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

Memorandum submitted by The Carbon Trust



  1.  Carbon markets are essential, but must be complemented by other action to prevent climate change. Essential because they provide firms with an incentive to abate whilst limiting overall emissions. However, complementary actions are required: to remove obstacles to greater energy efficiency, to accelerate the rate of innovation in low-carbon technologies, and to cut carbon from agriculture, forestry and land use.

2.  It would be harder to prevent climate change using a carbon tax: it is more difficult to get agreement on the right level(s) for the tax than it is to agree the right path for emissions reductions under a cap and trade scheme.

The EU Emissions Trading Scheme

3.  The series of booms and busts in the cost of carbon are a problem in achieving the scheme's goals because it creates uncertainty for firms' investment decisions. Reserve prices on auctions offer a near-term solution.

4.  Our study of 159 UK manufacturing activities, and similar analysis in other countries, suggest that the impact of the EU ETS on profitability and trade is limited to a handful of sectors. There are no easy solutions to the issue for these sectors. In particular, free allocation is not a universal remedy. In some very specific cases it may be preferable to implement border adjustments. However, these will take time to negotiate multilaterally.

5.  Phase III of the scheme is a significant step in the right direction, but issues remain: working out who should receive protection from "leakage"; working out benchmarks for free allocation; and price uncertainty, including uncertainty driven by the level of the cap in relation to governments' action on the renewable energy and energy efficiency targets.

Development of a global carbon market

  6.  The Clean Development Mechanism itself has triggered more than 4,000 emission-reducing projects in developing countries and is likely to save up to 2 billion tonnes of emissions reductions by 2012.

7.  Other mechanisms under the Kyoto Protocol, including emerging Green Investment Schemes, show great promise.

  8.  Many of the gains are at peril unless governments act to restore balance in the markets and learn the emerging lessons.


Carbon markets are essential, but must be complemented by other action

  9.  The obvious advantage of carbon markets is that the desired outcome is set (a level of emissions reduction) and then the full force of entrepreneurialism is unleashed to seek out the lowest cost way of achieving the outcome.

10.  However, our experience is that many energy efficiency actions are already profitable. Therefore carbon markets need to be complemented by other policies that remove obstacles to energy efficiency which often include intangible, transaction and transition costs, inertia, lack of awareness, immateriality, split incentives or system failures (these obstacles and potential actions are explained in greater detail in our publication The UK Climate Change Programme: Potential evolution for business and the public sector.)

11.  Similarly, the rate of cap reduction required from carbon markets means that early and directed action is required to accelerate innovation in key low-carbon technologies. This is required to ensure that they are available to firms in carbon markets, so that they can smoothly reduce their emissions. If innovation was left to the carbon market alone, then the carbon price would need to cover the risks in the research, development and scaling of the innovations. This would lead to an unnecessarily high carbon price which would create profitability difficulties for purchasing firms, and very large profits for innovators with low-cost abatement options. Furthermore, public sector support for innovation is required due to market failures such as those highlighted in the Stern Review: lack of niches and early adopters which usually provide the initial market for emerging technologies; risk averse suppliers (often resulting from the regulatory scheme in which they operate); knowledge spillover effects (so competitors can easily copy technology advances, reducing the incentive to innovate) and infrastructure tailored towards existing technologies.

  12.  Carbon markets therefore occupy a sweet-spot, encouraging companies to adopt energy efficiency actions when obstacles are removed and new technologies when they are ready for commercial deployment. The flip side of a carbon market's ability to seek out the lowest cost way of achieving a given emissions level is that there will be price uncertainty, which can be difficult for business and governments to manage.

Carbon taxes are not the answer

  13.  A large body of economic literature proposes that when faced with uncertainty about the costs of a given emissions cutback, taxation is to be preferred over the creation of carbon markets. This literature has some relevant insights but as a guide to policy it overlooks several problems and some evidence:

    (a) Taxation combines the setting of a price with the transfer of large revenues from industry to government. By combining two very difficult things in one instrument it guarantees that the price will not be set at an appropriate level—it will rather be constrained by the politics of large-scale revenue transfers. Emissions trading has the huge advantage of separating these two factors:

    (i)Overall caps can be set in line with the overall need for reduction; and

(ii)the distribution of the revenues created by the caps can be separately negotiated with industry, with the option of using free allowances to leave all of the revenues in the hands of industry.

    (b) The "additionality" of taxation is also very hard to establish, given widespread existing variation in underlying tax and subsidy regimes. It would be entirely possible for governments to introduce a carbon tax and offset this against changes in other tax structures, with the real effectiveness remaining opaque. Emissions trading focuses on the outcome—emission levels—and reveals the real costs of cutting emissions.

    (c) Carbon taxation consumed the politics of European climate policy for five years (1990-95) before being finally abandoned. Several more years of negotiations on harmonisation of energy excise taxes yielded an outcome which might be described as modest, with negligible impact on emissions.

    (d) The experience in the relatively similar and highly committed countries of Scandinavia in introducing carbon taxes in the early 1990s showed the difficulty in getting harmonised implementation of a carbon tax given differing domestic processes and politics of taxation.


Booms and busts in the cost of carbon are explicable and are a problem

  14.  The UK ETS, phase I of the EU ETS and most recently phase II of the EU ETS have all seen a pattern of high prices followed by dramatic declines. This pattern is to be expected:

    (a) The required reductions in emissions are small relative to the cap, and relative to very large uncertainty about what demand for emissions will be given uncertain fuel prices, uncertain GDP growth and uncertain scope and impact of energy efficiency actions. Our 2006 analysis of phase II of the EU ETS against a range of emissions projections showed the potential for very low carbon prices.(b) Industry holds more data than governments about the real emission prospects and the real potential for cutbacks. This information asymmetry, combined with lobbying by industry, can make it challenging for governments to design an emissions trading scheme objectively.

    (c) High prices are driven by the natural optimism of industrial companies about their growth prospects which drives demand for allowances.

    (d) Prices are volatile because the carbon market has similarities with capital intensive commodity markets where it is expensive and slow to adjust supply of products (in this case carbon allowances) to match shifts in demand.

  15.  The current "orthodoxy" is that once the quantity of emissions allowances is set, it doesn't really matter how the market behaves—it will still deliver the carbon reduction target. This reflects a fundamental intellectual confusion about the nature of emissions trading systems. It is not a natural market, connecting supply of a "natural" good to a private demand, but an instrument to achieve collective public goals. That is an absolutely fundamental difference, because it establishes that the instrument needs to be assessed against the goals it is intended to achieve. Such an assessment reveals:

    (a) Investment is already deterred by the uncertainties arising from the sequential nature of emission commitments, and the difficulties that business has understanding and predicting future government action; these naturally lead to a high discounting for political uncertainty. This will be greatly exacerbated if carbon prices collapse for an extended period again;

    (b) High price volatility increases the uncertainty around the correct course of action for businesses. This uncertainty means that unnecessary costs are incurred due to what turn out to be incorrect decisions, or additional costs are spent on managing the uncertainty. Both costs lower the economic efficiency of the scheme.

    (c) A "boom and bust" pattern does not provide a stable or predictable resource flow to developing countries, either directly or (as some propose) through channelling of auction revenues. Indeed over time it risks aggravating rather than improving engagement with developing countries, and discrediting market mechanisms.

  16.  Early commitments by key countries to steeper cutbacks post-2012, in advance of a global agreement, would send the strongest and most consistent signal to support carbon prices but may only provide a partial solution because of the indirect nature of the link between national targets and individual carbon markets.

  17.  A more direct intervention that could impact prices during the year of negotiating Copenhagen and also weather the storms of the credit crunch is to set a reserve price on auctions of emissions allowances. This has the benefit that it addresses directly an underlying cause of the problem—the fixed supply in the face of highly uncertain demand—without requiring substantial changes to the overall system.

Only a handful of sectors will have their profits or trade substantially affected. There are no easy fixes

  18.  Based on research by the European research network Climate Strategies, we analysed, for the first time, the impact of the EU Emissions Trading Scheme (EU ETS) on business competitiveness across the UK at a business sub-sector level. We concluded that overall, UK and EU competitiveness will not be damaged, even if deeper C02 emissions cutbacks are introduced beyond 2012 to achieve the EU's target for a 20-30% reduction in emissions by 2020 but that a few isolated sectors could be exposed. Businesses constantly face external impacts on pricing and competitiveness, be it from exchange rate fluctuations or differences in the cost of labour or raw materials. For more than 90% of manufacturing industry, carbon costs will remain trivial compared to these other influences on international competitiveness.

19.  The study, which looked at more than 150 manufacturing activities in detail, did find six—cement, steel, aluminium, pulp and paper, basic inorganic chemicals and fertilisers/ammonia—that are a cause for concern in terms of competitiveness. These six industries currently represent 0.2% of employment in the UK and one third of the manufacturing sector's carbon dioxide emissions—10% of the UK total. The report suggests "leakage" from the activities is likely to represent no more than one per cent of total EU C02 emissions (although this percentage is higher in the activities affected).

  20.  Free allocation can act as a temporary subsidy to the industries affected but doesn't fix the underlying problems (it is difficult to get the level of free allocation right so that it provides sufficient support without windfall profits; it prevents a useful price signal being sent to consumers; firms can take the free allocation and put up prices or reduce production anyway). In some very specific cases, it might be preferable to implement border adjustments. However, these will take time to negotiate multilaterally.

Phase III of the scheme is a significant step in the right direction

  21.  The design of phase III of the EU ETS is welcome: the expansion in gases and sectors is appropriate, as is the much greater use of auctioning and the opt-out provisions for the smallest sites. Most of all, the design sets out clearly the scale of emissions reductions required from the sectors.

22.  However, a substantial amount of detail remains to be worked out. In particular, the criteria for who should receive protection from "leakage" are complex and may end up giving sectors free allocation of allowances unnecessarily. We do not understand the generous way in which the relevant EU Directive appears to be being interpreted in this regard. Where free allowances are given, they will be based on benchmarks, but we foresee a great deal of difficulty in creating benchmarks that don't cause unintended decisions when manufacturers choose where to invest or how to operate.

  23.  Finally, price uncertainty remains. This is not just because of energy prices and economic growth uncertainties and that the cap may be reset in the light of a global deal. It is also because of uncertainty relating to how, and how much of, the renewable and energy efficiency targets in the EU climate change package will be met. This may accentuate the price volatility effects that have already been seen in phases I and II of the EU ETS.


The global mechanisms have been a success

  24.  Global carbon markets as set out under the Kyoto Protocol include: The Clean Development Mechanism (CDM); Joint Implementation (JI); and Inter-Governmental emissions trading—potentially including the creation of Green Investment Schemes (GIS) that could fund a step-change in the efficiency of east European economies.

25.  CDM and JI alone could deliver up to 2 billion tonnes of emissions reductions by 2012. In addition GIS, for which the first deals are now being struck, could be a key instrument to deliver emissions savings that the other mechanisms cannot reach, notably from small-scale renewables and energy efficiency.

The use of a limited number of offsets to meet targets is appropriate

26.  Our analysis suggests that the CDM offsets almost always do represent additional carbon savings, and therefore that it is acceptable to count them in the EU ETS and in meeting UK carbon budgets if that makes it possible for more ambitious and rapid targets for carbon reductions. Limiting their use to less than half of the required emissions reductions, as is proposed, appears appropriate to ensure that domestic action is taken to prepare for the mid-term reductions, so long as it means that the appropriately ambitious carbon budgets are set.

Reforms are required

27.  The mechanisms are a key part of global action, but reforms are needed and must be matched by stronger international targets—and associated policies on innovation and energy efficiency will still be needed to tackle climate change on a global level and put us on a path to long-term carbon reductions.

28.  To cope with the rapidly growing volumes in the Clean Development Mechanism (CDM), to learn from experience gained, and to increase public confidence, reforms are required in implementation structures and operating rules, supported by a more sophisticated debate about ensuring environmental integrity:

    (a) Too many roles are concentrated in the Executive Board that runs the CDM: strategy and governance should be separated from executive project decisions, with a separate appeals procedure.

    (b) This would free the Executive Board to focus on increasing stability, transparency and administrative efficiency of the rules for assessing the additionality of project emission savings, and adapting rules to facilitate a broader interpretation of environmental integrity and wider scope of individual project types and programmes.

  29.  The following should be examined as options to evolve the geographic, sectoral and temporal effectiveness of the different mechanisms and thereby support low-carbon economic development:

    (a) Incremental reform of CDM project additionality methodologies and eligibility rules to streamline the process eg programmatic CDM and to review current exclusions.

    (b) Radical reform of project crediting rules towards "top-down" assessments based on benchmarked performance and/or levels of market penetration.

    (c) Evolution to sector and possibly policy-based crediting and trading mechanisms for more advanced developing countries.

    (d) Establishing norms for Green Investment Schemes, mostly likely through a forum of participating countries which could also ensure collective international learning.

  30.  Credit discounting could be applied to any or all such developments, to help maintain aggregate additionality and/or contribute to the global supply-demand balance, although this would make the schemes significantly more complex.

The balance of the market needs to be restored by increasing demand

  31.  Overall, the success of international carbon markets makes them essential to any post-2012 deal, but the scale of potential supply makes it essential that expansion of the mechanisms is matched by sufficient demand. This will need to be created through a strong post-2012 deal and set of targets. This is particularly relevant in the context of the economic downturn and high energy prices which will reduce short-term demand from industrialised countries.

The mechanisms are essential, but should be part of a portfolio of actions

32.  However, for the longer term, the mechanisms of CDM and JI, on their own, won't be sufficient to reduce emissions in all sectors, for example, forestry and transport. Furthermore, delivering the scale of change that is required to tackle climate change will require policy reforms and incentives for energy efficiency and innovation in renewables and carbon capture and storage. CDM and JI as they stand will only be able to help stimulate up to 20% of the potential global annual carbon savings in 2030.


The following publications are available from or by calling 0800 085 2005

  1.  Carbon Trust (2008) Global Carbon Mechanisms: Emerging lessons and implications.

2.  Carbon Trust (2008) Climate change—a business revolution?

3.  Carbon Trust (2008) Cutting Carbon in Europe: The 2020 plans and the future of the EU ETS.

  4.  Carbon Trust (2008) EU ETS impacts on profitability and trade: a sector by sector analysis.

  5.  Carbon Trust (2007) EU ETS Phase II allocation: implications and lessons.

  6.  Carbon Trust (2006) Allocation and competitiveness in the EU Emissions Trading Scheme: Options for Phase II and beyond.

  7.  Carbon Trust (2005) The European Emissions Trading Scheme: Implications for Industrial Competitiveness.

  8.  Carbon Trust (2005) The UK Climate Change Programme: potential evolution for business and the public sector.

March 2009

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