House of Commons - Environmental Audit

Select Committee on Environmental Audit Second Report

Introduction

The EU ETS is the cornerstone of UK and EU climate change policy

1. The Government has made it clear that the EU Emissions Trading Scheme (ETS) is "the cornerstone of the Government's policy framework to tackle climate change."[1] Given that the Prime Minister has repeatedly emphasised that, as he puts it, "climate change is probably the greatest long-term challenge facing the human race," and that tackling it is thus "a top priority for this government, at home and internationally,"[2] it would seem no exaggeration to say that the Government has more staked on the success of this one policy instrument than perhaps any other.

2. The EU ETS began operation on 1 January 2005. It originated as a recommendation in the initial report (June 2001) of the European Climate Change Programme (ECCP), established by the European Commission (the Commission) in March 2000 "to help identify the most environmentally and cost effective additional measures enabling the EU to meet its target under the Kyoto Protocol, namely an 8% reduction in greenhouse gas emissions from 1990 levels by 2008-2012."[3] The importance of the Scheme in the context of the ECCP is underlined by the current European Commissioner for Environment, Stavros Dimas, who describes the EU ETS as "the European Union's single most important measure for reducing greenhouse gas emissions".[4]

3. The EU ETS currently covers around 11,000 power stations and industrial installations across all 25 Member States of the European Union (including over 1,000 sites in the UK), together responsible for approximately 45% of the EU's carbon dioxide emissions (including a similar proportion of the UK's carbon emissions). Under the Scheme, each Member State sets a national cap (referred to as a National Allocation Plan, or NAP) on carbon emissions from its power and industrial sectors, dividing allowances to emit CO₂, equal in aggregate to this overall cap, among each individual installation.(One ETS allowance covers one tonne of carbon dioxide.) As the Government's 2006 Energy Review explains, in order to make this design effective in cutting carbon emissions, "The overall number of allowances allocated should be set below industry's normal emissions levels". This ensures that "each company with a shortfall must either reduce its own carbon emissions or buy allowances from other companies." This in turn "enables companies who can easily lower their carbon emissions to make large cuts in emissions and sell their allowances to those who find it harder to do so."[5]

4. The additional rationale for the Scheme, beyond the simple objective of leading to emissions reductions, is that it will achieve these carbon savings "in a cost-effective and economically efficient manner," in the language of Article 1 of the European Directive which established the Scheme in law (henceforth the ETS Directive).[6] Indeed, the Commission has estimated that: "The scheme should allow the EU to achieve its Kyoto target at a cost of between €2.9 billion and €3.7 billion annually. This is less than 0.1 % of the EU's GDP. Without the scheme, compliance costs could reach up to €6.8 billion a year."[7] As the Department for the Environment, Food and Rural Affairs (Defra) explains, this cost-effectiveness is expected to follow from the way in which the Scheme allows for permits to emit carbon to be traded:

The Scheme is cost-effective for the economy because emissions reductions are likely to take place at the point of least cost. Most emissions abatement will be carried out by operators with the lowest abatement costs, since these operators will be able to bring the cheapest allowances to the market. Thus emissions trading keeps down the overall cost to the economy of tackling climate change relative to less flexible instruments.

The Department further explains: "This type of scheme is also ideally suited to regulating greenhouse gas emissions, since the nature of greenhouse gases means that emissions make the same contribution to the greenhouse effect wherever they are made. The corollary is that emissions savings have the same environmental benefit wherever savings are made."[8]

5. Doubts have been raised, however, as to the extent to which the Scheme has begun to deliver these objectives in practice since it commenced operation two years ago. Notably, in April-May 2006 the price of carbon allowances collapsed (see Figure 1), following the release of provisional figures which indicated that emissions in 2005 were lower than expected, leaving the Scheme with a surplus of some 44 million allowances after year one. This prompted fears that Member States had as a whole erred on the side of caution, or generosity, in giving their industries an over-allocation of allowances; and that the whole of Phase I of the Scheme (running 2005-2007) would therefore be ineffectual, failing to provide participating companies with the challenging caps, and accompanying financial incentives, to drive changes in behaviour and a reduction in emissions. Further concerns have been raised as to the prospects of the Scheme in Phase II (2008-2012), and even about its future existence beyond that.

Figure 2 The price of Phase I carbon allowances collapsed in April-May 2006

6. In addition, some observers have made more wide-ranging criticisms of the EU ETS, based on their reservations towards all emissions trading schemes. One set of such criticisms focuses on the practical difficulties facing an international trading scheme, involving the inter-relationships of many different governments and thousands of competing companies. For instance, the think tank Open Europe has argued that the aims of the EU ETS have been undermined by the way in which carbon allowances have been decided by a multiplicity of national bureaucracies; it argues that this has led to allocations which are both ineffective and inefficient, and that the Scheme places too great an administrative burden on participating installations.[9] Another major doubt which has been expressed about the Scheme concerns the fact that it is not a truly global scheme, meaning that those firms which are covered by it are not able to compete on a level playing field with international competitors based outside the EU. This has raised the fear that if the EU ETS imposes emissions caps which are truly challenging, the result will be some degree of "carbon leakage": the relocation of economic activity to other countries not subject to the same carbon constraints. The obverse fear is that, if this outcome looks likely, political lobbying will lead to weaker caps, protecting the competitiveness of EU firms, but undermining the effectiveness of the Scheme in driving down carbon emissions.

7. Another set of criticisms objects to emissions trading in principle, or at least an aspect of it: the mechanisms by which participating companies are partly allowed to buy their way out of their emissions targets by funding greenhouse gas abatement projects in other, essentially poorer, countries. The first argument here, notably as put by the campaigning group the Corner House, is that the extent to which such projects actually lead to the greenhouse gas reductions claimed for them is dubious, and that it is far better not to emit a tonne of carbon in the first place, rather than to emit the carbon and seek to buy an offsetting reduction elsewhere. A development of this argument is that allowing the use of offsets within the EU ETS reduces the investment that might otherwise go into low carbon technology within the EU, thus delaying its transition to a low carbon economy, and making its required emissions reduction path still steeper. Meanwhile, as we focus on in greater detail later in this report, unless subject to stringent and deliberate controls, investment in offsetting projects will tend to go towards projects devoted to abating "exotic" greenhouse gases (because these are easier to achieve and provide a much greater financial return), thereby failing to reduce the growth in carbon-intensive growth in developing economies.

8. In November 2006 the European Commission delivered a progress report on the functioning of the Scheme to the European Council and European Parliament. This concluded that the First Phase of the EU ETS "has proved to be a valuable learning period", but outlined a number of issues for further review in respect of the Scheme's design post-2012.[10] These and other issues will now be reviewed by a Working Group on the EU ETS, operating under the European Climate Change Programme, which is scheduled to report by June 2007.[11]

9. What is at stake, in this ECCP review specifically and in the performance of the EU ETS in its Second Phase more generally, is underlined by the Stern Review on the Economics of Climate Change. Commissioned jointly by the Prime Minister and the Chancellor, the Stern Review finds that, to mitigate the risks of dangerous climate change and the possibly irreversible social and economic disruptions which could accompany it—on a par with "the great wars and the economic depression of the first half of the 20^th century"—three main policies are required. Carbon pricing, "through taxation, emissions trading or regulation, so that people are faced with the full social costs of their actions",[12] is the first of these three key recommendations. (The others are: i) enhanced support for new technology; and ii) education and incentives to overcome the behavioural and institutional barriers to radically improving energy efficiency.) While Stern highlights the potential of three different means of imposing a price on carbon, it is emissions trading which has thus far made the most international progress, and which offers the most potential for establishing a global carbon price in the short to medium term future. Fledgling emissions trading schemes are beginning to emerge in other countries, but the EU ETS is by far the biggest, most ambitious, and most established of these. The development of the EU ETS will thus be instrumental in influencing the development of emissions trading worldwide; and thus the EU ETS should be regarded as the mechanism for putting a price on carbon internationally. Still more pointedly, as Stern puts it: "Decisions made now on the third phase of the EU Emissions Trading Scheme pose an opportunity for the scheme to influence, and be the nucleus of, future global carbon markets."[13]

10. Within a matter of months the European Commission is set to have reached decisions on the next two phases of the EU ETS which will be vitally important, not just to the success of this Scheme, but to the establishment of carbon trading worldwide. The EU ETS has received serious criticism for its design to date, concerning the efficiency and effectiveness with which it sets carbon allocations, and the way in which it relates to countries outside the EU, both in terms of dealing with international competition and of funding offsetting projects in developing economies. These challenges must be addressed if the EU ETS is to prove the credibility of emissions trading as the foremost mechanism for tackling greenhouse gas emissions worldwide. In meeting these challenges, and making a success of emissions trading, Europe would be in the position to mould a global carbon market, something which only underlines the importance of getting the design of the Scheme right. The converse risk, if Member States and the European Commission get the terms of Phases II and III wrong, is that the credibility and potential effectiveness of emissions trading is fatally and permanently undermined.

Focus of this inquiry

11. The Environmental Audit Committee (EAC) has substantively looked at the EU ETS in one previous report, The International Challenge of Climate Change: UK Leadership in the G8 & EU, which also looked at the Kyoto Protocol and the post-2012 framework. In this report, our predecessor Committee found that Phase I of the Scheme was unlikely to yield any significant carbon savings and that far tougher targets would be needed in Phase II. Its overall conclusion was that: "emissions trading will only work effectively if it results in an increase in the price of energy for industry, business and even domestic consumers. Only then will the necessary incentives to prompt behavioural change and investment in low-carbon technologies arise."[14] In this new report, and with the benefit of data from the first year of Phase I and information on the National Allocation Plans for Phase II, we examine the evidence on how much progress the Scheme is making towards these ends.

12. We launched this inquiry in July 2006, with evidence being taken in November and December. There were three reasons for this timing. First, the start of the inquiry came shortly after publication of end of year figures for the first year of the Scheme, and with that the collapse in the carbon trading market, allowing for an informed review of Phase I in its entirety. Second, with the publication in the summer of most of the proposed National Allocation Plans for Phase II, including the UK's, and the Commission's decisions on them by the end of the year, it allowed for a relatively confident appraisal of the Scheme's effectiveness throughout the whole of the Second Phase. Third, it allowed for publication of this report to come in time to make recommendations to the Government regarding its input into the ECCP review of the Scheme, looking forward to Phase III and beyond.

13. In the course of our inquiry we received memos from 26 organisations, taking oral evidence from the Environment Agency, WWF, RSPB, the Association of Electricity Producers, the TUC, EEF, Climate Change Capital, and the Carbon Trust, culminating in a session with the Minister for Climate Change, Ian Pearson MP. In addition we travelled to Brussels for useful discussions with Commission officials, and pan-European environmental groups. We would like to thank all involved for their assistance.

14. Throughout our inquiry we have had dual objectives in mind. The first has been to assess the effectiveness of the EU ETS overall, and to identify the main issues relating to its future success. The second has been to focus in particular on the UK, reviewing the effectiveness of Government policy, assessing the impacts of the Scheme on UK participants and carbon emissions, and making recommendations to the Government on its future policy, notably its input into the ECCP review.

1 Ev 91 Back

2 Department for the Environment, Food and Rural Affairs (Defra), Climate Change: The UK Programme 2006, Cm 6764, March 2006, p iii Back

3 "EU can affordably reach Kyoto target according to new report", European Commission press release IP/01/816, 11 June 2001 Back

4 "The EU and the fight against climate change", European Commission press release SPEECH/06/276, 4 May 2006 Back

5 Department of Trade and Industry (DTI), The Energy Challenge, Cm 6887, July 2006, p 28 Back

6 Council Directive 2003/87/EC Back

7 "EU action against climate change", European Commission brochure, September 2005, http://ec.europa.eu/environment/climat/emission.htm, p 8 Back

8 Ev 91 Back

9 The high price of hot air: Why the EU Emissions Trading Scheme is an environmental and economic failure, Open Europe, July 2006 Back

10 "Building a global carbon market - Report pursuant to Article 30 of Directive 2003/87/EC", European Commission COM(2006)676,13 November 2006, http://ec.europa.eu/environment/climat/emission.htm,, p 10 Back

11 "ETS Review", European Commission update, http://ec.europa.eu/environment/climat/emission.htm Back

12 "Publication of the Stern Review on the Economics of Climate change", HM Treasury press release, 30 October 2006 Back