House of Commons - The role of carbon markets in preventing dangerous climate change

The role of carbon markets in preventing dangerous climate change - Environmental Audit Committee Contents

3 The impact of the EU Emissions Trading System

Assessing the impacts of the EU ETS

14. Assessing the effectiveness of the EU ETS in meeting the Government's twin objectives, of limiting emissions and encouraging investment in low-carbon technology, is complicated by a number of factors:

the EU ETS' effectiveness can only be properly assessed at an EU level;
it is impossible to disaggregate the impact of the System from the impact of other economic factors and policy instruments which may affect businesses' operational and investment decisions and resulting performance; and
emissions at or below the cap cannot necessarily be taken as an indication of the success of the EU ETS because allowances might have been over-allocated in the first place.[19]

In addition, the evidence to date—in terms of caps, actual emissions, the carbon price and the responses of business—straddles two phases of the EU ETS: the whole of Phase I (2005-2007) and the beginning of Phase II (2008-2012). As the National Audit Office has observed, the full impact of the EU ETS can only be assessed fully at the end of each Phase.[20] In this Part, we examine the caps and emissions of Phase I, and consider the projected impacts of the EU ETS up to 2020, given the current design of Phases II and III.

THE EXTENT OF EMISSIONS REDUCTIONS WITHIN THE EU

15. The effectiveness of the EU ETS will be determined primarily by its success in reducing emissions. The UK and EU have adopted a commitment to 'avoid dangerous climate change', which they have translated into a target to limit the average global temperature rise to 2^oC above pre-industrial levels. According to the Inter-governmental Panel on Climate Change, to help set the world on a trajectory that would give us a chance of meeting the 2^oC goal, developed economies such as the UK need to cut their annual emissions by 25-40% (relative to 1990) by 2020.[21] In 2008, the EU adopted a 2020 target of a 20% cut in greenhouse gas emissions (relative to 1990), with a commitment to increase this to 30% if there were an agreement by other developed economies on a global deal at last month's UN climate change conference in Copenhagen.[22]

16. Some witnesses had a range of views on whether the EU targets, and the EU ETS caps, were challenging enough. DECC was clear however that those emissions reduction targets, and the Phase III cap, were set with reference to the climate science.[23] (Our recent carbon budgets report discussed in detail the basis for the EU emissions reduction targets, being the context for the UK's emissions reduction targets.[24])

17. Emissions increased throughout the course of Phase I. As Figure 1 shows, by the end of Phase I, EU ETS emissions were some 38 million tonnes of CO₂ higher than they had been in 2005.

Figure 1: EU ETS Phase I caps and emissions

Data source: National Audit Office

18. Mike O'Brien MP, the then DECC minister, defended Phase I by telling us that a Massachusetts Institute of Technology report had suggested that Phase I had produced a 4% reduction.[25] That MIT report, Over-Allocation or Abatement? A Preliminary Analysis of the EU ETS Based on the 2005-06 Emissions Data, by Denny Ellerman (of MIT) and Barbara Buchner (of the International Energy Agency), estimated carbon savings against the study's own business-as-usual projection.[26] We were disappointed that the Minister chose to defend Phase I by claiming it had reduced emissions across the EU ETS by 4%. He did not make it clear that this was not a reduction in absolute terms, but only a relative reduction from an estimate of how emissions might have grown in the absence of the EU ETS. We recommend that, when describing estimates of reductions in emissions, the Government always makes it clear whether they are absolute reductions in emissions or notional reductions against a business-as-usual scenario.

CAPPING EMISSIONS

19. The NAO reported that actual emissions across the three years of Phase I were 6,093 MtCO₂, some 449 MtCO₂ (7%) below the EU-wide allocated permits (or cap) of 6,542 MtCO₂ (Figure 1).[27]

20. In 2005, our predecessors published a report on the UK's role in international climate change policy-setting. Analysing the prospects for Phase I of the EU ETS at its outset, they concluded that: "Phase 1 of the EU ETS has rightly been described as a 'race to the bottom' in terms of the target caps set by individual member states. As a result, there is little prospect that it will yield any significant carbon reductions and this is reflected in the low price at which carbon is trading".[28] In March 2007, based on verified data for the System's first full year of operation, we wrote:

21. The Committee on Climate Change in October 2009 noted that the recession across Europe has cut output from energy-intensive industries:

By contrast, a study from analysts New Carbon Finance in 2008 concluded that, even taking reduced economic output due to the recession into account, "the largest cause of the reduction [in emissions since 2007] is the EU ETS itself encouraging greater use of gas in power generation".[31]

22. The NAO's survey in October 2008 of 56 UK companies involved in the EU ETS, representing two-thirds of the UK's total emissions covered in Phase I, found that:

64% of firms said the EU ETS had had an impact on their emissions, including 9% saying that that impact had been significant;[32] and
32% of firms stated that one of the key benefits of the EU ETS was that it had increased the importance of CO₂ emissions and energy efficiency at board level.[33]

23. As we acknowledged in our previous report on the EU ETS, Phase I was in many ways a success: it was a considerable achievement to create so large and complex a system so swiftly, with institutional mechanisms which could be tightened in the future to deliver better outcomes. The weakness of Phase I arose from over-allocation of allowances. In October 2007, the Treasury acknowledged that: "[…] Phase I has had a number of problems as a result of over-allocation of allowances in the EU as a whole […]".[34] Two months later, the Secretary of State for Environment, the Rt Hon Hilary Benn MP, told us: "[…] the lesson of the EU ETS is simply that you have to get the caps right. In Phase I, the cap was not good enough and we all know that to be the case […]".[35] In our current inquiry, DECC told us that there was a need to address "the problems of Phase I and improve the credibility of the EU ETS as an effective tool in tackling climate change".[36]

24. The NAO noted that the consensus at the end of Phase I was that European industries emitted significantly less than the cap, not because they were forced to cut their emissions to stay within the cap, but because the cap was set much too high.[37] The NAO summarised some of the reasons why Phase I was over-allocated:

inaccurate baseline data for the System's industrial sectors, made with reference to inaccurate 'business-as-usual' projections, which forecast strong underlying growth in emissions;
forecasts of industrial growth that proved too optimistic; and
the desire in each member state not to subject its industrial sectors to any tighter a cap than those imposed by other member states.[38]

25. The question of whether Phase II is over-allocated is debatable. The reducing cap means fewer allowances are available each year. But the cuts are unevenly distributed; they are primarily restricted to the power sector. Industrial sectors within the EU ETS have been given allowances in line with business-as-usual projections.[39] The NAO cautioned that: "The current recession is likely to lead to fewer emissions as production of energyintensive products decreases, and across the EU is likely to result in emissions in Phase II being lower than the total EU cap. The impact of the recession may dwarf any reductions which the EU ETS would otherwise have achieved".[40] It concluded that Phase II of the EU ETS may not result in significant emission reductions. Sandbag, one of our witnesses, commented: "The allowance made for growth in emissions in industrial sectors meant that even without the recession industrial sectors would have had surplus permits".[41]

26. The NAO said that allocations in Phase II were based on an assumption of economic growth. A decline in UK manufacturing due to the recession could lead to a considerable surplus of allowances.[42] Looking at the EU ETS across Europe, Sandbag concluded: "With the effect of the economic downturn included, industrial participants shared a surplus of 77 million permits in 2008. Modelled forward for the whole of Phase II (2008-12), this would represent nearly 400 million surplus permits".[43] Taken together, the recession and the over-allocation of allowances could greatly reduce the effectiveness of Phase II of the EU ETS.

THE DESIGN OF PHASES II AND III (2008-2020)

27. In 2007, we noted what appeared to be a move by the European Commission to impose more stringent national allocations for Phase II on a number of EU member states.[44] We commended the UK Government for submitting (at that time) the only national cap that was not revised downwards by the Commission[45] (subsequently, the UK was one of only five of the 27 countries not to have their Phase I national allocation plans reduced).[46] For Phase III (2012-2020)—whose design was then the subject of an EU review—we recommended:

the introduction of a single EU-wide cap, set in accordance with future carbon reduction targets in a transparent way;
greater auctioning of carbon allowances;
greater harmonisation in the application of the EU ETS among member states, especially on limits on the use of offset credits; and
increased stringency in proposals for the inclusion of aviation.[47]

28. The early indications were largely positive in respect of both phases. Following revisions imposed by the European Commission, the overall cap for Phase II was finalised at a level that looked likely to require some genuine effort to cut emissions. In our current inquiry, DECC told us that "EU effort, compared to 2005, is expected to produce a reduction of 215.8 MtCO₂. This is 9.3% per year below 2005 emissions—with UK effort 13% below 2005 emissions".[48]

29. In January 2008 the European Commission published its proposed design for Phase III, which contained all the key features that we had recommended.[49] The proposed cap for Phase III was set at a level that would see a 21% reduction (on 2005 levels) in the traded sector's emissions by 2020. Matthew Farrow of the CBI told us that companies he spoke to believed Phase III would be noticeably more stringent than Phase I, and to an extent Phase II as well.[50] In the absence of binding global emissions reduction targets following the Copenhagen conference, it is uncertain whether the EU will further tighten the cap. The Copenhagen Accord invites countries, individually or jointly, to commit to emissions reduction targets for 2020 by the end of January 2010 (paragraph 5). The Secretary of State for Energy and Climate Change told the House after the conference that "for Europe, provided that there is high ambition from others, that means carrying forward our [EU] commitment to moving from 20% to 30% [emissions] reductions by 2020".[51] Any attempt to tighten the EU targets would be subject to formal EU discussion and agreement through co-decision.[52]

30. Given that no cap has yet significantly challenged EU ETS participants, we examine below what measures are available to strengthen the regime.

Intervening to lower the cap

31. Paul Ekins, Professor of Energy and Environment Policy at King's College, explained that if additional policy measures are actually to cut emissions, governments must reduce the cap. A weak cap undermines both the environmental effectiveness of the policy and additional policies to reduce emissions, such as measures to promote renewable energy.[53] The Center for Resource Solutions in the US argued that "as organisations and individuals realise their purchases are not achieving additional emission reductions, but instead are simply shifting the costs away from those regulated under cap and trade and onto those taking voluntary action, voluntary purchases of renewable energy may dwindle".[54] During a visit by three of our members to the United States in 2009 we heard how in a regional trading scheme in the northeast United States, state authorities hold set-aside allowances that they retire when residents install renewable energy generation or sign up to green energy contracts.[55]

32. Sandbag advocated a similar mechanism—which they called 'cap and slice'—within the EU ETS. They argued for governments to set aside a significant proportion of allowances within the cap, and cancel them in line with voluntary efforts to cut emissions.[56] They also suggested that member states could give companies within the EU ETS financial incentives, such as tax breaks, for cancelling surplus allowances within their possession.[57]

33. We believe that it is imperative that there are 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. We recommend the Government press the EU to consider periodically whether to tighten the EU ETS cap. We further recommend that the Government investigate what financial incentives can be given to companies within the EU ETS to encourage them to cancel allowances they own voluntarily.

34. We recommend the Government consult on other mechanisms to remove EU ETS allowances from the market, especially where the threat of being forced to buy and retire allowances could drive other environmentally beneficial actions. For example, the Government could revisit the Carbon Emissions Reduction Target (CERT), which requires power companies to improve household energy efficiency. If CERT targets were toughened, with companies that fail to meet their targets having to buy and cancel additional EU ETS permits, it would reduce allowances directly in line with the success of the CERT scheme in cutting household emissions. The policy could thereby both cut emissions at the household level and cut emissions across the EU ETS as a whole.

CANCELLING NEW ENTRANT RESERVES

35. The EU ETS allows member states to set aside a national pool of spare allowances ('New Entrant Reserves') for new or expanding industrial installations. Unused allocations from installations that are closed down are added to the Reserves. Deutsche Bank suggested that, because of the recession, many more allowances would be added to New Entrant Reserves than would be distributed from them, and estimated that the total number of allowances in Reserves across the EU would amount to over 300 million by 2012.[58] While two member states have committed to cancelling any surpluses in their New Entrant Reserves, most states are committed to giving them away or auctioning them. Giving away New Entrant Reserves creates the same problems as the over-allocation of allowances. We recommend that the Government commits the UK to cancelling any surplus allowances in its New Entrants Reserve at the end of Phase II, and presses other member states to do the same.

USE OF OFFSET CREDITS

36. Over Phases II and III, companies will be able to use offsets worth 1.6 billion tonnes of CO₂e (1.4 billion in Phase II and 150-200 million in Phase III). Over the period 2008 to 2020, offset credits can be used to meet up to 50% of the cuts in overall emissions imposed by the caps.[59] So far the number of offset credits available has exceeded the demand for them. According to Deutsche Bank, in 2008 only 82 million out of an allowable 265 million offset credits were used by firms within the EU ETS.[60] Sandbag argued there are enough offset credits available for companies to meet all of their required emissions cuts for the remainder of Phase II without actually making any carbon emissions reductions themselves.[61]

37. Companies within the EU ETS can bank any surplus allowances and offset credits (up to certain maximum limits) they have at the end of Phase II for use in Phase III. As surplus allowances will be usable in what is expected to be a tougher third Phase, they still have value, and Phase II is perhaps unlikely to suffer the same collapse in carbon price as in Phase I (paragraph 52). But carrying over banked surplus allowances into Phase III will inflate its cap, and reduce its effectiveness in cutting emissions.[62]

38. The more that offset credits are used, the more EU installations will be funding emissions reductions in other countries, rather than cutting their own.[63] Although the EU ETS cap for 2020 has been set at a level approximately 21% below 2005 traded-sector emissions, in reality emissions reductions within the System's own countries themselves will be smaller. Therefore, the EU needs a much tougher 2020 cap.

39. The Clean Development Mechanism (CDM), which was set up alongside the Kyoto Protocol to fund projects in the developing world, is the most high profile offset scheme, and has been operational since 2006. Under the CDM, projects in the developing world that are deemed to reduce emissions can earn credits, each equivalent to one tonne of CO₂. These credits can be bought directly by industrialised countries to meet a proportion of their emission reduction targets under the Kyoto Protocol. A proportion of them may also be bought by businesses within the EU to use instead of EU ETS allowances in covering their emissions. Since the scheme began, some 1702 projects have been registered and 311 million CDM credits issued; by the end of 2012 the number of credits is expected to have risen to over 1.6 billion.[64]

40. The use of offset credits means that nations and industries with high levels of emissions may buy their way out of making carbon reductions themselves; in the process they might continue to invest in carbon-intensive technology, thereby 'locking in' their economies to a future of high emissions.[65] In our March 2007 inquiry into emissions trading we noted that "there is plenty of evidence that much CDM investment is currently going into projects of dubious merit".[66] We concluded that the Government should press, not just for quantitative limits on the use of CDM credits within the EU ETS, but for a qualitative limit to ensure both that they are funding genuinely additional emissions reductions and that they make a contribution towards sustainable development.[67]

41. In this latest inquiry, we have heard similar criticisms of CDM. The Corner House, one of our witnesses, argued that:

oversight of CDM projects was too weak, and the relationship between those responsible for regulation and those making money out of trading in credits too close;
because the emissions savings attributed to CDM projects are estimated with reference to projections of 'business-as-usual' emissions, rather than reductions in absolute terms, it was impossible to be sure whether a project is truly additional (i.e. whether it would have gone ahead anyway, without being funded through the CDM); and
there was a tendency to inflate business-as-usual projections in order to claim more credits for avoiding what are in effect non-existent emissions.[68]

The World Development Movement, another of our witnesses, argued that CDM investment often goes into projects that do not contribute to the well-being of local communities, and which do not replace the construction of carbon-intensive energy infrastructure.[69] According to Friends of the Earth, in some cases the CDM is being used to help finance new fossil fuel infrastructure.[70]

42. On the other hand, Professor Michael Grubb, chief economist at the Carbon Trust, told us that such investment was likely to accelerate expansion of additional renewable energy because the industry was established and looking to grow.[71] He argued that something like CDM was essential to encourage investment to flow to emissions reduction projects in developing countries.[72] Climate Change Capital, another witness, made a similar point,[73] stressing that carbon trading had been driving international investment into countries, regions, and sectors where it would not otherwise have gone.[74] The Carbon Trust told us that:

43. Some witnesses called for fundamental changes to the way the system worked in 'advanced developing countries', such as China and India. In January 2009 the European Commission published EU proposals ahead of the Copenhagen conference, including a proposal that for these countries the "CDM should be phased out in favour of moving to a sectoral carbon market crediting mechanism".[76] This was supported by the written evidence we received from DECC,[77] and by Global Carbon Trading: a Framework for Reducing Emissions, a report by Mark Lazarowicz MP (the Prime Minister's Special Representative on Carbon Trading, and a member of our Committee).[78]

44. Last month's Copenhagen Accord did not include any changes in the operation of carbon markets (paragraph 5). Nevertheless, the Clean Development Mechanism, or something like it, may be vital for achieving an international agreement on action to tackle climate change at a later date, functioning as a stepping stone towards bringing advanced developing countries within a system of binding caps in the future. We do not believe that critics of the Clean Development Mechanism have convincing alternative proposals for driving carbon mitigation in the developing world. We recommend that the Government press for a reform to CDM rules, in particular to exclude the construction of fossil fuel infrastructure, and more widely to embed sustainable development at the heart of project eligibility criteria.

AUCTIONING ALLOWANCES

45. Professor Grubb argued that increasing the proportion of allowances freely allocated, rather than auctioned, would not alter the overall cap on emissions and so would not affect the carbon price.[79] Handing out emissions permits to businesses for free, however, on the basis of their past emissions (known as 'grandfathering'), risks over-allocation of allowances. Provided that there is a limit on allowances, auctioning helps ensure that businesses only acquire the allowances they need. In December 2008, Phase III was redesigned so that free allocations to industrial sectors could continue to be used, in place of selling allowances through auctions. Member states may:

allocate up to 70% of power sector allowances free of charge (though with the percentage decreasing to zero by 2020);
keep giving free allowances to all industrial sectors up to 2027; and
continue to give free allowances to sectors they define as being vulnerable to international competition.

46. These changes were welcomed by the CBI and EEF, the manufacturers' organisation. Both expressed concern over the possibility that the tighter cap in Phase III might contribute to 'carbon leakage'—the relocation of industrial activities to other countries, not covered by an equivalent cap on emissions—and argued that the best means of protecting firms vulnerable to such international competition was to give them free allowances. Under the revised design for Phase III, they pointed out that allocations would be set initially on the basis of a benchmark of efficient operation and then be cut year on year, which would still encourage emissions reduction.[80] Professor Grubb, on the other hand, saw weaknesses in that approach:

47. WWF suggested that by the end of Phase II, the total revenues accruing to the Treasury from EU ETS auctions could be in the region of €1.6 billion.[82] After 2012, revenues should rise as the use of auctioning increases. The Carbon Trust estimate that the Government could receive between €4 billion and €8 billion a year during Phase III.[83] WWF wanted the Government to commit to spending all of the auction revenues it receives on climate change programmes,[84] whereas EEF argued against formal hypothecation of auction revenues on the basis that this might limit such investment.[85] The Government has, in common with other EU governments, through the European Council, adopted a non-legally binding political declaration indicating member states' willingness to spend at least half of the auction revenues or equivalent to tackle climate change, both in the EU and in developing countries.[86] The Government will not however hypothecate its auction revenues to specific purpose.[87] In our 2007 report we argued that revenues raised by auctioning allowances should be used demonstrably to assist measures to tackle climate change.[88] Because of the unique nature of the revenues raised by auctioning allowances, further consideration should be given to hypothecating the revenues for use on projects directly related to climate change. We urge the Government to consider on a cross-departmental basis how this might be done.

Conclusions on Phases II and III

48. Carbon allowances were clearly over-allocated in Phase I, and emissions as a whole went up between 2005 and 2007. But there is evidence that participating firms are incorporating the EU ETS into their business decisions, and adopting some measures to improve their carbon efficiency, though it is difficult to isolate the precise extent to which the EU ETS is a decisive factor.[89] For the subsequent Phases, DECC told us:

49. There is much to welcome in the current design of the EU ETS, especially the declining cap in Phase III that could drive genuine emissions cuts. But there is a real risk, especially if economic recession leads to a prolonged reduction in emissions, that Phase II will turn out to be significantly over-allocated. Given that surplus allowances may now be banked and carried-over into the subsequent phase, this could significantly weaken the effectiveness of Phase III. Even without the recession, we are concerned that in Phase II industrial sectors have again been allocated allowances in line with business-as-usual projections, and that in Phase III they may again have free allowances. This could significantly reduce the potential for the EU ETS to motivate businesses to make carbon efficiencies and invest in low-carbon research and development.

50. There is much uncertainty about the likely effectiveness of the EU ETS up to 2020. The current design for Phase III could be altered if the EU adopts a tighter cap despite the failure to agree a global deal at Copenhagen.[91] The UK should use that as an opportunity to improve the current design. The EU ETS needs to be strengthened. The System's cap still falls short of the efforts climate science suggests need to be made by developed economies. The EU ought to commit itself to make more significant cuts in its emissions by 2020, commensurate with the IPCC's recommendations of 25-40% for developed economies (paragraph 15), with any purchases of offset credits coming on top of that. In any future negotiations on Phase III, we recommend that the Government presses both for a significant tightening of the cap, and for as high a proportion of auctioning as possible.

19 National Audit Office, European Union Emissions Trading Scheme, p 6 Back

20 Ibid., para 3.16 Back

21 Inter-governmental Panel on Climate Change, Climate Change 2007: Mitigation of climate change, Working group III to the Fourth Assessment Report of the IPCC, 2007 Back

22 Meeting Carbon Budgets: the need for a step change, Committee on Climate Change, October 2009, p 32 Back

23 Q 281 Back

24 Carbon budgets, HC 228, paras 40-45 Back

25 Q 277 Back

26 Environmental Audit Committee, Second Report of Session 2006-07, The EU Emissions Trading Scheme: Lessons for the future, HC 70, para 22 Back

27 National Audit Office, European Union Emissions Trading Scheme, para 3.5 Back

28 Fourth Report of Session 2004-05, The International Challenge of Climate Change: UK Leadership in the G8 & EU, HC 105, para 30 Back

29 The EU Emissions Trading Scheme: Lessons for the future, HC 70, para 17 Back

30 Committee on Climate Change, Meeting Carbon Budgets-the need for a step change, October 2009, p 67 Back