The devil in the allocation

EU governments are working on plans to distribute billions of euros worth of greenhouse gas emissions allowances – and industry is on the alert for any competitive distortions. Mark Nicholls reports

In 12 months’ time, around 5,000 electricity plants and industrial facilities will find out what their greenhouse gas (GHG) targets will be under the European Union’s planned emissions trading scheme (ETS).

The ‘national allocation plans’, which the 15 governments are due to deliver to the European Commission by the end of March, will set the stage for the world’s largest emissions trading scheme, which is expected to begin operating in 2005.

Decisions made over the next year, some analysts believe, could potentially land some companies or sectors with a windfall – while leaving their competitors facing tough targets, and the costs associated with meeting them. Industry lobbying is already focusing on these potential distortions to competition – but some expect individual companies to begin a more forceful defence of their own interests as March approaches.

Maurits Henkemens, Dutch Ministry of Economic Affairs: communication between EU governments "only way to avoid a mess"

“The line Unice is taking is that any allocation process should not distort European competition, either within or between sectors,” says Nick Campbell, Paris-based head of the climate change working group at Unice, the European federation of employers’ associations. “But it’s going to be very difficult [for it] not to,” he cautions.

It’s a concern shared by many industrialists. “The [emissions trading] directive as it stands is open to interpretation in different ways. This opens the possibility of the distortion of the level playing field within Europe,” says Marco Mensink, the environment and energy director at the Netherlands’ Paper and Board Association.

The Emissions Trading Directive that establishes the scheme is not yet finalised. It is due to go before the European Parliament for a second reading before the middle of this year, but most of its provisions have already been agreed (see Environmental Finance, April 2003, pages 14–15).

It will cover carbon dioxide (CO₂) emissions from large sources in five industrial sectors, namely: power, heat and steam generation; oil refineries; iron and steel; pulp and paper; and building materials. These sources account for around 46% of the EU’s CO₂ emissions.

The vast majority of allowances are to be allocated free of charge, and the national plans must meet ‘common criteria’ set out under Annex 3 of the directive. These include the requirement that plans are consistent with progress to meet member states’ targets under the Kyoto Protocol, and take into account sectors’ potential to reduce emissions.

Once the plans are submitted, the Commission will judge whether they meet the common criteria, and comply with state aid rules that forbid member state governments unfairly supporting private companies with grants, tax breaks or public money.

But some argue that competitive distortions are, to some degree, inevitable. The emissions trading system is being superimposed upon the differentiated targets that EU member states took on under the 1997 Kyoto Protocol. The EU accepted an overall target to reduce its GHG emissions to an average of 8% below 1990 levels from 2008 to 2012. However, under the so-called ‘bubble’ arrangement, individual members states’ targets ranged from –28% for Luxembourg to +27% for Portugal.

This burden-sharing agreement attempted to take into account the rapid economic growth since 1990 of Portugal, Spain, Greece and Ireland. So, while Portugal, for example, may have a seemingly generous target, it will have to make dramatic emissions reductions – currently more than 16% – against a ‘business-as-usual’ scenario.

But this agreement was as much a result of political deals between member states as a scientific method of sharing reduction responsibilities. And it would be unrealistic for the emissions trading scheme to remove the resulting inequalities, the Commission believes. “You can’t, with a single instrument, overcome the structure of Kyoto,” says one Commission official.

Generating value? If an EU-wide emissions trading scheme (ETS) is likely to favour some companies over others, then investors should be paying extremely close attention.Anecdotal evidence suggests that, at present, they aren’t. However, analysts at Dresdner Kleinwort Wasserstein (DKW) – notably one of the first banks to produce ‘sell-side’ socially responsible investment research – have taken a close look at the effect of the scheme on 11 leading European electricity generators. In a March research note, pointedly entitled Emission Trading – Carbon Derby, the investment bank predicts that power prices could rise over the long term by 8–20%, at “minimal cost to the sector”, because governments plan to distribute free allowances to generators – estimated by DKW to be worth between €7 billion ($7.4 billion) and €20 billion each year. The report looks at the current state of ETS policy, how allowances could be distributed, possible prices of carbon dioxide (CO2), and likely impacts on power prices and the value of the companies analysed. Under DKW’s most likely scenario – a CO2 price of €7.50 per tonne and free allocation of allowances – RWE stands to be the biggest winner, seeing a 17% rise in market capitalisation. However, with its high proportion of coal-fired generation, a high cost of carbon (€20/tonne of CO2) and an unfavourable allocation of allowances could see it lose 29% of its value, DKW says. E.ON, Scottish & Southern, Electrabel and Iberdrola are likely to be winners regardless of the allocation basis chosen or the cost of CO2, the report finds. Portugal’s EDP and Endesa are most at risk from the ETS, it adds.

Under the terms of the proposed directive, governments are free to decide the share of the national reduction they expect companies covered by the trading scheme to deliver, compared to other parts of the economy (such as transport or households).

Also, governments have considerable freedom to set targets for certain sectors that are more generous than those set for the same sectors in different countries.

“One of the key issues for us is that there is equality of effort between sectors – both within trading sectors, and between trading and non-trading parts of the economy,” says John Scowcroft, head of environment and sustainable development at Eurelectric, the pan-European electric utility association.

To some extent, the Commission accepts that perfect “equality of effort” will be impossible to achieve: Annex 3 talks of “undue” distortion, rather than distortion per se. “What’s important is the ability to be able to spot biases,” says the official.“And there is lots of transparency built into the system.”

“The Commission has a very important task to ensure that state aid and competition rules are adhered to,” says Anders Lundin, a senior Swedish government official covering climate change policy. “But, at the same time, I’m not convinced that the Commission has the knowledge and the data to be able to make these judgements.”

However, Lundin believes that the obligation on governments to publish their allocation plans will act as a brake on any inclinations towards runaway generosity.“Swedish iron and steel companies, for example, will be looking carefully at [the allowances allocated to] their UK and German competitors,” he says.

“Our recommendation is that [governments] need to be as open and transparent as they possibly can, and discuss issues with the industries involved when they are formulating their plans,” says Unice’s Campbell.

Early indications, however, are that some governments are reluctant to enter into complex and drawn out horse-trading with industry. The Dutch government has already ruled out the “performance standard rates” preferred by industry, because these set ‘relative’ emissions targets (determined by production volumes) rather than the ‘absolute’ cuts mandated by Kyoto.

And industry insiders say the UK government has told business it will “consult, but not negotiate” over targets and allocation. This was confirmed by a government spokesman: “As always, we’ll take into account the responses of consultation in finalising targets and allocation, but we won’t be negotiating with the many hundreds of installations involved.”

But some believe a dialogue between member states is just as important as a dialogue with business. “It’s the responsibility of all EU countries to meet each other frequently, and to talk to each other frequently to find common solutions and send a common message to companies,” says Maurits Henkemans, a senior policy officer in the Dutch Ministry of Economic Affairs. “It’s the only way to avoid a mess,” he adds.

The Commission is certainly working to encourage such a dialogue. For example, on 1 April, it is planning to host a meeting of officials from all 15 governments to discuss the allocation issue, among other things.

Inevitably, some member states are more advanced in their preparations than others. The UK, Swedish and Dutch governments have already expended considerable effort in laying the groundwork for allocation. Some southern European states are less prepared, analysts say.

But even with high levels of cooperation between national authorities, the process is likely to be messy. As one industry source puts it, “at the end of the day, it’s going to be a case of chief executives ringing up their ministers and saying: ‘you can’t be serious about this allocation’”.

To some extent, however, emissions trading will address any such distortions over time, some experts say. “The trading system will iron these out, as long as [the distortions] are not gross,” says Bill Kyte, head of corporate sustainability at UK electricity utility Powergen.

Other concerns include the danger of overly-tight targets in the first trading period (2005–07). “It’s very important that there aren’t excessive shortfalls in the first period,” says Owen Wilson, manager of group health, safety and environment at the Electricity Supply Board in Ireland.

Major emissions reduction projects can take some years to bear fruit, which means there may not be sufficient reductions generated to make up any shortfall by 2007.“We’ve seen that the delivery of credits from [Kyoto Protocol emissions reduction] projects takes longer than originally anticipated,” he says. This, he says, could force allowance prices to rise towards the ‘penalty’ level of €40/tonne that companies which miss their targets would have to pay.

And Noel Morrin, international environment director at UK cement firm RMC stresses the importance of government plans taking early action into account – so as not to penalise those companies that have already taken strides towards reducing their emissions.

So what should companies be doing to prepare? Morrin says many companies lack the data on historic emissions necessary for them to lobby governments, let alone operate effectively in the planned trading scheme.The cement sector has produced a greenhouse gas reporting protocol – but Morrin notes that even with such a protocol in place, many of the idiosyncracies in measuring and reporting emissions only become clear once companies embark on the process.

“My concern is getting the data right – I don’t think many people are in this position,” he adds.

The stakes for affected companies could be high. ICF Consulting recently produced a report suggesting the ETS could “transform the competitive landscape of those industry sectors covered” by the scheme (see Environmental Finance, March 2003, page 21).

“We’re saying that companies need to work out their potential value-at-stake and their competitive position under various allocation scenarios,” says Abyd Karmali, its London-based director of European climate change services. “Once they understand that, they should talk to their regulators about where there could be significant downside.”

Karmali also notes that there is still significant uncertainty about the extent of ‘opt-outs’ in the first period of the ETS.The directive allows for installations or industry sectors to opt out until 2008, if they can show “equivalence of effort” – that is, that they will deliver the same reductions, with similar penalties for non-compliance, outside the trading scheme.

“There’s concern in the cement sector, for example, about the possibility that the entire German cement industry may opt out,” he says. “If decisions play out like that, there could be major competitive implications.” The Commission disagrees, saying that the equivalence of effort condition would prevent governments letting sectors off the hook.

Powergen’s Kyte notes that “it’s difficult to know how far [opt-outs] will go – it’s at such an early stage, but things are moving very rapidly. The whole timetable is extremely tight.”

It’s clear that much work needs to be done between now and next March. “There are decisions that should be taken consecutively, that will end up being taken in parallel,” says one industry source. “It’s not ideal, but we’ll get there in the end,” he adds.