House of Commons - Environmental Audit

Select Committee on Environmental Audit Second Report

An assessment of the Scheme's impacts to 2012

15. Two years into the operation of the EU ETS, there is much to applaud. The very existence of such a complex system, involving hundreds of firms and thousands of installations in 25 countries, is an impressive achievement in its own right, especially considering the tight timetable under which it was set up.[15] In operation, the Scheme has shown itself so far to be an administrative success, with the overwhelming majority of installations reporting their independently verified CO₂ emissions, and surrendering the appropriate number of allowances to cover them, to the required deadlines. In the UK, for example, over 99% of installations submitted their verified emissions reports and surrendered the correct amount of allowances within the deadlines or shortly thereafter.[16] Only a very small number of UK operators have been shown to have had excess emissions over their total of allowances, and firms without sufficient allowances to cover their emissions have been prosecuted and fined.[17] More widely, the systems for trading allowances have also proved to work effectively, with some 350 million allowances (worth an estimated €9 billion) being traded internationally during 2005.[18]

16. In reviewing the effectiveness of the EU ETS, however, our main interest is in assessing the extent to which it is driving significant cuts in carbon emissions. Here, the record of Phase I is much more dubious. The key issue is the size of the caps on emissions imposed by Member States' National Allocation Plans, and the resulting aggregate cap across the entire EU to which they add up. The fear expressed by many observers when these Phase I NAPs were first published was that most were far too unchallenging, meaning that little progress would be made in driving down EU carbon emissions. This was certainly the view of our predecessor Committee who, in examining the prospects for Phase I at its outset in early 2005, observed that "relatively few countries have set target reductions of more than 3%, even when they are very far from achieving their Kyoto target; while Portugal and the Netherlands have actually set caps above their business-as-usual forecasts."[19] This led them to conclude: "Phase 1 of the EU ETS has rightly been described as a "race to the bottom" in terms of the target caps set by individual member states. As a result, there is little prospect that it will yield any significant carbon reductions and this is reflected in the low price at which carbon is trading."[20]

17. If this was the view which many held at the outset of Phase I, what happened in May 2006, when first year figures for the number of allowances surrendered in each Member State were published, seemed only to increase the doubts. Emissions for 2005 were revealed to have been considerably lower than the number of allowances allocated, leaving a surplus of some 44 million allowances after the first year of the Scheme. The conclusion which many drew was that most Member States had allocated allowances to installations in excess of their ordinary needs. If true this would mean that Phase I will be even less effective than our predecessor Committee thought. It would suggest that most of the Business As Usual (BAU) emissions projections, used by Member States as a basis from which to calculate the size of the cut to be imposed by their National Allocation Plans, were seriously inflated and inaccurate. In this way, it would not just be that most Member States were cutting too little from their Business As Usual emissions; they would be cutting too little from a projected level actually above their BAU emissions. This in turn would mean that the majority of installations would have been given sufficient allowances to meet their ordinary needs in full and would not therefore be directly affected by participation in the Scheme. Meanwhile, the weak aggregate cap would lead to a low market price for traded allowances, meaning that those firms which did end up with a shortfall in allowances would be faced with only a weak financial incentive to strive for emissions reductions.

18. The majority of evidence we examined backed up this interpretation. While sounding a note of caution given that only one year's emissions figures had been published, the memo we received from Defra implied the belief that Phase I as a whole had over-allocated allowances: "Industry should have to take some action to achieve surpluses that can be sold, they should not receive more allowances than they need in the first place. However, it is evident from 2005 emissions results that more allowances were available than were required for compliance with the Scheme, hence deflating the value of allowances, and, consequently, diminishing the financial incentive to reduce emissions over buying allowances."[21] The Environment Agency was slightly more forthright, stating: "During the first year of the scheme, most Member States emitted less than their 2005 allocations. […] This suggests that most Member States have allocated allowances to industry above business as usual".[22] In the view of RSPB, "In Phase I, all member states have been afraid of placing their countries at a competitive disadvantage, and they have consequently overallocated allowances", with WWF concluding that the EU ETS "is currently failing to deliver real cuts in greenhouse gas emissions." A recent report by the Institute for Public Policy Research (IPPR) stated baldly: "In the first year of trading, 2005, the EU ETS did not yield any emissions reductions. […] Member states themselves decide the emissions reductions they will take. Many are anxious to avoid making more effort then their neighbours. Such a 'race to the bottom' can only lead to failure."[23] To the Carbon Trust, "The overarching lesson is that the market and verification has worked, but the initial allocation didn't".[24] (On this latter observation, that the verification system has worked, we would add a note of caution by observing that it has not yet been tested under the more difficult circumstances that would accompany genuinely challenging emissions caps and their resulting scarcity of allowances, a situation which might provide greater incentives to falsify emissions records.)

19. The situation in the United Kingdom stands slightly apart. While Phase I appears to have a surfeit of allowances, not every Member State has contributed to this over-allocation. In the figures for 2005, the UK is shown to be one of five Member States whose emissions exceeded their allocations; the UK's shortfall in allowances is far greater than any other country's. While this suggests that the UK has set a more challenging NAP than other Member States, it does not necessarily follow that this more stringent national cap has led to more - or indeed any significant - carbon reductions, whether in the UK or the EU as a whole. This is by virtue of the Scheme's multi-state trading nature. Given that there is a net surplus of allowances across the system as a whole, and that this appears to be the result of a general over-allocation, then not only will it have been cheaper for those UK firms with an under-allocation to make up their shortfall by purchasing allowances on the market rather than changing their production processes, but this money will have tended not to subsidise carbon abatement in other countries, rather to have simply bought an unneeded proportion of their excessive allocations. In a report published in July 2006, the think tank Open Europe estimated that the first year of Phase I could have seen a net outflow from UK participants of approximately £470 million to "companies in other member states which can then make windfall profits" without decreasing their emissions;[25] in other words, as the report put it, this money had bought nothing but "hot air". Neither the Environment Agency nor the Carbon Trust could confirm these figures; and Professor Grubb of the Carbon Trust did stress that, even in Phase I, "the UK could end up as a net seller still and make money out of the system" if, for instance, declining gas prices in the next year led to a switch away from more carbon-intensive coal burning in the UK. However, he also suggested that if UK emissions stayed at current levels, UK operators would need to purchase around 20 million allowances net per year in Phase I. (At the current allowance price of around €5, this would represent a sum of around £67 million.)[26]

20. We did receive some evidence to suggest, on the contrary, that Phase I was leading to some genuine carbon abatement. Appearing before us, the Climate Change Minister stated that "there will be a number of companies within the United Kingdom and in other countries that have reduced their carbon emissions directly as a result of the scheme", and drew our attention to a study by academics from the Massachusetts Institute of Technology (MIT) and Fondazione Eni Enrico Mattei (FEEM) that suggested that "emissions reductions across the EU resulting from implementation of the ETS in 2005 could be somewhere in the region of 50 million tonnes of carbon dioxide to 200 million tonnes of carbon dioxide".[27]

21. The study in question[28] begins from the starting point that it is impossible to tell, simply from the fact that 2005 emissions were below allocation levels, the extent to which it was the allocations that were too high or the emissions that were lower than forecast - and if the latter, the extent to which this reflected active carbon abatement. In setting out to find the answer, the study starts with the average historical baseline emissions data for the years 2001-03, gathered by Member States as the basis for their BAU projections for the years 2005-07 (in turn the basis of their caps from these levels represented by their Phase I National Allocation Plans). It then does its own calculations of what Business As Usual emissions would have been in 2005 in the absence of the EU ETS. By applying rates of rising economic output and declining improvements in carbon intensity since 2002 to these historic baselines, it projects that, if the EU ETS had not existed, the emissions for 2005 would have been between 50 million tonnes of carbon dioxide (MtCO₂) and 200MtCO₂ higher than the actual verified emissions for that year. It concludes that the EU ETS must have driven carbon efficiency improvements, equal to these figures, in its first year.

22. The MIT/FEEM study contains some interesting analysis and argument. Given that it was only published in November 2006, and only raised by the Minister in our final evidence session, we have been unable to study its methodology in great depth, nor gain the views of other witnesses and observers on its conclusions. However, we would make the following main observations as to the Minister's use of its findings. The first is that its stated carbon savings are from a BAU projection, rather than an estimate of absolute reductions from historical levels, and are therefore less impressive in terms of progress towards Kyoto targets, and further absolute reductions in carbon beyond that, than might at first appear. In other words, the cited figure of a 50-200MtCO₂ reduction does not mean that emissions from those installations in the EU ETS went down by a net figure of 50-200 million tonnes in 2005 compared to emissions in 2004 or some previous year; rather, it is that they are projected to have emitted this amount less than they might otherwise have emitted, had their emissions grown in line with (this study's) BAU forecasts. Secondly, the size of even these relative carbon reductions should be subject to some doubt, given that, as the authors themselves point out, their calculations "can never be determined with certainty because the counterfactual is not observed and never will be"[29]—in that such calculations depend on both the accuracy of historical baselines and the applicability of the modelled assumptions as to their BAU growth, none of which can be known for sure. Finally, in dwelling on the high-level plane of macroeconomics, the study neither cites any examples of a firm which has reduced its carbon emissions, nor offers a definite scenario for how firms might have reduced their emissions even in theory. Its portrayal of the means by which its projected carbon savings have arisen is vague: it imagines simply "the small, incremental changes in production and production processes that managers of existing facilities make in adjusting to new economic realities."[30] This is not to imply that its findings are necessarily wrong; but it is to suggest that they ought to be supplemented by further evidence before they can be relied on to state conclusively that Phase I has indeed had such effects on installations in practice.

23. In supplementary evidence, the Minister also referred to Defra analysis which suggested that:

[C]omparing 2003 and 2005 emissions in the UK from incumbent installations in the EU ETS shows a reduction of around 10MtCO₂ (4%). A number of new installations commenced operation and entered the Scheme in 2004 and 2005, emitting a total of around 5MtCO₂ in 2005. Therefore, the net total reduction in emissions from UK installations (incumbent and new) in the EU ETS was approximately 5MtCO₂ between 2003 and 2005.[31]

As we received this evidence at the end of our inquiry we are unable to assess the strength of its conclusions.

24. Other witnesses also suggested that Phase I was leading to some carbon reductions. Both the Carbon Trust[32] and the TUC[33] suggested that there was some evidence of resulting carbon reductions, though here again we did not hear any specific examples of individual installations. The Association of Electricity Producers (AEP), meanwhile, suggested that: "Putting a value on carbon has also aided the economics of achieving emissions reductions through the co-firing of biomass with coal or oil, and in 2005 this resulted in the sector generating about 3 TWh that were eligible for Renewable Obligation Certificates." In addition, they mentioned "one plant in the Sector" was converted from a Combined Cycle Gas Turbine (CCGT) to a Combined Heat and Power (CHP) plant "with significantly improved efficiency."[34]

25. The Environment Agency appeared to at least partially contradict this, however, suggesting that there had been no documented cases of businesses reducing their emissions as a result of participation in the Scheme, and in particular suggesting: "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 other than coal."[35] Indeed, AEP themselves admitted that overall the first year of the Scheme had had essentially no effect on emissions from UK power generation: "In fact […] there was no change in emissions as such in 2005, but then, equally, one has to recognise that if you look at gas prices during that period the level of the carbon allowance price was not sufficient to drive coal to gas switching".[36]

26. While the Scheme so far has been an administrative success, its record in reducing carbon emissions is far less impressive. It appears to us that Phase I will have very little impact on carbon emissions across the EU. Allocations of allowances to emit carbon were too generous, and the market price of them consequently too low, to drive a transformation in business strategies and technical processes. Overall, the emissions projections appear to have been inaccurate and inflated, and the national caps derived from them too unambitious. There is some excuse for this in Phase I, given the difficulties in collecting accurate baseline data and the compromises needed to achieve speedy implementation of the initial phase of the Scheme; and for these reasons it has always been characterised as a "learning by doing" phase. But lessons must actually be learnt, and things radically improved, in Phase II and beyond.

27. While this view is contradicted by the study by academics from the Massachusetts Institute of Technology and Fondazione Eni Enrico Mattei, we have some doubts as to the strength of its conclusions, particularly as it does not provide a single concrete example of an installation which has actually reduced its carbon emissions as a result of the EU ETS. In view of the reliance which the Minister is now placing on this one piece of research to argue that Phase I has significantly reduced emissions in the EU, the Government should commission an independent review of the study's findings. Overall, we would welcome more research into the effects of the Scheme on participating companies. Where there is strong evidence that the EU ETS is driving behavioural change that cuts emissions in absolute terms, this ought to be given significant publicity, both to spread the lessons of good practice and to bolster domestic and international support for emissions trading.

28. The UK stands slightly apart in Phase I in that it has set itself a more challenging national cap than other Member States. But owing to the general over-allocation of allowances across the EU ETS as a whole, it does not appear that the UK's shortfall of allowances has driven any significant carbon reductions either in the UK or in the EU overall. In other words, the UK has been a net buyer of allowances from the Scheme, and thus a net financial contributor to it, without necessarily funding any carbon abatement. This does not mean that the UK was wrong to impose a more stringent national cap, nor that the EU ETS is a failure, nor that the UK would always be disadvantaged within it. What it underlines, however, is the need for the European institutions to ensure that all National Allocation Plans are in future both stringent and equally stringent, so that the Scheme as a whole is effective, and so that all Member States are competing on a level playing field.

29. Overall, the extent to which the EU ETS, and any other trading schemes, is judged a success should depend on two main things: the extent to which emissions are reduced, and the extent to which a stable and effective carbon price is generated. To date, the EU ETS has had very questionable effects on both measures. In particular, it has been undermined by weak caps and inaccurate and unsatisfactory methods of allocating allowances to individual sectors and installations. Both shortcomings have been exacerbated, if not wholly caused, by the instrumental role of a multiplicity of national bureaucracies, which have set caps and allocations through a methodology which was not just cumbersome, but prone to being influenced by industrial lobbying.

The prospects for Phase II

30. Phase II of the EU ETS will run from 1 January 2008 to 31 December 2012. Prior to its operational start in January 2008, Member States had first to submit their proposed National Allocation Plans by 20 June 2006, and the European Commission had then to assess, amend if necessary, and approve them by 31 December 2006.[37] The Commission published its decisions on the first 10 NAPs (those of Germany, Greece, Ireland, Latvia, Lithuania, Luxembourg, Malta, Slovakia, Sweden and the UK), together accounting for 42% of the allowances allocated in Phase I, on 29 November 2006. In this first wave of decisions, the Commission revised the national caps in question downwards by an average of nearly 7% from the allocations as originally proposed by the Member States concerned, a cut equating also to around a 7% cut in absolute terms from verified emissions from the installations in these Member States in 2005. The United Kingdom was the only one of these 10 Member States whose proposed NAP was accepted as it stood, and not revised downwards. As Professor Grubb of the Carbon Trust understood it, the reason "the Commission did not challenge the UK Allocation Plan is firstly because it was actually the only one […] which involved any significant cut-back in aggregate from current levels, and also the UK is on track to meet or exceed its Kyoto commitment."[38] (On 5 February 2007, the Commission published its decision on the 11^th Phase II NAP, that of Slovenia, which had proposed a 9% reduction on its Phase I NAP. The Commission approved this without downward revision, making Slovenia only the second Member State, after the UK, to have its NAP approved as proposed.)[39]

31. The Government ought to be commended for its leading contribution to the robustness of Phase II, and future strength of the EU ETS, in proposing a more stringent NAP than many other Member States; as well as submitting it to the Commission on time, unlike many others. That the United Kingdom had the only national cap (in the initial batch of 10 to be reviewed) that was accepted by the Commission as submitted, and without being revised downwards, clearly highlights the fact that in terms of setting limits to emissions the Government is leading the way in Europe.

32. In view of the timings involved, most of the written and oral evidence we received reviewed the National Allocation Plans for Phase II as originally proposed by Member States, rather than as revised by the Commission. The consensus of opinion was that, overall, Member States had again refrained from imposing stringent cuts, and that thus the aggregate cap across the entire Scheme risked being too weak to drive significant carbon abatement within Europe. Diplomatically, the memo from Defra commented that: "The UK has worked with counterparts in other Member States, at the highest level, calling on caps to be set in line with the requirements of the Directive, and to ensure real scarcity in the market. It is inevitable that there will be some Member States who do not set sufficiently tight caps. The UK will therefore support the Commission in their consideration and rejection of such caps."[40] The Environment Agency was slightly more direct: "For Phase II, our indication, based on the published draft National Allocation Plans (NAPs), is that the same situation [of over-allocations as in Phase I] could be repeated."[41] According to the Carbon Trust's analysis, the collective impact of the proposed NAPs "was going to be too weak to sustain a credible carbon price during the 2012 period".[42] Climate Change Capital found that: "Domestic agendas have seen some Member States set caps in their Phase 2 NAPs that are far higher than those requested by the European Commission or that their verified data merits, putting the integrity of Phase 2 of the EU ETS at risk."[43] The verdict of RSPB, meanwhile, was that "the Phase II cap is lax across Europe".[44] To WWF, the proposed NAPs "suggest minimal level of effort beyond Business as Usual (BAU) for a number of countries", leading them to conclude that "collectively across Europe […] the cap for phase II could be very weak", and even that "potentially zero abatement could take place within the EU."[45]

33. That most of the draft National Allocation Plans originally proposed by Member States for Phase II were so inadequate suggests a worrying lack of public and political understanding of the dangers of climate change, and of the need to tackle it, across the EU as a whole. This highlights the vital role which must be played by the Commission, given its ability to operate at one remove from the competitive national interests of individual Member States, to impose the cutbacks in allocations required by the Scheme as a whole. A corollary of this is that the UK Government must do its utmost both to persuade other EU states of the need for greater action, and to bolster the position of the Commission in guiding Member States in the right direction.

34. Following the Commission's decisions on the first 10 National Allocation Plans, we took oral evidence from the Carbon Trust and from the Minister for Climate Change. On the basis of these initial decisions, the Carbon Trust estimated that the cutbacks imposed on all 25 Phase II NAPs in aggregate would be around 10%,[46] which they stated was the minimum figure required in order to generate a robust carbon price signal in Phase II.[47] For his part, the Minister welcomed the Commission's decisions, arguing that, as a result, "Phase II will be a significant improvement on Phase I in terms of the CO₂ reductions that will be seen as a result of it." He further commented that: "I would like to think that the UK and our approach in setting our own NAP and getting it in early to the Commission influenced their thinking and maybe facilitated them in taking a robust approach to Phase II".[48]

35. The European Commission's decisions on the National Allocation Plans for Phase II are encouraging—not just in terms of making it more likely that the EU ETS will begin to drive real carbon abatement in its Second Phase, but in terms of increasing confidence in the entire viability and future development of the Scheme.

36. While the Commission's decisions on these National Allocation Plans are indeed encouraging, they do not necessarily mean that Phase II of the EU ETS will in itself make an instrumental difference to the rise in global carbon emissions towards levels that may trigger dangerous and irreversible climate change. First, as the Carbon Trust submission argued, there are other variables beyond the simple aggregate cap on allowances that could affect the carbon price in Phase II. One is the expected reverse in the recent upward trend in gas prices as new gas supply infrastructure comes on stream; this could incentivise a switch back from coal to gas in electricity generation, which, as gas is less carbon-intensive than coal, would tend to lower emissions and with them demand for ETS allowances. (While lowering emissions in this way would be a good thing in the short term, it would also, by reducing the carbon price, reduce the financial incentive to seek energy efficiencies and invest in low carbon technologies.) Another is the use and plentiful supply of credits from Clean Development Mechanism (CDM) projects in the developing world (about which more will be said in a later section); given that in Phase II these can be used within the Scheme, in addition to and instead of ETS permits, their use will in effect inflate the cap on emissions within the EU to a certain degree.[49] The Minister himself argued that, even though the Government now had an idea of the size of cuts from BAU levels imposed by Phase II NAPs following the Commission's decisions, it was still very difficult to assess what the average carbon price would be in the next Phase.[50]

37. Secondly, as the Carbon Trust stressed to us, since the EU ETS only covers around 45% of the EU's carbon emissions, and only around a third of the EU's total greenhouse gas emissions, it is impossible to state simply from the cutbacks imposed by Phase II caps whether the EU as a whole and individual Member States within it will meet their Kyoto commitments. In amending the proposed NAPs for Phase II, the Commission has had a mandate to ensure these allocations give a broadly proportionate cutback to the sectors covered by the Scheme. However, it is possible Member States might not make sufficient progress in cutting emissions from the rest of their economies by 2012, the end of the first Kyoto period; in order to comply, they would then have to fund equivalent greenhouse gas reductions in other countries, for instance via CDM projects.[51]

38. Thirdly, it ought to be kept in mind that these Kyoto targets themselves are only a first step, and that much steeper cuts in greenhouse gas emissions will have to take place very soon after 2012 in order to meet UK and EU targets, and minimise the effects of global warming. Thus, as Professor Grubb outlined, while the Commission's decisions on the Phase II NAPs could be described as relatively tough within their own context, "The Commission's job formally is to enforce the agreement which exists in the form of the Emissions Trading Directive, not to impose tougher cuts per se. […] I think going beyond that would have been very difficult, both legally and politically, to be honest, for the Commission itself."[52]

39. While the Commission's decisions on the Phase II NAPs are encouraging, it is important to keep the potential impacts of Phase II in perspective. Its effectiveness in driving carbon reductions depends on several variables, not all of which can be known with certainty at this stage. And while it looks likely that it will put the EU roughly on course to meet its Kyoto commitments, this cannot yet be known for sure. Furthermore, in order to meet UK and EU climate change targets beyond 2012, much greater action—both within the EU ETS and in the form of complementary policies—will be needed, and soon.

40. One decision on the shape of Phase II, which will have a profound effect on its efficiency and effectiveness, and with which we are signally disappointed, was taken long in advance: the maximum limit of allowances which can be auctioned. Under the ETS Directive, a maximum of only 10% of allowances can be reserved for auction in Phase II, rather than being allocated to firms for free. We believe it was wrong of Member States and the Commission to impose such a restrictive limit on auctioning in Phase II. In our view, auctioning allowances should lead to more accurate allocations, reduced public costs and bureaucracy, and greater internalisation of environmental costs in business decisions. In sectors where there are not strong concerns as to the effects on competitiveness of requiring firms to purchase their allocations upfront, we strongly support 100% auctioning. In auctioning 7% of its Phase II NAP, the Government is doing far more than any other Member State in this Phase, but this level is still far less than the participants could withstand and which would be good for the Scheme as a whole. We look in greater detail at the mechanics of auctioning, and its advantages over other methods of allocating allowances to individual firms, in the section of the report where we make recommendations for Phase III.

Impacts on firms in the UK

41. The firms subject to the EU ETS in the first two phases can be broadly divided into two groups: power companies, on the one hand; and energy intensive manufacturing industries, such as steel, glass, paper, and ceramics firms, on the other. While there are certainly notable differences within these broad sectors,[53] overall we can talk about the power sector being differentiated from the industrial sectors in three main ways: i) it is more capable, at least in principle, of reducing carbon emissions fairly substantially in the short term (through fuel switching from coal to gas); ii) it does not suffer from the same exposure to international competition; and, following on from this latter point, iii) it is generally more able to pass on the costs of the Scheme to its customers.

42. In keeping with these broad definitions, the Government has treated these two types of firms differently in the first two phases of the Scheme: the power sector has been given cutbacks in allocations from its BAU emissions; and in Phase II is having to buy around 15% of its allocation of allowances (equating to 7% of the whole UK NAP) at auction. The industrial sectors, meanwhile, have overall been given all the allowances they need in line with BAU projections, and are also receiving all of their allocations in both Phases I and II for free. Throughout our inquiry we considered a large amount of evidence regarding the Government's treatment of these sectors, concentrating on their differing needs and capacity for carbon reductions, and the resulting economic impacts on them. In looking at these questions, we have taken an interest not just in how these sectors are responding to the Scheme in terms of carbon abatement, but also how they are being affected economically—both in the context of UK jobs and competitiveness, and in terms of the dangers of "carbon leakage" (in other words, the relocation of firms to other countries which are not subject to the same carbon constraints). We have also looked at how well the EU ETS appears to be working with other domestic policies designed to move these sectors towards a low carbon future.

43. The question of the impact of the EU ETS on the power sector is dominated by the issue of windfall profits. In November 2005, the DTI published a study which estimated that the UK power sector stood to earn an extra £800 million a year (net) throughout Phase I, as a result of its participation in the Scheme.[54] A June 2006 report by the Carbon Trust, meanwhile, gave a figure of €1 billion (£673 million) for the year 2005.[55] While the size of these figures was contested by the Association of Electricity Producers in their session with us, they did not contest the fact that the power sector was making a financial gain.[56] These profits have arisen because power companies have raised their prices to incorporate the market value of all the ETS allowances they have used to cover their emissions, even though the majority of these allowances were not purchased on the market but given to them, in their original allocations, entirely for free. Economists explain that the reason for this is that prices are set with reference to marginal producers, where the impact on profitability of allowance prices - not just in terms of those they might have to buy, but of those already allocated to them which they could choose to sell to the market rather than use up in producing electricity - is greatest. The other, crucially enabling, factor is that UK power companies essentially do not face any international competition, which might otherwise restrain price rises. For its part, the memo from Defra describes this as "a natural pricing response from the industry", and indeed welcomes it as reflecting the cost of carbon in the price of electricity.[57] The Government estimates that the EU ETS is responsible for a quarter of the rise in wholesale electricity prices (by 72%) between 2004 and 2005 (the remainder being due to wider rises in fuel prices).[58]

44. The Association of Electricity Producers were keen to point out that the power sector was the only sector to be given a cutback in allocations from Business As Usual projections in both Phases I and II, and was therefore the only sector bearing a direct cost from the Scheme. Indeed, we received several submissions from power companies which argued that their sector had been unfairly singled out by the Government in this respect, while arguing in addition that the resulting increases in power companies' costs was also hurting industry and consumers through raising electricity prices. A typical example came from Drax:

All effort on CO₂ reduction in Phase I and II has been allocated to the power sector on the assumption that fuel switching was fairly easy and possible. In reality, the sector did not respond in the manner that had been assumed and little switching occurred from coal to gas. Indeed, over the last few years the sector has seen an increase in coal burn. By setting a range of emissions reduction beyond what is technically and economically feasible for the sector, operators have had to purchase additional allowances in the market, leading to a considerably higher than anticipated cost of EU ETS compliance which in turn has fed through to increased electricity prices for the UK consumer.[59]

45. We find this argument rather odd. In effect, the power sector is arguing that the reason it is failing to reduce its emissions is that the price of allowances is too low to incentivise fuel switching from coal to gas; but then complaining of the cost of having to buy allowances instead of reducing emissions. What is more, it is hard to see how the cutback in its allocation is in itself having an impact on energy prices and thus on business and consumers. Given that the power sector is effectively charging for the market value of all the allowances it uses anyway, whether it receives these for free or has to buy them, it is hard to see how giving it a larger allocation of free allowances would reduce electricity prices. The only effect this would be sure to have would be to increase the power companies' windfall profits.

46. We were interested to find out how power companies were using these profits; in particular, whether they were investing it in low carbon energy generation. However, as Professor Grubb of the Carbon Trust observed to us, while the power sector

claims it is not getting enough revenue really to fund new investment [,…] we now have an instrument which is certainly giving it a significant amount of revenue. It is still not investing. Why? Partly because of uncertainty, and if you are faced with big uncertainty very often your ration choice is actually to sit there and wait, and I think that is what the power companies are doing. […] They might invest in renewables to the extent that the renewables support mechanism helps it, but basically the fundamental response of the power sector is to sit there transfixed while the number of uncertainties stare them in the face. Until we resolve that uncertainty and we resolve it in a low carbon direction and in a way which enables the sector to have enough resources to risk a few billion pounds here and there in new stations, we will continue to have problems in the power sector.[60]

47. This analysis is essentially supported by the memos we received from power companies themselves, which repeatedly stressed that there would need to be greater certainty regarding long term carbon pricing and policy before large scale investment in abatement would be forthcoming. The wider question raised in this context concerns the extent to which the EU ETS fits together with UK energy policy, as well as how both of these fit together with the UK Climate Change Programme. The main issue raised in this respect was made by members of the Clean Coal Task Group, who argued for favourable allocations to be given to new entrant coal-fired power stations in order to encourage their construction, along with extra support for Carbon Capture and Storage to mitigate their extra impact on emissions over gas. British Energy, meanwhile, argued that by maintaining subsidies for renewable energy in addition to the EU ETS there was a danger of providing renewables with a double benefit, at the expense of other low carbon options; they also called explicitly for the Climate Change Levy to be phased out "since it tackles the same issue" as the EU ETS.[61]

48. The Government has been right to impose cutbacks on the power sector's allocations, and to put a proportion of its Phase II allocation up for auction. The power sector has no grounds for complaint about this, given both that it is effectively earning windfall profits from those allocations it is receiving for free, and that it is broadly holding onto its profits rather than investing them in low carbon energy generation. Revenue raised by auctioning these allowances must not be subsumed into general spending commitments, but should be used demonstrably to assist measures to address climate change. The Government should also examine the benefits of recycling a proportion of this revenue in the form of reductions in other taxes. We outline our recommendations for the use of auction revenue in greater detail in the later section of this report, on Phase III and the ECCP Review. In the interim before Phase III (which we hope will set a higher limit on auctioning), the Government should examine the case for some form of windfall tax on power companies, where they are continuing to earn windfall profits and not investing them in low carbon generation.

49. The Government is also right to reject calls by the Clean Coal Task Group to promise new coal-fired power stations more favourable allocations, since this would be to go against the central point of the EU ETS, which is to put a price on carbon. Moreover, it should maintain subsidies for renewables alongside the pricing mechanism of the EU ETS. At the same time, given the power sector's own admission that policy uncertainty is impeding the flow of investment, the Government must provide clearer and perhaps more prescriptive guidance as to the kind of energy investments that the UK will need if it is to meet both its UK Climate Change Programme and energy strategy objectives. This must certainly be incorporated into the forthcoming Energy White Paper.

50. Regarding the Government's treatment of the industrial sectors within the Scheme, we heard strong calls from power companies and environmental NGOs for the industrial sectors to have been given a degree of cutbacks from BAU projections in their allocations for Phase II, and for a percentage of their allocation to be auctioned. One of the main arguments made was that industry would soon have to start making cuts in its carbon emissions in order for the UK Climate Change Programme to remain viable. As AEP remarked of the industrial sectors' allocations, "A BAU approach is not sustainable if the UK is to achieve a 60% reduction in CO2 emissions by 2050",[62] while Scottish Power argued that if electricity generators were to bear all of the CO₂ reductions needed to meet the trajectory set out in the 2003 Energy White Paper, the power sector would have to be carbon-free by 2020.[63]

51. EEF, meanwhile, argued strongly against such calls, on the grounds both that industry would find it very difficult to pass on resulting increases in costs, and that, in the short to medium term at least, the actual abatement potential in many industrial sectors was in fact very small. As they put it:

for an energy intensive sector, such as steel, energy price has been a significant driver for very many years. The steel industry has improved its energy efficiency by 40 per cent over about a 20-year period. Unfortunately, we have today reached the point, I suppose, where the law of diminishing returns has stepped in. On today's technology there is very little more carbon efficiency, energy efficiency, that we can drive out of the system.[64]

To achieve significant further reductions of emissions, they suggested, would in many cases require a step change in technology; aside from being complex and costly, this could only yield savings in the long term.[65] Professor Grubb's view of this argument, however, was that, while these sectors had already paid attention to their energy costs, "Carbon costs will make them pay more attention. They have thought of a lot, but they have not thought of everything".[66] In the Carbon Trust's view, all sectors should receive some cutback in their allocations, albeit these should be differentiated by sector, according to their competitive exposure and ability to pass costs through.[67]

52. As to the economic impacts of the Scheme on industrial firms, representative bodies such as the TUC and EEF argued that the EU ETS was already having a real and detrimental effect on the competitiveness of UK firms.[68] NGOs and power companies again took a much more sceptical line. They pointed to the fact that not only were industrial firms being given allocations in line with BAU projections, they in fact ended 2005 with significant surpluses of allowances—ranging from 34% in the pulp and paper sector to 6% in the iron and steel sector.[69] While both EEF and CBI stressed that these surpluses might have been exaggerated by a downturn in production in 2005, UK Steel confirmed that the steel sector's Phase I allocation "allows us to produce the volume of steel that we expect to produce during the three-year period."[70] Indeed, the main argument made to us by manufacturing groups themselves was that the impact of the EU ETS on industrial firms was coming not directly from its sectoral caps on allowances but from its contribution to already rising energy prices. This reinforces the conclusion made, following detailed analysis, by the Carbon Trust, that overall "competitiveness is not a serious concern in terms of the direct impact of Phase II EU ETS costs."[71]

53. One of the questions this raises is the extent to which the concerns expressed by industrial firms relate to wider economic circumstances, rather than their direct participation in the EU ETS. AEP, for instance, suggested that because of the weakness of the overall ETS cap, "the transfer of industry to developing countries will be driven by factors other than EU ETS, if it occurs at all."[72] Even if this is the case, however, as the Carbon Trust observed to us in passing, UK industry is generally more exposed to competition from outside the EU than its European competitors. This suggests the possibility that firms in the UK could potentially suffer a double disadvantage from inclusion in the Scheme: companies outside the EU might enjoy a cost advantage through not being affected by the EU ETS and its impact on energy prices, with companies in other EU states being less exposed to competition from them. Certainly, according to EEF the recent increases in energy costs, to which the EU ETS has contributed, have "contributed to the squeeze on profitability in manufacturing. If you look at the figures of net rates of return on capital employed, it is at its lowest level for 14 years."[73] For its part, the TUC was at pains to stress that in order successfully to deliver the transition towards a low carbon economy in the UK, without undermining competitiveness in the process, significant investment, workforce planning and skills issues will need to be addressed; and that to this end there should be greater co-ordination between Government, industry, and unions, including participation in the forthcoming Carbon Committee.[74] The view of the Carbon Trust was that, while concerns over competitiveness may be exaggerated in the short term, certain industrial sectors will be more vulnerable to competition than others—and that competitiveness could well become a significant issue in Phase III and beyond, as emissions caps begin to tighten on all sectors. (We discuss its proposals for protecting firms covered by the EU ETS in our section containing recommendations for Phase III.)

54. The impact of the Scheme so far on UK industrial firms is largely indirect, in the form of higher energy costs. Most of the recent rises in energy prices have come from other factors; and to the extent that the EU ETS is responsible, Defra's case that this is to be welcomed, as it ensures energy users pay more of their carbon costs.[75] We recognise that for some firms this represents a genuine challenge. Overall, however, industrial sectors should themselves acknowledge the need to pay external costs. Even more importantly, they must accept that they will soon have to be given some cutbacks in ETS allocations, and make some real reductions in their emissions, in order to play their important role in the UK and EU Climate Change Programmes. In any case, even if they were to avoid future cutbacks, the cutbacks given to the power sector would then have to be proportionately bigger if we were still to achieve our emissions targets, which would in turn result in higher energy prices; thus they would still not be able to escape from the rising costs of carbon.

55. This does not necessarily mean that the concerns expressed by industrial groups—about increased vulnerability to international competition, and about a limited immediate potential for rapid carbon abatement—are not genuine. There would indeed appear to be an assumption, built into the design of the Scheme and shared by the Government, that progressively reducing an emissions cap will just as smoothly reduce the carbon intensiveness of the European economy, and thus begin to reduce absolute emissions without a reduction in economic activity. This in turn appears to depend on a willingness to believe that there a number of step changes in technology that lie just around the corner, and that they can be discovered and can transform the market in a short timescale, simply through increasing the costs of carbon-intensive activities. But in reality, even if such step changes are possible, the market may in practice be too "sticky" for them to achieve rapid and widespread take-up. The Government should analyse and consult on the extent to which the economy needs greater support and guidance—in terms potentially of R&D investment, skills training, and trade agreements—in order both to realise the necessary carbon savings in the timescale required, and to do so without incurring the "carbon leakage" of firms relocating to countries with lesser carbon constraints.

56. Above all, however, where there are genuine concerns as to "carbon leakage", the emphasis of both Government and industrial lobbies should be firmly on developing trade agreement or protection measures, rather than seeking to water down the carbon caps on the UK and EU.

15 As the memo from Defra put it: "The EU ETS has been developed and implemented against a very tight timetable. The Emissions Trading Directive was finalised by the Council and the European Parliament in October 2003 and gave Member States just two months to transpose the Directive into national law. Member States then had just twelve months to prepare National Allocation Plans and to implement the Scheme only 12 months later. Although not all, Member States were able to meet this challenging timetable, the Scheme was operational across the majority of the EU by early 2005, demonstrating that it is possible to take swift and decisive action to implement measures to combat climate change." Ev 91 Back

16 Ev 1 Back

17 "Civil penalties issued today under EU Emissions Trading Scheme", Environment Agency press release , 6 December 2006 Back

18 Emissions Trading and the City of London, City of London, September 2006, p 4

Back

19 Environmental Audit Committee, The International Challenge of Climate Change: UK Leadership in the G8 & EU, para 27 Back

20 Environmental Audit Committee, The International Challenge of Climate Change: UK Leadership in the G8 & EU, para 30 Back

21 Ev 92 Back

22 Ev 2 Back

23 Trading Up: Reforming the EU Emissions Trading Scheme, IPPR, December 2006, p 6 Back

24 Allocations and competitiveness in the EU ETS: Options for Phase II and beyond, Carbon Trust, June 2006, p 7 Back

25 The high price of hot air: Why the EU Emissions Trading Scheme is an environmental and economic failure, Open Europe, July 2006, p 3 Back