Climate Change (Emissions Trading and Renewable Preference) Bill

Climate change, and how we deal with it, is one of the most important issues of our time. The introduction of this Bill is a critical step toward New Zealand playing its part to address climate change.

The Bill’s principal purpose is to amend the Climate Change Response Act 2002 to introduce a greenhouse gas Emissions Trading Scheme in New Zealand (NZ ETS). The Bill also amends the Electricity Act 1992 to create a preference for renewable electricity generation by implementing a moratorium on new fossil-fuelled thermal electricity generation, except to the extent necessary to ensure the security of New Zealand’s electricity supply.

Emissions trading schemes are increasingly being established in a number of countries and regions around the globe. Over time, the NZ ETS will cover all gases and all sectors, in order to minimise overall costs to the economy and operate with efficiency and equity. The scheme will apply an economy-wide price signal to activities that contribute to climate change.

Climate change is a global problem and New Zealand is reliant on international action to mitigate the risks associated with increased concentrations of greenhouse gases in the atmosphere. The design of the NZ ETS is compatible with the United Nations Framework Convention on Climate Change (the Convention) and the Kyoto Protocol (the Protocol), but is designed to endure under a range of possible future scenarios for international climate change agreements.

The objective that guided the design of the NZ ETS is:

That a New Zealand Emissions Trading Scheme support and encourage global efforts to reduce greenhouse gas emissions by:

• reducing New Zealand’s net emissions below business-as-usual levels; and

• complying with our international obligations, including our Kyoto Protocol obligations;

while maintaining economic flexibility, equity, and environmental integrity at least cost in the long term.

The NZ ETS is designed to operate as an integral part of the government’s broader climate change, sustainable development, and economic transformation agendas.

The preference for renewable electricity generation augments the NZ ETS goal of reducing New Zealand’s net greenhouse gas emissions below business-as-usual levels. It does this by implementing a moratorium on investment in new fossil-fuelled thermal generation, except to the extent required to ensure security of supply. This will reduce the potential for fossil-fuelled thermal electricity generation to increase the level of New Zealand’s greenhouse gas emissions.

The NZ ETS and the renewable generation preference are part of New Zealand’s wider effort to meet its international commitments under the Convention and Protocol to implement policies and measures to reduce greenhouse gas emissions.

Consultation and Engagement Process

This Bill was developed after an extensive process of consultation and engagement.

In December 2006, the government released five energy and climate change discussion documents, and embarked on a significant consultation process on a number of policy options. The high level of public engagement and feedback showed that New Zealanders take energy and land use sustainability seriously, and are keen to be part of the solution. Over 3 000 submissions were received and over 150 public meetings and hui with Māori held.

Following this consultation, the government established a cross-departmental Emissions Trading Group (ETG) to develop a proposal for an NZ ETS. The ETG includes representatives from the Treasury and the following agencies: Ministry for the Environment, Ministry of Economic Development, Ministry of Transport, and the Ministry of Agriculture and Forestry. The ETG also works closely with the Department of Prime Minister and Cabinet, Te Puni Kōkiri, the Ministry of Foreign Affairs and Trade, the Department of Conservation, the Ministry of Science, Research and Technology, and the Inland Revenue Department.

On 20 September 2007, the government released its proposal for an NZ ETS, and began an intensive period of engagement on the core design features, and with particular regard to Māori and to those sectors entering the scheme first (forestry and liquid fossil fuels).

The engagement also included the establishment of a Climate Change Leadership Forum, to facilitate communication between the government and the broader community on the proposed design of the NZ ETS. The Forum will continue until mid-2008 and its considerations will be taken into account through the legislative process. Issues that are likely to be discussed include the treatment of pre-1990 forests, the type of emission units allowed into the NZ ETS, phase-out of free allocation, and whether an intensity-based approach can be included within an absolute cap of free allocation.

Engagement process will continue throughout 2008, including on those aspects of the NZ ETS that are to be governed by regulations. A number of mechanisms are in place to achieve robust input, including technical advisory groups for energy and industry, and agriculture. A “Peak Group” for the agriculture component of the NZ ETS has been established. These groups will provide input on a range of matters.

In the longer term, the government will continue to engage with the broader community on the future evolution of the NZ ETS in light of changes to New Zealand’s obligations under international climate change agreements. The Bill provides a process for review of the NZ ETS, prior to the end of the Protocol’s first commitment period and each subsequent commitment period.

In October 2007, the government released the New Zealand Energy Strategy (NZES) and adopted a target for renewable electricity generation of 90% by 2025. Consistent with this, the NZES states a clear preference that all new electricity generation be renewable, except to the extent necessary to maintain security of supply. The NZES signalled consideration of regulatory options under the Electricity Act 1992 to support this objective.

The development of the NZES involved a large number of organisations, associations, interest groups and individuals offering comment on the ideas and options contained in the strategy.

Structure of the Bill

Part 1

Part 1 of the Bill contains amendments to the Climate Change Response Act 2002 to introduce the NZ ETS.

Clause 4 of the Bill sets out the dates from which certain provisions of the Climate Change Response Act 2002, once amended, will apply. Individuals and firms within different sectors will first assume NZ ETS obligations from the date when the relevant parts of Schedules 3 and 4 apply.

The entry of sectors into the NZ ETS is based on sectors’ preparedness for trading, administrative feasibility and consideration of price effects through the economy.

The table below reports when each sector first assumes obligations and first must comply with those obligations under the NZ ETS. Subsequent compliance periods for each sector extend from 1 January to 31 December in each calendar year.

Staged entry of sectors into the NZ ETS

By 2013, all sectors and all six major greenhouse gases will be covered by the NZ ETS, so that all major sectors of the New Zealand economy will be exposed to the international price of emissions, at the margin, for all operations.

The existing provisions in Part 2 of the Climate Change Response Act relating to the Crown’s trading in Kyoto units are amended to allow for the introduction of the NZ ETS. These amendments are mostly contained in clauses 6 to 28 of the Bill.

The core provisions that implement the NZ ETS are contained in a new Part 4 of the Climate Change Response Act 2002, inserted by clause 43. Part 4 covers participants, participants’ obligations, allocation of New Zealand units, compliance and enforcement, offences and penalties, review and appeals, future development and Ministerial review of the scheme.

The NZ ETS is based on the concept that “participants” incur obligations by doing “activities”.

The NZ ETS reduces compliance costs by ensuring that the activities giving rise to obligations are as high in the supply chain as possible. The activities that bring a participant into the NZ ETS are listed in new Schedules 3 and 4. Where possible, “activity” is defined with reference to other regulatory regimes to which participants might be subject.

Activities listed in Schedule 3 are those activities undertaken in New Zealand that will automatically give rise to obligations under the NZ ETS—a person who does one of these activities must register as a participant under the scheme and comply with their obligations in respect of that activity.

Although some sectors will not be brought into the NZ ETS for some years, the Bill contains the activities for all sectors. The dates are included now to give certainty to the “all sectors, all gases” principle that underlies the NZ ETS.

Persons can also elect to become participants if they do activities listed in Schedule 4. Schedule 4 covers:

• owners of, or holders of forestry rights/leases over, forests planted after 1989:

• producers who embed carbon in their products:

• major users of jet fuel used for domestic aviation:

• major users of coal and natural gas.

There are likely to be less than 200 participants in the NZ ETS not including those in the forestry sector. The number of forestry participants could range from 2 000 to 9 000, depending on the number of post-1989 forest owners or forestry right/lease holders who decide to become participants in the scheme.

The main obligation that participants will have under the NZ ETS is to surrender emission units to match the emissions from their activities in each annual compliance period. Participants are also obliged to:

• calculate their level of emissions, using prescribed methodologies:

• retain sufficient records to allow verification of emissions calculations:

• report their level of emissions:

• provide information, if required by the chief executive (NZ ETS administrator), to allow the chief executive to verify compliance.

The methodologies prescribed in regulations will include formulas to calculate emissions, such as scientifically-determined factors that relate activities to emissions (eg, the quantity of carbon dioxide emitted when a litre of fuel is burned). They will also include methods for measuring activities directly or indirectly resulting in emissions.

Participants undertaking “removal activities” will also be able to earn emission units. Post-1989 forest land participants, and participants who embed carbon in their products, may elect to account for both their emissions (if any) and removals, and receive one New Zealand unit for each tonne of carbon dioxide stored in their trees or products.

The primary unit of trade in the NZ ETS is a New Zealand unit (NZU), issued by the government. For the first commitment period of the Protocol (2008–2012), each NZU issued by the government will be backed by a Kyoto unit held in a Crown holding account in the Registry.

Participants may surrender Kyoto units to meet their NZ ETS obligations (subject to some restrictions). Kyoto units can be acquired overseas or domestically. The Bill itself does not contain a provision to limit the volume of Kyoto units that can enter the NZ ETS, but gives the responsible Minister the ability to place restrictions on which classes or subclasses of Kyoto units may enter the NZ ETS and what transactions may or may not be registered in respect of those units.

The government has already decided to exclude certain units (eg, Certified Emission Reduction units from nuclear projects). The government is still seeking feedback on the need for other restrictions. The Bill places no restriction on the entry of AAUs into the NZ ETS; this has been welcomed by some and criticised by other domestic stakeholders, who have expressed concerns about potentially damaging the integrity of the NZ ETS, and reducing New Zealand’s prospects of linking with other countries’ schemes. Consideration of these views needs to be weighed against the costs of compliance without AAUs entering the NZ ETS and recognition of the fact that all Parties have agreed to the provisions of the Protocol. Maintaining the spirit of the Protocol is critical to negotiating future inclusive agreements.

The amendments to Part 2 of the principal Act are designed to permit bilateral linkages with other countries’ domestic trading schemes in the future.

In terms of trading, the NZ ETS is designed to allow flexibility in how participants trade units in the market, whether trading occurs via trading platforms, or via direct exchange. Any person eligible to open a holding account in the Registry (not just participants) will be able to hold and trade emission units).

Subpart 2 of new Part 4 contains provisions for the free allocation of emission units to the forestry, and to trade-exposed industry and agriculture sectors.

New section 69 establishes the level of allocation to pre-1990 forest land owners at 55 million New Zealand units. The treatment of pre-1990 forests relative to post-1989 forests (particularly the free allocation of emission units equivalent to 55 million tonnes of emissions to owners of pre-1990 forests) has been criticised by elements of the forestry industry. Further advice is being prepared for Ministers on options for targeting of free allocation for pre-1990 exotic forests, such as on the basis of restrictions on land-use change since 2002 (when the government first signalled there would obligations associated with deforestation).

Electricity generators and liquid fossil fuel providers are not likely to suffer major (negative) impacts on their profitability through the introduction of the NZ ETS, as they are likely to pass on any extra costs imposed by an ETS to consumers down the supply chain. Consequently, they will not receive transitional assistance.

The approach to assistance to industry and agriculture (sections 70 and 71) is to limit the total level of assistance to be provided by firstly identifying the initial level of assistance to be provided, and secondly, by defining the way forward (including phase-out of assistance by 2025):

• The initial level of assistance to eligible trade-exposed industrial firms is 90% of their 2005 emissions from direct use of coal, natural gas or geothermal stream; direct consumption of electricity; and non-energy industrial processes.

• The initial level of assistance to agricultural firms is 90% of their 2005 emissions of methane and nitrous oxide from eligible activities.

The government is continuing to engage with sectors on allocation plans and the emission abatement paths. This will occur via the Climate Change Leadership Forum, the Māori Leadership and Reference Groups, the Peak Group, and the Technical Advisory Groups.

New section 68 provides for the making of allocation plans by Order in Council. The plans will set out a maximum free allocation for each sector over 2008–2012 and 2013–2025 and specify who is eligible for a free allocation of NZUs.

Sections 72 and 73 contain the process to govern the making of allocation plans. Before recommending that an Order be made to issue an allocation plan, the Minister must notify his or her intention to make the allocation plan, gather information from people who may be eligible for an allocation of NZUs, and seek public submissions on the draft plan.

Provisions dealing with compliance and enforcement are in Subparts 3 to 5 of new Part 4.

The NZ ETS follows a self-assessment model. Under this approach, all the obligations placed on participants are clearly set out in legislation. Participants are required to submit annual emissions returns. Since this information will be of a commercial nature it will not be publicly available; nonetheless, certain information will be disclosed in aggregated form. The government is engaging on whether firms would be willing to report more frequently.

The chief executive will have the ability to audit the compliance of emissions returns submitted by participants. If participants fail to meet their obligations, or are shown to have failed to comply following an audit, financial and make-good penalties will apply, and will increase with the degree of culpability. To aid compliance, the chief executive will be able to issue advance rulings (called “emission rulings”), which will bind the chief executive to a particular interpretation of the legislation.

Ministers and departmental chief executives are the principal decision-makers under the NZ ETS. The Bill creates the right to seek District Court review of decisions. Appeals on questions of law will lie with the High Court.

New Part 5 of the Climate Change Response Act 2002 contains the provisions specific to the forestry, transport and stationary energy sectors.

The forestry-specific provisions in Subpart 1 of Part 5 cover:

• The designation of forest land as either “pre-1990 forest land” or “post-1989 forest land”.

• Changing the land use of pre-1990 forest land gives rise to mandatory obligations under the NZ ETS. Exemptions are available for deforestation on land-holdings of less than 50 hectares and of land containing tree weeds.

• Owners of post-1989 forest land, or the holders of forestry rights/leases over post-1989 forest land, may elect to join the scheme (Schedule 4) to receive New Zealand units when their forest grows and surrender units when carbon mass decreases.

• Registration as a participant in respect of post-1989 forest land, possible deregistration, and the associated entitlements and liabilities.

The transport-specific provisions (Subpart 2 of Part 5) cover the ability of major jet fuel users to assume obligations under the NZ ETS if they wish. The stationary energy-specific provisions (Subpart 3 of Part 5) mirror these provisions in respect of major coal and gas users.

Part 1 of the Bill also provides for the consequential amendments that are required to ensure other statutes are consistent with, and support, the introduction of the NZ ETS.

The Income Tax Act 2004 and the Income Tax Act 2007 are amended to provide for the taxation treatment of the forestry sector of the NZ ETS. Provisions relating to the tax treatment of the NZ ETS for other sectors will be included in a tax bill scheduled to be introduced in early 2008.

The Forests Act 1949 is amended to provide for the potential use under that Act of verifiers recognised under the Climate Change Response Act 2002 and methodologies prescribed under the Climate Change Response Act 2002 (as provided for in this Bill).

The Forestry Rights Registration Act 1983 is amended to remove certain definitions that are superseded by definitions in this Bill.

The Personal Property Securities Act 1999 is also amended to allow security interests over emission units to be registered in the Personal Property Securities Register.

Regulations

The principal features of the NZ ETS, including obligations on participants, are provided for in primary legislation. Regulations (as provided for in new section 148) will supply further technical details. The areas that will be covered by regulations include:

• certain definitions where the definition may need updating on a regular basis (such as “obligation fuel”):

• specification of the methodologies to be used to calculate emissions and removals:

• exemptions from the NZ ETS:

• the manner and form in which information is to be provided to the chief executive:

• fees.

Part 2

Part 2 of the Bill amends the Electricity Act 1992 to create a preference for renewable electricity generation by implementing a moratorium on new fossil-fuelled electricity generation, except to the extent necessary to ensure the security of New Zealand’s electricity supply.

To help meet the government’s climate change objectives, the New Zealand Energy Strategy (NZES) contains a target for 90% renewable electricity generation by 2025, and states a clear preference that all new electricity generation be renewable, except to the extent necessary to maintain security of supply.

Modelling undertaken to support the NZES indicates that renewable generation is expected to be cost competitive with fossil-fuelled thermal generation, particularly under the range of potential carbon prices envisioned under the NZ ETS. It is feasible, however, that a combination of factors, such as a high exchange rate and low gas price (as could arise from a major gas discovery) could mean that, even with emissions pricing, fossil-fuelled thermal generation may become more economic. Unexpected high costs or other barriers to new renewables could also make fossil-fuelled thermal generation more economic.

Due to the economies of scale involved in electricity generation investment, any significant investment in fossil-fuelled generation could “crowd-out” renewable investment for a number of years. This would jeopardise the government’s climate change and NZES objectives and undermine public confidence in the climate change policy.

To minimise these risks, this Bill implements a 10-year legislative moratorium on new fossil-fuelled thermal baseload generation. This moratorium applies equally to all generators, whether state-owned or private, thereby ensuring competitive neutrality between generators with regard to the type of investments they can undertake. It is designed to influence generators’ investment decisions towards renewables in the short-term, allowing time for the full introduction of an emissions price via the NZ ETS, which will influence investment decisions over the longer term.

Part 2 of the Bill inserts a new Part 6A into the Electricity Act 1992 providing for a 10-year moratorium on new fossil-fuelled thermal generation. The moratorium will apply to all fossil-fuelled generation greater than 10MW in capacity. Nevertheless, because a moratorium on new baseload fossil-fuelled generation has the potential to adversely affect security of supply, the Bill provides for exemptions for specific fossil-fuelled generation proposals that address concerns over security of supply.

Applications for exemptions from the moratorium will be judged against a set of criteria aimed at addressing concerns over security of supply. Exemptions will be granted by the Minister of Energy on the recommendation of the Electricity Commission.

Clause by clause analysis

Clause 1 relates to the Title.

Clause 2 relates to commencement.

Regulatory impact statement

A proposed New Zealand emissions trading scheme

Executive summary

Human induced climate change is a real and serious phenomenon that the world must take action to address. New Zealand has ratified the Kyoto Protocol and consequently is liable for New Zealand’s greenhouse gas emissions above 1990 levels over the period 2008–2012.

Action to address climate change and to meet ongoing international obligations will incur economic costs and benefits. The government has a range of tools available to meet these challenges—some mechanisms will be significantly less costly and disruptive to the New Zealand economy than others. The government wants New Zealand’s future net emissions to be below business as usual levels and to meet international obligations in a least-cost manner over the long term.

On 20 September, the government released the document A Framework for a New Zealand Emissions Trading Scheme. This document noted that, subject to engagement with stakeholders and Maori, the government had decided in principle to introduce a New Zealand Emissions Trading Scheme (NZ ETS). The proposed transition period of the NZ ETS differs for each sector depending on their readiness and other factors. The main impact of the NZ ETS will be that the price of emissions will be reflected in prices throughout the economy. The government is working on an assistance package for firms and households to help manage some of these potential impacts.

The Cabinet paper recommending the NZ ETS, attached a Regulatory Impact Statement (RIS), which was publicly released. This current RIS updates the analysis of the original RIS and is to be read alongside the Cabinet paper A New Zealand Emissions Trading Scheme: 2007 Decisions.

Adequacy statement

The Regulatory Impact Analysis Unit has reviewed the RIS and considers the RIS is adequate according to the adequacy criteria.

Status quo and problem statement

Human induced climate change is a real and serious phenomenon that the world must take action to address. New Zealand greenhouse gas (GHG) emissions comprise a very small proportion of the global total and we are reliant on effective international action to reduce total GHG emissions, and thereby reduce the extent of future climate change. Our biologically-based economy relies on a benign and stable climate for production, and therefore effective international action on climate change where all nations play their part is crucial for New Zealand’s long-term economic, social and environmental wellbeing. Moreover, New Zealand’s clean green image is part of the international brand, which underpins important sectors of the economy, such as tourism, as well as the premium prices New Zealand exporters seek for the country’s products and services in overseas markets. A failure to act sustainably and responsibly could reduce New Zealand’s international credibility and influence in international forums. A failure to act now would see costs for New Zealand rise over the long term.

Status quo

New Zealand is party to the United Nations Framework Convention on Climate Change (UNFCCC) and its Kyoto Protocol. The major feature of the Kyoto Protocol is that it sets mandatory targets on GHG emissions for developed countries and economies in transition listed in Annex 1 to the UNFCCC. In New Zealand’s case, our commitment is to take responsibility for emissions above 1990 levels during the period 2008–2012.

New Zealand GHG emissions (excluding emissions from deforestation) are projected to grow to around 30 percent above 1990 levels by 2010.

The government has yet to implement an economy-wide mechanism to reduce GHG emissions. However, the government has undertaken and will undertake more specific policy interventions for selected sectors. These have been funded either directly from government via tax revenue (eg, solar water heating) or through compliance costs of legislation and regulations (eg, building standards). The emissions reduction expected from these measures is relatively small, and based on current projections, business as usual emissions levels in New Zealand are expected to continue to grow strongly.

New Zealand’s emissions profile has two major elements. Firstly, there is an underlying emissions path that rises steadily at approximately 1 percent per year in the period through to 2045. Secondly, it has a forest sink trend running through it. As the forests planted in the 1990s are due to be harvested (through the mid to late 2020s to mid 2030s), New Zealand’s overall emissions (including forest sinks) spike significantly.

It is estimated that under the business as usual model, New Zealand’s net emissions in 2023–2027 will be over 60 percent higher than in commitment period one (CP1) of the Kyoto Protocol (2008–2012).

The status quo (business as usual) is not a sensible option. It would leave the government to fund emissions above 1990 levels by purchasing units on the international market through general taxation. Firms would have little incentive to reduce emissions as they would not be directly incurring the costs of their emissions. Thus, emissions would continue to rise and thus become increasingly costly for government (ie, taxpayers), especially as the international agreements are expected to become more stringent.

Costs and benefits of climate change mitigation

There is a significant body of international work describing the range of costs and benefits of climate change mitigation and the cost of global action.

Action to address climate change is likely to incur real economic costs. Working Group III of the Intergovernmental Panel on Climate Change (IPCC) has concluded that in 2030, the macroeconomic costs for multi-gas mitigation, consistent with emissions trajectories towards stabilisation between 445 and 710 ppm CO₂-eq, are estimated at between a 3 percent decrease of global GDP and a small increase, compared with emissions with the level of GDP that would have occurred under a business as usual scenario (note, with projected rates of GDP growth, levels of GDP per head will be significantly greater than they are today, even with these estimated reductions).

The question, therefore, is whether the costs of action are justified by the benefits.

In deciding whether to reduce GHG emissions in New Zealand, the appropriate question is not whether it can be demonstrated that climate change will harm New Zealand and whether the damage to New Zealand averted by the reduction exceeds the costs it would impose. This question does not recognise that New Zealand is a participant in the international climate change policy process and has ratified the Kyoto Protocol. New Zealand has assumed specific obligations under that Protocol and has consistently stated that it is prepared to undertake commitments beyond 2012 in the context of the broadest international agreement to do so. Under international agreements, harm is not directly defined in environmental terms, but in terms of the cost to New Zealand of meeting these international commitments.

International studies have estimated the global potential for climate change mitigation. These studies suggest that there is a significant potential for mitigation, some of which have “negative cost” (ie, the savings in energy costs outweigh the costs of the investment). Even though some of these studies are not directly relevant to New Zealand, they show that there are abatement activities available around the globe which, through linking to the international market, will help to limit the cost of emissions in New Zealand.

Objectives

Specific climate change initiatives sit within New Zealand’s broader sustainability and climate change goals and objectives. These are outlined in the report “New Zealand’s climate change solutions: An overview”. The government’s guiding principles for its climate change policies are that they:

• (a) are long term and strategic:

• (b) balance durable efforts to reduce emissions with preparations for the impacts of a more variable climate:

• (c) engage with the wider public, industry and business to inspire their willing, effective and long-term involvement:

• (d) focus on international engagement that advances New Zealand’s national interests.

The government’s current policy development process is underpinned by some key assumptions that are consistent with the approach it has taken to climate change over the past few years. These include:

• (a) Faced with sufficient consensus on climate change science, responsible government must act to address the risks for New Zealand’s vulnerable environment, economy and way of life. While action to reduce greenhouse gas emissions over the long term will have a cost, the predicted costs and risks of inaction are expected to be unacceptably high.

• (b) Effective international action is needed to reduce global greenhouse gas emissions. To support and encourage international action, New Zealand needs to play its part in reducing emissions, as well as encouraging other countries, especially the major emitters, to act.

• (c) New Zealand’s response should maximise the economic advantages of using energy and resources more efficiently and facilitate our involvement in the development or adaptation of low emission technologies relevant to our needs.

• (d) Our policy response should start with the most achievable options and seek least-cost solutions.

• (e) All sectors of the economy should play a fair and equitable part in the national response to climate change, reflecting the fact that some sectors will be able to achieve emissions reductions more easily than others.

Key in a decision to implement specific climate change initiatives is an assessment that New Zealand will continue to operate in a carbon-constrained world.

These principles and assumptions (outlined above) have been synthesised to provide a more detailed NZ ETS objective to frame policy development in this area as follows:

• to develop climate change initiatives that support and encourage global efforts to reduce greenhouse gas emissions by:while maintaining economic flexibility, equity, and environmental integrity at least cost in the long term.

  • reducing New Zealand’s net emissions below business-as-usual levels;

  • complying with our international obligations, including our Kyoto Protocol obligations;

Alternative options

There are a number of possible policy approaches to reducing emissions including:

• (a) Direct regulation: this could include requiring a certain proportion of liquid fuels to be biofuels; prohibiting certain activities (eg, certain fuels in certain circumstances); imposing restrictions on certain activities (eg, requiring all new electricity generation to be from renewable sources). Some of these have already been implemented; others have been discounted or are still being considered. Overall, the regulatory options alone will not optimise New Zealand’s climate change response.

• (b) Information and promotion: initiatives that give consumers and businesses better information about the GHG emissions that their actions lead to, and encourage them to change their behaviour, can be effective in some areas. New Zealand already has a number of such initiatives in place (eg, energy efficiency labelling and promotional activities undertaken by the Energy Efficiency and Conservation Authority (EECA)).

• (c) Emission reduction incentives: the incentive option is problematic as in order to calculate the level of incentive to pay a particular firm, it is necessary for the government to estimate the level of emissions a firm would have emitted in the absence of the incentive. Due to the practical difficulties in establishing this emissions baseline, widespread use of an incentive approach is not likely to be effective. However, incentives can still be effective in certain key areas (eg, provision of subsidies for household insulation and solar heating).

• (d) Broad price-based carbon tax: a broad price-based mechanism, such as a carbon tax, results in the price of emissions being reflected throughout the economy. Although the government can control the overall stringency, decisions on which abatement activities occur are made at the firm and consumer level. In general, firms and consumers are better placed to make these decisions than central government. The effectiveness of taxes in reducing emissions is dependent on the sensitivity of consumers and firms to prices. If consumers and firms are not very sensitive to prices (in economic jargon, if demand is “inelastic”), then a large increase in price is required to induce even a small reduction in emissions.

Preferred option

A cap and trade ETS with a transitional introductory phase is the preferred option for meeting the detailed objectives set out above. The ETS, while an important element of New Zealand’s proposed climate change response sits within a suite of policies including direct regulatory measures, improved information and specific initiatives (eg, increased funding for relevant agricultural research).

The key difference between a carbon tax and an ETS is that with a tax, the government sets the price of emissions, while with an ETS they set the quantity of emissions. Under a tax, there would be an inevitable degree of uncertainty around the level of emissions that would result, and that the government would be responsible for, in any one year or commitment period. A tax would provide greater emissions price certainty to emitters. However, it would subject the government and taxpayers to potentially very large fiscal costs if the tax was set too low. Adjusting taxes to changing circumstances and to improve efficiency and effectiveness can also be problematic; as decisions by governments can be influenced by wider considerations than simply the narrow purpose for which the tax was designed.

An ETS allows greater flexibility in terms of price adjustments. Prices adjust automatically in an ETS as international carbon prices adjust, whereas tax-based systems tend to be sticky as they can only be increased by an explicit government decisions. Inevitability, under a tax-based system that the price of emissions in New Zealand would not reflect the international price of emissions. This would increase the cost New Zealand incurs to meet its international obligations. Having said this, it is important to note that price volatility as implied by an ETS is not costless. A permit system has considerable advantages when it comes to small open economies like New Zealand if there is a well-functioning international market for carbon, especially if the international price is subject to shocks. This is because under a tax, unless the government continually adjusted the tax in response to these shocks, government would face fiscal risk and New Zealand would either over or under invest in emission reducing activities.

It is proposed the NZ ETS be internationally linked. The NZ ETS will operate within the international cap on emissions that is agreed through international negotiations (currently Kyoto).

One of the key advantages of an ETS is that it is consistent with the nature of our international obligations (the Kyoto Protocol is a global cap and trade system). More generally, there is considerable strategic and economic benefit in taking the same broad approach to reducing emissions as some of our key trading partners.

The proposed NZ ETS would work by placing an obligation on participants to surrender emissions units to cover their emissions. Firms would have the flexibility to choose their best response to this obligation. Participating firms who value their emissions producing activities more than the cost of reducing them have the option to purchase units, while firms who value their emission less than the cost of purchasing units may choose to reduce their emission output. In this way, trading would result in emission reductions being made by firms who can do so most cheaply and encourages innovation.

By internationally linking the scheme, trading can occur in the much larger and more liquid international market. This effectively allows NZ firms to take advantage of low cost abatement opportunities offshore. The market would determine the level of domestic versus international abatement that would occur.

A key element of the preferred option is a transitional period that will allow affected parties time to adjust and help address equity issues. These are different, recognising varying levels of readiness. The dates of entry are set out in the table below.

The core obligation placed on participating firms will be defined in absolute terms, (tonnes of CO₂-e per year), rather then an intensity based measure (tonnes of CO₂-e per unit of activity). This will mean that participants must surrender one emission unit for every metric tonne of CO₂-e emitted each year. Adopting an absolute approach provides certainty over the (global) environmental outcome and is relatively simple to implement.

Staged entry of sectors into the NZ ETS

In each sector, there are a range of options for where to place the point of obligation. Points of obligations are designed to:

• (a) Keep compliance and administration costs low.

• (b) Capture as many of sectors’ emissions as practicable.

• (c) Reflect the feasibility of monitoring and verifying emissions at each point.

• (d) Create appropriate incentives to reduce emissions while not unduly deterring worthwhile economic activity and investment.

Impacts and Sector Specifics

The fundamental impact of an ETS is that it changes prices in the economy to reflect the cost of emissions. Price changes will incentivise abatement activity, which should see net emissions reducing from business as usual. Given the stringency of the Kyoto agreement, the overall macro impacts on the economy will be small over 2008–2012 . However the impacts on particular sectors of the economy (ie, the microeconomic effects) could be more significant due to emissions being concentrated around certain activities and sectors. To give a sense of magnitude, some indicative price changes are shown in the table below. These assume no assistance or compensation has been provided. These changes would be the same under a carbon tax set at the corresponding emission price.