House of Lords - European Union - Thirty-Third Report

Select Committee on European Union Thirty-Third Report

CHAPTER 4: Allocation and auctioning

83. The fair and transparent allocation of emission allowances is an important principle of emissions trading. In this chapter, we consider whether allowances should be given away for free, or whether they should be auctioned, and what the implications of these different allocation methods are.

BOX 5

Case Study—Phase 1 and 2 allocation of allowances in the UK

Phase 1 (2005-07)

Permits in the UK were allocated for free to each sector of industry within the scope of the ETS on the basis of projected emissions over the period 2005-07.
Within each sector, permits were then allocated on the basis of historic emission levels.
A New Entrants Reserve provided that allowances would be made available to new entrants to each sector from a reserve comprising 6.3 per cent of total allowances.
No auctioning took place in Phase 1.

Phase 2 (2008-12)

7 per cent of allowances are to be auctioned. Governed by the Community Emissions Trading Scheme (Allocation of Allowances for Payment) Scheme 2008[50], the first auction of ETS allowances took place in the UK on 19 November 2008.
The remaining 93 per cent of allowances continue to be allocated for free (including 6.6 per cent towards a New Entrants Reserve) on the same basis as in Phase 1, apart from a change in the baseline period (2000-03).
In Phase 2, the UK's total amount of allowances was reduced, a reduction that was borne entirely by the Large Electricity Producers sector.

Content of the proposal

84. Under the revised scheme, auctioning will be the basic mechanism through which emission allowances are allocated. The Commission explains that "auctioning best ensures efficiency of the ETS, transparency and simplicity of the system and avoids undesirable distributional effects."[51]. The Commission proposes that the power and carbon capture and storage sectors be made to buy 100 per cent of their emissions allowances at auction from 2013, which should mean that at least two thirds of the total quantity of allowances under the EU-wide cap will be auctioned in 2013.

85. For installations in other sectors, a more gradual transition is deemed appropriate, starting in 2013 with free allocation of 80 per cent of an installation's share of allowances, with the remaining 20 per cent bought at auction. The share of free allowances relative to allowances bought at auction will decrease over time by equal amounts each year, arriving at zero free allocation (i.e. "full auctioning") by 2020. Community-wide and fully harmonised implementing measures for the allocation of free allowances will be adopted by 30 June 2011. Special arrangements will apply to sectors deemed at risk from "carbon leakage" (see Chapter 5).

86. The Commission proposes that at least 20 per cent of the revenues generated from the auctioning of allowances should be earmarked by Member States for spending on various climate change-related measures, including the development of new technologies (such as renewable energies and carbon capture and storage), assistance to developing countries to facilitate their adaptation to the impacts of climate change, and measures to address fuel poverty. This system of earmarking is otherwise known as "hypothecation".

87. It is proposed by the Commission that five percent of the Community-wide quantity of allowances be set aside for new entrants to each sector, although no free allocation will be available to new electricity producers entering the market.

88. Finally, for reasons of fairness and solidarity and taking into account national circumstances, the Commission proposes that 10 per cent of the total quantity of allowances to be auctioned should be redistributed away from Member States with an average income per head of more than 20 per cent above the EU average. It is proposed that 19 Member States benefit from the redistribution of allowances to varying degrees depending on income levels per head (poorer Member States to benefit more), growth and emissions prospects in those Member States, and compliance costs.

Allocation

89. The CBI and the Scottish Executive supported the Commission's approach to the level of auctioning (CBI Position Paper, pp3-4 and Scottish Executive Memorandum, para. 6). A CBI representative explained that companies outside the power sector that were not at risk from carbon leakage needed time to adjust "before they bear a full carbon price, but that should be the aim" (Q 135).

90. The RSPB and WWF, on the other hand, supported a move to 100 per cent auctioning for all sectors from 2013 (RSPB Memorandum, para. 6.1 and WWF Memorandum, para. 7). The WWF explained that "within a trading scheme auctioning allowances is a key design feature which helps to ensure that the progression towards a low carbon economy takes place in the fairest and economically most efficient way". Similarly, the Centre for European Policy Studies (CEPS) argued that free allocation "constitutes a weakening of the price signal and thereby reduces the incentive for innovation" (Memorandum, p.137).

91. Dr Barker (4cmr) agreed that all of the allowances should be auctioned but proposed that some of the money raised could then be returned to industry as an explicit subsidy. He emphasised the importance of such transparency for markets to work well (Q 217). A representative from the European Commission, however, dismissed the idea of 100 per cent auctioning across the board from 2013 as politically improbable (Q 374) and suggested that the same result could be achieved through free allowances if these were allocated through a transparent, evidence-based approach (Q 375).

92. A number of witnesses were highly critical of the Commission's proposal to apply full auctioning to the power sector from 2013. Euracoal warned that the proposal "would lead to citizens and the national economies of the Member States with a considerable share of coal in their energy mix having to carry the financial burden of the European climate protection policy" (Memorandum, p.162). On behalf of the Polish Government, Professor Jerzy Buzek MEP explained that Poland was one such Member State. Poland's concerns were due primarily to the fact that coal and lignite, both of which have high carbon content, represent over 90 per cent of Poland's energy mix. Professor Buzek feared that the Commission's proposal would have a disproportionate impact upon Polish consumers for whom, he claimed, electricity prices as a proportion of household expenditure would rise from 10 per cent to 16 per cent (Q 407).

Levels of auctioning

93. The UK Government believes that Member States should not be constrained by fixed levels of auctioning, and expressed its support for a harmonised minimum level of auctioning instead (QQ 101-2). The Scottish Executive concurred, arguing that "this would provide flexibility to allow Member States to auction more should national circumstances call for it" (Memorandum, para. 6).

94. Other witnesses took a different view, favouring a harmonised level of auctioning in order to ensure fairness across the European market (British Cement Association Memorandum, para. 14.1 and CBI Q 141). The Centre for European Policy Studies (CEPS) argued that Member State discretion should be avoided because of problems in the past caused by different national approaches. By way of example, CEPS indicated that a new natural gas combined heat and power plant would, under the Phase 1 rules, have received allowances in Germany corresponding to 130 per cent of its expected emissions, whereas the corresponding figure in Sweden would have been 60 per cent (Memorandum, p.138).

Allocation Methodology

95. Some debate centred on the method of allocating allowances that would be made available for free. The Environment Agency (EA), Aluminium Federation (AlFed), CBI, the British Cement Association (BCA) and the Polish Government considered that this should be done on the basis of benchmarking within sector caps, whereby the least efficient technologies received fewer allowances.[52] (EA Memorandum, para. 3.6.1; AlFed Memorandum, para.7; CBI Position Paper, p.5; BCA Memorandum, para. 14.9; Q416).Professor Buzek (Poland) explained that, under a system of EU-wide benchmarking, free allowances would be awarded for the use of Best Available Technology (BAT)[53]. Those companies not deploying BAT would still need to top up their allowances at auction, thereby maintaining the incentive to introduce better technology. The Environment Agency added that the proposal for European benchmarks could be an important step towards achieving global sectoral emissions reduction agreements.

96. The RSPB and 4cmr considered that decisions on free allocation methodology should be made at the EU level "in order to prevent a race to the bottom by Member States" (RSPB Memorandum, para. 6.2 and 4cmr Memorandum, para.6). The Aluminium Federation asserted that an EU-level decision on this issue was required as soon as possible (Memorandum, para.6), a view shared by the Scottish Executive, which argued that the date for determining EU rules governing free allocation should be brought forward from 30 June 2011 to December 2009 (Memorandum, para. 6). 4cmr anticipated that a harmonised allocation methodology would increase fairness.

97. The Centre for European Policy Studies (CEPS) pressed for early certainty on allocation methodologies, along with a reasonable level of predictability as to how allocation methodologies would change over the medium to long term. This increased predictability should enhance the extent to which the scheme promoted technological innovation (Memorandum, p.136).

Redistribution of Allowances

98. Most witnesses were opposed to the Commission's proposal that 10 per cent of the allowances to be auctioned be redistributed away from relatively wealthy Member States to other Member States. On behalf of the UK Government, Mr Mackenzie (DEFRA) noted that "the ETS should be about creating the commercial incentives to reduce emissions, not a means of transferring wealth around Europe" (Q 86). The RSPB and the Aluminium Federation (AlFed) both considered that the ETS should not be a mechanism for supporting the economies of poorer countries (RSPB Memorandum, para. 8.1 and AlFed Memorandum, para.8). By contrast, the Church of England argued that the proposed redistribution made economic sense given the weak economic performance of many of the new Member States (Memorandum, para. 21).

Use of Auction Revenue

99. Phil Woolas MP (Minister of State) explained that the UK viewed hypothecation (see para. 86) as "an inefficient means of determining public expenditure priorities" but that policies would be considered on their merits, including the need to encourage carbon capture and storage (CCS) (Q 189). Mr Woolas also argued that hypothecation breached the EU's principle of subsidiarity[54], whereby decisions should be taken at the lowest appropriate level of governance. Similarly, the CBI feared that allowing the EU to decide on how the revenue should be spent "is perhaps a slippery slope towards more tax harmonisation" (Q 141). A CBI representative indicated that the UK's position on hypothecation was shared by other Member States (Q 84), a view confirmed by the Spanish Government (Memorandum, para. 4).

100. A number of our witnesses, however, supported the principle of hypothecation, at the EU level, including the Church of England, RSPB and the British Cement Association (Church of England Memorandum, para. 23; RSPB Memorandum, para. 4.1 and BCA Memorandum, para. 14.13). On behalf of Greenpeace, Dr Parr suggested that 50 per cent of auctioning revenues be earmarked for climate change related measures in the EU and 50 per cent be channelled towards assisting emissions mitigation in developing countries (Q 62). His suggestion was echoed by the WWF (Memorandum, para.7).

101. Earmarking of funds for climate change related measures also received support among those witnesses who had rejected the principle of hypothecation at the EU level. The CBI, for example, recalled that auction revenues would be coming from industry and consumers in order to pay a carbon price and therefore "given the challenges that as a country we face in terms of R&D [research and development] into energy technology and adaptation, it is right that the Government earmark a certain proportion of that revenue for spending in those areas" (Q 141). Business Europe agreed that the revenue should be used to improve the competitiveness of domestic business (Memorandum, para. 2.3). CBI representatives suggested that an acceptable package of spending might split funds between R&D, adaptation and fuel poverty (Q 145). They referred to the Stern Review, reminding us that it had identified the pricing of carbon and increased investment on public R&D and demonstration of new technologies as two (of three) pillars of climate change policy. The argument in favour of spending auction revenues on climate-related measures therefore followed, they claimed (Q 143).

102. Speaking on behalf of Lafarge Cement UK, Mr Dwight Demorais noted that carbon capture and storage technology was currently out of his company's reach but that the company would gladly seize "the option to recycle auction revenues back into R&D in these sorts of areas" (Q 141). Similarly, Euracoal took the view that auctioning revenues should be used primarily for climate protection, measures including power-plant related R&D and carbon capture and storage (Memorandum, p.163).

103. On behalf of the Polish government, Professor Buzek MEP was enthusiastic about carbon capture and storage (CCS), noting that its development would allow the EU to consider coal as a "very, very important source of energy" in the long term. This, he argued, would have energy security benefits because it would not be necessary to rely on imports of oil and gas, a view supported by the European Commission in its Impact Assessment of the proposed Directive[55]. Professor Buzek also anticipated that CCS would bring economic benefits as it was a technology that the EU could sell to third countries, such as China (Q 411), where almost 40% of total emissions from the power sector were projected to be captured by 2030, rising to two thirds in 2050[56]. He added that Poland was already planning two CCS demonstration plants and appeared confident that the technology could be ready by 2020 (Q 433).

104. Dr Barker of 4cmr pointed out that auction revenues could be used to accelerate technological change, in the same way that low carbon technological investment had helped Germany to develop a comparative global advantage in this area (Q 229). He explained that allocating revenues to innovation in low carbon technologies was economically sound because, without the subsidy, "innovators cannot capture all the rents from their innovation because other innovators take it from them" (Q 245).

105. On behalf of the European Commission, Mr Meadows confirmed that Member States were able "to use auction revenue or, indeed, any public revenue, in many, many ways to tackle climate change, for research and development, for carbon capture and storage" (Q 377). He noted that, over the last seven years, the Commission had approved 98 per cent of environmental state aid notifications made to it. The environmental state aid guidelines were reviewed when the energy and climate change package was published in January 2008 to increase the range of activities covered and the permitted amounts of aid[57].

New Entrant Reserve

106. The CBI and the British Lime Association (BLA) took the view that the proposed definition of a New Entrant should be broadened to include expansion and upgrading of existing facilities as well as the building of new facilities (Q 154 and BLA Memorandum, p.117). This, the CBI noted, would be in line with the current, Phase 2, definition of New Entrant.

107. The European Federation of Energy Traders (EFET) and Business Europe warned that the size of the New Entrant Reserve was too high (EFET Memorandum, p.163 and Business Europe Memorandum, para. 2.8). EFET noted that the reservation of too many allowances "may cause unnecessary uncertainty in the market". The CBI felt that the New Entrant Reserve should either be reduced to 2 per cent of the cap or alternatively there should be no cap, and allowances for new entrants should instead be drawn down from the auction pool as needed (Position Paper, p.7). A CBI representative explained that the UK Government's own analysis suggested that a 1.2 per cent reserve would probably be sufficient to accommodate needs, and that the CBI's proposal of 2 per cent allowed for some flexibility in that calculation (Q 154). EFET emphasised that, in order to improve transparency and predictability, "the proposal should also include clear rules about what happens to unallocated [allowances from the] New Entrant Reserve".

108. A new suggestion for use of the New Entrant Reserve was adopted by the European Parliament's Environment Committee on 7 October 2008. The Committee proposed that up to 500 million allowances in the Reserve (around two thirds of the Reserve) be awarded for free to large-scale demonstration projects that were undertaking the capture and geological storage of carbon dioxide (CCS) either in the EU or in developing countries and countries with economies in transition outside the EU that ratify any future international agreement. In its justification, the Committee explained that the amendment "works within the EU emissions cap to provide an immediate, certain and European financial mechanism to enable the first promoters of CCS projects to meet development costs which initially make the technology commercially unviable"[58].

Conclusions and Recommendations

109. We support in principle the 100 per cent auctioning of allowances from 2013 in all sectors other than those deemed subject to carbon leakage. Free allocation of allowances can lead to windfall profits and should for that reason be avoided wherever possible.

110. We acknowledge, however, the concerns of those Member States whose energy mix is fossil fuel-intensive and who therefore fear that the Commission's proposal may have a disproportionate impact upon them. We believe that time-limited derogations from the principle of 100 per cent auctioning in the power sector from 2013 could be granted to Member States with particularly fossil fuel-intensive energy sectors, on the condition that the transition period is used to develop and trial carbon capture and storage technology. Derogations should be phased out by 2020 at the latest, by which time full auctioning should be in place for the power sectors of all Member States.

111. Should the Commission's proposal for a gradual transition towards 100 per cent auctioning over the period 2013-20 for all but the power sector be adopted, we consider that a harmonised level of auctioning should be set across the EU, with no flexibility for Member States to either raise or lower the level set. This is crucial in order to prevent distortions of competition across the European Union. In any transition towards 100 per cent auctioning, free allocation should be based on sector-specific EU-wide benchmarking that rewards the use of Best Available Technology and stimulates further innovation.

112. With regard to how auctioning revenues are spent, we agree with the UK Government that it would be inappropriate for this to be prescribed at the EU level as it breaches the principle of subsidiarity. Without such earmarking, we do not see any remaining justification for the redistributive element of the Commission's proposal, under which a proportion of the rights to auction allowances would be redistributed towards Member States with low income per capita or particularly high compliance costs.

113. We are conscious, however, that the redistributive element of the Commission's proposal commands wide support among Member States. If this aspect of the proposal were to be accepted, and if any derogations from the principle of 100 per cent auctioning in the power sector were to be permitted, the levels of redistribution of auction rights among Member States should be re-considered. If the levels are not re-considered, the EU risks compensating the same Member States twice over for the compliance costs they face.

114. It is our firm view that Member States should invest considerable funds in climate change-related measures—including R&D and demonstration projects, as well as adaptation measures—and in measures to help ease the social problems that may arise as a result of the ETS, such as increases in electricity prices. In our view, this will be essential to secure the credibility of the scheme, by signalling that governments are willing to foot part of the bill that they are imposing on the private sector.

115. It is critical, however, that the measures into which such funds are invested should not cancel out the carbon price signal altogether by compensating industry and consumers fully for price increases arising from the ETS, as this would undermine the scheme's raison d'être. Investment should instead focus on providing viable, low-carbon alternatives and promoting the necessary transition.