Emissions Trading Market Issue 2: Allocation

Simon Watt, Partner | October 2001

Emissions trading is a key policy option for giving effect to New Zealand's climate change obligations if the Kyoto Protocol is ratified. The framework for a proposed New Zealand emissions trading market is emerging. This is the second in a series of commentaries on key features of such a market and deals with the issue of allocation of emissions units to participants in the market.

In the event that the New Zealand Government opts to establish a domestic emissions trading market, emissions units (EUs) would need to be distributed to scheme participants to trade with.

Each EU would represent one tonne of carbon dioxide or equivalent greenhouse gas. At specified points in the economy (known as "points of obligation") a participant's actual greenhouse gas emissions would be offset against the EUs it holds. Any surplus EUs could be onsold to other participants.

The method by which EUs are allocated by the Government is a key feature of an emissions trading market. The way in which the initial distribution would take place, the treatment of new entrants, and whether units would be allocated free of charge or at a cost are central issues.

In accordance with the Kyoto Protocol, the number of EUs available for allocation would be capped in the commitment period of 2008-2112 at New Zealand's 1990 emission levels. However, it is possible that not all EUs would be allocated at the outset. Reserve funds may be established to guard against excess emissions and to provide for new entrants and special cases.

The allocator

The competitiveness and stability of the market would depend to some extent on the nature of the allocating entity. Allocation directly by the Government may be impractical; a statutory allocating entity may become subject to judicial review proceedings; while allocation through a defined regulatory formula may be unduly inflexible.

The objective in determining the allocator would be to strike an appropriate balance between stability and flexibility. The choice would also be influenced by the means of allocation.

Means of allocation

There are a variety of ways in which EUs could be allocated. Two key methods are grandparenting and auctioning.

Grandparenting

The most widely used allocation method in similar overseas markets is "grandparenting". This method has been used successfully in the American SO2 market and pilot schemes in Canada and elsewhere to initiate a variety of emissions trading markets.

Grandparenting works on the basis that, once the scheme participants are determined, they are given EUs, usually free of charge.

In order to allocate EUs fairly, a distribution method is needed. In New Zealand, that method would probably rely on the historical emissions of entities. A point of obligation would, therefore, be required to produce details of its past greenhouse gas emissions (or of its supply figures, if the point of obligation is not an emission source). This data, when compared with data from other participants, would be used to determine the share of EUs the entity would receive.

Other factors may be considered when allocating EUs, such as the nature of the industry in which the entity operates and the opportunities available for reducing emissions.

One school of thought suggests grandparenting is a positive approach because EUs are limited and therefore not every participant receives sufficient units to maintain the status quo. That, in turn, signals to the market that innovative reduction measures are expected and that grandparenting does not simply authorise present emission levels.

An alternative view is that, because grandparenting is based on historical information, the approach does not offer the necessary incentives to improve the status quo. Another criticism of this approach is that it can reduce competitiveness by presenting a barrier to new entrants who do not hold
historical data.

Because grandparenting is less disruptive to the status quo and softens the impact of emissions trading, there could well be a strong industry lobby in favour of this allocation option.

Auctioning

Another option is to auction EUs to the highest bidders. Auctioning would be an effective way to establish the market value of EUs and by doing so would encourage trading, which is an important component of the market.

Equity issues arise from allocation by auction. Entities at points of obligation may need EUs to operate lawfully but may not be able to afford to purchase them at the price set by auction. There are, however, a range of auction designs that could be used to retain competitiveness.

Proponents of auctioning argue that it accords with the "polluter pays" principle. As a result, current emitters would have an incentive, before the scheme begins and once it is operating, to reduce their emissions. By placing a dollar value on EUs, auctioning provides more direct financial incentives to reduce emissions.

A further issue that arises with auctioning is what to do with the revenue raised. For example, the Government could fund research and development initiatives in the areas of energy efficiency and emission reductions, or it could use the funds to mitigate any negative impacts of an emissions trading regime.

Hybrid

A mixture of both models could be used. Some EUs might be grandparented to market participants, with the remainder reserved for auction. This approach would protect small entities and provide a measure of stability, while capturing the benefits of auctioning - reduction incentives and price signalling.

Other factors would affect allocation - New Zealand is likely to monitor the development of similar markets overseas and analyse the success of different allocation methods.

There is a good deal of policy work to be carried out before an allocation model can be chosen. The outcome of that work would have a significant impact on participants in an emissions trading market.