The EU Emissions Trading System - Energy and Climate Change Contents

Memorandum from the City of London Corporation, Office of the City Remembrancer (ETS 07)


1.  The City is a founder member of the London Climate Change Partnership and, in 1999, was a founder member of the UK Emissions Trading Group (UK ETG), which played an important role in laying the foundations upon which the UK, and then EU, Emission Trading Schemes were built.

2.  The development of the emissions trading market is the result of a combination of the policy requirement to reduce carbon emissions and a market opportunity. The signing of the Kyoto Protocol and the resulting EU Emissions Trading Scheme (EU ETS), have led to the development of the market in carbon allowances. London's pool of expertise in financial and professional services has enabled it to become Europe's emissions trading 'hub' in a market that has seen considerable growth in recent years and a cluster of firms servicing this emerging industry has already developed.

3.  The City Corporation therefore welcomes the opportunity to contribute to the Committee's inquiry.

Does the EU ETS remain a viable instrument for climate change mitigation in the EU?

4.  In establishing the EU ETS, policy makers created the demand for a commodity (an allowance to emit carbon) which was previously considered free. To this end, in establishing the world's only regional trading scheme, Europe has a massive potential advantage not only in the development of new financial products, but also in the financing of developments in new technologies to combat climate change. Now the price of carbon has been set, the commercial viability of abatement projects can be more readily calculated and capital or project finance sought from the private sector.

Can the EU ETS operate effectively in a world without legally-binding emissions reduction commitments and other cap-and-trade schemes?

5.  Whilst emissions trading is currently a significant tool in the fight against climate change, it is not a universal panacea and is reliant both directly and indirectly on enabling legislation which will lead society to a low carbon future. However, by harnessing the market in emissions abatement, cap and trade schemes allow specific reduction targets to be set and monitored, and the efficiency of the market will ensure that emissions reductions are met at the lowest possible cost.

What reduction in emissions will the EU ETS deliver in Phase III, within the EU and abroad?

6.  The overall cap in Phase III will inevitably be far more stringent than in previous phases. Unlike in the previous phases where discretion to determine the emissions cap was left to member states, it is likely that the cap will be set at an EU wide level in Phase III. Evidence suggests that the cap will be determined by using the average total quantities of allowances issued by Member States in Phase II as a starting point, and then reducing this by 1.74% each year. The effect of this would be that there will be far fewer allowances issued in this Phase which is likely, therefore, to lead to increased prices.

Could the environmental and economic efficiency of the EU ETS be improved by linking with other emissions trading schemes and how can this be achieved?

7.  Carbon trading is a broad church and currently two emissions trading markets are evolving in parallel:

—  Formal markets—epitomised by the EU ETS; and

—  Informal markets involving Verified Emissions Reductions (VERs), which are a key market in the US.

8.  Although the UK Government's new Quality Assurance Scheme[10] begins to address this, VERs currently lack market infrastructure, such as registries and monitoring. This Voluntary market may, however, evolve into a more formal trading system—in which case carbon offsets, such as Clean Development Mechanism credits, may form a bridge to a wider market, and could provide a common 'currency' between schemes. The development of carbon trading schemes will increase market value by an order of magnitude and is likely to spawn a plethora of new products and secondary markets.

9.  The primary impetus for this may come as other nations—China, Australia, South Korea and Japan move towards domestic carbon trading schemes, leading to a strong possibility that border carbon taxation may become the norm (with trading schemes effectively becoming a form of non-tariff trade barrier). To this end a formalised system of VERs could replace CDM as a bridge to a global market, and could provide a common currency between schemes.

10.  Whilst there are arguments in favour of developing a global trading mechanism, another school of thought suggests that the future success of carbon markets does not necessarily rely on a global scheme since no other commodity has one (although no other commodities scheme has the same aims as carbon trading). It may be that establishing a global system could be overly complex and thus counter productive. Many regions are setting up their own trading schemes and it might be better to allow subsidiarity whilst allowing cross scheme fungibility.

11.  Regardless of whether the future of carbon markets is in a global trading system or greater compatibility between regional systems, London (and therefore the UK) cannot afford to be complacent and cede any of its commanding lead in this field. It must capitalise on its experience in the market so far to develop new products, protect the integrity of existing markets and influence the development of new markets with the long term aim of encouraging growth in carbon trading.

What actions should the UK and the EU be taking to promote the development of compatible ETSs internationally?

12.  The free flow of information and expertise with countries developing domestic trading schemes, particularly China, should be encouraged in order to ensure that these nations benefit from the knowledge gained in introducing the EU ETS. In this regard, it may be appropriate for the EU and UK to enter into formal negotiations with China and other nations considering domestic or regional trading schemes, outside of the UN framework, in order to avoid the creation of non-tariff trade barrier and to agree international standards for VERS.

Could sectoral agreements form part of the future of the EU ETS?

13.  Sectoral agreements on aviation and shipping are already well developed. The UK Government has already gone further than other nations with the development of the Carbon Reduction Commitment. The scheme was originally envisaged as a trading scheme, which would have allowed the recycling of credits and the focusing of revenues on carbon reduction. To this end there was some dismay over the decision to remodel the scheme as a tax rather than on trading. In the future there may be merit in moving back toward the original trading scheme.

Will the EU ETS be able to access viable alternatives to international credits without the Clean Development Mechanism?

14.  Yes, if moves are made to create a formalised system for VER trading as discussed at para 9 above.

Is the EU ETS a constraint on unilateral action to reduce emissions and, on the other hand, how are Member States' own policies affecting the operation of the trading system?

15.  Individual Member States remain free to create the policy frameworks which enable their domestic industries to maximise competitive advantage within the EU ETS. The mechanism by which member states can do this is in three parts:

—  Legislation—the development of policy instruments to discourage negative behaviour.

—  Regulation—the management of markets to encourage positive outcomes (for example the development of industry standards and the development of transparent, long-term and clear policy frameworks).

—  Education—demonstrating market opportunities to industry and ensuring a strong skills base from which growth in the low carbon sector can grow.

How serious an impact have the recent cases of fraud had on confidence in the EU ETS? Are further improvements in security and auditing required?

16.  The large scale theft of allowances in January 2011 has given rise to a number of problems one of which is resolving issues of ownership of the allowances issued under the EU ETS. This is of concern because different national legislation across Member States means organisations which hold or trade the stolen allowances may be subject to prosecution. For example in the UK companies may fall foul of the Proceeds of Crime Act. As a result, given the hazards in this market, a number of large players are now withdrawing from trading and closing their desks. There may be further implications for futures and options trading unless this issue is resolved quickly.

17.  Practitioners are surprised at the decision by the Council to obscure the registration numbers of permits. It is not understood how this will aid security as it prevents the market from identifying the provenance of the allowances.

18.  In the short term the issue of liability needs to be resolved. Attempts to increase security in the registries are only temporary solutions. Some have argued for a system of licencing operators is needed although it would need to be sufficiently workable so as not to preclude project operators or day traders.

How can the EU ETS be strengthened to operate effectively in a world without legally binding emissions reduction obligations?

19.  As set out in paragraphs 7-11, it is essential that fungibility between regional schemes is enabled. To this end the issue of a replacement mechanism for CDM is one of pressing concern. The development of a formal mechanism for the trading of VERs is one possible solution to this issue, however it will require international agreement if it is to work.

August 2011

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Prepared 26 January 2012