Climate Change Leadership Forum reports

April 2008

Further Comments on Phase-out of Free Allocation to the Industrial Sector for Cluster B

1. Introduction

The Treasury paper provides commentary on the objectives for free allocation to trade-exposed industrial firms and an alternative proposal for a phase-out of these.

The SEIP TAG has formed sub-groups on both eligibility for free allocation, and allocation processes. These sub-groups have developed objectives for eligibility and free allocation, to guide their work. These also provide helpful context for a discussion of the objective for phase-out of free allocation, as well as specific mechanisms.

The comments presented in this paper draw specifically from the work of the SEIP TAG sub-committees (noting that this work has not been reviewed by the SEIP TAG itself), and present a proposal, and the logic that supports that proposal, for the phase out of free allocation that picks up from the Treasury paper and addresses the issues arising from the phase out proposal presented in the Bill.

2. SEIP TAG on Allocation

A broad range of climate change policies, emission reduction targets, and Carbon prices currently prevail across regions and countries in response to existing international Climate Change agreements. Expectations are that this fragmented global response to Climate Change will persist in the medium term. Understanding this, the Government recognises that some New Zealand industries could scale back production or even close because they face higher costs than many of their international competitors. Commodity producers are especially vulnerable because they are price-takers and have little or no ability to pass on costs in the price for their products. Further, foregone production in New Zealand will most likely be replaced by increased production offshore, often in countries that do not have, or do not intend to have, a price of carbon in their economies in the near future. It is also very possible that the energy sources and even processes used in these offshore jurisdictions will be more greenhouse gas intensive.

In such circumstances, the New Zealand economy is negatively affected through reduced output and exports. Also, the production displaced from New Zealand may be replaced with more emissions intensive production offshore and will incur higher transport emissions. Further, such a transfer of production would not have occurred had sufficient competitor countries imposed a similar price of carbon into their economies such that commodity prices reflected the cost of greenhouse gas emissions. A New Zealand domestic policy that produced this possibility (exporting rather than reducing emissions), would not be internationally credible.

There is a clear need to balance the desired outcomes resulting from placing a cost of carbon into the economy (allowing the market to reallocate resources appropriately) with the need to minimise economic and environmental regrets. This can be achieved through an appropriately designed free allocation of emissions permits. It needs to be stressed that this free allocation is a transitional measure only. Free allocation for an industry should be discontinued once it is clear that the international price for the commodities produced by that industry will include a price for carbon because sufficient other producers are also exposed to such a price in their own economies.

The preceding discussion can be summarised in the following objective of free allocation:
To minimise New Zealand’s economic regrets associated with reduced current or future output from eligible firms by providing cost protection to (trade-exposed) firms without reducing the marginal incentive to reduce emissions.

3. SEIP TAG Sub-Group on Eligibility

In the context of the NZ ETS, economic regrets will most often result from:

Loss of production offshore. This may be of products that are currently manufactured in New Zealand, and are not able to sustain competitiveness with imported substitutes. Or it may be exported products that are no longer competitive in the international market-place.
Decisions to not invest capital that would otherwise have been invested. For example, a firm that stops investing in expectation of lost competitiveness in the future.

These are manifestations of carbon leakage. Firms that are vulnerable to carbon leakage are termed “trade-exposed”. A criterion for trade exposure was agreed by the Sub-Group as:

Firms that are subject to a high degree of international competition on export markets and/or from imports (or the threat of imports), and the prices they receive for their goods and services do not reflect a cost of carbon.

Criteria for the materiality threshold test were agreed by the Sub-Group as:

Firms whose emissions are above a specified threshold, or whose emissions are greater that a specified proportion of production costs.

This avoids the need to determine the extent to which the climate change policies of other countries are more or less stringent than those in NZ.

Further work is required on data, processes and verification. However, it was considered that these criteria could be readily verified using firm-submitted data.

4. Implications of These Considerations for Phase-out of Free Allocation

Objectives for the ultimate phase-out of free allocation should be consistent with overall objectives for free allocation.

The potential for economic regrets is directly aligned with the pricing of products in the countries of firms that compete with New Zealand. Therefore any provisions for phase-out that do not address this issue (in particular the linear phase-out proposal in the ETS Bill), will inevitably fail to meet the earlier expressed objectives for free allocation and avoidance of economic regrets.

In contrast, the alternative option contained in the Treasury paper is consistent with these objectives. This option is:

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

Changing the zero free allocation date to 2030 does little for the outcome sought. It is probably better to retain the INTENT to achieve zero free allocation by 2025 – ultimate removal of free allocation will be possible once competing products from overseas incorporate a carbon price and the imperative for action on reducing global greenhouse gas emissions demands that these measures are not delayed unnecessarily. Thus, with a rolling review, it is appropriate to retain the ultimate goal of full phase-out by 2025.

Note also that the EU phase III will run to 2020 and it would be logical for NZ align the proposed Free Allocation to that same date rather than 2018.

Criteria for the reviews should include both economic and environmental considerations. For example:

the emissions pricing policies of New Zealand’s major trading partners;
the implications of any future international obligations with respect to its emissions and removals that New Zealand had undertaken.
Significant changes in emissions mitigation technology;
Fairness between business sectors, taxpayers and consumers;
Ensuring the environmental integrity of the Emissions Trading Scheme is maintained;
That the Government will not allocate more units than it receives under any post-Kyoto obligation;

Thus a clear signal can be maintained that free allocation will end in the foreseeable future (a rolling review does not mean that free allocation will be maintained indefinitely) – Trade Exposed firms will be expected to ultimately face the full price of their emissions, but at a time and in a manner consistent with the objectives of Free Allocation.

The benefits of this proposal (compared to the current phase-out proposal in the ETS Bill) are:

Provides greater flexibility to accelerate phase-out if there are international policy developments such as sectoral agreements.
Ensures that phase out can be refined based on future international obligations;
Ensures that the emissions pricing policies of New Zealand’s major trading partners and their effects on competing (or substitute) product prices, are taken into account;
Provides certainty to firms when making investment decisions that overseas developments will be taken into consideration in determining the phase out path;
Ensures that firms receive clear signals about both the short-term (still face the marginal price of emissions) and the long-term, (ultimately they will face a full price of carbon).

This approach significantly reduces the risk of leakage that could occur through reduced investment in New Zealand, and improves the environmental integrity of the New Zealand ETS. By ensuring that the review criteria are adequately considered in the review process, this phase-out proposal will not result in any net overall costs to New Zealand (by definition).