Memorandum submitted by Climate Change
Capital
SUMMARY
1. As a specialist merchant bank operating
exclusively in energy and environmental markets, Climate Change
Capital (CCC) sees international emissions trading as a pivotal
development in securing global action to address climate change.
International emissions trading is largely untested but has the
potential for significant and cost-effective emissions reductions.
We believe that commercial opportunities follow.
2. However, in order to work, market integrity
must be secured with significant caps, wide coverage, transparency
and robust enforcement. Above all, the market must be short in
order to function.
3. Emissions trading needs high-level political
commitment. Politicians must consistently and publicly assure
the business sector that they are serious and that emissions trading
is here to stay. The credibility gap between rhetoric and action
is damaging.
4. Capacity building is a precondition for
expansion of emissions trading.
5. The best approach is one of evolution,
not revolution. The first phase of the EU ETS and the first Commitment
Period of Kyoto are transitional phases. Having undertaken much
of the groundwork, the climate effort must be strengthened.
6. Transparency and the development of complementary
policies and measures are vital to ensuring widespread political
acceptability.
INTRODUCTION
7. Climate Change Capital (CCC) is a specialist
merchant bank focused on energy and environmental markets driven
or impacted by government policy. CCC has expertise in finance,
climate policy, power pricing, renewables and emissions trading
markets.
8. We believe that the increasing political
adherence to the climate change agenda and the development of
the emissions trading market in particular provides a stimulus
to innovation and a significant commercial opportunity. In a sense,
we are the proof of concept.
THE EMISSIONS
TRADING RECORD
9. Faced with growing international consensus
on the imperative to tackle the causes of anthropogenic climate
change, governments face a choice in the policy mechanisms available.
In very broad terms, the three main policy options are: establishment
of a traded market, a fiscal approach or a regulatory approach.
Each approach presents its own widely-recognised challenges in
securing the objectives of environmental integrity, equity, harmonisation
and economic efficiency.
10. In some respects, the regulatory approach
enjoys perhaps the best international track-record to date, demonstrated
through the impact of the Montreal Protocol which phases out ozone-depleting
substances. At the opposite end of the spectrum, there is no precedence
for an internationally agreed fiscal framework being employed
in respect of securing discrete policy objectives. Some progress
has been made towards harmonisation of VAT and energy taxes, but
only within the confines of the EU on the grounds of a common
market. Despite ongoing campaigns in favour of a Tobin Tax or
a global fossil fuel tax, in CCC's view international taxation
remains well outside the realms of the possible.
11. Like international taxation, international
emissions trading has yet to be proven as a means of securing
international obligations. However, due to its inclusion in the
Kyoto Protocol and the introduction of the European emissions
trading scheme, there is much greater political and institutional
momentum behind trading than there is behind taxes. But this momentum
should not be taken for granted. It will dissipate if trading
fails to deliver emissions reductions. Moreover, even cost-effective
trading is under constant challenge from industry. Emissions trading
needs high-level political commitment. Politicians must consistently
and publicly assure the business sector that they are serious
and emissions trading is here to stay. The credibility gap between
rhetoric and action is damaging.
12. The principles of a traded market for
emissions of polluting gases have been demonstrated and have proved
effective at a national level. The US Acid Rain Program established
a nationwide cap-and-trade scheme for SO2 emissions from power
plants. Emissions have been reduced by more than 6.5 million tonnes
from 1980 levels under the scheme and by 2010, the cap will be
lowered to 8.95Mt—a 50% reduction from 1980 levels. A number
of studies suggest that compliance costs would have been greater
if, instead of trading, a command-and-control approach had been
adopted. Meanwhile, the EU approach to reducing SO2 emissions
has been one of regulation, delivering a similar rate of emissions
reduction. A study commissioned by DG Enterprise this year found
that industrial air pollution expenditure as percentages of industrial
gross value added appear to be similar in the EU and the US and
that competitiveness impacts were very limited and certainly small
when compared with wider price effects in the market. [1]This
very limited comparison suggests that at the very least, the cost-effectiveness
and environmental record of emissions trading is equivalent to
that of a regulatory approach.
13. The UKETS cannot be regarded as a success
in securing the abatement of greenhouse gas (GHG) emissions, with
an excessive supply of emission credits from two principal sources
limiting incentives for wider abatement and inhibiting the development
of an actively traded market. Furthermore, questions over additionality
of much of the supply of emission credits within the scheme persist,
as does uncertainty regarding the continuity of the mechanism
itself. This experience should not, however, be interpreted as
a failing of the principle of a traded market, but is more properly
attributed to inappropriate application and flawed execution.
However, the UK ETS certainly contributed to the development of
institutional capacity, the importance of which should not be
underestimated. It was a useful learning exercise and has helped
to create a comparative advantage for the UK in global emissions
markets by establishing a UK emissions trading sector encompassing
banking, law, accountancy and consulting services.
14. The EU ETS will enter into operation
on a statutory basis with effect from 1 January 2005. To the extent
that forward trades have been executed, it is de facto an
operational market and is properly regarded as an international
market. The process of implementation has already afforded powerful
lessons with regard to establishing the integrity of an emissions
trading scheme as a policy tool and affords a realistic perspective
on prospects for the more widespread adoption of this model.
15. Notwithstanding the practicalities of
implementation and the political dimension to this process, CCC
has been well placed to observe the practical impact of the market.
Our experience has been that the introduction of the EU ETS has
had a significant impact in stimulating a commercial response
to the climate change agenda. While this response has not been
universally positive, the diverse, complex and dynamic set of
responses observed would appear—even at this early stage—to
set the establishment of a GHG market apart from other policy
measures as a catalyst for change and a stimulus for a creative
commercial response. This is manifested directly in the apparent
growth of activity in the emissions trading business, broadly
based around the City of London, and indirectly in the attention
that the wider clean technology market is attracting from institutional
investors.
16. Although the introduction of the emissions
trading scheme is in itself significant, both in environmental
terms and with respect to businesses such as CCC, it is important
to place it in perspective. Compared to traditional securities
markets, even the pan-EU EUETS is small: the total allowances
issued are some 2.4 billion tonnes of CO2 equivalent (
21.1 billion in nominal value at a price of
8.8 per tonne), as compared, for instance, to the
UK Gilts market with a nominal outstanding value of £320
billion. In scale terms the emissions market is more comparable
with the European power market, as indeed generation of 1 MWh
of coal-fired power emits approximately one tonne of carbon. Even
here the dynamics of the market may prove fundamentally different,
since the inability to store significant volumes of electricity
tends to drive short-term market volatility, whereas the ability
to redeem allowances on an annual basis may dampen activity in
all but a few, intensive trading periods.
17. Thus, the development of an efficient
and orderly emissions trading market is of central importance
to the ongoing development of CCC's business. The company's outlook
is not a fundamentalist one: CCC recognises that the market is
immature, that there are practical limits to the reach of the
market, and that while bearing the label of a market it remains
a political construct. However, the company is convinced that
on the limited body of evidence that is available today there
is considerable merit in pursuing an emissions trading approach
as a core element in international efforts to combat climate change,
and our submission is presented in this context. It focuses to
a great extent on that aspect of the inquiry upon which CCC's
expertise can be brought to bear, namely the role of international
emissions trading in delivering long-term climate targets.
MAKING EMISSIONS
TRADING WORK
18. Preventing dangerous levels of climate
change is primarily an investment problem. Success or failure
will depend upon whether the right investment framework can be
created in order to drive capital towards low- and no-carbon solutions.
If the EU is identified as one entity, the world's largest 12
countries represent about 70% of global emissions. This means
that the climate effort depends in very large part on establishing
the right investment framework in these 12 countries. It is therefore
important to set out how emissions trading can best be designed
in order to deliver this objective.
19. Before discussing this, it is important
to note that there are two main levels of international emissions
trading: international government-level trading and international
installation—or company-level trading. By way of illustration,
the Kyoto Protocol establishes the framework for government-to-government
trading, under which each party to Annex 1 of the Protocol faces
a cap, expressed in terms of greenhouse gas emissions above or
below a 1990 baseline. The traded currency of this inter-governmental
system is the Assigned Amount Unit (AAU). As one of the Annex
1 signatories, the EU has unilaterally decided to implement the
EU Emissions Trading Scheme (EUETS) as one measure to secure its
Kyoto target, with its own currency, the EU Allowance (EUA). The
two schemes are not additional: rather they are complementary,
with the EU scheme providing one—but by no means the only—measure
by which EU Member States can secure their own contribution to
the overall EU savings target.
20. The parallel operation of these markets
provides a powerful illustration of the choices facing Government
over where the burden of meeting our international obligations
should fall. At the present time, Member States are finalising
the details of their National Allocation Plans (NAPs), which determine
the overall cap on CO2 emissions from those installations included
within the scope of the EUETS. In deciding whether to set tight
caps under their National Allocation Plans that pass the burden
of reducing emissions onto industry or whether to buy Kyoto credits
on the government-to-government market, governments are essentially
deciding whether the customers of carbon-intensive goods, and
in some cases the shareholders in carbon-intensive processes,
or the taxpayer should bear the cost of the emissions reduction.
The existence of these parallel markets thus provides optionality
to governments facing difficult political choices, but it does
not avoid their fundamental obligations.
21. A second differentiation is needed between
the two broad types of scheme: cap-and-trade and baseline-and-credit.
The former applies to schemes like the US sulphur regime and the
EU ETS where total emissions are capped and participants trade
underneath this overall cap. Baseline-and-credit schemes, like
Kyoto's Clean Development Mechanism (CDM), are supposed to result
in lower emissions as compared with a hypothetical business-as-usual
emissions baseline. Under the CDM, a project developer generates
a volume of emissions credits equivalent to the difference between
the hypothetical emissions baseline and the actual project emissions.
The practical result is a lower level emissions as compared with
the situation in the absence of the project. Baseline-and-credit
schemes have more limited data and capacity requirements than
cap-and-trade schemes because they can be restricted to the project
level. However, they are much more uncertain.
22. Fortunately, environmental integrity
and economic efficiency have the same requirements when it comes
to emissions trading. Both require a well defined cap, wide coverage,
transparency and verification, enforcement and institutions.
Emission caps
23. First, the market must be short, ie
the total emissions allowed must represent a significant reduction
against the business-as-usual (BAU) emissions trajectory of the
trading parties. A reduction that is too small can result in market
collapse because if the price of carbon falls too low, there is
little incentive to trade. This occurs well before the price hits
zero.
24. BAU is an inherently problematic concept.
Because they are hypothetical, assessments of BAU can vary wildly.
The assumptions that result in BAU projections have been highly
contended in the implementation of the EU ETS. For instance, the
UK's National Allocation Plan (NAP) was revised in order to meet
industry concerns that emissions factors and output assumptions
were incorrect, so BAU had been underestimated and therefore the
"burden" faced by industry was greater than the government
anticipated at the time of publishing its first Plan. The questionable
validity of historical data, allied to the inherent uncertainty
over emissions projections, presents a very real risk that government
decisions may be built upon misleading information by affected
parties. Governments should monitor the extent to which the data
provided to it has been accurate as the carbon price plays out.
Experience in the US sulphur market and within the EU suggests
that industry usually overestimates compliance costs.
25. Practical experience of the allocations
process under Phase one of the EUETS has demonstrated a common
tendency on the part of Governments to set emissions reduction
targets relative to BAU, with less regard to the imperative of
securing the absolute reductions necessary to stabilise the climate
system. Although once set these caps are fixed rather than relative,
the process of setting the caps has resulted in a widespread divergence
between national caps and the emissions trajectories necessary
to secure Member States' Burden Sharing Agreements.
26. This experience demonstrates that transparent
process and political leadership will always be needed in determining
the level of reductions. In CCC's view, this has not yet been
achieved within the EU context, as caps under the EU ETS are not
yet consistent with Kyoto targets. Future caps must be, and extension
of the scheme beyond 2012 should create a predictable reduction
pathway aimed at achieving longer term climate objectives. However,
the first phase of the EU ETS and indeed the First Commitment
Period under Kyoto are transitional. Now that much of the groundwork
has been laid, we are in a position to improve the practice and
performance of emissions trading.
Coverage
27. Liquidity—best indicated by the
volume of trading but meaning the extent to which trades can be
made without moving the entire market—is determined by both
the cap and the size of the market. Liquidity improves with a
tougher cap and a bigger market. This means that wide coverage
of emitting sectors and installations by an emissions trading
scheme will contribute to its liquidity.
28. In addition, wide coverage can deliver
emissions reductions at potentially lower cost. The more countries,
sectors and installations are involved, the greater the range
of available abatement options. By increasing the number of abatement
options, it is possible to increase the number of low marginal
cost abatement options. This principle also applies to gas coverage.
By extending emissions trading beyond CO2 to the other greenhouse
gases, more so-called "low hanging fruit" become available.
Clearly, wide coverage has the potential to deliver greater or
cheaper emissions reductions and encourages parties to trade.
Transparency and verification
29. The acquisition of accurate emissions
data within the EU15 is challenging at both national and installation
levels. Data quality presents even greater problems in new Member
States and outside the EU. Despite the entry into force of the
Aarhus Convention, a culture of secrecy still pervades much environmental
data compilation. Business maintains a monopoly on data in many
countries and insists that emissions information is commercially
confidential, preventing governments from publishing it or at
least disaggregating it. This precludes transparent debate in
the implementation of emissions trading and ultimately undermines
market transparency. Such is the absence of data in Japan that
the government is designing a mandatory emissions reporting system
for industry before it can even prepare new climate policies,
including an emissions trading scheme.
30. There are problems inherent in determining
both hypothetical and actual emissions so efforts to improve data
quality are essential. All stakeholders must be able to rely on
published data in order to make reasonable judgements about the
market. Moreover, transparency enables actors and observers in
emissions trading to become enforcers as competing interests seek
to level the playing field.
Enforcement and institutions
31. Success relies upon the existence of
penalties for non-compliance and the capacity of institutions
to enforce them. Although the cost-effectiveness of emissions
trading limits likely political pressure on the compliance system,
penalties must still be set at a level which provides a robust
incentive for compliance. This objective has been achieved under
the EU ETS, where penalties are punitive[2]
and will be enforced by Member State governments. However, while
international law is binding on countries, it cannot be enforced
in the same way as national law. Ultimately, any country can drop
out of the Kyoto system at any time, as is true of any international
treaty. A major factor is political will, which is a determined
by diplomatic and public pressure as well as the existence of
incentives, such as access to knowledge and the flexibility mechanisms,
which encourage countries to stay in the system. This means that
the success of the compliance system is ultimately dependent upon
governments wishing to remain within the system and therefore
accepting as legally binding the consequences for non-compliance?
32. The Kyoto compliance system, designed
in Bonn and part of the Marrakech Accords, has yet to be adopted
even though key parameters have been agreed. The Protocol states
that it must be amended in order for consequences for non-compliance
to become legally binding. Resolution of this aspect of the institutional
framework is expected at the First Meeting of Parties to the Protocol
in 2005. The main features are eligibility requirements for participation
in the flexibility mechanisms and "legally binding consequences",
including a penalty of 1.3 tonnes in the next Commitment Period
for every tonne by which a target is missed in the current period.
33. The only compliance institutions that
have been established to date are the national registries under
the EU ETS, the international transaction log for government-level
trading under Kyoto and the CDM Executive Board. However, mature
markets need mature institutions. A Central Bank-type function
might be needed in order to underpin the market, preventing price
collapses through interventions as seen in currency markets. Such
an institution might also manage major liquidity events such as
auctions, new entrants and changes under Phase two.
Capacity building
34. Capacity building presents a challenge
under any international regime, but it is particularly important
in a context of international emissions trading where institutional
failure in one part of the system can affect the entire market.
Richer nations will have to increase significantly their financial
commitments in this area if any progress is to be made towards
a truly integrated international regime.
35. Institutional development can only proceed
in a step-by-step way as experience and confidence develop. Expecting
developing countries to adopt the most complex environmental instrument
in the first instance is too ambitious. Clearly, some countries
could develop capacity more quickly, particularly the newly or
rapidly industrialising nations. However, emission trading requires
not only policy and enforcement, but also competitive markets
and other conditions that cannot be created by international environmental
treaties alone. Installation-level trading is a challenge in an
EU context, let alone outside.
36. A major barrier to effective operation
of the market is the EU principle of subsidiarity. Success of
the EU ETS requires the harmonisation of financial regulation,
registries, VAT, credit risk management and the need for a common
delivery-versus-payment mechanism. The EU must overcome the fragmentation
of trading infrastructure by pan-European agreement on a range
of issues. This is a massive undertaking between countries of
a similar stage in institutional development but it will be infinitely
more challenging in a global context.
Different government-level trading-based approaches
37. Unless and until emissions trading is
brought into disrepute, any future international climate regime
will include it. However, regime design will affect the functioning
of the emissions trading market. Different frameworks for the
post-2012 regime essentially generate different government-level
emissions trading markets:
40 for each tonne of CO2e emitted by that installation
for which the operator has not surrendered allowances, rising
to
100 during Phase two. Payment of the excess emissions
penalty shall not release the operator from the obligation to
surrender an amount of allowances equal to those excess emissions
when surrendering allowances in relation to the following calendar
year.
(a) The extension of Kyoto, ie deepening
reductions within Annex 1 countries and widening its coverage
to include new countries, will require no new institutional development
at international level. However, very few countries that currently
do not have absolute caps are likely to take them on and those
that do will have to increase their policy, monitoring and enforcement
capacity considerably. This approach provides certainty regarding
environmental outcomes but limits the number of new participants.
(b) If, under a so-called "multi-stage
approach", new participants adopt targets of a different
nature to the absolute caps adopted by Annex 1 countries, then
international emissions trading will present new challenges. New
targets are likely to be relative targets, ie intensity or input
based or using baseline-and-credit systems; the inclusion of these
types of targets in the regime removes certainty in outcome and
increases market volatility, but it also increases opportunities
for participation by more reticent countries. Clearly, however,
participation in international emissions trading requires the
adoption of binding targets, whether relative or absolute. Variations
of the "multi-stage approach" are currently the most
widely endorsed at expert level, largely for reasons of political
acceptability.
(c) The key feature of a "Contraction
and Convergence" approach (C&C) is the concept that national
emissions entitlements are determined on a per capita basis, providing
some governments with a surplus entitlement akin to the "hot
air" available from economies in transition. Setting aside
the argument that, based on historic and current contributions
to global emissions, developing countries have a greater moral
claim to this hot air than Russia does, Russia's behaviour during
Kyoto's first Commitment Period should provide some useful lessons
about the effectiveness and capacity needs for this type of market.
C&C is similar to the extended Kyoto approach in that it provides
certainty in outcome. While it also provides the opportunity for
greater participation by some developing countries, it is not
politically attractive to higher per capita emitters amongst Annex
1 and non-Annex 1 countries. In order for the approach to work,
however, a much greater number of countries would have to improve
their institutional and emissions monitoring capacity than under
the first two approaches.
DIFFERENT INSTALLATION-LEVEL
TRADING-BASED
APPROACHES
38. CCC believes that until 2012, international
installation-level trading is most likely to grow organically,
ie from the bottom up with gradual linking across borders as domestic
trading schemes are introduced by Annex 1 countries. However,
international installation-level trading will most likely need
to be designed into the post-2012 regime: while a fully worked-up
framework may not be a realistic objective at this time, any regime
encompassing cross-border business trades will require appropriate
international institutions. International verification and capacity
building are preconditions for linking that is environmentally
and economically sound.
39. The Marrakech Accords, agreed in 2001
at the 7th Conference of the Parties to the UN Framework Convention
on Climate Change (UNFCCC), include rules for international trading
under Kyoto. Corporate or installation-level trading across borders
must be backed with the transfer of Assigned Amount Units (AAUs,
or government-level emissions allocations) to ensure that the
overall Kyoto budget is not breached.
40. It would be unwise for the EU to link
with emerging US state-level schemes (even if the legal hurdles
can be overcome) unless these schemes require reductions against
BAU comparable to those occurring in Kyoto Parties. If current
proposals for the introduction of unilateral CDM projects come
to fruition, nothing will prevent US states from recognising credits
from these projects and buying them on the open market in order
to lower implementation costs. Ultimately, similar provisions
may also apply to Joint Implementation. Gradual convergence of
US climate policy with international climate policy is desirable
but granting US participants access to the carbon market without
them having to comply with the rigours of Kyoto will undermine
the leadership efforts of others and do nothing to address the
competitiveness concerns of industries operating within the Kyoto
budget who are likely to face tougher emissions limits.
41. If new types of targets are adopted
by developing countries in the next phase of the international
climate regime then new rules will have to be identified for cross-border
trading. While international linking is desirable to improve the
cost-effectiveness of emissions reductions, it must not undermine
the integrity of emission reductions by countries with absolute
caps. Establishing a common basis now for the development of linking
rules could encourage early action by developing countries and
discourage them from linking with weaker systems originating outside
Kyoto.
BUILDING A
CREDIBLE POSITION
FOR 2005
42. The EU climate effort is the engine
room for Kyoto and has kept the treaty afloat in order for it
to enter into force. Russian ratification is a major achievement
of European diplomacy. However, a credibility gap has emerged
between the rhetoric of EU leadership and domestic action—a
gap that is starkly evidenced by the inconsistency of National
Allocation Plans under the EU ETS with Member States' Kyoto targets.
43. This credibility gap is also true for
the UK, which needs to work hard to maintain the progressive voice
of Europe in the world. The UK must ensure that the EU enters
the post-2012 climate negotiations with a credible position; this
means that the overall cap for the second phase of the EU ETS
must be consistent with Kyoto and the EU needs to present an ambitious
commitment to further action post-2012.
44. The UK must avoid the lure of insubstantial
US-centric initiatives arising from its G8 presidency. The Bush
administration is not representative of the level of concern and
action occurring within the US, particularly at state level. Moreover,
high oil prices provide a real opportunity to discuss and deploy
global decarbonisation strategies through EU-led partnerships
with Japan, Canada, China, India, Brazil, Mexico and others.
COMPLEMENTARY MEASURES
45. Too great a focus on trading will not
deliver an international agreement. Concessional finance from
government sources, whether provided through soft loans or other
mechanisms that present a lower cost of capital than commercial
sources, should be scaled up—after all, a stable climate
is a public good that needs public investment. Additional instruments
such as better export credits for renewables will accelerate international
decarbonisation. Technology initiatives must focus on the commercialisation
of near-term technologies.
46. Adaptation needs have to be addressed
for those climate change impacts that are already inevitable.
47. Finally, internationally scaled-up efforts
on public education and engagement are essential in order to provide
the political basis for action and encourage consumers to change
their behaviour.
DEPARTMENTAL CONTRIBUTIONS
48. DEFRA must work with DTI to improve
the integrity of the UK's domestic position. At times, this will
require stronger leadership from the Prime Minister. Recent adjustments
to the NAP have undermined the UK's credibility, despite protestations
that the cap has been tightened. A fundamental problem exists
with adherence to BAU projections; the political case must be
made for absolute reductions and execution advanced on this basis.
49. The Treasury should become more proactive:
emissions trading will drive wealth creation and enterprise in
high technology and the financial and professional services that
are central to the enduring growth of the UK economy. At the same
time, the Treasury must strive to secure a better understanding
of the impacts of the shift in value created by carbon pricing
in order to adopt an objective and dispassionate perspective that
prevents the exertion of undue influence by narrow, vested interests.
Treasury is also in a powerful position to drive the institutional
development of the market both domestically and internationally.
CONCLUDING REMARKS
50. CCC welcomes the opportunity to make
this submission to the EAC. We would be pleased to address any
queries or comments arising either directly or through the submission
of oral evidence.
17 November 2004
1 http://europa.eu.int/comm/enterprise/environment/reports-studies/reports/study1.pdf Back
2
The Emissions Trading Directive (Directive 2003/87/EC) dictates
that any operator who does not surrender sufficient allowances
by 30 April of each year to cover its emissions during the preceding
year shall be held liable for the payment of an excess emissions
penalty. During Phase 1 of the EUETS the excess emissions penalty
shall be Back
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