First deal shows problems in UK carbon trading rules

The first transaction under the UK's greenhouse gas emission trading scheme was announced in September between the US chemical company DuPont and Japanese-owned trading house Mieco. The deal has raised awkward questions at the interface between trading and conventional emission controls - and about windfall benefits from trading.

The trading scheme does not open for business until January (ENDS Report 319, pp 16-20 ). The transaction between DuPont and Mieco was a forward trade, with the chemical company selling emission allowances for 2002 equivalent to 10,000 tonnes of carbon dioxide. The deal, brokered by Natsource, will only be completed if DuPont makes a successful bid in next January's official auction which will determine companies' emission allowances.

DuPont has been one of the pioneers in inter-company trading in North America, and is eyeing opportunities elsewhere. Dave Findlay, its global business director for emissions trading, said that the company had wanted to make the new deal mainly to begin learning about the UK scheme. But its participation was also intended as a "vote of confidence in the [UK] Government" for creating an official market in greenhouse gas allowances.

Environment Minister Michael Meacher welcomed the transaction. "This is an important kick-start for the market," he said. "Any trade in allowances?contributes to the success of the UK climate change programme, including the UK emissions trading scheme, and the development of international trading."

The transaction, though, has raised some tricky issues about the relationship between trading and integrated pollution control (IPC) - as well as doubts whether all transactions under the scheme will involve real emission reductions.

The source of the allowances sold to Mieco is a DuPont plant at Wilton on Teesside which produces adipic acid, an intermediate in nylon manufacture. The process emits nitrous oxide, which has a global warming potential 310 times greater than carbon dioxide.

In the mid-1990s, the plant was emitting 50-60,000 tonnes of N2O per year, contributing a massive - for a single source - 3% of the UK's total greenhouse gas emissions.

After acquiring the plant from ICI in 1992, DuPont came under growing pressure from HM Inspectorate of Pollution and then the Environment Agency to reduce the emissions. It eventually installed an abatement unit in late 1998, with commissioning completed during 1999.

The unit was designed to reduce the plant's N2O emissions by 80-90%. It is also used to abate emissions of volatile organic compounds, and the energy produced in the process is used to raise steam, reducing DuPont's energy purchases. The Agency describes the unit as a "win-win" project - and it now looks like turning into a "win-win-win" investment for DuPont.

However, there appear to be important differences of view about exactly how many tradable allowances the N2O abatement project will potentially generate. These stem from a lack of clarity about the trading rules - and how these are settled will have important implications for other companies.

DuPont will enter the allowances generated by the project into the scheme as a "direct participant". For many emission sources entering via this route, this would mean that the baseline from which their potential allowances is calculated will be the average of their emissions in 1998, 1999 and 2000.

If this was the method followed for the Wilton operation then, according to data in the Agency's pollution inventory and DuPont's latest environmental report, the site's baseline would be 19,754 tonnes. This is calculated from its N2O emissions of 49,473 tonnes in 1998 - before the abatement unit was fully commissioned - 3,204 tonnes in 1999 and 6,586 tonnes last year.

As far as ENDS has been able to establish from several inquiries, this is indeed the baseline which DuPont has assumed it will have.

The allowances potentially available to the company would depend on future emissions from the Wilton plant. The N2O limit in its IPC authorisation is 7,500 tonnes per year.

On the conservative assumption that emissions are at this level, the company would have an annual surplus of close to 12,500 tonnes. This is equivalent to a massive 3.9 million tonnes of CO2 - no less than half of the total savings which the Government hopes the trading scheme will achieve over the next decade.

In fact, DuPont would not be able to bid anything like this quantity of emissions into the January auction. This is because the Government has said that no company can claim more than 10% of the financial incentive offered to businesses to join the scheme - worth £30 million per year after tax over the next five years. So exactly how many allowances the company could win will depend on the size of other participants' bids.

Even so, if this was the basis on which DuPont participated, serious questions would be asked about the scheme. For one, selling allowances generated on a large scale by a past emission reduction project to other companies would defeat the object of the exercise.

Equally, DuPont's potentially large claim on the financial incentive would be contrary to its stated purpose - to encourage firms to accept the risks involved in taking on a voluntary cap on their emissions. In the Wilton plant's case, there would be no credible risk.

However, this scenario appears unlikely to be realised in full. The reason can be found in a paragraph in the framework for the trading scheme published by the Department for Environment, Food and Rural Affairs (DEFRA) in August. This says that any direct participant wishing to enter a source which is subject to a regulatory limit must notify the Government, which will "consider the eligibility of these sources for entry into the scheme on a case-by-case basis."

The paragraph appeared to mean that sources would simply be judged to be eligible or not. However, it turns out that DEFRA has something else in mind. It will be looking for "policy additionality".

In practice, this appears to mean that the baseline for sources such as the Wilton plant will be their regulatory limits - with emission allowances only being generated by reductions below this. DEFRA's thinking will be set out in detailed rules later this year.

There are some further complications. Communication between the Agency and DEFRA appears to have left something to be desired. Local Agency inspectors have heard little about the DuPont transaction. At the same time, DEFRA seems to have been unaware that the Agency suspended the company's N2O limit last December because of reliability problems with the abatement plant.

Suspension of emission limits is relatively rare. But it will have implications for the trading scheme which remain to be thought through.

There is also a wider issue. It is not uncommon for emission limits for a novel abatement technology like DuPont's to be set at an initially generous level, and then to be ratcheted down as its performance settles.

However, with the onset of emissions trading, the financial stakes involved will clearly be higher, and the Agency may face greater resistance from companies to having emission standards tightened. Conversely, the Agency may feel that leaving operators a generous margin between actual emissions and regulatory limits would leave undue latitude to benefit from sales of allowances.

In DuPont's case, cutting the annual N2O limit to the level the plant achieved last year would be equivalent to a reduction of around 300,000 tonnes of CO2 - likely to be worth at least several hundred thousand pounds per year in the trading market.

Even within DEFRA's rules on policy additionality, there appears to be a reasonable prospect that DuPont could secure allowances up to its 10% limit. If it chose to do so, it could earn £15 million over five years in incentive payments, together with revenues from allowance sales likely to run into millions of pounds. That would be a handsome payback on the N2O abatement unit, which cost £6 million.

Dave Findlay says that DuPont is alive to the potential sensitivities involved. He said: "We're interested in a robust trading mechanism, so we're not going to do anything that would put the whole system in jeopardy."

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