Examination of Witnesses (Questions 359-379)
PAUL DAWSON,
LOUIS REDSHAW
AND CHARLES
DONOVAN
12 JANUARY 2005
Q359 Chairman: Good afternoon all of
you. Thank you very much indeed for coming in and also for your
excellent memoranda, which we have read with great interest. Can
I start by asking Mr Donovan, as well as obviously being involved
in Enviros I note that you are also involved in the London Climate
Change Services Providers Group. Can you tell us about the work
of that group, briefly?
Mr Donovan: The London Climate
Change Services Providers Group is a group of companies who have
as their primary focus services related to climate change. That
group of companies was, on the whole, starting to feel under represented
by the business voice that was available to them through the other
associations of which they may have been a part. These are companies
that are part of the building blocks for a low carbon economy
and for that reason have perhaps a different set of views with
regard to climate change policy and for that reason they wanted
to develop a business voice that would reflect their business
interests. So this comprises a group that includes banks, it includes
brokers, it includes engineering firms, it includes academic institutions
in the UK, and it includes consultancies and law firms.
Q360 Chairman: How often do you meet?
Mr Donovan: There is an executive
committee that has been formed, of which I am the chairman, that
has been meeting, I would say, on a monthly basis to date, and
there are open meetings that are being held quarterly. I should
emphasise that this is a new group and a lot of work is ongoing
to set up the structure under which it will exist.
Q361 Chairman: We look forward to hearing
of progress from that group. We want to do this afternoon is to
look at the EU Emissions Trading Scheme, the immediate issues;
then Phase 2 issues and then post 2012, if we can handle it in
that way. It is difficult not to observe that the whole thing
seems to have got off to a pretty lousy start. Do you have any
comments to make on the Press reports? There was a piece in the
Guardian a couple of days ago saying that the UK may even
be going to sue the European Commission over the disagreements
over the National Allocation Plan.
Mr Redshaw: I think it probably
got off to quite a good start in terms of the trading, which is
the focus of the scheme. Trading has been going on for over a
year now, and in some more reasonable volumes it has been trading
quite well since April law year; and in fact last Friday was a
record day, half a million tonnes traded, only to be superseded
by Monday of this week with one million tonnes traded, and we
had 300,000 tonnes yesterday and probably another half a million
tonnes traded again today. So on the trading side of things, which
is where we come in, it has got off to a pretty good start.
Q362 Chairman: So you do not think that
a possible legal dispute between the UK and the EU over the refusal
by the Commission to accept the EU's National Allocation Plans
is a problem?
Mr Dawson: I think any form of
uncertainty like that is a problem for a market that relies on
setting a target and then using trading as the most efficient
means of meeting that target. So I would not dismiss it as a problem,
but I think that Louis is right to emphasise that the scheme has
actually got going and is meeting to that requirement to reduce
emissions at least cost, well before the official start date of
1 January.
Q363 Chairman: Presumably this involves
an exchange of contracts, each party?
Mr Dawson: Yes.
Q364 Chairman: Those are legally enforceable,
are they?
Mr Redshaw: Yes.
Q365 Chairman: Even though there is not
an overarching legal context yet put in place by the EU?
Mr Redshaw: Yes. I think companies
got comfortable with the Emissions Trading Scheme when the directive
was passed into law. Some companies have actually traded emissions—I
think the first one was July 2003, although it traded rather sporadically
between then and April 2004. The pick-up in trading came as companies
got a realisation of what their shortfall and, in some cases,
excess emissions' position was going to look like, and as the
countries have passed the directive into law companies have got—including
ours—comfortable that the Emissions Trading Scheme would
actually start. We still have allowances trading today but they
are actually trading for delivery in December 2005 because allowances
still do not exist. So all the time it has been trading it has
been with the expectation that the law had been passed and the
allowances would actually be allocated and dished out. If the
scheme went away altogether then the contracts would have no validity,
but as long as the scheme exists and allowances exist then anyone
who is committed to buy and sell those must deliver.
Mr Dawson: I think that is an
important distinction, that the scheme is actually passed into
law and what the report on Monday reflected is to some extent
the end game, arguing about how many allowances to allocate and
to whom they should be allocated, but the obligation to surrender
allowances and the monitoring of verification is already effective.
Q366 Chairman: As far as you are aware,
is the UK the only country with a significant problem with the
Allocation Plan?
Mr Redshaw: There are delays to
the Greek, Polish, Czech Republic and—
Q367 Chairman: Germany?
Mr Redshaw: No, Germany has got
it sorted. Italian of course. Greece only put their Allocation
Plan in in December of last year and that was actually due in
on 31 March of last year.
Q368 Chairman: What price is carbon trading
at or are these agreements trading at?
Mr Redshaw: When I left the office
we had just traded at 6 Euros 95 cents.
Q369 Chairman: Is that high or low relative
to previous trades?
Mr Redshaw: It is actually relatively
low. The high over the last year and a half's worth of trading
has been 13 Euros, although those were trades on the back of pretty
much no information. A lot of the early trades were testing systems
and to prove that it could be done contractually. Then it settled
in the range seven to nine Euros in the last nine months and it
actually reached a low of 6 Euros 30 cents this week and bounced
back up as people realised it had been oversold.
Q370 Mr Challen: Can I ask if the volume
is increasing?
Mr Redshaw: It is, yes, it is
exponentially increasing.
Q371 Mr Challen: What sort of volume
are we talking about now?
Mr Redshaw: We probably traded
between 10 and 11 million tonnes over all, across all trading
through the brokered market. I only have access as a trading organisation
to reported trades that come through brokers. There are obviously
bilateral deals going on in the background also. But the amount
of volume of trades per day, we would have been lucky to get half
a million in a month over the summer last year and now we are
getting half a million in a day, and to have a million tonnes,
as I have mentioned, is unprecedented. That volume is starting
to pick up now that it is a real scheme.
Q372 Chairman: Can I turn to you, Mr
Donovan, again? In your August 2004 brief, which you kindly sent
through, I think you said that on the basis of the draft National
Allocation Plans, as they then stood, that emissions could in
fact increase between five and 11% over the next three years.
Obviously there has been some jiggery-pokery over the actual level
of the Allocation Plans since then. What is your estimate of the
likely possible increase now?
Mr Donovan: The trend for emissions
in the EU is absolutely on the upward. In the EU ETS, as it currently
stands, even with the revised National Allocation Plans, it will
do very little to dent that. We do expect there to be demand for
allowances in the first phase of the EU ETS but we do not expect
it to significantly reverse the trend upwards in emissions in
the EU 25. So while those numbers would need to be revised in
order to reflect the most recent version of the NAPs I am comfortable
still with the general indication that, yes, over the three years
of the first phase emissions in Europe will be increased.
Q373 Chairman: Which begs the question
of whether there is any point in the whole scheme?
Mr Donovan: You have to remember
that the point of the scheme is to cap emissions at some level
and if emissions are growing fast to have them grow less fast
is indeed a constraint. So placing any amount of burden on industry
or any of the sectors included in the EU ETS is a first step.
However, it is very true that there must be a scarcity for this
market to work, and for real change to occur that scarcity must
grow over time and we are not yet at the point where we will see
significant scarcity, in my opinion, where real substantial investments
in emissions reductions will occur.
Mr Redshaw: I think it is worth
pointing out that presumably Charlie's forecast of emissions across
the EU, including aviation, transport, et cetera, but not covered
by the EU ETS, clearly the emissions from those sectors cannot
increase because there is a capped amount of allowances—basically
people cannot pollute without those allowances.
Mr Donovan: I will respond to
that by saying actually that does include the trading sector.
The cap refers to capping their emissions at some point. The allocation
methodology that has been employed by most Member States is looking
at what are emissions in the business-as-usual case and then let
us look at how we would change emissions based on that business-as-usual.
So if we are constraining from business-as-usual, which is for
high rate of growth, we can still constrain those companies but
still see growth. So actually putting the cap does not mean capping
them at zero, it means capping them at some level and the level
is of course the critical question that has to be resolved by
each Member State.
Q374 Chairman: Is it not the case that
even more critical is the Phase 2 cap and the agreements that
are going to be reached about that, because part of the point
of Phase 1 is seeing whether it works at all, and I think we probably
have the beginnings to establish that it physically can be made
to work. Given that the setting of the first phase NAPs was hugely
contentious and subject to some pretty lengthy horse-trading between
Member States and within industries within Member States, do you
think that Phase 2 is going to be equally contentious or more
difficult?
Mr Redshaw: I would hazard a guess
that Phase 2 would be simpler because everybody knows what the
actual reduction targets of their country must be, and people
have a better idea of what allocations they are going to be able
to make to the covered sectors. Our view is that the covered sectors
in the trading scheme should be expanded to all sectors. In our
view there is no one obstacle that cannot be overcome in order
to include supply to domestic consumers of gas and emissions of
the transport sector.
Q375 Chairman: We are coming on to investigate
that more a little later.
Mr Redshaw: It should be more
straightforward because everybody knows what they need to do.
The difference with Phase 1 was that we had a bunch of countries
that did not want to constrain their industry relative to their
neighbouring country and every country was incentivised to be
as generous as possible. Under Phase 2 we have the Kyoto target
to meet and therefore the amount of room you have for manoeuvre
is limited.
Q376 Mr Challen: This question is for
Mr Donovan. There is a part of your report I did not quite understand
and it is about the issue of windfall profits for power generators.
You say that the problem is that the total revenues that that
will be gained by power generators by passing carbon costs to
consumers will far exceed the total cost from carbon trading and
this is a direct result of the European decision that most carbon
allowances should be given away for free. I just want you to expand
on that, to somebody who puts all his savings into building society
accounts.
Mr Donovan: If you will allow
me a moment let me explain a bit of the background for the scheme
so that I can answer what you are asking directly so that it makes
sense because there have been a lot of instances where people
have tried to answer or direct some amount of analysis towards
this question without really considering the scheme as a whole.
So if you will let me explain that? The EU ETS is what is known
as an upstream trading scheme. For many years, particularly in
the United States, there have been both practical experience as
well as academic research on the use of these schemes. The EU
ETS will take regulation at the point of fuel combustion. Where
the EU ETS is quite different from anything that we have done
before is in its coverage. We are including two parts of the energy
value chain, if you will. That is those people who are combusting
fuel to make electricity as well as those people who are using
electricity, and that is going to lead to some potential impacts
that may not have been totally envisioned. So the question about
profitability, we need to think about it in the terms of both
the marginal costs that power generators will face in terms of
producing their electricity and also the average costs that they
will face by complying with the scheme. When you have a scheme
where allowances are given away for free—and that is this
allocation method known as "grandfathering"—the
difference between the marginal cost and the average cost is quite
considerable because the average cost is based on what they paid
for the allowances—in this case very little—and the
marginal cost is the decision that they have to make each time
they produce an additional unit of electricity. So it is this
feature of the EU ETS as a type of Emissions Trading Scheme which
is giving rise to this disparity. I think it is quite a basic
relationship that has been noted by a number of organisations,
that the increase in revenues associated with marginal costs being
passed through the power sector will be in excess of the average
cost they will face in complying with the scheme.
Q377 Mr Challen: I shall have to study
the transcript on this one! Do I take it then that this is going
to be a permanent feature of the scheme? It is not just a start-up
situation, an initial windfall, but it is a permanent built-in
feature of the scheme because the allocation is free?
Mr Donovan: If grandfathering
were to continue—and the directive does say that in Phase
2 no more than 10% of allowances could be distributed by some
other means than grandfathering—then, yes, you would have
a situation that in a liberalised electricity market, such as
the UK, one would expect to see marginal cost pricing lead to
higher revenues for power generators; yes, indeed.
Q378 Mr Challen: The power generators
in the UK appear to face tougher targets under the National Allocation
Plan. How does this square with that perception? They are going
to make more money out of something which appears to be tougher.
The public are not going to warm to the idea of a trading scheme
in carbon if that appears to be the case.
Mr Dawson: I think the scheme
was drawn up and the free allocations were designed primarily
to mitigate the impact of introducing Emissions Trading on some
of the other industrial sectors, to the extent that if a company
in the EU faces international competition they may not be able
to pass on the cost of buying in carbon to meet their emissions,
and the allocations were designed to mitigate that impact on the
competitiveness. I think the fact that power generators also receive
those allowances and, as Charles has articulated, have the ability
to pass that cost on in the price of electricity means that the
general nature of the scheme may be more or less applicable to
particular sectors, and whilst there may be a windfall for power
generators that feature of the scheme is a very useful one for
other industrial sectors.
Mr Donovan: It might be worth
noting that there are some people who have asserted that there
could be a windfall for all industries who are within the EU ETS.
That is, that if each industry behaved the same way as power generators
they would be in the exact same situation. But I will tell you
quite honestly that my conversations with managers across a number
of the industries that are included in the EU ETS, very few of
them outside of the power sector are looking at it in that same
way; they simply do not operate in both closed—and by "closed"
I mean in the absence of international competition—and also
competitive markets; they simply do not have the same type of
market structure. Many of them are also looking at environmental
compliance for the EU ETS in the same way that they would for
other types of environmental issues; so, "Tell me what it
is going to cost. We will pay that and we will get on with doing
business." While this feature is not unique to power generators
in terms of the way that the scheme is set up, it may be that
due to the market structure and the actual type of competition
within these other industries that the power generators are one
of the few that actually end up behaving in this "economically
rational way".
Q379 Joan Walley: Mr Donovan, I am following
very closely what you are saying and I realise that we are talking
about something which is very new and which does not have a common
currency in terms of widespread understanding of this issue outside
the industries that are most acutely affected. I am wondering
whether or not in your first response to Mr Challen's last question
you could perhaps summarise it in terms of a bottom line position
about the windfall, and if I could ask you to explain that in
such a way that, for example, if you were on my local radio station
my constituents could actually understand what the real issues
are. They are complicated issues and it is almost a new language
that is needed to discuss all of this and I would hate to go from
here thinking that I had quite grasped the kernel of what it is
you are saying and what the implications are. You clearly live
with this all the time, we do not; so I would be very grateful
if you could just do that, please.
Mr Donovan: I will attempt to
do that as compact as I can, and let me also ask my colleagues
here if there is another way that they would rephrase that. Profitability
in the power sector is dependent upon the difference between the
cost and revenue. When revenue exceeds cost there will be profitability.
It is impossible to say what the profits of the power sector would
be in the absence of the EU ETS, just as it is impossible to say
what they will be with it. But it is very clear that there will
be additional revenues that will be earned if power generators
obey what we expect in a very free UK electricity market.
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