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

Memorandum submitted by AEA

  AEA is one of the world's leaders in the field of climate change and energy consultancy—operating in the UK, Europe, the US and China. It is the leading provider of advisory services to the UK Government and works extensively with the EU and major private sector organisations. With internationally renowned expertise in air quality and climate change, carbon management, resource efficiency and the environmental impacts of transport, AEA employs many world leading experts and provides a high-level of policy consultancy and a range of technical services to its public and private sector clients.

  AEA manages for the UK government's Envirowise project, one of the world's largest resource efficiency programmes and provides carbon management expertise to many of the UK's largest private sector organisations.

  AEA is voted Number One Consultancy for Climate Change and Renewables by

  industry consultants (Edie surveys 2006, 2007 and 2008).

  For further information please visit


  AEA sets out that:

    — The fall in price of emissions allowances over the last 12 months has resulted in missed opportunities for carbon abatement in the EU ETS. This highlights the weakness of long-term ex-ante cap setting in that it does not respond effectively to changing external circumstances.

    — In the context of the role of emissions trading schemes in avoiding dangerous climate change, delivering early carbon abatement is important. For that, a stable and "effective" carbon price is required.

    — Two mechanisms to provide such stability during a period such as the present are:

1.A ratchet mechanism on future caps

2.A mechanism for centrally regulating the supply of allowances to the market, as has been designed for the forthcoming Carbon Reduction Commitment

    — Although we recognise that it may be too late for these features to be included in the EU ETS, it is important that learning from the scheme's behaviour in the current economic climate is considered in the context of other trading schemes being developed internationally.


  1.  AEA's case to the Environmental Audit Committee inquiry on the role of the carbon markets in preventing dangerous climate change is that long-term ex-ante cap setting in the EU ETS is highlighting a weakness. The cap-setting process and subsequent supply of allowances to the scheme does not respond to external circumstances. The current, low EU ETS emissions allowance (EUA) price that has resulted means the opportunity to drive early investment in low-carbon measures and deliver early emission reduction is potentially being missed.

  2.  Over the last 12 months the price of EUAs has fallen by approximately two-thirds, from a high of around €28 in June 2008 to around €10 currently. The main driver of this fall is the reduction in demand for allowances from industry as output has fallen during the global economic slow-down. The supply of allowances into the scheme is rigid and follows each MS's National Allocation Plan (NAP), developed using forecasts prior to the start of the phase. Since demand is currently lower than was forecast, the market has been oversupplied with allowances. The impact of the price fall is to reduce the relevancy of carbon intensity to industry and move carbon abatement down the agenda. A carbon price of less than €10 makes investment in low-carbon measures relatively unattractive and reduces the near-term delivery of carbon abatement. AEA suggest that this fall represents firstly a weakness of the ex-ante cap setting process for the EU ETS and, secondly, a missed opportunity to deliver early emission reductions.

  3.  Therefore, considering the role of emissions trading schemes in preventing dangerous climate change and, concomitantly, the urgent need for substantial abatement efforts, it is important to set caps that will deliver "effective" carbon prices. Cap-setting in the EU ETS aims to establish the most stringent caps feasible given the alternative pressures of, for example, competition and carbon leakage. This process makes use of the best available projections for economic performance over the course of the scheme and accurate modelling of the abatement potential available in the scheme. However, the design of the current EU ETS phase is based on forecasts of increasing economic growth and expanding output. We suggest that introducing dynamism, through the capacity to make provisions to regulate the price of allowances when demand is depressed, would increase the effectiveness of the scheme.

  4.  Emissions trading schemes are valuable tools for pricing carbon and ensuring abatement is delivered with the greatest cost-efficiency. However, there is the potential to move away from a "fixed" system, whereby the caps are based only on what was forecast at the start of a scheme phase. There is valuable information gathered as the scheme progresses that could be made use of. Doing so could increase the effectiveness of the scheme for delivering emissions reductions, whilst also maintaining security, in carbon price terms, for scheme participants. Two mechanisms for achieving these goals would be:

    (a)  Adjusting the future scheme cap to reflect reduced emissions in the present.

    (b)  Regulating supply of allowances into the scheme.

  5.  The ability to adjust the level of future caps is a powerful lever that can be used to influence the price of allowances in the future.[1] If there is oversupply of allowances in the present, due to lower than forecast demand, their value can be increased if the future cap is "ratcheted" down. The carbon price of the present and future could therefore be stabilised and, additionally, the scheme could make better use of the abatement opportunity provided by the lower than forecast demand in the present. The mechanism relies on the fact that the market has confidence in the future value of allowances. This would argue against the potential to relax the ratchet mechanism in the future. Should output and demand recover, there is the potential for loosening the mechanism if carbon prices are likely to rise to levels that cause competition and carbon leakage concerns. The sooner abatement measures are put in place within the scheme, the greater cumulative reduction they can deliver. Relaxation of the ratchet can therefore be consistent with maintaining the environmental integrity of the scheme, provided the future cap is not loosened beyond its original level.

  6.  If the scheme included a mechanism for centrally regulating the supply of allowances into the scheme then an effective carbon price could be maintained with greater certainty. Taking the Carbon Reduction Commitment (CRC) as an example, during the capped phase of the scheme, allowances will be distributed through a Government auction each year. The sealed bid uniform price auction will enable Government to derive a demand curve for the scheme. Using the demand curve the number of allowances could be selected to deliver an effective carbon price. Therefore in years where participants as a whole forecast lower demand for allowances, the Government could release fewer and therefore maintain an "effective" carbon price. Note that for this to be possible, the scheme cap must be expressed as a percentage reduction against a business as usual projection that is updated annually with the most recent information from participants.

  7.  AEA appreciate that it may be too late to debate the inclusion of either of these features into the EU ETS. In addition, we would not want to add further complexity to an established and comprehensive scheme design. However, the EU ETS is the first multi-national emissions trading scheme and so it is important that we learn from its weaknesses and consider the implications for other trading schemes being developed internationally.


  8.  The following paragraphs set out some of the fundamentals to the discussion above.

  9.  The concept of emissions trading schemes is to establish a carbon price in order to deliver emission reductions. Carbon pricing principally increases the financial costs of operating a carbon intensive process, which creates the incentive to invest in and operate lower-carbon technology.

  10.  The level of incentive for lower-carbon technology and practices, hereafter referred to as measures, is dependent on the carbon price established. A higher carbon price increases the financial incentive of low-carbon measures and vice versa. Therefore, in order to deliver carbon abatement consistent with preventing dangerous climate change (discussed in more detail in Paragraph 13), an "effective" carbon price is required. The carbon price realised in a carbon market is the result of the cap applied to the scheme, and the supply and demand for emission allowances.

  11.  The cap sets a limit on the total emissions that can arise from the scheme as a whole. In this respect, the cap represents the principal control on supply of allowances within a trading scheme. On the other hand, demand for emission allowances is primarily driven by the emissions intensity and level of output from covered industry.

  12.  There are various criteria that should be considered when setting scheme caps, including effort sharing, competition from outside the scheme and carbon leakage. However, the most important could be considered to be environmental need and cost effectiveness.

  13.  Environmental need is informed directly by climate change science, which recommends the levels below which atmospheric concentrations of greenhouse gases must be stabilised to prevent "dangerous climate change". The UK's Committee on Climate Change (CCC) concluded that the global objective should be to limit central expectation of global mean temperature increase to 2°C or as close as possible and to limit the risk that warming of 4°C occurs to very low levels.[2] According to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (IPCC AR4), these objectives are consistent with emissions stabilisation targets of less than 550 ppm of CO2 equivalent.[3]

  14.  Whilst, the overarching emissions targets established through environmental need guide the objectives of emissions trading schemes, it is necessary to review the overall cost-effectiveness of the scheme taking into account costs and benefits of the likely abatement measures. Marginal abatement cost curves (MACCs) are a tool commonly used for evaluating cost effectiveness since they describe the relationship between available emission reduction potential (either cumulative or annual) and cost per unit of GHG abatement. MACCs can therefore be used to examine the carbon price required to deliver a certain level of abatement and vice versa, can be used to suggest what carbon price may result from a particular scheme cap. It is important to note that MACCs present a theoretical viewpoint and in most cases represent technical abatement potential; in other words, it is likely that only a fraction of the identified technical abatement will actually be delivered, and in many cases the timescale for delivery is uncertain. However, given that the earlier an abatement measure can be implemented, the greater the cumulative abatement that can be delivered, incentivising abatement early in an emissions trading scheme is beneficial. One of the barriers identified for delivery of technical abatement potential is the opportunity cost of not investing the capital required for a particular measure in an alternative manner, which may provide a better return.

  15.  Recent evidence suggests that the rate of emissions growth in the 21st century puts the current global trajectory near the uppermost scenario of the IPCC AR4. There is, therefore, a strong case for driving more significant near-term abatement efforts. In order to stabilise atmospheric GHG concentrations at or below the 550 ppm threshold, the CCC suggest that the trajectory of global emissions should peak at around 2016. In order to drive near-term abatement efforts an effective carbon price is required to stimulate investment in low-carbon measures, since the net present value and rate of return on the investment will consequently improve. In addition to financial incentive, an effective carbon price would provide impetus for behavioural measures that can be affected by an appreciation of the value attached to carbon emissions, such as energy efficiency measures.

6 March 2009

1   Provided the same allowances are fungible in the future scheme. Back

2   Committee on Climate Change, December 2008. Building a low-carbon economy-the UK's contribution to tackling climate change. London: The Stationery Office. Back

3   Solomon, S, et al (eds) Climate Change 2007: The Physical Science Basis. Contribution of Working Group I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change. Cambridge, UK, Cambridge University Press. Back

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