Interaction between the EU ETS and UK climate policy
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Back to the Drawing Board? Implications of the EU Emissions Trading Directive for UK Climate Policy Steve Sorrell Environment and Energy Programme January 2003 Research funded by the European Commission under the project Interaction in EU Climate Policy (INTERACT) Acknowledgements This research has been supported by the European Commission under the project Interaction in EU Climate Policy (INTERACT).1 The INTERACT project is co-ordinated by SPRU (Science and Technology Policy Research) at the University of Sussex, and involves partners in France, Germany, Greece and the Netherlands. The project is studying the conflicts and synergies between different climate policy instruments at the national and EU levels, with particular reference to emissions trading. The present report forms one part of the UK case study. The author would like to thank the many individuals who gave up their time to be interviewed for this project. These include representatives from the Department of Trade and Industry, the Department of Environment, Food and Rural Affairs, the Confederation of British Industry, UK electricity generators, manufacturing industry, and energy brokerage and advisory companies. Thanks also to the attendees at a SPRU workshop on the ‘Implementation of the EU Emissions Trading Directive in the UK’, held in June 2001, together with attendees at workshops on the same topic organised by the UK Carbon Trust and the Ad Hoc Group on Energy Taxation Strategy (AHGETS). Finally, thanks to Adrian Smith and Jos Sijm for helpful comments. The usual disclaimers apply. 1 EVK2-2000-00613. Contents ACKNOWLEDGEMENTS ................................................................................................................................. I CONTENTS ......................................................................................................................................................... II TABLES AND FIGURES ................................................................................................................................. III ABBREVIATIONS AND ACRONYMS ...........................................................................................................IV EXECUTIVE SUMMARY ................................................................. ERROR! BOOKMARK NOT DEFINED. CORE THEMES .................................................................................................................................................... VI Policy interaction and ‘double regulation ................................................................................................... vi Ownership of emissions and double counting .............................................................................................. vi Differential treatment and equivalence of effort ......................................................................................... vii Linking trading schemes and the fungibility of trading commodities.......................................................... vii CORE CHOICES IN UK CLIMATE POLICY ............................................................................................................VII The choice of policy objectives for each instrument: ................................................................................... ix The choice between upstream and downstream policy instruments ............................................................. ix The choice between direct and indirect treatment of electricity emissions .................................................. ix The choice to protect the domestic consumer. .............................................................................................. x POLICY RECOMMENDATIONS .............................................................................................................................. X 1. INTRODUCTION ............................................................................................................................................ 1 1.1 THE EU EMISSIONS TRADING SCHEME ......................................................................................................... 2 1.2 THE EU EMISSIONS TRADING SCHEME AND UK CLIMATE POLICY ............................................................... 5 1.3 CORE ISSUES IN POLICY INTERACTION........................................................................................................... 6 Policy interaction and double regulation ...................................................................................................... 6 Ownership of emissions and double counting ............................................................................................... 7 Differential treatment and equivalence of effort ........................................................................................... 7 Linking trading schemes and the fungibility of trading commodities............................................................ 7 1.4 ANALYSING INTERACTIONS .......................................................................................................................... 8 2. INTERACTION BETWEEN THE EU ETS AND THE UK CCL/CCLA PACKAGE ............................ 10 2.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 10 2.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 13 2.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 13 2.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 14 2.5 POLICY OPTIONS ......................................................................................................................................... 16 2.6 RECOMMENDATIONS ................................................................................................................................... 18 3. INTERACTION BETWEEN THE EU ETS AND THE UK ETS DIRECT PARTICIPANT SCHEME .............................................................................................................................................................................. 19 3.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 21 3.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 21 3.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 22 3.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 22 3.5 POLICY OPTIONS ......................................................................................................................................... 23 3.6 RECOMMENDATIONS ................................................................................................................................... 24 4. INTERACTION BETWEEN THE EU ETS AND THE UK ETS PROJECT SCHEME ........................ 25 4.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 25 4.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 26 4.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 26 4.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 27 4.5 POLICY OPTIONS ......................................................................................................................................... 28 4.6 RECOMMENDATIONS ................................................................................................................................... 29 5. INTERACTION BETWEEN THE EU ETS AND THE UK IMPLEMENTATION OF THE IPPC DIRECTIVE ....................................................................................................................................................... 30 5.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 31 5.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 32 5.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 33 5.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 33 5.5 POLICY OPTIONS ......................................................................................................................................... 34 5.6 RECOMMENDATIONS ................................................................................................................................... 35 6. INTERACTION BETWEEN THE EU ETS AND THE UK RENEWABLES OBLIGATION .............. 36 6.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 36 6.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 37 6.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 38 6.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 38 6.5 POLICY OPTIONS ......................................................................................................................................... 40 6.6 RECOMMENDATIONS ................................................................................................................................... 43 7. INTERACTION BETWEEN THE EU ETS AND THE UK ENERGY EFFICIENCY COMMITMENT .............................................................................................................................................................................. 44 7.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 45 7.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 45 7.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 46 7.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 47 7.5 POLICY OPTIONS ......................................................................................................................................... 47 7.6 RECOMMENDATIONS ................................................................................................................................... 49 8. CHOICES IN UK CLIMATE POLICY ....................................................................................................... 50 8.1 THE CHOICE OF POLICY OBJECTIVES FOR EACH INSTRUMENT ...................................................................... 50 8.2 THE CHOICE BETWEEN UPSTREAM AND DOWNSTREAM POLICY INSTRUMENTS ............................................ 51 8.3 THE CHOICE BETWEEN DIRECT AND INDIRECT TREATMENT OF ELECTRICITY EMISSIONS ............................. 52 8.4 THE CHOICE TO PROTECT THE DOMESTIC CONSUMER .................................................................................. 53 9. SUMMARY ..................................................................................................................................................... 55 10. FURTHER READING ................................................................................................................................. 59 REFERENCES ................................................................................................................................................... 60 Tables and Figures TABLE E.1 INTERACTION ISSUES FOR EACH OF THE SELECTED INSTRUMENTS .......................................................VII TABLE E.2 SPECIFIC POLICY RECOMMENDATIONS .................................................................................................XII TABLE 1.1 KEY ELEMENTS OF THE PROPOSED EU EMISSIONS TRADING SCHEME.................................................... 3 TABLE 1.2 THE NATURE OF THE INTERACTION BETWEEN UK POLICY INSTRUMENTS AND THE EU ETS .................. 9 FIGURE 2.1 OVERLAPS BETWEEN THE TARGET GROUPS FOR THE EU ETS, IPPC, CCL AND CCAS ....................... 11 TABLE 2.1 INCENTIVES FOR LOWER CARBON EMISSIONS FROM ELECTRICITY GENERATION ................................... 12 TABLE 2.2 CATEGORISING THE POTENTIAL INTERACTIONS BETWEEN THE EU ETS AND THE CCL/CCA PACKAGE .................................................................................................................................................................... 15 FIGURE 3.1 INTERNAL INTERFACES IN THE EU ETS .............................................................................................. 19 TABLE 3.1 COMPARISON OF THE UK ETS AND THE EU ETS................................................................................. 20 TABLE 3.2 FACTORS INFLUENCING THE FUNGIBILITY OF UK ETS AND EU ETS ALLOWANCES ............................ 24 TABLE 5.1 COMPARISON BETWEEN EMISSIONS TRADING AND IPPC. ..................................................................... 31 FIGURE 6.1 SUPPLY CURVE FOR RENEWABLES....................................................................................................... 39 FIGURE 6.2 COEXISTENCE OF THE RO AND THE EU ETS LEADS TO DOUBLE CREDITING ....................................... 40 TABLE 6.1 DEFINITIONS OF RENEWABLE ELECTRICITY UNDER DIFFERENT POLICY INSTRUMENTS ......................... 42 TABLE 9.1 INTERACTION ISSUES FOR EACH OF THE SELECTED INSTRUMENTS ........................................................ 55 TABLE 9.2 SPECIFIC POLICY RECOMMENDATIONS ................................................................................................. 57 iii Abbreviations and acronyms AAU CCL CCA CDM CHP DEFRA DETR DTI ECA EEC ERU ETS EU ETS EU GHG IET IPPC JI LCP LEC NETA RO ROC SDC TGC UK ETG UK ETS UKCP Assigned Amount Unit Climate Change Levy Climate Change Agreements Clean Development Mechanism Combined Heat and Power Department of Environment, Food and Rural Affairs Department of Environment, Transport and the Regions Department of Trade and Industry Enhanced Capital Allowance Energy Efficiency Commitment Emission Reduction Unit Emissions Trading Scheme EU Emissions Trading Scheme European Union Greenhouse Gas International Emissions Trading Integrated Pollution Prevention and Control Joint Implementation Large Combustion Plant Levy Exemption Certificate New Electricity Trading Arrangements Renewables Obligation Renewables Obligation Certificate Sustainable Development Commission Tradable Green Certificate UK Emissions Trading Group UK Emissions Trading Scheme UK Climate Programme iv Executive Summary On the 10th December 2002, European environment ministers agreed the ground rules for an EU-wide scheme for greenhouse gas emissions trading, thus paving the way for the largest and most ambitious trading system yet seen. The design of the EU Emissions Trading Scheme (EU ETS) represents a pragmatic compromise between economic efficiency and political acceptability and has won the broad support of both industry lobbyists and environmental groups. The Directive must still obtain the approval of the European Parliament, but there appears a very good chance that it will come into force in January 2005 as planned. This report explores the implications of the Directive for seven instruments within UK climate policy: the Climate Change Levy (CCL); the Climate Change Agreements (CCA); the UK Emissions Trading Scheme (UK ETS) - direct participants; the UK Emissions Trading Scheme (UK ETS) - emission reduction projects; the Integrated Pollution Prevention and Control Directive (IPPC); the Renewables Obligation (RO); and the Energy Efficiency Commitment (EEC). The main message of the report is that the Directive has major implications for the first four of these instruments and non-trivial implications for the remaining three. Since these instruments form the basis of the UK Climate Programme (UKCP), it follows that core elements of that programme may need to changed. The UK government does not appear to have fully acknowledged this and the implications of the Directive are only beginning to be appreciated by relevant stakeholders and commentators. Throughout the negotiation of the Directive, the strategy of the UK government has been to secure opt-out provisions. But this strategy has only been partially successful. The Directive allows only a portion of sectors to opt-out for only the first phase of the scheme (2005-2007). In the absence of national opt-out provisions, a strategy for implementing the Directive in the UK needs to be developed. This is likely to require changes to UK climate policy before 2005 and a major overhaul by 2008. None of this was anticipated when the UK Climate Programme (UKCP) was developed or when key elements of this Programme, such as the CCAs, were negotiated. There is a need, therefore, for a debate on the preferred shape of UK climate policy into the first Kyoto commitment period (2008-2012) and beyond and on the role of the EU ETS within the UK policy mix. This report is closely linked to an earlier report: The Climate Confusion: implications of the EU Emissions Trading Scheme for the UK Climate Change Levy and Climate Change Agreements, which was published in November 2002 (Sorrell, 2002a). The present report updates the conclusions of this earlier report to reflect the political agreement on the EU Directive, as well as extending the analysis to five other UK policy instruments. The aim of the report is to explore the nature of the issues that arise from the interaction between the EU ETS and the selected climate policy instruments and to identify the ways in which conflicts v can be avoided and synergies created. The report takes a structured approach to analysing policy interaction, examining in turn: the scope of the instruments, where scope means the sectors, sites, portions of sites and individual emission sources that are directly or indirectly affected by each instrument; the objectives of each instrument and the extent to which these reinforce or conflict with one another; the timing of the instruments in relation to each other and the Kyoto commitment period; and the operation of each instrument and the interactions between them assuming that they exist in parallel. For each instrument, one or more policy options are examined that could reduce the conflicts and/or encourage synergies with the EU ETS. On the basis of this analysis, a number of policy recommendations are made. Core themes The potential interaction between the EU ETS and UK climate policy raises four generic issues: Policy interaction and ‘double regulation The issue here is the extent to which any apparent ‘double regulation’ will be seen as imposing unfair burdens upon particular target groups. Double regulation may be loosely defined as a situation where an individual target group is affected by two or more instruments that have very similar objectives. While ‘double regulation’ is a negative term, there may be many instances where the interaction between policy instruments may be either acceptable or positively beneficial. To assess whether this is likely to be the case in any particular instance, it is necessary to examine the multiple objectives of each instrument, the obligations and incentives they place upon individual target groups, and the likely consequences in practice. Ownership of emissions and double counting The issue here is the ‘ownership’ and ‘control’ of carbon emissions and the problems that arise if ownership is disputed. For example, the EU ETS gives the ownership of emissions from electricity generation to power stations, while much of UK climate policy gives ownership to electricity consumers. Ownership disputes may lead to: a) double coverage, where two instruments give ownership of the same physical emissions to two separate parties, (or to the same party under two separate terms); and b) double crediting, where disputing claims over the ownership of emissions allow two separate carbon allowances or carbon credits to be generated from a single abatement action. Each type of problem introduces complexity into the regulatory situation and double crediting may threaten the environmental integrity of an emissions trading scheme. vi Differential treatment and equivalence of effort The issue here is the extent to which different groups are treated differently by environmental policy instruments and whether the obligations imposed upon one group can be deemed equivalent to those imposed upon another. Differential treatment may be challenged on legal, political or environmental grounds and is of central importance in the political debate over climate policy. Demonstration of equivalence of effort may be required as a means to avoid differential treatment when an installation, company, sector or Member State is exempted from a particular policy instrument. But in practice, differences in the scope, form and stringency of policy instruments may make equivalence of effort extremely difficult to assess. Linking trading schemes and the fungibility of trading commodities The issue here is the extent to which two trading schemes may be linked by the exchange of environmental commodities. The transfer of environmental commodities between two schemes will be governed by transfer rules, which may restrict movements in either direction or discriminate between commodities according to their origin (e.g. disallowing carbon credits from nuclear projects), together with exchange rules which establish the equivalence of commodities with different denominations. The combination of transfer and exchange rules defines the fungibility of the trading commodities - which means the extent to which the commodity used for compliance with the first scheme can also be used for compliance with the second. These rules will determine the scope for trading between the two schemes and the consequences of such trading. Table E.1 summarises the relevance of each of these themes for each of the instruments examined. Table E.1 Interaction issues for each of the selected instruments Acronym Double regulation Double counting Differential treatment Linking CCL CCAs UK ETS (DPs) UK ETS (projects) IPPC RO EEC Illustrative problems The following provides a number of examples of how these issues arise for individual instruments. vii Double regulation Electricity generators will incur abatement costs through participating in the EU ETS and will pass these on in electricity prices. Many electricity consumers are already paying the CCL, while others have targets for electricity consumption under their CCAs. These consumers will be effectively paying twice for the carbon emissions associated with electricity generation. Best Available Technology (BAT) regulation under IPPC is incompatible with emissions trading. BAT is frequently implemented through technology requirements rather than emission limits, but currently there is no provision for technology requirements to be relaxed for EU ETS participants. Double counting A CCA facility that improves electricity efficiency can create allowances for sale in the UK ETS. At the same time, the corresponding reduction in electricity generation will ‘free up’ allowances held by the electricity generators in the EU ETS. Two allowances will then be circulating for a single abatement action. A similar problem arises in the UK ETS project scheme when a project is awarded carbon credits for improving downstream electricity efficiency. If these credits are subsequently traded into the EU ETS, the cap will be breached and the environmental integrity of the scheme will be undermined. Equivalence of effort Some of the participants in the UK ETS are also eligible for the EU ETS. Since participation in both is likely to be unacceptable, these installations may seek to opt out. But subsidised abatement under the UK ETS is unlikely to be considered equivalent to mandatory targets under the EU ETS. A large number of CCA facilities may seek to opt out of the first Phase of the EU ETS. But equivalence of effort will be difficult to prove since the CCA targets are different in scope (coverage of emission sources), form (relative versus absolute targets) and stringency (economic versus technological potential) from the targets under the EU ETS. Linking The Commission may prevent trading between the UK ETS and the EU ETS owing to concerns about non-CO2 gases, hot air and double crediting. But this would leave the UK market relatively small and isolated and UK companies would be unable to benefit from EU-wide trading. If the Commission wanted to preserve environmental integrity by preventing UK project credits from entering the EU ETS, it would have to prevent any trading between the UK and EU schemes. This is because restrictions on the import of carbon allowances according to origin can be very easily circumvented. viii Core choices in UK climate policy To resolve these problems, it will be necessary to re-examine four key choices within UK climate policy: The choice of policy objectives for each instrument Double regulation may be considered acceptable where two instruments have different (if overlapping) objectives. For example, the coexistence of the EU ETS with the RO may be considered acceptable as the objectives of the latter go beyond CO2 abatement alone. But one difficulty with UK climate policy is that some instruments (notably the CCL), have multiple and partially conflicting objectives. A core objective of any climate policy should be to ‘internalise the external cost of carbon emissions’. But this may be subdivided into: a) internalising the cost of carbon in investment and operational decisions; and b) ensuring that polluters pay for the damage caused by residual emissions. Owing in part to pressure from the UK, the EU ETS uses free allocation of allowances in Phase 1 (2005-2008) and allows a maximum of 10% of allowances to be auctioned in Phase 2 (2008-2012). This means that, while the EU ETS can fulfil the first of these two objectives it can make only a limited contribution to the second. In contrast, carbon taxes can fulfil both objectives and can raise revenue which may substitute for other forms of taxation (‘environmental tax reform’). These considerations are central to decision-making on the future of the CCL and may override concerns about double regulation. The choice between upstream and downstream policy instruments Both emissions trading and carbon taxation can be implemented either upstream (on energy suppliers) or downstream (on energy users). While both options have their pros and cons, the EU ETS has constrained future policy by choosing a downstream scheme. Any attempts to introduce upstream carbon taxes along the lines recently proposed by the Royal Society (2002), will inevitably lead to double regulation for all fuel and electricity use by all participants in the EU ETS. The cost implications of this will either be politically unacceptable or will impose strict limits on the size of any upstream tax. But if UK climate policy remains downstream, carbon prices are unlikely to be uniform for all sectors and fuels. The choice between direct and indirect treatment of electricity emissions Most of the incompatibilities between the EU ETS and UK climate policy stem directly from their differing treatment of electricity. The EU ETS uses direct treatment of electricity emissions, where the ‘ownership’ of electricity emissions is allocated to the electricity generators, while UK climate policy uses indirect treatment, where ownership is allocated to electricity consumers. Combining the two leads to repeated problems of double coverage and double crediting. But it is important to distinguish between: a) situations where double crediting is effectively cancelled out by double coverage (CCAs, direct participants); and b) situations where the double crediting is not cancelled out (emission reduction projects, RO and EEC). The first does not threaten the environmental integrity of the EU ETS, while the second may do. A key challenge, therefore, is to find ways to mitigate this risk whilst retaining the valuable incentives created by the UK policy instruments. ix The choice to protect the domestic consumer The incompatibilities between the EU ETS and UK climate policy can be traced back to the choice to protect the domestic consumer from energy price increases. It is this which led the government to choose indirect treatment of electricity for the CCL in order to shield fuel poor consumers from electricity price rises. It follows that the elimination of fuel poverty is necessary not only to curb emissions from the domestic sector, but also to rationalise climate policy for other sectors. While the EU ETS will raise electricity price rises for domestic consumers, the increase appears unlikely to be excessive when set in the context of a 26% reduction in domestic electricity prices since 1995. Moreover, there are a number of options available to compensate fuel poor households and to encourage greater investment in energy efficiency in this sector. The EU ETS makes consideration of such approaches all the more urgent. UK climate policy is likely to remain unnecessarily complex and inefficient until the fuel poverty problem is eliminated. Policy recommendations Table E.2 summarises the policy recommendations made in this report. These recommendations are based upon a number of principles including: Goals: The development of policy options should be based upon clear principles and longterm goals. For climate policy, a stable an effective policy framework is required during the Kyoto commitment period. This means that policy should be developed by working back from where we want to be in 2008. Carbon pricing: Energy users in all sectors should pay for carbon emissions, whether through taxation or emissions trading. In the long term, organisations in the public, commercial and industrial sectors should either be paying a carbon tax or participating in a trading scheme. Supplementary policies will be required to address other barriers to energy efficiency and to achieve other policy objectives (e.g. promoting renewables). But for each target group, only a single instrument should be used for carbon pricing. Electricity: The approach in the EU ETS is preferable because: first, it gives ownership of electricity emissions to the companies directly responsible for the control of those emissions, thereby incentivising both fuel switching and energy efficiency; and second, it facilitates cross-border electricity trade in the EU. Targets: Absolute targets are to be preferred over relative targets because of their greater environmental integrity and consistency with the national emission targets under Kyoto. And allowance based trading is to be preferred over baseline and credit trading due to its greater economic efficiency, lower transaction costs and consistency with the Kyoto framework. The EU ETS reflect these considerations while the CCAs do not. The latter should therefore be considered a transitional measure only. Supplementarity: There is a risk that abatement in the EU ETS will be achieved through purchasing cheap ‘hot air’ from outside the scheme, rather than through domestic action. But domestic abatement may be incentivised by either restricting the interface between the EU ETS and the international carbon market, or by retaining (or establishing) ‘backup’ regulations for EU ETS participants. The first approach is preferable and there is a good chance that it will be adopted since the Commission is also concerned to restrict the import of ‘hot air’. Hence, ‘backup’ regulations should be abandoned as they are likely to x undermine economic efficiency, be more complex to administer and lead to additional costs for the target groups. There are scope for debate over these principles and over the specific recommendations listed in Table E.2. But the main point is to encourage wider recognition of the challenges that the EU ETS poses to UK climate policy. xi Table E.2 Specific policy recommendations CCL/ CCAs the CCL should be removed from electricity, extended to all fossil fuels (replacing excise duties on oil products) and changed from a downstream energy tax to a downstream carbon tax; eligible installations should join the EU ETS and their existing CCA agreements should be terminated; CCA facilities not eligible for the EU ETS should renegotiate their agreements such that the targets relate to fuel consumption only; participants in the EU ETS should be exempt from the CCL; and UK ETS (DPs) trading between the CCAs and the EU ETS should be controlled by a Gateway before 2008, with no trading after that date. the UK direct participant scheme should cease in 2006, with no further incentivised rounds; trading between the direct participants and the EU ETS should be allowed during the two-year overlap period; further expansion of trading in the UK should be based upon opt-in provisions to the EU ETS (based on direct emissions only) and/or sectoral expansion of the EU ETS, together with the development of interfaces between the EU ETS and the project mechanisms; and UK ETS Projects participants in the EU ETS should be exempt from the CCL. the UK should proceed with a small-scale pilot scheme only, with fuller development of the project mechanism being linked to the development of ‘modalities’ for interfacing the EU ETS to JI and the CDM; the pilot scheme should be developed in consultation with the Commission, with the rules taking into account the concerns of the Commission, Parliament and other Member States about environmental integrity; the rules should be consistent with those for JI and CDM and both nuclear and sink projects should be excluded; no project should be undertaken at sites that may subsequently become eligible for inclusion in the EU ETS; double crediting should be accepted in the pilot phase, but with an aggregate ceiling on credit volumes to preserve environmental integrity; and the UK should work to ensure that the subsequent EU proposals are compatible with the UK scheme. IPPC the interpretation of IPPC energy efficiency requirements that is outlined in the ‘non-paper’ and in UK guidance is sensible and should be retained; the Commission should specify in greater detail the recommended approach to non-CO2 GHGs for those installations where BAT requirements are expressed as technical requirements rather than emission limits; the provisions in Article 25 should be extended to those installations and gases that are not listed in Annex I but have chosen to opt-in to the EU ETS; to avoid problems with ‘hot air’, the inclusion of non-CO2 GHGs in Phase 2 of the EU ETS should be based upon both accurate monitoring protocols and very strict criteria for allowance allocation; installations should not be allowed to opt-out of the EU ETS on the basis of ‘equivalent’ IPPC energy efficiency requirements, since these are not ‘national policies’ and in practice are unlikely to be strictly enforced. xii RO the allocation of allowances to UK electricity generators should, as far as possible, take into account the renewables targets under the RO; during Phase 2, the EU ETS should either: allow one-way trading from schemes like the RO, using a similar framework to that adopted for the UK ETS; or encourage crediting projects for renewables through the development of suitable modalities for linking the EU ETS to projectbased mechanisms; if the first approach is adopted, this should only apply to overcompliance which has been demonstrated by the acquisition of surplus TGCs; the small potential for double crediting within such an arrangement should be considered and acceptable price to pay for providing an additional incentive for overcompliance with renewables targets. the incentive for overcompliance should not be considered a substitute for other measures to encourage renewables deployment, such as more ambitious targets for renewables after 2010, greater flexibility in the banking rules for ROCs and removal of the non-price barriers to renewables deployment. EEC the allocation of allowances to UK electricity generators should, as far as possible, take into account the energy efficiency targets under the EEC, which means that the latter need to be agreed within the next 18 months; during Phase 2, the EU ETS should either: allow one-way trading from schemes like the EEC, using a similar framework to that adopted for the UK ETS; or (preferably) encourage crediting projects in this sector through the development of suitable modalities for linking the EU ETS to project-based mechanisms; the small potential for double crediting within such arrangements should be considered an acceptable price to pay for providing an additional incentive for overcompliance with domestic sector energy efficiency targets - but this should be kept under review; the exemption of the domestic sector from the UK project scheme should be removed; and the incentive for overcompliance should not be considered a substitute for other measures, such as introducing more ambitious targets for the EEC after 2005 and removing the non-price barriers to domestic sector energy efficiency. xiii 1. Introduction This report explores the implications of the recently agreed EU Emissions Trading Directive for seven instruments within UK climate policy. These are: the Climate Change Levy (CCL); the Climate Change Agreements (CCA); the UK Emissions Trading Scheme (UK ETS) - direct participants; the UK Emissions Trading Scheme (UK ETS) – emission reduction projects; the Integrated Pollution Prevention and Control Directive (IPPC); the Renewables Obligation (RO); and the Energy Efficiency Commitment (EEC). The main message of the report is that the Directive has major implications for the first four of these instruments and non-trivial implications for the remaining three. Since these instruments form the basis of the UK Climate Programme (UKCP), it follows that core elements of that programme may need to changed. The UK government does not appear to have fully acknowledged this and the implications of the Directive are only beginning to be appreciated by relevant stakeholders and commentators. For example, organisations such as the Green Alliance (Ekins et al, 2002) and the Royal Society (Ash et al, 2002) have advocated replacing the CCL with a carbon tax, but these organisations have paid little attention to how such changes may fit alongside the EU Directive. Throughout the negotiation of the Directive, the strategy of the UK government has been to secure opt-out provisions. But this strategy has only been partially successful. The Directive allows only a portion of sectors to opt-out for only the first phase of the scheme (2005-2007). In the absence of national opt-out provisions, a strategy for implementing the Directive in the UK needs to be developed. This may involve rather larger changes to existing policy instruments than many groups had anticipated. And as with any such changes, this creates both risks and opportunities. This report is closely linked to an earlier report: The Climate Confusion: implications of the EU emissions trading scheme for the Climate Change Levy and Climate Change Agreements, which was published in November 2002. The present report updates the conclusions of this earlier report to reflect the political agreement on the EU Directive that was reached in the Environment Council meeting on the 10th of December 2002. It also extends the analysis to five other UK policy instruments, including the UK Emissions Trading Scheme and the Renewables Obligation, and draws some general conclusions on the future of UK climate policy. The remainder of this section introduces the EU Directive and the relevant instruments in UK climate policy, outlines some of the issues that the Directive raises, and provides an overview of how policy interaction may be analysed. The following six sections explore the potential interactions between the EU ETS and the selected policy instruments in turn. Each section uses a structured approach, examining the scope, objectives, timing and operation of the instruments, and identifies and assesses some of the available policy options. Section 8 identifies the key choices within UK climate policy that are responsible for the 1 incompatibilities with the EU ETS, while the final section summarises the policy recommendations for each instrument and provides an overall assessment of the implications of the Directive for the UK. 1.1 The EU Emissions Trading Scheme On the 10th December 2002, European environment ministers agreed the ground rules for an EU-wide scheme for greenhouse gas emissions trading, thus paving the way for the largest and most ambitious trading system yet seen. The proposed Directive will now be sent to the European Parliament for a second reading in Spring 2003, with remaining differences to be resolved through conciliation between the Presidency and the Parliament during Summer 2003. The Directive should be adopted in late 2003, which means that there is a good chance that the scheme will come into force in 2005 as planned. The design of the EU Emissions Trading Scheme (EU ETS) represents a pragmatic compromise between economic efficiency and political acceptability. The final text accommodates the concerns of key Member States such as Germany and has won the broad support of both industry lobbyists and environmental groups. There is much work still to be done, notably in devising acceptable allocation rules at the national level. But the key elements are now in place for a historic leap forward in the implementation of market-based environmental instruments. The EU ETS is a ‘cap and trade’ scheme, along the lines of the US Acid Rain Program (Sorrell and Skea, 1999). It will initially cover some 45% of EU CO2 emissions, and as the EU is enlarged and more sectors and gases are brought into the scheme, it will cover an increasingly large proportion of total Annex I emissions under the Kyoto Protocol. Participants in the scheme include electricity generators, oil refineries and energy intensive manufacturing installations in sectors such as iron and steel, paper and minerals. Each participant will be allocated a number of allowances each year on the basis of a range of criteria, including the technological potential to reduce emissions. On the 30th of April each year, each participant will be required to surrender a quantity of allowances equal to its emissions in the preceding calendar year. Participants with high abatement costs will be able to cover their emissions by purchasing additional allowances, while those with low abatement costs will be able to reduce emissions and sell their surplus allowances for a profit. The Commission estimates that the scheme will reduce total abatement costs by some 35%, leading to cost savings of some 1.3 billion Euros/year by 2010. The main features of the scheme are summarised in Table 1.1. 2 Table 1.1 Key elements of the proposed EU Emissions Trading Scheme Type of target Sectors included Size of market Timing Allocation Greenhouse Gases Links with Kyoto mechanisms Links with other schemes Monitoring Reporting Verification Allowance tracking Compliance Banking Review of system design Phase 1: 2005-2007 Phase 2: 2008-2012 (i.e. the first Kyoto Protocol commitment period). Absolute targets for all facilities. All combustion plant >20MW thermal input, including electricity generators Oil refineries, coke ovens, non-ferrous metals, cement clinker, pulp from timber, glass and ceramics Based on IPPC, but many IPPC sectors excluded (e.g. chemicals, food and drink, waste incineration) Sites below IPPC size thresholds in eligible sectors may also be included 4000-5000 installations 45% of EU carbon dioxide emissions Free during Phase 1 with national allocation plans based on Commission guidelines Member States have the option to auction up to 10% of allowances in Phase 2 The Commission retains the right of veto over national allocation plans Only CO2 in Phase 1 Other gases may be included in Phase 2, provided adequate monitoring and reporting systems are available and provided there is no damage to environmental integrity or distortion to competition Emission credits from JI and CDM projects to be recognised, subject to ‘modalities’ to be adopted by the EU by 2005 Agreements with third parties listed in Annex B of the Kyoto Protocol may provide for the mutual recognition of allowances between the EU ETS and other schemes Common monitoring, verification and reporting obligations to be elaborated. Verification through third-party or government authority. Linked/harmonised national registries with independent transaction log. To be based on Kyoto Protocol registry guidelines and US Acid Rain Program. Phase 1: 40 Euro/tonne penalty Phase 2: 100 Euro/tonne EU Banking across years within each compliance period Member States can determine banking from first compliance period (2005-2007) to first Kyoto Protocol commitment period (2008-2012). Review in 2006. Source: CEC (2002) The Directive was the subject of intense negotiation and the Commission found it necessary to compromise in several areas in order to secure political agreement. The issues that have caused the greatest difficulty are as follows: Opt-outs (Article 25a): The Commission intended the scheme to be mandatory, but this was opposed by the UK and Germany who were seeking to protect their existing negotiated agreements with manufacturing industry. The final text allows Member States to apply to the Commission for the exclusion of installations and ‘activities’ (interpreted as sectors) during Phase 1 of the scheme (2005-2007), but with mandatory participation being required in Phase 2 (2008-2012). Opt-outs will only be permitted if installations can demonstrate that they will, as a result of national policies, limit their emissions by as much as would be the case if they were subject to the requirements of the Directive 3 (‘equivalence of effort’). Equivalence is also required in the monitoring, reporting and verification requirements and in the penalties for non-compliance. Opt-ins (Article 23a): Several Member States pressed for opt-in provisions that would allow non-eligible installations to voluntarily join the scheme. Opt-in provisions have been included in the final text, but only for Phase 2 of the scheme. These are subject to approval by the Commission, taking into account the effect on environmental integrity, competition and the internal market. Sectoral coverage (Annex I): The sectoral coverage of the Directive is based on that of the IPPC Directive, but a large number of IPPC sectors and sub-sectors are excluded including chemicals, food and drink, non-ferrous metals and waste incineration. A number of Member States considered that the sectoral coverage was inadequate, but proposals for expanding the coverage met with strong opposition, particularly from Germany who wanted to ensure that the chemicals sector remained outside the scheme. However, Article 26 allows the Commission to propose the inclusion of additional activities (i.e. sectors) by 31 December 2004, and to review this issue in the context of an overall review of the Directive which is required by 30 June 2006. Gas coverage (Article 23a): The UK was one of several Member States who argued for the scheme to be extended to other greenhouse gases (GHGs). The Commission opposed this on the grounds that monitoring protocols were inadequate. But Article 23(a) allows other GHGs to be included in the scheme during Phase 2, on identical terms to the opt-in provisions discussed above. In addition, Article 26 allows the Commission to propose the inclusion of additional gases in Phase 1 by 30 December 2004. Hence, the inclusion of other GHGs during Phase 1 remains a possibility. Allocation (Article 9 and Annex III): The choice between free allocation and auctioning proved highly contentious, with disagreement between the Commission and the European Parliament. The final text requires free allocation during Phase 1, while Member States are allowed (but not required) to auction up to 10% of allowances during Phase 2. Concerns over international competitiveness may dissuade Member States from auctioning, while the 10% ceiling is restrictive and will reduce the economic efficiency of the scheme. Allocation plans must be drawn up by Member States and are subject to approval by the Commission. The Commission will draw up allocation criteria by 31 December 2003, but allocation must be consistent with: national burden sharing targets and progress towards meeting those targets; national energy and climate change policies; other EC policy instruments; the technological potential of the installation to reduce emissions; and state aid and internal market rules. This mixture of top-down and bottom-up requirements could be very difficult to interpret and disputes over allocation could well lead to delays. Compliance (Article 16): The compliance provisions have been weakened from earlier proposals, by reducing the compliance penalty for Phase 1 from 50Euros/tCO2 to 40Euros/tCO2 (£27/tCO2) and by removing the qualifier ‘…or twice the market price, whichever is higher’. In Phase 2, the compliance penalty increases to 100Euros/tCO2 (£66/tCO2). These penalties place a ceiling on allowance prices and marginal abatement costs, which for Phase 1 is relatively low. Pooling (Article 25b): Germany secured the inclusion of an additional provision which allows installations to form an emissions Pool. Here, a single authority (e.g. a sector association) takes on all the responsibility for issuing, trading and surrendering allowances for all members of the Pool. This provision, which was designed to protect the German negotiated agreements, provides for ‘joint and several’ liability for installations within a sector and creates incentives for free riding: i.e. installations that make efforts to reduce 4 emissions may be subsidising competitors that do not. Pooling has analogies with some existing arrangements for the UK CCAs but will require a very coherent sector to be successful. It is permitted for both Phase 1 and Phase 2. Interfaces (Article 24 and Article 26): Article 24 allows agreements to be concluded with third parties to allow for the mutual recognition of allowances between the EU ETS and third party trading schemes. The third party must have ratified the Kyoto Protocol, which would exclude (at present) trading with the US. Article 26 indicates that links between the EU ETS and the project-based mechanisms (JI and CDM) are desirable, and promises a proposal on the ‘modalities’; governing such links during 2003. If successful, this should allow for the use of CDM credits in the EU ETS during Phase 1. The exclusion of credits from sink and nuclear projects is likely, but given the fungibility of international carbon commodities after 2008, such rules may be difficult to apply. The relationship between the EU ETS and international emissions trading (IET) after 2008 will be addressed in the review promised for 2006. This issue is of particular importance, as a combination of the withdrawal of the US from Kyoto, the surplus ‘hot air’ in the allocations to Russia and the Ukraine, and the generous sink provisions negotiated at Marrakesh has created the possibility of very low carbon prices after 2008. In this context, any interface between the EU ETS and the international carbon market could reduce the EU ETS allowance price and substitute allowance purchase for domestic abatement. 1.2 The EU Emissions Trading Scheme and UK Climate Policy Over the last three years, the UK has developed a complex, elaborate and interdependent set of climate policies which are intended to deliver both its Kyoto obligations and its domestic target of a 20% reduction in CO2 emissions by 2010. Some elements of this policy mix, such as the Climate Change Levy (CCL), represent a significant political achievement given the strength of industrial opposition, while others, such as the UK Emissions Trading Scheme (UKETS) and the Renewables Obligation (RO), are important and innovative policy experiments. This policy mix is now fully operational, delivering emission reductions and attracting interest from around the world. But much of it is fundamentally incompatible with the EU ETS. The UK government is now faced with a choice between either accepting the coexistence of the EU ETS with UK climate policy, or replacing or modifying a number of policy instruments only a couple of years after they were introduced. The first option leads to double regulation, complexity and additional cost burdens for affected groups, while the second implies changing a complex and finely balanced policy mix which took several years to negotiate and which, in the case of Climate Change Agreements (CCAs), was anticipated to remain stable until 2013. Neither option is attractive and both will attract opposition. The extent of disruption will depend on the nature of the changes that are proposed, but to date there has been very little consideration of the specific options available. The report explores the nature of the issues that arise from the interaction between the EU ETS and selected climate policy instruments in the UK. It seeks to identify the ways in which conflicts can be avoided and synergies created, primarily through modifying the design and implementation of the UK policy instruments. The discussion represents a summary of the 5 more detailed analysis that has been conducted under the project Interaction in EU Climate Policy (INTERACT)2 and builds on that in the earlier report The Climate Confusion.3 The December agreement on the EU ETS has made an analysis of this type all the more important. Even with the inclusion of opt-out provisions in Phase 1, the Directive is likely to require changes to UK climate policy before 2005. Moreover, with the absence of opt-out provisions for Phase 2, a major overhaul of UK climate policy is likely to be required by 2008. None of this was anticipated when the UK Climate Programme (UKCP) was developed or when key elements of this Programme, such as the CCAs, were negotiated. The EU Directive has driven a coach and horses through UK climate policy and could lead to substantial adjustment costs as a result. There is a need for a strategic debate on the preferred shape of UK climate policy into the first Kyoto commitment period (2008-2012) and beyond and on the role of the EU ETS within the UK policy mix. This report aims to make an contribution to such a debate. 1.3 Core issues in policy interaction The potential interaction between the EU ETS and UK climate policy raises four generic issues: interaction and double regulation; ownership of emissions and double counting; differential treatment and equivalence of effort; and fungibility of trading commodities. These issues are central importance when assessing the potential impact of the EU ETS and will be referred to repeatedly in each of the following sections. Each issue is briefly introduced below. Policy interaction and double regulation The issue here is the extent to which any apparent ‘double regulation’ will be seen as imposing unfair burdens upon particular target groups. Double regulation may be loosely defined as a situation where an individual target group is affected by two or more instruments that have very similar objectives. While ‘double regulation’ is a negative term, there may be many instances where the interaction between policy instruments may be either acceptable or positively beneficial. To assess whether this is likely to be the case in any particular instance, it is necessary to examine the multiple objectives of each instrument, the obligations and incentives they place upon individual target groups, and the likely consequences of the double regulation in practice. For example, taxing the fuel used by a participant in an emissions trading scheme may be opposed in principle as it raises overall abatement costs, distorts the operation of the allowance market and potentially leads to a subsidy of competing firms that are participating in the trading scheme but are not subject to the tax. But if either the level of the tax or the price of allowances are very low, and are expected to remain low for the foreseeable future, the coexistence of the two instruments may be considered 2 3 http://www.sussex.ac.uk/spru/environment/research/interact.html http://www.sussex.ac.uk/spru/environment/research/ccfr.pdf 6 acceptable in order to enhance the incentives for downstream energy efficiency. This is an inefficient and second-best alternative to tightening the emissions cap or restricting the import of ‘hot air’ into the trading scheme, but may nevertheless be a pragmatic and sensible response given real-world constraints on UK and EU climate policy. Ownership of emissions and double counting The issue here is the ‘ownership’ and ‘control’ of carbon emissions and the problems that arise if ownership is disputed. ‘Ownership’ here is defined as the right to make use of a portion of the atmospheric commons as a sink for carbon emissions, and it includes the right to make use of, appropriate the returns from and (in the case of emissions trading) sell a legal asset such as a carbon allowance. The EU ETS gives full ownership of the emissions from electricity generation to power stations, while much of UK climate policy effectively gives the ownership of a portion of these emissions to electricity consumers. The ‘control’ that these two groups can exercise over these emissions is very different. For example, electricity generators have full and direct control over the carbon intensity of electricity generation but only indirect and partial control over electricity demand. Ownership disputes may fall into two categories: a) double coverage, where two instruments give ownership of the same physical emissions to two separate parties (or to the same party under two separate terms); and b) double crediting, where disputing claims over the ownership of emissions allow two separate carbon allowances or carbon credits to be generated from a single abatement action. Each type of problem introduces complexity into the regulatory situation and double crediting may threaten the environmental integrity of an emissions trading scheme. Differential treatment and equivalence of effort The issue here is the extent to which different groups are treated differently by environmental policy instruments and whether the obligations imposed upon one group can be deemed equivalent to those imposed upon another. Differential treatment may be challenged on legal, political or environmental grounds and is of central importance in the political debate over climate policy. Demonstration of equivalence of effort may be required as a means to avoid differential treatment when an installation, company, sector or Member State is exempted from a particular policy instrument. But in practice, differences in the scope, form and stringency of policy instruments may make equivalence of effort extremely difficult to assess. Linking trading schemes and the fungibility of trading commodities The issue here is the extent to which two trading schemes may be linked by the exchange of environmental commodities. The rapid development of GHG emissions trading at the national, regional and global level has led to increasing interest in linking trading schemes, but there is a risk that the resulting improvements in economic efficiency will be achieved at the expense of environmental integrity. At the same time, the growth of Tradable Green Credit (TGC) schemes for renewable electricity and (in the UK) trading schemes for energy efficiency has created the possibility of linking schemes with different types of trading commodity. The transfer of environmental commodities between two schemes will be governed by transfer rules, which may restrict movements in either direction or discriminate between commodities according to their origin (e.g. disallowing carbon credits from sink projects), together with exchange rules which establish the equivalence of commodities with 7 different denominations. The combination of transfer and exchange rules defines the fungibility of the trading commodities - which means the extent to which the commodity used for compliance with the first scheme can also be used for compliance with the second. These rules will determine the scope for trading between the two schemes and the consequences of such trading. 1.4 Analysing interactions For any policy instrument, it is useful to distinguish between directly and indirectly affected target groups. A directly affected target group has obligations and incentives imposed upon it directly by a policy instrument, while an indirectly affected target group is influenced in some way by the behavioural changes that are made by a directly affected target group. So for example, electricity generators are directly affected by the EU ETS, while electricity consumers are indirectly affected as they face higher electricity prices as a consequence of the abatement costs incurred by the electricity generators. Indirect effects permeate throughout the economy. But in this report, attention is confined to the indirect impact of policy instruments on the electricity market, as it is here that the greatest difficulties lie. The potential interactions between the EU ETS and individual UK climate policy instruments may then be classified as follows Direct interaction: where the target groups directly affected by the EU ETS overlap in some way with those directly affected by the UK policy instrument. Indirect interaction: where either: the target groups directly affected by the EU ETS overlap with the target groups indirectly affected by the UK policy instrument (or vice versa); or the target groups indirectly affected by the EU ETS overlap with the target groups indirectly affected by the UK policy instrument. Trading interaction: where the target groups affected by two policies are, or could be, linked by the exchange of an environmental trading commodity, such as a carbon allowance or tradable green credit (TGC). Table 1.2 lists the seven policy instruments examined in this report and indicates the type of interaction between each of these instruments and the EU ETS. In each case, more than one type of interaction is relevant. 8 Table 1.2 The nature of the interaction between UK policy instruments and the EU ETS Category Instrument Carbon/ energy taxes Negotiated agreements Emissions trading Emissions trading Industrial pollution control Support for renewables Promotion of energy efficiency Acronym Direct Indirect Trading Climate Change Levy CCL Climate Change Agreements CCAs UK Emissions Trading Scheme - direct participants UK Emissions Trading Scheme – projects Integrated Pollution Prevention and Control Directive Renewables Obligation UK ETS (DPs) UK ETS (projects) IPPC RO Energy Efficiency Commitment EEC The following sections summarise the potential interactions between the EU ETS and each of these instruments in turn. More detailed analysis may be found in the reports listed in section 10. The analysis assumes that the EU ETS is implemented while the existing instruments remain unchanged. In practice, this may be very unlikely for several of the instruments (particularly the CCAs), but it provides a useful framework for identifying the relevant issues. In each section, the following issues are examined in turn: the scope of the instruments, where scope means the sectors, sites, portions of sites and individual emission sources that are directly or indirectly affected by each instrument; the objectives of each instrument and the extent to which these reinforce or conflict with one another; the timing of the instruments in relation to each other and the Kyoto commitment period; and the operation of each instrument and the interactions between them assuming that they exist in parallel. Each section pays particular attention to the generic issues identified in section 1.3. Following the interaction analysis, one or more policy options are examined that could reduce the conflicts and/or encourage synergies between the selected policy instruments and the EU ETS. Given that the EU ETS is now relatively finalised, most of these options relate to modifying the UK policy instruments. On the basis of this analysis, some brief policy recommendations are made. 9 2. Interaction between the EU ETS and the UK CCL/CCA package The Climate Change Levy (CCL) and Climate Change Agreements (CCAs) need to be analysed together as they form a package. The CCL is a downstream, revenue-neutral energy tax for business, commerce and the public sector. It is levied on coal, gas and electricity use, with oil products, CHP fuel and renewable electricity being exempt. The indirect treatment of electricity was chosen to avoid electricity price increases for low income households, while an energy tax was chosen over a carbon tax to protect the UK coal industry. Both decisions have influenced the entire shape of the UKCP and have created serious compatibility problems with the EU ETS. The CCAs run until 2013 and give energy intensive industry exemption from 80% of the CCL, provided they take on binding targets for energy efficiency or carbon emissions. In practice, most sectors have adopted relative targets (e.g. energy use per unit of output), based upon a percentage of the estimated cost effective energy efficiency potential. The penalty for failing to meet the targets is a return to paying 100% of the CCL. Eligible sites are those located in sectors which are regulated under IPPC, and include many sites which lie below the IPPC size threshold. Some sites in non-IPPC sectors (e.g. horticulture) are also included The potential interactions between the EU ETS and an unchanged CCL/CCLA package are complex. Both the CCL and the CCAs directly interact with the EUETS, and there is substantial indirect interaction in relation to electricity emissions. Since the CCAs incorporate baseline and credit trading arrangements as part of the UK ETS, there is also scope for trading interaction. The interactions are explored in detail in Sorrell (2002b). This section summarises the main conclusions of that report and updates them to allow for the outcome of the Environment Council meeting. 2.1 Comparison of instrument scope The scope of both the CCAs and the EU ETS is based on that of the IPPC Directive. But despite this, there are considerable differences at four levels: Sectoral coverage: Differences in the sectoral coverage of the CCL, CCAs, IPPC and EU ETS suggest that individual sites in the public, commercial, manufacturing and energy sectors may face one of ten combinations of the four instruments (Figure 2.1). Site coverage: Differences in the coverage of individual technologies within an individual site expands the number of possible combinations of instrument coverage from ten to eighteen. The differences relate in particular to the coverage of combustion plant and process plant emissions and to the size of the main combustion plant. Emissions coverage: Further complications are introduced by the differences in coverage of CO2 versus other GHGs, combustion versus non-combustion CO2 emissions, and combustion emissions from different fossil fuels. Electricity coverage: A final layer of complexity is provided by the differing incentives each instrument creates for reducing emissions from electricity generation. Each instrument gives a different mix of direct and indirect incentives to both the supply and demand side of the electricity market, with the result that each instrument incentivises a 10 different mix of abatement options (Table 2.1). Particular complications are introduced by the inconsistent treatment of electricity from various renewable sources. Figure 2.1 Overlaps between the target groups for the EU ETS, IPPC, CCL and CCAs 1 CCL 2 8 3 7 EU ETS 9 IPPC 10 6 4 CCLAs 5 11 Table 2.1 Incentives for lower carbon emissions from electricity generation Supply side incentives Demand side incentives Measure Switch to generation from lower carbon fossil fuel Improve thermal efficiency of generation Invest in nuclear or large hydro Invest in new renewable generation sources Purchase electricity from new renewable sources Purchase electricity from nuclear, large hydro or lower carbon fossil sources Improve efficiency of electricity consumption Invest in CHP IPPC - EU ETS Direct via ESI emissions cap CCL - CCA - Direct via energy efficiency provisions Direct via ESI emissions cap - - - Direct via ESI emissions cap Direct via ESI emissions cap - - Indirect via increased demand from consumers who have switched to gain CCL exemption Direct by exemptions for new renewable electricity - - - - - Indirect via price advantage of zero carbon electricity - Direct via energy efficiency provisions Indirect via electricity Direct via CCL on price increases from electricity purchases generators Direct via energy Indirect via electricity Direct via exemptions efficiency provisions price increases (ESI); for CHP fuel and encouragement of offset by direct CHP requirement for additional allowances for CHP fuel (consumer) Note: The table shows the additional incentives created by the CCA targets. CCA sites still pay 20% of the CCL. 12 - - Direct via energy/carbon targets Direct via energy/carbon targets and requirements to assess CHP potential 2.2 Comparison of instrument objectives The core objective of the three instruments is the same, but they differ in terms of their relative stringency and the importance they give to various subsidiary objectives The stringency of the EU ETS is at present unclear and the proposed allowance allocation criteria include both top-down and bottom up elements which are potentially contradictory. But there is a possibility that the targets required under the EU ETS will be more stringent than those currently applicable under the CCAs, quite apart from the fact that these will be absolute, rather than relative targets. This has important implications for either the use of CCA targets as a basis for allocation in the EU ETS, or the use of opt-in and opt-out provisions within the EU ETS at the sector or installation level. The stringency of the EU ETS will be determined in the first instance by the size of the overall cap relative to the overall abatement cost curve. But an important complication is the possibility of interfacing the EU ETS to other trading schemes or to the Kyoto mechanisms after 2008. In the likely context of low carbon prices after 2008, any interface between the EU ETS and the international carbon market could have the effect of reducing the EU ETS allowance price and substituting allowance purchase for domestic abatement. The design of the CCL/CCA package reflects multiple explicit and implicit objectives, including the desire to protect domestic consumers, energy intensive industry, and UK coal producers, together with promoting energy efficiency and avoiding a ‘windfall’ to nuclear generators. These objectives explain the choice of a downstream rather than upstream tax and the choice of an energy rather than carbon tax. Each of these objectives is threatened by the introduction of the EU ETS. The Directive will disadvantage coal-fired electricity generation and accelerate its decline, raise electricity prices for household consumers, including the fuel poor, and improve the economics of nuclear power. The political importance of each of these objectives has changed since the CCL was introduced and is likely to have changed further by 2005 or 2008. This may make the introduction of the EU ETS easier than it would have been a few years ago. In particular, given the problems currently faced by the UK nuclear industry, a nuclear ‘windfall’ may now be positively helpful to government objectives. 2.3 Comparison of instrument timing The EU ETS is in phase with the Kyoto commitment period, but is due to begin well before the CCAs end. In contrast, the CCAs extend beyond the end of the Kyoto commitment period, but targets are only negotiated up to 2010. The CCAs also include emissions trading provisions as part of the UK ETS, but at present this does not extend beyond 2006. The situation is simplified somewhat by the inclusion of opt-out provisions in the EU ETS, as these may allow many of the existing CCAs to continue unchanged up to 2008. But since optouts require demonstration of equivalence of effort, it is likely that the UK electricity generators and other sectors such as oil refineries will need to join the scheme in 2005 since these have no ‘equivalent’ regulations. The inclusion of the electricity generators creates a host of problems for the CCL/CCA package, as a consequence of the resulting double regulation and double coverage/crediting of electricity emissions. Furthermore, it is far from clear that retaining the existing CCAs can be considered equivalent to participating in the EU ETS, owing to substantial differences in the scope, form and stringency of the CCA and EU ETS targets. As a consequence, it is possible that the partial opt-out provisions included in the EU ETS will create almost as many problems for the UK is having no opt-out provisions at all. And the absence of opt-out provisions after 2008, make it inevitable that major changes will be required to the CCL/CCA package well before the planned end date of the agreements. 2.4 Comparison of instrument operation Coexistence of EU ETS with an unchanged CCL/CCLA package appears very unlikely. The interactions in a coexistence scenario differ between target groups and include: price-price interactions: where the indirect impact of the EU ETS on electricity prices is additional to the direct price impact of the CCL; price-target interactions: where the indirect impact of the EU ETS on electricity prices is additional to the direct impact of a target under the CCAs; target-price interactions: where the direct impact of an emissions target under the EU ETS is additional to the direct price impact of the CCL; target-target interactions: where the direct impact of a target under the EU ETS is additional to the direct impact of a target under the CCAs. It is useful to distinguish four categories of target group in the public, commercial and manufacturing sectors, identified by the combination of instruments for which they are eligible: Group 1: CCL only Group 2: CCL and EU ETS; Group 3: CCA only; Group 4: CCA and EU ETS Table 2.2 categorises the potential interactions for each of these four groups. Table 2.2 Categorising the potential interactions between the EU ETS and the CCL/CCA package Type of interaction EU ETS CCL/CCA package Category price - price price - price indirect price direct price Group 1 electricity Group 2 electricity price - target indirect price direct target Group 3 electricity Group 4 electricity target - price direct target direct price Group 2 fuel target - target direct target direct target Group 4 fuel no interaction - - Group 1 fuel Group 3 fuel The scale and consequences of each interaction depends upon a range of factors, the most important of which is the allowance price in the EU ETS. If the allowance price is high, double regulation could lead to substantial economic impacts for affected groups and create pressure to modify the CCL/CCA package - although the compliance provisions provide an allowance price (marginal abatement cost) ceiling of £27/tCO2 during Phase 1. Conversely, if the allowance price is very low, the economic consequences of the double regulation could be relatively small and therefore acceptable. Under certain assumptions,4 an allowance price of £10/tCO2 would increase average electricity prices by 0.46p/kWh, which is equivalent to the current level of the CCL on electricity. Of similar importance is the underlying trends in industrial energy prices. For example, gas prices increased by 18% in real terms between 1995 and 2001, while electricity prices fell by 23%. Recent reductions in wholesale electricity prices have created a crisis in electricity generation and there seems little prospect that electricity prices will increase substantially in the near future. In a context of low energy prices and low allowance prices, there may be some appeal in retaining some of the CCL/CCA package unchanged, in order to maintain downstream incentives to improve energy efficiency (the ‘backup’ scenario). For example, the continuation of the CCL may be considered acceptable in order to incentivise electricity efficiency, even though it leads to ‘double regulation’ of electricity for all non-CCA sites (i.e. electricity prices increase as a result of the generators participating in the EU ETS, but electricity is also subject to the CCL). This would also ensure the continuation the revenue raising functions of the CCL. A portion of this remedy is used to fund other climate policy initiatives, such as Enhanced Capital Allowances (ECAs). Allowance auctioning in the EU ETS could provide an alternative source of revenue to the CCL, but the final text rules out auctioning for Phase 1 and imposes a 10% ceiling on 4 Namely: a) the trading scheme is introduced overnight without companies having the opportunity to change behaviour; b) the full costs of meeting the emission target are passed on to consumers through electricity price rises, with none being be passed on to suppliers or absorbed through lower returns; and c) the impact on electricity prices is independent of the method of allowance allocation (Sorrell, 2002a). auctioning for Phase 2.5 This means that the EU ETS cannot substitute for the revenue raising objectives of the CCL. In the absence of allowance auctions, there is no revenue-neutral mechanism to compensate electricity consumers for the price rises resulting from the participation of the electricity generators in the EU ETS. Since the CCL has encountered substantial political opposition, despite being revenue-neutral overall, the possibility of uncompensated electricity price rises could prove very unpopular. In theory, the increase in electricity prices will be solely a function of marginal abatement costs and will be independent of the method of allowance allocation (Sorrell, 2002a). But the EU ETS differs from the CCL in that the price impacts on electricity are indirect, relatively hidden and (at present) highly uncertain. The CCAs have trading provisions as part of the UK ETS. The participation of electricity generators in the EU ETS, combined with the continuation of these trading provisions will lead to double coverage and associated double crediting of electricity emissions. These problems only result from increases above or reductions below the CCA target and from changes in the emissions intensity of electricity use (Sorrell, 2002). This means that some emissions increases/reductions will be double covered/credited and some not. Overall, this double coverage/crediting will not threaten the environmental integrity of either the EU ETS or the CCAs, but will introduce complexity and confusion into the regulatory situation as a result of a conflict over the ownership of electricity emissions. The use of relative targets in the CCAs also means that output growth could increase the total number of allowances in circulation. If trading were allowed between the UK ETS and EU ETS, this would create a danger of inflation in the number of EU ETS allowances with a corresponding risk of violating the EU ETS emissions cap. Such problems could be avoided through the use of a Gateway arrangement to interface the CCAs to the EU scheme. 2.5 Policy options The CCL/CCA package may be modified in a number of ways to reduce the negative impacts of interaction. The most obvious modifications represent combinations of the following variables: CCL: a) remove the CCL on electricity; b) change the CCL to a downstream carbon tax. CCA: a) opt-out eligible CCAs from the EU ETS; b) replace eligible CCAs with the EU ETS; c) shift the remaining CCAs to fuel only. Trading interface between CCAs and EU ETS: a) interface via a Gateway; b) prevent trading between the two schemes. In addition, the appropriate mix of policy options may differ between Phase 1 and Phase 2. The options are described in detail in Sorrell (2002b). Nearly all of the options offer an improvement on the coexistence scenario. Similarly, the majority of options improve both economic efficiency and political acceptability, while reducing environmental effectiveness. 5 Auctioning is voluntary in Phase 2 and the UK is unlikely to take up the option. Article 25a of the Directive allows opt-outs at the installation or sector level. This is not equivalent to a national opt-out, since sectors such as electricity generation will find it impossible to demonstrate equivalence of effort. If electricity generators join the EU ETS, double regulation of electricity for sites eligible for the CCL would be unavoidable unless the CCL is removed from electricity. Similarly, CCA installations that have opted out or are not eligible to join the EU ETS6 will also have double regulation as these will face electricity price rises at the same time as having a target for their electricity consumption. This undermines the rationale for adopting the targets in the first place, particularly if the CCL is removed from electricity. Installation level opt-outs may also create complications if some installations within a sector chose to join the EU ETS, while others chose to continue with their existing CCAs. If the CCL is removed from electricity, there are benefits to be gained by going one step further and changing it to a carbon tax. The tax could be extended to oil products and could replace excise duties since these no longer have an economic rationale. The impact on the industrial coal market would be relatively small, since most coal is consumed by CCA companies which are exempt from 80% of the CCL. The attraction of opting-out is to minimise abatement costs. Movements out of the EU ETS cap (by high cost participants) should lower allowance demand, lower allowance prices, reduce marginal abatement costs and bring abatement cost within the cap closer to those outside. Opt-outs make the EU ETS more acceptable to industry and certain Member State governments, but the disadvantages include reducing the environmental effectiveness of the scheme and increasing administrative costs. Differential treatment via opt-outs could distort competition either between or within Member States. The demonstration of equivalence of effort could also prove problematic owing to substantial differences in: Scope: The EU ETS and CCAs cover different emission sources in different ways. Form: Relative targets (CCAs) are not equivalent to absolute targets (EU ETS) because: a) absolute targets gives certainty in the environmental outcome, while relative targets do not; b) absolute targets give scope for auctioning and revenue raising while relative targets do not; and c) relative targets act as a subsidy on production, leading to higher emissions for the same level of marginal abatement cost (Gielen et al, 2002). Stringency: The basis on which CCA and EU ETS targets are derived and the process through which they are developed is different. Current CCA targets appear relatively weak and may fall short of the allocation criteria listed in the Directive (Sorrell, 2002a). In contrast to opt-outs, allowing opt-ins to the EU ETS has a number of advantages, particularly if combined with restrictions on the fungibility of EU ETS and UK ETS allowances. But the text agreed at December meeting restricts opt-ins to Phase 2 (Article 23a). The exception is sites in sectors that are covered by the EU ETS but which fall below the IPPC size threshold. These sites, most of which have CCAs, can choose to join the scheme before 2008. In practice, however, relatively few of them are likely to chose to do so. While a range of policy options are available, the basic choice is between, on the one hand, giving priority to economic efficiency by allowing the EU ETS to operate relatively 6 This is an important group. It includes sites in the non ferrous, chemicals and food and drink sectors, together with sites in other energy intensive sectors which are eligible for a CCA but not eligible for the EU ETS. These account for a large proportion of total industrial energy use. unhindered; or on the other hand, giving priority to environmental effectiveness by retaining ‘backup’ regulations to incentivise domestic abatement. The second option may be attractive if EU ETS allowance prices are anticipated to be low, but forecasts of future allowance prices are speculative and depend in part upon assumptions about the interface between the EU ETS and the international carbon market after 2008. Beyond 2008, eligible CCA installations have no choice but to join the EU ETS. This will require renegotiation of targets, as the EU ETS applies to direct emissions only. This means that the CCA electricity targets will be lost, unless these installations are prepared to accept double regulation. The loss of these targets may run counter to UK policy objectives as there are reasons to believe that downstream targets can be more effective in incentivising electricity efficiency than indirect price rises.7 Pooling arrangements will be available to CCA installations, but these are unlikely to be attractive as they could lead to cross subsidy of competitors. 2.6 Recommendations If restrictions are placed on the interface between the EU ETS and the international carbon market, the following recommendations can be made (Sorrell, 2002a): the CCL should be removed from electricity, extended to all fossil fuels (replacing excise duties on oil products) and changed from a downstream energy tax to a downstream carbon tax; eligible installations should join the EU ETS and their existing CCA agreements should be terminated; CCA facilities not eligible for the EU ETS should renegotiate their agreements such that the targets relate to fuel consumption only; participants in the EU ETS should be exempt from the CCL; and trading between the CCAs and the EU ETS should be controlled by a Gateway before 2008, with no trading after that date. ETSU (2001) estimate that the CCAs will deliver 2.5MtC annual reductions by 2010, compared to 4MtC if ‘all cost effective measures’ were adopted. In contrast, ETSU estimate that the reductions resulting from the price effect of the CCL on its own (i.e. with no agreements and no associated discounts) would be only 0.25MtC. 7 3. Interaction between the EU ETS and the UK ETS direct participant scheme The UK Emissions Trading Scheme (UK ETS) is a voluntary, pilot scheme, jointly developed by government and business, which began in January 2002 and is intended to run until 2006 (KOKO). The government is providing £43m/year over five years as an inducement for companies to join the scheme and to adopt absolute emission targets. Electricity generators are excluded since the scheme uses indirect treatment of electricity, and participants continue to pay the CCL. The UK ETS is complex and allows for three forms of participation: direct participants: voluntary participation in a cap and trade scheme, encouraged by the financial incentive; CCA: baseline and credit trading by companies with a CCA; and project: generation of credits from emission reduction projects in the UK. As indicated in Figure 3.1, trading between the direct participants and those CCAs with relative targets is governed by the provisions of the Gateway (Sorrell, 2001). Figure 3.1 Internal interfaces in the EU ETS UK ETS internal interfaces CCLA relative sector allowances Gateway CCLA absolute sector Direct Particpants with absolute targets Project credits credits The differences between the EU ETS and UK ETS are summarised in Table 3.1. The discussion in this section is confined to the direct participants, while section 4 discusses the proposed project scheme. Table 3.1 Comparison of the UK ETS and the EU ETS UK ETS 1st period 2002-2006 No guarantee of 2nd period, but review in 2005. Absolute targets for direct entrants. Absolute or relative targets for CCA participants. All industrial sectors eligible except power generation. Transport, landfills, households exempt. EU ETS Phase 1 2005-2007 Phase 2: 2008-2012. Size of market 34 direct entrants (~ 1 MtC-reductions over 5 years) Much larger number of CCA businesses (~ 2.5 MtC/year). Allocation Financial incentive (auction) for direct entrants Negotiated energy saving targets through CCAs. GHGs All six GHGs. Non-CO2 sources require development of monitoring protocols. Intention to allow UK companies to trade internationally during 1st commitment period. Possibility of using CDM credits before 2008. Mutual recognition between UK and other national trading authority would be necessary. Emission credits from JI and CDM projects to be recognised, subject to ‘modalities’ to be adopted by the EU by 2005 Commission may conclude agreements with third parties to allow mutual recognition of allowances Guidelines prepared for using methodologies and reporting emissions. Baselines and annual reporting to be verified by third party. Common monitoring/verification/reporting obligations to be elaborated. Verification through third-party or government authority. Allowances tracked by electronic registry. Registry to evolve into Kyoto Protocol registry in 2008. Gateway will limit transfers from relative to absolute sector. Loss and repayment of financial incentive for direct participants. Statutory penalties to be introduced. CCA participants have a separate compliance procedures. Unlimited banking until the end of 2007. Banking into 2008 only allowed for reductions from absolute sector made by businesses themselves (no buy to bank). Linked/harmonised national registries with independent transaction log, based on Kyoto Protocol registry guidelines. 40 Euro/tonne penalty across EU. Increased to 100 Euro/tonne after 2008 Banking across years within each compliance period Member States can determine banking from first compliance period (2005-2007) to commitment period (2008-2012). Timing Target Sectors included Links with IET/JI/ CDM Links with other schemes Monitoring/ Reporting/ Verification Allowance tracking Compliance Banking Absolute targets for all participants. Combustion plant >20MW, including generators Subset of IPPC sectors, but excluding chemicals, food and drink and waste incineration 4000-5000 installations 45% of EU carbon dioxide emissions Free during Phase 1. Member States have the option to auction up to 10% of allowances in Phase 2 Commission retains the right of veto over national allocation plans Only CO2 in Phase 1 Other gases may be included in Phase 2, provided adequate monitoring and reporting systems are available and provided there is no damage to environmental integrity or distortion to competition There is a small degree of overlap between the direct participants in the UK ETS and the sources eligible for the EU ETS (direct interaction), together with indirect interaction related to the treatment of electricity. There is also the possibility of trading allowances between the two schemes. 3.1 Comparison of instrument scope Participation in the UK ETS is on a voluntary basis, subject to qualifying requirements. Thirty four companies have joined the scheme, securing annual emission reductions of 4MtCO2e by 2006, of which half is from non-CO2 GHGs. Participants are from a diverse range of sectors and the nine largest companies are responsible for over 90% of the total reductions. There is very little overlap between the 34 direct participants and the sites eligible for the EU ETS. This is because first, most of the direct participants are in sectors which are not eligible for the EU ETS (e.g. chemicals); and second, of those participants which are eligible, the emission sources covered by the UK ETS are mostly different from those covered by the EU ETS.8 Two exceptions are the non-combustion emissions from cement production at one site and the emissions from >20MW combustion plant at a small number of direct participant sites which are not already covered by a CCA. In other words, there is potential double regulation of only a proportion of direct emissions at less than 10% of the direct participant sites. There is a more significant overlap in the ~1MtC emissions from electricity consumption at all the direct participant sites, since these are directly covered by the EU ETS and indirectly covered by the UK ETS. These emissions are subject to double regulation, with associated double coverage and crediting. 3.2 Comparison of instrument objectives The UK ETS is both a voluntary scheme and a secondary element of the UKCP. In contrast, the EU ETS is intended to be mandatory and is considered essential for EU compliance with the Kyoto Protocol. The objectives in establishing a trading scheme are different for the UK and EU, in that the UK is well on course to meet its burden sharing target while on current trends the EU is heading for non-compliance. The UK ETS was intended to provide the UK with an early mover advantage in emissions trading, with benefits such as learning by doing, accelerating institutional developments such as the allowance Registry, and enabling the City of London to become an international centre for emissions trading. Similar ‘soft’ benefits are expected at an EU-level from the EU ETS, although the Directive has the additional objective of avoiding distortions to competition. However, the incompatibilities between UK ETS and EU ETS has led the UK to negotiate opt-out provisions for Phase 1. This means that many UK companies could be excluded from EU-wide trading in Phase 1, or at best be subject to trading restrictions. In other words, the 8 For example, the EU ETS excludes non-CO2 GHGs, while the UK ETS includes all six GHGs. Similarly direct participants in the UK ETS cannot include emissions that are already covered by a CCA on the same site and which may be eligible for the EU ETS. The latter are still included in the UK ETS, however, via the baseline and credit trading arrangements for the CCAs. EU ETS has made the UK’s early start in trading look more like a false start. Worse still, the UK has sought to stall and distort the implementation of the EU ETS in order to protect its own more limited scheme. 3.3 Comparison of instrument timing The first period of the UK ETS ends in December 2006, and at present the government has made no commitment to further incentivised rounds. There is therefore a two-year overlap between Phase 1 of the EU ETS and the UK ETS. Delays in introducing the EU ETS could reduce this to one year or zero, although in the latter case Phase 1 may be abandoned altogether. There are questions regarding the links between the two schemes during the overlap period and also the future of the direct participant scheme beyond 2006. If the UK ETS ends in 2006 and if most direct participants are unable to join the EU ETS until 2008, the learning experience gained through the UK ETS is likely to be lost. Conversely, if the UK ETS continues beyond 2006, it will remain a limited and isolated scheme unless trading links can be established with the EU ETS. 3.4 Comparison of instrument operation Coexistence of the UK ETS with the EU ETS leads to double regulation of a small proportion of the direct emissions from UK ETS participants, since these are covered by both schemes. As Phase 1 opt-outs are allowed, these sites could choose to remain in the UK ETS and retain their financial incentive but, since subsidised abatement is very different from mandatory targets, there may be considerable difficulties in demonstrating equivalence of effort. The attractions of opting-out will depend upon a range of factors, including the fungibility of UK ETS and EU ETS allowances. If these sites chose not to opt-out (or were unable to), they would need to join the EU ETS and relinquish their financial incentive and UK ETS responsibilities, with a consequent (limited) effect on the remaining UK ETS market. This option may also (unfortunately) involve splitting these installations into EU ETS and residual UK ETS components (e.g. CO2 emissions in EU ETS and non-CO2 emissions in UK ETS). Coexistence of the two schemes also leads to double regulation of electricity for direct participants, analogous to the price-target interactions for the CCAs. Electricity prices will increase as a consequence of the generators joining the EU ETS and incurring abatement costs and this price increase will be additional to the UK ETS targets which indirectly cover electricity emissions. Furthermore, since (unlike the CCAs) UK ETS participants continue to pay the CCL, there is effectively triple regulation of electricity at these sites. As before, the consequences of this will depend upon trends in energy and allowance prices, but should be independent of the method of allowance allocation in the EU ETS. Coexistence also leads to double coverage of electricity emissions and associated double crediting. Assuming: a) all allowances are used to cover emissions; and b) all UK ETS participants (including the CCAs) have absolute targets; an increase/decrease in electricity consumption by the direct participants will lead to an increase/decrease in emissions from the electricity generators and a corresponding decrease/increase of twice the size in the total emissions covered by the UK ETS and EU ETS combined. In effect, the double crediting will be cancelled out by the double coverage (Sorrell, 2002a). Since total emissions will remain less than or equal to the sum of the allowance caps in the two schemes, overall environmental integrity will be maintained. In practice, most CCA participants in the UK ETS have relative targets, which creates the risk that emissions will increase. But this is a consequence of having relative targets, and not of the double crediting. Nevertheless, the dispute over the ownership of emissions does create a confused situation, which will be made worse if trading of allowances is permitted between the two schemes. 3.5 Policy options The primary options are, first, to allow direct participants to opt-in to the EU ETS, and second, to allow fungibility between UK ETS and EU ETS allowances (‘linking’ the trading schemes). Following the December 2002 agreement, direct participants will only be allowed to opt-in to the EU ETS after 2008.9 Since this is after the end of the UK scheme (2006), these sites may have a two-year period in which they have no opportunity to trade. Conversely, if the UK scheme is extended beyond 2006, it could run into difficulties if some of its participants chose to leave in 2008 and join the EU ETS. The advantages of opting-in include widening the scope of the EU ETS, increasing allowance supply, lowering allowance prices and bringing marginal abatement costs down (most direct participants would be net sellers). The disadvantages include increased administrative costs and the risk of injecting (possibly subsidised) hot air into the scheme. The motivation for opting-in is likely to be either low cost abatement through allowance purchase, or (more likely) higher prices for allowance sales. If the Commission wished to avoid double coverage/crediting of electricity emissions, any opt-ins would need to be on the basis of direct emissions only. The incentive to opt-in to the EU ETS would also be increased if there were no fungibility between UK ETS and EU ETS allowances. The pros and cons of linking trading schemes is the subject of a growing literature (Haites and Mullins, 2001; Baron and Bygrave, 2002). In this particular case, the situation is greatly complicated by the uncertainties over timing and the complex structure of the UK scheme. Table 3.2 provides a summary of some relevant issues. For the period 2005-2006, the advantages of linking appear to outweigh the risks - although it is questionable whether it is worth the transaction costs involved. Linking beyond 2006 and into the commitment period may be more problematic however. The latter may be considered if there is a continuation of the direct participant scheme beyond 2006, and will also be relevant to the UK project scheme and to the CCAs. 9 Unless UK is successful in gaining their participation through the ‘review’ provisions in Article 26 Table 3.2 Factors influencing the fungibility of UK ETS and EU ETS allowances Factor Allocation method Absolute versus relative targets Coverage of GHGs Monitoring, reporting, verification Registry Compliance Banking Treatment of electricity Issues Direct participants have a competitive advantage through the financial incentive. But the majority do not compete with the sectors covered by the EU ETS. Also, the UK scheme was given state aids clearance and the relatively small number of direct participants may reduce equity concerns. To protect environmental integrity, a Gateway mechanism would be needed to govern trade between the CCAs with relative targets and the EU ETS. But no such restrictions are needed for trade with direct participants. The EU would need to approve the UK monitoring protocols. As with the financial incentive, allowing direct participants, but not EU ETS participants, to credit non-CO2 GHGs gives the former a competitive advantage. There may also be concerns regarding the potential ‘hot air’ associated with the non-CO2 GHGs in the UK scheme. The protocols should be broadly compatible in the two schemes The registries should be broadly compatible in the two schemes At present, there are no financial penalties in the UK ETS, but the possibility of losing the financial incentive provides a strong incentive to comply. Furthermore, statutory penalties are proposed for the UK scheme which are broadly equivalent to those in the EU ETS. So this is unlikely to be an obstacle. Both schemes allow unrestricted banking prior to 2008. The UK scheme restricts banking beyond 2008, but this is consistent with the EU ETS proposals. There is a conflict over the ownership of a small proportion of the emissions from electricity generation, with consequent problems of double coverage and double crediting. Since the first cancels out the second, the overall environmental integrity of the two schemes is not threatened. But the situation is confused and may not be acceptable to the Commission. Source: Irving, 2002 3.6 Recommendations the UK direct participant scheme should cease in 2006, with no further incentivised rounds; trading between the direct participants and the EU ETS should be allowed during the twoyear overlap period; further expansion of trading in the UK should be based upon opt-in provisions to the EU ETS (based on direct emissions only) and/or sectoral expansion of the EU ETS, together with interfaces between the EU ETS and the project mechanisms; participants in the EU ETS should be exempt from the CCL; 4. Interaction between the EU ETS and the UK ETS project scheme The project based component of the UK ETS is analogous to JI and CDM, but at a national level. Organisations will be encouraged to invest in emission reduction projects at sites not covered by the direct participant scheme or the CCAs, and will use these projects to generate credits which may be sold into the UK ETS. As with JI and CDM, the projects must generate emission reductions which are additional to those which would have taken place in the absence of the project scheme. The determination of additionality and the associated calculation of emission baselines is highly complex and technical (Begg et al, 2002a-d). The inherent uncertainty of counterfactual emission baselines creates incentives to free ride and to inflate estimates of the emission reductions achieved, but developing safeguards to prevent this may increase transaction costs and discourage investors from proposing projects. There has been extensive consultancy work on the project scheme (Begg et al, 2002a-d) and the government has announced its intention to go ahead with a pilot phase beginning in May 2003 (DEFRA, 2002). A cautious approach has been adopted in view of both the uncertainty surrounding the EU ETS and the novelty and technicality of the scheme. In particular, a quantitative ceiling has been proposed (but not yet defined) for the volume of credits allowed in the pilot phase. This is important, as banking credits into the commitment period implies allocating part of the UK's assigned amount to project developers - making it particularly important that the emission reductions are additional. To date, there has been relatively little interest from project developers, partly as a consequence of the low carbon price in the UK ETS. There appears to be some limited potential for direct interaction between the project scheme and the EU ETS if projects are undertaken at installations eligible for the EU ETS. There is also indirect interaction related to the treatment of electricity and the possibility of trading project credits into the EU ETS. The Commission is proposing to ‘develop modalities’ for importing JI and CDM credits into the EU ETS. Although UK projects are different from JI/CDM projects, this may provide a potential route for interfacing the UK project scheme. The compatibility between the UK scheme and these proposed rules is therefore crucial. At present, the Commission does not appear to have any plans for an EU-wide project scheme comparable to that in the UK. 4.1 Comparison of instrument scope The government has identified five priority ‘sectors’ for emission reduction projects electricity supply, CHP, built environment (excluding the domestic sector), methane abatement (including landfill gas and coal mine methane) and transport – and has also indicated that projects in other areas will be considered. This list creates a very wide range of possibilities. In all cases, there are potential interactions with other climate policy instruments that may require, fund, support or encourage emission reduction projects, and these may be relevant to the determination of additionality and/or the calculation of emission baselines. As a result, the potential interactions with the EU ETS are just one aspect of a highly complex picture (Sorrell and Smith, 2002). Electricity supply was originally proposed as a priority sector, then withdrawn, then reinstated. Possible hosts for projects include fossil fuel plants, transmission and distribution networks and nuclear plant. Energy efficiency at fossil fuel plants was the subject of a major consultancy study (Mott MacDonald, 2001), but this would lead to double regulation if the plant subsequently entered the EU ETS. The nuclear industry would like to gain credits for the life extension of nuclear plant, but this is a politically sensitive issue and may create difficulties for interfacing the project scheme to the EU ETS. Nuclear projects also have the potential to generate very large numbers of credits. If the electricity generators are in the EU ETS, any projects that improve the efficiency of electricity consumption will lead to double crediting. The project developer gains a credit for avoided electricity emissions, while the reduced electricity demand ‘frees up’ allowances owned by the generators. Two allowances are then circulating for only one tonne of emission reduction. Projects in the domestic sector are excluded from the scheme on the grounds that their inclusion could make it more costly for electricity and gas suppliers to meet their Energy Efficiency Obligation (section 7). This seems a very weak argument given the economic potential for energy efficiency in this sector and it is unlikely that similar restrictions will be included in any proposals for project mechanisms at the EU level. 4.2 Comparison of instrument objectives The UK’s objectives in developing the project scheme include incentivising cost effective abatement opportunities which lie outside the coverage of the CCAs and direct participant scheme, facilitating institutional developments in areas such as monitoring and verification, gaining experience with crediting arrangements to facilitate subsequent engagement in JI and the CDM, and influencing the subsequent development of project rules at the EU level. The Commission’s approach is more cautious, owing to concerns about environmental integrity. The Commission proposes to allow interfaces with JI and CDM from 2005 onwards (‘subject to modalities to be agreed…’), but there has been only limited consideration of the role of project mechanisms within the EU. It is possible that the Commission will allow UK projects to interface to the EU ETS on the same basis as JI and CDM projects, but restrictions may be placed on project types, additionality provisions and crediting rules. For example, both the Commission and the European Parliament have indicated their opposition to credits from sink or nuclear projects. Given both the current lack of interest and the difficulties in developing suitable rules for project mechanisms, it is very unlikely that the Commission will propose an EU project scheme before Phase 2 of the EU ETS. 4.3 Comparison of instrument timing The uncertainties over both the EU ETS and the UK ETS create difficulties for the project scheme and could deter developers from proposing projects. There is a risk that the UK will repeat the experience with the direct participant scheme and turn a first mover advantage into a first mover disadvantage. UK rule-making is taking place prior to final agreement on the EU ETS and before the Commission has begun work on the rules for interfacing to JI/CDM. Projects are intended to begin in 2003, before the EU ETS begins, and to continue well after 2006 when the current direct participant scheme comes to an end. The value of credits after 2006 will depend upon a range of factors, including the continuation (if any) of the direct participant scheme, the extent to which eligible CCA facilities join the EU ETS, the nature of the trading arrangements for the remaining CCAs, the fungibility of UK ETS and EU ETS allowances, and the rules for interfacing projects to the EU ETS. If there is no continuation of the direct participant scheme beyond 2006, and if the Commission refuses to allow UK project credits to be sold into the EU ETS, the market for credits after 2006 could be limited. Buyers will be confined to CCA installations that are either ineligible for the EU ETS or have opted out. If the Commission allows project credits to be imported after 2008, then pre-2008 credits could be banked - provided, again, that the Commission allows this. To give confidence to project developers, the government has indicated that the crediting period for most projects will extend to 2012. But this confidence may be unwarranted, given the uncertainties indicated above. Also, credit prices during the commitment period will be influenced by developments in the international carbon market and could be relatively low. Proposing projects in this context will be a highly risky venture and developers are only likely to do so if the estimated value of the credit stream makes only a marginal contribution to project economics - which in turn could make it less likely that the project is additional. 4.4 Comparison of instrument operation There is a risk of double regulation if projects are undertaken at sites which subsequently join the EU ETS. Take for example a project involving co-firing natural gas at a coal-fired power station. Reductions below the coal-fired baseline would generate credits. But if the plant subsequently joined the EU ETS, it would need to obtain allowances for its CO2 emissions, with the allocation being measured from some historical baseline which may be before or after the introduction of co-firing, or may straddle it. A single plant would then be both requiring allowances and generating credits at the same time. Entry into the EU ETS may trigger a revision in the project baseline or even invalidate the further generation of credits. Hence, unless the UK government can provide some guarantees, developers would be foolish to propose projects on such sites. As with the CCAs and direct participants, any project that improves electricity efficiency will lead to double crediting of the avoided emissions from electricity generation. But in contrast to the double crediting associated with the CCAs and direct participants, double crediting of projects will not be not balanced by associated double coverage. If there were no trading between the project scheme and the EU ETS, the environmental integrity of the latter would be maintained but the UK would need to allow for the double crediting in its climate programme. If there were trading between the two schemes, the environmental integrity of the EU ETS would be undermined. The EU could introduce restrictions on the import of project credits, but the these could easily be circumvented if there were trading links between the UK ETS and EU ETS - for example, a direct participant could purchase project credits, and then sell surplus allowances into the EU ETS instead.10 Differences in banking rules between Member States could similarly be circumvented. This implies that, if the Commission considers the threat to environmental integrity posed by the double crediting to 10 Proposals were made to restrict the purchase of project credits by the CCAs in the UK ETS, but these were eventually dropped because they were so easy to circumvent (Sorrell, 2001). be unacceptable, the inclusion of the project scheme in the UK ETS could prevent any trading of allowances between this and the EU ETS. The feasibility of trading project credits into the EU ETS may also depend upon the comparative stringency of the UK project rules and the criteria subsequently adopted by the EU. If the EU rules are more stringent than the UK rules, this could lead to the modification of UK project baselines and to the disallowing of some or all of the anticipated project credits. As with the direct participant scheme, developing the UK project rules in advance of the EU rules may create a hostage to fortune. 4.5 Policy options A simple option to avoid the above problems would be to abandon the UK project scheme altogether and rely on the subsequent development of project mechanisms at the EU level. But the government has now promised a pilot scheme and substantial work on the project rules has been undertaken. These rules are certain to precede the development of a comparable project scheme at the EU level. Hence, an abandonment of the UK project scheme could result in a lost opportunity to incentivise emission reduction projects at an early stage. An option to avoid double crediting would be to restrict the scope of the project scheme to direct emissions. But this would greatly reduce the potential of the scheme in high priority sectors such as the built environment and remove a potentially valuable instrument for promoting downstream electricity efficiency. The issue here is the relative effectiveness of indirect electricity price increases versus downstream crediting schemes in encouraging electricity efficiency. This is analogous to the choice between indirect price increases and downstream targets in the CCAs and the UK ETS. The UK government's view is that price signals alone are relatively ineffective, given the range of other barriers that inhibit energy efficiency, which leads to a preference for downstream, target-based instruments. This view has much to commend it and is one factor explaining the indirect treatment of electricity in the UKCP. If correct, it means that confining the project scheme to direct emissions would lead to a loss of environmental effectiveness which many groups would consider unacceptable. An alternative option would be to accept a limited amount of double crediting as a price worth paying for facilitating the introduction of the project scheme. A relevant analogy here is the existence of ‘hot air’ in trading schemes. While ‘hot air’ runs the risk of damaging public credibility and environmental integrity, it has facilitated political consensus on emissions trading and has been seen as a quid pro quo for persuading both countries and companies to accept a binding emissions cap. Whether a similar approach is acceptable for double crediting will depend upon the likely scale of the problem and the timescale over which it is anticipated to persist. If only a small number of relatively small scale emission reduction projects are expected, double crediting may be considered to be largely irrelevant. Conversely, if very large projects are expected, which will generate credits over a long period of time, then double crediting may be considered unacceptable. In practice, the importance of double crediting may be overshadowed by the potentially large volume of project credits from non-CO2 GHGs (e.g. methane capture) and the associated concerns over hot air (Begg et al, 2002d). The most obvious solution for both would be to impose an aggregate ceiling on credit volumes. This is required anyway to reduce the risk of non-compliance during the commitment period, and has been included in the UK proposals. 4.6 Recommendations the UK should proceed with a small-scale pilot scheme only, with fuller development of the project mechanism being linked to the development of ‘modalities’ for interfacing the EU ETS to JI and the CDM; the pilot scheme should be developed in consultation with the Commission, with the rules taking into account the concerns of the Commission, Parliament and other Member States about environmental integrity; the rules should be consistent with those for JI and CDM and both nuclear and sink projects should be excluded; no project should be undertaken at sites that may subsequently become eligible for inclusion in the EU ETS; double crediting should be accepted in the pilot phase, but with an aggregate ceiling on credit volumes to preserve environmental integrity; and the UK should work to ensure that the subsequent EU proposals are compatible with the UK scheme. 5. Interaction between the EU ETS and the UK implementation of the IPPC Directive The Integrated Pollution Prevention and Control (IPPC) Directive was transposed into UK legislation in 1999 and is being introduced in a phased manner, with all eligible installations coming under IPPC by 2007. The Directive shares many features with the existing UK regulatory system (Integrated Pollution Control, or IPC), which means that the UK has made fewer changes to legislation and regulatory practice than other Member States. IPPC requires operators of industrial processes to use the Best Available Techniques (BAT) to control polluting releases to all three environmental media (air, land and water) in an integrated manner. IPPC also requires that installations use energy efficiently (Article 3) and that energy efficiency is taken into account when determining BAT (Annex IV). A ‘non-paper’ from the European Commission in January 2002, clarified that the energy efficiency requirements of IPPC should provide a ‘baseline’ level of effort for energy efficiency, but should not be used to impose stringent requirements or to set emission limits for CO2 (CEC, 2002b). Article 25 of the EU ETS Directive proposes amending the IPPC Directive such that, when an IPPC installation is participating in the EU ETS, emission limits are not set for any GHGs unless they are required to prevent local pollution problems. This Article also gives Member States the opportunity of not imposing IPPC energy efficiency requirements on fuel use at these installations (although requirements may still be imposed on electricity use). Both these proposals reduce the potential for conflict between IPPC and emissions trading, while not removing it altogether. There is still direct and indirect interaction which may be important in some instances. Table 5.1 illustrates that the regulatory philosophies and practices of IPPC and emissions trading are fundamentally different. Table 5.1 Comparison between emissions trading and IPPC. Emissions Trading US origins: Offset policy first introduced in 1976 Economics based: Pollution arises from an absence of well defined property rights. Cost effective control is achieved through issuing a limited number of permits (rights) to emit which can be freely traded. Top down: Basis for pollution control is an aggregate emission reduction target for the whole source population. Target driven: Overall pollution target, with no specification of individual technologies or emissions standards. Hands off: Technology decisions are the responsibility of individual firms. Wide system boundary: The system under the aggregate emission target can be as wide as a sector, an economy or a geographic region. Single substance/media: Usually controls a single polluting substance in a single media. Climate change an exception as there are six greenhouse gases. Flexibility via the market: Installation operators can seek flexibility and reduced costs through trading in the permit market. Transparency via the market: Aggregate target, participants’ performance and permit price are public knowledge. Timetable given by budget period: Should be predictable and stable. Legitimacy depends on target: Secured through stringency of overall target. Resources sufficient to monitor trades and enforce transgressions are important. Problems with ‘hot air’ and rights to pollute. IPPC European origins: Technology based principles date from the last century. Engineering based: Pollution abatement is considered a technological problem, and regulation is designed explicitly to promote cleaner (or clean-up) technologies. Bottom up: Basis for pollution control is the sitespecific BAT for an installation. Technology driven: No overall pollution target, beyond the requirement to minimise pollution using BAT Hands on: Regulator is involved in individual technological decisions. Narrow system boundary: BAT limits are set for an individual installation at a single site. Multi substance/media: Controls releases of a wide range of substances to all three media in an integrated manner. Flexibility via negotiations: Installation operators can seek flexibility and reduced costs through BAT negotiations with the site inspector. Scope for this depends on Member State regulatory traditions. Transparency via an institutional process: Public can comment on operator applications. Public register of permit conditions and monitoring returns. Timetable determined by reviews: Regulator ‘periodically’ reviews and updates permit conditions. Legitimacy depends on implementation: Achieved by public regulator setting individual standards and monitoring specific installations. Regulatory resources sufficient for this task are important. Source: Sorrell and Smith (2001) 5.1 Comparison of instrument scope The EU ETS regulates IPPC installations in a subset of ‘IPPC sectors’, but excludes important sectors such as chemicals and food and drink. Also, the size threshold for combustion plant is lower for the EU ETS (>20MW) than for IPPC (>50MW), which means that some sites in non-IPPC sectors will be regulated by the EU ETS but not by IPPC. IPPC only covers direct emissions from regulated sites, but since electricity generators are included there will be an indirect (and probably small) impact on electricity consumers via electricity prices. IPPC also regulates electricity consumption at eligible industrial sites via the energy efficiency provisions, with an indirect (and probably small) impact on all electricity generators, regardless of fuel source, as a consequence of reduced electricity demand. The EU ETS only applies to CO2 emissions at present, but these may result from either fossil fuel combustion or from certain types of processes such as cement production. Article 23a allows other GHGs to be included in Phase 2, provided the environmental integrity of the scheme is not threatened. In addition, Article 26 creates the possibility that some GHGs will be included during Phase 1. In contrast to the EU ETS, IPPC regulates all non-CO2 GHGs from both combustion and process sources, but does not regulate CO2 directly (Annex III). Hence, in principle, IPPC only covers combustion CO2 emissions indirectly through the energy efficiency provisions, and excludes process CO2 emissions altogether. Similarly, IPPC does not have a mechanism to require a switch to a fuel with a lower carbon content, or to encourage the purchase of renewable electricity. If an installation qualifies for the EU ETS because of the size of combustion plant, then only the combustion plant is included. Conversely, if an installation qualifies because of an IPPC process, then both the IPPC process and the combustion plant are included. This means that a combustion plant smaller than 20MW may be covered by the EU ETS, if it is associated with a qualifying IPPC process. 5.2 Comparison of instrument objectives The EU ETS has the narrow objective of reducing aggregate GHG emissions in a costeffective manner, whilst minimising distortions to the internal market. The stringency of the EU ETS will be largely determined by the allowance allocation, but the proposed allocation criteria are difficult to interpret and potentially contradictory. In contrast, IPPC aims at both the best option for the environment as a whole and the adoption of BAT at the installation level. In IPPC, there is a tension between environmental cost-benefit analysis and the requirement that BAT be ‘affordable’ for an average company in the sector (Sorrell, 2002b). The objectives of IPPC are less clear with regard to CO2 abatement, which is only achieved indirectly and incompletely through the energy efficiency provisions and is secondary to the BAT requirements for other pollutants. The objectives in promoting energy efficiency go beyond CO2 abatement alone, while (as with BAT) the stringency of the provisions will depend inter-alia upon the content of the BAT Reference Notes (BREFs) published by the Commission, the content of Member State guidance notes, and the implementation practice of the relevant regulator. The determination of IPPC requirements in the UK is overwhelmingly a bottom-up, site specific process, based on informal negotiations between the site inspector and operator, with very limited use of formal economic techniques (Sorrell, 2002b). This contrasts with the allowance allocation in the EU ETS, which is based in part upon top down considerations, such as the EU burden sharing agreement. These two approaches have very different implications for incentives, information asymmetry, stringency, and the scope for regulatory capture. 5.3 Comparison of instrument timing Existing installations are being phased into IPPC and for some sectors (e.g. refineries) this process will not be complete until 2007. This means that the EU ETS may begin before all eligible installations are brought under IPPC. This may create administrative difficulties, since the EU ETS and IPPC permitting procedures are required to be co-ordinated (Article 8), but since most eligible installations are already regulated under IPC in the UK, this is unlikely to be a major problem. Of greater importance is the potential use of IPPC provisions to demonstrate equivalence of effort, under the opt-out provisions of Article 25a. Refineries, for example, would find it difficult to opt-out in 2005 on the basis of ‘equivalent’ IPPC energy efficiency provisions, since the latter would not have been defined. 5.4 Comparison of instrument operation For installations affected by both instruments, there is double regulation of electricity, combustion CO2 emissions and, from Phase 2 onwards, some or all non-CO2 GHG emissions, but the nature and importance of these interactions differ. Trading is incompatible with strict BAT requirements for non-CO2 GHGs, whether these are interpreted as quantitative emission limits or technology requirements. Regularly updated strict BAT requirements would eliminate the scope for cost-saving trades since, if an installation reduces emissions below IPPC requirements, this immediately signals to the regulator that the BAT standards need to be changed. Article 25 of the Directive attempts to get round this by scrapping IPPC emission limits for installations participating in the EU ETS, unless these are needed to prevent local pollution problems. In the latter case, the freedom to trade non-CO2 GHGs is constrained since emissions must remain below the IPPC limit, but if allowance allocations are more stringent than the IPPC limit, there is still scope for cost saving trades. However, the Directive fails to clarify the status of technology requirements imposed under IPPC, or the extent to which these may be updated. This is important, because BAT is often implemented through technology requirements rather than emission limits. An anomalous feature of Article 25 is that it is confined to activities and gases listed in Annex 1 of the Directive. It would therefore appear to exclude installations which have opted-in to the EU ETS and are regulated by IPPC, but which are not part of the core sectors. These installations will still be subject to strict BAT requirements on non-CO2 GHGs. If this provision remains unchanged, it could severely limit the scope for opt-ins of both activities and gases. At some sites in the UK ETS, IPPC emission limits are used as the basis for allowance allocation. Direct participants can earn credits for reducing emissions below these limits, while the freedom to tighten IPPC requirements over the duration of the UK ETS is restricted. This is a more restrictive approach than proposed for Annex 1 sectors and gases in the Directive, but it has still led to serious problems with ‘hot air’. IPPC emission limits were set for groups of pollutants (e.g. VOCs), rather than specific GHGs, which led to emission baselines being overestimated and subsidised hot air being granted to key participants such as Ineos Fluor (ENDS, 2002). This problem was exacerbated by the very high global warming potential (GWP) of some non-CO2 GHGs, with the result that over half the GHG emission reductions achieved through the direct participant scheme will be through non-CO2 gases. Ultimately, the effect of the Directive proposals will depend upon the allocation rules for non-CO2 GHGs, when they are eventually brought in to the scheme. But the UK experience suggests that there are serious ‘hot air’ risks with non-CO2 GHGs, which could be substantially increased if allocations are based on top down, benchmark criteria rather than site specific determinations. The ‘non-paper’ recommendation that participating installations adopt ‘baseline’ energy efficiency requirements has been translated into more detailed guidance in the UK (Environment Agency, 2001). The proposals for generic, low cost energy efficiency measures go substantially beyond current practice in many companies and include the preparation of an energy efficiency plan which describes all technically available efficiency opportunities and estimates their costs and benefits. Installations participating in trading schemes need only adopt the ‘basic’ measures in the plan, while installations outside the trading scheme must appraise each option using an ‘appropriate’ discount rate and implement those that provide cost savings. Measures that lead to net costs may also be required since: ‘…one would expect to spend money to reduce other pollutants and it is reasonable to expect to spend money to reduce the pollutants resulting from energy use’ (Environment Agency, 2002). The guidance also states that there is insufficient information to set an appropriate cost benchmark at present and provides a number of caveats regarding cash flow, business cycles, age of plant and so on. The ‘basic’ requirements can act as backup regulation to the EU ETS and ensure that participants take some action to improve energy efficiency, even when allowance prices are low. The requirements facilitate monitoring, reporting and verification and in principle should lead to net cost savings for participants. This appears, therefore, to be a pragmatic and sensible approach. The requirements for non-participants are more problematic, however. These are designed to ensure ‘equivalence of effort’ with trading scheme participants and to avoid competitive distortions. But if allowance prices are low, it is possible that the combination of EU ETS and ‘basic’ IPPC requirements imposed upon participants will be less stringent than the BAT-based IPPC requirements imposed upon non-participants.11 This differential treatment may be challenged by non-participants on legal or political grounds, but the distortions to competition are muted by the fact that EU ETS and non-EU ETS sectors are (generally) not direct competitors. 5.5 Policy options The approach adopted in the ‘non-paper’ and UK guidance towards the IPPC energy efficiency provisions appears sensible and is consistent with previous recommendations from the INTERACT project (Sorrell and Smith, 2001). But complications arise with the opt-out provisions in the EU ETS. Installations without CCAs (e.g. refineries) may wish to use the stricter, non-participant IPPC requirements as the basis for demonstrating equivalence of effort. As with the CCAs, this is problematic owing to differences in: Scope: EU ETS participants have targets for direct combustion and process emissions, but not electricity. Non-participants have double regulation of electricity and coverage of combustion CO2 emissions only. This applies both to combustion CO2 (where participants face ‘basic’ energy efficiency requirements plus allowance allocations) and electricity (where participants face ‘basic’ energy efficiency requirements plus electricity price rises which are related to allowance prices). 11 Form: Allowance allocations and BAT requirements differ in principle and substance, and while the former is fixed for 5 year period, the latter should be continually updated. Stringency: EU ETS allowance prices provide a measure of marginal abatement costs, but the informal, confidential and site-specific nature of IPPC negotiations and the lack of economic analysis makes assessment of the comparative stringency of IPPC and the EU ETS very difficult. Also, since most IPPC energy efficiency requirements have yet to be imposed, such assessments would need to be done ex-ante. In practice, much will depend upon the manner in which both the EU ETS allowance allocation and the IPPC energy efficiency requirements are implemented. Evidence suggests that the implementation of industrial pollution control in the UK has been based upon informal assessments of what the individual firm can afford and that site-level negotiation can lead to requirements being watered down (Sorrell, 2002a). This suggests that the energy efficiency requirements imposed in practice may be weaker than those suggested by the guidelines, and that as a consequence, installations may view opting-out as an attractive means to avoid abatement costs. The most obvious way to prevent this is to exclude IPPC requirements as a suitable basis for opting-out. Article 25a appears to allow for this by confining eligibility to those installations that are subject to equivalent ‘national policies’. Since IPPC is an EU Directive, it is not a national policy - although there are very large differences in how the Directive is implemented in different Member States. 5.6 Recommendations the interpretation of IPPC energy efficiency requirements that is outlined in the non-paper and in UK guidance is sensible and should be retained; the Commission should specify in greater detail the recommended approach to non-CO2 GHGs for those installations where BAT requirements are expressed as technical requirements rather than emission limits; the provisions in Article 25 should be extended to those installations and gases that are not listed in Annex I but which have chosen to opt-in to the EU ETS; to avoid problems with ‘hot air’, the inclusion of non-CO2 GHGs in Phase 2 of the EU ETS should be based upon both accurate monitoring protocols and very strict criteria for allowance allocation; installations should not be allowed to opt-out of the EU ETS on the basis of ‘equivalent’ IPPC energy efficiency requirements, since IPPC is not a national policy and in practice the energy efficiency requirements are unlikely to be strictly enforced. 6. Interaction between the EU ETS and the UK Renewables Obligation The Renewables Obligation (RO) is a Tradable Green Certificate (TGC) scheme in which obligations are placed upon electricity suppliers to purchase a percentage of their electricity from qualifying ‘new renewable’ sources (existing sources are excluded). The target for 2002/03 is for 3% of electricity to be purchased from new renewable sources and this target increases annually to 10.4% by 2010. No increase in the target is specified after 2011, but this will be kept under review. The RO requires a substantial expansion of UK renewables capacity and implies a much faster rate of increase than was seen during the 1990s under the previous Non-Fossil Fuel Obligation. Renewables Obligation Certificates (ROCs) are issued for each MWh of qualifying renewable electricity generated and each supplier must ensure it has enough ROCs to cover its RO target. Sales of ROCs are separate from sales of electricity and individual suppliers may comply by either investing in renewables capacity, purchasing ROCs from other generators or paying the Buyout Price of 3p/kWh. The latter mitigates the price risk of the RO by placing a ceiling on ROC prices, but creates the possibility that the RO targets may not been met. Since buyout revenues are distributed to competing suppliers (‘smearback’), there is an additional incentive to avoid paying the Buyout Price which should push the ROC price ceiling above 3p/kWh.12 The risk of price volatility is partly mitigated by the provision for banking allowances, which may be used to meet a maximum of 25% of the target in the subsequent RO period. Also, individual suppliers that overcomply with their obligation can convert their overcompliance from kWh to tonnes of CO2 (using a fixed conversion factor) and sell the credits into the UK ETS - even if the RO targets overall have not been met. This trading is one way, however: suppliers cannot buy UK ETS allowances to help them meet their obligations. 6.1 Comparison of instrument scope There is no direct interaction between the RO and the EU ETS, since the RO targets electricity suppliers while the EU ETS targets electricity generators and large industrial consumers. In the liberalised UK electricity market, many electricity generators have associated supply businesses and several companies have invested in renewables. This means that the same company may be involved in both the RO and the EU ETS, but not simultaneously for the same installation. The indirect interactions between the RO and the EUETS are complex and significant. Abatement to meet EU ETS targets will raise wholesale electricity prices, which in turn will improve the competitiveness of renewable electricity and increase investment in renewables. The RO will also increase investment in renewables by creating a second revenue stream for developers. Hence, both instruments will incentivise investment in renewables and this investment will displace fossil fuel electricity generation and reduce CO2 emissions. 12 The combination of the Buyout Price, smearback and the exemption of renewable electricity from the CCL may push the price ceiling as high as 4.8p/kWh (AEP, personal communication) . The EU ETS will raise consumer electricity prices as generators will pass on a proportion of marginal abatement costs. But the impact of the RO on consumer prices is ambiguous. If we assume that demand is relatively static and that wholesale electricity prices are set by the marginal fossil fuel plant, then wholesale prices may be reduced by the RO (Jensen and Skytte, 2002). This is because renewable electricity will have displaced fossil fuel plant and the wholesale price will now be set by a lower cost marginal plant. At the same time, electricity suppliers will need to purchase ROCS to meet their RO target – with the ROC price being equal to the difference between the long-run marginal cost of supplying renewables and the wholesale electricity price (ignoring price ceilings). These two effects offset each other and could lead to either higher or lower costs for electricity suppliers and, in turn, higher or lower prices for electricity consumers. In practice, higher costs are more likely and the government expects the RO to increase average consumer electricity prices by some 4.4% by 2010. Owners of fossil fuel generation plant must comply with their emission cap from the EU ETS, while at the same time they have an incentive to invest in renewables from the RO. New entrants with no existing plant have the same incentive to invest in renewables and have a disincentive to invest in fossil fuel generation since they would need to obtain allowances to cover all emissions. The RO creates a demand for renewable electricity from electricity suppliers, while exemptions from the CCL create a demand for renewable electricity from electricity consumers. Unlike the CCL, the EU ETS does not create a demand for renewable electricity from electricity consumers, since participants are only accountable for direct emissions. But by raising the price of fossil electricity, the EU ETS improves the competitiveness of renewables which should translate to increased consumer demand. At present, consumers in the manufacturing, public and commercial sectors can identify renewable electricity through the system of Levy Exemption Certificates (LECs). But there are no provisions for carbon labelling of electricity (disclosure) which would allow consumers to discriminate between high and low carbon sources and to identify zero carbon nuclear sources. 6.2 Comparison of instrument objectives The primary objective of the EU ETS is the reduction of CO2 emissions, but the primary objective of the RO is the promotion of renewable generation. While the RO will help to reduce CO2 emissions by an anticipated 2.5MtC by 2010 (if the targets are met), the RO has other objectives, including: nurturing an industry with large export potential; encouraging economies of scale and learning effects that should improve the competitiveness of renewable technologies; improving supply security by increasing the diversity of generation sources; contributing to rural development; improving air quality; and reducing acid deposition. The provision of these wider public goods and mitigation of non-CO2 externalities provides a justification for supporting technologies which do not provide the least cost option for CO2 abatement in the short term. As a consequence, the ‘double regulation’ of electricity consumers – who pay the CCL and are likely to pay higher prices as a result of the RO - is considered to be acceptable. The ROC price may usefully be split into two parts: a) the ‘value’ of CO 2 abatement to the UK; and b) the ‘value’ of the remaining objectives, expressed in monetary terms (Morthorst, 2000). The former may be set equal to the cost of alternative abatement options, or related to the international price of carbon (converted to p/kWh for the UK electricity system), with the latter considered as a residual, the size of which depends upon the ambition of the RO target. Since the non-CO2 objectives are local, regional or national in character, any international trade of ROCs would be problematic. For example, if a supplier purchased TGCs from the Netherlands, this would contribute nothing to supply security or employment in the UK. Hence, the RO does not, at present, allow for international trade. Similarly, international trade in TGCs would require associated adjustment of Assigned Amounts under the Kyoto Protocol. 6.3 Comparison of instrument timing The RO began operation in 2002 and the targets extend to 2010. The scheme will need to continue beyond 2010 to allow developers to recover their costs. A number of commentators have argued for more ambitious targets for renewables deployment out to 2020 (PIU, 2002), but further development of the RO will need to take into account the EU Renewables Directive, completion of the internal market in electricity, the expansion of cross-border trade in electricity, and the possibility of international trade in TGCs. The RO targets are increased annually during Phase 1 of the EU ETS, while the targets for Phase 2 are still unclear. The provisions in Annex III of the EU ETS require that allocation plans are consistent with national energy policies and EU legislation - including the Renewables Directive. This suggests that the UK should take the RO targets into account when deciding upon allowance allocation. But annual allocations in the EU ETS will be fixed during each Phase and cannot change each year in tandem with the RO. 6.4 Comparison of instrument operation Figure 6.1 shows a stylised supply curve for renewables. A quantity QE of renewables should be supplied in the absence of the RO, as this is competitive at the wholesale electricity price PE. QRO is the relevant target under the RO and this will only be supplied if a price P MC is obtained for electrical output. This can be achieved through a combination of the wholesale PE and the price for ROCs, PROC. The ceiling for the latter is provided by P BO, which exceeds PE by at least 3p/kWh. From this diagram it is clear that increases in wholesale electricity prices will increase renewables deployment and decrease the price of ROCs. If P E = PMC , the RO target will be achieved without the help of the Obligation and PROC will fall to zero. Similarly, decreases in wholesale electricity prices will increase the price of ROCs, up to a maximum set by the buyout price. Since the latter is defined in relation to PE, a sufficiently large fall in wholesale electricity prices will mean that the renewables target will not been met since: (PE + PROC) < PMC. The EU ETS will increase wholesale electricity prices, which suggests that a sufficiently stringent allowance allocation (i.e. a sufficiently high allowance price) could achieve the RO target by itself, and force ROC prices to zero. Similarly, a sufficiently stringent RO target could lead to enough displacement of fossil fuel generation by renewables to meet the CO2 targets under the EU ETS, without any further abatement being required. In the latter case, if the emissions trading scheme was confined to UK generators, the allowance price could fall to zero (Jensen and Kytte, 2002). But since the scheme is EU-wide, this is unlikely. Figure 6.1 Supply curve for renewables Supply Curve for Renewables Price (p/kWh) PBO PMC PROC PE QE QRO Renewables capacity (GW) Investment in renewable capacity will lead to double crediting of CO2 reductions (Figure 6.2). By displacing fossil fuel generation, this will free up carbon allowances in the EU ETS. At the same time, the displaced CO2 will be credited in the RO as the ‘CO2 value’ within the associated ROCs. Renewable generation will be ‘rewarded’ twice for the displaced emissions: first by PE, which has internalised the cost of carbon in the EU ETS; and second by PROC, which includes the ‘CO2 value’ of renewables deployment. Fossil fuel generators will lose market share, but this will be offset by the revenue obtain from the sale of ‘freed up’ EU ETS allowances. If the renewable generation and the fossil generation is owned by the same company, the investor will be rewarded by the sale of both ROCs and EU ETS allowances. As with the UK ETS project scheme, this double crediting will not be balanced by associated double coverage of electricity emissions. Nevertheless, the double crediting may be less problematic than for other instruments because, first, the EU ETS allowance allocation should have taken the RO targets into account, and second, the two markets are entirely separate with the RO ‘CO2 value’ hidden in the ROC. Also, the double crediting does not threaten the environmental integrity of either scheme since the EU ETS cap is not breached and the RO target is not undermined. But since the overall abatement achieved by the EU ETS and RO will not be equal to the sum of the estimated abatement from each scheme, there is a risk of double counting when evaluating the overall contribution of each instrument to UK carbon targets. Figure 6.2 Coexistence of the RO and the EU ETS leads to double crediting Fossil-fuel combustion plant generating electricity Reduce electrical output by ‘X’ Fall of ‘Y’ in CO2 emissions Releases carbon allowances for sale in EU ETS Increase electrical output by ‘X’ Invest in new renewable electricity plant Displaces ‘Y’ amount of CO2 from fossil plant Physical carbon mitigation ‘Y’ Contributes toward UK RO objective. Source: Smith (2002) There is no fungibility between EU ETS allowances and ROCs, since the Directive does not allow for this. This is in contrast to the present arrangements within the UK ETS, where overcompliance with an RO target can be used to generate UK ETS allowances, using a fixed carbon conversion factor. However, if there are trading links between the UK ETS and the EU ETS, this prohibition can be circumvented. For example, an overcomplying supplier could convert surplus ROCs into allowances and sell these to a direct participant, who in turn could sell them into the EU ETS. This possibility may inhibit trading links between the two schemes. In practice the renewables market will be influenced by a host of factors other than the RO. These include wholesale electricity prices, the treatment of intermittent generation within the electricity trading arrangements, the regulation of transmission and distribution networks and planning regulations. Most of these are currently unfavourable to renewables deployment (Smith and Watson, 2002). 6.5 Policy Options The flexibility of compliance with the RO and EU ETS could be improved through allowing full fungibility of trading commodities, such that suppliers could comply with their obligations by purchasing EU ETS allowances. But this approach ignores the non-CO2 benefits of renewables deployment. Given that CO2 abatement through renewables deployment is generally more costly than alternative options, the likely result would be very limited investment in renewables. For example, using the government’s recommended conversion factor of 0.43kgCO2/kWh, a buyout price of 3p/kWh is equivalent to a carbon price of ~£70/tCO2, which is at least ten times higher than current allowance prices in the UK ETS, 3.5 times higher than the Commission’s estimate of the marginal cost to the EU of meeting Kyoto commitments, and 2.5 times higher than the allowance price ceiling in Phase 1 of the EU ETS.13 13 0.43kgCO2/kWh is the conversion factor for delivered electricity in the CCAs. This takes into account the average carbon intensity of the UK generation fuel mix, together with efficiency losses in generation, An alternative would be to adopt the approach currently used in the UK and allow one-way fungibility. Suppliers who overcomplied with their renewables obligation could convert their surplus ROCs into carbon allowances and sell them into the EU ETS. This formalises what could happen anyway if the UK ETS and EU ETS were linked and is equivalent to assuming that the non-CO2 value of renewables is fully met by the RO targets and that any further increase is solely of benefit to CO2. But the current text of the EU ETS does not allow for such a link during Phase 1 and proposals have yet to be made to introduce it for Phase 2. The conversion process would lead to double crediting in the EU ETS, in that: first, the displaced fossil fuel generation will free up allowances in the EU ETS; and second, an approximate equivalent volume of new allowances will enter the EU ETS via the conversion process. The primary motivation with this option is to encourage overcompliance with the RO. At present, the only incentive for overcompliance is the ability to sell ‘green’ electricity at a premium price,14 coupled with the exemption of renewables from the CCL. The ability to create carbon allowances creates an additional revenue stream. In addition, such conversion allows overcompliance to be banked in the EU ETS market, which has more flexible banking rules than the RO. Of course, there may be more sensible and direct routes to encouraging greater renewables deployment, including: a) increasing the RO targets themselves (and the buyout price); b) setting a minimum price for ROCs and ensuring that the government will purchase any surplus; c) allowing greater flexibility in the ROC banking rules; and d) removing the non-price barriers to renewables deployment. The first of these options would lead to increased costs for electricity consumers while the second would require government expenditure, funded through general taxation. The last needs to be urgently addressed, whether or not the RO targets are increased (Smith and Watson, 2002). To overcomply with the RO, a supplier must obtain ROCs in excess of its RO target. These could either be in association with the renewable electricity (including situations where the supplier owns the renewable plant), or independently of electricity purchases. In the second case, the only motivation for purchasing surplus ROCs would be if the potential revenue from allowance sales exceeded the purchase cost of the ROCs, which in practice is unlikely. A supplier could also purchase a greater amount of renewable electricity than required by the Obligation, but not obtain the associated ROCs. This may be the case, for example, if the supplier is providing a 100% renewable ‘green tariff’. The electricity may be certified as renewable by the use of Levy Exemption Certificates (LECs) under the CCL, or by an independent certification scheme. Complications may be introduced by different definitions of renewables in the RO, CCL, Renewables Directive and independent certification schemes (Table 6.1). The conversion of this type of ‘overcompliance’ into carbon allowances could be problematic, particularly if the source of the renewable electricity is selling ROCs to another supplier. This would lead to triple crediting, since the avoided fossil fuel emissions will have: a) freed up allowances in the EU ETS; b) contributed to the carbon value of the ROCs; and c) created new allowances in the EU ETS via the conversion process. If the purchaser of the ROCs also chose to use them to create carbon allowances, there would be three allowances circulating for a single abatement action. This problem is avoided if the source does not qualify as renewable under the RO, but in many such cases (e.g. energy from waste) the transmission and distribution. Using the same factor for renewable generation implies ignoring transmission and distribution losses. Since renewables are usually ‘embedded’ at lower voltage levels, these losses may be lower than for centralised fossil fuel generation, but they are not zero. 14 This is only permitted for renewable generation which is surplus to the required under the RO. source emits CO2. Similarly, the problem could be avoided if this type of ‘overcompliance’ was not eligible for conversion into allowances, but this would remove a potential incentive for overcompliance. It should also be noted that: first, overcompliance by one supplier does not mean that the overall RO target has been achieved; and second, there is a possibility that conversion of surplus ROCs into carbon allowances could reduce the availability of ROCs and raise ROC prices. Table 6.1 Definitions of renewable electricity under different policy instruments Source CCL RO EU Renewable Directive Future Energy Large Hydro Small Hydro Geothermal Solar Wind Tidal and wave Landfill gas Sewage gas Biomass Co-firing of biomass Advanced energy from waste technologies Energy from waste incineration Notes: Light shade = fully supported; Dark shade = supported with qualification Future Energy was an independent certification scheme for ‘green energy’, run by the Energy Savings Trust. This has now been withdrawn and there is no obvious replacement. Source: OFGEM (2001) The use of a fixed emissions factor for conversion may also create problems of discrepancy between the actual and claimed emission reductions. The emissions displaced through renewable generation will depend upon the time of day, week and year and on the location of the source. A fixed factor based on the average fuel mix will become increasingly inaccurate over time, unless it is regularly updated. And since marginal fossil fuel plant is likely to be more carbon intensive than the system average, it is also likely to underestimate the carbon benefits of renewables. Of course, the same problem applies to the CCAs and the UK ETS. The above suggests potential problems with carbon accounting when interfacing the RO with the EU ETS, which may prove unacceptable to the Commission. One alternative which has been proposed would be to separate the CO2 and non-CO2 ‘values’ of the ROC and trade them independently in separate markets. The first could interface to the EU ETS and international markets, while the second could be confined to the UK. Suppliers would be required to purchase a certain quantity of both to meet their obligation. The difficulty here is that, with the EU ETS in place, the CO2 value of the ROC has already being reflected in the allowances ‘freed up’ by the displaced fossil fuel emissions. Creating a separate CO 2 value for the ROC and trading this into the EU ETS would lead to two allowances being created for all the emissions displaced by RO-obligated renewable electricity, rather than just from overcompliance with the obligation. Hence, the existence of the EU ETS would appear to create a serious obstacle to such a ‘splitting’ of the ROC. It is important to note that the double crediting problems described above could be largely theoretical. The price difference between ROCs and carbon allowances is very large and likely to remain so for the foreseeable future. With limited prospects of trading between the two schemes, the potential for double crediting could easily be ignored. 6.6 Recommendations the allocation of allowances to UK electricity generators should, as far as possible, take into account the renewables targets under the RO; during Phase 2, the EU ETS should either: allow one-way trading from schemes like the RO, using a similar framework to that adopted for the UK ETS; or encourage crediting projects for renewables through the development of suitable modalities for linking the EU ETS to project-based mechanisms; if the first approach is adopted, this should only apply to overcompliance which has been demonstrated by the acquisition of surplus TGCs; the small potential for double crediting within such an arrangement should be considered and acceptable price to pay for providing an additional incentive for overcompliance with renewables targets. the incentive for overcompliance should not be considered a substitute for other measures to encourage renewables deployment, such as more ambitious targets for renewables after 2010, greater flexibility in the banking rules for ROCs and removal of the non-price barriers to renewables deployment. 7. Interaction between the EU ETS and the UK Energy Efficiency Commitment The Energy Efficiency Commitment (EEC) is an innovative, market-based scheme for improving energy efficiency in the domestic sector. It is intended to deliver both energy and carbon savings and to alleviate fuel poverty among low income groups. The EEC sets obligations on gas and electricity suppliers to deliver a certain quantity of ‘fuel standardised energy benefits’ over the period 2002 - 2005 through investment in energy efficiency. Energy benefits can represent either reduced energy use for the same level of energy service, or improved levels of energy service for the same level of energy use. Energy benefits are denominated in GWh and are calculated by estimating the discounted (at 6%) energy savings over the lifetime of the investment, adjusted for the carbon content of the relevant fuel mix. The EEC targets are based upon number of customers and do not apply to suppliers with less than 15,000 customers. In total, the EEC is intended to deliver 64TWh/year of energy benefits by 2005 and to reduce CO2 emissions by 0.4MtC/year. The total cost is estimated at £162m/year over the three year period, which corresponds to £7.20/year per household. The benefits from the scheme will be confined to those households receiving subsidies, but the total benefits averaged over all households are estimated as £9.93/year per household by 2005. Energy benefits will continue over the lifetime of the energy saving investment (i.e. well beyond 2005), giving total benefits of around £2 billion. The EEC has many similarities with the RO, but the relative cost effectiveness of domestic sector energy efficiency explains the absence of a price ceiling in the form of a ‘buyout price’. The energy regulator, OFGEM, is responsible for administering the scheme in collaboration with the Energy Savings Trust (EST). The energy savings from different types of investment in different types of household are estimated on a discounted lifetime basis using models from the Building Research Establishment (BRE). This uses ‘comfort factors’ to take into account the likely proportion of the investment that is taken up in improved comfort (e.g. 30% for CFLs) and ‘dead-weight’ factors to allow for those investments that would have gone ahead anyway. The estimates can be converted into carbon savings using emission factors for the relevant fuel mix. The EEC scheme incorporates trading in two ways. First, suppliers can trade their targets (obligations) under the scheme, such that one supplier takes responsibility for a portion of another supplier’s obligation in exchange for payment. This resembles a cap and trade scheme and allows trading to take place at any time. Second, suppliers can trade their performance under the scheme such that one supplier sells GWh of achieved energy benefits to another energy supplier, who uses this towards their own EEC target. This is a form of baseline and credit trading and can only take place ex-post, after the compliance of the seller with its EEC has been verified. In most cases, this will be at the end of the three year period. Both forms of trading should provide a market incentive to minimise the cost of achieving the obligation. In a similar manner to the RO, suppliers who overcomply with their obligation can generate carbon credits for sale into the UK ETS. As with the RO, the trading is one-way: undercompliant suppliers cannot satisfy their obligations by purchasing carbon allowances. 7.1 Comparison of instrument scope There is no direct interaction between the EEC and the EU ETS, since the EEC targets electricity and gas suppliers while the EU ETS targets electricity generators and large consumers. Electricity companies with both generation and supply interests may participate simultaneously in both schemes, but these activities will be largely disconnected. The EEC will increase electricity and gas costs for all household consumers by an estimated £3.60 per fuel per year. Not only is this a much smaller increase than would be obtained by imposing VAT on domestic fuel,15 it is also hidden within the bill and therefore less visible in the context of changing supply prices. Furthermore, the benefits are returned to consumers in the form of energy efficiency investments. While all consumers will pay for the EEC, only those households in receipt of subsidies for energy efficiency investment will benefit. The EU ETS will increase household electricity (not gas) bills, by an amount related to the allowance price. Under certain assumptions,16 a £10/tCO2 allowance price will increase the average domestic bill by 6%, or ~£15/year. In the absence of allowance auctioning, there will be no mechanism for compensating households for this price increase. The coexistence of the EU ETS and EEC leads to double regulation of household electricity consumers, but the anticipated price increase should be placed in the context of a 25% reduction in household electricity prices between 1995 and 2001. In principle, the EU ETS could provide generators with an incentive to invest in household energy efficiency to reduce electricity demand and help them meet their cap (demand-side management). However, this appears very unlikely as the reduced demand will be shared between all generators and the abatement and transaction costs will be relatively high. A more effective incentive could be provided through a projects scheme within the EU ETS, which would allow generators to obtain carbon credits from individual demand-side investment projects. As presently structured, however, the EEC provides an obstacle to this. The UK project scheme excludes investment in the household sector, because (it is claimed) this would allow ‘cherry picking’ of the best projects to provide carbon credits, and thereby force up the costs to energy suppliers of meeting their EEC obligations. Similarly, only EEC obligated suppliers are allowed to convert surplus EECs into carbon credits for sale into the UK ETS. 7.2 Comparison of instrument objectives The focus on ‘energy benefits’ in the EEC reflects the fact that it has both energy and social policy objectives. High ‘comfort factors’ for energy efficiency investment indicate that many households would like higher levels of energy service, such as warmer homes. This is particularly the case for the 4.5 million UK households living in fuel poverty - defined as spending more than 10% of household income of energy. The EEC rules require that at least 15 VAT is currently charged at only 5% on domestic energy, compared to 17.5% on other goods and services. Imposing full rate VAT on domestic electricity would add £32.60/year to the the average ‘standard credit’ domestic electricity bill for England and Wales (£261/year). 16 Namely: a) the trading scheme is introduced overnight without companies having the opportunity to change behaviour; b) the full costs of meeting the emission target are passed on to consumers through electricity price rises, with none being be passed on to suppliers or absorbed through lower returns; and c) the impact on electricity prices is independent of the method of allowance allocation (Sorrell, 2002a). 50% of investment be in the 8.2 million households in receipt of income-related or disability benefits. These will receive a 100% subsidy for most forms of investment, compared to around 50% for non-priority groups. Other benefits of the EEC scheme include reducing building maintenance costs (through reduced mould and condensation), creating jobs in the energy efficiency industry, and creating market opportunities for new technologies. The EEC will reduce CO2 emissions by reducing fuel and electricity use. Estimates of the contribution from electricity efficiency assume a fixed emission factor (0.43kgCO2/kWh delivered) which leads to the same problems with discrepancy as with the CCAs, UK ETS and RO. The focus on fuel poverty means that minimising abatement costs is not the primary objective. The Energy Savings Trust estimates that the minimum cost of abatement measures under the previous EESoP was around £14/tCO2, while measures in low income households would cost significantly more, or even lead to zero abatement (Calder and Hough, 2001). In principle, the price of an EEC credit could be split into two parts: a) the ‘value’ of CO2 abatement to the UK; and b) the ‘value’ of the remaining objectives, expressed in monetary terms. As with the RO, the non-CO2 objectives are UK-specific. In practice, individual efficiency investments will make very different contributions to these two objectives - for example, CO2 abatement will be less (i.e. comfort taking will be higher) for insulation measures in low income households. Unlike with the RO, there has been no discussion about splitting the EEC in this way. 7.3 Comparison of instrument timing The present EEC runs from 2002 to 2005. It is expected to be followed by an expanded scheme, but the details of this have yet to be developed. The UKCP estimates that the EEC will contribute between 2.6 and 3.7MtC of abatement per year by 2010. This is five to seven times larger than the abatement expected from the first phase of the scheme, which suggests that a very large expansion of the scheme will be needed if the UKCP targets are to be met. The government estimates have been criticised by Ekins et al (2001), who argue that abatement on this scale would require the maximum market penetration of technologies such as cavity wall insulation and compact fluorescents.17 The reduced electricity demand resulting from the EEC may need to be taken into account when determining the allowance allocation for the EU ETS. At present, however, it is not clear whether the EU ETS allowance allocation will precede or follow the selection of targets for second phase (post 2005) of the EEC. The arrangements for trading surplus carbon credits into the UK ETS have yet to be finalised and so far there has been little interest from suppliers. The future of the UK ETS is uncertain beyond 2006 and there seems little prospect of linking the EEC with Phase 1 of the EU ETS. 17 The Energy Savings Trust estimates the cost-effective potential (>5 year payback) for energy efficiency investment in the domestic sector to be 5.8MtC (11.8%) by 2010 and 14.7MtC (34%) in the long term. 7.4 Comparison of instrument operation The EEC interacts with the EU ETS through the treatment of electricity. As with the RO, this occurs in two ways: target setting and double crediting. A sufficiently stringent EEC target could lead to enough reduction in domestic sector electricity demand to meet the electricity generators’ CO2 targets under the EU ETS without any further abatement being required. In practice this is very unlikely because, first, the second phase EEC targets are unlikely to be that ambitious; second, the domestic sector only accounts for a portion of electricity demand; and third, efficiency investment will be counteracted by comfort taking, rebound effects, falling wholesale electricity prices and underlying drivers of demand growth, such as increasing appliance ownership. A sufficiently stringent EU ETS target could lead to large reductions in domestic sector electricity demand, but this would not be equivalent to meeting the EEC obligation as the ‘energy benefits’ for low income households would not have been met. In fact, the EU ETS will impose ‘energy costs’ on these households in the form of higher prices. While higher prices will incentivise electricity efficiency, the existence of a wide range of barriers makes prices elasticities very low and the scale of price increase required to make serious inroads into consumption patterns would have damaging consequences for the fuel poor. Investment in domestic sector electricity efficiency will lead to double crediting of CO 2 reductions. By reducing fossil fuel generation, this will free up carbon allowances in the EU ETS, while at the same time the displaced CO2 will be credited as part of the energy benefits of the EEC. As with the RO and the project scheme, this double crediting is not balanced by associated double coverage. Nevertheless, it may not be problematic because, first, the EU ETS allowance allocation should have taken the EEC targets into account (although note the caveats in the previous section), and second, the two markets are (at present) entirely separate with the ‘CO2 value’ hidden in the EEC. Also, the double crediting does not threaten the environmental integrity of either scheme since the EU ETS cap is not breached and the EEC target is not undermined. But since the overall abatement achieved by the EU ETS and EEC will not be equal to the sum of the estimated abatement from each scheme, there is a risk of double counting when evaluating the overall contribution of each instrument to the UKCP. In principle, overcomplying suppliers can convert their EEC obligations into carbon credits and sell them into the UK ETS. But there are no comparable arrangements for selling carbon credits into the EU ETS. As with the project scheme and the RO, if there are trading links between the UK ETS and the EU ETS, this prohibition could be circumvented. For example, an overcomplying supplier could convert surplus EEC credits into UK ETS allowances and sell these to a direct participant, who in turn could sell them into the EU ETS. This possibility could inhibit trading links between the two schemes. But it should be noted that there has been very limited interest from suppliers in such trading links and the relatively high abatement costs in the domestic sector (resulting, in part, from comfort taking) would appear to militate against this. 7.5 Policy options As with the RO, The flexibility of compliance with the EEC and EU ETS could be improved through allowing full fungibility of trading commodities, such that suppliers could comply with their obligations by purchasing EU ETS allowances. But this approach ignores the non- CO2 benefits of the EEC. Since the comfort taking associated with domestic sector efficiency investment tends to make it more costly (on a £/tCO2 basis) than alternative options, the likely result of full fungibility would be less investment in domestic sector energy efficiency. An alternative would be to adopt the approach currently used in the UK and allow one-way fungibility with the EU ETS. This is not an option for Phase 1 of the EU ETS, but may perhaps be considered for Phase 2. Suppliers who overcomplied with their EEC could convert their surplus EEC credits into carbon allowances and sell them into the EU ETS. This formalises what could happen anyway if the UK ETS and EU ETS were linked. For investments that improve electricity (as opposed to fuel) efficiency, the conversion process leads to double crediting in the EU ETS, in that, first, the displaced fossil fuel electricity generation will free up allowances in the EU ETS; and second, an approximate equivalent volume of new allowances will enter in the EU ETS via the conversion process. As with the RO, the perceived importance of this double crediting will depend upon its likely scale. At present, it seems unlikely to be large enough to merit serious concern, although this may change over time and would need to be kept under review. The motivation in introducing one-way fungibility is to encourage overcompliance with the EEC. At present, individual suppliers may overcomply if they can sell EEC credits for a profit, but the only incentive for aggregate overcompliance is the potential to bank EEC credits into the second phase. In the absence of either finalised banking rules or targets for the second phase, the value of banked credits is unclear and the incentives weak. The opportunity to create carbon credits would provide an alternative revenue stream whose value would depend upon both the allowance price in the EU ETS and any differences in banking rules between the EEC and EU ETS. The benefits of overcompliance include additional energy benefits for household consumers and lowering of compliance costs in the EU ETS. The first of these is recognised as an important objective, that can be achieved very cost effectively. While encouraging overcompliance may be helpful for this objective, there may be more sensible and direct routes, including: a) establishing more ambitious targets for the EEC itself after 2005; allowing full flexibility in the EEC banking rules, combined with early agreement on the targets for phase 2; and c) addressing the numerous non-price barriers to energy efficiency in the domestic sector. One-way fungibility raises a number of issues (Calder and Hough, 2001). First, the monitoring and verification of carbon savings from EEC projects may not meet the required standards of the EU ETS. The estimated carbon value of kWh energy benefits will depend upon the accuracy of: a) the BRE models; b) the assessment of the types of households in which measures are installed; c) the assumptions about comfort taking; and d) the assumptions about fuel mix and emission factors, including the discrepancy problems with electricity. Taken together, these may introduce too much uncertainty to be acceptable. Second, fungibility may only be possible at the end of the three year period, when verification of supplier performance is complete. Third, the government may wish to prevent the generation of allowances by individual suppliers in circumstances where the overall EEC obligation (i.e. all suppliers) has not been met. But this would undermine flexibility and reduce the potential cost savings from the overcompliance mechanism. Finally, there are issues regarding the proceeds from allowance sales: consumers will pay for the additional investments (and some households will benefit from efficiency improvements), but the proceeds from allowance sales may go to the shareholders of the supply companies. This may be unacceptable to OFGEM.18 A related issue is the potential for non-obligated companies to invest in domestic energy efficiency projects and to trade the resulting carbon credits into the EU ETS. The proposed ‘modalities’ for linking the EU ETS to the project mechanisms may address this issue, but at present this is not an option for project developers in the UK since the sale of domestic sector credits into the UK ETS is blocked by the EEC rules. At present, the only way in which an independent company could generate carbon credits from domestic sector projects would be through selling energy benefits to an overcompliant supplier who in turn could convert them into credits and selling them into the UK ETS. This seems an unnecessary obstacle to cost effective projects in a sector which desperately needs additional investment. 7.6 Recommendations the allocation of allowances to UK electricity generators should, as far as possible, take into account the energy efficiency targets under the EEC, which means that the latter need to be agreed within the next 18 months; during Phase 2, the EU ETS should either: allow one-way trading from schemes like the EEC, using a similar framework to that adopted for the UK ETS; or (preferably) encourage crediting projects in this sector through the development of suitable modalities for linking the EU ETS to project-based mechanisms; the small potential for double crediting within such arrangements should be considered an acceptable price to pay for providing an additional incentive for overcompliance with domestic sector energy efficiency targets - but this should be kept under review; the exemption of the domestic sector from the UK project scheme should be removed; and the incentive for overcompliance should not be considered a substitute for other measures, such as introducing more ambitious targets for the EEC after 2005 and the removal of the non-price barriers to domestic sector energy efficiency. 18 The same consideration applies to overcompliance with the RO. 8. Choices in UK climate policy The problems of double regulation and double coverage/crediting have occurred repeatedly in the preceding sections. But lying behind these problems are four key choices within UK climate policy: the choice of policy objectives for each instrument; the choice between upstream and downstream policy instruments; the choice between direct and indirect treatment of electricity emissions; and the choice to protect the domestic consumer. These choices are explored briefly below. 8.1 The choice of policy objectives for each instrument The design of the CCL has shaped the subsequent design of the CCAs and UK ETS and led directly to the incompatibilities with the EU ETS. At present, the efficiency of the CCL is undermined because it is trying to meet several objectives at once in a manner that is far from transparent. These include: reducing CO2 emissions; encouraging energy efficiency; protecting the competitiveness of energy intensive industry; protecting the coal industry; avoiding ‘windfall’ benefits to nuclear power; promoting renewables and CHP; and preventing welfare losses among low income domestic consumers. It should be possible to achieve several of these objectives through a combination of a more efficient price instrument (i.e. a carbon tax) and supplementary policies such as subsidies for the fuel poor. This would give a much-needed clarity to the policy mix. ‘Double regulation’ may be considered acceptable where two instruments have different objectives - even if these objectives are overlapping. This is why the coexistence of the EU ETS with the RO and EEC is likely to be acceptable and why the coexistence of the EU ETS with the IPPC Directive should be acceptable once the latter has been suitably modified. But this may not be the case for the EU ETS and the CCL since, in this case, two market-based instruments are being used at the same time for the same primary objective - to internalise the external cost of carbon emissions. The coexistence of the two instruments raises marginal abatement costs, distorts the operation of the allowance market and potentially undermines the competitiveness of the relevant firms. However, a slightly different perspective may be given by recognising that ‘internalising the external cost of carbon emissions’ may be interpreted in two ways: internalising the cost of carbon in investment and operational decisions; and ensuring that polluters pay for the damage caused by residual emissions. The attraction of carbon taxes is that they achieve both of these objectives. But emissions trading only achieves the second objective if the allowances are auctioned. With free allocation, polluters do not pay for residual emissions and the government denies itself the opportunity to raise revenue. Free allocation is equivalent to a lump sum subsidy which will increase the value of the participating firms, thereby making shareholders wealthier. With auctioning, the economic rent is captured by the government and may be used in a variety of ways, including reducing other forms of taxation and compensating affected groups. As described in Sorrell (2002), the price impact for the consumers of a firm’s products (electricity in the case of the generators) should be identical in both cases. The price impact results solely from the marginal abatement costs and should be independent of the method of allowance allocation. Auctions tend to be advocated by economists as the revenue generated may be used either to reduce other forms of taxation, and thereby improve overall economic efficiency, or to compensate affected groups, (Cramton and Kerr, 1997). But auctions are strongly opposed by industry. During the negotiation of the EU ETS, the UK government argued strongly for free allocation in both Phase 1 and Phase 2, thereby protecting the interests of energy intensive industry at the expense of overall economic efficiency and the competitiveness of the wider UK economy. The EU ETS requires free allocation during Phase 1 and a maximum of 10% of allowances can be auctioned during Phase 2. Furthermore, Member States have the choice whether to use this provision or not, and it is likely that the UK will continue with free allocation during Phase 2. Since the EU ETS cannot, therefore, substitute for the revenue raised from the CCL, any changes to the CCL will have important implications for government revenue. For example, removing the CCL from electricity may reduce government revenue by up to £0.5 billion. This would create a corresponding requirement to either raise the revenue by other means or to reduce government spending. These fiscal considerations will weigh heavily in government decision-making and may potentially override concerns about double regulation. This all points to the need for a debate on double regulation, to identify where it is acceptable and where it is not. This must take into account: the objectives of the relevant instruments; the likely scale of the impacts, allowing for energy and allowance price forecasts; and the potential for revenue raising and the use of that revenue. Circumstances where double regulation may be considered acceptable include: where the two instruments have different (if overlapping) objectives; where the scale of impacts is likely to be small; and where the double regulation provides a pragmatic, second-best alternative to the theoretically ideal approach. Of particular importance will be the relative weight given to the two interpretations of ‘internalising the cost of carbon emissions’, given above. 8.2 The choice between upstream and downstream policy instruments The EU ETS is a downstream emissions trading scheme, in which fossil fuel users surrender allowances for their emissions. The alternative (which the Commission rejected) is an upstream scheme, in which fossil fuel producers, processors and transporters surrender allowances for the carbon content of the fuel. An analogous approach is available with carbon/energy taxes which can be levied either upstream on all fuel produced or sold, or downstream on a subset of fuel users. The CCL is a downstream tax which excludes the domestic sector. Each option has pros and cons. Upstream trading schemes may present difficulties as they effectively place a cap on the market for fossil fuels. Since fuel demand is inelastic in the short term, fuel prices may rise significantly, with negative effects for all classes of consumer. Upstream carbon taxes overcome this problem at the expense of unpredictability in meeting an emissions target. A legal obligation to meet an emissions target in a downstream scheme may be more effective in incentivising abatement than an increase in energy prices in an upstream scheme. But downstream schemes tend to be confined to large users and hence cover only a portion of fossil fuel emissions. Also, while upstream schemes ensure a single price for carbon throughout the economy, downstream schemes may lead to carbon being price differently between sectors and fuels. Whatever the relative merits of the two approaches, the EU ETS has constrained future policy by choosing a downstream scheme. The UK cannot now introduce an upstream carbon/energy tax without this leading to double regulation for all fuel and electricity use by all participants in the trading scheme. As it stands, the CCL only leads to double regulation of electricity for a subset of participants. Whether either form of double regulation is acceptable is a matter for debate. But the problem is clearly greater for an upstream tax than a downstream tax. The cost implications of the double regulation are likely to be vigourously opposed, thereby either ruling out an upstream tax or imposing strict limits on its size. This suggests that the EU ETS may have seriously undermined the scope for policy reforms along the lines recently suggested by the Royal Society (2002). While changes may be made to the CCL, it may nevertheless be preferable to keep it as a downstream tax to avoid these problems with double regulation. As a consequence, carbon prices may not be uniform throughout all sectors. For example, electricity prices should reflect the cost of carbon in the EU ETS, but this will be different from the cost of carbon in a downstream carbon/energy tax. A manufacturing site that is eligible for the tax but not eligible for the EU ETS will face different carbon prices for fuel and electricity. 8.3 The choice between direct and indirect treatment of electricity emissions Most of the incompatibilities between the EU ETS and UK climate policy stem directly from the treatment of electricity. The EU ETS uses direct treatment of electricity emissions, where carbon allowances are allocated to electricity generators, while the UK ETS uses indirect treatment, where carbon allowances are allocated to electricity consumers. The UK approach follows from the design of the CCL, which in turn stems from the objective of shielding domestic consumers from electricity price rises. In contrast, the EU approach stems (in part) from the objective of promoting cross-border trade in electricity. While the fuel poverty problem in the UK may be expected to decline over time, the volume of cross-border electricity trade in the EU may be expected to increase. This is one reason for preferring the EU approach. The choice between direct and indirect treatment of electricity emissions leads to very different implications for incentives and abatement options. Electricity generators have full and direct control over the carbon intensity of electricity generation, through investment and operational decisions such as fuel switching, but they have only indirect and partial control over total electricity demand through electricity prices. In contrast, electricity consumers have full and direct control over their electricity demand, through investment and operational decisions such as energy efficiency, but have no control over the carbon intensity of electricity generation unless some form of ‘carbon labelling’ (or disclosure) of electricity is available.19 It is likely that the UK approach will the more effective of the two in incentivising electricity efficiency, while it is certain that the EU approach will be more effective in incentivising fuel switching in electricity generation. Given that the government may wish to promote energy efficiency for reasons other than climate policy, and may also wish to restrict fuel switching for reasons of supply security, the EU approach may run counter to some government objectives. UK climate policy is consistent with an indirect treatment of electricity, but it is entirely inconsistent with the direct treatment of electricity in the EU ETS. It is this which leads to the repeated problems of double coverage and double crediting that are described in earlier sections. As with double regulation, a debate is required on double coverage and crediting to identify where it is acceptable and where it is not. This must take into account both the principles surrounding the ‘ownership’ and ‘control’ of emissions and the likely consequences of different options in practice. The problems fall into two categories: Situations where double crediting is cancelled out by double coverage: This applies to the CCAs and to the direct participants in the UK ETS. In this case the environmental integrity of the individual trading schemes is not threatened, but the conflicts over ownership create some confusion. This is worsened if trading of allowances is allowed between the two schemes. Situations where the double crediting is one way: This applies to the UK project scheme and also to the RO and the EEC, if these are interfaced to the EU ETS. In this case, the double crediting does threaten environmental integrity as it allows two allowances to be created for only one tonne of abatement. The importance of this may depend upon the likely scale of the problem. At present, for the RO and EEC double crediting appears to pose only a small risk and may easily be ignored. For the project scheme, the risk may be reduced through placing an aggregate ceiling on total credit volumes. 8.4 The choice to protect the domestic consumer If most of the incompatibilities between the EU ETS and UK climate policy stem from the differing treatment of electricity, the primary reason for this difference lies in the choice to protect the domestic consumer from energy price increases. At present, 4.5 million UK households (18%) are living in fuel poverty, defined as spending more than 10% of their income on energy.20 Fuel poverty is a highly sensitive political issue and has prevented previous governments from imposing VAT on domestic fuel. It also led the government to 19 Currently being discussed in the context of the proposed Directive on the Liberalisation of the European Electricity Market. 20 This is 1 million less than in 1996 due to reductions in domestic energy prices. choose indirect treatment of electricity for the CCL in order to shield fuel poor consumers from electricity price rises. Since all domestic consumers have been shielded from price rises in order to protect this vulnerable group, the government has created a fundamental tension between climate and social policy in this sector. And since the CCAs and UK ETS were required to adopt a similar treatment of electricity to the CCL, UK climate policy has come into direct conflict with the EU ETS. It follows that the elimination of fuel poverty is necessary both to curb emissions from the domestic sector and to rationalise climate policy for other sectors. The government has a target of eliminating fuel poverty among vulnerable groups by 2010 and has established a number of important initiatives, such as the EEC and the new Home Energy Efficiency Scheme (HEES) to achieve this goal. But research suggests that these initiatives need to be expanded if the target is to be achieved (Ekins et al, 2001). The EU ETS will raise electricity price rises for domestic consumers by an uncertain amount – the illustration given earlier was for a rise of ~6% for allowance prices of £10/tCO2. In the context of a 26% reduction in domestic electricity prices since 1995, this does not appear excessive.21 Moreover, there are a number of options available to compensate fuel poor households, including reductions in income tax, lump-sum redistribution through the social security system, council tax rebates, differential tariff structures or changing the balance between standing and unit charges in energy bills (Johnson, McKay and Smith, 1990). The EU ETS makes consideration of such approaches all the more urgent. UK climate policy is likely to remain unnecessarily complex and inefficient until the fuel poverty problem is eliminated. 21 However, this fall in prices has taken around 1 million households out of fuel poverty. 9. Summary The December agreement on the EU ETS has far-reaching implications for UK climate policy. Changes to a number of policy instruments will be required before 2005 and a major overhaul will be required by 2008. None of this was anticipated when the UK Climate Programme was developed or when key elements of this Programme, such as the CCAs, were negotiated. There is a need, therefore, for debate on the preferred shape of UK climate policy into the first Kyoto commitment period (2008-2012) and beyond, and on the role of the EU ETS within this. The implementation of the EU ETS raises a number of specific issues for each of the seven instruments examined in this report. In the case of the CCL, CCAs and UK ETS, these problems are serious enough to merit major reforms. In the case of IPPC, the RO and the EEC, the problems are less serious but still need to be addressed. The common themes that underlie these problems are: interaction and double regulation; ownership of emissions and double counting; differential treatment and equivalence of effort; and the fungibility of trading commodities. Table 9.1 summarises the relevance of each of these themes for each of the selected instruments. Table 9.1 Interaction issues for each of the selected instruments Acronym Double regulation Double counting Differential treatment Linking CCL CCAs UK ETS (DPs) UK ETS (projects) IPPC RO EEC To resolve these problems, it will be necessary to re-examine four key choices within UK climate policy: the choice of policy objectives for each instrument; the choice between upstream and downstream policy instruments; the choice between direct and indirect treatment of electricity emissions; and the choice to protect the domestic consumer. The recommendations summarised in Table 9.2 provide one way forward. These recommendations are based upon a number of principles including Goals: The development of policy options should be based upon clear principles and longterm goals. For climate policy, a stable an effective policy framework is required during the commitment period. This means that policy should be developed by working back from where we want to be in 2008. Complexity: The existing UK policy mix is complex and the relationship between different instruments is poorly understood by individual target groups. Hence, any changes should aim to simplify this mix and not to add further complexity. Carbon pricing: Energy users in all sectors should pay for carbon emissions, whether through taxation or emissions trading. In the long term, organisations in the public, commercial and industrial sectors should either be paying a carbon tax or participating in a trading scheme. Supplementary policies will be required to address other barriers to energy efficiency and to achieve other policy objectives (e.g. promoting renewables). But for each target group, only a single instrument should be used for carbon pricing. Electricity: The approach in the EU ETS is preferable because: first, it gives ownership of electricity emissions to the companies directly responsible for the control of those emissions, thereby incentivising both fuel switching and energy efficiency; and second, it facilitates cross-border electricity trade in the EU. Targets: Absolute targets are to be preferred over relative targets because of their greater environmental integrity and consistency with the national emission targets under Kyoto. And allowance based trading is to be preferred over baseline and credit trading due to its greater economic efficiency, lower transaction costs and consistency with the Kyoto framework. The EU ETS reflect these considerations while the CCAs do not. The latter should therefore be considered a transitional measure only. supplementarity: There is a risk that abatement in the EU ETS will be achieved through purchasing cheap hot air from outside the scheme, rather than through domestic action. But domestic abatement may be incentivised by either restricting the interface between the EU ETS and the international carbon market, or by retaining (or establishing) ‘backup’ regulations for EU ETS participants. The first approach is preferable and the Commission is concerned to restrict the import of ‘hot air’. Hence, ‘backup’ regulations should be abandoned as they are likely to undermine economic efficiency, be more complex to administer and lead to additional costs for the target groups. There is scope for debate over these principles and over the specific recommendations. But the important point is to encourage wider recognition of the challenges that the EU ETS poses to UK climate policy. Table 9.2 Specific policy recommendations CCL/ CCAs the CCL should be removed from electricity, extended to all fossil fuels (replacing excise duties on oil products) and changed from a downstream energy tax to a downstream carbon tax; eligible installations should join the EU ETS and their existing CCA agreements should be terminated; CCA facilities not eligible for the EU ETS should renegotiate their agreements such that the targets relate to fuel consumption only; participants in the EU ETS should be exempt from the CCL; and trading between the CCAs and the EU ETS should be controlled by a Gateway before 2008, with no trading after that date. UK ETS (DPs) the UK direct participant scheme should cease in 2006, with no further incentivised rounds; trading between the direct participants and the EU ETS should be allowed during the two-year overlap period; further expansion of trading in the UK should be based upon opt-in provisions to the EU ETS (based on direct emissions only) and/or sectoral expansion of the EU ETS, together with interfaces between the EU ETS and the project mechanisms; UK ETS Projects participants in the EU ETS should be exempt from the CCL; the UK should proceed with a small-scale pilot scheme only, with fuller development of the project mechanism being linked to the development of ‘modalities’ for interfacing the EU ETS to JI and the CDM; the pilot scheme should be developed in consultation with the Commission, with the rules taking into account the concerns of the Commission, Parliament and other Member States about environmental integrity; the rules should be consistent with those for JI and CDM and both nuclear and sink projects should be excluded; no project should be undertaken at sites that may subsequently become eligible for inclusion in the EU ETS; double crediting should be accepted in the pilot phase, but with an aggregate ceiling on credit volumes to preserve environmental integrity; and the UK should work to ensure that the subsequent EU proposals are compatible with the UK scheme. IPPC the interpretation of IPPC energy efficiency requirements that is outlined in the non-paper and in UK guidance is sensible and should be retained; the Commission should specify in greater detail the recommended approach to non-CO2 GHGs for those installations where BAT requirements are expressed as technical requirements rather than emission limits; the provisions in Article 25 should be extended to those installations and gases that are not listed in Annex I but have chosen to opt-in to the EU ETS; to avoid problems with ‘hot air’, the inclusion of non-CO2 GHGs in Phase 2 of the EU ETS should be based upon both accurate monitoring protocols and very strict criteria for allowance allocation; installations should not be allowed to opt-out of the EU ETS on the basis of ‘equivalent’ IPPC energy efficiency requirements, since these are not ‘national policies’ and in practice are unlikely to be strictly enforced. RO the allocation of allowances to UK electricity generators should, as far as possible, take into account the renewables targets under the RO; in Phase 2, the EU ETS should be modified to allow one-way trading from TGC schemes like the RO, using a similar framework to that adopted for the UK ETS; this one-way trading should only apply to overcompliance which has been demonstrated by the acquisition of surplus TGCs; the small potential for double crediting within such an arrangement should be considered and acceptable price to pay for providing an additional incentive for overcompliance with renewables targets. the incentive for overcompliance should not be considered a substitute for other measures to encourage renewables deployment, such as more ambitious targets for renewables after 2010, greater flexibility in the banking rules for ROCs and removing the non-price barriers to renewables deployment. EEC the allocation of allowances to UK electricity generators should, as far as possible, take into account the renewables targets under the RO; during Phase 2, the EU ETS should either: allow one-way trading from schemes like the RO, using a similar framework to that adopted for the UK ETS; or encourage crediting projects in this sector through the development of suitable modalities for linking the EU ETS to projectbased mechanisms; if the first approach is adopted, this should only apply to overcompliance which has been demonstrated by the acquisition of surplus TGCs; the small potential for double crediting within such an arrangement should be considered and acceptable price to pay for providing an additional incentive for overcompliance with renewables targets. the incentive for overcompliance should not be considered a substitute for other measures to encourage renewables deployment, such as more ambitious targets for renewables after 2010, greater flexibility in the banking rules for ROCs and removal of the non-price barriers to renewables deployment. 10. Further Reading CCL and CCAs Sorrell, S. (2002), The Climate Confusion: Implications of the EU Emissions Trading Directive for the UK Climate Change Levy and Climate Change Agreements, SPRU (Science and Technology Policy Research), University of Sussex, Brighton. Available at: http://www.sussex.ac.uk/spru/environment/research/ccfr.pdf UK ETS direct participants Irving, W. (2002) The EU Trading Proposal and the UK Emissions Trading Scheme, ICCEPT, Imperial College, London. Available from the UK Emissions Trading Group UK ETS project scheme Sorrell, S. and A. Smith (2002), Policy additionality for UK emission reduction projects, a report for the Department of Trade and Industry, SPRU (Science and Technology Policy Research), University of Sussex, Brighton. Available at: http://www.sussex.ac.uk/spru/environment/research/policyadd.pdf IPPC, RO and EEC Smith, A. (2002), Implications of the EU Emissions Trading Directive for IPPC, the Renewables Obligation and the Energy Efficiency Commitment, a report to DG Research under the project ‘Interaction in EU Climate Policy’, SPRU (Science and Technology Policy Research), University of Sussex, Brighton. Available at: http://www.sussex.ac.uk/spru/environment/research/wp5uk.pdf References Ash, E. et al (2002), Economic instruments for the reduction of carbon dioxide emissions, Royal Society, London. Baron, R. and S. Bygrave (2002), 'Towards international emissions trading: design implications for linkages', Third Workshop of the Concerted Action on Tradable Emission Permits, Kiel Institute of World Economics, Kiel, Germany, available at: http://www.ucd.ie/~envinst/envstud/CATEP Webpage/Papers/bygrave.pdf. Begg, K., T. Jackson, D. v. d. Host, C. Jepma, W. v. d. Gaast and A. Smith) (2002a), Guidance for UK Emissions Trading Projects: Phase 1 report - advice to policymakers, A report to the Department of Trade and Industry, University of Surrey, Guildford, April 2002. Begg, K., T. Jackson, D. v. d. Host, C. Jepma, W. v. d. Gaast and A. Smith) (2002b), Guidance for UK Emissions Trading Projects: Phase 1 report - priority sectors and projects, A report to the Department of Trade and Industry, University of Surrey, Guildford, April 2002. Begg, K., T. Jackson, D. v. d. Host, C. Jepma, W. v. d. Gaast and M. ten Hoopen) (2002c), Guidance for UK Emissions Trading Projects: Phase 2 report - policy document, A report to the Department of Trade and Industry, University of Surrey, Guildford, October 2002. Begg, K., T. Jackson, D. v. d. Host, C. Jepma, W. v. d. Gaast and M. ten Hoopen) (2002d), Guidance for UK Emissions Trading Projects: Phase 2 report - technical document, A report to the Department of Trade and Industry, University of Surrey, Guildford, October 2002. Calder, F. and C. Hough (2001), Potential interactions between new emissions trading related policies: minimising conflicts, maximising synergies and maximising consistent valuation of carbon savings, Energy for Sustainable Development Ltd. CEC (Commission of the European Communities) (2002a), Amended proposal for a Directive establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96//61/EC, Institutional file 2001/0245 (COD). CEC (Commission of the European Communities) (2002b) ‘Non-paper on synergies between the EC emissions trading proposal (COM (2001) 581) and the IPPC Directive’, D (02) 610019, 22nd January, Brussels, DG Environment. Cramton, P. and S. Kerr (1997), Tradable carbon permit auctions: how and why to auction and not to grandfather, Resources for the Future, Discussion Paper 98-34, Washington DC. DEFRA (Department of the Environment, Food and Rural Affairs) (2002), ‘UK emissions trading scheme: plans for further entry’, available from: http://www.defra.gov.uk/environment/climatechange/trading/pdf/trading-further.pdf DETR (Department of the Environment Transport and the Regions) (2000), Climate Change: the UK Programme, The Stationery Office, London. DTI (Department of Trade and Industry) (2002), Developing Energy Policy- Key Issues for Consultation for the White Paper, The Stationery Office, London. Ekins, P., C. Monkhouse, I. Skinner and R. Wills (2002), Next steps for energy taxation: A survey of business views, Green Alliance,London. Ekins, P., R. Cotton, A. Russell and C. Hargreaves (2001), Sustainable energy for the UK: the economic and environmental implications to 2020 of a sustainable energy strategy for the UK, Technical Report at TR5/01, Forum for the Future, London. ENDS (2002), ‘Hot air blows gaping hole in emissions trading scheme’, The ENDS Report, March, 326. Environment Agency (2001) Horizontal Guidance Note IPPC H2 – Energy Efficiency, 2nd Draft, January, Environment Agency, Bristol. ETSU (Energy Technology Support Unit) (2001), Climate Change Agreements – Sectoral Energy Efficiency Targets. ETSU, AEA Technology, Harwell. Gielen, A. M., P. R. Koutstaal and H. R. J. Vollebergh (2002), 'Comparing emission trading with absolute and relative targets', 2nd CATEP Workshop on the Design and Integration of National Tradable Permit Schemes for Environmental Protection, University College London,25-26 March 2002. Haites, E. and F. Mullins (2001), Linking domestic and industry greenhouse gas emissions trading systems, International Emissions Trading Association. Irving, W. (2002) The EU Trading Proposal and the UK Emissions Trading Scheme, ICCEPT, Imperial College, London. Jensen, S. G. and K. Skytte (2002), 'Simultaneous attainment of energy goals by means of green certificates and emission permits,.' Energy Policy, 31 (1): 63-71. Johnson, P, S. McKay and S. Smith (1990), The Distributional Consequences of Environmental Taxes, IFS Commentary No. 23, Institute for Fiscal Studies, London. Mott MacDonald (2001), Greenhouse Gas Emission Reduction: a study of options in the generation and transmission of electricity in the UK, a report to the UK Department of Trade and Industry, Brighton. OFGEM (Office of Gas and Electricity Market) (2001), Guidelines on green supply offerings: consultation document, London. PIU (Performance and Innovation Unit) (2002), The Energy Review, PIU, Cabinet Office, London. RCEP (Royal Commission on Environmental Pollution) (2000), Energy – the Changing Climate, 22nd Report of the Royal Commission of Environmental Pollution, The Stationery Office, London. Smith, A. (2002), Implications of the EU Emissions Trading Directive for IPPC, the Renewables Obligation and the Energy Efficiency Commitment, a report to DG Research under the project ‘Interaction in EU Climate Policy’, SPRU (Science and Technology Policy Research), University of Sussex, Brighton. Smith, A. and W. J. Watson (2002), 'The Renewables Obligation: Can it Deliver', Tyndall Briefing Note No. 4, SPRU, University of Sussex, Brighton, available from: http://www.tyndall.ac.uk/publications/briefing_notes/note04.pdf Sorrell, S. (2001), Work Package 3: UK policy context: emissions trading, a report to DG Research under the FPV project ‘Interaction in EU Climate Policy’, SPRU (Science and Technology Policy), University of Sussex, Brighton, available from: http://www.sussex.ac.uk/spru/environment/research/interact.html Sorrell, S. (2002a), The Climate Confusion: Implications of the EU Emissions Trading Directive for the UK Climate Change Levy and Climate Change Agreements, SPRU (Science and Technology Policy Research), University of Sussex, Brighton, available from: http://www.sussex.ac.uk/spru/environment/research/ccfr.pdf Sorrell, S. (2002b), ‘The Meaning of BATNEEC’, Journal of Environmental Policy and Planning, 4, 23-40. Sorrell, S. and A. Smith (2001), ‘Interaction between environmental policy instruments: carbon emissions trading and Integrated Pollution Prevention and Control’, International Journal of Environment and Pollution, 15 (1), 22-41. Sorrell, S. and A. Smith (2002), Policy Additionality Issues for Selected Emission Reduction Projects, a report for the Department of Trade and Industry for Phase II of the research project on Project Entry Routes for the UK ETS, available from: http://www.sussex.ac.uk/spru/environment/research/policyadd.pdf Sorrell, S. and J. Skea (1999), Pollution for sale: emissions trading and joint implementation, Edward Elgar, Cheltenham.
