Memorandum submitted by The Carbon Trust
SUMMARY
Overview
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.
OVERVIEW
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:
(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.
THE EU EMISSIONS
TRADING SCHEME
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.
DEVELOPMENT OF
A GLOBAL
CARBON MARKET
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.
RELEVANT CARBON
TRUST PUBLICATIONS
The following publications are available from
www.carbontrust.co.uk/publications 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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