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Crunch Time on Carbon

15 November 2006

The UK Government sees carbon trading as the most effective and practical way to limit greenhouse gas emissions. After one year of operation Kirsty Clough asks if the EU ETS has actually reduced emissions — and can it work any better in future?

CLIMATE CHANGE IS THE MOST SERIOUS THREAT facing the planet and human development. Levels of carbon dioxide (CO2) in the global atmosphere have risen by more than a third since the industrial revolution. Urgent global action is needed to prevent average global temperatures from increasing by more than 2°C above pre-industrial levels—a threshold above which the risk of severe and irreversible tipping points in the climate becomes increasingly likely.

To achieve this, the world’s emissions of greenhouse gases will need to peak and start to fall within the next ten to fifteen years and be halved by the middle of the century. The European Union (EU) emissions trading scheme (ETS) began on 1st January, 2005 and is the most ambitious and innovative intergovernmental policy so far aimed at reducing greenhouse gas emissions. This market-based mechanism covers approximately 11, 000 installations, from power plants to energy-intensive industries such as cement and iron and steel installations, which between them are responsible for nearly half of Europe’s CO2 emissions; so its success is vital to deliver the EU’s targets under the Kyoto Protocol. So far the ETS has been highly successful at creating a market for carbon. Indeed, across the EU at the height of the carbon price in 2005, the value of all carbon allowances equalled over €60 billion. Since mid-2005 the price of carbon has fluctuated between €20 and €30 per ton of CO2.

A flourishing market in carbon has been brought into being, and with rapidity. The obvious question it raises is has it reduced carbon emissions, adequately or at all? And will it do so in future? First introduced by the Kyoto protocol in 1997 to help developed nations to meet their international climate change targets, and as the first international CO2 ‘cap-and-trade’ scheme, the EU ETS has a vital role to play in showing the rest of the world that market-based mechanisms can achieve real emission reductions in the most cost-effective way.

Although the EU should be congratulated for establishing the first international CO2 cap-andtrade scheme, we have yet to see any real reductions in EU greenhouse gas emissions or any obvious shift towards investment in low carbon technologies. This is due, in no small part, to the way in which the caps are set by member states and the way in which allocations of CO2 emissions allowances have been given out to companies. In phase I the vast majority of allowances were given out for free (under the directive up to 5 per cent could be sold at auction) and the caps were directly informed by CO2 emissions projections. Basing the cap on emissions projections essentially acts as an incentive to industry sectors to inflate projections in order to maximise the number of highly valuable allowances they receive for free.

The data for 2005 UK CO2 emissions gives strong evidence to support this view. Although this shows that the power sector was short of allowances in 2005 (largely owing to a return from gas to coal burn and hence an increase in its CO2 emissions), the allocation to other energy-intensive industries was in fact 9.5m tonnes CO2 (approximately 12 per cent) above what they actually emitted.

Indeed there was an excess of allowances in most member states: in Europe overall, CO2 emissions from industry were 44m tonnes below permitted levels under the scheme. The clear conclusion has to be that member states had been far from ambitious when setting caps for phase I. The CO2 emissions they had permitted themselves were so over-generous that they could be met with no change in behaviour, and still have room to spare. The table opposite shows that 15 out of the 21 countries for which data are available showed a surplus of allowances for the first year of trading.

This apparent over-allocation had a major effect on the carbon market. As the information began to emerge in late April about the real level of emissions in member states, the price of carbon plummeted by more than 60 per cent, from around €30 to €11.5 per tonne of carbon.

Perhaps not surprisingly, the main players in carbon trades so far have been those who before the introduction of the ETS traded in energy1 — energy policy and carbon prices in the market are inextricably linked. The weak caps set during phase I (2005–2007) mean that we have yet to see real cuts in greenhouse gas emissions as a result of the scheme. Phase I may well be considered as a pilot but we must ensure that the weak caps set for this phase are not repeated in phase II (the first Kyoto commitment period) or in subsequent phases.

The UK picture
Unlike many other European countries the UK is actually on track to meet and exceed its Kyototarget to reduce greenhouse gas emissions to 12.5 per cent below the 1990 level by 2012. It must be recognised, though, that the UK’s Kyoto target is extremely undemanding, and that emissions have actually been below this level in every year since 1998. The target was essentially easy to meet because of the dash for gas in the 1990s (which was largely governed by market forces which meant that it became more economical to burn gas rather than coal). This, plus one-off abatements of industrial gases such as nitric oxide and hydrofluorocarbons, and closure of coal mines and improved regulation of landfill sites which led to a 50 per cent fall in total methane emissions.

Opportunities to pluck such low hanging fruit have now largely been exhausted, and the real challenge is to deliver on-going reductions in emissions of CO2, the main greenhouse gas.

Indeed, the UK has set itself a more ambitious domestic target to reduce CO2 emissions by 20per cent below 1990 levels by 2010. Phase II of the ETS offers the UK an opportunity to reclaim international leadership on the issue of climate change by setting a tough cap which would ensure delivery of its domestic target.

If the political will is there, how tough a cap can realistically be set for Phase II? Electricity generation is currently the biggest single source of CO2 emissions in the UK, responsible for about one-third of emissions. The mix of coal, gas and nuclear power are not the only players: there are also the renewables (wind, wave, solar and the like), and combined heat and power (CHP) schemes. The balance between these and the effectiveness of demand and reduction policies and measures in the future will largely determine our greenhouse gas emissions.

The power sector is unique in another way. In the UK (and in the majority of European countries) the power sector is subject to very little competition from companies outside the EU. This means that in order to remain competitive this sector does not have to keep the price of power at the levels outside the EU. In the first year of carbon trading the free allocation of allowances was profitable to the power sector — some would say hugely profitable. Although CO2 allowances are distributed mostly free of charge to installations during the first phase of the scheme, they now have a value on the open market.

So, under the ETS, power generators can choose either to stop generating and sell their allowances and fuel, or to generate electricity and use their allowances — or, hopefully, to generate at less cost in carbon and sell their surplus allowances. Power generators will not generate unless they can recoup the total value of the generating components, which now includes the value of the allowances. So, the price of the power generated now includes the full price of carbon. Because the price of power has gone up without any real increases in the generators’ costs, this extra profit as a result of the increased power price has been a windfall.

Essentially carbon now has a cost, and generators were able to pass on that cost to the consumers, though they did not have to pay it themselves. In the UK alone it is estimated that this sector made around €1 billion windfall profit in 2005 as a result of the scheme.

Phase II and beyond
The national allocation plans (NAPs) for Phase II are now being finalised across Europe. However, promising and there appears to be a race to the bottom. In March the UK Government announced that the cap for phase II would be set at a level of between 3m and 8m tonnes of carbon (MtC) reduction from current businessas-usual emissions projections in 2010. At the lowest end of the range (3 MtC) this would actually have meant that the cap for Phase II would have been higher than it was for Phase I.

However, in June the Government proposed a single figure at the top end of this range—a cut of 8 MtC from business-as-usual emissions projections. This is obviously a better result than we could have seen, but crucially, since March, the Government has revised the projections of industry’s future carbon emissions upwards. What this figure actually equates to now is an annual emissions cap of 65 MtC, which overall, when other existing policies and measures for the non-traded sector are taken into account, only equates to a 16 per cent reduction in CO2 levels by 2010.

The UK, along with several European countries have yet to submit their NAPs to the European Commission for approval so there is still time for the caps to be made more robust. The UK Government has consistently said that the EU ETS will be the main lever to achieve its domestic 20 per cent target—however, to do this the cap should be set at a level of 60.5 MtC not the 65 MtC proposed.

The higher the price of carbon and the more stable the market, the more effective it will be at levering emissions reductions from the sectors covered by the scheme as the cost of abatement becomes cheaper than the cost of buying more allowances to pollute. But the factor that primarily affects carbon pricing is the determination of governments.

As with most policies, carbon trading will only work if governments wish it to work and act accordingly by setting robust caps. Phase II has the potential to deliver real emissions reductions, to build confidence in market-based mechanisms—not only in Europe but globally—and to ensure that emissions trading forms a crucial part of any future global agreements to fight climate change. Whether it fulfils that potential will depend on whether governments take their obligations to it sufficiently seriously. If allocation plans Europe-wide are not stringent enough, Phase II will follow Phase I and fail todeliver. It would be the most devastating of missed opportunities.

References
1. Point Carbon 2006 report – http://www.pointcarbon.com/Research%20&%20Advisory/article15032 365.html
2. See http://www.wwf.org.uk/climatechangecampaign.

● Kirsty Clough is a Climate Change Policy Officer at WWF-UK. She undertakes policy and advocacy work with regards to the EU emissions trading scheme and provides support to WWF-UK’s Climate Change Campaign. This article first appeared in Significance, the magazine of the Royal Statistical Society, Vol 3 (2006), part 3, pages 102-105


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