Leaving the EU: negotiation priorities for energy and climate change policy Contents

5EU Emissions Trading System

Introduction

53.The EU Emissions Trading System (EU ETS) was established by the EU to meet its international obligations under the Kyoto Protocol.98 The system sets an EU-wide cap on total greenhouse gas emissions from energy intensive sectors, including power stations and industrial plants. Over time the cap is lowered so that total emissions fall. Companies receive or buy emission allowances which they can trade with one another as needed, and they are fined if they do not buy adequate allowances to cover their emissions.99 A robust carbon price within the system is an important driver for investment in climate change mitigation technologies.100 The EU ETS is currently in its third phase, which is running from 2013 to 2020. Negotiations are also underway for Phase IV, which will run from 2021 to 2030, with plans for better targeted and more dynamic allocation of free allowances, and two new Funding Programmes.101

54.Around one third of witnesses in our inquiry suggested that the UK should remain in the EU Emissions Trading System.102 One said that the UK should leave,103 and several were undecided, noting the need for reform,104 or did not comment. A few witnesses argued that the UK should not leave the EU ETS until at least its third phase is completed in 2020, as this would cause unnecessary disruption.105 These included witnesses that were both for and against remaining in the EU ETS longer term. The Minister of State for Climate Change and Industry, Nick Hurd MP, was unable to clarify the Government’s intention on the UK’s continued engagement with the EU ETS.106

Performance of the EU Emissions Trading System

55.Emissions trading is widely seen as a cost-effective means of decarbonisation, at least in theory.107 The Committee on Climate Change describe the EU ETS as having the potential to be a least-cost approach without creating competitiveness challenges for the industry.108 The merits of the EU ETS were also recognised by Minister of State for Climate Change and Industry who told us that:

The cap and trade system is an intelligent system, because a cap gives you certainty on emissions and the trade mechanism allows participants to pursue emission reductions at the lowest possible cost. It works. The mechanics of it work pretty well as a system.109

56.A number of witnesses highlighted the role of the EU ETS, and the associated carbon price floor (discussed in Box 1), in driving climate ambitions and the transition to a low carbon economy.110 In the UK, the EU ETS is central to the delivery of our carbon budgets (see Box 2 for discussion). Witnesses noted that, despite criticisms, the EU ETS had delivered its 2020 targets. They also highlighted the strategic importance of the EU ETS for climate change action. The EU ETS is important globally as the first working demonstration of an emissions trading system. If it fails, this will have ramifications for the uptake of similar schemes elsewhere. Departure from the EU ETS, and therefore an implicit decision not to help other Member States to reform the System, would undermine the UK’s reputation as a global leader on climate change. Professor Michael Pollitt from the University of Cambridge told us:

If we are serious about being a global leader on climate and if Europe is similarly serious, we cannot be seen to leave the European Emissions Trading System of our own choice, and we should do everything to stay a member of it… if we have a hard exit from that, it could seriously undermine global efforts on climate and certainly will undermine our role in global leadership on climate solutions.111

57.However, the EU ETS has been subject to substantial criticism. It is not seen to be on course to deliver the EU’s long term targets, and more generally it is not seen to be providing a carbon price that can drive the changes required to move to a low carbon economy.112 The Royal Society for the Protection of Birds explained in its written submission that the scheme has struggled for a number of reasons, including the over-allocation of allowances and the financial crash of 2008, which drove down the carbon price due to reduced activity and emissions in the energy and industrial sector.113 Aldersgate Group told the Committee that the surplus of allowances is approximately 1.78 billion, and the price of carbon at the time of writing relatively weak, at €4.66 per tonne at the date of their submission.114

The case for reform

58.Short and long term reforms have already been made to the EU ETS to address the over-supply of allowances. For example the European Commission postponed the auctioning of 900 million allowances during Phase III, through so-called ‘back-loading’. In the longer term, a market stability reserve, to allow an adjustment to the supply of allowances, will be introduced in 2019.115 Further proposals have been put forward by the European Commission for negotiation for Phase IV, which will run between 2021 and 2030.116

59.Over a quarter of our witnesses argued that the EU ETS is in need of reform, and several witnesses noted that it will be important for the UK to retain influence during negotiations for Phase IV to drive more ambitious reforms.117 Some witnesses specified that reform and ongoing influence should be conditions of continued UK participation.118 The Minister of State for Climate Change and Industry acknowledged the issues with the system and the need for reform, explaining that:

There is a structural flaw with it [the EU ETS], which you will fully appreciate, which has not delivered a sufficiently robust price signal, and that is the focus of the reform negotiations at the moment.119

60. The Secretary of State also told the Committee that:

reform of the emissions trading scheme matters a lot to this country, and whether we are in or out, we are very active in being at the table to play a positive, constructive role in the negotiation of the reform of phase IV, which runs from 2021 [ … ] and our European partners, irrespective, are actively seeking our input.120

The EU Emissions Trading System and the Carbon Price Floor

61.Energy intensive industries were concerned about the detrimental impact of the UK Carbon Price Floor (CPF)—which the Government introduced to deliver a stable price given the weak EU ETS (see Box 1 below). It was argued that the CPF causes competitive distortions for UK manufacturing and fossil fuel power plants.121 Kevin Dibble, Director of Strategy and Communications at Engie UK, explained to the Committee that the price floor was the main driver for the wholesale power price differential with the continent.122 The Committee was also told by Andrew McDermott, Technical Director at the British Ceramic Confederation, that

It is a unilateral UK-only measure, which increases industrial electricity prices by about 10% and makes us less competitive versus our EU competitors, let alone our international competitors.123

62.Sara Vaughan, Director of Strategy and Corporate Affairs at E.ON, argued that the UK should remain in the EU ETS and focus on fixing the roots of its problems to drive a stable carbon price, rather than applying a domestic Carbon Price Floor as a temporary solution:

We would be in favour of continuing… with a European-wide scheme… we would like to see broader trading schemes, rather than narrower trading schemes. I will make one point: from a UK perspective, as a company that operates in the UK and as an investor, we want to see continuing clear signals around decarbonisation. I would question whether the CPF is the right way of doing that.124

63.Despite these concerns, several witnesses noted that the CPF has played a key role in the delivery of UK emissions reductions. Centrica noted that the doubling of the CPF in April 2015 played a key part in a coal-to-gas switch in power generation, which it highlighted as one of the cheapest ways of delivering UK carbon abatement.125 National Grid also noted the success of the Carbon Price Floor in driving emission reductions, and the importance of sustaining it in providing investor confidence.126

64.The difference of views and interests on the CPF across industry was acknowledged by the Minister of State for Climate Change and Industry, who told us that:

there has been consistent concern expressed by our energyintensive industries about the relative price of UK industrial electricity prices… there is another business voice that is saying what is important here is to continue on the high levels of ambition, to set a longterm trajectory and visibility, as far as possible, so that we can continue to invest in this transition to the low carbon economy.127

65.Emissions Trading Systems are in theory the most effective means of reducing emissions at lowest cost. The UK and EU benefit by being part of a wider system able to import and export carbon allowances to reduce emissions in a way that is most cost efficient. The EU ETS is also a good example of international collaboration and ambition to tackle climate change. In practice, the EU ETS is performing poorly, due to a low target and domestic policies causing oversupply of EU ETS permits. We share concerns that not enough is being done to protect UK industry from carbon leakage, in particular due to the unilateral UK Carbon Price Floor.

Box 1: UK Carbon Price Floor

The Government introduced a Carbon Price Floor (CPF) in April 2013 to mitigate fluctuations in the EU ETS market price of carbon, and to support greater certainty for investors in low carbon technologies. The EU ETS carbon price had fallen substantially from an all-time high of €29.20 in July 2008, reaching a low of €2.78 in April 2013.128

The CPF policy originally set a trajectory for the UK price of carbon to increase to £30/tonne in 2020 and £70/tonne in 2030. These prices would be achieved by implementing a UK-specific ‘Carbon Price Support’ tax, effectively a top-up on the EU market price, paid by UK industry. The Carbon Price Support was introduced in April 2013 at £4.94/tonne. The 2013 Budget confirmed the rates for the Carbon Price Support up to 2016 (reaching £18.08/tonne), and set an expectation that it would increase further in future.129

In response to the widening gap between the UK and EU carbon prices, the Government announced in 2014 that the Carbon Price Support would be capped at £18 per tonne from 2016 to 2020, in order to limit the competitive disadvantage faced by business and to reduce energy bills for consumers.130

On 21 April 2017 the EU ETS carbon price was €4.58, or £3.89.131 While companies based across the EU pay this amount to emit a tonne of carbon dioxide, UK companies pay the Carbon Price Support tax in addition.*

* This corrected text replaces that published in the printed version of the report.

Opportunities and risks of leaving the EU Emissions Trading System

66.Witnesses highlighted a range of risks of leaving the EU ETS, including increased cost and barriers to achieving our carbon reduction targets, and reduced access to funds for innovation.132 The Grantham Research Institute at the London School of Economics and Political Science also noted that leaving the EU ETS would entail a need to change the accounting approach for the UK’s carbon budgets (discussed in Box 2).133

67.Regarding the potential benefits of leaving, the Institution for Engineering and Technology noted that leaving the EU ETS could result in lower power production prices, giving large fossil-fuel powered plant an economic advantage over other fossil-fuelled plant in the EU. However, it also noted that such benefits were unlikely to be realised because the UK’s Carbon Floor Price has to date exceeded the EU ETS’ traded carbon price.134

68.The Grantham Research Institute at the London School of Economics and Political Science noted that leaving the EU ETS could make it easier for the UK to introduce a more coherent carbon pricing system across the whole economy.135

69.Energy intensive industries argued that Brexit should be used as an opportunity to take a more industry friendly approach to climate change policy. Andrew McDermot, Technical Director at the British Ceramic Confederation, raised concerns that the EU ETS incentivises a reduction in output, supports investment in renewables but not industrial technology, and creates uncertainty through a perpetual discussion and review of arrangements to prevent carbon leakage. He said that Brexit offers “a golden opportunity to do something else”.136

Box 2: The role of the EU ETS in delivering the UK’s carbon budgets

The 5th Carbon Budget implies a 57% reduction in emissions from 1990 to 2030. It was adopted by the Government last summer following the Committee on Climate Change’s recommendations, which were themselves based on continued UK participation in the EU ETS. The 57% figure is the target for the “net UK carbon account”. This takes account of trading in the EU ETS, with the expectation that the UK will have net positive sales of emissions allowances. In other words, the target assumes that the UK’s power and energy-intensive industries will make greater emissions reductions than they are required to, and they will sell these extra emissions allowances to companies in other Member States. The actual (gross) emissions reduction required by the Carbon Budget, without EU ETS trading, is 61%. This is necessary to keep the UK on the “cost-effective path”137 to meeting our target of an 80% reduction by 2050.138

70.The 5th Carbon Budget adopted in 2016 was calculated assuming ongoing UK participation in the EU ETS. If the UK leaves the EU ETS, the Carbon Budget will need to be revised upwards in order for the UK to remain on a cost-effective path to meeting our target of an 80% emissions reduction by 2050.

71.We recommend that—if the UK leaves the EU ETS—the Government revises the 5th Carbon budget, on the advice of the Committee on Climate Change.

Alternatives to the EU Emissions Trading System

72.The British Ceramic Confederation argued that the UK should leave the EU ETS and adopt an alternative emissions reduction scheme.139 It proposed options including: voluntary climate change agreements already in operation, which allow relative targets; expanding the existing EU ETS small emitter opt-out; and amendment of environmental permitting regulations to include carbon.140 However, these alternatives were challenged by Dr William Kyte, a fellow of the International Emissions Trading Association. He explained that voluntary climate change agreements provide no guarantee that the Government will meet its carbon caps, and that other command and control alternatives are extremely expensive.141

73.The Committee received mixed views on the benefits and viability of setting up alternative national schemes, and the option of linking to the EU ETS. Some witnesses suggested that a withdrawal from the EU ETS could allow the UK to have more specific rules while retaining our climate change ambition.142 Others emphasised that any national ETS would need to be linked with the EU ETS or another international ETS in order to retain the benefits of trading in a large market.143

74.Several witnesses stressed, however, the substantial cost and complexity of setting up a new national ETS.144 It was argued that agreeing links to other international ETS might take some time to achieve: we note that Switzerland has been in negotiations to link its national ETS to the EU ETS for several years, with talks currently stalled due to a separate disagreement on immigration. Sara Vaughan questioned the rationale behind arguments to abandon the EU ETS and establish a new system:

At the moment, the question I would ask is why you would rush to something else that will cause cost and disruption when you have something that is there already and in which we are playing a part.145

In oral evidence, the Minister of State for Climate Change and Industry said that the Government had not yet evaluated alternative options to the EU ETS.146

75.It is not clear that there are as yet any alternative options to membership of the EU ETS that could deliver our emissions reduction target at least cost. The most realistic aim should be a more ambitious EU ETS, with permit prices and the UK carbon price floor aligning across the EU to ensure the most cost efficient and competitive reduction in overall carbon emissions.

Timing of any potential departure

76.Whatever options are considered, witnesses giving oral evidence to the Committee were unanimous in their view that if the UK is to leave the EU ETS then it would be imprudent to do so before the end of Phase III in 2020.147 A number of witnesses also stressed the importance of retaining membership in the short term to avoid disruption.148 In particular, Dairy UK told us that failing to retain participation until the end of Phase III would cause the dairy industry and the food and drink sector a plethora of problems.149 We recommend that the Government seeks to retain membership of the EU ETS until at least end of Phase III in 2020, and that it seeks to negotiate longer term membership of the EU ETS on the condition of commitment to future reform.

77.If sufficient reforms to the EU ETS do not appear achievable, we recommend that the Government considers alternative options, such as establishing a separate UK system linked with wider international schemes. We further recommend that the Government should not seek to leave the EU ETS until it has established clear and well-tested alternative approaches which can deliver our emissions reduction targets at low cost and without destabilising investment or undermining the UK’s commitment and ambition to tackle climate change.


98 European Commission, EU ETS Handbook, p7

99 European Commission, EU ETS factsheet: The EU Emissions Trading System

100 Carbon Capture and Storage Association (EUC0017); European Commission, EU ETS factsheet: The EU Emissions Trading System

101 European Commission, EU ETS factsheet: The EU Emissions Trading System

102 Renewable Energy Association (LEU0009); The Prince of Wales’s Corporate Leaders Group (LEU0012); Nuclear Industry Association (LEU0013); Grantham Institute, Imperial College London (LEU0015); DONG (LEU0021); EDF Energy (LEU0024); Grantham Research Institute, London School of Economics and Political Science (LEU0029); Oil & Gas UK (LEU0032); New Nuclear Watch Europe (LEU0033); Aldersgate Group (LEU0038); Energy UK (LEU0040); Centrica (LEU0042)

103 British Ceramic Confederation (LEU0020)

104 Chatham House-UKERC (LEU0006); E3G (LEU0017); RSPB (LEU0011)

105 University of Sussex (EUE0034); British Ceramic Confederation (LEU0020); EDF Energy (LEU0024); Dairy UK (LEU0027)

106 Q258

107 International Emissions Trading Association (IETA) (EUC0003); Shell International Petroleum Co Ltd (EUC0015); Ricardo Energy & Environment (EUC0019); RWE UK (EUC0024); Grantham Research Institute at the London School of Economics (EUC0032); ScottishPower (EUC0035); Aldersgate Group (EUC0048); Global Warming Policy Forum (EUE0060); Grantham Institute, Imperial College London (LEU0015); New Nuclear Watch Europe (LEU0033); Energy UK (LEU0040); Centrica (LEU0042)

108 Q46 [Sara Vaughan]

109 Q258

110 International Emissions Trading Association (IETA) (EUC0003); Shell International Petroleum Co Ltd (EUC0015); EDF Energy (EUC0021); Citizens Advice (EUC0030); Grantham Research Institute at the London School of Economics (EUC0032); E.ON (EUC0038); Aldersgate Group (EUC0048); Vattenfall UK (EUC0055); Renewable Energy Association (LEU0009); Centrica (LEU0042)

111 Q206

112 Greenpeace (EUC0052); Renewable Energy Systems Ltd (RES) (EUE0059); Chatham House UKERC (LEU0006); RSPB (LEU0011); Nuclear Industry Association (LEU0013); E3G (LEU0017); Grantham Research Institute London School of Economics and Political Science (LEU0029)

113 RSPB (LEU0011)

114 Aldersgate Group (EUC0048)

115 European Commission, EU ETS factsheet: The EU Emissions Trading System

116 As above

117 EDF (EUC0021); E.ON (EUC0038); EEF (EUC0047); Chatham House-UKERC (LEU0006); Renewable Energy Association (LEU0009); RSPB (LEU0011); The Prince of Wales’s Corporate Leaders Group (LEU0012); Nuclear Industry Association (LEU0013); E3G (LEU0017); DONG Energy UK (LEU0021); Oil & Gas UK (LEU0032); Department for Business, Energy and Industrial Strategy (LEU0036); Aldersgate Group (LEU0038); Centrica (LEU0042)

118 Renewable Energy Systems Ltd (RES) (EUC0026); E3G (LEU0017); Oil & Gas UK (LEU0032); Energy UK (LEU0040)

119 Q258

120 Q241

121 Energy Intensive Users Group (EUC0031); E.ON (EUC0038); BASF (EUC0041); British Ceramic Confederation (LEU0020); Energy Intensive Users Group (EUC0031); E.ON (EUC0038); BASF (EUC0041); British Ceramic Confederation (LEU0020)

122 Q14

123 Q78

124 Q47

125 Centrica (LEU0042)

126 National Grid (LEU0026)

127 Q260

128 Sandbag, EU carbon price falls below €4, accessed 3 May 2017

129 House of Commons Library, Briefing Paper: The Carbon Price Floor, Number CBP05927, 23 November 2016; HM Treasury Budget 2013, HC1033, March 2013

130 House of Commons Library, Briefing Paper: The Carbon Price Floor, Number CBP05927, 23 November 2016

131 According to Carbon Pulse: EU Markets: EUAs hit 2017 low as pre-compliance slump continues, 24 April 2017, Sterling value calculated use xe.com exchange rate of 1 EUR = 0.848901 GBP on 24 April 2017, http://www.xe.com/currencyconverter/

132 Carbon Capture and Storage Association (EUC0017); Mineral Products Association (EUC0022); Grantham Research Institute at the London School of Economics (EUC0032); Greenpeace (EUC0052); Energy UK (EUC0049); Scottish Carbon Capture & Storage (EUC0050); Renewable Energy Association (LEU0009); The Prince of Wales’s Corporate Leaders Group (LEU0012); Aldersgate Group (LEU0038); Grantham Institute, Imperial College London (LEU0015)

133 Grantham Research Institute, London School of Economics and Political Science (LEU0029)

134 Institution of Engineering and Technology (LEU0010)

135 Grantham Research Institute, London School of Economics and Political Science (LEU0029)

136 British Ceramic Confederation (EUC0013)

137 The “cost effective path” is the term used by the Committee on Climate Change to denote the cheapest route to meeting the 2050 target.

139 British Ceramic Confederation (LEU0020)

140 Q50 (Andrew McDermott)

141 Q50 (William Kyte)

142 Carbon Connect (EUE0005); techUK (EUC0043); EEF (EUC0047); CF Fertilisers UK Limited (EUC0051); British Ceramic Confederation (LEU0020); Grantham Research Institute London School of Economics and Political Science (LEU0029)

143 Grantham Research Institute at the London School of Economics (EUC0032); The Prince of Wales’s Corporate Leaders Group (LEU0012); New Nuclear Watch Europe (LEU0033)

144 Renewable Energy Association (LEU0009); The Prince of Wales’s Corporate Leaders Group (LEU0012); E3G (LEU0017); Dairy UK (LEU0027); Grantham Research Institute London School of Economics and Political Science (LEU0029)

145 Q51

146 Q259

147 Q57 [John Lanchbery, Andrew McDermott, Sara Vaughan, William Kyte]

148 University of Sussex (EUE0034); British Ceramic Confederation (LEU0020); EDF Energy (LEU0024); Dairy UK (LEU0027)

149 Dairy UK (LEU0027)




4 May 2017