House of Commons - Environmental Audit Committee

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

Memorandum submitted by the World Wildlife Fund

SUMMARY

— The expansion of the global carbon markets through linking domestic cap and trade schemes could play a positive role in global mitigation efforts. However, it is very important that certain criteria are met before any schemes are linked.

— Baseline and credit "offset" mechanisms such as the CDM are at best a zero sum game for the climate. The current project-based mechanism suffers from several structural problems and substantive reform and potentially widespread replacement with a credible sectoral based mechanism is needed post-2012.

— Carbon markets are not a panacea for tackling climate change. Other policies and measures are certainly required both to deliver decarbonisation within developed countries, and to deliver financial flows to help developing countries move on to a low-carbon pathway. In Europe the impact of the recession on the EU ETS makes it even more crucial that additional policies and measures are rapidly put in place to buttress the carbon price and drive low-carbon investment.

— With specific regard to the power sector in the UK and Europe, WWF is advocating the adoption of a plant-based greenhouse gas emissions performance standard to prevent lock-in to a new generation of unabated coal-fired power plants.

— The revenues from auctioning pollution allowances should be used to fund climate protection measures domestically, and also crucially within developing countries. The UK should also consider additional innovative ways of financing climate change mitigation and adaptation in developing countries.

1. Potential contribution of international emissions trading to delivering a global greenhouse gas stabilisation target, consistent with the UK's goal of limiting global warming to 2°C

Based on the latest science WWF believes that global emissions must be cut by at least 80% below 1990 levels by 2050. By 2020 the IPCC suggests that developed country targets should be in the range of 25-40% cuts below 1990 with developing countries deviating from business as usual emissions by 15-30%. WWF notes that even with these cuts we will only have a 50% chance of keeping below the 2°C tipping point

This leads WWF to conclude that:

— Cap and trade schemes will alone not be able to deliver the radical global decarbonisation needed. Serious targeted policies and conscious decisions on infrastructure will be needed to drive this, particularly in the strategically important power sector.

— Baseline and credit "offsetting" schemes for international emissions trading will merely help developed countries meet their 25-40% targets. Additional financial mechanisms are needed to assist developing countries in meeting a 15-30% deviation from business as usual emissions. If these mechanisms are not put in place then there is clear risk that emission reductions will be double counted.

The expansion of the global carbon markets through linking domestic cap and trade schemes in industrialised countries could play a positive role in global mitigation efforts. However, it is very important that certain conditions are met before any schemes are synchronized. The carbon markets are only one tool to reduce emissions and must not be considered the universal silver bullet. Other policies and measures, including setting standards, and implementing phase-outs are also important to achieve the aim of sustainable, low-carbon economies. Policies and measures at the national level, enhanced where possible through bi—or multi-lateral cooperation, are vital for many sectors, to phase out inefficient technologies and to incentivise efficient ones.

Carbon markets are efficient in finding lowest cost carbon credits. However, they may not be effective in driving the development and deployment of technologies that will be necessary to achieve a rapid decarbonisation of the economy.

In addition, many developing countries are looking to enhance their existing mitigation actions under the Copenhagen post-2012 climate change deal. It is essential that no-regrets and low-cost mitigation options in developing countries—the "low hanging fruit"—are not cornered by CDM project developers and used to count towards developed country targets.

In WWF's view all credits generated under the CDM, or any comparable mechanism post-2012 must be Gold Standard equivalent certified.[5] There are currently several worrying structural problems with the current project-based CDM, and substantive reform and potentially widespread replacement with a credible sectoral based mechanism is needed.

2. Whether, and under what circumstances, emissions trading ought to be supplemented or replaced by tax or regulation

There is currently a lively debate underway, particularly in the US, about whether a carbon tax of cap and trade mechanisms are the best options at hand to tackle climate change. We consider that neither mechanism will be sufficient on its own. Indeed both are subject to being undermined by a lack of political will and special interest lobbying which will weaken their implementation.

Whilst a well-designed and ambitious cap and trade scheme can offer several advantages it is in no way a substitute for regulation, incentives and policies to develop and deploy low-carbon technologies. For example there is a clear need for focussed policies on energy efficiency, the deployment of renewables and an emissions performance standard for power plants. These are essential in order to overcome barriers which an uncertain and variable carbon price will not achieve.

3. The extent to which the carbon price will be sufficient to drive low-carbon investment, in particular decarbonisation of energy

In 2006 the Stern review warned that during their development carbon markets would need to be complemented by other policies, such as tax and regulation, and also by targeted action to promote the rapid deployment of emerging low-carbon technologies. The Review noted that "Carbon pricing alone will not be sufficient to reduce emissions on the scale and pace required."[6] "In this transitional period, while the credibility of policy is still being established and the international framework is taking shape, it is critical that governments consider how to avoid the risks of locking into a high-carbon infrastructure, including considering whether any additional measures may be justified to reduce the risks."[7]

With specific regards to Europe and the EU ETS WWF recognise that the scheme should be a key element of EU climate change policy, but we consider it reckless to regard it as the only tool to drive forward decarbonisation of the sectors covered by the scheme—particularly the power sector. Indeed, the UK Government already accepts the need for targeted policies to support renewable electricity, as does the EU through its support for ambitious renewable energy targets for 2020.

Former Energy Minister Malcolm Wicks also conceded that the EU ETS is only part of the answer: "I agree with Nick Stern's analysis……I certainly concede that, as far as we can tell at the moment and for the foreseeable future, it is not the whole answer, just part of it[8]….I have always been happy to concede that, in the foreseeable future the ETS is unlikely to be the whole answer as it will depend on the price of carbon."[9]

The recent report from the UK's Committee on Climate Change also noted that "Any feasible path to a 80% reduction by 2050 will require the almost total decarbonisation of electricity generation by 2030" "There is a strong case for buttressing the carbon price lever by establishing a clear and publicly stated expectation that coal-fired power stations will not be able to generate unabated beyond the early 2020s".[10] The Committee's report made clear that decarbonising the power sector is critically important for several reasons—it is the biggest polluter, a range of low or zero carbon technological options exist, and a low-carbon power sector is a route to decarbonise other sectors such as transport and heating through electrification. However, it also clearly concluded that the ETS alone will not deliver this strategically important outcome.

Finally, an article by ENDS Europe regarding a new report by Deutsche Bank stated "Outlining the report in a conference call on 24 February, lead author Mark Fulton stressed the important role currently being played by command-and-control regulation and legal mandates rather than carbon markets 'Day to day what's driving investable markets is regulations' he said. Mr Fulton described legal mandates for renewable energy as 'very important'".[11]

All these comments are particularly relevant given the current proposals to build between 60 and 70 new coal fired power stations across the EU, with six or more of these proposed for the UK.[12] To support the EU ETS and the carbon price as it develops WWF is calling for the immediate introduction of an individual plant based emissions performance standard (EPS) on all new EU power plants at a level of 350g CO2/kWh (and all existing plants by 2020-25). We consider this will be necessary to prevent high-carbon lock-in. An EPS is already in force in California, and other U.S states are following suit—moreover, a recent proposal in the US by an impressive coalition of business and environment groups proposed a three-legged policy of cap and trade, emissions performance standards and demonstration programmes to bring forward emerging technologies, particularly carbon capture and storage.[13] The introduction of an EPS for new power plants was supported by the European Parliament in its vote on the EU climate and energy package in October, and the policy is also backed by the UK Conservative and Liberal Democrat parties.

WWF also notes with interest the recently-announced Government target to reduce CO2 emissions from aircraft to below 2005 levels by 2050. Correspondence with the Department for Transport has indicated that this will be a gross target relating to the sector's actual emissions, ie carbon credits or offsets will not count towards it (if this were not the case, the target would be effectively meaningless, since under the terms of the EU ETS aviation is capped at this level anyway). This is a further (and welcome) acknowledgement from Government that emissions trading should be supported by other policies. We only regret that the target was established at the same time as permission was granted for construction of a third runway at Heathrow—a perfect example of the long-lived, high-carbon infrastructure that the EU ETS is currently failing to prevent and for which supporting policies are necessary. To grant permission for the runway without first assessing its impact on meeting the target is surely to conduct policy backwards.

THE EU EMISSIONS TRADING SCHEME

4. The record of phase II of the EU ETS, and prospects for the success of phase III

Phase II (2008 to 20120)

Whilst some reports indicate that in 2008 phase II of the EU ETS was starting to influence operational decisions, specifically with regard to fuel switching from coal to gas in the power sector during 2008,[14] there is no indication that the scheme is as yet influencing longer-term investment decisions.

Indeed between 2008 and 2012 we are likely to see continued windfall profits accruing to the power sector due to the free allocation of the majority of pollution allowances[15]—although these may be reduced in the short term due to the indirect impact of the recession on the carbon price.

The economic recession and it's knock on impact on the carbon price, which has plummeted recently, is now raising concerns that as with phase I (2005 to 2007), the carbon price in phase II will be suppressed for a significant period of time.

Phase III (2013 to 2020)

Some significant improvements have been made to the third phase of the scheme such as the introduction of a harmonized cap set at the EU level, harmonized allocation methods, and full auctioning of allowances to the power sector in most countries.[16] However, major weaknesses still persist:

— Weak criteria for establishing the "carbon leakage" threshold may mean that around 90% or more of the manufacturing industries emissions could be defined to be at risk from carbon leakage and as a result they may continue to get all their allowances for free.

— As a sop to the German power industry the revised EU ETS also allows for the use of revenues from the auctioning of allowances to support the construction of power plants—including new coal build. Given the UK's commitments to reduce greenhouse gas emissions under its Climate Change Act and the recommendations of the Climate Change Committee's report that the UK power sector needs to be almost completely decarbonised by 2030—we would urge the UK Government to give explicit assurance that it will not use any revenues generated from the auctioning of pollution allowances to support the construction of new coal fired power plants. We would also urge the Government to encourage other Member States not to make use of this optional provision.

*Despite its opposition to the ring-fencing of auctioning revenues it is worth noting that the UK Government is supportive of allowing the revenues raised from the auctioning of 300 million allowances from the New Entrants Reserve to be used to fund carbon capture and storage demonstration projects within the EU.[19] Surely this could be considered a form of hypothecation.

There are also several implementation measures which still need to be addressed such as the establishment of benchmarks for the industrial sectors (although these will be largely be dealt with through the Comitology procedure). In addition once a global climate change deal has been signed the Commission is obliged to come forward, within three months, with proposals which include the adjustment from a 20% to a 30% EU emission reduction target.

5. Impacts of economic recession on the workings of the EU ETS

Since June 2008 the carbon price has fallen from around €30 to around €11 today.[20] This has been driven by the slow down in manufacturing within the EU resulting in lower emissions and hence less demand for pollution allowances, and has been exacerbated by the sell off of unwanted carbon allowances by manufacturing industries. One recent newspaper article notes "Up to €1 billion-worth of carbon emissions permits are said to have been sold off in recent months as industrial companies see an opportunity to bring in funds at a time when their carbon output is expected to fall due to lower production."[21]

The price of carbon is unlikely to drop to zero, as is it nearly did during the first phase of the scheme, due to provisions which allow unlimited banking of EUAs between phase II and phase III. However, banking of this excess "hot air" could significantly reduce the additional environmental effect of the scheme. It will make 2020 emission targets easier to hit and deflate the carbon price—further reducing the scheme's influence over operational and more crucially longer-term investment decisions. For example the scheme may have driven some fuel switching from coal to gas in 2008 but the plummet in the carbon price is likely to mean that fuel switching is not, today, incentivised by the scheme.

There has also been a fall in the price of credits in the CDM market (which is closely linked to the EUA price) with CERs currently trading at around €8 having fallen from over €20 in the Summer of 2008—resulting in a slowdown in investment in offset projects in developing countries.

The falling carbon price has led some carbon market commentators such as Deutsche Bank to suggest that the EU should intervene if low prices persist. Options proposed include the establishment of a reserve-price mechanism for the EUAs that are to be auctioned from 2013, and changing the ETS Directive to allow for regular reviews of the annual cap reductions beyond 2020.[22] Other options could include further restricting access to certified emissions reductions (CERs), which inflate the cap, or stopping access entirely; and immediately tightening the cap in line with an EU economy wide 30% 2020 emission reduction target.

WWF considers that the impact of the recession on the EU ETS makes it even more crucial that additional policies and measures are rapidly put in place to buttress the carbon price and drive low-carbon investment, particularly within the power sector. Without these additional measures there is a clear risk that power companies will continue to invest in long-lived unabated coal plants—locking us in to decades of soaring emissions. Similar measures may be necessary in other sectors which are planning significant investment in potentially high-carbon infrastructure. Please see our response to question 3 for further details.

6. Implications of the EU ETS for business competitiveness, and how to address them

Please see relevant briefing sent with this submission (please note that this assessment pre-dated the recent tumble in the carbon price).

8. Allocation or auctioning of EU ETS credits, and the use of auctioning revenues

For a comprehensive response to this question please see our submission to the recent EAC inquiry into the Pre-budget report in January 2009, enclosed. In short WWF believes that the UK should commit to use a sum equivalent to the full revenues from auctioning of allowances under the EU Emissions Trading Scheme (ETS) for climate protection measures. In our view, half of this sum should be used to aid the transition to a low-carbon economy in the UK. Equally importantly, the other half should be set aside to help meet the adaptation and mitigation needs of developing countries (including stopping deforestation)—this second purpose will be critical to ensure a successful global climate deal in Copenhagen this year. WWF notes that the Government is opposed to hypothecation as a budgetary principle but this does not prevent it from committing to spending the equivalent amount accrued from the auctioning revenues.

Whilst the use of revenues from auctioning carbon allowances may provide a significant contribution post 2012 (depending on the carbon price) the UK must also consider other additional measures to finance mitigation and adaptation in developing countries. This is particularly important in light of the current economic situation which will have an impact on the levels of revenues raised from auctioning.

It is also perhaps worth noting that US President Obama is planning to allocate a proportion of the revenues raised from auctioning pollution allowances, in an economy wide cap and trade scheme, on climate protection measures. The new federal US budget blueprint stated that "Through a 100% auction to ensure that the biggest polluters do not enjoy windfall profits, this program will fund vital investments in a clean energy future totalling $150 billion over 10 years, starting fiscal year 2012,"[23]

DEVELOPMENT OF A GLOBAL CARBON MARKET

9. Progress of cap and trade schemes in other countries (notably, the US), and the prospects for, and practicalities of, linking between them

The EU ETS should only be linked to other credible cap and trade systems. So as not to undermine the structure of the EU ETS strict criteria must be set before linking to other systems takes place. For example these criteria should include (but are not limited to):

— absolute caps;

— equivalent emission reduction trajectories in the same sectors;

— similar carbon prices;

— similar compliance failure penalties;

— no price caps; and

— equal and fair access to pollution permits across schemes, and comparable Monitoring Reporting and Verification (MRV) structures.

10. The robustness and effectiveness of "offset" schemes such as the CDM, and the issues around linking them to cap and trade schemes

The current project based CDM has demonstrated the limitations of market mechanisms for delivering sustainable development, particularly in the absence of adequate quality criteria such as those defined by the Gold Standard. For example India sets rather ambitious criteria on paper but to date the government has failed to reject a single project put forward for approval. The mechanism has been blighted by poor quality, structural inefficiencies, concerns over lack of additionality of many projects, and misguided investments in sub-prime business-as-usual projects. This clearly undermines financial assistance to developing countries in core sectors such as sustainable power generation, and low-carbon industrial production. To highlight just two of the growing number of studies that have raised concerns over the lack of additionality in particular:

The current CDM (a baseline and credit scheme) is at best then a zero sum game when used to offset emissions from industries covered by a cap and trade scheme. At worst, when credits from non-additional offset are used, the result is an increase in overall global emissions.

Furthermore, continued reliance on offsetting, even when these offsets come from credible projects, creates several serious problems:

will result in fewer incentives for innovation and investments within EU Member States, creating a severe risk that we will not be able to achieve the objectives of all three pillars of our climate change and energy strategy, especially improving energy security, driving innovation and domestic job creation

— High levels of access to imported credits risks greatly undermining any real policy drive for energy efficiency or investment in renewables.

— Conversely, offsets can be used to legitimise investment in long-lived, high-carbon infrastructure (with new coal-fired power stations being just one example).

— In the UN negotiations, the EU is calling for developed countries to reduce emissions by 25-40% below 1990 levels by 2020. The latest climate science makes it clear that only the top end of this range will give confidence that global warming can be kept below 2°C—and that the substantial majority of this reduction needs to be made domestically.

— It is also clear, and confirmed by the EU's presentations at the UN climate change negotiations in Poznan in December 2008, that any offsetting by industrialised countries to help meet the 25-40% range needs to come in addition to, and not instead of, very significant "MRV" action to help developing countries reduce emissions by 15-30% below business as usual. As already stated—offsetting is, at best, a zero sum game for the climate.

UK CARBON BUDGETS

11. The relationship between emissions credits and the UK carbon budgets set up under the Climate Change Act

WWF notes that clauses 11 and 15 in the Climate Change Act require the Government to "have regard" to domestic action on climate change and to set a limit on the use of carbon offsets to meet the carbon budgets. In WWF's opinion clause 11 is the more important but it allows the Government to set a limit at its choosing and to exempt any type of carbon unit from this limit. The Government, therefore, could set a very lax limit on carbon offsets and significantly limit the scope of this restriction. The Government has until 1 June 2009 to set this limit for the first carbon budget (2008-12)

12. Transparency of and justification for counting the purchase of emissions credits (especially from "offset" schemes) as decreasing emissions from the UK

The UK Government recently consulted on the type of carbon units that can count towards the net UK carbon account (which would be used to would monitor compliance with the targets and budgets set under the Climate Change Act).[26] Although this consultation focused on carbon accounting it gave a clear indication of the Government's continuing intention to rely excessively on the crutch of "offsetting" and the EU ETS to deliver the carbon budgets. WWF is very concerned that this excessive reliance on offsetting is undermining the clear need, which is only reinforced by recent climate change science, for rapid and radical decarbonisation of industrialised countries' economies in addition to significant mitigation action in the developing world.

WWF has consistently called for a very substantial majority of the emission reductions under the Climate Change Act to be made domestically, within the UK. In our view, the preferred approach would be that the UK's actual emissions should be recorded in the carbon account (with an appropriate provision to allow flexibility around this figure by accounting for carbon trading). This approach would require an effective strategy and policy framework to guide decarbonisation across all sectors of the economy. In contrast, the Government's accounting proposals appear in theory to allow essentially unlimited potential for use of offset credits across the economy as a whole.

With particular regard for the sectors covered by the EU ETS the consultation document noted that "…whether or not actual emissions by UK EU ETS operators exceed or fall short of the cap, the final contribution from the EU ETS to the net carbon account will be equal to the cap..". This completely opaque "smoke and mirrors" accounting approach somehow makes the real pollution from industrial sectors—accounting for half of the UK's CO2 emissions—disappear into thin air. WWF finds it completely unacceptable that the actual emissions from the EU ETS sectors (including the power sector) will not actually be recorded in the UK's carbon account and that these sectors may therefore not be required to make any additional effort to meet the carbon budgets. This is particularly alarming given the clear recognition by the Committee on Climate Change and others that the power sector must play a critical role in decarbonising the UK economy.

It is particularly remarkable that the Government's proposed approach to accounting for emissions under the Climate Change Act is only valid for four more years. The consultation fails to recognise that beyond 2012 there will no longer be such a thing as a "UK cap" for the ETS sectors,[27] making this method of accounting redundant.

March 2009