Pricing Carbon: Who should surrender?

Corey Allan, Research Analyst, Motu Economic and Public Policy Research

With only 99 regulated participants, New Zealand is able to cover 100% of its CO₂ emissions from the energy sector (liquid fossil fuels and stationary energy) in the NZ ETS. Europe has only managed to cover 43% of total GHG emissions from energy, in a scheme where more than 11,500 installations are covered. New Zealand has been able to obtain full coverage because of a unique feature of its scheme – we placed the point of obligation for the energy sector upstream. The rationale behind an upstream point of obligation is discussed in a recent paper co-authored by Suzi Kerr. The paper highlights the benefits of an upstream point of obligation in energy and the lessons that China (and other countries) could draw from New Zealand’s experience with an upstream point of obligation.

The point of obligation refers to the point in the supply chain that is responsible for surrendering emissions units under an emissions trading scheme (or paying a carbon tax under a tax regime). An upstream point of obligation places the surrender obligation on firms that are upstream in the supply chain from where most emissions actually occur. In the energy sector, ‘upstream’ refers to those companies who dig the fuel out of the ground or import the fuel into New Zealand. Europe places the point of obligation on the entities that actually burn the fuel. Placing the point of obligation upstream for energy does not compromise the quality of monitoring – quality may even be improved.

Economic theory, supported by evidence, says that the behavioural response to an emissions price is the same regardless of what part of the supply chain is required to surrender permits. If all competitors are covered by the regulation (i.e. there is no ‘emissions leakage’), the emissions price will be passed efficiently along the supply chain.

New Zealand adopted an upstream approach in energy for two key reasons: to achieve a broad coverage of the emissions from energy, and to make monitoring and enforcement easy. Broad coverage means that all those who use energy (i.e. everyone) face an incentive to reduce their energy use and/or switch to a low-carbon fuel. A given emissions reduction goal can be met at a lower cost, relative to a case where some emissions are excluded. Fewer participants also makes the administration of the scheme easier. The Environmental Protection Agency (the government agency that administers the NZ scheme) has to audit only 99 participants in the energy sector. Emissions from fossil fuels are relatively easy to measure at the point of import or extraction. Fuel imported or produced will be burnt at some point; using the quantity imported or mined to measure emissions is the same as using the quantity burnt at each point source. Data on the quantity of fuel imported or extracted is already collected by these companies, which avoids the development of new data systems for compliance purposes.

The NZ ETS has another feature relating to the point of obligation in the energy sector – large energy users have the option to opt-in as a point of obligation. As of 30 June 2013, 10 companies had exercised this option (four for purchasing jet fuel, three for purchasing natural gas, and 3 for purchasing coal). Competence and competition were the main reasons for including the opt-in provision. Some large downstream companies felt that the upstream firms would not be very good at managing their carbon liabilities as these upstream firms did not have much experience in trading commodities. The downstream firms, who are more experienced at trading commodities (e.g. electricity companies) thought they could reduce their carbon costs by managing the liabilities themselves. A perceived lack of competence is exacerbated by the lack of competition among the upstream firms. If an upstream firm passes on a higher carbon price, either due to incompetence or market power, the downstream firms cannot easily switch fuel providers.  This issue of price-pass through has resulted in court cases.

When designing an emissions trading scheme, simplest is often best. An upstream point of obligation for energy reduces the burden on the regulatory agency and on the private sector by reducing the number of participants, while ensuring everyone (all consumers and businesses) face the incentive to reduce their energy use or switch to low-carbon fuels.