Examination of Witnesses (Question Numbers
320-339)
Mr Miles Austin, Ms Coralie Laurencin, Mr Nick Haslam
and Mr Sam Fankhauser
8 OCTOBER 2008
Q320 Chairman: If you do have this price
difference, what are the implications in terms of location of
industries?
Mr Fankhauser: This is a very oft debated
question. It has come up a lot in the context of the EU ETS. It
has been fairly well studied. The most convincing study that I
have seen is that the competitiveness issue can be quite narrowed
down into a handful of industries: steel, aluminium, lime. It
is concentrated into a small part of the economy. There are distributional
issues, if you happen to be in the south of Wales, it is a big
part of the economy. But from the UK or European point of view
competitiveness is concentrated in very few industries for which
one can probably find tailor made solutions that do not contradict
the state aid rules one has.
Mr Austin: It is part of the package
that the Commission in 2010 will produce a list of sectors that
are vulnerable to international competition and it will then issue
free allocation of EUAs as is deemed appropriate. Also, in terms
of industries that are adversely affected in domestic markets,
a potential way of addressing that would be the French proposal
for some kind of border adjustment mechanism. For instance, goods
coming in from other parts of the world would have to pay some
kind of levy, be that in credits, be that in hard cash, to compensate
for the fact that they have not taken on similar commitments.
Chairman: It sounds a very French proposal.
Q321 Viscount Ullswater: You have identified
some of the problems that are recognised and you mentioned some
of the sectors which need to have this special treatment, but
it creates a great deal of uncertainty at the moment because the
solutions have not been identified. How does it affect your work
with your clients, as to what you need to factor in possibly for
the future and how to deal with that?
Mr Austin: In terms of the uncertainty
for sectors that will appear on the list or not, I think certain
sectors are almost eschewing. The steel sector will almost definitely
be there.
Q322 Viscount Ullswater: Cement?
Mr Austin: Possibly. Possibly not. It
depends. I have heard various different versions of how the cement
market functions and what it has to compete with. There is an
issue of leakage in southern Spain where cement can be shipped
across the Mediterranean from Morocco. I have heard recently that
there could potentially even be European-wide problems of leakage
with cement shipments coming for instance from China. A way of
addressing that would be potentially to push for some kind of
global, sectoral deal that would cover those sectors. For instance,
the whole of the cement industry would be covered by a sectoral
deal.
Q323 Viscount Ullswater: I think we were
given an indication this morning by Dr Barker that one way of
treating it would be to sell credits to every industry but, for
those that were subject to leakage, you would give them the money
back. Have you heard that proposition made?
Mr Austin: That is something that to
some extent Defra has undertaken with phase two. If you look at
the historical emissions, the steel industry in the UK is over-allocated.
They have been given more credits than they will probably need.
To some extent, not only will that not cost them anything but
they have sufficient credits to either allow for some expansion
in production or to sell to cover the administration costs of
being part of the EUETS.
Ms Laurencin: And the increased electricity
cost. They get the double hit. They pay electricity costs and
they have been imposed into the EUETS. That was the reasoning
up until now but phase three will definitely mark a change from
that situation.
Mr Austin: There is an issue for industries
that are not covered by the EUETS but are affected like for instance
the aluminium sector, which currently is not covered but uses
huge amounts of electricity. There might be some argument for
some other kind of mechanism to compensate for that.
Mr Fankhauser: Generically, I only see
three ways in which one can deal with the leakage problem. One
is the border tax adjustment that we talked about. The second
is the global, sectoral agreements that are being discussed, for
example for steel. The third is giving allowances away for free.
Giving allowances away for free seems to be the one that has the
fewest obstacles attached to it, so that is probably what is going
to happen. As an economist, I have some misgivings about that.
What giving allowances away for free does is it increases profitability.
It does not increase competitiveness because at the margin we
still face the cost of carbon. It is just that you have been given
something for free to compensate for that. If my stepson sells
something on Ebay, a piece of equipment, whether he bought it
for himself or it was bought by his mother, the decision whether
to sell or not does not depend on it. It has to do with whether
he still needs the piece, whether there is something else in the
market that he needs, whether he can get a good price for it.
How you get your allowances does not define how you behave at
the margin when you make your location and production decisions.
Q324 Lord Brooke of Alverthorpe: You
are not enthused by subsidies?
Mr Fankhauser: It is a subsidy. I can
see why it is being done because it is easy to do and not everybody
behaves in the hard nosed way that I have just described. There
are some complications in it.
Lord Wallace of Tankerness: One of the
arguments for the subsidy was its transparency. You could see
there was a sum of money and you could see what was done with
it.
Q325 Lord Cameron of Dillington: The
companies themselves might look at that money and say, "This
is for greenhouse gas savings" as it were. That is slightly
different to, "We get a lot of free allowances so we do not
have to do anything."
Mr Austin: If you do something, you can
sell those allowances and not have to use them for your compliance
obligation. There is a counter to that. To address subsidies slightly,
again I do not think they are an unreasonable tool in a suite
of tools, given certain contexts. To look at the German tariff,
the renewable energy which was in effect a subsidy for renewable
energy, it has made Germany the world leader in wind. If you look
at the European context, we should be the world leader in wind
because we have a far larger resource than Germany does.
Q326 Lord Brooke of Alverthorpe: They
do not have the planning problems that we have. The World Bank
has pointed out that some of the cheapest mitigation opportunities
are in some of the sectors that we talked about before, such as
building, forestry and agriculture but these have been barely
taken up so far. Could you endeavour to give us an explanation
as to why you think these opportunities have not been tapped into
and indicate whether you expect this to change in the future?
What is the kind of timescale?
Mr Fankhauser: Forestry is a special
case because there are Kyoto related rules on forestry that have
restricted what is possible and what is not. Deforestation was
not possible and afforestation was. Forestry has its own special
accounting issues which have to do with leakage, with permanence,
additionality and those sorts of things. It is the eternal question
as to whether there is such a thing as negative cost opportunities
in building. Every cost curve that has ever been drawn has had
that negative part to it. The question is why has that negative
part not been taken up. The answer is that there are some hidden
costs, some difficulties that make the thing more expensive than
it appears from a pure engineering point of view. You also have
information issues; you have asymmetric information issues; you
have rigidities in the system. That makes it difficult to realise
some of those opportunities. When it comes to buildings—dare
I say it?—the easiest way is probably just to regulate these
opportunities away rather than trying to have it done through
the market.
Ms Laurencin: I would completely agree
because on top of the hurdles that you were mentioning there is
the fact that, as an individual, if you want to invest in your
home, it might almost be more attractive to buy a new couch or
create a new kitchen rather than insulate your walls, even if
by insulating your walls you would get your money back over a
certain period of time. Because of the energy savings that you
will get from that investment, you will derive the benefit but
unless you regulate these types of investments it is very difficult
to see how it would work. I think regulation should be matched
by financial incentive to help people deal with the up front costs
which are required in this type of investment. It is difficult
to see how it would happen otherwise.
Mr Austin: It is a question of up front
costs versus ongoing costs. To insulate your house you would have
to come up with a large sum of money in one hit, whereas if you
do not insulate your house then your energy bills will be higher
by an amount. You would not know what that amount is until you
put in the installation.
Q327 Chairman: What would you do about
agriculture?
Ms Laurencin: Agriculture is a very difficult
topic.
Q328 Chairman: It contributes a significant
proportion.
Mr Fankhauser: It does contribute a huge
amount. A practical issue that we found when we looked at emissions
in the UK is that the uncertainty of monitoring is much greater
in the non-CO2, non- industrial sectors. That makes it more difficult
to structure it as a CDM project, going back to all those worries
about environmental integrity. It is far more difficult to ascertain
in those sectors just because it is more difficult to measure.
I do not think that is the reason why these things have not been
taken up. It probably has more to do with the small scale nature
of many of these things, agriculture being a very difficult sector
for foreign investors to enter and make sense of.
Mr Austin: Another reason for the low
uptake in forestry besides the slightly convoluted CDM rules around
it is that forestry credits are not admissible under the EU ETS,
which is the largest market, providing annual demand.
Q329 Lord Brooke of Alverthorpe: You
do not see any movement in these areas?
Mr Austin: There is a big discussion
going on under the Lieberman Warner Bill on the latest amendment
that was proposed which allowed tropical deforestation credits.
Q330 Lord Brooke of Alverthorpe: On agriculture,
we are taking evidence from the New Zealand government tomorrow
on their programme. More generally, could you outline for us which
countries and sectors have been the dominant sources of project
credits so far and which countries and sectors you expect to break
into the market in the future?
Mr Austin: You mentioned New Zealand
and the inclusion of agricultural land in New Zealand was controversial
because the rules devalued or increased the value of certain types
of land, so some land holders suddenly found themselves with a
considerably reduced value assets.
Viscount Ullswater: We will ask them about that tomorrow.
Q331 Lord Wallace of Tankerness: How
did that happen?
Mr Austin: There is a compliance obligation
that is placed upon the land. My understanding is that a certain
number of credits are given out once to cover the compliance obligation.
The compliance obligation is then tied to the land so if you sell
it on the new owner also has the compliance obligation as well.
Certain types of land were quite severely affected. The Maoris
were particularly unhappy as they seemed to own a fair sized tranche
of this particular kind of land. I do not know the full details
but I do know that there was a devaluation of certain types of
land.
Q332 Lord Brooke of Alverthorpe: Which
have been the dominant projects?
Mr Fankhauser: In terms of countries,
the dominant two are China and India. China tends to have bigger
projects than India. Whether one looks at it in terms of volume
or in terms of number of projects therefore makes a slight difference
but China and India between them have about half of the number
of projects. Why is that so? The projects probably go where the
emission reduction opportunities are. If one looks at how much
carbon is being emitted in CDM eligible sectors in those countries,
the picture evens out because there is a lot of carbon is emitted
in China and India. They do have a slightly bigger market share
which probably has to do with first mover advantage, putting good
institutions in place and making it easier for investors to do
CDM business in those countries. In terms of the sectors, the
earlier projects were in the industrial gases, in HFC 23, N20.
If we look at the registered projects, which are the early ones
in the pipeline, I think a third at least is from those sectors.
In the second generation of projects, these sectors have lost
a lot of their significance. What can be done there has been done.
The more recent pipeline has about one third of renewable projects
in it.
Q333 Lord Brooke of Alverthorpe: Looking
at the consequences and effects of the economic downturn that
we may be facing, have you been doing any work on what the likely
consequences of that might be on the price of carbon and, in turn,
what will be the knock-on effects from that on the system that
has been devised for 2012?
Mr Fankhauser: We did crunch some numbers
on that. We have a market that goes all the way out to 2020 and,
because we have the flexibility between years, the market can
optimise over those 12 years. If we have two years of recession
now, over a 12 year horizon it does not change all that much in
the average GDP growth over those 12 years, hopefully. Once we
know that, we have an elasticity which says a 10% reduction in
GDP growth from 2% to 1.8% would reduce the carbon price by between
4% and 4.5%. If you use that elasticity and assume that the recession
is not much more than two years, I think we should probably lose
about a euro or so in the carbon price. That is just the sheer
short and medium-term mechanics. The more complicated story is
probably what is happening in the psychology of the people who
are active in the market. Is it more difficult to have access
to credit to finance those projects? Our indications are that
one can still get money for these things at the moment but that
could affect the market more than the fact that GDP is down and
therefore emissions and prices are down.
Ms Laurencin: I would definitely agree.
There is an impact on reduction of GDP which will impact the net
demand in the EU system. That will have an impact on EUA prices
and therefore supposedly CER prices. It is also important to mention
that we anticipate that there will be a fourth phase in ETS post
2020 so it is not just a 10 year horizon. It could be more and
that is very important in the face of wider economic events. At
the same time, this could put pressure on different participants,
especially EU participants, which will have a wider level of compliance
to provide from their own portfolio of activities. It is very
important that they do so to meet their targets but, as the rapporteur
said yesterday from the Environmental Committee in Parliament,
this issue is much more important in the longer scheme of things
and so it must be dealt with.
Mr Austin: There will be a downward adjustment
in the price of carbon if output falls so to some extent it is
self-correcting. In terms of finance available for projects, I
was at the Environmental Industries Commission's carbon trading
working group this morning and this very topic was being discussed.
The general feeling was that the availability of credit was to
some extent still there. It had become more risk averse and also
the due diligence process was taking longer so there is a definite
slowing down being experienced at the moment in terms of investment
in projects as a result of the current economic circumstances.
Q334 Lord Brooke of Alverthorpe: My final
point is on the ethics. We have a new market developing at a very
fast pace indeed. In the light of recent experience and questions
being raised about markets and ethics, do you feel that the regulatory
regime is appropriate or do you see areas in which the regulatory
regime could be strengthened?
Mr Fankhauser: Something we said long
before the current crisis was that the CDM market in particular
is focusing on environmental regulation and environmental integrity.
What is lacking is the financial regulation. The FSA does not
care all that much about the carbon market just yet. That is my
understanding. Maybe there was no need until now. But the gap
is not necessarily in environmental regulation. It is there and
you could make that more efficient, more predictable and more
streamlined in the way that Miles has been talking about. The
bigger gap is financial regulation. If we want carbon to be an
asset class in the same way as other commodities are assets, then
before long we have to get serious about the financial regulation
of that asset class. So far, that has been more implicit than
explicit and probably more so than ever it is something that needs
to be addressed.
Q335 Chairman: We can have faith that
the FSA will be on the ball, can we not? I want to go back to
environmental regulation. I think what it amounts to is policing.
Some EU Member States argue very hard that their targets are too
demanding and ought to be relaxed. What is to prevent that Member
State from cheating and just letting its industries, its plants,
carry on emitting at a level that is incompatible with the EU
centrally allocated target? Does the technology exist to pick
up what a particular factory is emitting?
Mr Austin: All of the emissions reports
that installations submit are independently verified. If there
was an entire state wide conspiracy involving the whole of industry
and all of the verifiers, it would be possible to do that.
Q336 Chairman: Who are the verifiers?
Mr Austin: In Germany, for instance,
the verifiers are TUV Sud and TUV North who also verify
CDM projects so they are fairly experienced in measuring and verifying
emissions or emissions reductions.
Q337 Lord Cameron of Dillington: Are
these government organisations?
Mr Austin: No, they are private organisations.
Under the CDM, they had to be accredited, there is a formal accreditation
process. Under the EU ETS they are state accredited.
Q338 Chairman: Poland, Bulgaria and Romania?
Mr Austin: There are suggestions that
in phase three monitoring and reporting verification standards
should be standardised across the EU and I do not think that is
an unreasonable suggestion.
Q339 Chairman: Until then there is a
possibility?
Mr Austin: It would have to be a huge
conspiracy to be effective.
| 
