Five lessons from the Emissions Trading Scheme

Opinion: Basil Sharp offers Emissions Trading Scheme insights that could help Government deliver property rights that create value and certainty for business.

Security of ownership is vital for a well-functioning ETS – the proposal to exclude exotic forests just dilutes value and creates investment uncertainty. Photo: iStock

New Zealand’s Emissions Trading Scheme has been promoted on the international stage as an example of cap and trade. The economic principles behind cap and trade are well known: they set a limit on emissions, define rights to emit CO2, decide who will get the initial rights and how, and then let trade within the market decide who holds the rights. Simple eh?

Since 1986, New Zealand has been at the forefront of using rights-based systems of governance in natural resource management. For example, in the allocation of fishing rights to the fisheries sector where New Zealand is a world leader. Another example is rights to use in the radio spectrum where frequencies for broadcasting are allocated to radio, television, mobile phone and emergency services. Unfortunately, the initial design of the rights-based system in this case was a textbook example of how not to run an auction. So, a lesson learned!

This is what being at the forefront of rights-based systems has meant – New Zealand has had to learn by doing. Experience has shown that learning by doing requires flexibility in the design of rights, isolating the system from political tinkering and, when necessary, adjusting governance in recognition of outcomes and uncertainty.

And so it is with the Emissions Trading Scheme (ETS) and lessons that we have learned about design, minimising the opportunity for political game playing, and adapting as the challenge unfolds. Empirical evidence going forward is essential. The Climate Change Commission’s latest recommendations highlight the importance of signalling future emission caps that enable business to adapt and plan with relative certainty, and manage expectations over what can be achieved.

It took almost 15 years for the scheme to finally have an emission cap – hardly an exemplar of implementing a cap-and-trade system. Successive government tinkerings compromised its effective. Lesson one: minimise the opportunity for government to alter a rights-based system for political gain.

Lesson two: property rights create economic incentives. The recent proposal to exclude exotic species from the permanent forestry category was based on encouraging the right tree, in the right place, for the right reason. This verges on extreme government intervention over what landowners can do with their land.

What if a landowner wants to plant trees on marginal agricultural land? Is this the right place? Who decides the right tree? Clearly the landowner’s rights have been diluted in favour of the government. Furthermore, the landowner may decide to continue with pastoral production which works against the intent of policy. Passing this on to the administrators of a reformed Resource Management Act could impose additional costs on landowners seeking approval for land use. It would also inhibit the movement of resources to their highest valued use.

Lesson three: the status quo matters. Landowners have based their investment in exotic forestry on the additional benefits from carbon sequestration up to the point of harvest. Changing the rules of the game impacts value and has distributional consequences. In this case, forest landowners lose. Compensation for the diminution in value would surely get the attention of policy advisers.

Lesson four: the shape of property rights determines their value. This should be obvious. Under the scheme, emission rights are transferable, which is good. Longer rights are of more value than rights of shorter duration – the value of leasehold land is less than fee simple title. Security of ownership is vital for a well-functioning ETS – the proposal to exclude exotic forests just dilutes value and creates investment uncertainty.

Lesson five: a one tool-one policy objective. The number of emission units released for auction is designed to meet New Zealand’s international obligations. Ratcheting down the number of units will, at least in the near term, increase the price of emission units. Business faces the choice – buy units to cover emissions or invest in low-emission technologies. This is what a cap-and-trade system is designed to do.

A well-designed ETS can meet New Zealand’s international commitments at least cost to the economy. To be sure, there are design challenges ahead. But the government needs to keep the focus on delivering a well-functioning set of property rights that create value and relative certainty for business – this will achieve targets at least cost.

Dr Basil Sharp is Emeritus Professor of Economics and former Director of The Energy Centre, at the University of Auckland Business School.

This article reflects the opinion of the author and not necessarily the views of the University of Auckland.

Used with permission from Newsroom Five lessons from the Emissions Trading Scheme 9 August 2022

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