Select Committee on Environmental Audit Minutes of Evidence

Examination of Witnesses (Questions 1-19)


21 NOVEMBER 2006

  Q1 Chairman: Good morning and welcome to actually our first evidence session on the EU ETS. Would you like to introduce yourselves to the members of the Committee and explain your positions.

  Mr Gray: Thank you very much. I am Jim Gray. I am Head of Regulatory Development. I am also Deputy Director of Environmental Protection and I am representing the Director here today.

  Dr Bigg: I am Martin Bigg. I am Head of Industry Regulation at the Environment Agency.

  Ms Ormerod: I am Lesley Ormerod. I am Policy Adviser working on the EU Emissions Trading Scheme in Martin's team.

  Q2 Chairman: Thank you very much. Would you like to say how you think the scheme is going so far?

  Mr Gray: Maybe I could kick off with a few words and Lesley and Martin can join in. I think the first thing is to understand our role and then we could give you some views on how we think the scheme is progressing so far. You may know this, but it is worth running through it anyway. The Environment Agency is the competent authority for the ETS in England and Wales, so we have issued all of the carbon permits, we look after the monitoring, reporting and verification of the emissions and we also have enforcement powers, and we run the emissions trading registry which is the electronic registry which keeps track of the emission allowances. We do not determine the caps or the allocations; that role is done by government. Defra is the lead on the National Allocation Plan and DTI is the lead on the allocation methodology, so we work very closely with government and although Defra and DTI lead on the caps, in Phase II we are doing the calculations on the Phase II allocations for Defra and DTI to their methodology. In terms of how we think it has gone and what has been positive, we think the mechanics of the scheme are in place and working well. There were very tight implementation timescales which we met, so we think the mechanics of the scheme are working well, we think industry has engaged very well, we think the ETS functions as a market and the volume of trades has grown quite steadily. We recognise that it is the only cross-border trading scheme in the world and we think it has been successfully operating. The UK operators, as I said, have engaged well and they have also been very compliant. We have had 99.6% of operators submitting their verified emissions reports around allowances for last year and they did that in April, pretty much on time, so there is 99.6% compliance in the UK. In Europe, the compliance is probably not as good, but there is still pretty high compliance across Europe with something like 6.5 billion euros traded in 2005 across Europe, so I think in terms of the mechanics and the mechanisms of the scheme, from our perspective, that has worked pretty well. I think the real issue is about whether there is scarcity of emissions and how the market develops from here, so I think that would be our summary of how we see things, unless my colleagues want to add anything.

  Dr Bigg: I think our concern at the moment is what is actually delivered in the short term and what it is capable of delivering in the long term. Clearly with the uncertainty and low price of the carbon, there has been little adjustment by industry and, unless there is a significant tightening up of allocations and tightening of the price, we will not see any significant change in the performance of industry. If anything, at the moment, with the expectations around the scheme and some of the changes and investments which have been made, we are actually seeing some movement to previous positions.

  Q3  Chairman: Are there any documented cases where a particular business has reduced its emissions because it has been in the scheme?

  Dr Bigg: In the short term, no. What we have seen is some companies, for example, Drax, has invested time and money in putting in facilities for the burning of biofuels. But, because of the low carbon price, at the moment I understand that has actually almost stopped because there is little incentive to burn fuels other than coal.

  Mr Gray: I do not think it is clear whether we are really seeing any environmental benefits just yet, but I think it is early days and really this first phase of the scheme was about bedding the scheme in and getting the scheme running properly. What it does really bring out is that the scarcity of emissions and scarcity of allocations is really the crucial thing. The fall of the trading price, it is down to about nine euros at the moment per allowance and it was 30 euros in April and obviously the over-allocations in a number of Member States is all part of this, so I do not think we are seeing environmental improvement right now, but it is very early in the scheme of things right now.

  Q4  Chairman: Given that is the case, are you really saying that Phase I, therefore, will have to be regarded, the whole of Phase I, as an experimental period and the earliest we can really hope to see any actual reduction in emissions being driven by the scheme is in Phase II?

  Mr Gray: Yes, I think that is pretty much the case. I think we have to look towards Phase II and it is really down to the Commission now to apply pressure on the plans, the national allocation plans, across Member States for Phase II. I think that is pretty crucial. The Member States have all submitted their allocation plans for Phase II back in August and the Commission have got three months to scrutinise those, and I think whether we see the benefits largely relates to how the Commission approaches those Phase II national allocation plans.

  Q5  Colin Challen: I am a bit disturbed really because we are putting a lot of faith into the ETS, with all our eggs practically in one basket and a huge amount of confidence, so I am just wondering if you can be a bit clearer about the short term and the long term. What is the long-term success—is it 10 years away or 15 years away? Stern is talking about doing things, very, very starkly in the Stern Report, in less than 10 years. Are we going to get real, positive results in that period?

  Dr Bigg: Our concern is that with the initial returns from the national states for Phase II, unless the Commission takes a very strong line, we will see very little difference between Phase I and Phase II, so the only hope for significant change will be at Phase III where there are clear proposals to increase the scope of the trading scheme both in terms of number of pollutants and the installations covered. There is also the possibility, for example, of introducing aviation into Phase II, but, quite bluntly, unless there is a tightening up on the market and a real price for carbon, then the benefits that we are expecting will not be delivered.

  Q6  Colin Challen: Do you detect an appetite for that change in the Commission?

  Dr Bigg: Yes, we do, we have indications, but, unless we see something formal, we will continue to work with Defra in terms of putting pressure on the Commission to do something about it.

  Mr Gray: There have been very strong statements from the EU Environment Commissioner about the scrutiny that the Commission will bring to bear on the Phase II allocation plans. What we are hearing at the moment is that most of the national allocation plans in the other Member States, on average, are about 3% tighter than the Phase I plans and I do not think 3% tighter will really, given the over-capacity across Europe in Phase I, deliver the kind of downward trajectory we need to see. This is a bit anecdotal, but the Commission are looking to and applying, or certainly we are aware anecdotally of some very strong pressure that the Commission are applying, to specific members and very robustly challenging their Phase II NAPs. To come back to your question, the whole thing turns on the Phase II NAP, otherwise it is beyond 2012 for Phase III.

  Q7  Mr Hurd: Leaving aside the Commission for a time, can I press you a bit about the attitudes of other Member States. Meeting with one utility company recently, they said, "Do not underestimate how fragile the ETS is", because in this country we talk exactly the language of Martin Bigg about the need to tighten and toughen, "but in Germany", they said, "the language is completely different and it is about whether this scheme is going to be around in 2012". How fragile is the scheme, in your view?

  Mr Gray: It is a good question.

  Dr Bigg: Certainly the returns we see from individual countries suggest very different approaches being taken by them in terms of how much flexibility they are giving. Our concern is with what is being delivered and the allocation is being determined in very different ways in different states. One of the very strong points we are pushing for is transparency in the means of determining the allocations as well as robustness in those allocations and, ideally, a common approach in determining those allocations across Europe. One of the fundamental questions is how those allocations are made as well, whether it is grandfathering or auctioning, as that will have a dramatic effect on the price and how it is implemented.

  Mr Gray: We are kind of hearing the same things as you have said about the German position, but there are other countries which are more passionate than that. The Netherlands, for instance, are a very strong advocate. In terms of your principal question about the fragility of the scheme, yes, the caps are the important thing, but we deal with the whole cross-section of implementers across Europe and we have a network. These are not the guys that are involved in the caps, but they are the guys that run the schemes in the various Member States. There is certainly a pretty strong commitment from the implementers, the EPAs, in the Member States to deliver this and have a strong implementation and enforcement, certainly at the level of the EPAs. I think the comments that you were making about Germany comes from the industrial push, I think, so in terms of how the scheme works, the mechanics and the cross-European trading, there is a pretty strong commitment from the European EPAs and the real test comes back to, as you say, the politics of the allocation plans.

  Q8  Joan Walley: Could you just give a little bit more detail about the countries which see it the same way as we do, the sort of alliances that are building up in terms of where the tension is between perhaps the more industrialised countries, and the ones who are looking at it more from an environmental perspective. Who are we working closely with to share our approach to take it further forward?

  Ms Ormerod: Through our work with other regulators, we work closely with the Netherlands, and the German regulators are involved in some work that we are doing. This is focusing on the practical implementation of the scheme rather than setting caps or NAPs, it is on the sort of nuts and bolts of implementing the scheme. There are 17 Member States we have worked with over the last 12 months, out of the 25, looking at the practical implementation issues and trying to come up with common approaches.

  Mr Gray: We see a lot of enthusiasm at the EPA level. I think, to try and come back to your question about who is really committed at the political level, clearly the Netherlands are and they show a lot of leadership, but I was going to come back and maybe an easier way of answering that is saying who were the five Member States that had a deficit of allowances in 2005, the ones who, in order to get allowances, had under-allocated, and it is probably a pretty good test, I think. Those countries, and Lesley will check this, were the UK, Spain, Italy, Ireland and Austria, so I would suggest that if those were the countries that had a deficit of allowances, they are probably the ones that are most committed to the overall position, but that is partly speculation. It is encouraging that there were five, but then, as you say, there were quite a lot which had over-allocated.

  Q9  Dr Turner: Looking at the outcome of the first year of Phase I, it would look as if the UK is the only major industrial country which has taken carbon abatement seriously in this scheme. It has cost us nearly 500 millions, but has it actually led to any more CO2 abatement at all or has it simply subsidised the countries who have been over-allocated and who have not actually had to change their behaviour one little jot? Has it actually saved a single tonne of CO2?

  Mr Gray: Can I just check the figure you said there? You said—

  Q10  Dr Turner: This is the figure I have in front of me and it may, or may not, be correct and I would be very grateful if you have more accurate figures.

  Dr Bigg: We do not have any detailed figures of the impact on the UK economy of particular companies. I would simply draw a parallel, as my colleague Jim Gray has done, with other countries in similar positions. We are aware that there are other countries, which have had significant surpluses and not had to recover, or trade to cover, their costs, but we would not have learnt from these perhaps shorter-term impacts on the market. If we get a robust market in place and real trading going on, then that impact will be more even across the European Union, which is where it comes back to the importance of setting the targets and having a real market.

  Q11  Dr Turner: Can I come back to the purport of my main question which is: how many tonnes of CO2 do you estimate were reduced over the whole area of the scheme in its first year of operation, if any?

  Dr Bigg: We have seen no change in UK performance over the past year and, if anything, the market has been driven more by the price for fuel than by the cost of trading CO2, so the answer is no, we have not been aware of any significant impact.

  Q12  Dr Turner: So a scheme which is designed to reduce carbon emissions has, in its first year of operation, not had any effect?

  Mr Gray: I am not clear. It is difficult for us to give a very black-and-white answer. Lesley here is pointing to something else which suggests there have been some reductions, but of course the cold winter and switching from gas to coal has an impact on this, so I could not give you a black-and-white answer on cause and effect, it is much more complicated than that, and I do not know if it has saved any or not. I know that winter coal switching is pretty significant because of gas issues over the winter, so I cannot give you a black-and-white answer, but I would just come back to that it has to be the longer gain and the number of nations trading in this. There is no other scheme in the world where one nation trades with another, let alone so many in a single European scheme, but it is early days and I cannot give you an answer in black-and-white terms as to whether it has saved anything or not.

  Q13  Dr Turner: Can you explain what seems to be the outstanding mismatch between the UK's allocation and its actual emissions, 27 million tonnes of CO2 more than the allocation?

  Mr Gray: I think that was largely down to the fuel switching. Most of that was on the power generators.

  Dr Bigg: It basically comes down to the price of fuel and, with the price of gas going up, a significant increase in the burning of coal and, therefore, higher coal consumption. That was a far bigger driver than the cost of buying additional CO2 allowances.

  Q14  Dr Turner: Given that I do not remember hearing any squeals of pain from the generators during this year, it is obvious that the actual effective price of carbon today is not enough to deter them from whatever they were doing and certainly not enough for them to invest in abatement. Therefore, what is your view on the price of carbon? It clearly is not sufficient. Can the ETS deliver a price of carbon that is (a) sufficient to influence investment and (b) high enough and stable or remotely stable and predictable? Can it do that?

  Dr Bigg: The straight answer is yes, if there is a real market. I cannot come up with a particular figure as to what the price of carbon has to be, but clearly there has to be a real market where there is a shortage of supply in carbon and, therefore, real trading such that there is a realistic price and, therefore, that is taken into account in determining operating costs, ie, the cost of carbon is internalised in the processes. At the moment we do not see that happening, so, precisely as you say, it is not having a significant impact.

  Q15  Dr Turner: How many years do you anticipate it will take to achieve that?

  Mr Gray: These are precisely the questions to be asked and I congratulate you. These are exactly the questions and one would hope that the European Commission is asking those same questions in a very robust way. The whole thing turns on the scarcity and the allocations. My feeling, and this is a feeling, is that the current carbon price of nine euros an allowance is not going to drive reduction or abatement. Before it was apparent there was a market surplus, the April price of 30 euros per allowance or per tonne feels intuitively more like the kind of figure that would drive reduction because that is a figure that operators were entering almost blindly without knowing the market and whether there was a surplus or not. Operators did not know whether there was a surplus and they were trading on a commercial value basis and that market was around 30 euros a tonne. That intuitively feels about right. You will not get that kind of price without creating the scarcity. The UK Government can create a scarcity in the UK allowances, but you still need the whole European position to be a real market and to have the scarcity, I think.

  Q16  Dr Turner: Is it not fair to say that this is a very complex and not very transparent process, somewhat open to abuse, and would it not be simpler and clearer if we achieved a fixed price for carbon by a carbon tax? Would it not be much more effective as an investment driver?

  Mr Gray: That is for the Government as the Government issued that scheme, not the Environment Agency, but inherently, if it is working correctly, the theory is that trading should give you more reductions per euro than the tax will because the trading drives the reductions to the lowest cost and then you can get more reductions for unit cost, so the economic side of this, and I am not an economist, you would have to ask the Treasury or the Government, but the economic side of this really does say that trading would drive it.

  Chairman: We will ask the Government about that.

  Q17  Colin Challen: As you have said, the Environment Agency is responsible in Phase II for calculating the emissions from individual installations. I wonder if you could say a bit more about how you would go about doing that. How do you obtain the information and how do you verify it?

  Ms Ormerod: We effectively turn the handle on the calculations for the Phase II installation level allocations, but that is done following instructions and in accordance with allocation methodologies that are provided by Defra and DTI, so in that respect we are just really number-crunching, if you will. For the Phase II National Allocation Plan, unless there were significant changes in installation levels, then baseline data from Phase I was used and that is independently verified data. Effectively, Defra would set the overall cap for UK industry and then that is chopped up into the individual industry sectors.

  Q18  Colin Challen: Who independently verifies it?

  Ms Ormerod: Third-party verifiers. They are independent verification bodies.

  Mr Gray: When the operators submit their returns to us, they have to be independently verified by a third-party verifier, so the returns we get, we do not go out and check every single return, but we do some sampling and auditing, so the returns we get for the emissions from the different installations come pre-verified, if you like, with independent verification engaged by the company. That was part of the design that Defra established, and we do some checks on that.

  Ms Ormerod: It is the same for the baseline data that goes into the allocation calculations. That is also independently verified by private companies.

  Q19  Colin Challen: On the independent verification, there are enough independent verifiers, are there, to do the whole job? In the building industry, for example, which is quite separate, I know, but we tend to find that there are not enough inspectors to do the job, so these independent verifiers are able to go and visit sites, to interview people and to take measurements themselves or do they rely on information which they may think is correct or not coming from certain installations?

  Ms Ormerod: I am not so sure about doing measurements themselves, but they go in and they audit. It is fairly detailed auditing of operator records and how they have come up with their figures, so yes, and they have done it for Phase I.

  Mr Gray: There are standards for the verifiers that we agree and the verifiers are accredited to the standards that we have agreed with, and I guess it is with UKAS.

  Dr Bigg: There is a very detailed methodology spelled out by the Commission as to exactly how this is undertaken, which we have then added to in order to prescribe very clearly to operators and verifiers exactly what procedures they have to follow to ensure consistency across the UK.

  Mr Gray: I would come back though to how we are calculating the Phase II UK cap. As Lesley has said, it is Defra's and DTI's methodology and I think it is a better methodology than for the Phase I because there is more benchmarking in it than previously.

  Ms Ormerod: Most industry sectors have been allocated through the grandfathering methodology for Phase II which was the same approach taken in Phase I, although the large electricity producer sector has been benchmarked for Phase II and there has been some other new entrant benchmarking done for Phase II as well.

  Mr Gray: So with Phase I people were given allocations virtually based on their history and business-as-usual projections and part of that is just standard practicality, whereas in Phase II the biggest emitters are the large power stations and we are looking more at what is achievable, what is the benchmark. Grandfathering favours people who have not done so well in the past and they are just allowed to carry that practice on, so we are doing more benchmarking for the big emitters. If you look on a risk basis or a targeted basis, it kind of makes sense to target the big emitters for the benchmarking exercise because the big emitters emit, I do not know what the figure is, the majority of the CO2.

  Dr Bigg: The large emitters contribute around 70% of CO2. It is about 40 individual plants which make the biggest contribution, so clearly the biggest burden will fall on them and, proportionately, the biggest reduction will be coming from that sector. Just to stress one point, although the whole model for the allocation plan is clearly one for Defra, another aspect which Defra have built into their scheme is to provide more favourable allocations for CHP plants.

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