House of Commons - Environment, Food and Rural Affairs

Select Committee on Environment, Food and Rural Affairs Written Evidence

Supplementary memorandum submitted by Steve Sorrell (CIT 03a)

EXECUTIVE SUMMARY

This submission expands upon the practical challenges associated with implementing a "hybrid emissions trading" scheme as an alternative to a system of personal carbon allowances. The key points are as follows:

— There are relatively few practical obstacles to implementing a hybrid trading scheme and the administrative costs should be relatively small. Instead, the biggest difficulties relate to its potential impact on business competitiveness and income distribution.

— The impact of a hybrid scheme on business competitiveness may easily be overstated. The impacts should be positive for many sectors and with targeted recycling of revenues, most negative impacts could be substantially reduced.

— Revenue recycling may also be used to minimise the impact of the scheme on low income households However, the scheme could still worsen the position of a significant number of households that are worst affected by fuel poverty. This may make it difficult to introduce the scheme within the next 10 years—and possibly for longer if the elimination of fuel poverty is delayed.

— Introducing a hybrid scheme on top of existing and proposed policy instruments could be economically damaging and politically unrealistic. Current policy proposals could therefore preclude the introduction of a hybrid scheme for as much as 14 years—which may be longer than is required to eliminate fuel poverty.

— A hybrid scheme has many similarities with a programme of environmental tax reform, but at present both business and the general public have a poor grasp of the implications of such reforms A variety of measures may need to be taken to make such changes more acceptable.

— A personal carbon allowance (PCA) scheme will have very similar impacts on business competitiveness and income distribution. It will also face similar problems of policy interaction and may face greater difficulties with public understanding and acceptance. It is therefore even less likely to be introduced in the near future.

— In addition, the aggregate costs of meeting an emission target are likely to be higher with a PCA scheme; the administrative costs of establishing, introducing and monitoring the scheme will be much higher; and a PCA scheme will not offer the opportunity to link to the EU ETS and the global carbon market.

— While carbon pricing mechanisms such as a hybrid or a PCA scheme are necessary to reduce carbon emissions, they will not be sufficient. A range of supporting policies will also be required.

INTRODUCTION

1. I provided an earlier submission to this inquiry, focusing specifically on the topic of personal carbon allowances (PCAs). In response to a follow-up request from the Committee, this submission looks at some of the practical questions of implementation in more detail.

2. Many of the issues raised are similar to those associated with implementing a programme of environmental tax reform. One advantage a of hybrid emissions trading scheme is that can provide most of the benefits of such reforms and reduce overall abatement costs by interfacing with the global carbon market.

THE NATURE OF A HYBRID SCHEME

3. First, I would like to clarify the terminology. The key element of my proposal is for an upstream carbon emissions trading scheme in which fossil fuel producers (or importers) surrender allowances for the carbon content of the fuel they sell. However, a conventional upstream scheme would lead to double regulation or double counting of emissions that are already covered by the EU ETS—an outcome that I consider undesirable. To avoid this, I propose that producers should only be liable for the carbon content of fuel sold to consumers outside the EU ETS. The downstream EU ETS would then operate alongside the upstream scheme to give a hybrid that covered all of the fossil fuel emissions from the UK economy, while avoiding any overlaps between the two schemes. Since this proposal differs somewhat from an upstream scheme as normally understood, I have used the term hybrid scheme. While the terms "upstream" and "downstream" are widely used in this context, the term "hybrid scheme" (for a combination of the two) is less well established.

4. A hybrid scheme should avoid double counting of emission reductions, since a reduction of fossil fuel emissions anywhere in the economy should "free up" carbon allowances in one scheme or the other, but not in both at the same time. For example, a reduction in household gas consumption will free up allowances in the upstream scheme, while a reduction household electricity consumption will free up allowances in the downstream scheme (the EU ETS). In contrast, double counting is unavoidable feature of the current PCA proposals.

5. In principle, the hybrid scheme should also avoid the double regulation of fuel consumption. Fuel suppliers will incur additional costs for purchasing allowances in the auction and will seek to pass these on in fuel prices. However, the marginal cost of supplying fuel to EU ETS participants will be lower than that to non EU ETS participants, since the latter includes the cost of allowance purchase. Assuming competitive fuel markets and an adequate system for tracking fuel sales, these differences should be reflected in lower fuel prices to EU ETS participants. Hence, fuel prices for individuals and companies outside the EU ETS should include the price of allowances in the upstream scheme, while fuel prices for EU ETS participants should not. If allowances can be traded between the two schemes (ie if the two schemes are "linked") the carbon prices in the two schemes should converge, leading to a single price for carbon throughout the UK economy.

THE FEASIBILITY AND COST OF A HYBRID SCHEME

6. All existing carbon emission trading schemes are downstream, in that they regulate emissions from fuel users directly. An upstream scheme that involves fuel suppliers is therefore a significant departure from existing practice. Nevertheless, this approach has been widely discussed within the academic and policy community for a number of years and several well-developed policy proposals include elements of an upstream or hybrid approach.[3]

7. The upstream approach is also a less radical departure from existing practice than it first appears, because it has a great deal in common with an upstream carbon/energy tax. This type of tax has have been implemented in a number of OECD countries and is subject of a considerable academic literature (Ekins and Barker, 2001; Zhang and Baranzini, 2004). In principle, the macroeconomic impacts of an upstream trading scheme should be broadly similar to those from an upstream carbon tax, as should many of the practical issues associated with implementation. Generally speaking, it is the impacts on industrial competitiveness and income distribution that provide the biggest challenge to implementing such schemes, rather than practical issues such as monitoring and verification. But the experience and analysis accumulated over the last 20 years provides a good basis for the design and implementation of such a scheme.

8. The hybrid scheme does involve some additional design challenges that are not faced by carbon taxes, but again there is a great deal of relevant experience on which to draw. For example, the design of the allowance auction can be informed by the experience with airwave spectrum auctions, as well as by the experience with auctioning emission allowances in the US Acid Rain Programme, the UK Emissions Trading Scheme (UK ETS) and the EU ETS. Similarly, the mechanisms for tracking fuel sales may be informed by UK experience with Levy Exemption Certificates and the Renewable Transport Fuel Obligation (RTFO). In each case, the practical challenges appear significantly less than those associated with creating an entirely new currency of personal carbon allowances.

9. I cannot provide estimates of the administrative costs associated with establishing a hybrid scheme, since the relevant research has yet to be undertaken. As an illustration, the costs of administering the RTFO (which is a tradable obligation on fuel suppliers to supply biofuels) is estimated to be around £1 million/year for the government and £2 million/year for industry . The costs are low because only around 20 companies are involved and because fuel sales are already monitored for the purposes of levying fuel duty (Grayling, et al, 2006).

10. The total administrative costs for the hybrid scheme would be greater than this because coal and gas suppliers (who do not pay fuel duty) would also be included, systems for tracking fuel sales would need to be established and mechanisms such as allowance auctions would need to be administered. Nevertheless, the total administrative costs are likely to represent only a small fraction of either the total revenue raised from the scheme, or the turnover of the companies involved. For example, if the clearing price in the allowance auction was £10/tCO2, (approximately 15€/tCO2) the revenue raised from the upstream scheme would be of the order of £3 billion.[4] This compares to approximately £0.8 billion from the existing Climate Change Levy, £24 billion from fuel duties, £134 billion from income taxes and £483 billion from all forms of taxation (in fiscal year 2005-06). A hybrid scheme with a carbon price of 15€/tCO2 (broadly equivalent to current prices in the EU ETS) would therefore allow income taxes to be reduced by around 2.2%.

11. The biggest obstacles to implementing a hybrid scheme are the potential impacts on business competitiveness and income distribution. Both of these will depend upon how the revenues from the allowance auction are redistributed. As with carbon taxes, the revenue raised from the auction may be used to reduce other taxes that charge for—and thereby discourage—beneficial activities such as employment. As a consequence, a hybrid scheme has the potential to deliver both environmental and economic benefits—the so-called "double dividend" (Bovenberg, 1999). However, there is likely to be a trade off between economic efficiency in revenue redistribution and political acceptability. While mechanisms are available to mitigate many of the adverse impacts on business competitiveness and low income groups, it will not be possible to satisfy all the competing claims and attempts to do so could both reduce the efficiency of the scheme and increase administrative costs. The relevant issues are briefly reviewed in the following sections.

THE IMPACT ON BUSINESS COMPETITIVENESS

12. The impact of an upstream scheme on a firm or sector's competitiveness depends upon a host of factors.[5] As a result, the impacts are hard to predict, may be greater in the short term than in the long-term and may easily be overstated by well-organised and influential lobby groups. If auction revenues are recycled to reduce labour taxes, many sectors will gain from the scheme. But energy intensive sectors may lose and may therefore seek additional forms of compensation.

13. Claims regarding the potential impact of carbon pricing on industrial competitiveness frequently lack a sound analytical basis. For example, recent studies by the IEA (Reinaud, 2005) and the Carbon Trust (Carbon Trust, 2005a; b) have suggested that, for carbon prices around €10/tCO2, the EU ETS is unlikely to reduce the profitability of most industrial sectors and that the anticipated increases in product prices will be insufficient to make non-EU imports profitable on a large-scale. While the impacts on individual companies may be greater, this analysis suggests that the claims made by many industrial groups during the process of negotiating the National Allocation Plans were greatly exaggerated. This, in turn, has contributed to the negotiation of relatively weak targets in Phase 1 and Phase 2 of the EU ETS[6] and has allowed the electricity generators to enjoy large windfall profits (Sijim, et al, 2006).[7]

14. The most energy intensive UK companies are already included in the EU ETS, or are likely to become included at a later stage. This suggests that the majority of companies affected by the proposed upstream scheme will be relatively non-energy intensive. At present, however, a total of 6,000 companies from 54 industrial sectors are signatories to Climate Change Agreements (CCAs) (a total of 14,000 sites). The CCAs provide exemption from 80% of the Climate Change Levy (CCL) in return for meeting negotiated targets to reduce energy consumption or carbon emissions. The rationale for the CCAs was that the full rate of the CCL could damage the competitiveness of these sectors because energy forms a significant proportion of total costs. In practice, however, for many of these sectors, energy accounts for a small fraction (<2%) of total costs.

15. It seems reasonable to assume that many of the sectors currently signed up to a CCA will either oppose the introduction of an upstream scheme or seek special treatment to compensate for the higher fuel costs that will result. However, there are at least three reasons why the need for special treatment should be less than in the case of the CCL:

— The proposed upstream scheme only affects fuel costs, while the CCL covers both fuel and electricity. Companies are already paying higher electricity prices as a result of the participation of the generators in the EU ETS, but this will be case regardless of whether an upstream scheme is introduced. Fuel costs in turn, are much less than electricity costs for a large number of CCA companies.

— Exemptions from carbon taxes and trading schemes are commonly justified as a transitional arrangement, to avoid high adjustment costs. However, after a nearly a decade of the CCL the grounds for such exemptions are now weaker.

16. If there is a case for special treatment, the most appropriate mechanism would be to increase the amount of revenue recycled to those sectors and companies that are considered vulnerable. In general, revenue recycling may take place in a variety of ways, with different implications for administrative costs and for the relative burdens imposed upon different sectors. For example, the £0.8 billion of revenues raised by the CCL were primarily recycled through a reduction in employers' national insurance contributions. This meant that sectors that were relatively labour intensive were net winners, while those that were relatively energy intensive were net losers. However, reductions in labour taxes are not the only option available. To compensate vulnerable sectors for the high fuel costs from the upstream scheme, additional revenues could be recycled in proportion best practice benchmarks of energy intensity, or some comparable measure. Experience with the CCAs suggests that this type of compensation could be complex to administer, but at the same time the CCAs have provided a mass of data with which to build. However, additional recycling of revenue to energy intensive sectors will reduce the pool of revenues available to compensate non energy intensive sectors and households, as well as increasing overall abatement costs.[9]

THE IMPACT ON INCOME DISTRIBUTION

17. In the absence of revenue recycling, an upstream scheme would be regressive and could have a damaging impact on the "fuel poor" who spend more than 10% of their income on energy. However, there are a wide range of options available to reduce the regressive impact of the scheme, including: increasing income tax thresholds or reducing rates of tax on low incomes; raising welfare payments such as unemployment, disability and child benefit; providing subsidies for energy efficiency improvements in low-income households; increasing winter fuel payments; and returning an equal lump sum to each individual (Clinch, et al, 2006).

18. Lump-sum redistribution is straightforward and partially corrects for the distributional impacts because low income households will receive a higher amount, relative to their income, then high income households. However, reductions in income taxes or changes in the benefits system are likely to be more effective. While earlier studies have suggested that careful targeting of tax and benefit changes could minimise distributional impacts (Metcalf, 1999), research by the Policy Studies Institute has suggested that this is unlikely to prevent a worsening of fuel poverty for up to a third of the poorest households (ie those in the lowest income decile), including those who are already badly affected by rising fuel prices (Dresner and Ekins, 2006). The reason is that low income households vary widely in energy consumption, owing largely to wide variations in the energy efficiency of housing—and some are very high energy users. Electrically heated homes and those with solid walls present the greatest difficulties, and these have been largely untouched by the Energy Efficiency Commitment (EEC) and Warm Front programmes Moreover, estimates from the Fuel Poverty Advisory Group suggest that meeting the White Paper target of eliminating fuel poverty by 2016 will require a investment of up to £6.4 billion, which is approximately twice the anticipated expenditure of current government programmes (Fuel Poverty Advisory Group, 2003).

19. These negative impacts on the fuel poor are of critical importance for the political feasibility of either an upstream or PCA scheme. They may make it very difficult to introduce such a scheme for at least the next 10 years—and possibly for longer if additional policy measures are not introduced and the elimination of fuel poverty is delayed. This makes the scaling up of existing energy efficiency measures and the introduction of new measures in this sector an urgent priority. For example, in its submission to the Energy Review, the Fuel Poverty Advisory Group recommended increasing the Warm Front budget by up to 30% over the period to 2010.

20. Concern over distributional impacts has led to household gas and electricity consumption being subsidised through VAT exemptions. It makes little sense to internalise carbon prices in this sector while such large subsidies remain. Similarly, if the government continues to exempt all households from carbon pricing in order to protect the fuel poor, emissions in this sector will rise making it more difficult to meet carbon targets in the future. There is therefore a need for a dual approach: to accelerate the elimination of fuel poverty (or at least ensure sufficient investment to meet the 2016 target) while at the same time introducing alternative approaches that encourage improvements in the energy efficiency of non-fuel poor households. The proposed doubling of activity levels for EEC3 is a welcome step forward, but additional measures may also be needed. For example, Dresner and Ekins (2006) have proposed a council tax surcharge for households who fail to implement cost-effective energy efficiency measures within a year of receiving a notification, together with a comparable incentive scheme linked to Stamp Duty.

21. In contrast to energy use in homes, the impact of an upstream trading scheme on energy use for transport should be broadly progressive (Dresner and Ekins, 2004). Nearly two thirds of households in the lowest income quintile do not own a car, compared to only one third of households overall. However, the scheme may be regressive among motorists, with larger impacts for motorists in the rural areas who lack public transport alternatives (Blow and Crawford, 1997). A 30% increase in fuel prices, for example, would reduce the standard of living of the poorest tenth of motorists by around 2%. As with household energy use, there is considerable scope for reducing distributional impacts through measures such as abolishing vehicle excise duty (VED), subsidising public transport and increasing benefits. Dresner and Ekins found that abolishing VED was the best method of compensating low-income motorists, while increasing benefits was the best method of compensating the population overall.

22. It is important to note that increases in petrol and diesel prices that would result from an upstream carbon trading scheme could be relatively small. For example, a carbon price of 15£/tCO2would increase petrol prices by less than one pence a litre, which compares with current duty levels of 47 pence per litre, and total taxation (including VAT) of 60 pence per litre. Distributional impacts in this area are therefore a much smaller concern.

PUBLIC UNDERSTANDING AND ACCEPTABILITY

23. Whatever the impact on competitiveness and income distribution, an upstream trading scheme could also face more general problems of public understanding and acceptability. The nature of these was highlighted in a recent European-wide project that used interviews and focus groups to assess social responses to environmental tax reform . This found that:

trust

understand

visible

incentives

24. These factors will need to be taken into account in the design of a hybrid scheme. For example, the trust issue may potentially be mitigated by devolving decisions about cap setting and revenue distribution to the proposed Carbon Committee (although this raises issues of accountability). The understanding issue may partially be dealt with through a prolonged public information campaign that also raises awareness about the link between energy use and climate change and the opportunities available to reduce energy consumption. The visibility issue may be partially dealt with through the use of regular lump-sum payments to each household that are clearly linked to their "share" of the overall carbon cap. Finally, the incentive issue may be dealt with by using a portion of the revenue to encourage investment in energy efficiency and renewable energy projects. None of these approaches are straightforward and each involves trade-offs with other objectives. The reaction of the UK popular press to a recent leaked memo on environmental tax reform ("a green stealth tax") suggest that there is much work to be done in improving understanding of such measures and in gaining public support. This again suggests that a lead time may be required before a hybrid scheme can be implemented.

COMPARABLE BARRIERS TO A PCA SCHEME

25. It is important to note that the barriers described above apply equally, or to a greater extent, to a PCA scheme. Moreover, these costs will be in addition to the much higher costs of establishing, introducing and monitoring a PCA scheme compared to an upstream scheme.

26. While households will receive allowances for free in a PCA scheme, the distributional impacts and hence political disputes over allocation will be broadly similar. It is also possible that a hybrid scheme may be able to protect low income households more easily than PCAs. This is because it allows straightforward adjustment to existing tax and benefit arrangements without a loss of government revenue. In contrast, a PCA scheme is more likely to address such concerns by changing the number of allowances allocated to different groups (eg giving bonus allowances to pensioners), which could be more costly to implement. Alternatively, if the PCA scheme uses fiscal measures to address such concerns, the government may lose revenue.

27. With a PCA scheme, approximately 60% of allowances would be auctioned to banks and other primary traders who would then sell them on to energy using organisations. The mechanisms for compensating these organisations for their allowance expenditures have not been specified,[10] but could be broadly similar to those outlined above. As with an upstream scheme, the revenue raised from the PCA allowance auction may be used to reduce "distortionary" taxes—potentially providing a double dividend. However, while the hybrid scheme allows the revenue from 100% of the allowances to be used in this way, the PCA scheme only auctions 60% of the allowances—with the remainder being distributed free. This suggests that the aggregate costs of meeting an emission target could be higher with a PCA scheme since the available revenues are smaller.

28. For organisations, a PCA scheme is analogous to both a hybrid scheme and environmental tax reform, since it involves additional expenditure on fuel and accompanying reductions in other forms of taxation. To that extent, it faces similar problems of understanding and acceptance to those discussed above. For household, a PCA scheme is analogous to rationing, which has a variety of negative connotations. As indicated in my previous submission, it is a matter of judgment whether an explicit form of rationing would be more or less acceptable than a hybrid scheme in which the origin of the fuel price rise is somewhat hidden (and in my judgement, it would be less acceptable).

29. Another key difference between a hybrid and a PCA scheme is that the latter includes the emissions from electricity consumption. But these are already covered by the EU ETS and electricity consumers are already paying higher prices as a result. This suggests that a PCA scheme would have a significantly greater impact on energy costs for all consumers. Moreover, these higher costs would have no immediate environmental benefit because any reductions in the emissions from electricity generation that result will simply "free up" allowances in the EU ETS. These will either be sold to other participants or banked, and will therefore be used to cover emissions somewhere in the EU. While it is possible that UK emissions will be reduced, the contribution to EU and global CO2 emission reductions will nevertheless be zero. The coverage of electricity consumption by the PCA scheme will only lead to real environmental benefits if it contributes to a subsequent tightening of the overall EU ETS cap . This important point is frequently overlooked in policy debates.

THE PROBLEM OF POLICY INTERACTION

30. As argued in my earlier submission, I believe that a hybrid scheme is substantially simpler than a PCA scheme and could therefore be introduced within a considerably shorter timescale. It also interfaces much more effectively with the EU ETS and the global carbon market. However, a policy proposal needs time to gain interest and support, needs "windows of opportunity" for implementation (such as when an existing scheme come to an end) and must "fit" within an increasingly crowded policy landscape. This last issue is problematic for both the hybrid scheme and PCAs. Both provide a comprehensive approach that caps the total fossil fuel emissions from the UK economy and the former offers the potential of a uniform carbon price—as recommended by the Stern Review. But both also have the potential to interact negatively with a number of existing policies that target different sectors of the economy in different ways. For example, introducing a hybrid scheme on top of the existing Climate Change Levy (CCL) would create a "double regulation" problem, in that fuel purchases would include the carbon price from the hybrid scheme as well as being eligible for the CCL. In the case of the PCA scheme, this problem would also apply to electricity (indeed, if the CCA was retained, the PCAs would effectively lead to triple regulation of business electricity use—ie PCA, CCL and EU ETS).

31. Such overlaps already exist in the UK policy mix and may sometimes be acceptable (Sorrell and Sijm, 2003). But in many cases, they are likely to increase the cost of meeting UK carbon targets. If a PCA or hybrid scheme were simply to be imposed on top of existing instruments, such problems could be made substantially worse. This suggests that the introduction of such a scheme may need to coincide with the removal of such instruments. However, the government is currently proposing to introduce two additional instruments that are likely to increase the complexity of the overall policy mix. These are:

Energy Performance Commitment (EPC)

Energy Efficiency Commitment (EEC)

32. In addition, the Climate Change Agreements (CCAs) for large industrial sites are expected to continue until 2013. Companies with CCAs will still be allowed to trade carbon allowances as part of the UK ETS, even though the "direct participant" part of that scheme ends in December 2006.

33. If the above two proposals go ahead as planned, the net result will be four different types of carbon allowances (EU ETS, EPC, EEC and CCA), trading within four separate markets at four separate carbon prices. In each case, there will be problems of "double regulation" of electricity, because the electricity generators are already participating in the EU ETS and therefore pass on the carbon price within the price of wholesale electricity. Each UK market will also lead to "double counting" of emission reductions, because two carbon allowances (in two separate markets) will be generated from a single one-tonne reduction in emissions. This, in turn, will make it difficult or impossible to "link" the schemes to allow trading between them. As argued by the Stern Review, linking trading schemes offers great potential to reduce the cost of emission reduction. Taken together, these policies do not provide a comprehensive coverage of UK carbon emissions, while at the same time introducing multiple administrative requirements.

34. I do not want to argue that the above policies are without merit: on the contrary, the EPC proposals, in particular, appear to be the product of much careful analysis. However, introducing a hybrid or PCA scheme on top of these instruments is likely to be both economically damaging and politically unrealistic. While the current consultation on the EPC does not define explicit timeframe, it suggests that the scheme could remain in place until 2020. Similarly, the government is committed to some form of supplier obligation until 2020, which could well take the form of a cap and trade scheme. Hence, in combination, current policy proposals could preclude the introduction of a hybrid or PCA scheme for the next 14 years.[11] This timeframe could be longer than is required to eliminate fuel poverty.

35. With a forthcoming Climate Change bill and the proposed establishment of a Carbon Committee, it may be appropriate to ask whether a more comprehensive approach such as a hybrid or PCA scheme provides a better alternative to current policy proposals. In practice, however, such a development appears unlikely. The EPC and EEC proposals have considerable momentum and appear likely to go ahead in some form. This leaves the current discussion on personal carbon allowances in something of a vacuum, as there seems little prospect of introducing such a scheme before 2016 at the earliest.

THE NEED FOR A POLICY MIX

36. Carbon pricing is a necessary but not sufficient condition for a transition to a low carbon economy. It is necessary, because the theoretical benefits of market-based instruments are strongly supported by empirical evidence. In particular, the inverse relationship between energy (carbon) prices and energy consumption (carbon emissions) that it is predicted by basic economic theory appears confirmed by empirical data (Figure 1).

Figure 1 KOKO RELATIONSHIP BETWEEN ELECTRICITY PRICE AND ELECTRICITY INTENSITY IN OECD MEMBER STATES (1998)

Source: Verbruggen (2003).

Notes: The figure shows cross sectional data from 24 OECD countries for 1998. A double log function ln(Intensity)=a+b*ln(Price), gives an R2 of 82.3 and a residual standard error of 0.2296. The estimated elasticity b equals -1.17 (standard error 0.12 and t-value -10.11), implying that a 1% increase in electricity prices leads to a 1.17% reduction in long-term electricity intensity.

37. Carbon pricing in isolation, however, is insufficient because it only addresses the environmental externalities of fossil fuel combustion and does not overcome the variety of reinforcing market failures that inhibit the innovation and diffusion of low carbon technologies (Jaffe, et al, 2004;; Sorrell, et al, 2004). On its own, carbon pricing is likely to provide insufficient support for promising low carbon technologies that are in the early stages of deployment as well as being relatively ineffective in encouraging energy efficiency in sectors with a low energy intensity.

38. This is particularly the case in the household sector, where the adoption of cost effective energy efficiency improvements is hindered by a series of market failures. These include: the presence of hidden costs (including the opportunity cost of time, disruption etc.); limited information (about energy use, cost of measures, benefit of measures); uncertainty about length of tenure at a property and the associated inability to recoup any uncapitalised expenses; split incentives (most notably between landlords and tenants); and difficulties in accessing capital. The net result is that the price elasticity of energy consumption is very low in this sector, which means that carbon prices would need to be very high to have a significant impact on behaviour and emissions. The associated distributional impacts are unlikely to be acceptable. At same time, there is no prospect of curbing emissions in the domestic sector over the longer term without increasing energy prices.

39. This points to the need for a coordinated policy mix that "gets the prices right", overcomes barriers to the adoption of cost effective technologies and facilitates and encourages the complex processes of technological change. This is not an argument for a "kitchen sink" approach, but does suggest that a range of measures will be required. For example, I would argue that there is a strong case for traditional regulatory measures to eliminate standby power and to impose minimum energy efficiency requirements on electric appliances. Many of these measures are better focused on the supply chain for energy using devices, rather than the consumer, and need to be targeted and differentiated by energy service. The revenue stream from an upstream trading scheme may be used in part to fund R&D, demonstration projects, investment subsidies and other measures to facilitate the diffusion of energy efficient technologies. Hence, it is not a question of either a trading scheme or traditional regulatory measures: instead, both are likely to be required.

LINKING TRADING SCHEMES AND THE PURCHASE OF OFFSETS

40. The linking of trading schemes to allow allowances to be traded between them is likely to be a central feature of the emerging global carbon market. Such links offer considerable economic benefits and are relatively unhindered by differences in the design of the two schemes. The EU ETS is likely to be the centre of the global carbon market for the foreseeable future and is expected to establish links with other trading schemes both within and outside the Annex I countries of the Kyoto Protocol. It follows that proposals for new trading schemes should take into account the opportunity for links with the EU ETS. Such linking is possible with a hybrid scheme, since double counting of emission reductions is avoided. In contrast, linking is problematic with the PCA proposals owing to the double counting of the emission reductions associated with electricity consumption.

41. A link to the EU ETS offers several important benefits for the hybrid scheme. First, it reduces overall abatement costs by equalising the carbon price throughout the UK economy. Second, it reduces the potential for the exercise of market power by fuel suppliers in the upstream scheme. Third, it reduces the risk of both high allowance prices and price volatility. Finally, it allows access to project credits from Joint Implementation (JI) and the Clean Development Mechanism (CDM).

42. A link between the upstream scheme and the EU ETS will increase the carbon price in one market and reduce it in the other. A low carbon price may reduce the incentive for developing or adopting low carbon technologies, while an excessive reliance on CDM credits could conflict with the Kyoto Protocol requirement that this be "supplemental" to domestic action. There may also be concern about the environmental integrity of the emission reductions achieved by JI/CDM projects and by the dominance of credits from the abatement of non-CO2 industrial gases. These are important issues for the EU ETS as a whole and may be best addressed at the EU level through harmonised rules. These could include, for example, stringent caps in future phases of the EU ETS, a harmonised limit on the number of JI/CDM credits that can be imported and the greater use of allowance auctioning, including a price floor.

43. While the linking of the upstream trading scheme with JI/CDM should be encouraged, the import of credits from voluntary offset projects may be less desirable. The voluntary market remains largely separate from the regulated market and is much smaller. The main buyers are non-regulated companies and organisations, together with individuals who are concerned to reduce the environmental impact of their activities in a relatively painless way. At present, there is no global standard for the verification and certification of project based voluntary emission reductions and the market is highly differentiated. Given the difficulties in estimating baselines for these projects, establishing whether they are "additional" to business as usual and avoiding "carbon leakage", the environmental credibility of many offsets may be questionable. This is especially the case for forestry projects, where there are serious methodological difficulties in estimating carbon uptake and concerns about the permanence of this uptake in a rapidly warming world.

44. Given these difficulties, it may be better to confine any links with an upstream scheme to fully regulated carbon markets, and not to allow the import of voluntary carbon offsets. However, this recommendation could change if more standardised and credible verification protocols become established.[12] In any case, these offsets would primarily be purchased by fuel suppliers for compliance purposes. While there would be nothing to stop or to ganisations and individuals from purchasing voluntary carbon offsets, the upstream scheme would not encourage this directly—although if a link were to be established, there could potentially be scope for the sale of these offsets into the wider carbon market.

SUMMARY

45. This submission has expanded upon the practical obstacles to implementing a hybrid trading scheme and speculated on the timescales involved. The key points are as follows:

— While carbon pricing mechanisms such as a hybrid or a PCA scheme are necessary to reduce carbon emissions, they will not be sufficient. A range of supporting policies will also be required.

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Steve Sorrell

Senior Fellow, Sussex Energy Group, SPRU, University of Sussex

December 2006

3 Perhaps the best know is the Climate Stewardship Act, proposed by Senators John McCain and Joseph Lieberman, which would cover more than 70% of US carbon dioxide and industrial greenhouse gas emissions. Large installations in the industrial, public and commercial sectors would participate directly in a similar manner to the EU ETS. However, transport emissions would be covered through the participation of refineries and fuel suppliers, who would surrender allowances for the carbon content of fuel sales. This is therefore a hybrid scheme, since it includes both upstream and downstream elements. Back

4 Approximately 300MtCO2 of emissions would be covered by the scheme. Back

5 Including the stringency and future predictability of the emissions cap, the timeframe for introducing and tightening the scheme (relative to asset lifetimes), the contribution of fuel to total input costs, the carbon intensity of fuel use, the extent to which the relevant product markets are open to international competition, the extent to which competitor companies in other countries face comparable carbon prices, the scope for switching to lower carbon products, the own-price elasticity of the relevant products and the opportunities available for abating emissions through energy efficiency improvements or fuel switching (Barker & Kohler, 1998). Back

6 The aggregate Phase 1 cap was approximately 3% above baseline emissions and only 1% below official 'business as usual' projections. When verified emission data was released in May 2006 it showed that emissions were a below allocations-leading to a substantial fall in allowance prices. The caps proposed in the National Allocation Plans (NAPs) for Phase 2 were sufficiently weak to create a risk of a zero carbon price in Phase 2 (Rogge, et al, 2006). The Commission has recently requested more stringent targets in nine out of the 10 allocation plans it has reviewed (the exception being the UK). Back

7 The primary reason for the large windfall profits (ie beyond what is required for compensation) was that the allowances were allocated for free, rather than being sold in an auction. Windfall profits for UK electricity generators during Phase 1 have been estimated at £0.8 billion/year (IPA Energy Consulting, 2006). Back

8 Eligibility for CCAs was originally based on the coverage of the Integrated Pollution Prevention and Control Directive, but following extensive lobbying the eligibility rules were widened to include other "energy intensive" sectors. Back

9 Another possibility would be to introduce border tax adjustments, with exports receiving a refund while imports are taxed. This would need to use relatively crude methods to estimate the carbon content of imports and must be consistent with World Trade Organisation rules (Ismer and Neuhoff, 2006). Back

10 Indeed, the disproportionate focus on the implications for households, rather than organisations, is a weakness of the current PCA proposals. Back

11 The difficulty here is one of inertia. For each instrument, a legislative framework will be established which may be difficult to change; regulatory institutions will be established, or responsibilities assigned to existing institutions; procedures and standards will be established for functions such as monitoring, reporting and verification; a network of private organisations become involved in implementation; and the target groups themselves will invest substantial time and money in gaining familiarity with the policy instruments and putting the appropriate procedures in place. All these activities will cultivate vested interests and encourage resistance to change. Back