EU Emissions Trading System

Memorandum submitted by the Department of Energy and Climate Change (DECC) (ETS 01)

1) The Government welcomes the Select Committee’s inquiry into the EU Emissions Trading System (EU ETS) which is timely. The Government has recently published to ETS installations for scrutiny the draft National Implementation Measures setting out UK industry allocations of emissions allowances for phase III. The Government has also begun reviewing the UK Greenhouse Gas regulations, which implement the System and the amendments made to these since 2005 to examine the scope for deregulation and simplification in the UK application of the EU ETS rules.

2) The EU ETS is a central component of the UK Government’s policy for delivering emissions reductions in line with our EU targets and in line with the UK targets established in the Climate Change Act. The ETS will deliver over 50% of the UK’s CO2 emissions reductions between now and 2020. It is an important part of ensuring the correct incentives are in place for low carbon investment, and for ensuring that emissions are reduced across the EU, not just in the UK.

3) The system has been in place since 2005, and is currently in its second phase which runs between 2008 and 2012. It was the very first system of its kind anywhere in the world and has provided an example for others of how to deliver emissions reductions at least cost. Over phase II we expect the ETS to deliver EU emission savings of around 580 MtCO 2 e relative to 2005 levels.

4) Given both the novelty and scope of the ETS, it is not surprising that there has been an element of learning by doing in the development of the system. Over this time, we have learnt a lot about how to optimise such a system to ensure it achieves its environmental impact while maintaining the competitiveness of UK and EU industry. In 2009 the EU amended the ETS Directive to provide new rules for the third phase of the ETS (2013-20). In particular phase III will see a centralised and tighter cap which declines over the phase; much greater volumes of auctioning with free allocation according to harmonised rules to mitigate against carbon leakage; more harmonised monitoring, reporting and verification; and a centralised registry system with greater levels of security to protect against criminal activity.

5) These changes will ensure greater emissions reductions (estimated as 3,100 MtCO2e (relative to 2005 levels) over the period 2013 to 2020), a more harmonised approach to the implementation and enforcement of the scheme, which will provide a more level playing field for installations across Europe, more efficient allocations which avoid creating windfall profits and sufficient protection for those sectors most vulnerable to carbon leakage. By addressing security in the registries we are helping to safeguard a market in emissions trading worth around £90bn [1] in 2010, which is predominantly based in the UK. [2] .

6) Phase III will also see the inclusion of additional sectors such as Aluminium and gases such as Nitrous Oxide. From the start of 2012 we will see the biggest expansion of the system since its inception, with the inclusion of the aviation sector. This will ensure that this important and fast growing sector will also have the right incentives to reduce emissions and inclusion is expected to deliver up to 2020 approximately 94 MtCO 2 e emission savings relative to 2005 levels and 560 MtCO 2 e reductions relative to Business as Usual levels [3] .

7) Phase III will put the ETS on a stronger path towards emissions reduction, but looking ahead, the key challenge for the system is to make sure that it continues to provide a strong enough incentive for the investment we need to deliver a low carbon economy. The coalition Government is committed to moving to a tighter emissions reduction target at an EU level and to a tighter cap in the EU ETS as part of delivering this.

8) This memorandum will address each questions raised by the Committee in turn.

Q1: Does the EU ETS remain a viable instrument for climate change mitigation in the EU?

9) Yes. The Government continues to see the EU ETS as a central component for delivering emissions reductions within the UK and across the European Union. It is a key part of ensuring we comply with the legally binding system of five-year carbon budgets to reduce emissions by at least 35% in 2020 below 1990 levels and by 80% in 2050 as set out in the Climate Change Act. The EU ETS is also central to meeting the 20% EU emissions reduction target by 2020.

10) The EU ETS operates by setting an overall cap on emissions that cannot be exceeded without incurring severe penalties. It allows organisations to reduce emissions where the cost of the reduction is lowest by trading in emissions allowances. Each company has a choice to invest in abatement technology or purchase allowances from those who have made such investments, thus funding the lowest cost abatement in the System.

11) While there has been room for improvement within the system, evidence suggests that this approach works:

· There has been a high level of compliance by companies within the scheme across Europe.

· The cap for phase II was set at a level which would deliver 6% reductions across the EU on 2005 emissions, equivalent to 580 MtCO 2 e

· The scheme has led to greater investment in abatement technology; 59% of EU ETS installations surveyed by Point Carbon responded that the EU ETS already caused them to reduce emissions. An additional 9% stated the EU ETS has caused reductions to be planned [4] .

· In the same survey, half of respondents agreed with the statement that "the EU ETS is the most cost efficient way to reduce emissions in the EU".

· The EU ETS has established itself as a credible and liquid emissions trading market worth $120 billion in EU emissions allowance (EUA) trades in 2010 with a further $19.8bn of trading in CDM (mostly for EU ETS compliance) [5] . High levels of trading ensure liquidity in the market and the achievement of the cap at a minimum cost.

· Although the recession has reduced BAU emissions to a level broadly in line with the cap, we are still seeing a significant carbon price as the market can see stringency of the future cap. This carbon price has incentivised abatement – with Bloomberg New Energy Finance estimating c. 260 MtCO 2 e of abatement from 2008-10 driven by the carbon price.

12) To build on this and to address those areas of the ETS where improvement could be made, we are taking steps to improve further the performance of the System. In March 2007, the EU set an overall target for 2020 of a 20% reduction in emissions on 1990 levels. In 2009, within this context, the EU ETS Directive was significantly revised to make a much greater contribution to tackling climate change.

13) The changes, which will take effect from 2013, include:

· A more ambitious EU-wide cap on emissions, set top down with harmonised rules. From 2013 the cap will reduce by 1.74% per year towards an overall target of 21% reduction in emissions from ETS installations on 2005 levels by 2020. This annual reduction continues beyond 2020;

· Auctioning as the preferred means of allocation, with 100% auctioning to the power sector. This will ensure that the cost of carbon is better integrated into business decisions and will reduce windfall profits as a result of pass-through of the carbon price to consumers.

· Free allocation of allowances (based on benchmarks) to ensure adequate protection for those sectors at significant risk of carbon leakage while maintaining incentives to reduce emissions;

· Additional access to project credits from outside the EU, but in a lower proportion than in phase II to ensure actual behaviour change in the EU while maintaining international linkages.

· An improved single ETS registry with greater security to ensure the ETS is more secure against criminal activity, protecting the integrity of the valuable global market in emissions trading ;

· The development of stronger Monitoring, Reporting and Verification (MRV) regulations, applied to the same standard across the EU ETS;

14) And recognising the benefits of cap and trade, from January 2012 the aviation sector will also be included in the EU ETS. Emissions from all flights into and out of EU airports will be capped under the EU ETS. Net CO2 emissions from aviation in the EU will be under a legally-binding cap of 97% of average 2004-06 levels, with the cap tightening to 95% of average 2004-06 levels from 2013 onwards. Any emissions above these levels will only be possible by purchasing allowances from the market (i.e. allowances resulting from equal reductions in other sectors in the EU ETS). The result is that any expansion of UK and EU aviation would lead to no net increase in CO 2 emissions.

15) These changes will result in many more emission reductions, more predictable market conditions and improved certainty for industry. Reductions in the cap should lead to EU emissions savings (compared to 2005 emissions) during Phase III of around 3,100 MtCO 2 e.

16) Looking ahead, it is clear that the ability of the ETS to continue providing a strong signal for innovation will be related to the stringency of the cap. A tighter cap, in the context of a move in the EU to a 30% emissions reduction target by 2020, would be consistent with the EU’s target of a long term transition to a low-carbon economy (80-95% emissions reductions by 2050) and improve the effectiveness of the EU ETS to drive investment.

Q2: Can the EU ETS operate effectively in a world without legally-binding emissions reduction commitments and other cap-and-trade schemes?

17) Yes. The EU ETS is currently working effectively, delivering emissions reductions and investment in abatement technology in the EU, although as noted above there is potential to improve the system. The ETS also provides a good demonstration of the workings and benefits of a trading system as a model to others in developing their climate change mitigation policies.

18) The EU ETS has a wide scope, covering around half of EU emissions, and covers sectors with substantial and varied emission reduction potential. This has led to the creation of a liquid market balancing demand and supply and leading to effective price discovery. Although linking to other cap-and-trade scheme could increase liquidity and improve cost-effectiveness (see Q4 for more detail), the EU ETS can continue to operate effectively even without the creation of other cap-and-trade schemes and without linking these schemes to the EU ETS. The UK’s vision though is that by 2020, we would be able to start linking with other compatible cap-and-trade schemes to create a network of linked ETSs.

19) We believe that the EU ETS provides a model for other countries to implement similar cap-and-trade schemes. Although progress in the creation of new cap-and-trade schemes has been slower than expected, there has still been some positive signs of progress, notably:

· In December 2010, California announced the creation of an ETS starting in January 2012. Following a legal challenge, commencement has since been delayed to January 2013 to allow for additional cost-benefit analysis to compare the benefits of cap-and-trade compared to other policy instruments.

· On 10 July 2011, Prime Minister Julia Gillard announced the Australian Climate Change Plan. A key feature of the plan is to implement a cap-and-trade scheme. From 1 July 2012, a carbon price of £15 (AU$23) will be adopted (higher than current EU ETS price ~£11-12), covering 60% of Australia’s emissions (electricity generation, stationary energy, some business transport, waste, industrial processes, and fugitive emissions) and rising by 2.5%/yr until 1 July 2015, at which point carbon price will turn into a cap and trade scheme. There is an explicit scope to link with other cap-and-trade schemes.

· In March 2011, the Government of China announced its 12th five-year plan, including provisions to pilot cap-and-trade schemes in key provinces.

20) In addition, DECC has been directly involved in the development of cap-and trade systems – for more detail, see Q5.

21) In the absence of an international deal however, it is important that provision is made for sectors at significant risk of carbon leakage. We need to retain a competitive industrial base as part of ensuring a balanced growth path for the UK. There would be no environmental benefit if industry simply relocates to avoid ambitious climate policies. The EU ETS has addressed this problem through the proportionate free allocation of allowances to sectors at significant risk of carbon leakage. We believe this is the right approach and avoids raising barriers to international trade.

22) We are also conscious that some industries may be particularly affected by the increase in electricity costs stemming from both the EU ETS and wider UK climate change policy measures. So before the end of the year we will be announcing a package of measures for those energy intensive businesses whose international competitiveness may be most affected by our energy and climate change policies.

Q3: What reduction in emissions will the EU ETS deliver in Phase III, within the EU and abroad?

23) We estimate cumulative (global) GHG reductions from the EU ETS over Phase III will be :

· 3,100 MtCO2e relative to 2005 levels

· 3,200 MtCO2e relative to forecast Business As Usual Emissions [6]

Further details of these methods of estimation are given in Annex A

24) Within this, the EU is likely to import around 750 MtCO2e of international offsets during Phase III of the EU ETS. Once these offsets have been taken into account this will mean that around 2,350 – 2,450 MtCO2e [7] of reductions are likely to be within the EU.

Q4: 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?

25) Yes, linking with other cap and trade increases efficiency gains. The Lazarowicz Report on ‘Global Carbon Trading: A framework for reducing emissions‘ (2009) suggests that global carbon trading, through linking of ETSs and use of international credits, could reduce emission reduction costs by up to 70%. This would allow reduction of global emissions by an additional 40-50% at the same costs and provide substantial financial flows to developing countries.

26) By linking different systems, a broader range of emission reduction potential will be covered, which will promote cost effective abatement. A network of linked ETSs would also achieve greater liquidity in the market and help avoid competitive distortions.

27) However, to avoid diluting the ambition of the EU ETS, we would need to ensure that any system that would link to the EU ETS had a comparable level of ambition and rules. Analysis based on the Lazarowicz Report suggests that four design features need to be coordinated to link cap-and-trade schemes:

i) Monitoring, reporting and verification rules as well as compliance and enforcement mechanisms should be robust and trusted by ETS authorities, so that they could confidently link in the future.

ii) The rules to use international credits (offsets) should be aligned in order to avoid undermining the cap.

iii) Banking and borrowing rules should be aligned.

iv) Price interventions (e.g. price floors and ceilings) can also impact linking.

28) The UK has a vision of a network of linked trading schemes among, first, developed countries and, later, more advanced developing countries. Norway, Iceland and Liechtenstein have already been integrated within the EU ETS, having adopted the ETS Directive. The EU is now in discussions over linking with Switzerland.

29) Currently, the EU ETS is linked to the global carbon market through international credits including the Clean Development Mechanism (CDM), which helps provide valuable financial flows to developing countries ($26.5bn of carbon finance since 2005 [8] ) while also resulting in emission reductions at lower cost than those within the EU.

30) We are also advocating for the improvement and expansion of global carbon markets through:

· Reform of the CDM to promote the widespread use of standardised baselines and improve institutional arrangements (e.g. rules-based approach in the approval process applied by the CDM Executive Board to decrease administrative burden). DECC is also working closely with DFID to improve access to CDM projects in Least Development Countries (LDC - as defined by the World Bank), as post-2012, only new CDM project credits taking place in LDCs will be allowed for compliance in the EU ETS.

· Creation of new large scale market mechanisms internationally (e.g. sectoral crediting and sectoral trading). These new mechanisms will encourage developing countries to pursue their own emissions reductions, hence contributing to the creation of a level-playing field for sectors exposed to international competition, and will provide a new supply of international credits for use in the EU ETS.

Q5: What actions should the UK and the EU be taking to promote the development of compatible ETSs internationally?

31) The UK will seek an agreement in the UNFCCC negotiations for an overarching framework of rules for future international credits and trading. The UK is actively advocating for the reform of the CDM and the creation of new market mechanisms (as mentioned in Q4).

32) Regarding the implementation of domestic ETSs in other countries, it is worth noting that ETSs are one policy tool among others, and that in some specific national contexts, they might not be a suitable mitigation policy. Although the UK remains committed to market-based instruments globally as a cost-effective tool that can help increase global ambition, market-based instruments are only a mean to an end. ETSs are not a silver bullet; they will have to be implemented in combination with other policy tools (e.g. policy tools that directly impact behavioural change and promote investments in new low carbon technologies).

33) Currently, the UK is working with other governments to create compatible trading systems that could be linked in the future:

· Last January 2011, Secretary of State Chris Huhne signed a UK-China low carbon memorandum of understanding that covers three provinces (Hubei, Guandong, Chongqing) and includes a cap-and-trade component. DECC is currently working closely with the Foreign Office to define and agree detailed areas of collaboration with the Government of China. This will help accelerate the development of cap-and-trade schemes in China.

· The UK, along with other EU Member States, has pledged a £7million ($11.4m) contribution to the World Bank Partnership for Market Readiness that aims at building capacity for market-based instruments including cap-and-trade in 10-15 middle income developing countries. This will allow the UK to share its experience on the EU ETS and other market-based instruments with other countries and accelerate the expansion of carbon markets and hence mitigation activities globally. To date, eight countries (China, Indonesia, Thailand, Chile, Mexico, Colombia, Costa Rica, Turkey) are planned to receive a preparation grant of $350,000.

· DECC, in collaboration with DFID and FCO, has been helping the Government of India to design and implement their new energy efficiency trading scheme (‘PAT’ scheme – Perform Achieve and Trade), which covers around 10-15% of Indian emissions. The scheme is very similar to UK Climate Change Agreements and is a positive step towards the creation of a domestic carbon market.

· DECC has also been working closely with the Republic of South Korea to help them draft their ETS Bill, which is now planned to start in 2015.

34) Finally, the EU set up the International Carbon Action Partnership (ICAP), this is made up of a number of countries and regions that have implemented or are actively pursuing implementation of carbon markets through mandatory cap and trade systems. The partnership provides a forum to share experiences and knowledge. Through this knowledge sharing it is intended that ICAP will make possible future linking of trading programmes. The UK is a member along with other Member States and the EC. Other trading programmes that take part include the Western Climate Initiative (WCI) and their members, the Regional Greenhouse Gas Initiative (RGGI), the New Zealand ETS and the Tokyo Metropolitan Government. Japan, South Korea and the Ukraine also have observer status.

Q6: Could sectoral agreements form part of the future of the EU ETS?

35) Yes. The EU ETS Directive includes a provision on the use of bilateral sectoral agreements to allow the use of credits from new large scale ‘sectoral’ mechanisms such as sectoral crediting and sectoral trading. This opens up the possibility of using sectoral agreements to generate credits for compliance in the EU ETS. This would be dependent on those agreements establishing comparable rules and accounting procedures in accord with the EU ETS.

36) In practice, a sectoral crediting mechanism only issues credits for emissions reductions that are beyond a baseline which is set at a level lower than business as usual emissions. This ensures that these countries are making their own contribution to the global emissions reduction effort and over-achievement against their pledges is incentivised by the possibility of earning sectoral credits. Such credits could potentially be used in the EU ETS for compliance. Such sectoral mechanisms could greatly reduce competitive distortions by incentivising an appropriate degree of "own-action" in the host country and contribute to creating a more level-playing field for internationally competitive industries

37) The UK’s position, which is in line with the EU position, is that such sectoral agreements should be developed under an international architecture agreed through UNFCCC negotiations. However, short of an international agreement, there is a possibility for the EU to start developing such agreements bilaterally in the future.

38) The UK is a strong advocate for the creation of new market mechanisms internationally. To promote progress on the ground and demonstrate feasibility, the UK has pledged a £7million contribution to the World Bank’s Partnership for Market Readiness to ensure that capacity is built on the ground with a view to a pilot sectoral market mechanism in the future. (see Q5 for more detail on this initiative).

Q7: Will the EU ETS be able to access viable alternatives to international credits without the Clean Development Mechanism?   

39) Although the UK is actively advocating for a successor to the Kyoto Protocol to be agreed internationally, there is indeed a risk that we end up without a successor to Kyoto. In this event, the UK (and EU)’s view is that the CDM could continue – there are no legal barriers for this to happen. However, the challenge will be to secure political agreement from other countries.

40) Up to 2012, an estimated 1,100 MtCO2e of international credits are likely to be issued [9] , of which 900 MtCO2e are estimated to be surrendered into Phase II of the EU ETS. The EU ETS directive allows for around 1,650 MtCO2e of project credits to be used over Phases II and III combined. Thus after accounting for Phase II use, there be a demand for credits from the EU ETS over Phase III of around 750 MtCO2e. As a result, if the CDM stops existing post-2012, there is likely to be remaining demand for alternative types of credits post-2012. In the current context, we do not have such alternative sources of international credits, although the UK is strongly advocating for the creation of new sources of supply (see Q7 for UK activities to promote creation of sectoral mechanisms).

Q8: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?

41) The ETS is an important part of the Government’s policy framework for tackling climate change, ensuring emissions reductions across a range of industrial sectors and within the power sector, and delivers reductions across the EU. By its design, the ETS delivers these reductions at least cost and therefore where it is most efficient for them to take place. As a market based mechanism the ETS readily accommodates complimentary and additional policies as the market readily prices in any such policies by Member States,

42) While the EU ETS provides a clear carbon price, there are other market failures which justify government intervention to help reduce emissions. The current ETS alone is also insufficient to deliver the scale of emissions reductions needed to ensure the UK is in line with our 2020 and 2050 trajectories. In the UK we see the need for additional policy measures to complement the impacts of the EU ETS and to strengthen the signals within the UK, particularly to investors in low carbon electricity generation. For instance, as part of the Electricity Market Reform White Paper, we set out our intentions for a carbon price floor (CPF) to provide a stronger carbon price signal to encourage investment in low-carbon electricity generation in the UK. The CPF will give a clear and credible early signal to investors on the trajectory of carbon prices, avoiding lock in of high-carbon technologies, which could prove expensive as the ETS cap gets tighter. We are also pursuing ambitious policies to drive emissions reductions in the non-traded sector, such as the Green Deal, which will encourage significant energy efficiency savings within the domestic sector.

43) The UK is not alone in pursuing wider decarbonisation policies beyond the EU ETS, with most major EU countries pursuing additional policies targeted beyond the ETS.

44) Given the efficiency of reductions under the EU ETS, we do of course consider the impact of any complementary policies on the incentives created by the ETS, and would not want to pursue a policy which actively undermined the effects of the ETS. Looking ahead we will be carefully considering the impact of the proposed Energy Efficiency Directive on the EU ETS. In many cases this directive has the potential to drive energy efficiency savings outside of the traded sector. Where there is overlap with the EU ETS, we will need to look carefully at the level of the ETS cap to ensure that the incentives of the ETS are preserved. Improved energy efficiency across the economy whether driven by the EU and/or Member State action will make achievement of an EU 30% reduction target easier and less costly. The cheapest energy is that which is not used.

Q9: 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?

45) The EU ETS is supported by a system of electronic registries to issue, transfer, hold and cancel EU emissions allowances    (EUAs). Currently each MS has a registry; all companies that participate in the ETS and all companies or persons wishing to trade EUAs and Kyoto Units (units assigned under the Kyoto Protocol) within the EU ETS must have an account in a registry which holds those EUAs and Kyoto Units. From 1st January 2012, the member state Registries functioning in relation to EUAs and will be moved to a single Union Registry, hosted by the European Commission, which will hold all EUAs and Kyoto Units.

46) The registry system has been subject to fraud to date. In September 2008 the carbon market fell victim to VAT carousel fraud in a similar way to other markets previously. The UK acted swiftly to address this, first zero rating carbon, before introducing a reverse charge mechanism, which means it is no longer possible to conduct carousel fraud in the UK carbon market. Many other member states have since taken similar steps and the UK has supported the European Commission in pressing those member states still to implement this mechanism to do so.

47) During 2010 and 2011 there were a number of cyber attacks on several Registries in various EU Member States (not including the UK). These attacks resulted in the alleged theft of approximately 4.3m carbon allowances which were transferred out of operators’ accounts into different accounts.

48) Fears about registry security and the subsequent uncertainty around ownership of allegedly stolen allowances had an impact on trading in the carbon market. Most notably, trading in spot allowances (i.e. for immediate delivery), which accounts for around 10% of the market, almost ceased. There was less practical impact on the futures market, the majority of which is based in London. However, market participants were naturally keen to see increased security across the registry system and clarity on transfer of title given the differing legal regimes across the EU.

49) Since the attacks, work has been underway to improve the security of the system, in which the UK has played a leading role. This included proposals to amend the existing Registries Regulations, and introduce yet tougher regulations for phase III of the ETS.

50) The EU’s Climate Change Committee voted in June to adopt a regulation to enhance security of the EU ETS registries and therefore to promote confidence within the carbon market. UK lobbying ensured a much improved final regulation, with a better balance between security, certainty for market participants and the efficiency of the market.

51) Provisions in the new regulations, which we believe will strengthen security and confidence in the market include:

· Improved clarity on issues of title in the registry system, which should give purchasers of EU emission allowances greater confidence;

· Greater powers for registry administrators to freeze accounts or allowances e.g. where they suspect money laundering;

· Provisions to impose a 24 hour delay to transactions, with exemptions possible in certain situations, to provide time for fraud to be detected;

· A range of provisions which will improve security, including ‘two factor authentication’; double validation of all transactions; and better ‘know your customer checks’.

52) The regulations will come into force in three stages between now and June 2012.

53) Later this year, we are also expecting Commission proposals on regulation and oversight of the carbon market. These will build on the security provisions already established in the registries regulation, as well as looking more widely at lessons which can be learnt from other markets e.g. to mitigate the risks of market abuse, protect customers and improve transparency. The UK Government supports this further work on the risks facing the market and options for addressing them in a proportionate way, balancing the integrity of the market with openness and efficiency.

Q10:How can the EU ETS be strengthened to operate effectively in a world without legally binding emissions reduction obligations?

54) As discussed in the responses to questions 1 and 2, the EU ETS is already operating well in a world without legally binding emissions reductions. Given the element of learning by doing within the development of the system, there has been room for improvement and measures are being taken as part of the move to Phase III of the ETS to strengthen the ETS further. These revisions include a more ambitious cap, auctioning being used as the preferred means of allocation, free allocation according to benchmarks for sectors at risk of carbon leakage, reduced access to project credits, greater registry security, stronger MRV standards and also from 2012 the inclusion of aviation (as mentioned in response to question 1).

55) These changes will ensure that the EU ETS can deliver a greater level of environmental ambition. However, they also mean that: a) we can ensure a more level playing field for UK installations, by ensuring a more even implementation of the EU ETS across member states; and b) we will maintain the competitiveness of EU industry alongside this increase in environmental ambition, which is critical in the absence of an international agreement.

56) Over the longer term, the Government is committed to pushing for a greater degree of auctioning in the EU with a view to further improving the way in which allowances are allocated.

57) The Government is committed to pushing the EU to move to a 30% emissions reduction target in the EU (in 2020 relative to 1990 emissions), with a commitment to a tightening of the EU ETS cap to deliver this. We believe that this will put the EU and the UK on the right pathway to meet our longer term climate change goals, such as those legislated in the UK’s Climate Change Act and the EU’s commitment to limit climate change to 2°C and reduce EU emissions by at least 80% by 2050. A tighter EU ETS cap will increase the incentives to invest in low-carbon technologies. Given the provisions that exist within the Directive to manage the risk of carbon leakage, we believe that such a move is in our own economic interest even in the absence of an international agreement.

August 2011
Annex A

We have estimated the savings associated with the EU ETS in 2 ways

Method 1

We have looked at the cap level (and thus net EU emissions) relative to 2005 levels.

This is best shown by diagram 1.

Diagram 1


This approach is relatively easy to estimate. While using 2005 levels may seem a somewhat arbitrary point to estimate emission reductions, such an (historical) point is justifiable in that it is not effected by when the assessment is made (see below issues with method 2) and is in line with much of the legislative structures of the EU ETS, which regularly use 2005 as a baseline.

Method 2

Another way of estimating the savings of the EU ETS is to compare the ‘business as usual’ (BAU) emissions with those of the cap.

Such a method compares the cap level with the estimated emissions under a zero carbon price. This is illustrated by Diagram 2. [10]

There are however issues with this approach to estimation. These include;

- The order in which policies are considered will affect the savings associated with them. For instance, if one considers the renewable energy target before the EU ETS (as has been done for this analysis), then the savings of the EU ETS are substantially less. Alternatively if the EU ETS is considered first, no emission savings would be attributed to the renewable energy target.

- BAU will significantly change over time as fundamental drivers change; so the estimated BAU (and therefore emission savings) are significantly lower today than they were when the EU ETS cap was set, as a result of the recession significantly lowering the estimated level of emissions. Similarly changes in fossil fuel prices will cause BAU emissions to change. This approach to estimation, with emission savings falling and rising in line with changes in external drivers ignores the fact that the main purpose of the EU ETS is to limit emissions to a pre-determined level.

Diagram 2

[1] $142bn (£87bn) - World Bank (2011) State and Trends of the carbon market, available at:

[2] (since 2009, the London-based European Climate Exchange has traded over 96% of futures and options EU ETS allowances contracts).

[3] [1] Forecast of aviation emissions (without a carbon price) from Bloomberg New Energy Finance, using their Global Energy and Emissions Model. All assumptions are from Bloomberg and may not be consistent with wider assumptions used for analysis across DECC. Note that this figure is an update to the estimated savings published in the Impact Assessment of “Second Stage Transposition of EU Legislation to include Aviation in the European Union Emissions Trading System”, which estimated savings relative to BAU levels of 480 MtCO 2 e . .

[4] Point Carbon (2011), Carbon 2011

[5] World Bank (see previous reference)


[6] Forecast of emissions (without a carbon price) from Bloomberg New Energy Finance.

[7] Depending on whether you use a baseline of 2005 emissions or business as usual emissions

[8] World Bank (2011) State and Trends of the carbon market

[9] UNEP Risoe CDM/JI Pipeline Analysis and Database, August 1st 2011

[10] Forecast of emissions (without a carbon price) from Bloomberg New Energy Finance.

Prepared 21st September 2011