Select Committee on Environmental Audit Minutes of Evidence


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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