House of Commons - Environmental Audit

Select Committee on Environmental Audit Fourth Report

The EU Emissions Trading System

22. The primary responsibility for tackling climate change must lie with governments. Only they can provide the long-term policy direction within which industry can plan for investment. They have various tools at their disposal, of which regulation has proved to date by far the most effective means of delivering environmental improvements. Recently, however, attention has focussed on trading systems as a way of ensuring both certainty in terms of delivering target improvements and economic efficiency in the way those improvements are delivered.

23. The basic concept underpinning emissions trading is relatively simple. An emissions "cap" is determined, this being the level to which emissions must fall over a certain period of time. The cap is then shared out among the participating entities either by basing entitlement on each participant's current share of the market ("grandfathering") or by a process of auctioning. By the end of the period, participants must reduce their emissions to equal their allocations—or else pay a financial penalty depending on the extent of the shortfall. However, trading in allocations is also allowed: those participants which are able to reduce their emissions below their targets may sell any spare allocations to those which cannot reach their target.

24. Emissions trading has some significant attractions as in theory it maximises economic efficiency for each participant and guarantees certainty of environmental outcome.[24] While it has been applied within individual countries before,[25] the European Union Emissions Trading Scheme (EU ETS) is the first example of a supra-national ETS. We therefore decided to investigate the lessons which could be learned so far from implementing the EU ETS, both for its own sake and for any implications they might have for the role of emissions trading in a post-2012 framework.

25. The EU Emissions Trading System (ETS) formally commenced on 1 January 2005. Phase 1 of the scheme will run from that date to 31 December 2007. Phase 2 will cover a period of five years, from 1 January 2008 to 31 December 2012 (the same period over which Kyoto signatories are required to have met their target reductions). The scheme is based on trading between companies.[26] It covers only carbon dioxide emissions, not emissions of other greenhouse gases, and—at least in Phase 1—it only covers fixed ground-based industrial installations such as power generators, cement and paper manufacturers etc. As it therefore excludes other major sectors such as domestic housing and transport, it covers less than 50% of the EU's total greenhouse gas emissions.

Phase 1 allocations and targets

26. In implementing the EU ETS, no overall EU-wide emissions cap or target was set: member states were free to set their own national caps for Phase 1, though in doing so they were supposed to have regard to their Kyoto commitments. Member states were therefore required to draw up National Allocation Plans (NAPs) which set out their target level of emissions at the end of Phase 1 and the basis on which these emissions would be allocated to different industrial sectors.

27. In both the written and oral evidence we received, many organisations argued that allocations for Phase 1 of the scheme right across Europe have been very unchallenging and were largely based on allocating sufficient allowances to cover "business-as-usual" projections. The RSPB, for example, described the process as a "race to the bottom" because of the way states had sought to protect the short-term competitiveness of their own economies.[27] Indeed, the following table demonstrates that relatively few countries have set target reductions of more than 3%, even when they are very far from achieving their Kyoto target; while Portugal and the Netherlands have actually set caps above their business-as-usual forecasts. Even the UK NAP formally submitted in April 2004 was based on a mere 0.7% reduction, and it was only an upward revision of its BAU forecast which appears to make it a little more testing.

EU 15 National Allocation Plans:

Comparative effort against business-as-usual

Country	Cap relative to BAU in NAP	Distance from Kyoto target in 2001
Denmark	-15.0%	+11.4%
Luxembourg	-8.8%	-28.8%
Austria	-6.0%	+16.8%
Spain	-6.0%	+23.8%
UK revised approach (November 2004)	-5.2%	-5.2%
Ireland	-3.0%	+23.9%
Finland	-3.0%	+4.7%
France	-1.7%	+0.4%
UK original approach (April 2004)	-0.7%	-5.2%
Germany	0.0%	-6.8%
Portugal	+1.6%	+21.6%
Netherlands	+3.0%	+7.4%
Belgium	Not available	+10.5%
Italy	Not available	+10.7%
Sweden	Not available	-5.5%
Greece	Not submitted	+9.8%

Source: DEFRA, EU Emissions Trading Scheme consultation document, 11November 2004

Note: The "distance from Kyoto target in 2001" is assessed as the distance from a linear progression towards the Kyoto target. A negative figure means that a country has reduced its emissions to below the linear progression, and is therefore on course to meet the target.

28. Importantly, the view that the Phase 1 targets are very unchallenging was shared not only by environmental organisations but by financial institutions involved in the fledgling carbon trading market. James Cameron (Climate Change Capital), Louis Redshaw and Paul Dawson (Barclays Capital), and Charles Donovan (Enviros) all suggested that it had resulted in a lower price of carbon than was desirable. In their view, the price may be insufficient to create a liquid market and prompt investment in low-carbon technologies, as the targets could easily be reached by a limited amount of fuel switching: too much was being left to Phase 2.[28]

29. An analysis which Enviros conducted in August 2004 of allowance price projections graphically illustrates this.[29] It shows that carbon will remain at its current price of about $7 a tonne (or lower) to the end of Phase 1, but may then rise sharply in Phase 2 to over $30 a tonne (mid-range value). Indeed, it is quite clear from the evidence presented to us that it is only the existence of the Kyoto targets which will force member states to set more demanding targets for Phase 2. There would appear to be little point in having an ETS unless it achieves significant absolute cuts in carbon emissions, and it is unfortunate that Phase 1 has set such an undemanding pace.

30. Phase 1 of the EU ETS has rightly been described as a "race to the bottom" in terms of the target caps set by individual member states. As a result, there is little prospect that it will yield any significant carbon reductions and this is reflected in the low price at which carbon is trading. Far tougher targets will need to be set in Phase 2 of the scheme and should be based on agreeing an overall cap for the EU. Indeed, it is only the existence of the Kyoto targets which will provide the driver for this process. This demonstrates the importance of such absolute targets within a post-2012 framework.

31. In Phase 1, not all aspects of implementation were precisely defined and there is therefore considerable flexibility in the way member states have interpreted some aspects of the scheme. For example, most emissions have to be allocated on a "grandfathering" basis (ie based on the share of emissions which individual sectors and companies have emitted in the past). But the scheme does allow member states to auction up to 5% of allocations (10% in Phase 2), and different states have taken a variety of approaches to this issue. Other differences in the way member states have implemented regulations include the treatment of new entrants, the definition of new plant etc. In giving evidence to us, both Barclays Capital and Climate Change Capital made it quite clear that these technical aspects were of considerable importance to market traders, and they argued the need for more harmonisation in Phase 2.[30]

32. In Phase 1, not all aspects of implementation were precisely defined. There are therefore differences between arrangements in individual member states—including the extent to which auctioning of permits is used, and the size of any new entrants' reserve. The UK should work to ensure that there is greater harmonisation and consistency in the way in which Phase 2 of the scheme is implemented.

Windfall profits for power generators

33. We also noted that the use of grandfathering as a means to allocate emissions permits is likely to result in substantial windfall profits for power generators throughout the EU. The potential for such profits has been known for some time, though the issue has received surprisingly little attention in the UK.[31] The Enviros briefing paper of August 2004 provided a range of estimates for the extra revenues that might be generated—1.3 to 3.6 billion Euros in 2006, and 14 to 30 billion Euros in 2010. It also pointed out that profits are likely to be particularly large in the UK due to the de-regulated nature of the market here.

34. Witnesses confirmed to us that UK power generators are likely to maximise the financial benefits they might gain from the EU ETS, and the extra revenue which they may enjoy may be well in excess of £500 million a year.[32] There would be a peculiar irony here as the UK power generation sector is the one sector for which slightly tougher targets have been set in the UK NAP—and indeed there have been vociferous complaints on this score from both power generators and other organisations such as the CBI and the EEF. We raised the issue with John Healey MP, the Economic Secretary of the Treasury. He confirmed that the Treasury was aware of it but he did not consider that any Government action was required. [33]

35. It is widely accepted that UK power generators are likely to make substantial windfall profits from the EU ETS amounting to £500 million a year or more. We regard this as unacceptable and particularly ironic in view of the complaints from the power sector over the targets set for them under the UK National Allocation Plan. The Government must take steps to address this issue by promoting the greater use of auctioning of emissions permits for the power generation sector in Phase 2, or by ensuring that windfall profits are re-invested in renewable and low-carbon technologies.

'Business-as-usual' and the UK NAP

36. National Allocation Plans have to be approved by the European Commission and Member States were required to submit their draft NAPs by 31 March 2004. Only a few states managed to meet this deadline. The UK issued a draft NAP for public consultation in January 2004 and subsequently formally submitted a revised version to the Commission on 30 April. On 7 July, the Commission announced it would accept the UK plan subject to the provision of further information on a number of minor issues. However, the UK subsequently published a revised plan in November 2004, increasing the total emission allocation by 20 million tonnes of carbon dioxide (to 756 million tonnes) on the basis that its previous provisional forecasts of emissions over the period had been understated.

37. The Commission has refused to consider the revised UK plan, not only because it was submitted after the deadline for any revisions but also because it has already approved the earlier draft NAP and cannot accept any subsequent upward revision of emissions. On 11 March 2005, the Government announced that, in order to enable UK business covered by the EU ETS to start participating fully, it intended to issue allowances as soon as possible; and that it would do this on the basis of the April 2004 submission. But at the same time it announced that it will be launching legal proceedings against the Commission.[34]

38. In considering this issue it is interesting to note the way in which, during 2004, the UK government successively increased the emissions cap it set itself in its National Allocation Plan. The cap rose from 714 million tonnes of carbon dioxide in its first consultation version (January 2004), to 736 million tonnes in the formal submission to the Commission (April 2004), and finally to 756 million tonnes in the revised November NAP. In addition, the UK has adopted a particularly cautious approach by setting aside (within this overall cap) a surprisingly large reserve for new entrants to the market.[35]

39. These increases in the UK cap partly reflect the strength of industry lobbying and the "race to the bottom" which the RSPB described. Throughout 2004, some trade organisations such as the Confederation of British Industry argued for a more lenient cap on the grounds that it would otherwise damage the competitiveness of the UK. They also raised wider concerns about the effect of the scheme on the competitiveness of the EU. However, a recent report from the International Energy Agency (IEA) suggests that the impact of the EU ETS on international competitiveness will be relatively small and manageable for most sectors.[36] This is supported by other reports, such as that carried out by Oxera for the Carbon Trust.[37] Indeed, it is interesting that the Carbon Trust has publicly criticised the Government for upwardly revising its carbon target.[38]

40. In attempting to revise upwards its emissions cap for Phase 1 after the EU deadline had passed, the UK Government has become embroiled in a damaging legal argument with the European Commission and is in danger of wantonly squandering its reputation for leadership on climate change. We find the UK position particularly surprising since the cost of the disputed amount—some £33 million a year over the three year period of Phase 1[39]—would be borne by the power generating sector and pales into insignificance beside the £500 million a year in windfall profits they are likely to earn from the scheme.

41. The other reason why the Government revised the UK emissions cap upwards during 2004 was because the DTI were so late in updating their earlier energy forecast,[40] and were therefore unable to produce in time reliable estimates of future UK energy projections. This is unfortunate as it has affected other aspects of the Government's strategy such as the robustness of the Energy Efficiency Implementation Plan published in April 2004. Indeed, we commented extensively on this issue in our report last year on the Budget, Budget 2004 and Energy, and highlighted the need for far better and more timely monitoring of the impacts of policy instruments.[41]

42. In this context, however, what is of interest to us is that the DTI could have got it so wrong. The November 2004 emissions limit of 756 million tonnes is 42 million tonnes greater than the limit suggested in the initial consultation document of January 2004. This represents an increase of 6%. Moreover, various UK industry sectors are currently exempted from participating in the EU ETS on the grounds that they are facing equally challenging targets under their existing Climate Change Agreements. Yet we have previously noted that most of these agreements are based on relative efficiency targets rather than absolute targets, and we therefore question—given the difficulties the DTI has experienced in providing energy forecasts—how reliable and meaningful are the targets which they contain. We welcome the Government's commitment, in response to a previous recommendation of ours, to reporting on these agreements in a more transparent way and we await progress in this area.[42]

43. The difficulties the DTI has experienced in providing reliable energy forecasts are reflected in the sheer scale of the upward revisions to the emissions cap in the UK NAP during 2004. Such difficulties undermine the very concept of "business-as-usual" (BAU) as a reliable basis on which to set targets and we therefore favour the adoption of absolute targets wherever possible.

Extending Phase 2 to include other sectors and gases

44. Phase 1 of the EU ETS covers only carbon dioxide and applies only to fixed industrial sources of emissions. It therefore excludes other key sectors—such as transport and the domestic sector—which between them account for nearly half of all carbon emissions. The coverage of Phase 2 has not as yet been finalised, and there were significant differences of view in the evidence we received as to the merits of incorporating other sectors and gases within it.

45. With regard to greenhouse gases other than carbon dioxide, given their very high carbon equivalence factors, we have concerns over the extent to which a relatively small number of high-value projects could increase investment uncertainty and detract from efforts to move to a truly low-carbon economy. Indeed, we agree strongly with the view expressed to us by Charles Donovan of Enviros—that regulation, rather than trading, might provide a better approach to reducing them.[43] In coming to this conclusion, we were very much aware of similar arguments over the Clean Development Mechanism, a topic we discuss below. Similarly, while we can understand the attractiveness of incorporating the road transport sector, it was unclear to us from the evidence we took whether this would in fact be feasible, given the current shortage of non-carbon sources of fuel. The concept of Domestic Tradable Quotas provides a possible mechanism which could prove effective in bringing about behavioural change in the transport sector, and we would urge the Government to give serious consideration to introducing such a policy which could be more palatable than further increases in carbon-related taxation.

46. We are sceptical of the desirability of incorporating other greenhouse gases and sectors within Phase 2 of the EU ETS. We are also concerned that this may destabilise carbon-trading markets and undermine investment at precisely the time when far more stringent targets need to be set. The UK government should therefore work to ensure that there are minimal significant changes to the shape and scope of the scheme, and that non-carbon greenhouse gases are addressed through regulation rather than trading.

Aviation

47. Aviation represents a particularly important source of carbon emissions in view of the wider impacts it has on global warming and the rate at which these are increasing. As a Committee, we have reported some four times on this topic in the last two years and we have demonstrated that the forecast growth in aviation will make it totally impossible for the UK to achieve its 60% carbon reduction target for 2050.[44] In the evidence presented to us on this inquiry, various organisations—including British Airways, the British Airports Authority, and Shell—favoured including aviation in the EU ETS.[45]

48. The Government is committed to incorporating aviation within Phase 2 of the EU ETS. Indeed, this constitutes its only policy for tackling the escalating environmental impacts of aviation. However, the current EU agenda on aviation reflects the fact that other member states consider that taxes or charges represent at least as effective a basis on which to proceed. In the context of our regular Pre-Budget and Budget inquiries, we questioned the Economic Secretary closely on this point, and he was unable to give us any assurance that a consensus could be reached in time.[46] We see no possibility of the UK Government achieving its objective of incorporating aviation in Phase 2 of the EU ETS, and we continue to think that a mixture of other policies—including the scope for taxation and emissions charging—should be pursued.

49. Other considerations also need to be taken into account if aviation is ultimately incorporated within the EU ETS. As is well known, in addition to carbon dioxide, aviation emissions include water vapour and Nox—both of which are thought to contribute to global warming. Indeed, in calculating aviation emissions, the Treasury itself has used a factor of 2.5 to reflect this, and some recent evidence suggests that the appropriate factor might be significantly larger. We strongly believe that, if aviation were to be included in the ETS, it should be only on the basis of accounting for all its global warming impacts and not simply on the basis of its carbon emissions.

50. There are also significant problems in relation to determining an appropriate allocation of allowances for aviation. In their evidence to us, British Airways argue for an allocation which would reflect the forecast growth of the industry.[47] But, as we have seen, emission caps for Phase 2 and subsequent phases will need to be far tighter, and other industrial sectors will face real challenges in making the cuts which will be necessary. The concept of adding at each stage a bundle of significant extra allowances to facilitate the growth of aviation would simply undermine the integrity of the whole scheme and weaken the targets.

51. What is essentially at stake here is the basis on which aviation would take part in the EU ETS. Our view is that it cannot continue to be treated as a special case indefinitely, and any attempt to ring-fence aviation in some way and construct some kind of restricted trading portal with the rest of the market would be futile. But if aviation is to be incorporated on an equal basis with other sectors, even if some allowance were to be made for several years' growth, the profile of allocations would need to stabilise and subsequently reduce along with other sectors. As we have already graphically shown, if we are to stand any chance of achieving carbon reductions of 60% or more, it is self-evident that the growth of aviation cannot increase to the extent forecast. Any assumptions regarding the future growth of aviation for the sake of calculating allowances should be based on the need to clearly limit them both in quantity and duration. Moreover, the Government should consider the effectiveness of carbon neutrality schemes as a short-term measure to offset the environmental impacts of aviation emissions.

52. We would support the inclusion of aviation within a rigorous emissions trading system only on the basis that our concerns over allocations and global warming impacts were addressed. In such circumstances we accept that, as there is currently no possibility of achieving significant reductions in aviation emissions, emissions trading would act on aviation as a demand management tool and this would be reflected in very considerable increases in the price of air travel. If the Government is really concerned about the impacts on social equity, it should explore other avenues to address this—including, for example, the concept of Domestic Tradable Quotas.

Wider issues

53. Emissions trading can provide an effective means for reducing carbon emissions but only in the context of a strong regulatory and legal framework within which absolute caps and tough compliance penalties can be enforced. Such a framework exists within the EU. Not only does the EU ETS contain within itself sufficiently draconian penalties, but also member states cannot simply walk away if the going gets tough because of the complex web of economic, regulatory and legal ties which bind them together. However, no such framework exists at an international level and we see little willingness on the part of national governments to put one in place.

54. However, the EU ETS does not currently represent a comprehensive solution to emissions reductions, as it only covers half the total carbon emissions of member states. As the RSPB has pointed out, this can sometimes make it difficult to assess EU ETS targets against Kyoto targets as one member state may, for example, place more reliance than another on reducing transport or domestic emissions and may therefore wish to set a less challenging ETS target.[48] Moreover, the targets set for the EU ETS are still relatively short term and undemanding. They may therefore fail to provide an adequate framework within which industry can invest in low-carbon technologies. Some of the organisations which gave evidence to us called for targets to be set at least 10 years in advance.[49]

55. In addition, it is obvious to us that, if a truly liquid market in carbon does arise, there will be considerable overheads involved in emissions trading. Not only will there be the costs of operating the system itself—the need to allocate, track and verify emission permits and trades; but there will also be the costs individual companies bear in participating meaningfully in the market and maximising the financial benefit to themselves. Indeed, it was for that very reason that Lord Marshall, in his 1998 report on UK domestic energy policy, argued that emissions trading would only be appropriate for larger companies and that other policy instrument were needed for SMEs and other sectors.[50]

56. In the final analysis, emissions trading will only work effectively if it results in an increase in the price of energy for industry, business and even domestic consumers. Only then will the necessary incentives to prompt behavioural change and investment in low-carbon technologies arise. Moreover, if technological improvements cannot deliver sufficient emission reductions, "cap and trade" systems will result in large price increases and will therefore become demand management policy instruments rationing activity in certain areas.

24 In this respect, it differs significantly with taxes, where the additional financial cost is fixed but the environmental outcome cannot be determined Back

25 The US sulphur trading scheme, introduced from 1990 is often held up as a particularly successful example in which substantial reductions in emissions were achieved far more cheaply than had been predicted. However, some of the evidence presented to us contradicted such claims. See Q99 Back

26 More strictly, individual point sources of emissions. See FoE's comments on this at Ev 69 Back

27 Q17.See also Q393 and Ev265 Back

28 Ev127ff, 157ff Back

29 Enviros, European Emissions Trading Scheme Executive Briefing Two, August 2004 Back

30 Ev121, Ev215, Q391. See also Ev73, Ev76, Ev82, Ev259, and Q266 Back

31 The issue was raised in a consultancy report to DEFRA, DTI and OFGEM in 2003.See Ilex Energy Consulting, The implications of the EU ETS for the power sector, September 2003.The US Pew Centre also commented on it in early 2004 Back

32 QQ310-312, Ev 156, QQ378-386 Back

33 Oral evidence taken before the Environmental Audit Committee on 9 February 2004. Cf Q584 Back

34 DEFRA press release, UK announces next steps on EU Emissions Trading Scheme, 11 March 2005 Back

35 The reserve accounted for 7.7% of allocations. See The Ends Report, Smoke and mirrors as UK revises allocation plan, November 2004 Back