ETS under review

The National Government, as part of its confidence and supply agreement with the ACT Party, has initiated a review by a special select committee of the Emissions Trading Scheme (ETS) that was passed into law on September 24, 2008. Chris Taylor (pictured) from PricewaterhouseCoopers looks at the angles.

The Special Select Committee’s terms of reference are broad ranging and have been widely reported. While the review includes a range of issues to be considered, and as a result can be expected to take some time, recent comments from committee members indicate a desire to move to prioritise some form of carbon pricing mechanism to be introduced in a timely manner, rather than for example re-litigate the climate change arguments.

Regardless, the potential delay of the implementation of the ETS puts a brake on those parties who had been preparing to enter the scheme in 2010 and 2011. Many believe that it makes little sense to introduce complex monitoring and reporting mechanisms if there is a chance that the system will be modified, or even discarded. It has also put a halt to the purchase of emissions units by potential participants, even though the price of these units has tumbled over the last few months.

The Prime Minister, John Key, has been clear that his Government will adhere to its commitments under the Kyoto Protocol and that he wishes to see carbon priced from 2010. The National Party’s views on an ETS are set out in its Emissions Trading and Environmental Policy Papers and its six key principles provide that the ETS:

• Should balance New Zealand’s environmental and economic interests;
• Should be fiscally neutral;
• Should be as closely aligned as possible to Australia’s scheme;
• Should encourage the use of technologies that improve efficiency and reduce emissions intensity;
• Needs to recognise the importance of small to medium enterprise and not to discriminate against them in allocating permits; and
• Should have the flexibility to respond to progress in international negotiations.

He has signalled his Government’s intention to introduce amending legislation for an ETS later in 2009. It is reasonably clear that regardless of the outcome of the Select Committee review, New Zealand will have a price-based measure to encourage emissions reductions. In whichever form the measure is designed, the costs will eventually flow through the entire economy.

Setting a carbon price

Putting a price on greenhouse gas emissions assigns a cost to pollution, therefore creating a financial incentive to reduce emissions. Emissions trading under a cap and carbon taxes are two ways of achieving such an outcome.  Emissions trading is a market-based mechanism which limits the level of pollution permitted and leaves it to the buyers and sellers of pollution permits to establish a price for them. It is a mechanism explicitly designed to incentivise businesses and households to reduce their emissions.

Under an ETS, participants are required to surrender emission units annually to cover their ETS liabilities.  In the current ETS, there is no cap on the price of carbon.  Permit scarcity is guaranteed by New Zealand’s excess emissions over 1990 levels. However, access to permits in other countries or credits generated under UN approved schemes means that the New Zealand price will ultimately be determined by international demand for credits.  In contrast, taxes are a pollution price imposed by governments.  A carbon emissions trading scheme secures the quantum of emissions reductions required at a market price that is not known in advance whereas a carbon tax provides security around the price of emissions reductions efforts but cannot guarantee that any particular level of reductions will be achieved.

In the design of an ETS or even a carbon tax, one of the most contentious issues is the treatment of the Kyoto gases other than carbon dioxide. The initial carbon tax proposal, scrapped in 2005, was to apply only to carbon dioxide emissions from the consumption of fossil fuels, such as coal, gas, petrol and from industrial processes, such as chemical reactions involved in manufacturing.

The ETS is intended to progressively extend to include methane and nitrous oxide (which constitute almost half of New Zealand’s emissions) notwithstanding the measurement and management challenges posed, particularly in the agricultural sector.

Continued coverage of agriculture in any amended ETS or revived carbon tax will be a key issue. While there are available means to reduce nitrous oxide emissions from agriculture, enteric methane remains a significant challenge for which a technical silver bullet does not yet exist.  While no other country has yet extended an ETS to agriculture, no other developed economy has such a high proportion of its emissions coming from agriculture.

What should businesses do now?

Businesses should continue to develop the tools to measure and manage emissions.  An ETS and/or a carbon tax will put a price on carbon that will flow through into the costs of goods and services. Businesses should be well aware that the implementation of either mechanism will have far reaching effects on both businesses and households, regardless of whether they are participants in any scheme.

To manage these impacts, increased attention to energy efficiency is vital and robust carbon management strategies should be implemented by all businesses to price carbon into all business decisions. To ensure long term sustainability, businesses will need to focus on how to carbon proof their operations and change business operations to take account of a future carbon constrained world.

Points of obligation for future ETS or carbon tax participants

The term ‘point of obligation’ refers to the point in the supply chain where the obligation for monitoring, reporting and offsetting of emissions arises. Under the ETS, mandatory participation is required for certain obligated parties within specific sectors. Anyone carrying out a listed activity for mandatory participation is a point of obligation and will either have to register as an ETS participant, or under a tax regime will be liable to a carbon tax on their emissions.

Areas of Uncertainty

The Government’s decision to review the ETS creates uncertainty in many sectors.

While the ETS is under review, pre-1990 foresters continue to be required to purchase permits to cover the emissions represented by any deforestation. While some free allocation has been provided for, costs will still fall on those who wish to clear pre-1990 forest and change the land use.  The postponement will also affect post-1989 foresters who wish to enter the ETS and earn carbon credits. Currently credits can still be earned but with the continued uncertainty around the ETS, investment in forestry is likely to be deferred. 

The position of trade-exposed emitters is similarly in doubt although, in fairness, the treatment of this category of business had not been settled even under the amended ETS. From the very beginnings of policy development on meeting New Zealand’s Kyoto commitments, there has been fierce debate over how and to what extent some firms should be exempted from the rigour of a universal carbon price. It has been particularly difficult to negotiate how large trade-exposed emitters would be allocated free units (under an ETS) or rebates (under a carbon tax), thereby limiting the impact of these schemes on their international competitiveness.

Under the ETS, trade exposed entities in the stationary energy and industrial processes sector have been offered free allocations or assistance to cover the increased flow-on costs or increased electricity costs of these pricing mechanisms. The key issue has been whether this shielding was sufficient to maintain international competitiveness.

Under the ETS as enacted, the issue of trade-exposed businesses is dealt with by way of free allocations. The detail of these was to have been finally settled by way of regulation, but clear expectations had been raised in respect of a number of sectors including forestry, agriculture, trade exposed industry, and fishing vessel operators. The process of eligibility and extent of protection is still contentious, but the regulations enable a more transparent path to shielding trade exposed entities.

No matter what the final form of the policy instrument the new Government adopts, protection for trade-exposed businesses will be controversial and the subject of intense lobbying. It is in the interests of businesses to minimise their exposure to additional cost; it is in the interest of the Government to provide no more assistance than is absolutely necessary. Every tonne of free allocation to a trade-exposed business represents an additional tonne of cost that the rest of the economy must carry.

Concluding comments

Virtually all aspects of a company’s operating environment – its supply chain, customers, operations, investors, regulation and even competitors – are exposed to carbon emissions and the uncertainties that have been raised by the need to respond to climate change. A carbon-constrained world will carry risks for those heavily dependent on emissions. It will also offer new opportunities.

Whatever the outcome of the Select Committee’s enquiry, businesses are likely to remain under pressure to protect and enhance shareholder value by minimising downside risks and maximising the upside opportunities of climate change. We rank the chances of New Zealand walking away from taking steps to reduce its greenhouse gas emissions as very low. One way or another, emissions will become the subject of increasing scrutiny and most likely become more expensive.

While we consider that price-based policy instruments are most likely to be deployed, their precise shape must once again wait further examination. Australia’s decision to adopt a cap-and-trade scheme and the new US Administration’s declared preference for cap and-trade make it likely that New Zealand will stay with some form of the ETS that has already been developed.

In any case a robust carbon management strategy that addresses the foreseeable impacts of emissions reduction requirements and the effects of climate change itself remains essential.

While astute companies have long ago realised the need for managing carbon in their business operations, the case for all businesses to prepare for a carbon-constrained world remains compelling. The review of New Zealand’s ETS is more a reflection of the way New Zealand’s political and policy development environment operates than any fundamental question mark over the need for emissions reductions. The only question is the extent to which another round of navel gazing will see New Zealand scrambling to catch up if the momentum for more ambitious emissions reductions picks up at the global level.

New Zealand exports are already at risk from increasing consumer and retailer vigilance about the carbon footprint of goods and services. If this spilled over into regulatory requirements to account for the emissions embedded in our exports, New Zealand businesses that had failed to manage carbon could find themselves in difficulty. Similarly, if some trading partners decided to take more ambitious measures but protect their own producers through border tax adjustments, New Zealand exporters could find themselves disadvantaged to the extent that domestic action was lagging behind the rest of the world.

These risks are even harder to assess than those surrounding the final shape of New Zealand’s regulatory environment. All businesses can do, in the meantime, is get on with taking sensible steps to measure and minimise their emissions. The policy makers will eventually enact something. Those who have delayed taking action could find any short-term savings outweighed by the speed with which they then have to react.

• This article has been based primarily on extracts from PricewaterhouseCoopers’ Emission Critical Publication (Issue 7: December 2008), as amended for recent announcements and commentary from Select Committee members and Government officials.
• Copies of this and other Emission Crictical publications can be obtained from PricewaterhouseCoopers’ website: www.pwc.com/nz