Analytical note

The value of taking a portfolio approach to climate policy (AN 22/06)

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Extract from paper#

Key findings

  • Market instruments such as emissions pricing are critically important to supporting New Zealand’s low-emissions transition. However, while emissions pricing, such as through the New Zealand Emissions Trading Scheme (NZ ETS), is necessary it is unlikely to be sufficient for a number of reasons.
  • There is significant value in pursuing a dynamic portfolio approach to climate policy with emissions pricing at its core, complemented by a number of additional measures that are supported by robust intervention logic and are designed so as not to substitute for or hinder market signals and mechanisms.


New Zealand is in the midst of a significant transition to a low-emissions, climate resilient economy. The Government’s first Emissions Reduction Plan (Ministry for the Environment, 2022) published this year marks a foundational step towards meeting its long-term climate objectives. However, there is much work yet to be undertaken between now and 2050 to shape the country’s transition.

New Zealand has made commitments to domestic and international targets aimed at meaningfully driving emissions down in an effort to curb the worst anticipated impacts of climate change. These include New Zealand’s first Nationally Determined Contribution (NDC) under the Paris Agreement – a 50% reduction of net emissions below its gross 2005 emissions level by 2030 – and commitments under the Climate Change Response (Zero Carbon) Amendment Act 2019 – net-zero long-lived gases and a 24% – 47% reduction in gross biogenic methane levels by 2050.

Achieving these targets will not (and cannot) be achieved solely through government action. The key to success will ultimately lie in the investment decisions and behaviour of firms and households. The core role for government is to ensure that policies, market signals and structures are in place to incentivise and support, rather than create barriers to, these actions by firms and households.

In a perfect world, economic theory tells us that we would achieve the socially optimal amount of greenhouse gas emissions since, assuming property rights were perfectly assigned, markets would naturally find their way to this state, taking the most efficient pathway to get there.[1] However, we do not live in a theoretically perfect world - a world that economists often refer to as ‘first best’. Markets fail (eg, polluters do not always face the full costs of pollution) and consumers do not always act as perfectly optimising agents (eg, individuals often have limited information and will often make choices that are satisfactory, rather than optimal).

This more realistic world in which we live, which includes market failure and imperfections, is often referred to by economists as ‘second-best’.[2] Robust economic policy has the opportunity to pursue the efficiencies of ‘first-best’ policy outcomes in a ‘second-best’ world by working to identify and target these market imperfections and gaps where possible. While the imperfections of reality may preclude ever truly achieving first-best outcomes, taking a mindful approach to policy development and portfolio management over time can help move us closer to first-best outcomes than the application of first-best policies in a second-best world on their own.

In a climate policy context, this means taking a portfolio approach to policy that leverages the strengths of different, complementary, policy instruments and flexes over time in line with New Zealand’s climate transition to support more effective and efficient outcomes overall. In this paper complementary measures are defined by the fact that they inherently support and strengthen, rather than detract from or weaken, core economic policies such as emissions pricing. Importantly, not all complementary measures require government funding. Some of the strongest tools to align incentives and remove barriers can often be non-fiscal, such as robust regulatory policy. A true portfolio approach also means flexing the portfolio approach itself to adjust and update for new information and learning-by-doing as policymakers gain more information about the ease and efficacy of implementing different policies.

There has been a great deal of debate among economists, politicians and amongst commentators more generally about the efficacy of first-best economic policy instruments in achieving climate-related objectives.[3] At the core of this debate is a focus on the role of emissions pricing in driving least-cost emissions reductions across the economy and whether additional ‘complementary’ measures truly complement, as opposed to substituting for or hindering what emissions pricing is able to achieve on its own. The purpose of this Analytical Note is to contribute to this ongoing conversation.

This paper first provides an overview of the core proposed rationale for taking a portfolio approach to climate policy in New Zealand. It then supports this proposal by first articulating why first-best policy instruments such as emissions pricing are necessary, but unlikely to be sufficient, to drive the broader set of outcomes and objectives associated with New Zealand’s climate transition, including but not limited to the existence of several market failures and imperfections. It then highlights specific intervention logic and rationale that create strong opportunities to consider additional policies to complement rather than substitute for or hinder emissions pricing instruments such as the New Zealand Emissions Trading Scheme (NZ ETS). Importantly, not all additional policies can be considered complementary – this paper provides suggestion for how policymakers can consider designing them to ensure that they do not materially hinder the ability of the emissions pricing to play its critical role. Finally, the paper emphasises the benefit of pursuing a dynamic approach over time that suits for information obtained about the ease and returns from implementation of various policies that can support the portfolio to adapt to the intervention logic and policy administrative landscape as it shifts and evolves.

  1. [1] See Varian (2010) as an exemplar of an intermediate neoclassical microeconomics textbook for coverage of the theoretical underpinnings of an economic ‘first-best’ world. For the importance of effective property right assignment, see Coase (1960).
  2. [2] See Bennear and Stavins (2007) for a classic description of ‘second-best’ theory and the case this makes for the use of multiple policy instruments.
  3. [3] See Hepburn et al (2020) and Hall and McLachlan (2022) as recent academic contributions to this debate.