The EU Emissions Trading System - Energy and Climate Change Contents

Memorandum submitted by Friends of the Earth (EWNI) (ETS 23)

1.  Friends of the Earth EWNI welcomes the Energy and Climate Change Committee's current enquiry and is grateful for the opportunity to comment on a number of the issues that it has chosen to examine.


2.  The UK government should not support the continuation of the EU ETS and immediately shift its resources and attention to the better alternatives already being pursued. The EU ETS has not and will not deliver the genuine emissions reductions necessary to meet the UK's obligations in averting catastrophic climate change. The first two phases have failed to cut emissions, while Phase III looks set to start with a surplus of permits so large that it would require no domestic reductions until 2018.

3.  The EU ETS has handed over huge sums of taxpayers' money to the power sector and industrial polluters at a time of great austerity, with little obvious benefit: subsidies could amount to almost £100 billion by the end of phase II. This is the combined effect of "passing through" to consumers the costs of permits received for free, plus the resale value of surplus permits. A windfall tax should be considered to re-capture these surpluses, with the income spent on domestic energy efficiency work.

4.  While the UK government should not support the continuation of the EU ETS, the very least it can do is address extensive loopholes throughout the scheme. These include measures to exclude all international offsets, putting a stop to the practice of freely allocating permits to polluters, imposing a much tighter cap, and preventing the use of banked permits from earlier phases of the ETS scheme. Measures to expand the ETS by linking with schemes outside of the EU, or promoting "new market mechanisms" (such as sectoral crediting or trading) with developing countries should be stopped. These recommendations do not obviate the need to reconsider support for the ETS altogether.

5.  A stop should be put to the dangerous obsession with the ETS. Instead, much greater priority should be given to other policy options, including but not limited to regulations such as energy efficiency standards, renewable energy incentives such as feed-in tariffs, and financial incentives for cleaner investment such as a financial transaction tax or redirected EU structural funds.

6.  Friends of the Earth has published a number of reports analysing carbon trading, which include:

A Dangerous Obsession: The evidence against carbon trading and for real solutions to avoid a climate crunch,

Clearing the Air: Moving on from Carbon Trading to Real Solutions

The EU Emissions Trading System: failing to deliver

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

7.  The EU ETS has failed to significantly reduce carbon emissions across Europe. The first "pilot" phase (2005-07) saw too many permits handed out, with an overall surplus of 267 Mt CO2e (Megatonnes Carbon Dioxide Equivalent), more than the annual emissions of the UK.1 The permit price collapsed when markets saw that the scheme was over-allocated.

8.  Phase II of the ETS, from 2008 to 2012, is also misfiring badly. The Commission has claimed some successes—for example, emissions from installations covered by the scheme fell by 11.6% in 2009. However, this needs to be set against falls in production of electricity and industrial goods of 13.85% in 2009 as a result of the recession.2 This comparison indicates that emissions reductions were the result of less production (in the context of an economic downturn) rather than the ETS itself.

9.  The combined effect of the economic downturn and generous provisions for the purchase of international offsets is an oversupply of permits. All credible predictions for phase II expect there to be a significant surplus by 2012. Permit prices have not collapsed to zero (as in Phase I), but this is only because it is possible to "bank" them for use in Phase III (2013-20). However, this same possibility undermines environmental integrity. More than three-quarters of installations have surplus permits, which means they can delay taking action to reduce their greenhouse gas emissions at source.3 These surplus permits should be cancelled.

10.  By the end of Phase II, the EU ETS could well have awarded polluters close to £100 billion in subsidies. This includes an estimated €19 (£16.7) billion to power companies in Phase I, and up to €71 (£62.5) billion in Phase II; and up to €20 (£17.6) billion to heavy industry.4 These perverse incentives result from the "pass through" of costs to consumers, plus the estimated worth or freely allocated surplus permits.

11.  Phase III will still see further significant subsidies paid to industry. The free permits being enjoyed by three-quarters of manufacturing has resulted from lobbying by heavy industry, and could yield at least €7 (£6.2) billion in windfall revenues annually.5 In addition, the Commission is currently undertaking a review of "state aid" rules which could see the granting of direct financial subsidies for "indirect" losses—in effect, subsidising cost pass through. The University of Groningen Centre of Energy Law has pointed out that this "artificially reduces the operating costs of high carbon-content generation capacity lower in the merit order (from hydro and nuclear to coal, combined fuel and gas) leading to the building of more coal-fired power plant."6 Such a measure is counter-productive, in other words. The DECC submission to the Commission's state aid rule consultation also notes that the number of sectors exposed to carbon leakage risks is small.7 The UK should therefore seek to address at the earliest opportunity the over-generous allocation of free permits to heavy industry.

12.  In the process of passing the revised ETS Directive, energy companies successfully lobbied for an estimated €4.5 (£4) billion in subsidies for Carbon Capture and Storage (CCS), with a smaller amount for "clean" energy that includes biofuels.8 Such investments could be an impediment—CCS delays the transition to renewable energy; while biofuels cause significant environmental and social harm.9 These measures are counter-productive: auction revenues should not be used to subsidise fossil fuel infrastructure, CCS, or other impediments to a low carbon transition.

13.  The use of international offsets is a further, endemic problem. Carbon offsetting is, at best, a zero-sum exercise: it moves the obligation to reduce emissions away from the EU, and counts reductions from "emissions-savings" projects as equivalent to domestic reductions. In reality, between one-third and three-quarters of these projects do not represent reductions by any reckoning. The net effect of the scheme is therefore to increase emissions.

14.  To date, the CDM has mostly substituted a reduction to reduce CO2 emissions with spurious industrial gas offsets (from HFC and N2O). Even though these credits are banned from phase III, the "banking" of permits means that they can continue to be "cashed in" until 2012, displacing permits and so reducing obligations in the longer term. The emissions reductions claims of the other most numerous project types (including hydro-power and wind) are also highly questionable - the volatility of offset prices, combined with the mix of other incentives, makes it highly likely that such projects would have happened anyway (they are "non-additional" in the emissions trading jargon). Research by Friends of the Earth EWNI has further shown that offsetting does not ensure positive sustainable development and is profoundly unjust.10

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

15.  The ETS should exclude offset credits, and a broader reconsideration of policy should be undertaken. The scheme is increasingly isolated internationally. Proposed emissions trading schemes in the USA, Japan and Canada have stalled indefinitely; new markets in Australia and South Korea face significant delays; and a court action in California has also delayed the start of a planned scheme there. According to the latest World Bank figures, the EU ETS drives up to 97% of the global trade in carbon.11 The assumptions that the ETS would lead to the emergence of a global carbon trading system are not being borne out. This has led to a situation in which the availability of permits and credits already exceeds demand. New carbon market mechanisms (eg sectoral), the expansion of the CDM into new areas (eg agriculture) or longer-term moves towards offsets from REDD, would significantly worsen this situation (see below).

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

16.  If current policies remain unchanged, there are significant reasons to doubt that the EU ETS will deliver domestic emissions reductions in Phase III. Current estimates suggest that the second phase of the scheme could end with an overall surplus of 1,280 Mt CO2e, which could be carried over ("banked") for use from 2013 onwards.12 These figures are swelled by the use of offset credits. The phase II surpluses alone could allow the scheme to continue without any domestic emissions reductions until 2018.13

17.  Beyond these loopholes, the EU ETS is fundamentally incapable of meeting the necessary ambition to tackle the planetary emergency and keep temperatures below 2 degrees or the 1.5 degrees now being called for by over 100 developing countries and Christiana Figueres, Executive Secretary of the UNFCCC. The stated aim of the phase III cap is to achieve a 20% reduction in greenhouse gases across the 27-state bloc by 2020 compared to 1990 levels. This falls a long way short of what climate science suggests is needed to avoid dangerous climate change. By comparison, Friends of the Earth has shown that an immediate target to reduce greenhouse gas emissions within the UK and EU by 40% or more by 2020 without offsets and the use of carbon markets is both achievable and desirable.14, 15

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?

18.  In theory, the linking of emissions trading schemes underneath a global cap would make the scheme run more smoothly: reducing competition distortions, and doing away with the need for offsets. However, such as scheme would be unlikely to respect the requirement of "common but differentiated responsibility" within the international system; and it would still (if it worked as planned) incentivise short-term reductions over longer-term transformative changes.

19.  In practice, there is no credible possibility that a global cap-and-trade scheme will be introduced. Linking emissions trading schemes is far more likely to result in a patchwork of rules, and trigger a race to the bottom. At present, the EU ETS excludes credits from Land Use, Land Use Change and Forestry (LULUCF) and from hydro-power projects that do not comply with World Commission on Dams guidelines. It will also exclude HFC and N2O offset credits from April 2013. Such measures would be impossible to police if the scheme were linked with others that did not share these exemptions, since it would be impossible to tell if trading units entering the EU ETS had been freed up by their displacement (within a linked scheme) by others that the EU would not accept for compliance. Put simply, if the EU bans LULUCF credits, but an Australian scheme accepts them, Australian installations might buy LULUCF credits for compliance purposes and sell their own permits into the EU ETS scheme. This form of "arbitrage" is not so much an abuse of the system as a symptom of a flawed design.

20.  The claim that carbon markets are "economically efficient" also needs to be examined more critically - again, with an eye to looking how the practice has diverged from the theory. In theory, emissions trading incentivises companies to trade permits in a way that allows for the cheapest reductions to happen first. This is the basis of the claim that it is "efficient." In practice, cheap permits circulate because of structural surpluses awarded to heavy industry within the EU, and because offsets are allowed in the scheme. These are cheap because these are mostly paper "reductions" that do not require changes in industrial or power sector practice.

21.  Emissions trading has not incentivised significant technological changes. At best, it has had localised and temporary effects in incentivising power generation switches from coal to gas. But this should be set against some of the scheme's perverse incentives—most notably, the generous award of free certificates to hard lignite plants in Germany (through the "new entrants reserve") has contributed to a "dash for coal" in German power production.16 Such generosity is not an anomaly, but is the result of industry lobbying (and protectionism).

22.  Temporary power production switches from coal to gas can also be seen to illustrate the limitations of the EU ETS. They do nothing to encourage the transition to clean technology. Indeed, the "flexibility" of permit trading tends to trigger a "lock in" of outdated forms of power and industrial production, by offering a means to delay this transition. Such delays can end up costing more in the long-term, however.

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

23.  Rather than spending money and effort on trying to export the failed carbon trading model, the UK should spend those resources promoting measures that directly catalyse cleaner development. For example, the UK has pledged £7 million of its fast-start funding to the World Bank's Partnership for Market Readiness, which promotes cap-and-trade in middle income countries; as well as putting resources into ICAP (International Carbon Action Partnership).

24.  There are multiple actions that the UK and the EU could take to promote and support more effective action on climate change. These include market mechanisms, such as feed-in tariffs, which are estimated to be responsible for almost 90% of the growth that has occurred in Europe's wind energy sector since 1995.17

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

25.  Climate Change Agreements, which agree a significant discount from the Climate Change Levy in exchange for an agreed sectoral target, are hampered by significant information asymmetries between government and industry. They have so far proven ineffective, offering a financial transfer from taxpayer to business in exchange for what amounts to little more than "business as usual." This model would not address the problems of the EU ETS.

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

26.  The UK should be actively trying to exclude alternative international credits in lieu of the CDM. International offsets offer an escape hatch for the avoidance of emissions reductions commitments, and shift the burden of climate mitigation to developing countries—contributing to breaches of the global carbon budget.18 As we have shown above, the inclusion of international credits is a considerable "hole" in the scheme's cap, which should be closed.

27.  Closing the door to CDM credits would require a swift cut in their supply, if it is to be meaningful. This is in contrast to the implementation of the ban on HFC and adipic acid credits, which was delayed to April 2013 despite Commissioner Hedegaard's recognition that such projects exhibit a "total lack of environmental integrity."19 Delaying the closure of this loophole is likely to see the over-surrender of the banned credits in the short term, with surplus allowances banked.

28.  New market mechanisms, such as "sectoral crediting", do not offer a viable alternative to international crediting. In fact, EU efforts to pursue these new mechanisms in the context of a declining global trade in carbon are likely to further undermine the scheme by generating surplus credits that would collapse the carbon price.

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?

29.  The EU ETS does not constrain unilateral actions, but it does have the capacity to undermine them at a time when we should be aggressively pursuing effective alternatives. For example, the Integrated Pollution Prevention and Control (IPPC) Directive was modified to explicitly exclude CO2 emission limits for installations which are covered by the EU ETS, amid fears that efficiency requirements under the IPPC could damage carbon prices.20 Leaked documents (from 2007) suggested that the UK government sought to weaken energy efficiency measures and renewable energy targets on the grounds that these could collapse the carbon price. Such fears are not arbitrary—a recent European Commission Impact Assessment on the proposed inclusion of industrial sectors in EU energy efficiency regulations suggested a scenario in which the carbon price could collapse to zero.21

30.  Carbon floor prices have been suggested as a means to address this risk, and the UK has taken a lead in implementing such measures. However, as reports by both Credit Suisse and IPPR have pointed out, the most notable effect of the UK's policy is likely to be a rise in consumer energy prices, exacerbating fuel poverty, and windfall profits for existing energy generators of around £1 billion per year—while doing nothing to reduce emissions.22 Its environmental effectiveness may, arguably, be increased if a floor price were European-wide—but appending such a measure to the ETS would remain considerably more cumbersome (and less cost-effective) than other forms of taxation, such as financial transactions taxes or carbon taxes. However, this should not stop the UK introducing a windfall tax to capture the surpluses unduly gained by energy companies which, along with income from the carbon floor price, should be spent on domestic energy efficiency work.

31.  The underlying point is that the EU ETS contradicts more effective policies, and that making it the central climate change mitigation policy is counter-productive. Member States and the Commission should be encouraged to develop a suite of climate-related policies, including binding energy efficiency targets; and national climate laws to tackle industry or industry sector emissions.

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?

32.  The fraud cases have further damaged confidence, but the recent changes to registry rules have not addressed many of the risks associated with trading carbon. It is certainly the case that new registry rules include basic improvements (eg know-your-customer checks). But the new rules also include some steps in the wrong direction—for example, a provision for "non-disclosure of the serial number of allowances" (except for law enforcement agencies) reduces transparency in an already opaque system, and could actually make it more difficult for civil society groups and the media to draw attention to fraud cases.23

33.  Changes to registry rules do not fully address the problems faced when trading carbon, however. Regulations should consider environmental effectiveness criteria, such as those proposed in Senator Kerry's American Power Act (the latest version of the leading climate bill in the U.S. Senate).24 These include mandatory exchange trading and clearing of carbon, and also measures to orient trading so that it is mainly restricted to compliance traders, rather than speculators. At present, the majority of trades are for speculation, resulting in a carbon price that is highly volatile. This means that it sends a poor signal to investors seeking to make longer-term decisions on infrastructure investments. Position limits and capital and margin requirements on traders could also help to rein in some of this speculation.

34.  There is a limit to what such regulations might achieve, however. Currently, carbon traders are lobbying for exemptions from derivatives and commodity regulations being developed in the wake of the financial crisis.25 A key problem with regulating carbon markets is that there is no clarity on the underlying asset (eg it is not agreed whether carbon is a "financial instrument"). The relative complexity and size of this market in an intangible commodity leaves it susceptible to gaming or full-blown fraud. These problems are better addressed at the level of fundamental market structure, rather than simply through derivatives legislation or market abuse rules designed to contain their excesses. Simplifying the market structure by excluding offsets or credits from "new market mechanisms", and limiting the sectoral scope of the ETS, would be steps in the right direction. However, this does not obviate the need to reconsider support for carbon markets altogether.

August 2011

1  Ellerman, D et al 2010. Pricing Carbon: The European Union Emissions Trading Scheme Cambridge: Cambridge University Press, p 48.

2  Morris, D and B Worthington, 2010. Cap or Trap?How the EU ETS risks locking-in carbon emissions p 18.

3  European Commission DG Clima. 2011. Verified Emissions for 2008-2009-2010 and allocations 2008-2009-2010, 15 April

4  Ellerman et al, p 326; Point Carbon, WWF. 2008 EU ETS Phase II—The potential and scale of windfall profits in the power sector. The figure for industry combines an estimates of "pass through" costs (€14 billion) with an estimate for the value of surplus permits (€6.5 billion). See De Bruyn, S et al 2010. Does the energy intensive industry obtain windfall profits through the EU ETS? Delft: CE Delft; Morris and Worthington, p 26.

5  Ralf Martin, Mirabelle Muûls and Ulrich J. Wagner. 2010. "Still time to reclaim the European Union Emissions Trading System for the European tax payer", Policy Brief, Centre for Economic Performance, London School of Economics.

6  State Aid Group of the Groningen Centre of Energy Law. 2011. "Comments on the Commission's Consultation paper dealing with: 'New State aid Guidelines in the context of the amended EU Emissions Trading Scheme'".

7  UK Government. 2011."UK response to The European Commission consultation on New State aid Guidelines in the context of the amended EU Emissions Trading Scheme",

8  This figure corresponds to the auction revenues from 300 million permits in the New Entrants' Reserve, and assumes a €15 carbon price.

9  Bowyer, D 2011. Anticipated Indirect Land Use Change Associated with Expanded Use of Biofuels and Bioliquids in the EU—An Analysis of the National Renewable Energy Action Plans. London: Institute for European Environmental Policy.

10  Friends of the Earth EWNI, 2009. A Dangerous Distraction: Why offsetting is failing the climate and people.

11  World Bank 2011. State and Trends of the Carbon Market 2011 Washington: World Bank Group, p 9.

12  World Bank 2011, p 63.

13  Morris, D 2011. Buckle Up! Tighten the cap and avoid the carbon crash London: Sandbag, p 16.

14  Friends of the Earth Europe and the Stockholm Environment Institute. 2009. The 40% Study: Mobilising Europe to achieve Climate Justice. Brussels: FOEE.

15  Friends of the Earth. 2009. Cutting Carbon Locally—and how to pay for it. London: Friends of the Earth.

16  Pahle M et al 2011. "How emission certificate allocations distort fossil investments: The German example." Energy Policy, doi:10.1016/j.enpol.2011.01.027, p 12.

17  AtKisson, A. 2009. Global Green New Deal for Climate, Energy, and Development, UN-DESA, p 11.

18  Friends of the Earth EWNI, 2010. Reckless gamblers: How politicians' inaction is ramping up the risk of dangerous climate change.

19  Carrington, D 2010. "EU plans to clamp down on carbon trading scam" The Guardian, 26 October.

20  Gilbertson, T and Reyes, O 2009. Carbon Trading: how it works and why it fails Uppsala: Dag Hammarskjöld Foundation, p 21.

21  European Commission DG Energy. 2011. "Impact Assessment Accompanying the document Directive of the European Parliament and of the Council on energy efficiency" SEC(2011) 779 final, 22 June, p 30.

22  Maxwell, D 2011. Hot Air: The carbon price floor in the UK London: IPPR; McCabe, J 2011. "£7bn windfall for UK utilities from carbon price floor" Environmental Finance, 28 June.

23  European Commission DG Clima. 2011. Questions & Answers on Emissions Trading: new registry rules, 8 July.

24  Friends of the Earth USA, 2010. Comments to Commodity Futures Trading Commission on Oversight of existing and prospective carbon markets, 17 December.

25  IETA, 2011. Response to MiFID Consultation, 2 February.

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Prepared 26 January 2012