have long-term implications for our carbon balance. However, the ETS is positive towards replanting long term. Forestry and the ETS is the subject of a dedicated group who are producing a report on the issue. Due to high interest, Cluster B recommends that this report be discussed in a specific forum.

Group members expressed concern that the risk of leakage may lead to a sharp drop in new overseas investment. This includes investment in new technologies required to address climate change. Investment is particularly crucial for the forestry sector. Forestry investors currently compare New Zealand economic conditions to alternatives in Chile and Indonesia.

Uncertainty in the legislation is one reason for this perceived risk to investment. Government representatives pointed out that there is little alternative to having uncertainty in the legislation, since fixing terms now would preclude reviewing them in response to changes in global policy. Group members felt that some terms could be more concrete. For example, will the free allocation phase-out process be linear or linked to any changes in the emissions target? Can there be ‘shock absorbers’ if the cost of carbon goes above a certain level?

Small and medium enterprises appear more at risk from leakage.

The dynamic effects of losing a sector through leakage are not clear.

Organisations unable to bear the costs of the ETS are probably not contributing greatly to the economy. Financially supporting these organisations through free allocation or similar would be at the taxpayers’ expense.

The group spent some time discussing who or what would not be at risk of leakage. Few examples were put forward; milk and meat processing are one example of processing industries that cannot be outsourced. Additionally, agricultural producers cannot move offshore and retain their quota-based access to some markets.

Government delegates proposed a distinction between land-use-related regrets and industrial regrets, on the assumption that plant-closures are likely to be permanent while land use changes can be reversed. According to the ETG, the arguments for free allocation in land-based industries are equity-based, and regrets are given higher weight in the Government’s allocation principles. In response, group members noted a risk of reduced investment and of skill leakage in land-based industry.

Group members from a range of sectors noted that there are a number of existing pressures on exporters. The ETS will exacerbate these pressures, but it is very difficult to establish which are more fundamental.

Border Tax Adjustment (BTA) is a possible response to leakage. BTA is contrary to current WTO regulations, though members of the group expressed interest in following current EU negotiations about the concept. It was noted that New Zealand would be reliant on other countries to set fair and consistent BTA levels. The Government will respond to the possibility of BTA following the outcome of the UNFCCC meeting in Bali.

Changes in production intensity due to leakage are an environmental issue: our competitors may not be included under the Kyoto cap and in addition, offshore producers are more emissions intensive.

Modelling actions – next steps

  1. ETG to provide more information on the benefits of allowing leakage. 
  2. Business representatives to, with colleagues, describe 5-6 major stories of economic impacts of leakage.  The key issues of concern are where short run and adjustment costs from a fall in production would be high, and/or the long run dynamic effects of losing specific capacity would be serious (e.g. lost investment or human capability that would be replaced if leakage ceases to be an issue in future either because of more complete global participation or effective border adjustments.  These accounts can be brief.  The aim is to provide a focus for independent analysis to verify them and consider their total impact on New Zealand.

4. Stranded assets

What assets will be stranded and who owns them?

Are there significant stranded assets (with concentrated ownership) where leakage is not a significant driver of the loss?

What is the life of any identified stranded assets?

In the context of the ETS, a stranded asset is any capital asset, land, education, a plant or similar, which drops in value when a carbon cost is applied.

The group recognised a need to identify examples of stranded assets for the wider forum. It is possible that stranded assets only occur where there is also leakage – group members’ examples can explore this idea.

Much of the conversation framed stranded assets as a result of leakage. A member noted that it is difficult to relocate plants and equipment offshore. It was also noted that stranded assets could occur as flow on effects of a plant closing, for example loss of human capital or housing value.

A first step for this debate would be to determine classes of stranded assets. It is possible that there are relatively few true cases of concentrated stranded assets that are not driven by leakage, other than land values. It is also possible that stranded assets are relatively evenly spread; in this case compensation is less crucial.

Compensation for stranded assets needs to take into account the life of the asset and likely technological changes.

Modelling – Next steps

  1. Business representatives to identify examples of significant stranded assets that would not be addressed by allocation aimed at addressing leakage.  These examples could be explored through independent research.

One key issue is identifying the extent to which rural land values are driven by profitability and hence to which rural land will be a stranded asset.

5. Allocation

The two key questions were:

What are the major objectives of any free allocation in each sector?

For a given objective, what is the best free allocation method?

The November 29 meeting focussed on free allocation. 

ETG members presented an internal paper titled “Issues around free allocation,” written following a request from the group. This paper is available elsewhere so will not be reproduced here. Its purpose is to clarify the purpose of free allocation in the ETS. Concluding a list of five reasons for free allocation the authors write, “the most prominent of the issues are around attempting to avoid economic regrets, and around equity.”

The meeting agenda listed the following allocation issues (reordered here) as a framework for the discussion. Each had been identified in the November 20 meeting as a significant design challenge for the ETS.

The conversation addressed these issues both at a macro level and for individual sectors. The discussion surrounding individual sectors (forestry, agriculture and industrial processing) is set out under section 5.1. ‘Case studies’. This is relevant as the Bali meeting may also bring a sectoral approach to allocation and other issues.

Free allocation (gifting NZUs to emitters) has fiscal and opportunity costs for the government. Any free allocation to businesses essentially costs the taxpayer – this needs to be a guiding principle for the discussion. There is some existing modelling of the likely costs to households/consumers.

Opportunity costs listed by one member include reduced financing for other climate change mitigation, including:

ETG members responded that there is a genuine need to balance support for incumbents with consideration for opportunity costs. It is difficult to predict what those costs will be.

There was uncertainty about the size of the pool of freely allocated units (and related, the number of NZUs that would be available within the trading system at each point in time). ETG members said that this information could be made available for the larger CCLF.

ETG members pointed out that the phase-out of free allocation is designed to mitigate opportunity costs to the taxpayer. A group member stated that the Government’s proposed examination of a longer phase-out period undermines that goal because free allocation becomes open-ended.

New entrants are currently excluded from free allocation. The paper Government paper tabled in the week beginning December 3 is to include potential provisions for providing allocation to new entrants.  Allocation for new entrants would happen automatically within an intensity approach under an overall cap. This would create better incentives than the current model.

5.1 Case studies

Case study 1: Forestry

For foresters the key issue is stranded pre-1990 forests and equity (rural sectors should be treated equally).

Protecting agriculture through late entry does not treat rural sectors equally. The ETS does provide some reward to changing land use from agriculture to forestry. This is slowed by agriculture’s late entry.

The ETG responded that forestry is receiving its assistance up front, while agriculture is receiving its in a number of chunks. The total level of assistance related to historical emissions is the same for both sectors. This may lead to inequities in the phase-out period.

This issue was not discussed in depth because a paper on allocation of compensation to pre-1990 forestry is being presented at the next CCLF meeting.

Case study 2: Agriculture

Primary concerns are regrets and, closely related, leakage (different from regrets because it is indefinite) and loss of profitability (particularly agricultural producers) potentially leading to loss of land value. Agriculture has little opportunity to pass on its carbon costs until other countries also put a price on carbon.

Agricultural delegates said that both overseas ETSs and the availability of mitigation technologies should be built into a review mechanism to drive phase-out decisions.

The same delegates assumed that allocation should be linked to farm size to some degree. There would be complicated calculations to determine which sub-sectors would receive what portion of the allocation. They believe that the total allocation proposed is considered fair.

ETG delegates noted that intensity vs. absolute is one of the central issues for the ETS. The issue is whether allocation is addressing leakage (a continuous issue) or stranded assets (a historical calculation).  By the end of the discussion we felt we had clarified the tradeoffs.  Under intensity based allocation the fixed total pool is shared using an annually updated rule based on output.  Some protection is provided against regrets and leakage and assets that continue to be used are less ‘stranded’.  New entrants and farmers that expand production automatically receive extra units but at the expense of existing farmers.  An allocation based on historical data compensates for stranded assets and provides capital to existing farmers to ease adjustment but provides no protection against carbon prices.  New entrants receive no protection under an absolute, historical allocation.   

Case study 3: Industrial processing

Allocation in this sector primarily addresses leakage, but potentially also stranded assets.

An intensity approach for industrial processes would differ by industry and potentially even by product. It is extremely difficult to identify which products and processes are vulnerable to leakage. The data for this is not always available. Whatever approach is used in this sector will be imperfect. 

The currently proposed ETS uses an absolute method of free allocation, which does not address leakage except to the extent that firms cannot close down altogether.  Industry is free to suggest alternative approaches, which could include intensity-based allocation.  Intensity-based allocation would address leakage but is difficult to define because ‘output’ is not homogeneous.  This is a problem that requires more thought and information.

One (imperfect) option to consider could be having allocation linked to some measure of output as the default allocation method but allow sub-sectors to propose an alternative.  Incumbents may have a competitive incentive to oppose intensity-based allocations because some share of the free allocation will go to new entrants.  Firms that are not expecting growth will be particularly opposed to an intensity basis. This may have an implication for the extent to which intensity based allocation automatically addresses stranded assets by directly resources to firms with high emissions intensity. 

The key economic disadvantage of having intensity-based modelling for all parts of industrial processing (and some of the users of stationary energy?) are that some products would not be facing a full carbon price signal when they should. They will be cross-subsidised by other sub-sectors that genuinely face leakage.

Industrial sectors are candidates for a global sector approach coming out of Bali, which could ease leakage pressure in some sub-sectors such as steel or aluminium.

This discussion could be further clarified with detailed case studies on specific sub-sectors within industrial processing.

Modelling - Next steps

  1. ETG to provide estimates of the freely allocable pool and the total NZUs that are likely to be available in the market at each point in time. 
  2. All members to determine whether they agree that this group’s advice to Government can be that leakage is the primary purpose of allocation in all sectors other than forestry.
    a. Are there firms who have significant stranded assets who will not also be at significant risk from leakage?

6. Mitigation

What are the mitigation opportunities in each sector? 

This has significant implications for appropriate timing of entry. It is also relevant for leakage because firms that can cheaply reduce emissions intensity are less likely to reduce production of these products.

Modelling – next steps

Research to improve our knowledge on this would involve collecting more international evidence (already being incorporated in some MFE and MAF work) but then a longer-term analysis and modelling effort within New Zealand.