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However, we started not with a blank sheet of paper, but with the experience of the first two phases of the ETS. The scheme was Europe's response to the Kyoto Protocol, which runs out in 2012, so the third phase of the ETS will be a very important contribution to the next stage of European climate change planning. We have examined the scientific advice, and we have listened carefully to a number of business voices and environmental voices, as well as to Governments. There appears to be agreement that we must tackle this problem now and not leave it to future generations, but it is not clear that the scope of the trading scheme envisaged for 2013 is wide enough to deliver the reductions required to reduce emissions by 20 per cent by 2020 from the 1990 level.

Although the report notes the difficulties of including agriculture and forestry within the ETS because of weaknesses in verification and monitoring, we heard from the New Zealand Government, who seem to have overcome these difficulties. Shipping is another area that should be brought in, but the co-operation of the International Maritime Organisation is needed. Reduction measures in those sectors of the economy that are excluded from the scope of the ETS account for 50 per cent of emissions. They must be brought in before too long to provide a proper cap for the system. As an aside, the Kyoto Protocol has not been ratified by the United States, which accounts for 20 per cent of global manmade greenhouse gas emissions, while other large emitters such as India and China were not included in the protocol.

The first phase of the system allowed nation states to set their own emissions limits to reflect their commitment under the Kyoto treaty and to allocate nearly all the permits free of charge. As the noble Lord, Lord Sewel, said, this has resulted in windfall profits for some industries. However, with the carbon price at about €8 or €9 per tonne last week, it is unlikely to stimulate environmentally efficient investment. Governments will lose out on expected revenues while companies sell unwanted permits in order to maximise their cash positions because of the recession.

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We have argued that all the permits, other than those in the sectors liable to carbon leakage, should be auctioned in the third phase, in order to allow the marketplace to find the correct level. There is no doubt that the oil price and the carbon price are related, hence the dramatic fall in the price of the permits. It is considered that permits trading in the range of €35 to €45 would provide the necessary stimulus to encourage green investment decisions. However, the decision taken by the European Council in December 2008 watered down its original proposals, and it has agreed that 70 per cent of permits should be auctioned by 2020 and 100 per cent by 2027.

Although it is tempting to comment on all the recommendations in our report, I shall comment on only one further point which I consider to be important—the use of external credits. In our report, we suggest that external credits in phase 3 should be limited to those available and unused in phase 2. We note in paragraph 225:

“External credits can play an important role in reducing global emissions cost-effectively as long as they do not crowd out developing countries’ own efforts to cut emissions”.

The offset mechanisms created under the Kyoto Protocol are the clean development mechanism and joint implementation. These are methods to allow businesses and Governments in developed countries to fulfil their emission reduction commitments by purchasing carbon credits generated by projects that result in emission reductions elsewhere. Over 1,000 projects have been registered with the CDM executive board. The UK was the primary purchaser of 59 per cent of CDM/JI credits in 2007, largely for onward transmissions. The EU will have to monitor this trade very carefully to make sure that the emissions target set for the various member states is not fulfilled more than their allocation by external credits.

The European Council meeting in December had to balance the scientific evidence and the agreed targets for emission reduction against the political climate of a deepening recession. That is what politicians do; and, of course, the result was a bit of a fudge, with brave words about commitment and then the announcement of a compromise deal. There is auctioning phased in over a much longer period, with extra time-limited derogations and the continuation of free permits in several sectors. The threshold for small emitters was raised from 10,000 tonnes to 25,000 tonnes. Generous concessions were made on the extent to which national targets on CO2 reduction could be made by CDMs. The energy trading system is a tax on industry, which will be passed on to consumers by higher prices, especially in the energy field. With demand for industrial products falling fast, businesses will have to think very carefully about energy-efficient investments, but without that investment we run the risk of missing our national target and the EU its commitment to the international protocols.

5.38 pm

Baroness Sharp of Guildford: I thank the noble Lord, Lord Sewel, both for his excellent introduction to the debate and for his chairmanship of the committee, of which I was a member.

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The noble Lord, Lord Sewel, described the emissions trading scheme as hugely complex and cumbersome. Yet, in essence, it is actually a very simple scheme. Once—this in itself is something of a question—you can measure carbon emissions among large carbon emitters, you place a cap and, in principle, the tighter you screw that cap, the greater the demand for permits and the higher the price. As the price rises, so this encourages those who can easily make savings in emissions to do so, thus providing an incentive to energy efficiency and innovation. The cap puts on the pressure to reduce emissions while the trading allows this pressure to be absorbed flexibly by those who can most easily change their ways.

This hands-off market mechanism has a lot of attractions for government because it is neutral—it is the market that is effecting the changes—and it has indeed been the Government’s favoured way of cutting carbon emissions not only within the EU as a whole but specifically for the UK. A series of White Papers has come out. In the 2006 White Paper, the Government described the EU Emissions Trading Scheme as the cornerstone of the Government’s policy framework to tackle climate change. It is the main policy that we have picked up in this country for tackling climate change. The energy policy White Paper of May 2007 said:

“The best way to encourage a change in investment patterns towards a low-carbon economy, and the most cost-effective way of reducing global emissions, is to establish a price for carbon ... Trading mechanisms such as the EU ETS and the CDM”—

the clean development mechanism—

Phase 1 of the EU scheme ran from January 2005 to December 2007—three years in all—and in many respects was a success, although I know that the noble Lord, Lord Sewel, has picked up some of the other aspects of it. It embraced more than 11,000 firms, and covered all major power stations and industrial installations in 25 countries, which together are responsible for some 45 per cent of carbon dioxide emissions in the EU, with the vast majority of these installations reporting their independently verified CO2 emissions and surrendering the appropriate number of allowances to cover them to the required deadlines. In addition, an active market for emission permits was established, with the City of London as its headquarters.

Nevertheless, phase 1 failed miserably to achieve its main aim: the reduction of carbon emissions. Allocations to emit carbon, which were agreed by national Governments for each member state under a national allocation plan, were much too generous, and as a consequence the market price of carbon collapsed before the end of the three-year period. That provided no incentive to any installation to cut emissions. Instead, it put large profits—both noble Lords mentioned this—into the pockets of utilities that had raised prices to consumers in anticipation of increased costs.

Phase 1 has generally been regarded as a learning phase. Phase 2 came into play on 1 January 2008 and is for five years, lasting until 31 December 2012. It has promised to make good many of the deficiencies of phase 1. The Commission has set a much tighter cap—6.5 per cent below 2005 levels—to meet our

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Kyoto targets, and has vetted the national allocation processes to prevent overgenerous allocations. Only 90 per cent of the allocations were awarded free of charge; the remaining 10 per cent are to be auctioned. More plants and installations were brought into the scheme and include the aviation sector, which is to come in on 1 January 2012.

As the noble Lord, Lord Sewel, said, with only one year’s trading to date it is much too early to judge how far the new scheme will succeed. However, it is noteworthy that, as in phase 1, the price of emissions permits has fallen. On this occasion, the blame is very much with the recession; the noble Viscount, Lord Ullswater, mentioned the degree to which the price of permits has fallen.

Our report, as the noble Lord, Lord Sewel, said, is not about phase 1 or phase 2, but actually about phase 3, which is to start in 2013 and run through to 2020. The Commission’s proposal for phase 3, which it produced last spring, was successfully negotiated through the Council in December, with final clearance due later this week. Again, the proposals take into account the lessons learnt from phase 1. Instead of a series of national caps, there is to be a single EU cap which would hold, and the aim would be to cut emissions by some 21 per cent. A number of new industries such as petrochemicals and aluminium are to be brought in, and a much larger proportion of emissions licences will be auctioned. As the noble Viscount, Lord Ullswater, mentioned, the committee would also opt for a larger proportion. However, under the concessions made in the December talks we see that in fact a number of Governments have caved in, so it looks as though it will be smaller rather than larger. Where permits are given away rather than auctioned, it is in effect a subsidy for the utilities and firms concerned. New regulations on monitoring and verification are to be introduced, and the degree to which external credits can be used to offset domestic emissions under ETS obligations will be restricted.

Our report examined the proposals put forward by the Commission last summer and in general endorsed the stronger stance, particularly the notion of a tighter overall cap—a 30 per cent rather than 20 per cent reduction—provided that a broader agreement was reached in Copenhagen around climate change. If the ETS is to work, it is sensible to extend its coverage to areas such as transport and shipping. Agriculture and forestry, as the noble Viscount, Lord Ullswater, mentioned, were the subjects of an interesting teleconference with the New Zealanders on their approach to these measures. However, I do not agree that they are coping with it all, and indeed it struck me that they still have much to learn. We are also particularly keen to see auctioning extended and the free allocation of permits limited to those industries that are likely to relocate out of the EU—those that comprise the so-called carbon leakage.

We are and have been much in accord with the UK Government in all this, as their response to our report implies. However, we part company on two issues. First, we have argued that where allowances are auctioned, part of the revenue should be ring-fenced for policies that promote low-carbon technologies. The noble Lord, Lord Sewel, mentioned the importance we place on

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promoting carbon capture and storage. The Commission asked that a proportion of these funds be put at its disposal, but we agree with the Government that that is not a good idea. However, the money should be directed as a matter of urgency into R&D in the UK. We also parted company over the use of clean development mechanisms and similar schemes for offsetting carbon. While understanding the general argument that a reduction in carbon usage is just as useful whether it derives from an advanced country such as the UK or from a developing country such as Nigeria, it nevertheless sends all the wrong messages. If we are to meet the tough carbon reduction targets necessary to prevent global warming, all countries have to make the shift towards low-carbon technologies, with the developed countries leading the way.

In this respect, I think that the agreement on these issues concluded last December in Brussels was extremely disappointing, caving in as it did to much too great an extent to national and industrial interests on so many points where a tough stance was needed—the commitment to the 30 per cent target is still very tenuous; limiting the number of new industries to be brought into the fold was not clear; there was a caving in on the auctioning of allowances and allowing free allocations to a lot of the major players; and there was agreement that up to two-thirds of emissions reductions could be outsourced to third-world countries.

I can only agree with a letter written to the Guardian by the Green MEP, Caroline Lucas, who was a member of the European Parliament’s team working on the package. She wrote:

“EU leaders ended up with such a dramatically weakened agreement, devoid of any serious ambition ... A 20 per cent emissions reduction target by 2020 is far too little too late and, scandalously, around two-thirds of the emissions reduction could be outsourced to developing countries. This is scientifically unsound and ethically wrong. It means the EU can cherry-pick the cheapest climate mitigation potential in developing countries in order to prolong our own unsustainable model”.

I have for some time been something of a sceptic about the European Emissions Trading Scheme. I worried that it was too clever by half to work effectively, another of those schemes dreamt up by economists that get distorted in practice and never work out as planned. I confess that the probing that we undertook as a committee for the report somewhat reassured me. For all its limitations, it seemed to be beginning to get a carbon market off the ground and to provide a model that could be extended to link with others—a link that would be so important if President Obama manages to get a similar scheme off the ground in the United States.

Although my scepticism is somewhat abated, it is important to put the ETS into perspective. Its record is, as we say in the final chapter of our report, unproven. In particular, the UK Government need to beware of putting too many of their eggs in that one basket. Few dispute today the gravity of the climate change agenda. All the data coming out of last week's science meeting in Copenhagen emphasise how important it is. It is important that the Government back the scheme as wholeheartedly as they can, but other policies on that agenda that promote energy efficiency and encourage the uptake of low-carbon technologies also play a part

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in the strategy. As I have said before, the public mood is now receptive to the climate change message and the public are looking to the Government to provide the lead. Hiding behind the seeming neutrality of market mechanisms is not necessarily the most effective way to show that leadership.

5.52 pm

Lord Giddens: I venture with some trepidation into this incestuous debate, but I start by congratulating the committee on the excellence of its report. I do not want to question its excellence, but I want to comment on the wider context of the ETS. It is worth remembering its background. The European Commission originally wanted a carbon tax. Carbon markets have their origin in the US, where they were used with some success to control emissions of sulphur dioxide. The EU switched to carbon trading in the face of opposition to EU-wide taxes, and I fear that this country was one of those opposing such a tax.

The Commission originally proposed to auction credits. The noble Baroness mentioned economists. Some American economists invented the notion of carbon trading. It is worth remembering that they insisted that auctioning the credit was crucial for the success of the scheme. What happened in the European Union in the run-up to phase 1 was that lobbying from business and some nations sunk the proposal to auction credits.

That is one, but not the only, reason for the conclusion drawn by the noble Baroness, Lady Sharp, which I also draw, that phase 1 of the ETS was a failure. As is mentioned in the report, the Commission likes to call it a learning experience. Putting it bluntly, one has to say that it is a failure. We have some data on its consequences for lowering emissions. Some studies indicate that emissions were something like 5 per cent lower than they would otherwise have been if the scheme had not come into operation. That figure is almost certainly empty. It is more apparent than real, because it probably comes from the fact that originally member states produced tactical exaggerations of their emissions in the build-up to the scheme. We know that they did that; it is quite well documented.

I am pleased to see, in a phrase that was also quoted by the noble Baroness, Lady Sharp, that the committee says that,

I hope, with the committee, that the scheme in its new form will meet with success, but it is plainly an open question at the moment. The noble Baroness, Lady Sharp, also said that it is worth asking why Governments like emissions trading schemes. In principle at least, they are quite popular with Governments. The reason is basically the one to which the noble Baroness alluded; all will be resolved by the magic of markets, and it does not seem like a tax even though it is a tax, so it has a certain intuitive political appeal.

The ETS in its new form, just like in its previous forms, must be situated in the context of a diversity of other policies and strategies that Governments have to follow. To me, that is a really crucial point, and I should like to make three sets of observations about it.

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First, we must be careful not to measure success in terms of turnover. I have seen this so much in studying the literature on this over the past year. In 2007, the World Bank estimated the size of the global carbon market at $64 billion a year. Yet plainly that is irrelevant. What counts is how far it has actually reduced emissions. The report has a very good section on monitoring and standards, but it mostly covers monitoring the standards involved in the actual operation of the scheme itself. It is crucial that we monitor outcomes, but this is not discussed in the report. We must try to work out how far such schemes on the ground actually reduce the proportion of CO2 or greenhouse gases going into the atmosphere. I assure noble Lords that we have only very partial data on this at the moment. Most of those who favour carbon trading talk in terms of the sheer volume of trading that is generated. Whatever other benefits that might bring, it does not show us anything about the case under consideration.

Secondly, as noted on page 18 of the report, carbon pricing on its own will not deliver new technologies, although it could provide something of a stimulus to them. As for low-carbon technologies and limiting emissions, we need one or more significant technological breakthroughs.

I note what the committee says on CCS. The committee is discussing it in the context of the emissions scheme. As noble Lords quite rightly said, it is problematic. We do not really know how effective it will be in the longer term, no matter how much money is pumped into it. I feel very strongly that, alongside the ETS, Governments need to reverse their attitude towards technological innovation. I remember the noble Lord, Lord Browne, speaking eloquently about this in a debate that we had in your Lordships’ House about climate change. Governments should talk less about costs and emphasise competitive advantage instead. They should stop talking only of problems and start talking of opportunities.

I note that President Obama has been dragged into duty in this discussion. He wishes to set up a trading scheme for the United States, but there is a massive contrast between his approach to climate change and innovation and that of the European Union, which—and I say this as a strong pro-European—is still a typically bureaucratic, complicated concern with regulation above all. President Obama’s approach has an inspirational quality to it. He says, “Look, we’re on the cusp of a new economy. Let’s invest in it and promote innovation. Let’s see if government can help businesses to secure a competitive edge”. There is probably a gestalt switch in business and technology whereby the companies that are environmentally progressive will be more competitive in the marketplace, and a strong reversal of emphasis is needed to go along with carbon trading and the other target and regulation-bound commitments to which the Government have signed up.

Thirdly, no matter how successful or otherwise the European trading system might be, it will not take away the need for a robust fiscal policy, and the Government should not shirk from that. We know that fiscal policy must take the form of a mixture of penalties and incentives. We know, not least because of work done in BP and the inspiration of the noble Lord, Lord Browne, that however the carbon cap is

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set, it is not going to be enough to guarantee adequate pricing for most low-carbon technologies. We know that we will need further taxation-based platforms for those technologies to get off the ground, because they are not competitively priced against existing fossil fuel technologies.

We also know that we need an overall fiscal order on climate change. I have been studying all the major EU countries that are signed up to the ETS in this respect, and I have found that hardly any of them have made an overall fiscal audit. By that I mean not only introducing carbon-based taxes but auditing existing subsidies for fossil-fuel businesses. I do not know how far the Government have got in making such an audit, but I would like to see them at the leading edge of the European countries in so doing.

My conclusion is that the report should be situated in a wider context, which has to involve diversity of policy. Wherever one looks in climate change—I say this having now spent a couple of years immersed in the literature of it all—there are strongly problematic elements. I support the principle of a more rigorous European trading scheme for carbon trading. I also support the principle of the internationalisation of that scheme, but that second objective is a long way off.

At the moment, my conclusion will be similar to that of the noble Baroness, Lady Sharp, in that there is a strong component of faith in the ETS at the moment. It can therefore be no more than one set of policies in the context of a whole series of other robust policies that have to be instituted elsewhere.

6.04 pm

Lord Cameron of Dillington: I, too, served on Sub-Committee D and was involved in the report. I say without any embarrassment that I found it an immensely complicated area, even if others seem to find it basic.

If an emissions trading scheme were to work effectively day to day worldwide, it would be a step forward for mankind that was almost on a par with the introduction of paper money and banks 250 years ago.

Lord Sewel: Look where that got us.

Lord Cameron of Dillington: That is the point; that introduction involved a whole new way of thinking about wealth and prosperity as well as—for most of the time, anyway—being a major boost to the world economy. A worldwide carbon trading scheme would also involve a whole new way of thinking, and the idealists hope that it will represent a major new economy and increased prosperity as well as saving the world. They are idealists, after all. They might eventually be right, but at the moment the Stern review describes the economics of climate change as,

We have a long way to go, and therein lies the problem; how do we get from here to there, particularly now that we are in a worldwide recession and, as has been alluded to, the carbon price has fallen as low as €8 a tonne? It is, however, a road that we have to take. I

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need only repeat the Stern review mantra that the sooner we take action, the less it will cost us in the long run.

Furthermore, we do not need only an EU ETS; we must end up with a worldwide scheme. The EU is responsible for only 14 per cent of the world's CO2 emissions, so a 20 per cent cut on the EU stage would represent only a 3 per cent cut in global emissions. We need a worldwide scheme, and eventually we need to think of a carbon economy that affects not only all businesses but all people. Having said that, my two messages for today are: first, “softly, softly, catchee monkey”; and, secondly, let us try to create a climate of certainty over a long period so that businesses and individuals know where and how to invest over a 20-year period.

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