Benefit-cost analyses for some new Budget bids will take into account the “shadow price” of carbon over the lifetime of the investment, Marc Daalder reports
New Zealand will join other climate leaders in accounting for the climate impacts of new policies in some benefit-cost analyses (BCAs) prepared for the upcoming Budget.
The change, disclosed in a Treasury briefing to Finance Minister Grant Robertson obtained by Newsroom under the Official Information Act, marks the first time Budget bids have subjected to a systematic evaluation of their climate impacts. While Climate Change Minister James Shaw said only a limited number of bids would have their climate costs priced for Budget 2021, he expected the programme to expand in the coming years.
The scheme will see the BCAs for certain bids include a shadow carbon price devised by Treasury, meant to represent the cost to abate a tonne of carbon. If the project would lead to increased emissions, the shadow price would count as a cost. If it would instead reduce emissions, the benefits would be adjusted accordingly.
Accounting for these climate impacts should see the balance tipped further in favour of carbon-cutting projects and away from high-emitting ones.
“You increasingly want agencies that are putting Budget bids together to use a shadow price of carbon as part of their cost-benefit analysis. Not everything gets funded in every Budget, so it’s quite useful to know what is the best bang you can get for your buck when it comes to reducing emissions,” Shaw said.
“It kind of prices in the future. So if you’re making a decision today and you’re expecting the impact to last that long, although the formal carbon price today in the ETS is only $37, you can see that over a reasonable time period, the economics of that will change.”
Ivan Diaz-Rainey, an associate professor in environmental economics at the University of Otago, said the shadow price effectively calculated the real cost of carbon.
“Really this is trying to incorporate best estimates of a cost of carbon into investment decisions. I guess the surprising thing is this hadn’t happened before,” he said.
The United Kingdom and Europe, among others, have previously used a shadow price for their investment decisions.
ETS price not sufficient
Applying a shadow carbon price to government funding decisions was a recommendation of the Productivity Commission’s 2018 report on decarbonising New Zealand.
“When emissions prices are absent or too low, governments should consider using a shadow price of emissions in their investment decisions,” the Commission wrote.
“It is preferable to have a system in which emissions are priced at a level that reflects their harm and will achieve New Zealand’s emissions reduction targets. If, however, emissions prices are absent or too low, then a convincing case exists for governments to use a shadow price of emissions to guide their investment decisions.”
Because New Zealand’s Emissions Trading Scheme doesn’t include some sectors of the economy and provides subsidies for others, the market price for a carbon credit in the scheme is not reflective of the true cost of reducing emissions, Treasury found.
“Shadow prices are different from market traded prices in the Emissions Trading Scheme (ETS) which do not currently reflect the full marginal cost of achieving New Zealand’s emissions targets. The approach that the Treasury is proposing represents an initial estimation of the full marginal cost of meeting both New Zealand’s domestic emissions budgets towards the 2050 target and the steeper reductions for the 2030 target under the Paris Agreement,” officials wrote.
While shadow prices can incorporate the “social” cost of carbon – which officials defined as “an estimate of the damage caused by each additional tonne of CO2-equivalent” – Treasury decided to base the price on abatement costs.
Ralph Chapman, the director of environmental studies at Victoria University of Wellington, said Treasury should have used the social cost.
“A conceptually better approach is to recognise that if NZ is going to have a shortfall in abatement against its target, those emissions will incur a damage cost that is much greater – it will be the social cost of carbon, or somewhere in the $200 to $600 per tonne or more range,” he said.
Instead, Treasury’s proposed shadow price is a range of between $61 and $122 for emissions released or reduced in 2021. It then rises to between $119 and $238 a tonne by 2050. The current market price in the ETS for a tonne of emissions is under $40.
“Obviously there’s been a very significant uptick in the ETS in recent years in the price, but everybody knows that it’s coming from a very low base and it’s not a true reflection of the transition. The price today is not the price tomorrow,” Shaw said.
Tipping the scales towards the green
The Treasury figures are derived from the 2017 High Level Commission on Carbon Pricing, an international benchmark for estimating global abatement costs to limit warming to 2 degrees above preindustrial levels. They are slightly higher than some estimates – the Productivity Commission’s modelling went from $25 a tonne in 2020 to $150-$250 in 2050 and NZTA uses a flat shadow price of $75 for its own calculations.
However, other estimates offer far higher potential prices. Modelling from NZIER for the Ministry for the Environment found abatement costs over the next two decades could rise as high as $569 and reach nearly $2000 by 2050. France and the European Investment Bank similarly forecast prices surpassing $1000 by 2050.
In the end, officials chose to align themselves with the High Level Commission on Carbon Pricing, with an expectation that the figures would be updated each year and that ultimately a shadow price tailored to New Zealand in particular could be calculated.
Chapman said that if the Government wouldn’t use the social cost of carbon, its shadow price should at least be based on the abatement costs to limit warming to 1.5 degrees, a pledge which New Zealand has legally enshrined in the Zero Carbon Act.
The new figures are still expected to tip the scales towards greener projects in future investment decisions. While Treasury cautioned that “it is important to note that CBA itself is an important input into public sector decision-making, but isn’t determinative on its own,” trials of the shadow price found that the Net Present Value (roughly the total value of a particular investment opportunity) was bumped from low or even negative to “higher positive values where emissions are a large part of the overall costs and benefits”.
In other words, projects which might seem uneconomical without accounting for shadow prices become much better investments once the costs of climate change are factored in.
Shaw told Newsroom he expected to see the shadow price factored into more BCAs over the coming years.
“The idea here is that it sort of started with what will be a handful of bids for Budget 21, and then you apply it to a wider set for Budget 22 and so forth,” he said. He was keen to see it applied not just to policies with obvious climate impacts, like new renewable electricity generation or new roads, but also more those with more obscure impacts, like investment in houses which might not be energy efficient.
“In some ways it makes more impact when it’s the non-obvious things, because it does start to bring that kind of thinking into the broader sets of government decision-making, which obviously have an impact on our ability to meet our climate targets but where the connection isn’t so obvious that ministers will necessarily think of it straight off the bat,” Shaw said.
Diaz-Rainey said it should be applied to every major policy.
“I would love to see these shadow carbon prices being applied to every long-term investment project.”
Bringing the private sector along
Moreover, if the Government showed that using such a price was prudent financial management, the private sector might follow suit.
It wouldn’t surprise me if a number of businesses looked at that and said: ‘It’s useful to have that assessment because then we might use that as our own internal shadow carbon price,’” Shaw said.
However, both Shaw and Diaz-Rainey said that some of New Zealand’s larger emitters had long been pricing future emissions impacts into their investment decisions.
“I know for a fact, for instance, a lot of our [electricity] gentailers here in New Zealand, they’ve had a shadow price in their investment decisions for some time. And they’ve had some quite hefty prices for carbon in there. I would say the more sophisticated corporates already doing this,” Diaz-Rainey said.
Shaw pointed to Synlait’s 2019 installation of New Zealand’s first large-scale electrode boiler as a key example of the impact of shadow pricing.
“Synlait did this with their electrode boiler at their plant in the South Island. When the price was $20 a tonne and they needed a new milk-drying unit, rather than install a coal unit, they installed an electrode boiler which cost roughly twice as much as a coal boiler. At $20 a tonne that doesn’t make any sense. But as they said, well, it won’t be $20 a tonne for much longer,” he said.
“I think maybe $40 a tonne was the point when an electrode boiler makes more sense than a coal boiler and the price is just under $40 a tonne now, only a couple of years later. Given that that asset has a lifespan of 30 years, if they’d bought a coal boiler two years ago, they would be losing money on it for 28 out of 30 years.”
The key question for Diaz-Rainey is, how seriously will the Government take these figures. He said he was concerned by wording in the briefing which merely says shadow pricing “will provide useful information”.
“I guess that gives quite a lot of wiggle room, right?” he said.
“That wording around, this is helpful in making that decision. I would love to see some wording saying this guides the decision-making and if you’re going to deviate from it, then you have to have a justification why you’re ignoring it.”