Just fix industrial allocations

New Zealand's Emissions Trading Scheme includes industrial allocations of carbon credits aimed at avoiding inefficient carbon leakage.

But the formula is wrong. 

Imagine that you're a domestic firm producing stuff that generates CO2 emissions. You correctly have to surrender NZU - one for each tonne of emissions. But if competitors in foreign markets do not face a carbon charge, there's a problem. They'll undercut you because their costs are lower, you'll scale down or shut down in response, the other outfit scales up, and their unpriced emissions go up.

It can easily result in a net increase in global emissions.

So, what to do about it - if you want the ETS to solely be about net emissions?

Identify firms in that situation. Look at the intensity of carbon emissions in their foreign competitors' products. Then, do the following.

Take the local firm's production in base year. Multiply it by the GHG-intensity of the foreign producers' products. Then give the firm that many NZU as an industrial allocation.

Simple example. 

Suppose that the NZ company produces 100,000 units of widgets. Each widget produced abroad by relevant competitors creates one tonne of CO2-e. So give the NZ firm 100,000 NZU regardless of its own GHG emissions. 

If the firm is more carbon-efficient than international competitors, it will on-sell surplus NZU. It will also have strong incentive to invest in decarbonisation-tech so long as the cost of reducing emissions is less than the going carbon price. Why? Because that means it can sell more valuable NZU for others to use. 

If the firm is less carbon-efficient than international competitors, it will have to purchase NZU to make up the difference. That will increase its costs, and that is perfectly fine. It will have strong incentive to invest in decarbonisation-tech so long as the cost of reducing emissions is less than the going carbon price, because that's cheaper than buying units. And if it cannot do so cost effectively, and international competitors take their markets, that's fine - at least as far as the ETS is concerned. It is, in that case, carbon efficient for the local firm to scale down or shut-down. That kind of carbon leakage is a-ok because net global emissions go down. 

You would regularly rebase the measure of international carbon intensity, so that firms would have incentive to keep up with what's going on in the rest of the world. 

But that isn't what the ETS does. Instead, the ETS allocates NZU based on the local firm's own emissions, on a schedule that declines over time. And you can easily then wind up in spots where a local firm that is more carbon-efficient than international competitors loses business to those international firms that do not face a carbon price, shuts down, and net emissions go up. Because the local firm winds up facing a carbon price at the margin that leaves them less competitive than overseas firms that do not face a carbon price. 

Fixing it isn't simple; running the figures on international carbon intensity could be tricky. And the thing will have to update as emission budgets reduce: either provide firms with the cash-equivalent of the NZU allocation so they can purchase credits from carbon foresters, put in a CBAM to reduce the distortion on imports, or a mix of the two. 

But the alternative is firm-by-firm bailouts. This week it's cement. Who knows who it'll be next time.

I'd had a chat with Heather at Newstalk on this earlier this week.