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Wider, longer, deeperThe EU Emissions Trading Scheme is not without its critics, particularly regarding its impact on competitiveness. But Paul Dawson argues that the answer is more, not less, emissions tradingMay 2006 saw the completion of the first full compliance cycle of the EU Emissions Trading Scheme (ETS), with the publication of verified carbon dioxide (CO2) emissions data for some 11,000 factories, power plants and other installations across Europe. With the first full year behind us, and some valuable lessons learned in the process, attention is now shifting to the future. The process for setting the CO2 targets for industry for Phase II of the EU ETS which runs from 2008 is already in train. The Commission is engaged in a fundamental review of the scheme with a view to improvements for Phase III (from 2013) and beyond, and early discussions between the parties to the Kyoto Protocol have begun on a post-2012 framework for a successor international climate agreement. Now is therefore a good time to ask what the future should look like for emissions trading post-2012 and whether, as intended, the EU ETS provides a workable template for an international emissions trading system post-2012. Amid the excitement of the first year, it is easy to forget that the EU ETS has actually worked as intended in establishing a market price signal for emission reductions, accelerating Clean Development Mechanism (CDM) projects and providing a verified baseline of actual emissions from which to assess the planned Phase II reductions. Nevertheless, several problems remain.There is concern about the impact of the scheme on industrial competitiveness; the adequacy of the scheme in driving long-term low-carbon investments; and its ability to deliver global emission reductions in the light of emissions growth in sectors and countries operating without similar constraints on greenhouse gases.
The temptation when faced with these problems is to conclude that 'cap-and-trade' systems such as the EU ETS do not work and to seek alternative solutions (eg, sector baselines, technology initiatives, etc) to fill the gap. This is a gross error. Far from demonstrating that emissions trading does not work, these problems stem from the limited time horizons and scope (both sectoral and geographic) of the EU ETS. The solution is not to walk away from emissions trading as the primary instrument in tackling climate change, but to expand its horizons significantly and to go wider, longer and deeper in developing a long-term, international and cross-sectoral cap-and-trade scheme. Wider The EU ETS has fundamentally changed EU industry's cost function. It now faces the cost of purchasing (or not selling) allowances to match actual emissions and the indirect cost associated with the inclusion of carbon prices in electricity prices. Although free allowance allocations have largely mitigated the direct cost to industry, the pass-through of carbon prices into electricity prices and the associated concerns over 'windfall profits' accruing to electricity generators, has proved to be one of the most controversial aspects of the EU ETS. These impacts have generated opposition to emissions trading on the grounds that it is damaging the competitiveness of European industry. This is based on a misconception: the fact that carbon has a price in Europe – and that price feeds through into the electricity market – is a function of EU policy on climate change rather than the EU ETS. Emissions trading is merely the instrument to deliver EU carbon reductions and the cost of achieving similar reductions via carbon taxation, direct regulatory controls, reduction obligations etc would be significantly higher. Nevertheless, as long as the geographic scope of emissions trading – under the EU ETS and Kyoto – remains limited, these schemes remain subject to the criticism that they damage the competitiveness of covered countries while failing to deliver on the ultimate goal of reducing global emissions (as emissions continue to rise unchecked in countries without corresponding carbon constraints). The only acceptable and credible solution to delivering the required global emissions reductions must therefore ultimately be a global cap-and-trade scheme. At a stroke, industry everywhere would face the same price for the 'common currency' of emissions and the opportunities to ensure that the required reductions are made at the lowest possible global cost would be maximised. An international trading scheme also has significant advantages either as a substitute for, or as a complement to, other international schemes, mechanisms and initiatives. For example:
Unlike sector approaches based on emissions intensity targets (addressing emissions per unit of production), an international trading scheme would ensure absolute emissions reductions and, via seamless trading between sectors, ensure that reductions are carried out in the sectors and applications where they are most efficient. International emissions trading is an essential supplement to international technology sharing initiatives in providing the direct commercial incentive to accelerate the adoption and dissemination of low-carbon technologies. Attempts to favour or protect domestic industry (eg, via free allowance allocations) would become squarely an international trade issue rather than an environmental negotiation (and, in this context, it's interesting to envisage a system of trade tariffs and subsidies as the means to enforce the acceptance of emissions caps on otherwise recalcitrant nations). Although negotiations over the respective national caps will no doubt be challenging, every nation would presumably be willing to accept some level of reduction and/or expansion. Focusing discussion on the level and trajectory of caps – rather than their very existence – should therefore form the starting point for post-2012 international discussions. Longer Another challenge for the EU ETS is that its time horizons are currently relatively short when compared to those for investments in energy efficiency and low-carbon generation technologies. Phase I of the scheme runs for only three years, with subsequent five-year phases, but with the caps and allocations for each phase only known 18 months to one year before the start of each period. Although the horizons of the EU ETS – and the CDM – continue beyond 2012, and some form of carbon constraint post-2012 can reasonably be expected, continued uncertainty over the post- 2012 framework leads investors to discount the value of post-2012 reductions and increasingly threatens to slow delivery of long-term investments in emission reductions, both within the EU and via the CDM.
A longer-term framework for emissions caps (and associated allowance allocations) would significantly increase certainty and reduce the risk (and hence costs) associated with investment. In doing so, it would also deliver the required reductions more efficiently by allowing more efficient trade-offs between short-term measures and large-scale, long-lived investments in low-carbon technologies. Although longer-term caps are desirable, the duration of the caps cannot be divorced from the geographic scope of emissions trading post-2012. For example, in the absence of an international trading scheme, it seems likely that the EU will continue to allocate a sizeable proportion of free allowances to reduce potential effects on competitiveness. However, longer compliance periods make it more likely that free allocations (based on grandfathering or benchmarking) become detached from the underlying requirements across different sectors and increase the potential for economic distortions associated with closure of installations or the entry of new emitters. In the absence of a global trading system from 2013, the EU may also be unwilling to show its hand by committing to long-term caps in advance of negotiations on an international scheme. By contrast, an international trading scheme would open up the potential to set very long-term caps on emissions (potentially 30 years or more). Indeed, negotiations over long-term targets in 30 years time – and the associated trajectory towards those targets – may prove a more tractable base for international negotiations than negotiations on what emissions should be for each nation in six years time. The development of longer-term caps to facilitate efficient investment in carbon abatement, while dependent on a broader global system of emissions caps, could therefore in itself make a major contribution to facilitating negotiations on an international emissions trading system. Deeper Having established the need for a wider and longer system of emissions trading, there is one final dimension to explore – how deeply should the scheme extend to a nation's sources of emissions? The EU ETS experience is instructive in this regard. It only covers roughly half of EU emissions from installations in heavy industrial sectors (energy, ferrous metals, minerals, pulp and paper) but excludes emissions from transport and other industrial, commercial and domestic sources.This raises the concern that emissions outside of the scheme (notably in transport and aviation) continue to rise and offset the overall environmental effectiveness of the scheme in reducing total emissions. However, even tight controls on emissions outside the scheme will be inefficient if the marginal cost of the reductions achieved exceeds the cost of abatement within the scheme. For this reason, there is a prima facie case for extending emissions trading beyond heavy industry to the aviation and transport sectors and to other commercial and domestic energy users. Covering all relevant sources of emissions ensures that all sectors contribute to achieving the required national reductions and – via a common price for carbon – ensures that business and individuals make efficient trade-offs between their emitting activities in delivering the required reductions at the lowest possible cost to the economy.
Against these benefits, the main challenge is the transaction costs involved in expanding emissions trading to millions of additional emitters. Short of a technological solution to this issue (and there is already a nascent debate on personal carbon quotas), the solution is a flexible approach to the compliance responsibility for the associated emissions. For example, the obligation to surrender allowances could be imposed on suppliers of primary fuels. There are relatively few gas, oil and coal suppliers and each will already know in detail how much fuel they have supplied to their customers. It would then be relatively straightforward to calculate the associated carbon emissions by applying typical emissions intensity factors for the fuel supplied. The other main objection to expanding emissions trading to new sectors is that the low elasticity of demand for petrol and domestic fuel means that such expansion would translate into a 'carbon tax' on these fuel uses with little, if any, impact on overall emissions and with negative consequences for the existing traded sectors. However, this fails to account for the following: Including the additional emissions (and the associated potential for abatement) within the scheme can only be beneficial since, if demand were genuinely inelastic, the traded sector would have to meet any shortfall in abatement from the non-traded sectors to meet an overall national cap. Unlike a suite of taxes (where the associated demand response is unpredictable), the price of carbon would provide a single, unified signal that responded dynamically to the overall tightness of the carbon constraint and hence would be more credible,more popular and less susceptible to short-term intervention than taxes. Greater consumer awareness of the emissions associated with consumption will in itself help to reduce customer inertia and improve demand response. Extending emissions trading would complement – not substitute for – other policy instruments targeting emission reductions (eg, appliance, building and vehicle efficiency standards, labelling requirements, etc). In conclusion, as the lessons from the first full compliance year of the EU ETS bed down and attention shifts to post-2012 arrangements, there is a danger of misinterpreting the lessons to date. The story is not one of emissions trading not working as an instrument (it has), but the inevitable consequences of reducing emissions within a scheme with limited time horizons and partial geographic and sectoral coverage. As we develop the post-2012 discussions, we need to accept the (perhaps uncomfortable) truth that reducing global emissions ultimately requires long-term global emissions caps and that emissions trading is the best instrument by far to deliver the required reductions.We therefore need to focus on the best, forget the rest, and start thinking wider, longer, deeper in the development of a truly international emissions trading scheme. Paul Dawson is director of regulatory affairs at Barclays Capital, a London-based investment bank. E-mail: paul.dawson@barcap.com
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