Brian Fallow: Smog clears on climate message

Businesses and consumers are getting, at last, the same message in stereo from both major parties on climate change.

It is this:

* The day is coming when emitting greenhouse gases will incur a monetary cost. Get used to the idea.

* The price will be set by a market and not by political fiat.

* This will apply across the economy, even to the sacred cow of agriculture - eventually.

* These will be the rules of the game regardless of which major party is in power.

The prospect of convergence and durable policy settings in this area, especially for business investment purposes, is overdue and welcome.

Strictly speaking, the Government has not committed itself to emissions trading, merely saying it is likely.

Labour is proceeding extremely gingerly in this area, having convinced itself that it paid an electoral price for getting too far ahead of public opinion on climate change. It sees itself as having carried the torch on climate change - one lit by the previous National Government's Simon Upton at Kyoto - and as having been scorched by it.

Nonetheless, it appears the Government's energy strategy, due in draft form within weeks, may at least outline an emissions trading regime for the electricity sector.

The National Party's position on climate change, meanwhile, has moved on from its stance that it is all nonsense and it will be the ruin of us. Its "bluegreen" policy announced last Friday declared a tradeable emissions-permit system to be the best way forward.

Spokesman Nick Smith indicated the likely sequence would be electricity, then the industrial sector, then transport and finally agriculture.

"The first step will be capping electricity emissions by requiring all additional emissions from fossil-fuel power stations to be offset by forestry planting or other emission reductions."

The key word there is "additional".

Although they have been growing fast, the electricity sector's emissions, as of 2004, amount to less than 10 per cent of the country's total emissions.

Much of the additional generation now planned is either wind farms or geothermal, and will not add to global warming.

But that does not detract from the usefulness of giving a clear signal to generators that they will have to factor in a price for emissions into future investment decisions. The lead times for thermal power stations, or a liquefied natural-gas import terminal and regasification plant, are long.

And the assets, once built, have long lives. And they cost a lot of money, which means the need to avoid stranding those assets is acute.

Even at a cursory glance, the problems of designing a cap-and-triad regime for the electricity sector are daunting.

First, there is the question where to set the cap, the level of emissions an emitter is allowed. Any emissions beyond that it would have to buy permits to cover; any less it would be able to sell.

Should the cap be set at emissions in one particular year, or perhaps at an average to take account of dry years, when the amount of rain and snow falling in the catchment of the hydro lakes is abnormally low?

Should the cap be allowed to rise over time? The case for doing that might be that we need to preserve something like the present two-to-one split between renewable and fossil fuel generation to ensure enough thermal capacity to keep the lights on in dry years. Or would the ordinary working of the electricity market provide enough comfort on that score?

Another problem with setting the cap is that no one knows what the national cap might be after 2012 when the Kyoto Protocol's first commitment period ends. Or even if there will be one.

There is always a possibility that the Kyoto system will collapse under the weight of free-rider problems, as it covers only a minority of world emissions.

Even if it does not, the tricky geopolitics of climate change has the Government talking about the need for "flexibility and conditionality" in the design of a local emissions-trading regime.

"You do have to have an eye on international competitiveness," says Climate Change Minister David Parker.

"You might say we will not do this at all unless x per cent of the world's emissions are doing something similar. Or you might say we will introduce this because it makes sense to do anyway, but we will not make it too stringent unless x per cent of the world's emissions are doing this."

A key consideration is how to deal with large, energy-intensive plants like the Tiwai Point aluminium smelter, the Glenbrook steel works or the pulp-and-paper and cement industries.

Some counterpart of the negotiated greenhouse agreements - that would have exempted them from the carbon tax in return for world's best practice on emissions - is needed. Fundamentally, the same calculations for how much protection from a carbon price is warranted, would apply.

Smith says: "Announcing a tradeable permits system and saying to the industrials 'You are likely to be next in the queue' gives the Government some negotiating leverage to reinvigorate the negotiated greenhouse policy."

There is a more general problem, however: the market power of thermal generators.

If a carbon price is to alter generators' behaviour they have to feel at least some of the pain, so to speak, and not just be able to pass it all on to their consumers.

But the way the wholesale electricity market works means that the most expensive electricity needed to clear demand in any given half-hour period sets the price for all the generators called on in that period. Much of the time, and especially when demand is high, that marginal price is set by a thermal generator.

And what about the supply side of the market?

National envisages permits arising from permanent new forests and other certified - that is, Kyoto-compliant - emissions reductions.

Forest-sink credits would figure in the Government's scheme too, Parker says.

That imparts some retrospective sense to the permanent-forest-sinks initiative unveiled a few weeks ago. As announced it would push on to landowners all the costs and risks of establishing permanent forests on erodible hill country and recompense them with bits of paper for which there is no local market.

To provide liquidity and reduce the risk of gaming, it would seem desirable to have some kind of link with emissions markets offshore.

The Australian states are working on a cap-and-trade regime for electricity and industry. California has also announced plans to go cap-and-trade. But neither of those markets will exist for some years

The big carbon market already up and running is Europe's emissions-trading system which covers nearly half of EU emissions.

Forest-sink credits are debarred from that market. That could complicate any future link-up with the mother ship of carbon trading.