House of Commons - Environmental Audit

Select Committee on Environmental Audit Written Evidence

Memorandum submitted by Steve Sorrell, Senior Fellow, Sussex Energy Group, SPRU, University of Sussex

EXECUTIVE SUMMARY

This submission proposes a hybrid emissions trading as an attractive alternative to Personal Carbon Allowances (PCAs). It argues that a hybrid scheme provides most of the benefits of personal carbon allowances, but is likely to cost much less to implement and is more likely to gain political acceptability. Most importantly, the hybrid allows an effective interface with the EU Emissions Trading Scheme (EU ETS) and the global carbon market.

This document is based upon evidence submitted in August 2006 to the EFRA Select Committeee inquiry on Climate change: the citizens agenda. In addition, the Annex to this document is based upon follow-up evidence to the EFRA inquiry, submitted at the request of the Clerk in December 2006. At the time of writing (July 2007), the EFRA Committeee has still to publish its final report.

The main message of this submission is that personal carbon allowances should not be investigated in isolation. Potential alternatives need to be considered, together with the interaction of such schemes with other existing and proposed policy instruments. These interactions may preclude the introduction of either a hybrid scheme or a personal carbon allowance scheme within the short to medium-term. However, given its potential benefits, I recommend that the government investigate a hybrid scheme as a possible basis for UK climate policy in the long-term.

INTRODUCTION

Interest in a Personal Carbon Allowance (PCA)[8] scheme has grown in recent years, encouraged through research and advocacy work by Mayer Hillman of the Policy Studies Institute (Hillman, 2004), the Environmental Change Institute at Oxford University (Fawcett, 2005) and the Tyndall Centre for Climate Change Research (Starkey and Anderson, 2005). The proposal has gained widespread media attention, with strong views being expressed both in support of the idea and in opposition to it.

The government commissioned a scoping study on PCAs in 2006 (Roberts and Thumin, 2006). This noted how researchers had focused excessively upon the operational minutiae of specific schemes and neglected assumptions about public responses and political feasibility (Roberts and Thumin, 2006). The 2007 Energy White Paper promised a programme of further research on PCAs, but highlighted concerns about the practical viability of such a scheme and the implications for social equity. Both of these issues are addressed in this submission.

Given the radical nature of the PCA proposals, it is encouraging that the government should show such an interest in the idea. However, concerns over the cost, practicality and political feasibility of PCAs may be well founded. In investigating a PCA scheme, it is essential to ask whether there are simpler and more practical alternatives that could provide comparable economic and environmental benefits, as well as be introduced within a shorter period of time. I believe that a hybrid emissions trading scheme provides such an alternative and deserves serious consideration.

This submission describes the basic elements of such a hybrid scheme and compares it with the PCA scheme under five headings: economic efficiency; environmental effectiveness; social equity; administrative costs; and political acceptability. It concludes that, overall, the hybrid scheme provides the more attractive option.

BASIC ELEMENTS OF A HYBRID SCHEME

In the design of a carbon trading scheme, there is a basic choice between a downstream scheme, in which fossil fuel users surrender allowances for their emissions, and an upstream scheme, in which fossil fuel producers (or suppliers) surrender allowances for the carbon content of the fuel they sell. The EU ETS is a downstream scheme confined to the largest emitters, while PCAs are a downstream scheme for all emitters, including households. An upstream scheme places a cap on carbon emissions from the whole economy, while most downstream schemes only cap the emissions of a subset of the economy. What is unusual about the PCA proposal is that it combines a downstream scheme within economy-wide cap.

The EU ETS is already in place and is likely to remain in its present form for the foreseeable future. In this context, both an upstream trading scheme and a PCA scheme would face potential problems of:

— Double regulation: EU ETS participants could simultaneously face two sets of carbon prices for the fuel they consume (ie the EU ETS price and the PCA/hybrid price), while all electricity consumers could face two sets of carbon prices for the electricity they consume (because the EU ETS carbon price is reflected in the wholesale price of electricity).

— Double counting: A single abatement action could lead to two separate carbon allowances being sold—one in each scheme (Sorrell and Sijm, 2003).

Proponents of the PCA s scheme have not provided adequate proposals for how these problems would be addressed. However, with an upstream scheme these problems could be avoided relatively simply through a hybrid approach (Hargrave, 2000; Mazurek, 2002). In this, the EU ETS would operate alongside an upstream scheme that covered all other fossil fuel CO₂ emissions, including those from households, non-domestic buildings and transport.

In a hybrid scheme, fossil fuel producers or suppliers would be responsible for the carbon content of fuel sold to downstream consumers that are not participating in the EU ETS. The upstream participants would include oil refineries, oil and gas importers and coal companies and the relatively small number of companies involved should keep the administrative costs low. These companies would need to surrender an allowance for each tonne of carbon contained in the fuel sold to eligible customers, and would pass these allowance prices on in fuel prices. The incentive effect for downstream consumers would be akin to a carbon tax.

To avoid double regulation and double counting, the system would need to ensure that the fuel purchased by EU ETS participants did not include the price of carbon allowances in the upstream trading scheme. This would require a "paper trail" to be established to track fossil fuel sales along the supply chain, via wholesalers and intermediaries to final consumption. Upstream producers would require allowances for all the fuel sold, unless they could demonstrate that a participant in the EU ETS ultimately consumed the fuel.

The UK could introduce an upstream scheme in parallel with the EU ETS to create a hybrid that covered the majority of CO₂ emissions from the UK economy. This could accommodate the expansion of the EU ETS in Phase 2 and beyond by simply modifying the accounting system for fuel sales (ie extending the exemptions) and adjusting the cap in the upstream scheme.

If the upstream scheme used free allocation of allowances, fossil fuel suppliers would receive large windfall profits. These firms will raise fuel prices to reflect the opportunity cost of allowances, while only incurring expenditures for any net allowance shortfalls. This is similar to the current situation in the EU ETS, where free allocation of allowances has allowed UK electricity generators to benefit from windfall profits of the order of £1 billion/year (Sijm, et al, 2006). Hence, in an upstream stream, the great majority of the allowances should be auctioned and the revenues redistributed to fuel consumers to compensate for the higher prices they face. As with carbon tax proposals, the overall scheme would then be revenue neutral.

The redistribution of funds could take place through the existing tax and benefit system, or a separate system could be established. A commonly cited model is the Alaska Permanent Fund, which distributes mining and drilling royalties on an equal per capita basis to all Alaskan citizens. An equal per capital allocation has the advantage of simplicity and should minimise administration costs.[9] However, the rules could be modified to reflect a variety of distributional objectives, including compensating the fuel poor. The impact of the scheme on fuel prices should be identical, whether free allocation or auctioning is employed.

ECONOMIC EFFICIENCY

By putting a price on carbon, both schemes encourage economic efficiency in fuel use and emissions reduction. The PCA scheme encourages fuel consumers to engage directly in trading. If a consumer chooses to use more fuel than her PCA allocation allows, she must either purchase additional allowances or pay a premium on the fuel price—thereby foregoing the consumption of other goods and services. Conversely, if she chooses to use less fuel than her PCA allocation allows, she may sell her surplus allowances and use the money in other ways.

The incentives in a hybrid scheme are entirely analogous. Fuel is more expensive since it embodies the carbon price, but consumers are allocated a lump sum from the auction revenues with which to compensate. If a consumer chooses to use more fuel than her lump-sum allocation (of money) permits, she must forego the consumption of other goods and services. Conversely, if a consumer chooses to use less fuel than her lump sum allocation permits, she has additional money available to spend.

The key point is that if the cap (and hence carbon price) is the same in both schemes and if the rules for allocating PCAs are the same as those for allocating auction revenues, then the economic impact on individual consumers is the same in both schemes. As a result, the economic incentive to reduce fossil fuel consumption should be the same. It should be noted, however, that consumers would need to engage in trading in the PCA scheme if they wished to convert their surplus allowances into money. In a hybrid scheme, consumers would be given the money directly.

Business and the public sector face a uniform carbon price in both schemes and would seek to include this in the price of their goods and services. The extent to which they can do so will depend upon the extent to which the relevant goods and services can be imported from outside the UK from companies that do not face a comparable carbon price. Again, if the cap and allocation rules are comparable in both schemes the impact on the price of goods and services should be broadly the same in the two schemes. In practice, the price impact will also depend upon the administrative and transaction costs of the scheme and the manner in which they are distributed between different participants. As argued below, these costs are likely to be higher in the PCA scheme than in the hybrid.

The economic efficiency of either the PCA or hybrid scheme could be increased (at least over the short to medium-term) if there was scope for trading allowances with other schemes, including the EU ETS. Such "links" should equalise allowance prices in the two schemes, which means that allowance prices in the PCA or hybrid scheme could either rise or fall. If credits from Joint Implementation (JI) and Clean Development Mechanism (CDM) projects were allowed to be imported into the PCA or hybrid scheme, allowance prices would probably fall, thereby reducing compliance costs in the UK. As Box 1 shows, there are legitimate concerns over whether such short term cost reductions may actually increase the cost of reducing emissions over the long-term. This highlights the difficult trade-offs that need to be made in the design of any emissions trading scheme. Both a hybrid and a PCA scheme face the same trade-offs, but the scope for linking is greatly constrained in the latter because of the risk of double counting emission reductions. In particular, links with the EU ETS may not be feasible. A hybrid scheme avoids these difficulties since there is no double counting of emission reductions.

Proponents of PCAs have argued that, when faced with a personal carbon allowance individuals may respond by engaging "more fully" in the task of identifying emission reduction opportunities, thereby reducing the cost of carbon abatement (Starkey and Anderson, 2005). Comparable arguments have been made by the Carbon Trust in support of the Carbon Reduction Commitment for business and the public sector (Carbon Trust, 2005b). These propositions deserve further research, since neither the Tyndall Centre nor the Carbon Trust cite any empirical evidence in their favour. Moreover, any efficiency benefits that do result need to be set against the greater administrative cost of the PCA scheme.

Box 1 Open or closed trading schemes

The ability to trade carbon allowances between different trading schemes is known as "linking". An "open" trading scheme allows linking while a "closed" trading scheme does not, although in practice there will be a range of choices over which links are established and with what restrictions. The Linking Directive allows credits from Joint Implementation (JI) or Clean Development Mechanism (CDM) projects to be imported into EU ETS and it is envisaged that the EU ETS will be linked to other regional or national trading schemes in the future. Hence, the potential for linking UK trading schemes with the EU ETS and with schemes in other countries needs to be seriously considered—especially over the long-term.

As argued by the Stern Review, linking should reduce the overall cost of compliance in the two schemes, help prevent the abuse of market power, improve liquidity and reduce allowance price volatility. In addition, links to the CDM may allow investment finance to be channelled to environmentally beneficial projects in developing countries, thereby encouraging technology transfer and sustainable development.

Linking should equalise the allowance prices in the two schemes, or at least bring them closer together. Hence, if a UK trading scheme is linked to a scheme with lower allowance prices, the allowance price in the UK will fall. While this will reduce compliance costs for UK participants, it will also reduce the incentive for developing or adopting low carbon technologies. There may also be concern about the stringency of the caps in the linked schemes, the implications of design features such as non-compliance procedures and the environmental integrity of emission reductions achieved through project-based mechanisms such as the CDM (Ellis, et al, 2007). Some of these concerns are reflected in the Kyoto Protocol requirement that international trading be "supplemental" to domestic action, but this requirement has yet to be operationalised in an effective manner.

Trading schemes that are relatively "open" can minimise abatement costs in the short-term by maximising the flexibility to trade. But if this flexibility is combined with uncertainties over long-term carbon prices and relatively unambitious caps, the incentives for structural change, innovation and investment in low carbon technologies will be undermined. The consequent lock-in to carbon intensive technologies and infrastructures could make it prohibitively expensive to achieve deeper emission cuts in the long-term as well as reinforcing the political opposition to such reductions.

In contrast, trading schemes that are relatively "closed" will increase abatement costs in the short-term by restricting the ability to trade. But if these restrictions are combined with greater predictability over long-term carbon prices and more ambitious caps, the incentives for structural change, innovation and investment in low carbon technologies will be increased. The drawback is that the consequent increase in short-term abatement costs and could make it correspondingly more difficult to agree ambitious short-term targets.

ENVIRONMENTAL EFFECTIVENESS

The environmental effectiveness of the scheme depends upon the stringency of the overall cap. In principle, this could be the same in both schemes. The PCA proposals typically include a "carbon budget" that gives some long-term (eg 20-year) predictability in carbon targets, and hence indirectly in carbon prices. Since this is very similar to the proposals contained in the Draft Climate Change Bill, it suggests that a PCA scheme could provide a straightforward means of implementing the Bill's provisions. But this applies equally to the hybrid scheme, since both can provide an economy-wide cap on emissions.

The carbon price will depend upon both the stringency of the cap and the balance of supply and demand. A shortage of allowances could push the carbon price to a high level, which could be politically unpopular. This disadvantage is balanced by the advantage that (unlike with a carbon tax) both schemes could guarantee attainment of a particular CO₂ target. This price/quantity trade-off is central to the choice between carbon taxes and carbon trading (Weitzman, 1974). One way of mitigating the allowance price risk would be to introduce a "safety valve" in the form of a relatively low penalty price for non-compliance (Mckibbin and Wilcoxen, 2002). The penalty price would set a ceiling on compliance costs and allowance prices. If abatement costs are higher than anticipated, and the price of allowances rises above the level of the penalty, participants will prefer to pay the penalty rather than purchase allowances from the market.

A "safety valve" could improve the political acceptability of both schemes, but it would remove the guarantee of meeting a particular emission target as well as creating an obstacle to linking to other trading schemes (Ellis and Toirpak, 2006). An alternative therefore may be to establish a link to the EU ETS and/or other emissions trading schemes. The resulting expansion of the market should reduce price risk and volatility, and—in the case of the hybrid scheme—reduce the potential for the exercise of market power by fuel suppliers.

The key point, however, is that the risk of high allowance prices is an issue for both schemes. While this risk could be mitigated in both schemes, there is greater scope for doing so with the hybrid scheme since there are few obstacles to linking.

SOCIAL EQUITY

Research by the Tyndall Centre on PCAs has paid particular attention to social equity, with a focus on the philosophical rationale for allocating allowances on an equal per capita basis. A difficulty with this approach is that it could hurt the fuel poor. Research by the Policy Studies Institute has shown that low income households vary widely in their energy consumption, owing largely to wide variations in the energy efficiency of housing (Dresner and Ekins, 2006). As a result, an equal per capita allocation would be regressive. While the impact could be reduced through the allocation of additional allowances to fuel poor households, in practice these are difficult to identify.

A hybrid scheme faces similar problems. Dresner and Ekins (2006) have shown how the regressive effect such a scheme could be mitigated through recycling the revenues through the existing tax and benefit system. However, this would not prevent a worsening of fuel poverty for 20% of the poorest households, including those who are already most badly affected.

Fuel poverty is therefore a generic obstacle to both types of scheme. The accelerated elimination of fuel poverty, coupled with the development of compensation schemes to protect low-income households is likely to be an essential prerequisite for the introduction of either. However, such compensation may be much simpler to administer with the hybrid scheme, since it would simply involve modifying the existing tax and benefit system. In contrast, the PCA scheme requires allocation rules for a newly created currency of carbon allowances.

The Tyndall researchers have also argued that allocating emission rights to individuals gives them additional "control" over those emission rights compared to the lump-sum recycling of auction revenues—including choosing to whom to sell (or not sell) units and choosing to retire units (Starkey and Anderson, 2005). But consumers could also choose to purchase and retire allowances in the hybrid scheme, using their lump-sum allocation. Decision rights over allocated allowances may potentially be valuable for a small group of "ethical" consumers, but is likely to be a marginal concern for most.

ADMINISTRATIVE COSTS

The PCA proposals amount to establishing an entirely new currency in which 45 million citizens will be participating, together with all of business and the public sector. Individuals would primarily participate through a new electronic card system, similar to existing credit/debit cards or the proposed ID cards. The Tyndall Centre has argued that this is administratively feasible, but has not been able to estimate the associated costs. It seems reasonable to assume that these will be large. Business and the public sector would participate via auctions. Interestingly, research on PCAs has tended to focus disproportionately on the mechanics of individual participation, and has paid relatively little attention to the implications for energy-using organisations. Research into the proposed Carbon Reduction Commitment for non-energy intensive organisations in the business and the public sector has suggested that, for smaller sites, the transaction costs can easily exceed the benefits of participation in emissions trading schemes (Radov, et al, 2006). As a result, the government has raised the proposed size threshold for participation (DEFRA, 2007).

In contrast, the administrative costs associated with a hybrid scheme should be relatively small. The total number of participants should be less than 50, monitoring and verification arrangements would be straightforward and the recycling of auction revenues could be implemented relatively easily through the existing tax and benefit system or some other means. The requirement for a "paper-trail" for fuel sales would impose administrative costs on the fuel supply chain, and would require independent auditing and verification. But while these costs require further examination, there are parallels in the current electricity market with the use of Levy Exemption Certificates. In general, it seems reasonable to conclude that a hybrid scheme would be substantially cheaper to set up and administer than a PCA scheme.

POLITICAL FEASIBILITY

Both schemes are likely to attract opposition from both households and business. As argued above, the carbon cap and hence the carbon price could be broadly equivalent in each scheme, together with the mechanisms for compensating badly affected sectors or individuals. Hence, what matters is how the two schemes are likely to be perceived by different groups.

From the perspective of consumers, a hybrid scheme is similar to a carbon tax. However, instead of a fixed and visible tax rate, the carbon price will be variable and largely hidden within the price of fuel. In some respects, the scheme would resemble the existing Renewables Obligation and Energy Efficiency Commitment. The cost of these is recovered through household electricity and gas bills, but the premium is not explicit and the instruments remain uncontroversial, partly because the price impacts are relatively small (although not trivial) and partly because their implications are poorly understood. However, this may not be the case for a hybrid scheme if the cost implications are much greater. Potential mitigating measures here include the use of a relatively weak cap at the inception of the scheme (gradually tightening over time), the inclusion of a safety valve provision and the scope for reducing carbon prices by linking the scheme to the EU ETS and the international carbon market.

For the perspective of consumers, a PCA scheme is similar to rationing—indeed, "carbon rationing" is Mayer Hillman's (2004) preferred term. Of course, a hybrid scheme also amounts to rationing, but since it is indirect and less visible, it may also be less controversial. With its connotations of wartime austerity, the notion of "carbon rationing" could prove unpopular in many quarters.

Proponents of PCAs argue that individual allowances should encourage greater awareness of the threat of climate change, provide a more tangible "share" of a common resource and generate a sense of common purpose in tackling the problem (Starkey and Anderson, 2005). However, it is equally likely that this level of awareness is a precondition for the acceptance of PCAs in the first place. The relative acceptability of the two approaches should be a priority for further research—together with the measures necessary to improve the acceptability of either. However, my judgement is that the hybrid approach is likely to be more feasible in the medium term.

SUMMARY

While PCAs are an attractive idea, I do not believe their time has come. In my judgement, a combination of high administrative costs, the inability to link with the EU ETS and the political difficulties associated with carbon rationing considerably reduce the attractiveness of the scheme.

However, most of the benefits of PCAs can be achieved through a hybrid scheme, in which an upstream cap on fuel suppliers is combined with the downstream EU ETS. This combines comparatively small administrative costs with (in my judgement) greater political acceptability, while at the same time delivering comparable performance in terms of economic efficiency, environmental effectiveness and social equity. Most importantly, it has the potential to interface effectively with the global carbon market.

The government has indicated its interest in including surface transport within the EU ETS, but it could be difficult to do this in a way that is acceptable to all Member States. A hybrid scheme provides an alternative means of capping the emissions from surface transport, as well as from other sectors, while at the same time achieving other policy objectives and avoiding the need for EU-wide agreement.

As discussed in the Annex, both the hybrid scheme and a PCA scheme may run into conflict with other existing and proposed policy instruments. These interactions may preclude the introduction of either scheme within the short to medium-term. However, given its potential benefits, I recommend that the government investigate a hybrid scheme as a possible basis for UK climate policy in the long-term.

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Annex: Implementing a hybrid scheme

INTRODUCTION

This Annex expands upon the practical challenges associated with implementing a "hybrid emissions trading" scheme as an alternative to a system of personal carbon allowances. Many of the issues raised are similar to those associated with implementing a programme of environmental tax reform as well as a system of PCAs. One advantage a of hybrid emissions trading scheme is that it 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

First, I would like to clarify the terminology. The key element of this 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.

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.

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

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 (Hargrave, 2000; Mazurek, 2002) and several well-developed policy proposals include elements of an upstream or hybrid approach.[10]

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.

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.

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 (DfT, 2006). 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).

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, (approx. 15€/tCO₂) the revenue raised from the upstream scheme would be of the order of £3 billion.[11] 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%.

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

The impact of an upstream scheme on a firm or sector's competitiveness depends upon a host of factors.[12] 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.

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 exaggerated. This, in turn, has contributed to the negotiation of relatively weak targets in Phase 1 and Phase 2 of the EU ETS[13] and has allowed the electricity generators to enjoy large windfall profits (Sijm, et al, 2006).[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 6000 companies from 54 industrial sectors are signatories to Climate Change Agreements (CCAs) (a total of 14000 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.

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.

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 to 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.[16]

THE IMPACT ON INCOME DISTRIBUTION

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).

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.

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 difficult to introduce such a scheme within the medium term—and possibly for longer if 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.

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 while at the same time introducing alternative approaches that encourages improvements in the energy efficiency of non-fuel poor households. The measures proposed in the 2007 Energy Review (in particular the Supplier Obligation) represent a welcome step forward, but it is unclear whether these will be sufficient.

In contrast to energy use in homes, the impact of an upstream trading scheme on energy use for surface 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 (2004) 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.

It is important to note, however, that the increases in petrol and diesel prices that would result from an upstream carbon trading scheme will be relatively small. For example, a carbon price of 15£/tCO₂ would 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. The distributional impacts for transport users are therefore a much smaller concern than those for households.

At the same time, if the price impacts are small, the incentive to reduce emissions in this sector is correspondingly small, suggesting the need for complementary policies. Including surface transport in any wider trading scheme could be problematic, since the high abatement costs in this sector may push up carbon prices for other sectors, with adverse effects on industrial competitiveness and income distribution. However, this issue is broadly the same whether surface transport is included in a hybrid or PCA scheme, or within the EU ETS. The government is currently reviewing the latter option and has encouraged the Commission to do the same.

PUBLIC UNDERSTANDING AND ACCEPTABILITY

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 (Clinch, et al, 2006). This found that:

— People did not trust assurances that the revenues will be used in the way promised by government and wanted the use of the revenues to be transparent.

— People did not understand the purpose of increasing taxes on energy while lowering taxes on employment, and did not accept the double dividend argument when it was explained to them.

— People were aware of higher energy taxes since they were visible, but were not aware of the lowering of income and other taxes since they were less visible.

— People wanted incentives as well as penalties and expressed a strong preference for the revenues to be used for encouraging energy efficiency improvements and related measures.

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 Committeee on Climate Change. 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 proposals for 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

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.

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.

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,[17] 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.

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 the main submission, it is difficult to judge 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. This issue is therefore priority for further research.

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 (Sorrell and Sijm, 2003). This important point is frequently overlooked in policy debates.

THE PROBLEM OF POLICY INTERACTION

As argued in the main 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 and proposed 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 CCL was retained, the PCAs would effectively lead to triple regulation of many organisations' electricity use—ie PCA, CCL and EU ETS).

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 2007 Energy Review proposed additional instruments that are likely to increase the complexity of the overall policy mix. These include:

— The Carbon Reduction Commitment (EPC), which is a downstream cap and scheme for large organisations in the public, commercial and industrial sectors that are not eligible for the EU ETS. Allowances are to be distributed throughout revenue neutral auction.

— The post 2011 Supplier Obligation (EEC) which may take the form of a cap and trade scheme for gas and electricity suppliers. The cap could be denominated in either energy or carbon and will relate solely to the energy supplied to households.

— Expansion of the EU ETS: The European Commission has published a draft legislative proposal for the inclusion of aviation emissions in the EU ETS from beyond 2011, while the UK government is proposing the inclusion of surface transport as well.

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.

If the above proposals go ahead as planned, is likely that the majority of UK carbon emissions will be covered by one or more trading schemes by 2012. It is also possible that four different types of carbon allowances (EU ETS, CRC, SO and CCA) will be being traded 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. Taken together, this patchwork of policies will not provide a comprehensive coverage of UK carbon emissions, while at the same time introducing multiple administrative requirements.

I do not want to argue that the above policies are without merit: on the contrary, the CRC proposals, in particular, are the product of much careful analysis (Radov, et al, 2006). However, introducing a hybrid or PCA scheme on top of these instruments is likely to be costly, unnecessary and unrealistic. The government has indicated that both the Carbon Reduction Commitment and the Supplier Obligation will remain in place in some form until 2020. Hence, in combination, it is possible that the current policy proposals could preclude the introduction of a hybrid or PCA scheme for the next 14 years.[18] This timeframe could be longer than is required to eliminate fuel poverty. Alternatively, the introduction of a PCA or hybrid scheme will require the early termination of existing policy proposals. This leaves the current discussion on personal carbon allowances in something of a vacuum, as current government policy may preclude the introduction of such a scheme in the short to medium-term.

THE NEED FOR A POLICY MIX

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: 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.

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.

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.[19] 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.

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.

SUMMARY

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:

— 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 can 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 short to medium-term.

— Introducing a hybrid scheme on top of existing and proposed policy instruments could be costly, unnecessary and unrealistic. Current policy proposals could therefore preclude the introduction of a hybrid scheme in the short to medium-term.

— 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.