Memorandum by the Centre for European
Policy Studies (CEPS)
The Centre for European Policy Studies (CEPS)
wants to address a number of questions that has been raised by
the Sub-Committee.
QUESTION 4, THE
KEY STRENGTHS
AND WEAKNESSES
OF THE
PROPOSAL
(a) The extent to which the scheme as currently
designed will encourage technological innovation?
Technological innovation depends to a large
extent on certainty or rather predictability (see below), the
level of price and whether the price signal is undistorted. In
this section, we will only focus on the former. The third item
will be answered under the next question.
Within multi-stakeholder CEPS Task Forces, comprising
of (almost) all industries, government and EU officials, NGOs
and independent experts, the issue of predictability has been
covered intensively. The conclusion has been the following; There
can be no absolute certainty. Uncertainty is a normal factor for
many investment decisions. Uncertainty relates to demand, prices
for electricity and other products, factor prices (primary energy,
feedstock, labour, transport, etc), technological progress, competitors'
strategies as well as regulatory risks, under which the EU ETS
falls. Instead of absolute allocation certainty, increased
predictability in the total allocation and the allocation
rules for individual installations based on the principle of a
(relative) reward for low emissions and a (relative) penalty for
high emissions will facilitate investment to reduce emissions
in existing installations and investment in new efficient installations,
thereby replacing old inefficient plants. Such predictability
can be achieved through the following:
— Assurance that the EU ETS will continue
until 2030 and beyond. That condition is already met.
— Early certainty on "allocation
methodologies" (for the commitment period) and a reasonable
level of predictability as to how allocation methodologies change
over the medium to the long-term, for example by determining how
future allocation methodologies will be developed, through for
example a road map how and when methodologies will be adapted.
— The actual length of the commitment
period is not as important as usually thought. A five to eight
years period seems reasonable according to our findings. Because
of the unpredictability of international negotiations on the global
situation and climate science, very long-term allocations over
20 or 30 years or more are not recommended. These could lock the
EU into an arrangement involving unsustainable capital stock and
result in stranded investment in the future.
— A final precondition is that there
is reasonable predictability on the future medium to long-term
target. This can either be done at EU-level (eg similarly to the
proposed EU integrated climate and energy package) or at member
state level. Different member states including the UK are experimenting
with different models. The key is that methodologies for setting
long-term targets are transparent.
The Commission proposal by and large seems to
meet the conditions that the CEPS multi-stakeholder work has proposed.
[See: CEPS (2007), Shaping the Global
Arena: Preparing the EU Emissions Trading Scheme for the Post-2012
Period, CEPS Task Force Report no 61; Chairman: Dan Gagnier;
Rapporteurs: Christian Egenhofer & Noriko Fujiwara, CEPS:
pp 15-17[18]]
(b) Whether the ETS will result in the appropriate
price signal being sent
Once "reasonable" predictability is
ensured, the next important issue is that the price signal is
undistorted. This will be analysed in the next session.
Within the EU ETS, a weakening of the price
signals can be due to (i) national differences and (ii) free allocation.
Weakening of distortions from national differences would disappear
under the Commission proposal, if properly implemented. More complicated
is the issue of a weakened price signal because of free allocation.
Continued free allocation, which constitutes
a subsidy is foreseen for sectors in risk of losing "competitiveness"
as a combination of CO2 being a significant factor in variable
costs and being subject to international competition. While such
free allocation may be justified, it constitutes a weakening of
the price signal and thereby reduces the incentive for innovation.
There is also a risk that the EU hands out free allowances to
those sectors that in fact can pass through all or parts of the
carbon costs. This would mean another round of windfall profits,
although this time not for the power sector but for industry.
Subsidising industry—unless justified—would be bad
macro-economic policy. As a result the European Commission under
the leadership of DG Enterprise and Industry has launched a process
involving industry, member states, research and stakeholders to
assess as exactly as possible the vulnerability of sectors and
sub-sectors, to be completed by mid-2011. This process has been
criticised by industry as undermining predictability. While theoretically
this might be true, practically there is no reason why this process
could not be concluded by the mid-2010 (ie one year earlier as
the European Commission has proposed). This would mean could that
there is certainty for industry as to allocation rules for 2013
for at least two years ahead the commitment period and somewhat
more than a year after the new ETS directive is expected to be
formally adopted.
(c) Whether the ETS will be efficient and/or
equitable
The vast ETS literature[19]
has identified four major design flaws; (i) overallocation, (ii)
distortions to competition within the EU internal market, (iii)
windfall profits to the power sector, and (iv) lack of transparency
and predictability. These design flaws have been a caused by a
high degree of decentralisation, free allocation and short-term
allocation periods. The mixture of a centralised EU-wide cap,
EU-wide allocation methodologies and auctioning to the power sector
as proposed by the European Commission addresses these shortcoming.
The issue of predictability has been addressed in question 4a)
and the one on equity will be covered in question 6.
QUESTION 5, THE
POTENTIAL APPLICATION
OF ARTICLE
24A
The proposed article 24a has in the literature
been referred to also as so-called "Domestic off-set projects"
(DOPs). DOPs mirror the concept of the project mechanisms articulated
in the Kyoto Protocol, but are used within the home country to
reduce emissions in the non-trading sectors (eg transport and
buildings).
There are two principal argument in favour of
DOPs. The first is that they extend the price signal and thereby
initiate a "market search" for abatement opportunities.
The second is that DOPs can reduce total compliance costs by bringing
hitherto non-identified low-cost reduction sources into the fold
and thereby assist in decarbonisation.
The first argument, ie the "market search
function" is unquestionable. The second argument needs qualification.
DOPs give the ETS sector access to the non-trading sectors. This
would normally mean that low-cost options would be picked up by
the EU ETS sectors. While this can lower the EU ETS allowance
price, reaching the EU climate change targets can be more costly
from the macroeconomic point of view. This would be so if the
emissions reduction obligations in the non-trading sectors were
not adapted by taking into consideration that the low-cost reductions
are accounted for by the EU ETS sectors. Ie when allowing additional
credits into the ETS, it would require an adjustment of the ETS
cap to avoid this potential negative macro-economic effect. As
the ETS does not foresee an ex-post cap adjustment, this would
almost automatically mean an (ex-ante) quota for DOP credits.
In addition, there is fear that DOPs are potentially
complex and incur transaction costs inherent in all project mechanisms.
This may run counter the objective of keeping the EU ETS as simple
as possible. The discussions around the CDM have shown this. In
particular, DOPs would introduce the issue of "additionality"
into the ETS as only additional reductions will contribute to
the EU targets. No doubt, many other contributions to the inquiry
will focus on this.
The House of Lords Sub-Committee may instead
investigate whether there is really a need to create an additional
clause for DOPs or whether they cannot de facto be better
implemented under the current Art. 24 on unilateral opt-ins.
QUESTION 6, WHAT
DECISIONS ABOUT
THE PROPORTION
OF PERMITS
TO BE
ALLOCATED FOR
FREE RATHER
THAN AUCTIONED
SHOULD BE
TAKEN AT
EU OR MEMBER
STATE LEVEL?
The high degree of discretion of member states
regarding allocation has led to a situation where industry has
been able to put pressure on governments not to hand out fewer
allowances (for free) than other governments. While EU-wide allocation
rules would do away with this, member states discretion as to
the split between free allocation and auctioning would lead to
the same situation with the likely result of a race towards free
allocation. The experience from phase 1 and 2 suggest a EU-level
decision as default option.[20]
Still, one could image that a high level of
auctioning to the power sector could pose in some member states
either security of supply risks or drive up power prices dramatically.
In this cases, one could imagine that member states could apply
for a derogation based on EU rules and criteria and to be approved
by the European Commission.
As to the industrial sector, where free allocation
may cover a high percentage of allocation, member state discretion
should be avoided as a result of the phase 1 and 2 experiences.
One would expect that the European Commission process (described
in answers to question 4b) would be able to identify the sectors
and installations that may be vulnerable to carbon leakage.
QUESTION 7, WHICH
SECTORS (IF
ANY) SHOULD
CONTINUE TO
RECEIVE A
PROPORTION OF
THEIR EMISSIONS
FOR FREE?
The first phases of the EU ETS has triggered
a debate on "competitiveness" (of industry) and carbon
leakage which is documented in a sizable body of literature.[21]
There is an emerging EU consensus (see Matthes and Neuhoff,
2007) that the following sectors could claim a risk of carbon
leakage (as a combination of CO2 being a significant factor in
variable costs and being subject to international competition):
— Non-refractory ceramic goods other
than for construction purposes; refractory ceramic products.
— Pulp, paper and paperboard.
— Basic chemicals, man-made fibres.
— Basic precious metals and non-ferrous
metals.
While the choice of free allocation is pragmatic—free
allocation constitutes a subsidy—it allows only for compensation
of direct effects, ie costs arising due to the fact that emissions
need to be covered by an allowance. It does not address the vulnerabilities
of those sectors that results from indirect effects, ie through
higher input costs, notably higher power prices as a result of
the ETS. This would need to be addressed by some sort of subsidies,
meaning the relevant policy instrument is the State aid guidelines.
QUESTION 10, THE
LIKELY FEASIBILITY
OF CREATING
LINKS BETWEEN
THE ETS AND
OTHER SIMILAR
SCHEMES
The importance of a global carbon market has
been demonstrated among other by the Stern Review. The relative
low costs for achieving climate change objectives assumes global
trading of emissions rights. The most likely and possibly fastest
way to develop a global carbon market is through linking of national
and regional schemes. There is plenty of evidence that such schemes
will be in operation in Australia, New Zealand, the US or Japan
for the post-2012 period.
While the current EU ETS directive in Article
25 has allowed for linking the EU ETS with other emissions trading
schemes by international agreement, the proposed new directive
goes a step further. It foresees different types of linking arrangements,
eg via a treaty, an international agreement as foreseen under
EU law and through a "reciprocal recognition" of non-EU
allowances. This provision is innovative both internally
and internationally as essentially schemes could be linked through
administrative decisions. Whether the clause will actually be
used remains unclear at the moment. At this stage the principal
value is that it triggers a debate on "linking" and
"linkability" in internal discussions on Australia,
New Zealand or the US. While initially "linkability"
has not been very prominent in US discussions, this is now changing.
We should expect the EU clause on a "reciprocal recognition"
of allowances helps that schemes are converging rather than diverging.
This is even more important as the study of forthcoming non-EU
emissions trading schemes shows,[22]
the design of these emissions trading schemes is driven by the
domestic political economy with little or no concern for effects
on linking.
While formal linking through an international
agreement or "reciprocal recognition" is important,
a global carbon market may yet emerge as participants of different
emissions trading schemes search for arbitrage possibilities between
different carbon markets or commodities. Such arbitrage is highly
probable as most national or regional climate change policies
or ET schemes foresee the use of project type of mechanisms either
in the form of the Kyoto Protocol projects mechanisms (CDM/JI)
or comparable mechanisms. As long as domestic or regional emissions
trading schemes allow for the use of credits from such projects
and there is sufficient volume, carbon prices will converge.
Another option for an emerging global carbon
market would be to move towards sectoral agreements on an international
scale. Yet, today it is highly uncertain whether sectoral agreements
will be part of the post-2012 architecture.
June 2008
LITERATURE
CEPS (2007), Shaping the Global Arena: Preparing
the EU Emissions Trading Scheme for the Post-2012 Period, CEPS
Task Force Report no 61; Chairman: Dan Gagnier; Rapporteurs: Christian
Egenhofer & Noriko Fujiwara, CEPS.
Carbon Trust (2004), The European Emissions Trading
Scheme: Implications for Industrial Competitiveness. London:
The Carbon Trust, June.
Climate Policy (2006) Special Issue on EU ETS, Vol.
6, Issues 4 (Edited by Michael Grubb).
Climate Strategies (2007), Differentiation and
dynamics of EU ETS industrial competitiveness impacts. (Authors:
Jean-Charles Hourcade, Damien Demailly, Karsten Neuhoff and Misato
Sato with contributing authors, Michael Grubb, Felix Matthes and
Verna Graichen).
Egenhofer, C "The Making of the EU Emissions
Trading Scheme: Status, Prospects and Implications for Business",
European Management Journal, Vol 25, No 6, pp 453-463,
December 2007.
Ellerman, D and P Joskow (2008), The European
Union's Emissions Trading System in perspective. Pew Center
on Global Climate Change, May.
Ellerman, D, B K Buchner, C Carraro (2007) (eds),
Allocation in the European Emissions Trading Scheme. Rights,
Rents and Fairness. Cambridge University Press.
McKinsey and Ecofys (2006), EU ETS Review: Report
on International Competitiveness, Brussels and Utrecht, December.
Matthes, F, V Graichen and J Repenning (2005), The
environmental effectiveness and economic efficiency of the European
Union Emissions Trading Scheme: Structural aspects of allocation,
Report to the WWF, Öko-Institut, Freiburg.
Matthes, F and K Neuhoff (2007), Auctioning in
the European Union Emissions Trading Scheme. Report commissioned
by WWF.
Reinaud, J (2005), Industrial competitiveness
under the European Union emissions trading scheme, International
Energy Agency Information Paper 2005.
Swedish Energy Agency (2006), The EU Emissions
Trading Scheme after 2012. A report from the Swedish Energy
Agency and the Swedish Environmental Protection Agency.
18 Free download: http://shop.ceps.eu/BookDetail.php?item_id=1474 Back
19
eg Matthes et al, 2005 ; Swedish Energy Agency, 2006 ;
Special Issue of Climate Policy (2006) edited by Grubb;
Ellerman, Buchner, and Carraro, 2007; Egenhofer, 2007; Matthes
and Neuhoff, 2007,; Ellerman and Joskow, 2008. Back
20
For example under rules of phase 1, a new natural gas combined
heat and power plant-producing both electricity and heat-would
in Germany receive allowances corresponding to 130% of its expected
emissions. The corresponding figures are 120% for Finland, 90%
for Denmark and 60% for Sweden. For a new natural gas combined
cycle electricity production unit (no heat) the differences are
even larger. In Germany the installation would receive 105% of
the required allowances. In Finland 100%, in Denmark 82%, and
in Sweden 0%-Sweden does not give allowances for non-combined
heat and power. Back
21
See, for example, Carbon Trust (2004), Reinaud (2005),
McKinsey & Ecofys (2006), Climate Strategies (2007) or Matthes
and Neuhoff (2007). Back
22
The emissions trading schemes such as the Regional Greenhouse
Gas Initiative (RGGI) in the North-east of the US, in California
or the various proposals for a US cap-and-trade scheme in the
US Senate or in Australia5 exhibit very different design features
to the EU ETS with regard to sector coverage, commitments, allocation
and even monitoring, reporting and verification. Back
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