Memorandum submitted by the Department
of Energy and Climate Change
SUMMARY
— The Stern Review of the economics of
climate change highlighted the need for a carbon price signal
across countries and sectors to ensure that emission reductions
are delivered in the most cost effective way.
— The UK is committed to building on the
EU Emissions Trading System (EU ETS) as the principal way of pricing
carbon in the economy.
— Building on the lessons learnt from Phases
I and II of the EU ETS, including as set out in previous reports
from the Environmental Audit Committee, Phase III (from 2013)
has been significantly revised. The combination of a more ambitious,
EU-wide cap on emissions with an annually declining trajectory
to 2020 and beyond; auctioning as the preferred means of allocation;
and limited access to project credits from outside the EU will
result in more emission reductions, more predictable market conditions
and improved certainty for industry and investors.
— The potential of the global carbon market
is only just being realised. It is important to get the design
of the EU ETS right. With the right focus, and improved credibility,
the EU ETS can become the basis for a global carbon market.
— National and regional carbon markets
offer significant potential for international climate policy.
Making the global carbon market deeper, wider and more liquid
will increase the potential to reduce emissions at least cost.
The UK Government and the EU are keen to build a global carbon
market by linking the EU ETS to other emerging trading systems
which demonstrate a high level of environmental integrity and
robust design.
OVERVIEW
1. This memorandum sets out the Government's
view on the issues highlighted by the Committee as areas it would
like to explore in its inquiry.
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 2oC
2. The Stern Review of the economics of
climate change highlighted the need for a carbon price signal
across countries and sectors to ensure that emission reductions
are delivered in the most cost effective way.
3. International emissions trading through
a cap and trade system can keep emissions within set limits, whilst
allowing emission reductions to be made at least cost through
the trading of allowances. This is the UK's carbon price instrument
of choice.
4. Participation in national and regional
carbon markets offers a significant contribution to tackling global
climate change, in particular we consider:
— mandatory cap and trade systems developed
with a high level of environmental integrity and robust design
are cost-effective instruments to reduce greenhouse gas emissions;
— robust monitoring, reporting and verification
rules underpin credible emissions trading;
— future linking of emissions trading systems
may provide more emissions reductions at lower cost, and accelerate
the scale of innovation;
— larger trading volumes and improved market
liquidity are likely to yield more robust price signals; and
— linked systems may stabilize investor
expectations, provide political certainty on the continued existence
of the carbon market and help mobilize capital for the transition
to a global low-carbon economy.
Whether, and under what circumstances, emissions
trading ought to be supplemented or replaced by tax or regulation
5. Emissions trading uniquely provides the
opportunity to set a global price on carbon, delivering true transparency
of the cost of carbon and ensuring this cost is met by those who
produce emissions. However, emissions trading can only be part
of the solution to tackle climate change. Other measures such
as tax incentives and regulation will also be required.
6. Taxes and trading will have equivalent
outcomes in certain circumstances. When there is uncertainty over
the damage value of the marginal unit of emissions, trading is
preferred, because emissions trading imposes an absolute cap,
above which emissions cannot rise.
7. The Stern review highlighted the need
for polices such as the EU ETS, which price carbon, to be supplemented
with other policies which overcome the barriers to innovation
of low-carbon technologies, and the barriers to consumer behaviour
change. Additional policies, including taxes and regulation, will
complement the aims of emissions trading systems by unlocking
opportunities to reduce emissions at lower cost than otherwise
possible.
THE EU EMISSIONS
TRADING SYSTEM
The record of Phase II of the EU ETS, and prospects
for the success of Phase III
8. The challenge of Phase II, running from
2008-12, has been to address the problems of Phase I and improve
the credibility of the EU ETS as an effective tool in tackling
climate change. In Phase II, UK effort is expected to produce
a reduction of 29.3 Mega tonnes of CO2 (MtCO2) annually compared
to projected business as usual emissions for 2010. This is due
to a tighter Phase II cap of 2082.68 MtCO2 (per year). EU effort
compared to 2005 is expected to produce a reduction of 215.8 MtCO2.
This is 9.3% per year below 2005 emissions—with UK effort
13% below 2005 emissions.
9. To increase the efficiency of the system
and to help prevent windfall profits, auctioning of allowances
has been introduced as an allocation methodology. The UK is auctioning
7% of its allowances in Phase II, with fewer free allowances to
the large electricity producers sector.
10. The next Phase of the EU ETS from 2013,
builds on the lessons of Phases I and II, and contains a number
of major improvements. Most importantly, the EU has put in place
the measures to deliver a unilateral 20% reduction in greenhouse
gas emissions by 2020 from 1990 levels, with the potential to
rise to 30% as part of an international climate agreement.
11. The revised EU ETS Directive provides
for a fundamentally different and more rigorous approach to setting
the cap on emissions. A central EU cap will guarantee that the
EU ETS will deliver its share of emission reductions. The cap
is set at a more ambitious level. For the first time, there is
an annually declining trajectory for the cap to 2020 and beyond
which will deliver emissions 21% below 2005 levels by 2020.
12. There will also be a significant increase
in auctioning in Phase III, including 100% auctioning in the power
sector in the UK and across most of the EU, and a greater harmonisation
of the rules of the system to eliminate distortion across the
EU.
13. Detailed implementation measures will
be agreed through technical comitology procedures led by the European
Commission over 2009-11.
14. We believe the revised EU ETS should
result in more predictable market conditions, a more stable carbon
price and improved long-term certainty for industry.
Extent to which the carbon price will be sufficient
to drive low-carbon investment, in particular decarbonisation
of energy
15. Setting the emissions cap on the EU
ETS in order to meet our emissions reduction targets creates a
price for carbon allowances arising from abatement costs in the
industrial sectors covered by the system. This price is a result
of the cap setting. Government has not taken a view that any particular
price of carbon is the "right" price for other policy
areas, other than through internal Government guidance on how
to cost carbon impacts in policy appraisal. The carbon price creates
dynamic incentives for firms to invest in low-carbon technologies.
The level of incentive will depend on the carbon price, and on
future expectations for the price. High carbon prices will increase
returns from low-carbon investments or from developing low-carbon
technologies. However, in order to meet emissions reductions at
least cost—particularly in sectors outside the ETS- further
policies to support innovation in low-carbon technologies and
to drive behavioural change, will also be required.
16. In order to provide the correct incentives
for low-carbon investments, firms need to form expectations about
the future level of the carbon price. This is particularly important
for capital intensive sectors with lengthy payback periods on
investments, such as electricity generation. Failure to signal
future carbon constraints clearly could result in investors underestimating
future prices, and to lock-in of high-carbon investments, increasing
the overall cost to the economy of meeting emissions reduction
targets. The revised EU ETS Directive agreed in December sets
an annual reduction in cap of 1.74% per annum from 2013 to 2020
and beyond, and so gives a long-term price signal sought by investors.
Impacts of economic recession on the workings
of the EU ETS
17. In the EU carbon market we are currently
witnessing a reduction in volumes and lower prices resulting from
reduced manufacturing output, lower electricity demand and lower
forecasts for GHG emissions in the short term. The fall in the
price of carbon has also followed the fall in other commodity
prices. Due to reduced manufacturing demand some companies are
also selling their allowances, thus increasing the overall supply.
Allowing carbon prices to reflect these changing market fundamentals
is necessary for achieving fixed emissions reductions at least
cost as it incentivises participants to change their behaviour
accordingly.
18. It should become easier for firms to
comply with emissions targets under a lower carbon price as compliance
costs will be lower. In turn, the cost pass-through to consumers
should fall.
19. There are significant risks in attempting
to manage the carbon price. Introducing price caps or floors could
make emissions trading more uncertain by in effect generating
speculation on the next possible Government intervention in the
market. Our approach is to set the right, long-term regulatory
framework with a reducing cap on emissions (as with Phase III
of the EU ETS), and allow the market to help achieve these reductions
cost-effectively.
Impacts on and responses by UK firms covered by
the EU ETS
20. In Phase II, UK emitters are expected
to be net purchasers of allowances from installations in other
Member States. That said, some installations received more allowances
than required and were able to sell them on. Increased auctioning
of allowances in Phase III and the tighter cap will reduce the
potential for such gains to be made.
Implications of the EU ETS for business competitiveness,
and how to address them
21. The UK Government recognises that carbon
leakage (production moving out of the EU because of the price
of carbon) is an issue which must be addressed in Phase III of
the EU ETS. However, current analysis indicates that only a small
number of sectors will be at significant risk of carbon leakage.
Of course, the best solution in the long term is to develop the
global carbon market as part of an international agreement so
as to provide a more level playing field for business. In the
interim, we support the allocation of allowances for free, based
on efficiency benchmarks, to those sectors at significant risk.
This assessment should be made on an evidence based approach.
The revised EU ETS Directive provides for a reassessment of this
approach based on a reappraisal of the carbon leakage risks facing
EU manufacturing industries, considered in light of any future
international climate agreement.
Effects of the expansion of the EU ETS to encompass
aviation
22. On 24 October 2008, the Council of the
European Union adopted a Directive that will include all flights
arriving at and departing from European airports in the EU ETS
from 2012 onwards. This means that net aviation emissions cannot
increase beyond 97% of average 2004-06 emissions levels in 2012
and 95% of average 2004-06 emissions levels in 2013. Any growth
in aircraft emissions above these levels will only be made possible
by the aviation sector paying for commensurate carbon savings
elsewhere in the EU economy.
23. The European Commission estimates that
by 2020 a total of 183 million tonnes of CO2 will be saved per
year on the flights covered by the EU ETS, a 46% reduction compared
with business as usual.
Allocation or auctioning of EU ETS credits, and
the use of auctioning revenues
24. The Government supports high rates of
auctioning under the revised EU ETS from 2013. Auctioning is the
simplest and most transparent allocation methodology and it reinforces
the incentive to reduce emissions, and to invest in and develop
cleaner technologies.
25. The revised Directive provides for a
substantial increase in auctioning levels and overall at least
60% of allowances will be auctioned by 2020, compared to around
3% in Phase II. Auction levels will be 100% for the power sector
in the UK and across most of the EU.
26. As part of the revised EU ETS Directive,
the European Council adopted a non legally binding political declaration
indicating Member States' willingness to spend at least half of
the auction revenues or equivalent to tackle climate change both
in the EU and in developing countries. The Government is content
with this approach, which we believe will provide a strong signal
of the EU's willingness to invest in a low-carbon economy and
offer support to the international community ahead of negotiations
in Copenhagen at the end of this year.
DEVELOPMENT OF
A GLOBAL
CARBON MARKET
Progress of cap and trade schemes in other countries
(notably, the United States), and the prospects for, and practicalities
of, linking between them
27. We recognise the economic and environmental
benefits of expanding the reach of the EU ETS and are working
with our international partners towards linking of emerging emissions
trading systems. There are practical constraints to linking with
other trading systems, with comparability one of the main challenges.
The European Commission has developed criteria for linking to
the EU ETS. These include:
— A robust and environmentally ambitious
emissions cap. The EU will only link to mandatory cap and trade
systems—with an absolute cap on greenhouse gas emissions.
— Trading systems should be free of Government
intervention, such as price caps or ex post adjustments.
— Credible emissions trading systems that
deliver real greenhouse gas emissions reductions. This means covering
sectors or sources where reliable monitoring and reporting of
emissions is possible and having robust and trustworthy compliance
and enforcement.
28. The first regional cap and trade system
in the US, the Regional Greenhouse Gas Initiative covering North
Eastern States, became operational this year. There are two other
regional cap and trade initiatives under development; the Western
Climate Initiative and the Midwestern Climate Change Accord. President
Obama has announced his intention to seek the agreement of Congress
to a Federal cap and trade system. The EU is committed to encouraging
a single US Federal emissions trading system that can link to
the EU ETS.
29. Australia's Carbon Pollution Reduction
Scheme is due to commence trading in 2010. They have introduced
price caps for the first phase of their system and the EU will
not consider linking the system to the EU ETS whilst these are
in place. A voluntary emission trading system has been developed
by Japan—however there are no moves as yet to make this
mandatory. Regional voluntary Emission Trading Systems are under
development in Taiwan, and are also being considered in South
Korea.
The robustness and effectiveness of "offset"
schemes (ie those without a cap), such as the Clean Development
Mechanism (CDM), and the issues around linking them to cap and
trade schemes
30. The Clean Development Mechanism (CDM)
helps to drive global investment in low-carbon technologies. It
provides a source of income and technology valued by developing
countries to support a shift away from high-emitting "business
as usual" development, essential for their long-term transition
to low-carbon economies.
31. Nevertheless, the Government regards
CDM as a transitional mechanism towards building our long-term
vision of a truly global carbon market. In the medium term, we
wish to see advanced developing countries move away from CDM towards
sectoral crediting and trading under sectoral caps.
32. CDM will continue to play a role in
the least developed countries. The Government believes that a
number of reforms are needed of CDM, including:
— Improvements to administrative efficiency
and transparency of the assessment process.
— Improved methods for assessing emission
reductions. Benchmarking should replace the less reliable, more
subjective, assessment against "Business As Usual" emission
projections.
— Development of special approaches for
sectors where abatement is particularly cheap in comparison to
the number of emissions that can be generated.
33. The UK Government has been clear that
the EU must demonstrate it is serious about the transition to
a low-carbon economy through emission reductions within its borders.
We should not rely disproportionately on third countries in order
to meet Europe's own targets. Therefore, we see a limit on the
use of international project credits as appropriate in the context
of the EU's unilateral commitments to reduce emissions.
34. There has been a small increase in access
to CDM credits in Phase III of the EU ETS, to harmonise some of
the discrepancies in allocation that occurred in Phase II. However,
this increase has been limited such that at least 50% of absolute
reductions (in terms of effort) in the EU ETS take place within
Europe. This compares to access to credits in Phase II equivalent
to more than four times required effort. This restriction on access
to credits provides a strong incentive for developing countries
to sign up to a global deal in order to increase their access
to a global carbon market.
UK CARBON BUDGETS
The relationship between emissions credits and
the UK carbon budgets set up under the Climate Change Act
35. The Climate Change Act 2008 creates
a new approach to responding to climate change in the UK through
setting ambitious targets, taking powers to help achieve them,
and strengthening the institutional framework in this area. To
help provide long-term clarity, the Act requires the Government
to establish a system of "carbon budgets" capping emissions
over successive five-year periods.
36. The Act allows carbon units purchased
from overseas to be counted as credits against carbon budgets,
while units sold to other countries should be counted as a debit.
This is important to ensure that the UK and UK businesses are
able to participate in emissions trading systems such as the EU
ETS, and access cost-effective abatement opportunities outside
the UK. The independent Committee on Climate Change is required
to provide advice, in relation to each budgetary period, on the
appropriate balance between domestic and international effort,
and the Government must set a legally-binding limit on the amount
of credits that may be counted towards each budget. In addition,
the Act requires the Government to consider the need to reduce
UK emissions when considering how to meet the targets and budgets.
Together, these provisions ensure the maximum possible transparency
about our plans for meeting targets and for moving the UK to a
low-carbon economy, while retaining the option of using international
credits where appropriate.
Transparency of and justification for counting
the purchase of emissions credits (especially from "offset"
schemes) as decreasing emissions from the UK
37. The concept of tradable carbon units
is an important part of the international climate change architecture.
Under the Kyoto Protocol, countries may trade carbon units with
each other provided this is supplemental to domestic action to
reduce emissions. The provisions in the Act allowing overseas
credits to count towards carbon budgets are therefore consistent
with the existing international approach as well as the policy
approach set out in the Stern Review.
38. In terms of whether credits from "offset"
schemes may count towards carbon budgets, we propose that only
units which are internationally recognised under UN and EU rules
may be eligible. These units have been subject to significant
scrutiny and are widely accepted as representing genuine and verifiable
emissions reductions.
February 2009
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