NZIER Analysis Of ETS Passes Review

NZIER media release – for immediate release

Tuesday 20 May 2008

NZIER Analysis Of Emission Trading Scheme Passes Review

An independent review released today of NZIER’s analysis of the proposed Emissions Trading Scheme (ETS) finds that NZIER’s methodology is appropriate and that its conclusions follow logically.

Dr Brent Layton, Chief Executive of NZIER, said that “the review’s findings are in stark contrast to Hon David Parker’s accusation in Parliament last week that NZIER’s analysis has a ‘fundamental flaw in it’.”

The review was undertaken by Dr Adolf Stroombergen of Infometrics Ltd. Dr Stroombergen prepared the analysis of the economic impact of an ETS for the government.

Some of the differences between NZIER’s analysis and Dr Stroombergen’s work are caused by assumptions. “Economists always debate assumptions, but it is clear from the review that our assumptions are reasonable”, said Dr Layton. “What is important is that we understand the economic risks of an ETS and pick the best policy. Dr Stroombergen concludes that our economic analysis is a useful contribution to that understanding.”

Hon David Parker was also completely wrong to state that the NZIER work assumes that subsidies provided to agriculture would increase New Zealand’s overall GDP, and that this flies in the face of general economic theory. NZIER did not model a subsidy to agriculture, nor is it an assumption of the model. But it is not surprising that a tax rebate to the pastoral sector would have the effect of raising GDP given the many distortionary policies in place; a rebate could shift resources from the less productive non-tradable sectors to the more efficient export sectors, such as the pastoral sector.

“We were always confident in the rigour of our model and our analysis, not least because the underlying model is used all over the world, and was developed with the assistance of world experts in the field”, said Dr Layton. “The main point we are trying to get across is that moving ahead of our international competitors with an ETS would hurt the economy at little or no environmental benefit”.

The NZIER report, released on 30 April, estimated that by 2025 the proposed Emissions Trading Scheme would reduce GDP by $5.9 billion, reduce average household spending by $3000 a year and cost four times as much as if the Government simply purchased credits arising from worthwhile international projects to reduce emissions.

A copy of the review by Dr Stroombergen is attached to this media release. NZIER’s full report on the impact of the ETS is available at www.nzier.org.nz

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Review of NZIER report:

The impact of the proposed Emissions Trading Scheme on new Zealand’s economy, April 2008.

I have been asked to consider the following:

• Appropriateness of the methodology and the ORANI model in particular.

• Validity of conclusions in relation to the modelling results.

• Role and validity of key assumptions.

• Gaps in the analysis.

• How any of the above might undermine the report’s conclusions.

My comments below are based on reading the report, an exchange of emails with NZIER and a meeting with NZIER.

1. Appropriateness of methodology

A general equilibrium model is a very appropriate tool for analysing the costs of policies aimed at reducing greenhouse gas emissions. Such policies are likely to have diffuse and far-reaching economy-wide effects. Thus partial equilibrium techniques such as traditional cost-benefit analysis would be inadequate. Models of the ORANI type have a long and credible history of use, especially in Australia, such as by the Australian Productivity Commission. A similar model is used in New Zealand by BERL.

ORANI type models are not unusual from a general equilibrium theoretic perspective. Their special feature is that equations are expressed in logarithmic differential form, making them linear, and thus avoiding the need for complex nonlinear solution algorithms. The NZIER solution algorithm incorporates a technique for dealing with linearisation errors.

2. Validity conclusions from results

The report’s conclusions follow logically from the modelling results. The main issue though, is what is driving the modelling results, in particular the finding that the ‘NZ Pays’ scenario has lower national cost than the ‘ETS’ scenario?

3. Role and validity of the key assumptions

Assumptions are taken to include both the macroeconomic closure assumptions dealing with scenario specification, and the equally important embedded model assumptions.

With respect to macroeconomic closure, none of the assumptions appear to be unreasonable when taken on their own, in particular sets of circumstances. The issue, however, is more subtle – what are reasonable assumptions to use in particular situations, how do they interact with the embedded assumptions, and how crucial are they to the results obtained?

To try to answer these questions I consider the report’s results for 2025, though some of the discussion will also apply to the results for 2012 and 2015.

In quantitative terms the results are generally of the same order of magnitude as those presented in Infometrics’ research for the Emissions Trading Group. Differences will be caused by macroeconomic closure assumptions and a whole array of differences (some very minor) around the parameterisation of the model’s production structures, demand functions, industry aggregation, energy substitution possibilities and so on.

The surprise in the report is that the NZ Pays scenario has a lower national cost than the ETS scenario, whether measured in terms of GDP or private consumption. While all of the factors mentioned above will contribute to the size of the difference, the direction of the difference would seem to be driven primarily by four main features of the model:

• The capital closure assumption – the ETS produces such a strong negative effect on rates of return that aggregate investment falls (relative to BAU), leading to a smaller capital stock and thus lower GDP.

Arguing that aggregate investment would fall under an ETS is not necessarily implausible,[1] but neither is it certain. That the ETS scheme results in pressure on profitability in some industries is understandable, but the ETS is about changing relative prices, not lowering profitability. Indeed some industries see a potential increase in profitability? Examples (from the report) include fishing, tourism and some manufacturing. To understand why total investment declines we need to consider the points below.

• Agriculture – agricultural exports are extremely sensitive to what happens to rates of return and to costs in general. Indeed NZIER confirm that a subsidy to agricultural raises GDP – quite apart from any carbon pricing issue. The loss of profitability in agriculture is a key determinant of the overall reduction in investment. No land is left idle, but some does shift to less productive use under an ETS.

3. Taxes – taxes are not explicitly modelled. This means for example that investment is more affected by the ETS, which lowers rates of return, than by the NZ Pays scenario where taxes are (implicitly) increased – which should affect the user cost of capital. The difference between how a carbon tax affects private consumption and how income tax affects private consumption is also not explicitly modelled. Thus the analysis appears to ignore the effects of changes in different types of taxes on allocative efficiency.

4. Closure with regard to the external balance – Payment for the purchase of international emission units is treated as an increase in net factor payments offshore. To maintain the current account balance (which is fixed at the BAU ratio to GDP) there is a reduction in imports in the ETS scenario. In the NZ Pays scenario there is a reduction in imports and an increase in exports. In effect this is similar to what happens in the Infometrics modelling.

On the capital account of the balance of payments there is also a reduction in a foreign liability. Given that, as an accounting identity, the change in the capital account must equal the change in the current account, and that the change in the latter is zero (by the closure assumption) there must be an offsetting change in the capital account. This takes the form of an increase in foreign investment in New Zealand (which is modelled as a net reduction in capital outflows), which is an increase in foreign liabilities.

In the ETS scenario the larger contraction of the capital stock means that less foreign investment in New Zealand by foreigners is required than in the NZ Pays scenario. Looked at in reverse, less foreign investment is forthcoming because of the reduction in the return to capital. Thus the capital closure assumption is tied up with the external balance closure assumption.

4. Gaps in the analysis

There are no gaps in the analysis in the sense of issues that need to be addressed, but there are gaps in the explanation needed to understand the results of the analysis – as evidenced by the discussion of the points above. Having said that, however, there is a limit to the kind of detail that one can incorporate in a public report, and I have no complaints about the willingness of NZIER staff to answer my questions.

5. Robustness of the report’s conclusions

Some sensitivity testing of the results is described in the report, and the general conclusions with respect to those tests are robust. What was not tested (or at least not publically released) is the robustness of (2025) results to changes in the capital closure assumption, to the changes in the sensitivity of agricultural production and exports to prices, and to changes in different types of tax. I understand that changing the capital closure assumption has been analysed and that the relativity of the results – namely a greater welfare loss under the ETS than under NZ Pays – is unchanged, although quantitatively diminished.[2] Changing the agricultural price elasticities is presumably not too arduous a task, but modelling different tax rates requires extensions to the model.

In summary the NZIER analysis presents a useful contribution to economic analysis of the options for meeting New Zealand’s international emissions reduction obligations. Once one understands what has gone into the model, one can understand what has come out – which is not true of all models. What goes into a model is mix of things we know something about and things we know very little about. Over time the latter category hopefully shrinks, but many assumptions and parameter values issues will continue to be disputed. They need to be addressed by sensitivity analysis within the model framework and by debate outside the model framework.

As mentioned above, the quantitative results from the modelling are comparable to those obtained by Infometrics, suggesting that running both models with identical closure assumptions and agricultural demand/supply elasticities would lead to similar results. Such analysis would be usefully complemented by more detailed research into the sensitivity of investment to pre-tax rates of return and of the sensitivity of agricultural production to prices.

Adolf Stroombergen

Infometrics

19 May 2008

[1] Indeed our own modelling for the New Zealand Business Roundtable looked at such a scenario.

[2] NZIER make the point that changing the capital closure assumption does not fit well with the closure assumption regarding the balance of payments.

ENDS

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