Select Committee on Treasury Fourth Report


Theoretical considerations


48. Emissions trading is a mechanism designed to produce a market for greenhouse gas (GHG) emissions so that those emissions can be reduced in an economically efficient way. A cap is set for the total amount of emissions permitted and each polluting business is then allocated a proportion of this total. Participants can then either:

As participants have to pay to emit more GHG than their allocation allows, and can profit from emitting less, emissions trading should create a financial incentive to reduce emissions. An emissions trading scheme therefore provides a framework for achieving a socially-desired level of emissions in an economically efficient manner.

49. The first stage of setting up an emissions trading scheme involves allocating emission permits to participants, either via an auction or, alternatively, by reference to existing levels of emissions. Then, when trading commences, innovative firms should identify ways to reduce their emissions, and thus be able to sell unused permits, via the market, to other firms with a greater need for them. Firms therefore have an incentive to invest in cleaner technology, and the dirtiest firms should struggle to retain a competitive advantage. One applied example of an emissions trading scheme is that established by the European Union. This chapter considers the theoretical case for emission trading schemes, the successes and challenges of the existing European Union Emission Trading Scheme (EU ETS) and how the EU ETS might be extended to other countries and industries, in particular to aviation.

Theory of Trading Schemes

50. The primary benefit of an emissions trading scheme is that, if successful, it limits the quantity of emissions to the level chosen by society, achieving an environmental aim via the use of an economic mechanism. Kate Hampton of Climate Change Capital explained how emissions trading can deliver very large volumes of emissions reductions, "as we are starting to see with the EU Emission Trading Scheme and its impact on investments in the developing world through Kyoto's Clean Development Mechanism". She considered that, in creating a market, emissions trading was "unleashing the private sector's ability to go out and discover the lowest cost reductions".[89]

51. Initially, permit trading would be expected to encourage those forms of mitigation that are relatively easy and cheap to deploy. Emissions trading should therefore allow emissions reductions to be made efficiently, in contrast to a system of regulation whereby emitters are simply told that, if they exceed a specific target, they will be punished by a fine. An emissions trading scheme can ensure a particular level of emissions is achieved, but at an uncertain price. An alternative to emissions trading is environmental taxation, which can give certainty over the price of emissions, but no certainty over the level of emissions. Environmental taxation is discussed in Chapter 5.

52. Sir Nicholas told us that the most important advantage of trading schemes was that they promoted carbon financial flows from developed to developing countries, and did so via a market mechanism, rather than through overseas aid. He explained that countries such as India and China were looking to rich countries for help with moving to low-carbon economies, and that the UK should therefore be "scaling up" activities such as the Clean Development Mechanism, in order to facilitate these financial flows to developing countries.[90]

Problems with emissions trading

53. Most witnesses agreed that the theoretical elegance of emissions trading was hard to recreate in a real-world setting. Professor Ekins, for example, told us that due to political pressures the schemes which actually come into existence bore little relation to the textbook expositions of emissions trading.[91] The Centre for Sustainable Energy agreed that "there is a political process … which sometimes is missed in the theoretical understanding of how efficient a taxation or trading system is".[92] Indeed, Lord Lawson characterised the permit allocation process of trading schemes in general as "highly arbitrary" and subject to a "tremendous amount of horse trading and corruption".[93] He argued that the administrative infrastructure required to operate an emission trading scheme was "hugely more expensive" than that required for tax-gathering.[94] He ranked emissions trading as "better than regulation and direction", but less efficient than taxation. The biggest failings he cited were the problem of identifying the appropriate cap on emissions and that of selecting the industries which would participate:

    Will this system apply to the personal sector as well as the power sector and one or two others? Unless you do it across the board the more economic distortions there will be, whereas taxation would apply all over the place.[95]

54. An emissions trading scheme requires a rigorous measuring system in order to ensure that all emissions are accounted for by permits. This is, generally speaking, easier to achieve with larger industries such as power generation, as opposed to small factories, shops or individuals. Sir Nicholas told us that in cases where emission measurement was difficult, it could be easier to operate a tax on goods rather than a trading scheme.[96]

55. Professor Ekins acknowledged that there was an opportunity for fraud by participants in trading schemes, but was confident that "a very great deal of effort has been invested in … monitoring and verification mechanisms both in this country and in Europe and to some extent elsewhere in order to try to ensure that [such fraud] does not happen". He explained that:

    In principle, it is quite easy to calculate how much carbon is released when one burns a certain quantity of fossil fuel because it is known how much carbon is in it and all of it will go into the atmosphere. The difficulty arises when one starts to allocate allowances on the basis of estimated base lines. What would have happened if one had not done certain things? The "what would have happened"—the counter-factual—is always an uncertainty and people have vested interests in arguing that base lines are different from what they would have been. That debate that has dogged the whole issue of how one might take into account reductions in deforestation. Mechanisms to deal with these issues have been evolved and I believe that in the European context they are reasonably robust. [97]

56. Professor Ekins noted that the Stern Review saw emissions trading as a long-term way to cap emissions. In the short term, he argued, there would probably be a need to make use of a price mechanism such as an environmental tax. Therefore, there would have to be a carbon tax subject to adjustment in order to deliver a long-term quantity of emissions trading.[98]

European Union Emission Trading Scheme


57. In 2003 the European Council adopted the Emissions Trading Directive, which laid out the framework for the European Union Emissions Trading Scheme (EU ETS).[99] The aim of the EU ETS, which officially came into operation on 1 January 2005, is to help EU Member States achieve compliance with their commitments under the Kyoto Protocol. It does not attempt to set new environmental targets, but rather allows for cheaper compliance with existing targets, by letting participants trade emission allowances so that the targets can be achieved at least cost.[100] The 11,500 energy-intensive installations that are currently covered by the scheme account for close to half of all EU emissions. These installations include combustion plants, oil refineries, coke ovens, iron and steel plants, and factories making cement, glass, lime, brick, ceramics, pulp and paper.[101]

58. The Minister confirmed that the EU ETS was the UK's principal carbon pricing instrument, covering half of the UK's emissions.[102] In October 2006, the Government published its vision for the long-term future of international emissions trading, stating that it intended to develop the EU ETS as the basis of a global carbon market. The UK's key proposals are:

  • set a new Europe-wide emissions reduction target of 30 per cent by 2020 and then at least 60 per cent by 2050, providing greater long-term certainty for business;
  • foster a deeper, more liquid market by considering expansion of the EU ETS to cover more sectors and gases;
  • move towards more auctioning of allowances in future phases to ensure a more efficient allocation; and extend the scheme beyond Europe - first, by guaranteeing that credits from Clean Development Mechanism projects in developing countries will be valid for compliance in the EU ETS beyond 2012, which will enable not only financial flows but technology transfer to the world's poorest countries; and second, by enabling similar schemes in other countries, such as those being developed in Japan, Australia, the North Eastern American states and California, to trade with the European scheme.[103]


59. The Better Regulation Commission (BRC) commended the Stern Review's analysis of the issues that needed to be dealt with by the EU ETS: namely, creating adequate scarcity of allowances to ensure a meaningful carbon price, ensuring that there was appropriate transparency and liquidity, and working towards the inclusion of all sectors. The BRC stated that the UK Government had considerable influence in Europe on these issues.[104]

60. Simon Bullock from Friends of the Earth told us that the cap on emissions in Phase I was not sufficiently demanding to result in a carbon price that would offer economic incentives or induce any real behaviour change by emitters.[105] Professor Ekins said that "easily the biggest problem with the European scheme is that governments are allocating too many emissions allowances".[106] He thought that the European Commission was "absolutely right to take a tough stand" on national allocation plans under Phase II.[107] He also pointed out that, in relation to Phase II, of the 10 to 15 allocation plans that had been submitted by national governments, only the UK's had been approved so far and nine had been rejected.

61. Sir Nicholas said that the EU was only in the first couple of years of the EU ETS and the lesson of giving away too many permits in the early stages had been learnt. Sir Nicholas added that the EU Commissioner for the Environment with responsibility for the EU ETS, Commissioner Stavros Dimas, had made a strong case in the second round of the national allocation plans for much more stringent allocations, and had taken "very much on board" the criticisms of the overgenerous Phase I permit allocation.[108]


62. The Environment Agency pointed out that the mechanism of the EU ETS itself works, and it had been demonstrated to work by the fact that the emissions permit price had been driven down to low levels, indicating that the market was finding the most cost-effective ways of delivering emissions reductions under the (albeit over-generous) cap.[109] Kate Hampton argued that Phase I of the EU ETS (covering the period 2005-07) was a learning phase, and was entered into "before the EU had adequate data", and she considered that it was therefore inevitable that there would be a price adjustment when the real data came out. She was optimistic that recent European Commission decisions over Phase II allocations (covering the period 2008-12) would provide a higher price for carbon, noting that emitters are already are investing in technology on the basis of a higher carbon price than before.[110] Sir Nicholas agreed that we should see the early experiences of emission trading as a learning process:

    these are early days. I think we are learning quite quickly. I have been impressed by how rapidly that learning process has gone ahead given that [the EU ETS] has been going for only a couple of years[111]

63. Phase I of the European Union Emission Trading Scheme was hamstrung by its initial over-allocation of emissions permits, resulting in a carbon price that was too low to have sufficient influence in changing its participants' behaviour. The scheme has been successful in showing that the architecture of the trading system works, and provides a foundation from which to develop an effective scheme with a meaningful overall cap, but it is absolutely essential that Phase II features a more rigorous allocation of permits. We recommend that the UK Government work with the Commission and other Member States to ensure that Phase II involves tough, but achievable, caps across Europe.

Moving to a global emissions trading scheme

64. One of the Government's three key proposals relating to the EU ETS is that it should be developed in a way that enables "similar schemes in other countries to trade with the EU ETS and to guarantee that credits from Clean Development Mechanism projects in developing countries will be valid for compliance in EU ETS beyond 2012".[112] The Minister assured us that it was realistic for the Government to aim for worldwide carbon trading systems, although he admitted that achieving such systems would be tough. He saw the EU ETS as the cornerstone of international climate change architecture for the future:

  • providing the capacity to set emissions' limits;
  • establishing a carbon price;
  • encouraging the transfers in investments and technologies that needed to take place into countries like India and China; and
  • linking trading schemes that are beginning to be established in other countries.[113]

65. Professor Ekins agreed that the EU ETS offered the "best hope of some kind of global accommodation with the carbon constraint". He explained that there were already "straws in the wind", suggesting how it might develop:

    The EU scheme is already linked to the mechanisms of the Kyoto Protocol … and, if other countries and perhaps even individual American states such as California evolved their own robust emissions trading schemes … in principle there would be no reason why those permits should not become tradeable across borders as well.[114]

66. Simon Roberts was less optimistic that a truly global arrangement could be established soon, but emphasized that this did not mean that the UK should not act prior to such an arrangement being established:

    What is important is that one starts to map out what the rules would be for an international system so one build that into it and joins together any more regional systems. One certainly does not need a global system to kick off, as the EU ETS shows.[115]

67. Whilst the EU moves ahead with Phase II of its Emissions Trading Scheme, we note that other countries and states are developing their own, different schemes. The existence of different schemes offers policymakers the chance to see what works and what does not, but there is a real danger that the international community will be unable to join up this patchwork of schemes, if so desired, at a point in the future. Without establishing common principles between schemes, we are not confident that the Government's ambition of connecting up the European Union Emission Trading Scheme with other schemes can be achieved. We recommend that the Government strengthen relationships with policymakers in other countries and other organisations beyond the EU to discuss the development of trading schemes.

Inclusion of airlines in the EU ETS


68. Emissions from aviation are forecast to be the UK's fastest growing source of greenhouse gas emissions, rising from 5% of UK emissions now, to potentially 25% by 2030.[116] The European Commission plans to broaden the scope of the EU ETS to include civilian aviation emissions. The Minister explained that the Government's aim was to see aviation included in the EU ETS as soon as possible.[117] Sir Nicholas also regarded aviation's inclusion as very important.[118]

69. The general view amongst airline industry representatives was that, of all the economic tools available to curb emissions, the first choice would be a global emissions trading scheme, the second choice would be a regional trading system (although they pointed out that several problems would arise about whether to include non-European carriers flying to European airports), and the third choice would be a tax on emissions (which would be very costly to the industry). EasyJet said that aviation's inclusion in the EU ETS would "incentivise airlines to operate much more efficiently; otherwise, they will be penalised". It explained that this would not solely mean cleaner planes, but would also influence how those planes were used and how full each plane would be.[119] The British Air Transport Association (BATA), the UK Aviation trade body, believed that the EU ETS was the right way forward, and stated that the UK industry was taking the lead in persuading airlines around the world to that effect.[120]

70. Anthony Concil, the Communications Director of the International Air Transport Association (IATA) was quoted in November 2006 as saying "for Europe to act before a global agreement is putting the cart before the horse".[121] However, in evidence to us, IATA's Director of Aviation Environment, Philippe Rochat, gave a cautious welcome to aviation's inclusion in the EU ETS,[122] whilst admitting that IATA continued to lobby in Brussels for changes to be made to "fit with aviation's requirements".[123] IATA noted that a truly global aviation emissions trading scheme would take a long time to coordinate, bearing in mind how long it has taken for the EU States to forge an agreement,[124] but its Chief Economist, Brian Pearce, was optimistic that, in tandem with the EU ETS, a patchwork of similar schemes was gradually gaining ground, and these could ultimately be linked up to a worldwide scheme.[125]


71. One of the difficulties faced by the EU ETS in seeking to include aviation will be creating a level playing field between European and non-European airlines. BATA told us that a European Commission working group had been grappling with issues such as deciding which flights should be included in the scope of the scheme, concluding that a two-stage process would be appropriate, whereby intra-Europe flights are included in 2011 and flights arriving in or departing from Europe in 2012.[126] Virgin Atlantic accepted that there was opposition from non-European governments to the introduction of such a scheme, but added that the UK industry had done its best to persuade airlines around the world of the merits of this approach.[127]

72. Philippe Rochat from IATA was convinced that emissions trading was "a far better tool than taxes and charges". However, he stressed that for a scheme to work in the global aviation industry, it must be of a global nature, and not regional or national:

    We have always supported a global scheme through ICAO [International Civil Aviation Organization] according to what the Kyoto Protocol suggests for aviation and we regret to say that at the last ICAO assembly IATA insisted on the development of a global scheme for aviation and no one state supported that idea … We consider that aviation emissions are global; they take place all over the world. More than half of aviation emissions take place over the high seas where no state is entitled to impose emissions trading, so we think that only a global solution through ICAO will work. ICAO has the mandate to regulate air transport over the high seas in the international air space.[128]


73. The aviation industry is not scheduled to enter the EU ETS until 2011 at the earliest. Friends of the Earth argued that, in the meantime, interim measures were urgently needed.[129] Besides changes to the aviation taxation regime (see Chapter 5), we also considered the possibility of eco-labelling as a way of encouraging airlines and passengers to make environmentally-conscious decisions.

74. Flybe introduced an eco-labelling scheme for its aircraft in June 2007. The labels are modelled on those used in the sale of white goods and show a range of environmental indicators (such as fuel burn, carbon emissions, noise footprints and total environmental cost) for each aircraft. These labels are presented as part of the on-line ticket booking process, in onboard literature and in advertising.[130] The aim of the Flybe scheme is to inform consumers about the environmental impact of their flights. British Airways (BA) acknowledged that it was important that airlines communicated more effectively with their customers about the environmental impact of flying.[131] When pushed on why ideas such as the Flybe initiative has not led to a coordinated response from the airlines, Easyjet suggested that the industry had been inhibited in the past by its "competitiveness nature", saying that their appearance before the Treasury Committee was "the first time we have appeared like this together".[132] Virgin Atlantic indicated that they were "coming up with proposals" on an eco-labelling scheme, although at present no such scheme was in place.[133] IATA argued that it was promoting eco-labelling among its members, "but only a limited number of them are today receptive".[134]

75. Other airlines have environmental codes and programmes, and several publish data on emissions, efficiency and fuel consumption. However, typically this information is not readily accessible at the point of sale and is not easily comparable with other airlines' environmental records. We suggested to IATA that they might get involved in promoting the kind of "eco-competition" made possible by the Flybe scheme. IATA assured us that they were in favour of competition, but thought that it was "up to the individual airlines to promote their environmental performance".[135] At an oral evidence session on 23 January 2007, Virgin Atlantic committed to writing to the Committee with plans of how the aviation industry would cooperate on new environmental initiatives.[136] At the time of agreeing this Report, the Committee had not received any such letter.

76. The UK Government has signalled its desire to see aviation included in the European Union Emission Trading Scheme in 2011. If that aim is achieved, the Scheme should be able to ensure that the aviation industry will be offered real incentives to improve the efficiency of its fleet of aircraft, develop cleaner technology and continue to grow in an environmentally-sustainable way.

77. We are concerned that, in the interval before aviation's inclusion in the European Union Emission Trading Scheme, the aviation industry appears to be dragging its feet in cooperating on environmental schemes. We see the airlines' failure to write to the Committee, as promised, with details of how the industry would cooperate in future, as symptomatic of this approach. Instead of cooperation, a hotchpotch of company-specific initiatives are developing, with a huge variety of responses from different airlines, preventing consumers from comparing the environmental performance of one airline with another. One information improvement to the market for passenger flights would be an industry-wide system of eco-labelling, where each flight's environmental impact would be independently rated and then publicised to customers at the point of purchase. We urge the Government, the airlines and aviation's representative bodies to work together to devise and introduce such a scheme at the earliest opportunity.

88   "Emissions trading: the theory", the Carbon Trust, 22 February 2005


89   Q 117 Back

90   The Clean Development Mechanism, established under the Kyoto Protocol, allows industrialised countries with a greenhouse gas reduction commitment to invest in projects that reduce emissions in developing countries as an alternative to more expensive emission reductions in their own countries. Back

91   Q 7  Back

92   Q 117 Back

93   Q 224 Back

94   Q 225 Back

95   Q 224 Back

96   Q 145 Back

97   Q 12  Back

98   Q 7  Back

99   EU Directive 2003/87/EC Back

100   EU website  Back

101   The Carbon Trust website  Back

102   Q 262 Back

103   "Analysis paper on EU Emissions Trading Scheme Review options", DEFRA, September 2007, p 3 Back

104   Q 347 Back

105   Q 348 Back

106   Q 12 Back

107   Q 10 Back

108   Q 148 Back

109   Q 392 Back

110   Q 119 Back

111   Q 146 Back

112   Pre-Budget Report 2007, p 117, para 7.17 Back

113   Q 279 Back

114   Q 11  Back

115   Q 122 Back

116   "The Future of Airport Transport", Department for Transport, 16 December 2003, Chapter 3, p 10, para 3.35 Back

117   Q 294 Back

118   Q 165 Back

119   Q 59 Back

120   Q 31 Back

121   "Airlines attack Europe's plans to tackle flight emissions", Financial Times, 16November 2006 Back

122   Q 480  Back

123   Q 478  Back

124   Q 471 Back

125   Ibid Back

126   Q 52 Back

127   Q 56 Back

128   Q 471  Back

129   Ev 139  Back

130   Flybe website:  Back

131   Q 83 Back

132   Q 85 Back

133   Q 88 Back

134   Q 457 Back

135   Q 453 Back

136   Q 90 Back

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