Emissions Trading: Managing Economic Risk

Motu Economic and Public Policy Research, New Zealand’s leading independent economic research institute, is leading a Foundation for Research, Science and Technology-funded research programme that looks at climate change and ways to lessen its environmental and economic impact. Part of this research involves designing an effective emissions trading system for New Zealand and involves internationally recognised experts in emissions trading.

Motu is a charitable trust that makes all its findings readily available for the New Zealand public. We have put together some information here to be used as an aid for those interested in the use of emissions trading to address climate change. We hope that this technical information can help make the public debate on emissions trading better informed and hence more constructive.

Essential information about emissions trading systems

Part 4 – Managing Economic Risk

An emissions trading system helps reduce global climate change, lowers the risk of New Zealand non-compliance with Kyoto, and reduces the risk that controlling New Zealand’s emissions will be extremely expensive to the economy. It also introduces the risk that the price of emission units may be very high and volatile. This is a particular risk in the short run when international trade in emission units is new and trading rules are still being established in all countries; it is unclear how New Zealanders will be able to buy and sell in international markets and prices are likely to be very volatile. The current price for emission units in the European Emissions Trading System is well above the often-cited NZ$15 per tonne CO2 equivalent. It is unclear that New Zealand wants to face these high prices immediately – although those, including post-1989 foresters, who are likely to sell units, would be pleased.

One way to avoid the risk of very high prices is to limit international sales. When people buy units overseas this lowers the price in New Zealand – there is no economic reason to restrict this. In contrast, when they sell units overseas they bring our carbon price up to the international price. A temporary ban on international sales would protect those who will be buying emission units. The price will then be the lower of the international price at which we can buy emission units and a price set in the domestic market. The domestic price results from the domestic supply of units (from forestry plus those issued by government) relative to the demand from the sectors that are included in the system at each point in time. Buyers of emission units would be protected at the expense of sellers.

Alternatively, the risk of a very high carbon price could be controlled if the government offers to sell unlimited emission units at a fixed price. This is often referred to as a ‘safety valve’. This would move some risk from the private sector (including all consumers) to the taxpayer and would benefit emission unit buyers at the expense of sellers.

Like a blanket limitation on international sales, when prices are very high and a safety valve operates, it is incompatible with unrestricted banking (saving emission units for use in a later period) or allowing people to sell emission units internationally. This is because people could play the system. They could buy units from the government and then sell them at a higher price somewhere else or at a later time. If the safety valve were ever invoked, emission units issued for that year would need to be held within the country. The market would be closed to international sales until prices fell or a higher market carbon price was considered acceptable. Banked units could not be carried into the newly opened market. Some emission units may have been sold already but the extent of this would be limited by restrictions on sales in each year from New Zealand.

For more information on emissions trading see www.ecoclimate.org.nz/ETS.htm

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