Memorandum submitted by EEF
INTRODUCTION
1. EEF is the representative voice of manufacturing,
engineering and technology-based businesses with a membership
of 6,000 companies employing around 800,000 people. Comprising
11 regional EEF Associations, the Engineering Construction Industries
Association (ECIA) and UK Steel, EEF is one of the leading providers
of business services in employment relations and employment law,
health, safety and environment, manufacturing performance, education,
training and skills. UK Steel, the trade association for the steel
industry, is a division within EEF, and therefore the submission
draws heavily on the experiences of that sector.
2. Manufacturing supports attempts to tackle
climate change by reductions in emissions, and the sector has
already contributed substantially to the UK's efforts in this
area. However, while EEF is committed to emissions reductions,
we believe it remains of paramount importance to ensure that such
initiatives do not become harmful to the competitiveness of industry
to the extent that there may result an exporting of the emissions
problem to less regulatory environments.
3. We welcome this inquiry, as it is clear
that there are a number of lessons to learn from Phase I of the
EU Emissions Trading Scheme (ETS). However, we are also concerned
that, in some respects, the inquiry comes too late to apply the
lessons to Phase II. The draft National Allocation Plan (NAP)
has already been submitted to the European Commission in August
2006, and DTI and DEFRA have been categorical that there is no
further opportunity to consult on changes to policy decisions
concerning Phase II.
4. As not all of the questions posed by
the committee are of direct relevance to EEF, we have answered
those on which we feel we have our experience will contribute
to the debate.
THE EU EMISSIONS
TRADING SCHEME:
LESSONS FROM
PHASE I
Q1. What are the key lessons to learn from
Phase I of the scheme?
5. As it is only the first year of a three
year phase, it is difficult to assess the full impact of both
the competitiveness of manufacturing and its effectiveness as
a tool to reduce CO2. However, there are still some
lessons that can, and should, be learnt.
6. One of our major areas of concern has
been the ability of power generators to pass on the costs of emissions
trading to all sectors of the economy through higher energy prices.
The result has been windfall profits for power generators, and
a higher burden of energy costs to industry. In a globally competitive
market place, companies find it difficult to pass on the cost
of CO2 to their customers. As a result—in order
to retain customers—many manufacturing companies are simply
obliged to absorb these higher energy costs, and will suffer a
competitive disadvantage as a result.
7. First year reporting of the scheme would
appear to have given industry—and specifically the steel
sector—an over allocation of allowances. However, in reality
this has not been the case. Production in the steel sector fell
in 2005 as a result of a temporary deterioration in market conditions.
It is only the first year of trading and differences and improvements
in the way emissions are monitored and reported have all contributed
to this apparent over allocation. These factors all reflect the
inadequacies of the current allocation methodology which we discuss
in more detail throughout this submission.
8. EEF feel that the allocation methodology
is oversimplified: allocating on historic emissions and forecasting
over long periods is bound to be inaccurate and creates winners
and losers. The inevitable inaccuracies and oversimplification
has undoubtedly reduced the administrative burden for government
departments but has at the same time created inequalities within
the system.
9. The DTI has insisted that all sectors
should be treated the same. However we believe that this approach
has also created inequalities within the system because it does
not take into account different operational environments. This
is particularly the case with the benchmarking approach that has
been adopted in Phase II. It has treated each sector the same
despite quite distinctly different ways of operating. (In reality,
ensuring that all players within a sector are able to compete
on an equal footing is more important than creating identical
treatment between sectors). It also creates a barrier to investment
and implementing practices that could lead to more efficient and
less CO2 intensive production techniques.
10. The timetable of the scheme has been
too tight. The sheer number of consultations with sometimes unrealistically
tight deadlines as well as the implementation of the requirements
of the scheme has created massive resourcing issues for those
expected to engage in the process.
11. Government departments rely heavily
on consultants to inform them of key aspects of a sectors performance
and operational practices. Unfortunately, we feel that there has
been some questionable advice provided by consultants to the government.
Many industrial experts have disputed the accuracy of the information
that the government have relied upon to make key policy decisions.
Considerable efforts have been devoted to arguing the corner for
industry with government officials, partly as a result of some
of this work done by consultants. This has also lead to a question
mark over the degree of trust in the relationship between government
and industry representatives.
12. Reliance on a "cap and trade"
system to reduce emissions will require companies to choose one
of three options: either to buy CO2 credits; to invest
in new technology that will reduce CO2; or cut production.
Cap and trade relies on the market to help deliver reductions
where abatement of carbon production is cost effective. For energy
intensive industries—where cost effective abatement potential
is a less available option—this means purchasing CO2
allocations or even cutting production. This inevitably introduces
distortions: and EEF would argue that any cap and trade system
needs to introduce a level of sophistication that links the cap
to abatement potential and technology. Some form of cap is necessary
to give a signal to investors; but it must also be recognised
that investment in emissions reduction technology in capital intensive
sectors may be slow to filter through.
To overcome some of the inequalities, address
the distortions and encourage CO2 reductions we believe
that serious amendments need to be made to the scheme and the
Green House Gas (GHG) Emissions Trading Directive. An alternative
to the Cap & Trade should be seriously considered with ex-post
adjustment.
Q2. 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
13. The purpose of the EU ETS is to realise
reductions of emissions at the lowest cost, so that it is more
financially rewarding to improve energy efficiency and lower CO2
emissions than it is to buy CO2 or face higher energy
costs. The scheme captures energy intensive users and these have
tended to have already achieved significant gains in energy efficiency.
Further reductions in CO2 tend to require significant
investment or a step change in technology to deliver any further
improvements. Figure 1 illustrates the decoupling of economic
output from energy use from 1970 to 2004 for all sectors except
transport. Note that the industrial sector appears to have levelled
off since the mid 1990s. One of the reasons for this is the diminishing
returns to energy efficiency in some industries, particularly
in energy intensive manufacturing such as steel.
Figure 1 Energy efficiency gains in industry
levelling off
INDEX OF ENERGY INTENSITY (ENERGY USE PER
UNIT OF OUTPUT) 1970=100
Source: Building Research
Establishment, Department for Environment, Food and Rural Affairs,
Office of National Statistics and DTI.
14. Figure 2 illustrates how the steel industry
is close to hitting the theoretical minimum in the amount of carbon
(414 kg/tonne of hot metal) required to produce a tonne of hot
steel in a blast furnace, unless we see a major technological
breakthrough.
Figure 2 Steel industry hits theoretical
limits
KG/T HOT METAL IN INTEGRATED STEEL PROCESSES
Source: Thyssen Krupp.
15. What this indicates is that many energy
intensive processes have been implementing energy efficiency measures
for sometime. Further significant reductions of CO2
emissions will require more complex and costly solutions. This
may include further R&D or investment in large projects like
cogeneration and in some instances only a step change in technology
will deliver gains in energy efficiency and faster reductions
in carbon emissions. Therefore the only alternative in this environment
will be to displace carbon emissions through trading, and not
reductions of carbon as is desired.
Q3. What have been the effects of the method
chosen for allocating allowances in Phase I?
16. To reduce the administrative burden
for government departments and meet the very tight timetable for
delivery of the NAP to the Commission, oversimplification and
a consistent approach has been applied. The outcome, as has already
been highlighted, has been to create winners and losers and an
approach that has resulted in inequalities. Other issues include:
— Forecasting emissions. Future predictions
of industry emissions have formed the basis for the scheme. The
Phase I period covers 2005-07 and the forecast for energy use
had to be finalised before the NAP was submitted to the Commission
during 2004. Similarly Phase II (2008-12) required a forecast
for energy use in 2006—almost six years in advance of the
final year of the phase. Clearly, it is very difficult to predict
output so far in advance, especially when government predictions
vary substantially from those of the industry. This approach will
never be accurate and will inevitably lead to situations of over
and under allocation—"winners and losers". The
impact on the loser will be determined by their ability to pass
on the cost of the CO2 they will be forced to purchase
as a result.
— Grandfathering: A bottom up approach
is also factored into the allocation methodology where installations
take the emissions from a period in the past known as the baseline
years (2003-04 in Phase II). Together with the projections, the
allocation is worked out. If during the baseline years a company's
output was lower then this will lower their allocation. In the
steel sector we are aware of companies that were in periods of
bankruptcy during the baseline years, and as a result their output
was particularly low. This has significantly lowered their allocation
as a result, causing substantial difficulties now the companies
are out of financial difficulty. Ideally, the scheme should have
taken this into account and that it why forecasting is used as
the mechanism for addressing the potential under allocation. However,
it is clear that the government is determined to not over-allocate
at all costs, and are seeking guarantees that projections from
companies will occur as predicted. Clearly, this guarantee can
never be given.
— Sector to installation allocation:
The sector forecast is aggregated and then proportionally distributed
between the installations according to their share of the sector
emissions. This again can create winners and losers. An example
of this is the steel sector. One company in this sector dominates,
so clearly their projections dominate the sector aggregate. This
has led to companies within the sector with higher projections
receiving significantly lower allocations (up to 70% lower than
required) because proportionally they occupy a much smaller share
of the sector.
— Benchmarking approach: The benchmarking
approach for Phase II has taken an average approach comparing
emissions from one plant to another, taking an average and then
applying across the sector. Again this is oversimplification and
does not reflect the reality. For example, in the steel sector
high quality steels which are more carbon intensive were compared
with lower quality, less carbon intensive steels and an average
derived and applied to the whole sector. This has resulted in
one part of the sector subsidising the others allocations where
both operate in completely different markets. Although this particular
example has been partly resolved the average approach is still
adopted for other aspects of benchmarking resulting in similar
outcomes.
Q4. Has the Government identified the correct
proportion of allowances to be auctioned in Phase 2? Should these
be drawn solely from the power sector's allocation? What will
the effect of this auctioning be on industry and the price of
carbon?
17. We recognise that auctioning of allowances
might be the most economically efficient and environmentally effective
way of distributing allowances to the electricity generating sectors,
and to any other such sector that is able to pass the costs on
to its customers as a result of not being subject to international
competition. However, obliging sectors who are subject to international
competition to purchase allowances relating to the entirety of
their emissions would simply impose an additional, unrecoverable
cost burden on companies. It would be unlikely to yield any additional
environmental benefits compared to the current system, because
it would be unrelated to the abatement potential of companies.
It would put companies at a severe competitive disadvantage and
encourage imports from countries not covered by the scheme. Given
that industry is currently subject to high energy prices and the
pass through costs of carbon, we are concerned about the impact
that this will have on manufacturing, and particularly energy
intensive users.
18. UK Steel, with some of its members,
will be undertaking some analysis on the impacts that the pass
through cost has had on the sector in Phase 1. We will be happy
to share these findings with the committee as and when this research
is completed.
Q5. What have been the effects of Phase 1
so far on the competitiveness of (1) business in the UK and (2)
business in across the EU
19. It is too early to draw any concrete
conclusions as to the impact on competitiveness.
Q6. What are the key issues for Phase II
in terms of ensuring that emissions reductions from EU States
are not cancelled out by transferring of industry to developing
economies?
20. In the short term it is important that
efforts are made to address the oversimplified approach that has
led to inequalities within the sectors. However, due to the tight
timetable, it is now difficult to address the key issues in time
for Phase 2. Going forward into Phase 3, we believe it is essential
that the price of carbon fully reflects the operational realities
within sectors and so fully demonstrates the abatement potential.
This requires a move away from the cap and trade model for those
sectors subject to international competition. Detailed energy
efficiency benchmarks could be established and regularly reviewed
within sectoral agreements. At the end of each accounting period
an ex-post adjustment would then be undertaken that, on the one
hand penalises companies that had performed worse than the benchmark,
but on the other rewards companies that performed better than
average. There are a number of variants to this proposal that
can be considered, but the essential element is that the "accounting"
takes place in response to actual performance against energy efficiency
benchmarks. Thus, this removes the need for both government-imposed
allocations and auctioning, thereby safeguards the competitiveness
of the sectors as a whole.
Q8. How should aviation be included with
the ETS. What are the latest indications that it will be included
21. It is believed that the Commission will
be drafting legislation by mid-2007 that will allow for aviation
to be included within the EU ETS. This is of concern since there
appears to be little potential to abate the emissions from aviation.
Essentially this means that the sector will only meet its targets
by buying carbon to make up the shortfall. This could push up
the price of carbon which sectors like steel—with little
abatement potential and limited ability to pass on the cost—will
have no alternative but to absorb. This clearly will have dramatic
implications on business competitiveness.
22. A report published by ICF1[1]
supports the inclusion of aviation but in its assessment of the
impact, it quotes carbon prices as €21, when we have in reality
seen higher prices than this. It also relies on large amounts
of assigned amounts units (AAU) carbon credits becoming available
from Russia for aviation to purchase to meet their targets. If
these do not become available the cost of carbon will inevitably
increase increasing potential problems already experienced within
the scheme.
Q11. What work needs to be done now to help
design a third phase?
23. It is clear that officials and industry
need to work together to address the problems and work out solutions
together. The Nairobi COP12/MOP2 will be discussing the post 2012
agenda and we believe that government and industry should have
engaged prior to this so that the meeting could have been approached
informed with the views of all stakeholders. The GHG Emissions
Directive is currently under review and it is essential that the
review gives time to allow for developments that may come out
of the COP12/MOP2 and discussions around alternative arrangements.
CONCLUSIONS
24. EEF feels that there are a range of
lessons that can be learnt from Phase I of the EU ETS. We have
aimed to raise most of these within this submission. We feel that
more can be done to ensure that emissions are reduced while simultaneously
not damaging the economic competitiveness of manufacturing.
October 2006
1 Including Aviation into the EU ETS: Impact on EU
Allowance Prices (Final Report)-ICF Consulting for DEFRA and DfT
(1 February 2006). Back
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