In December, Environment Ministers reached agreement on a proposed emissions trading Directive (ENDS Report 335, pp 50-51 ). The new scheme is intended to be a key part of the EU's strategy to meet its greenhouse gas targets under the Kyoto Protocol.
The UK's main concern in the negotiations was to secure opt-outs from the trading scheme's first phase, which is due to run for three years from January 2005. The aim was to minimise disruption to core elements of the UK's own climate change policies - particularly the UK emissions trading scheme, the climate change levy and the associated sectoral climate change agreements (CCAs).
The agreed text allows certain installations and activities to be excluded until 2008 provided they achieve equivalent emission reductions, and are subject to equivalent monitoring, verification and penalties as installations under the scheme.
But as the dust settles it is becoming clear that major sectors of UK industry - most notably the electricity generators and oil refineries - will not qualify for this opt-out. As a result, they will need to take on emission caps from 2005.
Andy Limbrick of the Association of Electricity Producers said that "we're sure the generators are in, though that hasn't yet been formally confirmed by the Government." Officials in the Environment Department confirmed that the generators are expected to join the EU scheme from the outset.
This partial coverage of UK industry in the first phase of the EU trading scheme will add another layer of complexity to the UK's tangled policies on industrial greenhouse gas emissions. But the problems posed by the Directive go much deeper, according to a report prepared for the European Commission by Sussex University's Science Policy Research Unit.1"The EU Directive has driven a coach and horses through UK climate policy and has turned the UK's early start in emissions trading into a false start," says Steve Sorrell, the report's author. "The full implications have yet to be appreciated by government and industry."
SPRU argues that the Directive "will require major changes to the climate change levy and CCAs, and may signal the end of the UK emissions trading scheme." It also highlights important interactions with the renewables obligation, the energy efficiency commitment (EEC) and the implementation of integrated pollution prevention and control (IPPC).
Most of the problems stem from the fact that the EU scheme makes the generators responsible for emissions arising from electricity production. In contrast, UK policies allocate ownership of emissions to electricity consumers - a move driven by the Government's desire to protect households from higher energy prices. SPRU believes that the choice "may now need to be reconsidered."
The "fundamental incompatibility" between the EU and UK approaches will not be resolved by the opt-outs, not least because the generators will come under the EU scheme from the outset. There are several important consequences.
Firstly, SPRU says, there is the issue of "double crediting" where reductions in electricity use to meet CCA targets, the UK emissions trading scheme or the EEC would also count towards the generator's target.
Second, the report sees problems of "double regulation" where, for example, generators pass on the costs of complying with the EU scheme to customers who are already paying the climate change levy.
The report concludes that the climate change levy should be removed from electricity and extended to all fossil fuels as a downstream carbon tax, with compensation to protect fuel poor households. The Government is already under pressure to reform the levy in its forthcoming energy White Paper (ENDS Report 334, pp 7-8 ).
SPRU also recommends that installations under CCAs but which are not eligible for the EU trading scheme should renegotiate their agreements to relate to fuel consumption only.
Bill Kyte of electricity generator Powergen, who is chairing a new UK Emissions Trading Group committee looking at the implications of the Directive, broadly accepts SPRU's analysis of the problems but not necessarily its recommendations.
"One could tear everything up and start with a clean sheet of paper, or else argue that UK policy is inviolate - though the Commission may have something to say about that," Dr Kyte said. "Between those positions, the Government has got to be pragmatic and say what is and is not acceptable on double regulation and double crediting."
Little time is available to resolve such fundamental issues. Under the proposed Directive, Member States have until the end of March 2004 to publish a national plan setting out how they will allocate allowances for the first phase of the trading scheme. The Government may be hoping that the timetable slips, giving it longer to resolve the implications for wider UK climate policy.
The Commission is due to produce guidance on national allocation plans by the end of 2003. In the meantime, policy-makers have a list of criteria in the draft Directive as a guide - although SPRU's Steve Sorrell says these are "vague and potentially contradictory."
The electricity generators provide a vivid illustration of the issues at stake. The sector's CO2 emissions fell from 54 million tonnes of carbon (mtC) in 1990 to 42mtC in 2000. The most recent Government forecasts suggest that emissions should fall to 33-38mtC by 2010 - although many observers reckon that coal burn, and hence emissions, will be higher than expected.
The UK and Germany succeeded in adding a new clause to the draft Directive which would allow national allocation plans to "accommodate early action". Another late addition was that the allocation should take into account national energy policies.
On one interpretation, this means that an early baseline year could be set for the UK generators. Andy Limbrick says that the AEP has yet to agree a position - but observed that "it would be human nature, and maybe good business, to take 1990 as a starting negotiating position."
Such a move could allow UK generators to sell huge amounts of "hot air" allowances into the EU scheme. The UK's own emissions trading scheme has shown how generous baseline allocations and banking provisions can create large quantities of "hot air", greatly undermining environmental effectiveness (ENDS Report 327, pp 3-5 ).
It remains to be seen whether the UK will take this approach. A historic baseline would present difficulties in allocation because of major structural changes in the electricity supply industry over the past decade. Moreover, the Commission has retained a right of veto over national allocation plans, despite opposition from the UK, and is likely to resist "hot air" allocations.
A related question is how ambitious the Government will be in setting national and sectoral targets under the allocation plan.
The Directive requires the quantity of allowances allocated to reflect the degree to which a Member State is on course to meet its share of the EU's overall greenhouse gas target. According to the European Environment Agency, only Germany, the UK and Sweden are on course to meet or exceed their "burden-sharing" targets.2 These countries may be expected to set less stringent targets, and to be net sellers of allowances.
However, the UK could set more ambitious targets in order to move towards its domestic goal of reducing CO2 emissions by 20% by 2010 from a 1990 baseline. Much will depend on the forthcoming White Paper on energy, and the degree to which the Government believes that its existing climate programme is on track.
There is much to play for over the coming year. It is already clear that climate and energy policies will continue to evolve rapidly - and that the framework is unlikely to get any simpler.