House of Commons - Environmental Audit Committee

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

Memorandum submitted by the Aldersgate Group

INTRODUCTION

The Aldersgate Group (AG) is a coalition of private, public and third sector organisations who believe that high environmental standards are essential for long-term economic growth and international competitiveness. The Group engages actively with government and other key decision makers to contribute to the future development of UK economic, environment and sectoral policies, as well as providing a distinct voice that advances the better regulation and sustainability agendas (see attached briefing for more information and list of members).

SUMMARY

— The EU ETS is undoubtedly the single most important policy instrument for the reduction of greenhouse gas emissions in Europe, if not the world.— The current fall in the price of carbon to around eight euros a tonne suggests that key design features must be improved to ensure the optimum distribution of emissions and efficiency of resources, spurring growth and employment. The scheme must ensure a credible and stable long-term carbon price for investors and business.

— The Aldersgate Group believes that key features of an optimal emissions trading scheme are as follows:

— a strong policy with a carefully regulated cap on carbon that drives the required reductions in emissions as efficiently as possible;

— a greater use of auctioning permits; and

— a tight emissions cap and careful regulation to ensure that off-setting does not become the dominant emissions-reduction approach in the EU and provides genuinely additional emissions reductions.

— The UK government should examine forms of market intervention that would adequately address the current fall in the carbon price, such as restructuring the scheme or setting a price floor.

— The Aldersgate Group welcomed the European Commission's proposal of 23 January 2008 that will ensure that the auctioning of allowances will be much more widespread.

— Research shows that competitive concerns relating to carbon leakage are often exaggerated and the potential economic benefits of driving resource efficiency ignored.

— Strong regulation should prevent excessive reliance on external credits, thus help drive emission reductions within the EU, and lead to competitive advantage and emission reductions for domestic industry.

Trading for Growth

1. The Aldersgate Group released a report in December 2007 Trading for Growth which examines how the EU ETS can best deliver the necessary cuts in carbon emissions and maximise the economic benefits that can flow from higher environmental standards.

2. The EU ETS is undoubtedly the single most important policy instrument for the reduction of greenhouse gas emissions in Europe, if not the world. If it drives the substantial emission reductions that governments predict, it could become the cornerstone for a worldwide trading scheme and its core design features would become universal. There is perhaps more riding on its success than any other policy instrument to combat climate change.

3. The EU ETS is not only crucial for the environment, but also a policy where effective regulation makes a difference to the economy. Strong regulation of the EU ETS can manage the incentives facing participants so that protection from gamesmanship, future benefits from more efficient resource use, increased competitiveness, fair distribution of burdens and a stable path to a low-carbon economy, are all maximised.

4. The management of the EU ETS should send long-term signals to the economy that an optimal distribution of emissions allowances will both improve the environmental effectiveness of the scheme and the extent to which emissions trading can stimulate innovation, investment and employment. This will support economic success in the EU and deliver the required long-term cuts in emissions cost-effectively. In doing so, it will produce a beneficial outcome for society in economic and environmental terms.

5. To date, there have been undoubted successes. Importantly, the trading system is working on a practical level. As stated by the European Commission, the "EU ETS has put a price on carbon and proved that trading in greenhouse gas emissions works. The first trading period successfully established the free trading of emission allowances across the EU, put in place the necessary infrastructure and developed a dynamic carbon market."[7]

6. However, the collapse in the price of carbon to near zero in Phase I (due to an over-allocation of permits) and to its current level of around eight euros a tonne suggests that key design features must be improved to ensure the optimum distribution of emissions and efficiency of resources, spurring growth and employment. The scheme must ensure a credible and stable long-term carbon price for investors and business.

7. The Aldersgate Group believes that key features of an optimal emissions trading scheme are as follows:

— a strong policy with a carefully regulated cap on carbon that drives the required reductions in emissions as efficiently as possible;

— a greater use of auctioning permits; and

— a tight emissions cap and careful regulation to ensure that off-setting does not become the dominant emissions-reduction approach in the EU and provides genuinely additional emissions reductions.

CAPPING EMISSIONS

8. Fundamental to an environmentally and economically effective trading scheme is the overall cap on emissions. The acid test for the cap will be whether a stable and significant market price for carbon is established from future trading scheme phases.

9. The emissions cap in Phase I of the EU ETS was too high, so it failed to ensure that carbon was adequately included in companies' investment decisions. It is also becoming evident that the emissions cap in Phase II might also be too high, and current policy design does not allow its adjustment to effectively address the fall in output (and hence emissions) in relation to the economic recession. The carbon price has recently fallen by around 75% to just over eight euros a tonne—a trend which might have been accelerated by firms cashing in now on 2008 permits by borrowing from their 2009 quota.[8]

10. Too high a cap on emissions results in a lose-lose-lose-lose for society, as:

— the environment loses out because emissions are higher than otherwise;

— carbon permit holders lose as the over-allocation is revealed and the price collapses to near zero;

— businesses lose out on opportunities to innovate, and find resource efficient solutions with an inherently lower cost base; and

— therefore, the economy loses competitiveness—it fails to achieve resource efficient outcomes, and misses opportunities to grow through the associated innovations and investments.

11. These difficulties are the opposite of the potential benefits that the Aldersgate Group argues are available. The objectives of the EU ETS should be to achieve wins in each of these areas. To maximise the economic benefits of emissions trading, strong regulation is needed of, for example, the emissions caps in future phases, or the terms on which aviation is brought into the scheme. Policy must send a clear long-term signal about the future level and trend in the price of carbon, and thus help avoid shocks to the economy. Confidence in the tightness of future caps can benefit business—just the announcement of future constraints can stimulate resource efficiencies.

12. The UK government should examine forms of market intervention that would adequately address the current fall in the carbon price, such as restructuring the scheme or setting a price floor. This is recognised by Ed Miliband, the Secretary of State for DECC, who recently made the following statement to the Energy and Climate Change Committee:

DISTRIBUTION OF ALLOWANCES

13. It is clear that the European Commission's regulation of Phase I, based on free grandfathered allocations, failed to determine the optimal cap on carbon emissions for society. Free allocation transfers wealth to emitters (a profit), and so creates an incentive for strategic behaviour from economic interests to lobby for a higher cap and allocations. However, as the scheme itself requires installations to provide independently verified emissions data on an annual basis, this over-allocation was revealed during the phase. This verified data also assists with regulation of allocations in subsequent phases, but the economy's interim changes mean that the strategic incentives remain.

14. Auctioning reduces these incentives. Auctioning transfers wealth from polluters to society (a loss to businesses that emit, in line with the polluter pays principle). As business is loss-averse, the loss entailed in auctioning provides an incentive to business to accurately state their emissions allowance needs as the auction takes place. As a result, auctioning leaves less room for strategic behaviour in relation to the emissions cap, as individual purchases at auction mean that demand for allowances, and a realistic price, are revealed earlier. This would benefit the economy, as it would create confidence in future emissions caps, and strengthen competition for carbon-reduction potentials. Auctioning therefore has an economic benefit as a result of reducing incentives for strategic behaviour in the cap-setting and allowance distribution process.

15. With this is mind, the Aldersgate Group was disappointed that the final level of auctioning was weakened from 100% to 70% by 2020 (with a view to reaching 100% by 2027). In the long term, it should be the EU's ambition for its ETS to be the basis of a global system, in which competitiveness considerations will be left to market forces to resolve. Therefore, the ability to move to full auctioning of allowances is needed, to show that the EU ETS is an appropriate system to assist the global transition to a low-carbon economy.

16. Full auctioning for the power sector from 2013 is welcome as the combination of free allocation and full cost pass through (due to closed markets) increased the profitability for the UK power generation sector by approximately £800 million per year over Phase I.[10]

17. In December 2008, it was announced that there will be more details in the Directive on the criteria to be used to determine the sectors or sub-sectors deemed to be exposed to a significant risk of carbon leakage, and an earlier date of publication of the Commission's list of such sectors (31 December 2009). It is clear that competitive concerns have been raised by a number of industries in regions facing more stringent environmental regulations than others, with a minority threatening to relocate "lock, stock and barrel" overseas.[11] While, in some cases, these costs can be significant, often they are exaggerated and the potential economic benefits of driving resource efficiency ignored.

18. A recent Carbon Trust analysis is the "nail in the coffin for the myth that the EU ETS presents a threat to overall business competitiveness"[12] as it finds that carbon costs remain trivial compared to other influences on international competitiveness for more than 90% of UK manufacturing activities. In truth, when businesses decide on a production location, environmental costs tend to be low relative to considerations of the cost of capital, fiscal regime, wage costs, workforce skills, exchange rate fluctuations, infrastructure and proximity to the market.

19. Where permits are allocated for free, the allocation should not be based solely on static information about the costs of current abatement opportunities. It should also be designed to create incentives for innovations in carbon-efficiency that reduce future abatement costs. The current system of free allocation is failing to encourage investment in low-carbon energy generation capacity, as it provides allowances in proportion to different technologies' carbon emissions. Auctioning increases future costs for technologies with higher emissions, and so overcomes this failure.

20. It is welcome that the share of auctioning revenues that Member States are recommended to use to fight and adapt to climate change mainly within the EU, but also in developing countries, is raised from 20% to 50%, as announced in December 2008.

OFF-SETTING

21. The EU ETS allows access to approved emissions off-sets (certified emissions reductions, CERs, and emissions reduction units, ERUs) from Joint Implementation and Clean Development Mechanism (CDM) projects. The use of external credits facilitates "business as usual", and reduces incentives to improve resource efficiency in the UK or EU economy. Without harmonised restrictions across the EU, excessive reliance on external credits would remove the need for EU industry to improve resource-use efficiency and reduce emissions, delaying the transition to a low-carbon economy. For example, this could lead to lock-in to high-carbon investments in heavy industry, and the power sector. This would have a negative effect on the EU economy, reducing the rate of innovation in carbon-mitigation, resulting in a failure to exploit the first-mover advantage the EU ETS offers.

22. The use of external credits represents an investment flow to carbon off-setting projects outside the EU. This may be beneficial to the recipients in the short term,[13] and encourages transition to low-carbon technologies elsewhere in the global economy. However, it is essential for the credibility of the EU ETS that approved off-sets are genuinely additional. While CDM criteria try to ensure additionality, it is not straightforward to regulate. Off-sets' additionality is inevitably subjective; being relative to a hypothetical future (what would have happened without the off-setting project?), which may not be easy to determine.

23. Approved off-sets may only slow the rate of increase in emissions in the country where the project is located. However, they increase the baseline of emissions across which the EU's cuts are taking place. These extra emissions have not been part of the baseline used to determine the cap in the EU ETS. Therefore, for off-sets to be part of a policy delivering a year-on-year fall in global carbon emissions, the EU ETS's emissions reductions would need to exceed the emissions growth in countries providing approved off-setting projects. This is unlikely in the foreseeable future.

24. Strong regulation can prevent excessive reliance on external credits. If the emissions cap is tightened far enough, the demand for off-sets, and therefore their price, will eventually rise until they are no longer cheaper than addressing emissions within the EU. However, the lower cost base and large scale of economies outside the EU, and the possibility that avoided deforestation projects will be eligible in future, means that the cap would have to tighten substantially. Therefore regulation should directly limit the use of off-sets. Although caps already exist,[14] the European Commission estimates that if the full use of credits is made by operators, few domestic reductions would occur and in an extreme case emissions in the EU ETS could even increase making it more difficult to achieve the EU's overall 2020 reduction targets.[15]

25. In the long term, the major emissions reductions required to tackle climate change cannot be met only through actions outside the EU; technologies will need to change in Europe. Excessive reliance on external credits should be avoided by tightening the emissions cap and strong regulation. This will ensure that future trading phases of the EU ETS require emissions reductions in the EU, and reward the comparative advantage of EU businesses that are able to implement emissions reductions measures efficiently. If not, the EU economy will lose valuable time in relation to; the timetable of policy goals for climate stabilisation; the development of low-carbon business competitors outside Europe; and in the transition to a low-carbon economy.

February 2009