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Climate Change Leadership Forum reports

Further Analysis of AAUs in the NZ ETS

Briefing for the Climate Change Leadership Forum
Prepared by the Emissions Trading Group
27 November 2007

Purpose

This report provides further material for the Leadership Forum on possible scenarios regarding inclusion of ‘hot air’ assigned amount units (AAUs) in the NZ ETS.[The paper addresses the possibility of private firms being able to access hot air AAUs.  It does not (directly) cover the possibility of the government accessing these AAUs, and on-selling them to the private sector.  Depending on the nature of any arrangements of this nature, the effects would be similar. ]  It also draws together some of the underpinning arguments on this issue (Annex).[Previously, the CCLF have been given a briefing paper “Unit of trade in the NZ ETS” that also traversed the hot air AAU question and other issues.]

Section 1: Scenarios

Simple scenarios relating to two hypothetical firms have been developed, along with the New Zealand economy as a whole.  The financial implications of emissions trading on both of those firms (and the economy as a whole) are tested given higher and lower Certified Emission Unit (CER) price scenarios[CER’s are the units that flow from the Clean Development Mechanism (CDM).  Trading in CER’s dominates international carbon trades at present.  This paper uses the term lower and higher prices, not low and high.  There is currently a large variation in prices depending on a variety of factors such as risk profile (the price for premium CER units is approximately $30 at present).], and with the inclusion / non-inclusion of hot air AAUs. 

The firms can be described as follows:

In terms of the New Zealand economy, in the absence of an ETS, New Zealand’s net deficit is estimated to be 45 million tonnes (or more, depending on assumptions around deforestation).  In the presence of an ETS, New Zealand’s net deficit is estimated to be 25 million tonnes over the 2008-2012 period (prior to any abatement associated with different carbon prices).[These figures relate to the sum of the New Zealand economy, not the deficit to the Crown.  The figure of 25 million tonnes is an estimate only at this stage.  An (updated) formalised analysis of New Zealand’s Kyoto position will be undertaken early next year and published in the Budget Economic and Fiscal Update.] 

Assumptions used in the scenario analysis are:

Section 2: Results

The results of the analysis are outlined in the table below.  These are expressed in terms of cost to the firm / nation in terms of dollars, as well as the percentage change relative to a base scenario where no hot air AAUs enter the NZ ETS.

Table 1: Effect of Different Scenarios re Inclusion of hot air AAUs

 

Base - No entry of hot air AAUs

Hot air AAUs enter at 10% discount

Hot air AAUs enter at 30% discount

 

Firm A

 

Financial cost of ETS ($000)

% change (saving) from base

Financial cost of ETS ($000)

% change (saving) from base

Financial cost of ETS ($000)

% change (saving) from base

Lower CER price

$1,200

 (0%)

$1,146

 (5%)

$1,035

 (14%)

Higher CER price

$2,160

 (0%)

$2,075

 (4%)

$1,897

 (12%)
Firm B

Lower CER price

-$400

 (0%)

-$380

 (5%)

-$340

 (15%)

Higher CER price

-$800

 (0%)

-$760

 (5%)

-$680

 (15%)

New Zealand economy

Lower CER price

$500,000

 (0%)

$478,088

 (4%)

$433,288

 (13%)

Higher CER price

$870,000

 (0%)

$838,850

 (4%)

$772,650

 (11%)

 

A key feature of these results is that the savings from including hot air AAUs are driven as much by the extent to which AAU prices are lower than CER prices, as whether the underpinning CER prices are high or low.  Further to this, in the short run, a higher price on carbon (whether through CER or hot air AAUs) is unlikely to drive significant abatement in New Zealand.

For firm A, the cost of ETS compliance ranges between $2.16m per year and $1.04m, depending on underpinning CER price and also the availability of hot air AAUs.  The saving associated with the inclusion of hot air AAUs is between 4 and 14% of the cost of ETS compliance, depending on the scenario chosen.

Firm B (the forestry company) symbolises that for firms that will benefit out of an ETS, to the extent that they are price-takers within the New Zealand market, they would be worse off if hot air AAUs entered the NZ ETS.  As such, the inclusion of hot air AAUs in the NZ ETS represents a loss of income for those firms.  This would, of course, not be the case if the value of forestry units (in this case) were to be unaffected by the presence (or otherwise) of hot air AAUs.[There is currently differentiation between different types of units in the market.  It is likely that there will continue to be differentiation between different types of units in the carbon market – although it is not possible to determine what that differentiation will be in the future. ]

In terms of the nation as a whole, the cost of compliance with Kyoto ranges from $433m to $870m (over the entire 2008-2012 commitment period), given the assumptions implicit.  The trends in terms of the cost to the nation as a whole largely mirrors firm A.

These figures are based on half of New Zealand’s obligations being met by hot air AAUs, assuming these become available.  If it were assumed that 100% of New Zealand’s obligations were met by hot air AAUs then the savings / loss of income associated with the inclusion of hot air AAUs would increase.

These scenarios model short-term influences only.  Longer term influences are by no means less important but are harder to model given (inter-alia) the lack of clarity on post 2012 international policy settings.  

How Realistic are these Scenarios? 

The scenarios developed are simplistic in terms of the effects on individual firms and on the nation as a whole.  More sophisticated modelling is possible but is considered to be unwarranted given the various uncertainties around this issue.  The most obvious uncertainties are:

In terms of the first of these, there are several Eastern European countries with hot air AAUs potentially available for sale and there appears to be interest from a seller viewpoint.  It is hard to be definitive however, and it is particularly hard to be definitive as to whether hot air AAUs will be sold to private sector players (as opposed to being limited to government to government transactions).  

In terms of the price question, the incentives on the sellers of hot air AAUs are not to collapse the price.  Deutsche Bank have estimated the cost of producing a AAU at between 1-2 Euros (compared with costs of 3-10 Euros for producing CERS).  Relative to their cost, countries selling AAUs could theoretically discount the price of other Kyoto units by large margins. Two factors make this unlikely. Firstly, AAUs are legitimate Kyoto units with zero or minimal risk of non delivery. Therefore, their value in a compliance market is arguably comparable to prices for other Kyoto units with a low risk of non delivery. Secondly, as a major gas supplier, Russia, the major potential seller of AAUs will want to see a strong gas price.  A flood of cheap AAUs would undermine the gas price as it would lessen the attractiveness of gas as a fuel relative to coal. 

The two assumptions made in this paper describe scenarios of a low and medium level of discounting that we regard as possible (given the uncertainties present). Conceivably the level of discounting could be even higher by some sellers.  

Annex: Background Arguments

Assigned Amount Units / ‘Hot Air’

For most countries, it will be necessary to reduce emissions or purchase credits on the international market in order to meet Kyoto targets.  However, the position is different for a number of countries in Eastern Europe and the former Soviet Union (including Russia).  These countries suffered an economic recession in the early 1990s.  This meant that their emissions levels have also reduced and are not expected to attain 1990 levels during CP1.  Accordingly, these countries will have surplus AAUs in CP1. 

These surplus AAUs are often described as ‘hot air’ AAUs because they do not result from emissions reduction initiatives.  Instead they are the consequence of an economic recession in the host country.

The exact number of surplus AAUs that will be held by each country in respect of CP1 will depend on a number of factors.  Accordingly, any indication of surplus AAUs will be an estimate only.  One commentator estimates that Russia will have around 3.1 billion tonnes worth of AAUs available in CP1.  The same commentator estimates that the Ukraine will have 1 billion tonnes worth of surplus AAUs over this period, and other Eastern European countries could have an additional 1.2 billion tonnes worth of surplus AAUs.  The potential supply of AAUs is sufficient to meet all Annex 1 countries’ targets (the collective shortfall of countries needing to buy units to meet their Kyoto obligation is estimated at 2 billion tonnes), but many market commentators suggest that there is unlikely to be a flood of hot air AAUs entering the Kyoto markets.[Many commentators suggest that the supply of CERs and ERUs from the Kyoto Protocol’s flexibility mechanisms will broadly match this demand.]

‘Green’ AAUs

Seller countries have recognised that market perception is affecting demand for their surplus units, and have devised a mechanism to monetise their AAUs, while addressing environmental concerns.  The ‘Green AAU’ concept was born in Russia during the ratification discussions and is now strongly supported by the World Bank, among others.

There are two ways in which hot air AAUs can be “greened”:

Under the Joint Implementation process, AAUs are converted into Emissions Reduction Units (ERUs) by reference to emissions reduction projects.  In order for ERUs to be issued, a project has to meet the additionality requirements of the Joint Implementation mechanism which are designed to show that genuine emissions reductions have been achieved relative to business as usual as a result of the investment from carbon credit purchasers.   

The potential for Joint Implementation projects to be carried out in Russia has been discussed for some time.  However, the Russian government did not approve procedures for Joint Implementation projects in Russia until very recently (May 2007). 

Green Investment Schemes (GIS) are mechanisms that have developed outside the Kyoto Protocol as a way of making ‘hot air’ AAUs more commercially acceptable.  The idea behind GIS is to earmark the revenue from selling hot air AAUs so that the seller is required to use this revenue to invest in environmental initiatives.  There are two different types of GIS: 

‘Green’ AAU Market Activity

Latvia was the first seller country to announce specific deals under a GIS.  In May 2007, it announced plans to sell 5 million AAUs to the Netherlands and Finland.  It is also reported to be in talks with Austria and Japan on AAU deals.  Many other countries in Eastern Europe, including Russia, are also looking into GIS possibilities.  However, relatively few details are available at this stage.

Media reports suggest that Japan is negotiating to purchase AAUs from Poland[“Poland eyes €10 billion AAU sales”, Point Carbon, 19/9/07], and that a GIS was being investigated.  Slovakia and the Czech Republic are both developing national legislation to sell AAUs, with the former submitting the first draft law designing a GIS.  It is also expected that Ukraine, the Czech Republic, and Hungary will have finalised national GIS legislation by the beginning of the Kyoto commitment period.

Factors to Consider

New Zealand’s International Reputation

Some environmental groups have expressed concern that allowing ‘hot-air’ credits into the NZ ETS could undermine New Zealand’s reputation as being serious about addressing climate change and environmental policy in general.  They believe that the international community may regard it as a cheap way for New Zealand to buy its way out of serious action.  Therefore, they argue that restricting AAU trades with certain countries could enhance the reputation of the NZ ETS.  (By implication, it could be argued that allowing  AAUs into the NZ ETS could adversely affect our ability to negotiate successfully in future international climate change fora, or could work against New Zealand companies wishing to sell units offshore).

Environmental Integrity

The environmental integrity of ‘hot air’ credits is perceived by some to be low due to their lack of linkage to deliberate emission reduction policies or investments, and potentially the fact that the emission reductions have already occurred.

Nonetheless, the AAU is a legitimate unit in the Kyoto protocol, even the so-called ‘hot-air’ AAUs.  The atmosphere does not differentiate between emissions reductions that have occurred through economic collapse or by deliberate climate change policy design.  In fact, given that an AAU represents a right to emit (and will be used at some point assuming Kyoto style arrangements persist), it can be argued that retiring an AAU is as (or more) environmentally friendly than use of the CER.[There are additionality concerns associated with the CDM (see the Point Carbon report titled 'Functionality in the International Carbon Reduction Project Market' on www.climatechange.govt.nz for more details).]  Consequently, the argument that ‘hot air’ AAUs do not have environmental integrity does not make sense unless hot air AAUs will not be valid in the future international climate change frameworks, or countries selling AAUs either subsequently withdraw from the Kyoto Protocol during the first Commitment Period or from obligations under a successor agreement.

Maintaining the Spirit of the Kyoto Protocol

Some groups argue that the world has changed since the Kyoto Protocol first came into effect (ie. the United States and Canada are not buying units), and that we should extract ‘hot air’ units from the system in order to ensure a greater level of environmental gain.

The risk to this line of argument is that it may have the opposite effect in the long term.  Many Eastern European countries ratified the protocol because they had relatively generous targets in CP1.  In fact, the allocation of 1990 levels of AAUs was likely a key factor in Russia’s decision to ratify the Kyoto Protocol.  This is significant because it was only through the ratification by Russia that the Protocol entered into force in early 2005. 

Banning trades in AAUs from selected countries could be seen as undermining the spirit of the Kyoto Protocol and may hamper attempts to negotiate future inclusive agreements.[It is worth noting that European governments are permitted to purchase hot air AAUs under current policy settings even though these AAUs are not permitted to enter the EU ETS.]  It is conceivable that developing countries may see signing up to future commitments as more risky if they suspect they may be discriminated against in a manner contrary to the agreement.

Linking  - with the EU ETS – and others

Placing restrictions on (hot air) AAU trades may allow us to work towards bilateral linking with the EU ETS either during the first commitment period or more likely some time after 2012.  Some groups are advocating linking to the EU ETS as soon as possible to improve liquidity in the New Zealand market. 

At around €23, EU ETS market prices are far higher than the lower market prices for trades in Kyoto-compliant credits undertaken outside of the EU, which are often around €11 for primary and €16 for secondary market credits.  This price differential is mainly due to restrictions on the types and volumes of units that can be traded in the EU ETS (e.g. forestry credits are not included).

A one way (buy only) link would prevent the NZ unit price from increasing to the level of the EU ETS, but would ensure that NZ ETS participants have access to a huge (but expensive), low transaction cost market with emerging financial instruments.  Allowing hot air into the NZ ETS may well compromise the ability of such a one-way link to emerge.[Some have suggested that it may be possible to sell forestry units into the EU ETS – this would be unlikely to be possible if hot air were allowed into the NZ ETS.  Regardless of this, it is not clear that this could be achieved without forcing the NZ unit price up to same level as the European unit price.] 

In the longer term, allowing hot air AAUs into the NZ ETS could compromise the ability of New Zealand to link with other ETS’s.  Although this may be a relatively small risk, it is difficult to be definitive on this point as carbon markets (and different governments’ policies) are developing rapidly.

Economic Cost

To the extent that cheap AAUs become available on the international market, restricting the purchase of them has the potential to increase the cost for New Zealand firms to comply with their obligations.  But the price that New Zealand ETS participants could expect to pay for ‘hot air’ AAUs depends on a number of factors.

It would not be in the interests of sellers to flood the market with units as this would result in hot air sellers receiving low or no revenue from AAU sales.  Instead, they would be likely to act strategically by selling a restricted amount of AAUs and by banking some for the post-2012 period.  Modelling has suggested that hot air countries would maximise their revenues by selling around 20–30% of their surplus AAUs in the market, depending upon the demand-side scenario[Natalia Gorina of ICF Consulting discusses this issue in her article entitled “Cooling down hot air”, published in Global Carbon in May 2006.].

In addition, it is unlikely that Russia would want to flood the market with cheap AAUs because of the likely impact on gas prices.  As a major gas supplier, Russia will want to see a strong gas price.  A flood of cheap AAUs could undermine the gas price as it would lessen the attractiveness of gas as a fuel relative to coal.  Mark Lewis of Deustche Bank supported this view at his presentation to the Treasury in August 2007.

In summary, it is difficult to predict accurately the volume, timing and expected prices of ‘hot air’ AAUs and how they would impact on the economic cost of New Zealand meeting its obligation.  We can say though, that if restricting AAU purchasing influences the direct economic cost of meeting our Kyoto commitments, then this can only be negative.

Practical Considerations

Russia and the Ukraine are often quoted as holders of ‘hot air’ AAUs.  However, in reality there are a number of countries whose emissions have reduced or not grown as rapidly due to economic decline or some other fortuitous event that leads to emission reductions[For example, the UK has achieved significant emissions reductions through replacing coal electricity generation with gas electricity generation.  This change had little or nothing to do with climate change policy, however, as it was driven by a combination of the deregulation and privatisation of the electricity supply industry, combined with lower fuel prices, greater fuel availability, and improvements in turbine performance.].  It would be extremely difficult to make a list of ‘banned’ countries based on sound principles, so any such list would end up being subjective.

Determining ‘acceptable’ countries with which to trade could become complicated, as they themselves may be purchasing AAUs from one of the banned countries.  For example, if Japan purchases AAUs from Poland, then Japan’s stock of AAUs would also be tainted. 

When you exclude the ‘hot air’ countries from the list of acceptable traders, it is unlikely that many of the remaining countries will be in a position to sell their AAUs.  In fact, many of these countries have embarked on Kyoto unit purchasing strategies of their own.

It may not be possible or attractive for NZ companies to import cheap AAUs from many of the ‘hot air’ countries due to the transaction costs involved.  The Russian government has elected not to deal in AAU trades with private entities, and will only trade with other governments.