The Economic Effects of Greenhouse Gas Emission Policies

Transcription

1 The Economic Effects of Greenhouse Gas Emission Policies A quantitative evaluation REPORT TO The Greenhouse Policy Coalition and The Petroleum Exploration Association of NZ November 2001 NZ INSTITUTE OF ECONOMIC RESEARCH (INC.) 8 Halswell St. Thorndon P O BOX 3479 WELLINGTON NEW ZEALAND Phone: Fax: Website: The Institute, its contributors, employees and Board shall not be liable for any loss or damage sustained by any person relying on this report, whatever the cause of such loss or damage.

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3 The Greenhouse Policy Coalition and the Petroleum Exploration Association funded this work in the interest of well-informed public debate on climate policy change. The views and recommendations in the report are NZIER s. NZIER trust the public will find this report a valuable resource to inform their submissions to the consultation process.

4 EXECUTIVE SUMMARY Introduction While uncertainty persists, there is nevertheless credible scientific evidence that accumulated greenhouse gas emissions from human activities are contributing to global warming. If unchecked, global warming will have complex social and economic consequences. Some effects will be negative, others positive. There is currently widespread belief that, on balance, the effects may be sufficiently unpalatable to justify taking preventative actions. The Kyoto Protocol represents the current attempt at devising a framework for taking such preventative action on a global scale. As the agreement currently stands, most developed nations and some former communist countries provided they each ratify the treaty will take upon themselves a commitment to reduce their greenhouse gas emissions either to the level prevailing in 1990, or to some agreed fraction of the 1990 level by In practice, only the developed countries will be constrained by this agreement, since the former communist countries have already seen substantial declines in their carbon emissions due to the industrial collapse suffered in the 1990s. Although signatories to the Kyoto Protocol, developing countries will not face binding emission restraints in the first commitment period, 2008 to 2012, but the success of the regime critically depends on them having such obligations in subsequent commitment periods. If that does not occur, a global reduction in emissions will not be possible. The Protocol is a market-based mechanism to manage a global environmental risk. For developed countries, the commitment to reduce greenhouse gas emissions implies the introduction of some form of greenhouse gas charge as a means of changing the behaviour of businesses and consumers. The need to cut emissions can be offset by the production of carbon sinks that is, afforestation and similar activities, which lock up atmospheric carbon. In addition, the Kyoto Protocol envisages a trading regime, where countries can meet their NZIER ii

5 obligations by purchasing credits from other countries that have exceeded their commitments. During the implementation period, such credits will largely come from Russia, where the precipitous decline in heavy industry since 1990 has left the country with a substantial holding of excess credits. A significant portion of New Zealand s greenhouse gas emissions come from burning fossil fuels (about 45%). But our analysis also takes account of agricultural emissions (about 55%), specifically methane and nitrous oxide. Hence, throughout this report, references to energy-related emissions may implicitly also apply to agricultural emissions. The fact that the Kyoto Protocol is not a global agreement from day one poses two key issues: Countries, such as New Zealand, which accept a commitment to reduce their greenhouse gas emissions, will suffer a decline in competitiveness compared to those countries that remain outside the regime. This decline in competitiveness will come from having higher energy costs. The significance of such a decline will depend on the importance of energy in each country s competitive positioning. Countries that remain outside the regime will become beneficiaries of business relocations, as energy-dependent production is shifted to escape costs imposed in developed countries. As the economies of developing countries become more dependent on energy-intensive production, their incentive to join the global regime may decline. Hence, in considering the consequences of ratifying the Kyoto Protocol, a country like New Zealand needs to consider the following questions: What is the likelihood that the response to climate change policies will take the form of business relocation to developing countries, thus imposing an economic cost on New Zealand without any environmental benefits? How can that risk be minimised? The economic effects of greenhouse gas emission policies iii

6 Do the economic costs incurred by New Zealand justify the benefits, particularly given the uncertainty about other countries either meeting their obligations or joining the regime at a later stage? Quantitative evaluation This study seeks to address the above questions quantitatively. We use a specially adapted model of the New Zealand economy adapted to reflect the complex detail of our energy sectors, and the available options for substitution between energy sources, and between energy and capital to assess the economic consequences of different policy scenarios. We also consider the consequences of different global prices for emission permits should an international trading regime be put in place. New Zealand would be a price taker in such a market. We conclude that the economic effects are likely to be substantial. People s livelihoods and living standards will be adversely affected. Hence, it is important to conduct open public debate about the price that New Zealand s population is willing to pay for the uncertain outcomes under the Kyoto Protocol. We hope that this publication will contribute to that debate. The community may well decide that the price is worth paying, but it is important that this decision be made with a full understanding of the consequences. We also find that there are substantial differences in economic outcomes between different policy scenarios. There are some opportunities to insulate New Zealand from the adverse economic effects during the 2008 to 2012 period. Our analysis suggests that there are strong arguments for New Zealand to adopt a precautionary approach: until the Kyoto Protocol becomes a truly global regime, New Zealand should not impose costs on its industries that would result in a loss of competitiveness internationally and/or prompt them to relocate to other countries. Since the Kyoto Protocol has become such an icon of saving the world, we are fully aware that this study runs the risk of being branded anti-environmentalist. We want to emphasise that we are not questioning the science of climate change, or the need for NZIER iv

7 humanity to respond to the challenge. Rather, the purpose of this study is to ensure that New Zealand has a clear understanding of the costs, benefits and risks of various policy options, and is able to make an informed choice. The final shape of future policies is far from certain. To deal with the uncertainty, we have undertaken a number of policy simulations designed to capture the main elements of different policy options currently under discussion. Our scenarios are designed to triangulate around the likely policy options. While no single scenario can claim to reflect all the elements of future policies, the overall results reflect the key consequences of policy choices. Our analysis focuses on a subset of greenhouse gases: carbon dioxide, methane and nitrous oxide from energy, industrial processes and agricultural emissions, which in 1990 accounted for 95% of New Zealand s greenhouse gas emissions. For simplicity, we have translated methane and nitrous oxide emissions into their CO 2 equivalents, and have assumed that the same taxes or permit prices will attach to the equivalent emissions of each gas. We estimate emissions of each gas in the 2008 to 2012 period on an annual basis using current expectations of growth over 1990 levels from the government s public consultation documents. The results are as follows: CO 2 emissions from energy and industrial processes: CH 4 emissions from energy and industrial processes: Methane and nitrous oxide emissions from agriculture: 38.8 million tonnes (Mt) 0.8 Mt 49.7 Mt Total emissions: 89.3 Mt of CO 2 equivalent The policy target is assumed to be a return to the 1990 emission levels, which we take to be a total of 69 Mt of CO 2 equivalent for the gases we are concerned with. We use a static computable general equilibrium model to consider the initial adjustment to climate change policies. Computable general equilibrium models describe the national economy using stylised representations of the microeconomic agents in the economy: The economic effects of greenhouse gas emission policies v

8 producers, consumers and governments (local and central). Producers choose the mix of inputs and the amounts they produce so as to maximise profits. Consumers decide how much to spend on various goods so as to maximise their well-being. The modeller specifies government decisions so that the model can be used for policy analysis. Importantly, general equilibrium (GE) models may understate or overstate the effects of shocks. For example, as labour becomes redundant in a declining sector, the model makes it available to other sectors, and wages decline until all excess labour is absorbed. The assumption of well functioning markets is important to make the model consistent and computationally tractable, but it clearly does not reflect the real world perfectly. In reality, redundant workers often do not have the skills to be readily re-employed elsewhere in the economy, or they may reside in wrong locations. Similarly, capital scrapped in one sector is not immediately available for redeployment elsewhere. We have made the following assumptions in the model: Greenhouse policies commence in We use the current emission growth projections from the government s consultation documents to set business as usual (BAU) emission levels for that period. The structure of the economy in the future is assumed to be the same as it was in In other words, we do not attempt to project the future structure of the economy. New Zealand is a price taker in world markets, and the goods it exports are highly substitutable for the goods produced by other countries. Given the small number of players in the New Zealand cement and steel industries, and the high level of substitutability between domestic and foreign production for these goods, we have assumed the existence of threshold effects. In other words, once domestic capacity utilisation falls below a certain level, it is assumed that domestic production of cement and steel is discontinued and all such product is imported. NZIER vi

9 In addition to the general equilibrium model, we use an econometric, or statistically-oriented, model for certain aspects of the analysis. Econometric models are based on equations that describe the relationships between different variables, and are useful in predicting changes in output due to changes in input variables. For this research, we estimate an economy-wide production function. A production function is a summary description of the New Zealand economy as a production process: how it takes inputs such as capital, labour and energy, and transforms them into output, GDP. The key innovation in our analysis is an explicit treatment of energy as an input into the production process, both at an economy wide level, and at industry levels. The production function approach allows us to consider the likely trend growth rate in the economy following the introduction of climate change policies. In particular, the production function based on long term economic data sheds light on the implications of energy constraints for GDP growth. Experiments using general equilibrium analysis We have produced ten scenarios using the GE model, focusing on the following choices: Policies with and without international trade in emission rights. This reflects a distinction between unilateral (early) action and participation in an international regime. The choice can be broadly described as being with or without Kyoto. In addition to international permit trading, two key features separate the with and without options. First, under a unilateral regime, the New Zealand government collects the amount of carbon tax necessary to induce the desired reduction in emissions, and then recycles this in the form of a lump sum tax rebate. By contrast, under an international trading regime, the carbon charge reflects an international permit price. Purchases of emission permits from the international market by New Zealand entities do not represent a revenue to the New Zealand government, and hence provide no revenue to be recycled. The economic effects of greenhouse gas emission policies vii

10 Second, we assume that with Kyoto, carbon sink production can be used to offset emissions. Narrow and broad emission regimes. Under a narrow emission regime, a carbon charge is applied to emissions from energy use and from industrial processes. Under a broad based emissions regime, in addition to the emissions subject to the previous carbon charge, agricultural methane and nitrous oxide emissions would also require the acquisition of emission rights or receipt of emission credits. We assume that there is no difference in the New Zealand abatement target between the scenarios with the narrow and broad based emission regimes. Rather, we assume that the difference lies in how the policy is implemented domestically: with a narrow regime, a bigger adjustment burden is allocated to energy use, while with the broad regime, adjustment is spread between agriculture and energy. Exemptions for sensitive sectors. We concentrate on the sectors which are most prone to leakage, i.e. relocation of production to countries outside the Kyoto regime. We include aluminium, cement and steel production in that category. However, other sectors may also be included, such as forest products manufacturing or methanol production. In essence, these two issues (narrow/broad and leakage) relate to an expectation that some mechanism will be implemented to prevent the decline in sensitive business activities in New Zealand. Depending on the scenario, we include pastoral agriculture, cement, steel and aluminium production in the definition of sensitive sectors. The point of obligation. We consider two broad options: the point of obligation resting with the emitting industry, and the government acting as the point of obligation for the nation as a whole. NZIER viii

11 From the above, the specific scenarios are: 1a No trade in emission credits, no exemptions, broad emission regime, obligation at point of emission. 1b No trade in emission credits, narrow emission regime (agricultural methane and nitrous oxide emissions not covered), no further exemptions, obligation at point of emission. 1c No trade in emission credits, narrow emission regime (i.e. agriculture not covered) and the steel, cement and aluminium industries exempt from emission liabilities. Under all three variants of scenario 1, we impose an emission reduction target and configure the model to generate a carbon price that ensures that the target is reached. By contrast, under scenarios 2 and 3 below, we impose a carbon price, and observe how emissions change in response. The range of emission prices used in these scenarios has been selected to represent the range of expected prices generated by various international models. Hence, scenarios 2 and 3 are as follows: 2 International trade in emission credits, broad emission regime, no further exemptions, obligation at point of emission. We run three scenarios, 2a, 2b and 2c with different assumed international emission permit prices: NZ$13, NZ$32.50 and NZ$65 per tonne of CO 2 equivalent (representing US$20, US$50 and US$100 per tonne of carbon, respectively). 3 International trade in emission credits, narrow emission regime, cement, steel and aluminium exempted, obligation at point of emission. Again, we run three scenarios at three permit prices. 4 International trade in emission credits, no domestic emissions regime government is the point of obligation. The government appropriates all carbon sink entitlements from private owners and raises a general tax to cover imports of any additional entitlements required to meet our Kyoto obligations. The economy-wide results of policy simulations using the general equilibrium model are presented in the following table. The economic effects of greenhouse gas emission policies ix

12 #IITGICVGGHHGEVUHTQOVJG)'OQFGN &RPSDUHG WR WKH EXVLQHVV DV XVXDO VFHQDULR SHUFHQW FKDQJH Scenario Gross output Household consumption Household income Terms of trade PPI (Outputs) Real wages 1a 1b 1c 2a 2b 2c 3a 3b 3c 4 (1) 6RXUFH 1=,(5 1RWH 7KH FKDQJHV LQ WKLV VFHQDULR DUH OHVV WKDQ Gross output can be thought of as total sales by all firms in the economy. Household consumption is a general measure of welfare, i.e. how well off New Zealand citizens are. Household income represents the flow of income accruing to the country. It consists of wages, salaries, profits, and income from the sale of surplus emission rights to foreigners. Both household consumption and income are in real terms. The terms of trade is a (weighted) index of the price of exports relative to the price of imports. Hence, a decline in the terms of trade represents imports becoming more expensive relative to exports. PPI outputs is an index of producers output prices. And finally, real wages is the return on labour relative to the aggregate consumption good, i.e. the CPI bundle. Depending on the scenario, national income may decline by more or less than household consumption. This is due to revenue recycling: under some scenarios while domestic output is suppressed, consumption is maintained. The required carbon tax rate predicted by the model is $20.67 per tonne of CO 2 under scenario 1a (no exemptions), a staggering $ under 1b (agricultural emissions exempt), and $ under 1c (agricultural methane and nitrous oxide emissions and carbon emissions from steel, cement and aluminium sectors NZIER x

13 exempt). The required price is estimated to be low if pastoral agriculture is included in the regime as emissions from that sector are expected to be reduced at relatively low cost to the economy through declines in sheep and dairy farming. The price rises as the burden of adjustment is concentrated on fewer and fewer sectors. It is interesting to note, however, that output losses from scenario 1c are lower than from scenario 1b. In other words, exempting methane and nitrous oxide emissions from agriculture makes the burden of adjustment greater compared to a policy of no exemptions. However, once agriculture is exempt, adding the industrial sectors to the list of exemptions appears to reduce the economic impact. As expected, the model predicts that all other things being equal, a Kyoto regime with internationally traded emission rights results in dramatically less economic cost to New Zealand. But all other things are not equal. It turns out that the results are highly sensitive to how broad or narrow the regime is, how many exemptions apply, and whether emission tax revenues can be recycled to New Zealand or represent a liability to the rest of the world. Finally, the model predicts that the least distorting tax i.e. a tax that does not alter the relative prices in the economy results in least economic cost. There is nothing surprising in this result, as it is consistent with the theoretical literature on optimal taxation for raising revenue to meet permit requirements. While we assume that the government recycles any carbon tax revenue in the form of a lump sum tax rebate, this still involves substitution of a more distorting tax for a less distorting one. Scenario 4 produces practically no change in output. The overall results are consistent with the general observation that an abundant and low cost energy supply is one of New Zealand s key competitive advantages, which explains our high and growing energy intensity. Low cost energy also explains the size of the likely impact on New Zealand. The economic effects of greenhouse gas emission policies xi

14 Experiments using econometric analysis Our econometric modelling highlights that energy is an important component of New Zealand s long-term economic growth. Over the past 20 years New Zealand achieved average GDP growth of 2.0% per annum. Of this GDP growth, approximately: 0.44% pa came from increased energy supply; 0.47% pa from increasing the stock of capital; 0.41% pa from increased employment; and 0.66% pa can be attributed to technology change (higher productivity). %QPVTKDWVKQPVQ)&2ITQYVJ 3HUFHQW RI WRWDO DYHUDJH IRU WR Technolog y chang e 33% Energ y 22% Labour 21% Capital 24% 6RXUFH 6WDWLVWLFV 1= 1=,(5 The importance of energy in New Zealand is partly attributable to our economic structure. The New Zealand economy has undergone structural changes over the past two decades. As in many other OECD countries, the service sector has become more important. However, compared to other OECD countries: The relative size of the service sector in New Zealand is smaller. The service sector (excluding transport industries) in the US and NZIER xii

15 Australia, for example, accounted for about 65% of total GDP in 2000, compared to less than 50% in New Zealand. Growth in the relative share of the service sector came at the expense of light manufacturing. The share of the more energy intensive industries, such as those in the primary sector, has in fact increased over time, although it has fallen back since the mid- 1990s due to the decline of the petrochemicals sector. Access to a growing supply of energy inputs is therefore critically important for New Zealand s economic well-being. We consider that New Zealand s high current account deficit limits our ability to substitute capital for energy. In essence, this would require us to substitute a relatively scarce input for a relatively abundant one. And doing so is costly. Experience also suggests that it is extremely difficult to alter the trend productivity growth rate. Moreover, greenhouse gas emission policies which impose economic costs may also constrain growth in productivity, as they may reduce New Zealand s ability to acquire the most efficient capital inputs. #NVGTPCVKXG)&2ITQYVJRCVJU )URP EDVH RI RYHU \HDUV Years from base BAU With climate change policies 6RXUFH 1=,(5 The economic effects of greenhouse gas emission policies xiii

16 We have undertaken a number of projections, using Statistics New Zealand demographic projections for the labour force, and allowing for the substitution of capital for energy up to various assumed current account constraints. On average, these projections predict a decline in the trend growth rate of about 1% per annum from around 2.5% per annum under business as usual to around 1.5% under the assumed climate change policies. The combined effects of the structural adjustment and a subsequent decline in trend growth are illustrated in the preceding graph. The deviation from the business as usual path picks up the following effects from the date the policy is introduced: It assumes that the final policy design will be consistent with lower-end effects predicted by the GE model. Hence, adjustment cost is modelled at 4 percent of GDP spread over 5 years. It assumes that there is an initial boost to GDP from the sale of the accumulated emission rights from the Kyoto forests acquired over the period. This is a one-off positive shift. It assumes that growth turns negative after the introduction of the policy, then the economy recovers with a degree of catch up growth before settling to the new trend path. This describes a typical overshooting adjustment path. The new long-term trend growth rate for the New Zealand economy is estimated at 1.5 percent per annum. On this simulation, New Zealand GDP 15 years out is 18% below what it would have been without the greenhouse gas emission policy. Conclusions Overall, our analysis shows that the New Zealand economy will adjust to climate change policies primarily through shutting down or reducing production in the emitting sectors, rather than by substituting inputs. Since both New Zealand and the world will continue to demand the outputs, the overall global emissions are unlikely to be reduced. Developing country suppliers will be able to step up production to substitute for the output lost in New Zealand. NZIER xiv

17 The key issue is that climate change policies will not be applied globally. If all countries faced the same marginal cost of greenhouse emissions, and if that marginal cost reflected the cost of global warming, one could argue that any reduction in emissions would be efficiency enhancing. However, under the proposed developed country only policy regime (i.e. the Kyoto Protocol), policy-makers have no way to discriminate between efficiency enhancing adjustments (such as investments to use energy more efficiently) and efficiency reducing adjustments (such as shifting production to developing countries). This suggests that New Zealand should be extremely cautious about enforcing any emission abatement on its domestic economy in the absence of a global regime. In this instance, leading by example can prove to be both costly and counterproductive. At worst, the example will serve as a demonstration of the economic costs of climate change policies, and will lead other countries to resist joining the global action. If New Zealand chooses to ratify the Kyoto Protocol, the application of a precautionary approach would suggest that we should look for ways to fulfil our obligation that would minimise the risk of inducing efficient output reducing abatement activities. One possibility is to have a policy, which aims to raise revenue to purchase a given quantity of emission permits in the world market, without distorting New Zealand markets. Assuming that by the second commitment period (post 2012), Kyoto becomes a global regime, New Zealand would be better off if it arrives at the end of the first commitment period without shedding the industries that would have remained here had the action been global in the first place. This approach is simulated in our scenario 4. The economic effects of greenhouse gas emission policies xv

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19 CONTENTS 1. Introduction Background to the climate change issue How the Kyoto Protocol would work Basic economics of possible emission control measures The purpose of economic modelling Macroeconomic Effects Analytical techniques Background Change in trend growth: econometric results Adjustment: General Equilibrium results Policy Implications Leakage Double dividend Analysis Sectoral Adjustments Agriculture Forestry and logging Food manufacturing Wood and wood products manufacturing Refined petroleum and rubber products manufacturing Cement Steel and aluminium Machinery and equipment manufacturing Transport Services The economic effects of greenhouse gas emission policies xvii

20 5. Effects on the Energy Sectors Coal Other energy Conclusions APPENDICES Appendix A: Description of GE model Appendix B: Production sectors Appendix C: Production functions and growth accounting FIGURES Figure 1 The impact of emission costs on the market for a typical product... 5 Figure 2 Adjustment between equilibria Figure 3 Energy use per dollar of GDP Figure 4 Contribution to GDP growth Figure 5 New Zealand s economic structure Figure 6 MED energy use model Figure 7 Capital energy substitution to maintain 1999 output level Figure 8 GDP growth with constrained energy use Figure 9 Alternative GDP growth paths NZIER xviii

21 Figure 10 Factors contributing to output growth in the agriculture, fishing, and hunting industry Figure 11 Factors contributing to output growth in the forestry and logging industry Figure 12 Factors contributing to output growth in the food manufacturing industry Figure 13 Factors contributing to output growth in the wood and wood products manufacturing industry Figure 14 Factors contributing to output growth in the petroleum, chemical, plastics, and rubber products manufacturing industry Figure 15 Factors contributing to output growth in the non-metallic mineral products manufacturing industry Figure 16 Exports and imports Figure 17 Price of Portland cement (other than white) Figure 18 Factors contributing to output growth in the basic metal product manufacturing industry Figure 19 Factors contributing to output growth in the machinery and equipment manufacturing industry Figure 20 Factors contributing to output growth in the transport and storage, and communications industry Figure 21 Factors contributing to output growth in the community, social, and personal services industry Figure 22 Energy production Figure 23 Non-energy production Figure 24 Household consumption Figure 26 Investment demand The economic effects of greenhouse gas emission policies xix

22 TABLES Table 1 Industry structure: New Zealand and Australia Table 2 Structure by energy intensity Table 3 Aggregate effects from the GE model Table 4 Output and input growth Table 5 Emissions by sector and energy source Table 6 Sheep and beef farming Table 7 Dairy farming Table 8 Mixed livestock and cropping Table 9 Horticulture Table 10 Other agriculture, hunting, fishing and other mining Table 11 Forestry Table 12 Logging Table 13 Dairy manufacturing Table 14 Meat manufacturing Table 15 Other food manufacturing Table 16 Wood and wood products Table 17 Pulp and paper products Table 18 Refined petroleum products Table 19 Cement Table 20 Steel Table 21 Other manufacturing Table 22 Transport Table 23 Services Table 24 Wholesale and retail trade Table 25 Coal Table 26 Changes in coal sector output to all other sectors NZIER xx

23 Table 27 Oil extraction and exploration Table 28 Gas extraction and exploration Table 29 Electricity generation Table 30 Electricity transmission Table 31 Electricity supply Table 32 Gas treatment and distribution Table 33 Base case emissions by source Table 34 Substitution elasticities in production Table 35 Production sectors Table 36 Industry concordance The economic effects of greenhouse gas emission policies xxi

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25 INTRODUCTION This report presents a quantitative evaluation of the economic effects of possible climate change policies on New Zealand. It does not, in any form, address the science of climate change, but rather aims to clarify the policy costs of achieving climate policy objectives, so as to better inform the community as it decides whether the benefits justify these costs. The final shape of future policies is far from certain. To deal with this uncertainty, we have undertaken a number of policy simulations designed to capture the main elements of different policy options currently in prospect. No single scenario can claim to contain all the elements of future policies, but the overall results reflect some key consequences of broad policy choices. 1.1 BACKGROUND TO THE CLIMATE CHANGE ISSUE There is significant scientific opinion that the warming trend observed recently in the earth s climate is associated with humaninduced increases in atmospheric concentrations of greenhouse gases. Possible impacts of continuing increases in these concentrations include shifts in the location of climatic zones, increasing frequency of severe climatic events, spread of pests and diseases and rising sea levels. One response to this growing concentration could be to just wait and deal with adverse impacts when they arise. But given the scientific uncertainty about how greenhouse gases affect climate, the scale and irreversibility of these effects and when and where they occur, risk averse communities may prefer to reduce potential problems by taking steps now to reduce the emission intensity of human activities. In 1992 the international community recognised these potential impacts by adopting the United Nations Framework Convention for Climate Change (UNFCCC). This aimed to stabilise greenhouse gas concentrations at a level that would prevent human-induced interference with the climate system, but it implied major reductions The economic effects of greenhouse gas emission policies 1

26 in global emissions compared to current levels and future business as usual (BAU) projections. By the mid 1990s it became clear that the Framework Convention targets were not being met, largely because the Convention lacked teeth to give them effect. In December 1997 UNFCCC parties signed the Kyoto Protocol, which would commit developed countries to legally binding emission reduction obligations. It also provided for flexibility mechanisms to enable these commitments to be traded between countries so that emission reductions could be located where they were least costly to achieve. 1 The aim of the Protocol was to reduce the emissions across the developed country participants to around 5% below their level in 1990, as a first step towards deeper and more widespread reductions in future periods. International negotiations on the detailed implementation of the Kyoto Protocol have continued since The Protocol will come into force if it is ratified by 55 countries, whose combined emissions accounted for at least 55% of carbon dioxide emissions in If this happens, New Zealand s primary obligation will be to monitor its emissions of the six Kyoto greenhouse gases over the years , and ensure that on average they are equal to or less than its 1990 emissions, or otherwise take responsibility for emissions above that level HOW THE KYOTO PROTOCOL WOULD WORK Although many implementation details have yet to be finalised, the broad framework of the Kyoto Protocol is now well established. At 1 There are three flexibility mechanisms under the Protocol: international emissions trading, between countries or individual companies; Joint Implementation, whereby reductions undertaken in one developed country receive entitlements transferred from another; and the Clean Development Mechanism, whereby developed countries can create additional assigned amount through achieving certified emission reductions in developing countries. 2 The greenhouse gases are methane, carbon dioxide, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulphur hexafluoride. In compiling national inventories the gases are converted to carbon dioxide equivalents. Methane and carbon dioxide are by far the largest components of New Zealand s inventory. NZIER 2

27 its core is a system by which participating countries report their emissions internationally and account for any excess or deficit in their emission entitlements by trading entitlements amongst themselves. Each country has an assigned amount of emission entitlement based on a historical level of emissions. In New Zealand s case this is its emissions in 1990, which form its entitlement for each year during the commitment period. Business as usual emissions over this period have been projected to exceed this assigned amount by around 70 to 100 million tonnes of carbon dioxide equivalent. To meet its Kyoto obligations New Zealand will have to show that it has sufficient assigned amount to match its reported emissions at the end of the commitment period. To do this it will have to reduce its domestic emissions, buy assigned amount from other countries, or generate new assigned amount through the creation of carbon sinks by new tree planting. It would not be economically rational to undertake emission reduction where the cost of achieving that reduction exceeds the alternatives of purchasing emission entitlements or the creation of sinks. By allowing entitlements to be traded between nations, such a system means that in any country, emission reduction should take place up to the point where the marginal cost of abatement equals the marginal cost of alternatives, which is in turn reflected in the international price of emission entitlements. Under Kyoto, emission rights will be traded amongst countries, and from that market an international emission price will arise. New Zealand, as a small participant, will have to accept that price. In other words, no matter what policy New Zealand pursues, the international permit price will not be affected. Stated differently, New Zealand will be a price taker in the market for emissions permits. As all participating countries will therefore face the same international price of emission entitlements, such a system will tend to relocate abatement to those countries where it can be achieved at least cost. However, a feature of the Kyoto Protocol is that, at least The economic effects of greenhouse gas emission policies 3

28 for the first commitment period, not all major emitting countries will face binding emission restraints. Developing countries will not face any restriction on their emissions, and will obtain a cost advantage over comparable production in the participating developed countries until participation in the Kyoto mechanisms broadens to truly global coverage. It is intended that this will occur some time after At a minimum, the government, as a party to the Protocol, will have responsibility for New Zealand s excess emissions, which it can either discharge by buying emission entitlements on the international market, or by encouraging domestic emission abatement or sink creation. All of these options are likely to impose costs on the government, which it can recover through general taxation spread across the community. Alternatively, the Protocol allows it to devolve responsibility for emissions to New Zealand entities and individuals through price measures, such as emissions trading by domestic entities or the imposition of a carbon tax. Such measures would be more selective and have costs that fall particularly on those whose actions create the excess emissions. 1.3 BASIC ECONOMICS OF POSSIBLE EMISSION CONTROL MEASURES Any restriction on emissions confers value on emission abatement and increases the cost of economic activities associated with emissions. The same principle applies whether the restriction is given effect through a carbon tax, emissions trading, or a more rigidly prescriptive regulation on the level of emissions or technology used. But these emission control instruments are not equivalent in all respects. Under an emissions or carbon tax, the emissions cost raises the price of each unit of output in proportion to the emission intensity of its production, as illustrated in Figure 1. Figure 1 represents the market for a typical product. The demand schedule for the product is given by the line D and the initial supply response by the line S1. In equilibrium, Q1 of the product is supplied and demanded and the price is P1. The introduction of emission costs NZIER 4

29 raises the cost of production and pushes the supply curve up to S2. Demand contracts as the price rises and the new market equilibrium (in the long run) settles at the point (Q2, P2). The policy shock causes consumers surplus (an approximation of welfare) to go down by the area (a+b+d) and producers surplus by the area (c+e). Demand and supply contract in response to the higher price, creating a deadweight loss on the economy equivalent to area (d+e). But the tax also generates revenue for government, area (a+b+c), which it can recycle by lowering other taxes, or return as a lump sum rebate to households who ultimately face the additional cost of the policy on their consumption. The purpose of the tax is to ensure those who control the emitting activity bear the cost of emissions and thus face the incentive to reduce emissions where it is cost effective to do so. (KIWTG6JGKORCEVQHGOKUUKQPEQUVUQPVJGOCTMGVHQTCV[RKECN RTQFWEV Price S2 P2 P1 MC2 a c b e d S1 D 0 Q2 Q1 Quantity 6RXUFH 1=,(5 The economic effects of greenhouse gas emission policies 5

30 The effects of domestic emissions trading are similar, although it works by fixing the quantity of emissions rather than setting the tax rate to achieve the necessary reduction in emissions. The market determines the price of entitlements, output prices increase and the quantity supplied and demanded decrease accordingly, with the same deadweight loss as with the emissions tax. But the distribution of entitlement value differs from the emissions tax, depending on how they are initially allocated. If the government chooses to sell the entitlements it will receive revenue that it can use in the same way as carbon tax revenue. Alternatively, government could give entitlements free ( grandfathering ) to affected industries, in which case the value of entitlements accrues to the recipients and lessens the impact on them. At a domestic level, the choice between emissions tax and emissions trading largely depends on their respective transaction costs in implementation, and the certainty required in achieving the desired emission reduction. A carbon tax may be relatively simple to administer alongside other existing taxes, but setting the right rate to achieve a desired reduction is more hit and miss than setting a quantitative limit on emissions through a trading regime. There is a trade-off in choice of instruments between price certainty and quantity certainty. International emissions trading operates slightly differently because the international price of emission entitlements sets a ceiling on the entitlement price in the domestic market. If domestic demand is strong enough to push the price of entitlements to the international price, affected entities will abate less and purchase entitlements from the market. This means that in an international emissions trading system, although there is a limit on the combined emissions across participating countries, emission reduction targets in any one country need not be fixed. They will depend on the relative cost of abatement in that country and the international price. Compared to a tax or domestic trading scheme without international trading as might arise, for instance, if a country sought to reduce its emissions unilaterally outside the provisions of the Kyoto Protocol international emissions trading would be expected to NZIER 6

31 lower the cost of emission control, if it makes available lower cost entitlements or abatement opportunities in other countries. In this case the differences from a domestic tax are likely to be: Less domestic emission reduction and hence less deadweight loss from contraction in associated activities. Less revenue for recycling. Increased purchase of emission entitlements from the international market. 1.4 THE PURPOSE OF ECONOMIC MODELLING A general equilibrium model is useful for examining the impact of different policy choices as they feed through the various sectors, and change relative prices throughout the economy. It can trace the effect of imposing a shock to the price of fossil fuels and carbonaceous materials, as cost increases in one sector feed through into rising prices and changes in demand for its outputs in other sectors. Revenue gathered through carbon taxes or the sale of entitlements can be returned to households as a lump sum rebate, which has an income effect stimulating demand. A comparison of detailed policy options is not possible at this stage, given the current lack of firm proposals. It is difficult to model the benefits of adopting policies to control greenhouse gases, most of which are in the form of avoided costs of climate change a long time into the future. But within constraints of necessary simplification, modelling can illustrate economy-wide impacts of broad policy options for greenhouse gas control. The broad options examined here are: Unilateral pursuit of emission reduction by New Zealand with a carbon tax resulting from quantitative restrictions on emissions. Participation in an international emissions trading regime with wide coverage of domestic emissions under the regime. Participation in an international emissions trading regime with narrow coverage of domestic emissions, and exemptions for major emitting sectors. The economic effects of greenhouse gas emission policies 7

32 Participation in an international emissions trading regime with government doing all the trading of entitlements and recovering its costs through general taxation. A note on the emission figures used in the modelling This report focuses on a selection of greenhouse gases, rather than the full range covered by the Kyoto Protocol. The gases covered are carbon dioxide from energy and industrial process emissions; methane from energy and industrial process emissions; and methane and nitrous oxide from agriculture. Together these comprised 95% of New Zealand s emissions in its 1990 inventory. The principal emissions excluded from the analysis are methane and nitrous oxide from waste management, and emissions of hydrofluorocarbon, perfluorocarbon and sulphur hexofluoride which amounted to less than 1% of 1990 emissions. For simplicity, we have translated all the modelled emissions into their CO 2 equivalent values, and have assumed that the same taxes or permit prices will attach to the CO 2 equivalent emissions of each gas. Forecasts of future emissions are highly uncertain and subject to change. Our estimates of emissions of these gases in the 2008 to 2012 period are based on the 1990 inventory values multiplied by the growth estimates cited in the government s public consultation documents: 38 52% above 1990 levels for carbon dioxide and 0 15% for the other gases. 3 As there has already been substantial growth in emissions in line with the government s upper end estimates, and in order to better illustrate the differences between broad policy choices, we have forecast emissions using the upper end growth estimates. On an annual basis, all in millions of metric tonnes (Mt) of CO 2 equivalent, these forecasts are as follows: 3 Climate change: New Zealand s greenhouse gas emissions Information sheet from the New Zealand Climate Change Programme, October NZIER 8

33 CO 2 emissions from energy and industrial processes: CH 4 emissions from energy and industrial processes: Methane and nitrous oxide emissions from agriculture: 38.8 Mt 0.8 Mt 49.7 Mt Total emissions: 89.3 Mt of CO 2 equivalent The policy target is assumed to be a return to the 1990 emission levels, which we take to be a total of 69 Mt of CO 2 equivalent for the gas categories we are concerned with. The share of energy and industrial process emissions attributable to the different fossil fuels has been estimated using the emission shares from the Ministry of Economic Development s Energy Greenhouse Gas Emissions. We have excluded the 5% of energy emissions from geothermal and biomass in estimating these shares. We use livestock numbers as the proxy emission source for both agricultural methane and nitrous oxide emissions. Attribution of emissions to livestock has been done using estimates of enteric fermentation and manure management emissions for different classes of animal taken from the National Inventory information provided by the Ministry for the Environment. The model has three agricultural subsectors that contain livestock. Dairy cattle emissions are totally attributable to the dairying subsector, but 7.5% of other cattle emissions, and 8.7% of sheep emissions, have been attributed to the mixed farming subsector on the basis of the share of national farmed area occupied by mixed livestock and crop and sheep farms. 4 This sector also includes emissions from goats and deer. The balance of emissions from other cattle and sheep are attributed to the sheep/beef sector. On this basis, of the 1990 agricultural emissions, 18% were attributable to dairying, 72% to sheep/beef farming and 10% to mixed farming. Since 1990 the shares attributable to dairying and mixed farming have increased and that from sheep/beef has declined. 4 Sourced from Statistics New Zealand, Official Year Book. The economic effects of greenhouse gas emission policies 9

34 2. MACROECONOMIC EFFECTS 2.1 ANALYTICAL TECHNIQUES We assess the effects of possible climate change policies using two techniques. The first involves the use of a static general equilibrium model. The logic of the model is described in Appendix A. In essence, general equilibrium models trace the effects of a shock on the economy when it settles at a new equilibrium. If the shock is a relative increase in the price of fossil energy, the new equilibrium involves all relevant behavioural responses to the new set of relative prices. Indeed, solving for the new set of relative prices in every market included in the model is precisely what the model does. Computable general equilibrium models describe the national economy using stylised representations of the microeconomic agents in the economy: producers, consumers and governments (local and central). Producers choose the mix of inputs and the amounts they produce so as to maximise profits. Consumers decide how much to spend on various goods so as to maximise their well-being. The modeller specifies government decisions so that the model can be used for policy analysis. Importantly, general equilibrium models may understate or overstate the effects of shocks because they assume smoothly functioning markets. For example, as labour becomes redundant in a declining sector, the model makes it available to other sectors, and wages decline until all excess labour is absorbed. The models may overstate the effects of shocks where adjustment mechanisms are not incorporated. The assumption of well functioning markets is important to make the model consistent and computationally tractable, but it clearly does not reflect the real world perfectly. In reality, redundant workers often do not have the skills to be readily re-employed elsewhere in the economy, or they may reside in wrong locations. Similarly, capital scrapped in one sector is not immediately available for redeployment elsewhere. NZIER 10