Memorandum submitted by AEA
AEA is one of the world's leaders in the field
of climate change and energy consultancyoperating 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
For further information please visit www.aeat.co.uk.
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
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
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.
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
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.
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.
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
Committee on Climate Change, December 2008. Building a low-carbon
economy-the UK's contribution to tackling climate change. London:
The Stationery Office. Back
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