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Emissions trading is central to the Government's efforts to reduce greenhouse gas emissions in the UK. This is our third report on UK policy on emissions trading. We undertook this latest inquiry to examine the prospects for a global carbon market and the implications of this for further development of the European Union Emissions Trading System (EU ETS). In doing so, we have reviewed the impact and future prospects for the EU ETS in meeting the Government's twin objectives of reducing emissions at lowest cost and setting a carbon price that delivers investment in low-carbon technologies.
Carbon allowances were clearly over-allocated in Phase I of the EU ETS, which ran between 2005 and 2007, and emissions as a whole went up over that period. In due course, the declining emissions cap in Phase III (2013-2020) could drive genuine emissions cuts, but in the meantime there is a risk, if economic recession leads to a prolonged reduction in emissions, that Phase II (2008-2012) will also turn out to be significantly over-allocated. The EU ETS could also be significantly weakened because surplus allowances may be banked and carried-over into Phase III, because industrial sectors have again been allocated allowances in Phase II in line with business-as-usual projections of their emissions, and because in Phase III they may again have access to free allowances.
The Copenhagen conference in December failed to set binding global emissions reduction targets. Whatever the progress of continuing international negotiations following the conference, the Government should push for the EU to adopt an emissions reduction target which more closely reflects the climate science, and to adopt a revised cap for the EU ETS which might act as a real lever to achieve those targets.
Mechanisms for reducing the EU ETS cap—whether in response to recession-driven reductions in demand for allowances, the success of complementary policies in cutting emissions, or the efforts of the public in reducing their carbon footprint—are urgently needed. The Government should press the EU to consider periodically whether to tighten the EU ETS cap.
Emissions trading can help promote action to tackle climate change. However, the EU ETS has emissions caps set too high to force emitters to make the often costly investment decisions which would reduce emissions. The recession has only served to loosen what little constraint the cap provided. The carbon price, because of the lack of tautness in the EU ETS, has been too low to encourage the necessary investment in low-carbon processes and infrastructure.
The cap mechanism therefore needs to be significantly tightened. This should be supported by cancelling 'new entrant reserve' allowances and auctioning as many allowances as possible, rather than giving them away for free (with the revenues possibly hypothecated to climate change measures). The Government should explore the possible use of a carbon tax. It should also encourage more use of allowance auctions with reserve prices, more use of incentives for low-carbon power generation and emissions performance standards for electricity generation. If necessary, the UK should be prepared to act in these areas unilaterally, to demonstrate a continuing leadership role on tackling climate change.
The emphasis, nevertheless, should be on harmonising the approach internationally, and on extending effective emissions trading systems. There will be a need for emissions trading for decades to come, however optimistic we might wish to be on the rate of global progress on emissions reductions. There are other trading schemes in prospect elsewhere in the world, and the Government should urge the EU to link the EU ETS with other schemes. Differences in the parameters of the schemes, for example in terms of the use permitted of offset credits, could make that difficult, so the EU ETS should take care that linking schemes does not undermine the environmental effectiveness of the EU ETS or weaken the carbon price.
Some variation in different schemes would not be an insurmountable hurdle in linking them together. If the EU ETS is merged with other emissions trading systems with a more generous allocation of allowances and greater access to offset credits from other countries, or more generous subsidies for low-carbon emitters, then terms of trade—some sort of carbon 'exchange rate'—could ensure a level playing field. The Government, with its European partners, should however ensure that schemes are not merged without such an 'exchange rate' being carefully calibrated.
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