Memorandum submitted by the Environment
Agency
SUMMARY
The EU ETS forms a central plank of UK climate
change policy—it is expected to deliver reductions of 8MtC
from electricity generators and major industrial processes by
2012. It is important that the scheme is strengthened for the
future so that it delivers real emission reductions at least economic
cost.
Key issues for the future development of the
scheme are:
— Simplification and harmonisation,
particularly of the way that allowances are distributed, so that
there are clear and strong incentives to invest in low carbon
technology, and to prevent distortions to the EU internal market.
— Consideration of whether more sectors
should be included in order to maximise opportunities for significant,
cost-effective carbon savings.
— Reducing the administrative burdens
of the scheme particularly for smaller emitters and the exclusion
for the smallest emitters where coverage by the scheme is disproportionate.
— The need for a long-term price signal
and tighter caps in line in line with long-term EU and domestic
emission reduction targets.
1. INTRODUCTION
The EU ETS is the UK's most significant climate
change measure and the Government used the recent Green Paper
setting out the first outputs of the Energy Review (July 2006)
to reaffirm its commitment to the scheme beyond 2012. The European
Commission is currently reviewing the EU ETS Directive, the outcomes
of which will shape the third phase of the scheme starting in
2013.
The Environment Agency is the Competent Authority
for the EU ETS in England and Wales. We also manage the Emissions
Trading Registry and the new entrant reserve (NER) on behalf of
the other UK regulators (SEPA, DoENI and DTI offshore). We were
also responsible for production of installation-level allocations
in the Phase II National Allocation Plan (NAP). We have focused
our response on those questions that are most relevant to our
experience and expertise.
2. RESPONSES
TO QUESTIONS
2.1 What are the key lessons to learn from
Phase I of the Scheme?
Implementation
Phase I was designed to be a learning period
and 2005 was the first year of operation. Yet we have already
demonstrated in the UK that the mechanics of the scheme are sound.
The majority of UK operators (99.6%) submitted their verified
emissions reports and surrendered the correct allowances within
the deadlines or shortly thereafter.
Monitoring and reporting of CO2 emissions
by the operators has improved considerably compared to that enforced
under previous regimes so that we now have far more accurate information
about actual CO2 emissions from UK installations. Better
quality emissions data will feed into other statistics such as
the UK's Greenhouse Gas Emissions Inventory and will inform future
policy making.
Small emitters and transaction costs
For small emitters the costs of compliance are
disproportionate relative to their level of emissions (or potential
savings). Administration costs for small emitters are in the range
1-2 £s per tonne CO2 emitted versus less than
1 pence per tonne for the largest emitters. Installations that
emit less than 10kt of CO2 per year, constituting 45%
of all installations, account for less than 1% of emissions. The
smallest emitters, many of whom are in the public sector, have
limited ability to pass through costs the costs incurred. [1]
Achieving real reductions in emissions
The EU ETS is designed to deliver real emission
reductions by providing a fiscal incentive for "fuel switching"
and/or investment in low-carbon technology. Therefore any assessment
of the success of the scheme should consider indicators of its
environmental impact, eg emission reductions compared to business
as usual, changes in fuel mix and the emergence of low-carbon
technologies. With the scheme only operational for a year it is
too early to see direct environmental results, but the currently
low allowance price is unlikely to be sufficient to drive long-term
changes in behaviour.
During the first year of the scheme, most Member
States emitted less than their 2005 allocations. UK installations
in the EU ETS emitted 27Mt (million tonnes) more CO2
than the number of allowances issued to them—one of only
five Member States in this situation. This suggests that most
Member States have allocated allowances to industry above business
as usual and provided them with a financial windfall. This excess
of allowances in the market has devalued the allowance price.
For Phase II, our indication, based on the published draft National
Allocation Plans (NAPs), is that the same situation could be repeated.
The European Commission has a vital role to play in scrutinising
and approving the Phase II NAPs so that the caps lead to real
scarcity of allowances. In this way, the allowance price will
come to reflect more closely marginal abatement costs and thus
provide a long term incentive to investors in emission reduction
technologies.
Harmonisation of implementation
Compliance data for 2005 was released early
by some Member States. This distorted and destabilised the allowance
price as the market reacted to the early publication of data.
The Environment Agency is leading an IMPEL funded project to harmonise
implementation of the scheme across the EU since the integrity
of the scheme relies upon consistent implementation and enforcement
of penalties across all 25 member states. The European Commission
has a crucial role to play in ensuring that this occurs.
2.2 How likely is it that UK firms would successfully
reduce emissions by at least 7MtC by 2012, in line with the proposed
Phase II NAP?
The overall "short" position in the
UK in 2005 was mainly due to the Large Electricity Producers which
were allocated fewer allowances than their business-as-usual projected
emissions in Phase 1. High gas prices and a steady coal price
led to increased coal use. The low relative carbon price (cf gas
price) did nothing to reverse this trend. Consequently CO2
emissions from coal-fired power stations were typically above
expectation.
In Phase II the cut has again been borne by
the Large Electricity Producers, which will be allocated based
on a benchmark, whereas the rest of the industry sectors are allocated
on "Business As Usual" projections.
The EU ETS is a market mechanism. In a perfect
carbon market we would see reductions providing the cost of abatement
is less than the allowance price. The allowance price depends
on many factors including allocations in the rest of Europe and
the extent to which Clean Development Mechanism (CDM) and Joint
Initiative (JI) credits are used.
The current Phase II CO2 allowances
prices on the carbon markets do not suggest any incentive to reduce
UK emissions. These prices are critically dependent upon the actions
the European Commission take during the scrutiny of member States
Phase II NAPs. However the global nature of climate change means
that environmentally it does not matter where emission reductions
are made.
2.3 What have been the effects of the method
chosen for allocating allowances in Phase I?
In Phase I, allowances were allocated to incumbent
UK installations using a "grandfathering" methodology
ie based on their historical emissions and sectoral projections.
This approach rewards inefficient practice and provides incentive
to industry to provide inflated growth projections in order to
secure extra allowances.
We therefore support the move away from allocations
based on sector projections towards sector benchmarking which
rewards best practice within sectors. We see this as a stepping
stone to full auctioning of allowances.
The LETS Update[2]
project, which was led by the Environment Agency and involved
other EU Competent Authorities, concluded that in Phase I, the
preparation of NAPs by Member States and their scrutiny by the
European Commission lacked transparency. This is particularly
true for the use of growth rates in setting the overall, sectoral
and installation level allocations. As we have seen, this has
left the potential for the use of inflated growth rates, which
is likely to be the single most important factor affecting the
environmental integrity of the scheme and the level of competitive
distortions between Member States. The study presents a template
for Member States to use in the preparation of their NAPs, which
facilitate greater transparency.
2.4 Has the Government identified the correct
proportion of allowances to be auctioned in Phase II? Should these
be drawn solely from the power sector's allocation? What will
be the effect of this auctioning on industry and the price of
carbon?
Auctioning adheres to the polluter pays principle
and is part of establishing an efficient market. The Environment
Agency believes that 100% auctioning should be a long term objective
for the scheme. In Phase II Member States are allowed to auction
a maximum of 10% of the allowances they will issue. In the UK,
auctioning for Phase II has been set at 7%, which is a step in
the right direction. The allowances to be auctioned will be taken
from the Large Electricity Producers' allocation. This sector
is relatively insulated from international competition and can
pass on the cost of carbon to consumers.
Allowance price is not dependent upon the UK
NAP alone but on the interaction of all Member State NAPs. Auctioning
allowances as opposed to the current system of allocating free
allowances adds a cost to industry. Analysis[3]
has shown that the volume of allowances that would need to be
auctioned in order for industry to be worse off in terms of profitability
after the introduction of the EU ETS is significantly greater
than the 10% limit achievable under Phase II. The Oxera report
indicates auctioning of 50-70% of up to allowances can be achieved
in some industry sectors without adversely affecting profitability.
This result depends on the characteristics of the industry itself
and the underlying carbon price assumed in the model. Beyond this
there are options for recycling auction revenues to reduce any
competitiveness effects.
2.5 What have been the effects of Phase I
so far on the competitiveness of (1) business in the UK, and (2)
business across the EU?
No comment.
2.6 What are the key issues for Phase II in
terms of ensuring that emissions reductions from EU states are
not cancelled out by the transferring of industry to developing
economies?
Managing competitiveness is an important aspect
of designing an effective emissions trading scheme. The objective
is to impose tough, but achievable emission limits on industry
sectors that will not damage the EU economy as a whole. We would
like to see all sectors given less free allowances than projected
business as usual emissions, but differentiate the cut back according
to sector exposure.
A number of issues need to be considered in
determining the level of a sector's exposure, particularly the
potential for passing compliance costs or the consequential rises
in electricity prices through to consumers. Sectors that are highly
exposed to international competition will be less able to pass
on these costs, which has implications for their bottom line.
However, there needs to be careful analysis of where the cost
threshold for different sectors lies. The demand for local production
of materials; the costs of long-haul transport; institutional
inertia; labour costs and the sensitivity of the sector to energy
costs are all factors in determining at what point a sector will
be forced to move beyond the EU borders to escape the costs imposed
by the EU ETS. Detailed sectoral-level economic analysis is needed
to understand these factors to inform the cap setting process.
[4]It
should be noted that the cost of carbon allowances makes up a
relatively small proportion of the fuel price.
In Phase II of the scheme most countries have
allowed operators to use allowances from the Kyoto project mechanisms
to comply with their commitments under the EU ETS. The UK has
set a limit on the use of project allowances of 8%. The project
market is dominated by private investors and is, in part, being
driven by demand for cheaper abatement options than those available
within the EU. In this way the project mechanisms can act as a
pressure valve for industry concerned about high compliance costs
during the Phase II of the scheme.
2.7 How well are the EU ETS and the Clean
Development Mechanism, working together? What needs to be done
to better integrate these markets? Is the CDM funding the right
projects?
In 2005 there were 397Mt of carbon dioxide equivalent
reductions generated by the CDM. More than 70% of this figure
came from a few large HFC-23 reduction projects in China. [5]Currently,
the EU ETS is providing some demand for these CDM allowances and
this demand is likely to increase if there is a scarcity of allowances
in Phase II of scheme.
The Environment Agency wants to see greater
clarity over the UK and EU objectives for the EU ETS. In the Government's
recent Green Paper, The Energy Challenge, it reaffirmed
its commitment to using the EU ETS to provide UK industry with
a long term price signal to drive domestic investment in low carbon
technology. At the same time, we are likely to see greater integration
of global markets to improve their efficiency and bring down costs.
It is difficult to see that both are possible without careful
analysis of the supply of CDM credits relative to the EU cap.
A scheme that allows unrestricted access to the CDM market will
drive down allowance prices making it more attractive to buy allowances
rather than achieve domestic emission reductions.
2.8 How should aviation be included within
the EU ETS? What are the latest indications of when it will be
included?The Environment Agency favours using the EU ETS to
tackle emissions from aviation. However the inclusion of the aviation
sector does pose some specific challenges. Our current understanding
is that a separate, but linked scheme, would allow the sector
to benefit from the efficiencies of a wider market yet keep distinct
allowances that would be non-Kyoto compliant. We want to see the
commercial carriers purchasing allowances via auction to prevent
windfall profits at the expense of customers. This may also help
to prevent distortions in the market.
The global warming impact of aviation is three
times greater than that of the equivalent amount of ground level
emissions of CO2 therefore the wider climate change
impacts of aviation must also be considered (RCEP, 2002). We want
Government to consider the introduction of flanking mechanisms
like emissions charges and fuel taxation to mitigate non-CO2
climate impacts, rather than trying to deal with them within the
EU emissions trading scheme.
2.9 The Environment Secretary has said "we
will support the Commission in its efforts to enforce tough caps".
What exactly should the Government be doing to influence this?The
Environment Agency considers that achieving a tough EU-level cap
is the most important element in achieving its environmental benefits.
Currently, it is difficult for Member States to be ambitious when
the Directive allows for significant flexibility in implementation,
for example on auctioning and new entrant rules, and the lack
of penalties for Member States that over-allocate. The current
system encourages Member States to allocate in line with concerns
over their own competitiveness rather than truly focusing on areas
where abatement could be achieved. We want to see the scheme moving
as quickly as possible to 100% auctioning and a single EU cap.
It is important that the UK Government shows
leadership in cap setting and implementation to demonstrate that
it does not have to adversely affect the national economy. It
should also lobby the Commission to carry out a detailed and thorough
review of all 25 Member State NAPs and, where necessary, support
their calls for Member States to strengthen their caps. Further,
the UK can play an essential role in pushing forwards work to
increased harmonisation in allocation methodology eg through the
development of EU-harmonised benchmarks, and rules on new entrants
and closures.
2.10 How well integrated are the ETS and other
EU climate change policies?
The EU ETS is just one of a number of greenhouse
gas emissions-related policies and measures at the EU level. It
is fundamentally different from the majority of other policies
that had been introduced previously in that it is a market based.
Historically emissions reduction policies have been in the form
of, for example, regulatory emissions limits, standards, tax incentives,
subsidies or voluntary agreements. These generally allowed little
or no flexibility in compliance.
The LETS Update Project[6]
identified the policies that currently have the highest degree
of interaction and overlap with the EU ETS are the:
— Integrated Pollution Prevention
and Control (IPPC) Directive.
— Renewable Electricity (RES-E)
Directive.
— Combined Heat and Power (CHP)
Directive.
— Energy Performance of Buildings
Directive (EPBD).
Waste treatment legislation and carbon capture
and storage are relevant policies to consider in the future.
When any emissions policy is developed or revised,
its interaction with the EU ETS should be considered and the areas
where each policy takes priority must be clearly delineated. Critical
areas of overlap should be considered comprehensively from the
early stages of policy development. A structured approach should
be used in this to ensure that interactions are properly considered
at all points.
A decision needs to be made at the Commission
level, in consultation with Member States, on how to balance different
policy approaches in the case of interactions. This involves making
decisions about the fundamental approach they wish to take in
terms of emissions policy and the signals being sent out by the
whole policy mix. For example, where IPPC requires standards to
be met within a Member State versus the flexibility to achieve
goals outside the EU indicated by CDM within EU ETS.
2.11 What work needs to be done now to help
design a third phase of the EU ETS? How can the experience of
the EU ETS be used to help the design of a post-2012 Kyoto mechanism?
The European Commission recently stated7 that
a high priority for the review of the EU ETS was to streamline
the current ETS design through, for example, harmonisation of
NAPs, new entrant reserves, closure and transfer rules.
The Environment Agency wants to see the following
issues addressed by the European Commission's review:
— Movement towards a more harmonised
allocation methodology. Allocation methodologies should incentivise
investment in low carbon technology, and prevent distortions to
the EU internal market. In Phase III, we favour increasing the
level of allowances that are auctioned, and for those allowances
allocated free, we favour establishing EU-wide benchmarks to reward
best practice.
— Rules on new entrants and closures
need to be simplified and harmonised across the EU to prevent
competitive distortions between countries.
— Removing the smallest installations
from the scheme will reduce the administrative burden on both
operator and regulators.
— The EU ETS needs to provide a stronger
and longer term price signal. Phases longer than five years should
be considered beyond 2012. Alternatively the EU should consider
setting an emissions pathway to signal the direction of caps with
a mid to long term horizon. This would give more certainty to
companies planning long-term investments.
— The EU ETS already covers emissions
from a substantial proportion of the economy (~45% of the EU's
total emissions). However, there are major sources including other
industry, commercial, householder and transport sectors that remain
outside the scheme. The LETS Update project carried out an assessment
of a wide range of sectors to see whether it would be feasible
to include them in a future phase of the scheme. It found that
the inclusion of the aluminium, coal-mining and parts of the chemicals
sector would be possible within the existing framework and would
increase the current CO2 equivalent coverage by an
estimated 9% across the EU.
3. CONCLUSIONS
The strong performance of the UK economy over
the past nine years has led to growing energy consumption. This
growth combined with higher levels of electricity generation from
coal has led to higher CO2 emissions. Further we have
an opportunity to drive investment into an estimated 25 GW of
new generation capacity over the next few years towards lower
carbon technology, providing the long-term price signals are in
place. The EU ETS is currently "the only show in town"
to set an EU-wide price on carbon. For this reason it is important
that the scheme is strengthened for the future.
October 2006
7 Peter Zapfel at an Environmental Finance Conference
on EU Emissions Trading on 11 July 2006.
1 Draft report-Costs of Compliance with the EU Emissions
Trading Scheme, AEA Technology plc on behalf of the Environment
Agency, April 2006. Back
2
LIFE Environment Preparatory Project for the EU Emissions Trading
Scheme Update, April 2006. Back
3
Oxera report for the Environment Agency "What impact would
auctioning allowances have on Phase II of the EU ETS", November
2005. Back
4
The European Emissions Trading Scheme: Implications for Industrial
Competitiveness, July 2004. Back
5
Point Carbon, 28 February 2006. Back
6
LIFE Environment Preparatory Project for the EU Emissions Trading
Scheme Update, April 2006. Back
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