Many of the paper's proposals reflect ideas developed by the industry-led Emissions Trading Group (ETG) over the past year (ENDS Report 297, pp 19-23 ). The Government signalled support for a scheme this summer by announcing a £30 million inducement in 2003/04 for companies to take on binding targets. The incentive will be available at the same level for five years. There will be a limit on the share any one company can claim, with 10% being put forward for "illustrative purposes".
Although many of the detailed rules remain to be settled, the consultation paper suggests that enough of the framework will be in place in time for some trading to begin next April. But the rules are not expected to be finalised until next autumn, when bids for the initial £30 million incentive are also due.
Companies may well hold back until then before deciding whether, and on what terms, to participate, although Margaret Mogford, who chairs the ETG, believes there may be some speculative forward trading before then.
The scheme will not get into full swing until 2002, the first "compliance period". Companies' performance against targets will then need to be verified, and the first incentive payments will be made in April 2003.
Many of the key proposals announced in the paper are tentative, in part because decisions will depend on further work on the scheme's rules and on the outcome of negotiations under the Kyoto Protocol.
Grandfathering is also favoured by the ETG. But it is open to criticism because companies could benefit financially from past emission reductions which may have resulted from plant rationalisations, reduced output or fuel switching by their electricity suppliers - a concern which grows the further back the base year is set because of major reductions in CO2 emissions achieved in the electricity sector's switch to gas in the past decade.
The Government has addressed this concern by proposing that the baseline for emission targets for firms entering the scheme in 2001 should be their average annual emissions of greenhouse gases in the three years up to and including 2000. A shorter period may be allowed for companies able to demonstrate to external verifiers that they do not have reliable data for all three years.
The proposal is a blow to business. The ETG suggested last autumn that grandfathering should be over five years, or longer if verifiable emission data were available. In March, it softened its stance, suggesting a period of up to five years. But the Government's proposal will not have come as a surprise to ETG members, who were told by the Department of the Environment, Transport and the Regions earlier this year that no significant windfall benefits would be allowed.
A team led by consultancy ERM is drawing up a blueprint for the bidding process. To maintain the scheme's environmental credibility, it has been asked to assume that bidders will need to offer a minimum percentage reduction in emissions versus their baselines. What this minimum will be "will be decided in due course" - but a figure of 1% per year or its equivalent over the full period of the target "has been used recently for illustrative purposes only," the paper says.
The paper says there is a "good case" for treating emissions from power generation in the same way as under the sectoral climate change agreements, with the emissions being allocated to electricity users. This would increase the liquidity of the trading market.
Exactly how long the generators will have to wait before being allowed into the scheme is not made clear, although a delay of one to two years is being talked about.
There is, though, a difficulty with the delay which is not spelled out in the consultation paper. Even if the generators are left to trade only the 40% or so of their emissions which arise from producing power for households, this could be enough to make a major difference in the value of trades. Other participants may therefore want to know the likely entry rules for the generators before committing themselves.
The "cap and trade" approach will be applied to the latter. They will receive annual allocations of emission allowances and meet them either by emission abatement or by purchasing credits.
Companies in the sectoral climate levy agreements will not be eligible for financial incentives under the trading scheme because they will benefit from an 80% discount on the levy. Their incentive to trade will come from finding ways of meeting targets which are cheaper than in-house abatement.
For firms in sectoral agreements, the Government is proposing a "baseline and credit" approach, in which credits from reducing emissions below their targets can be traded only at the end of each two-year compliance period because the level of the credit will not be known until then.
Companies with output-weighted targets under the sectoral agreements - the so-called "unit" sector - will face a series of restrictions on participation in the trading scheme. The Government feels these are needed because such targets do not guarantee absolute reductions in emissions.
One restriction, as proposed by the ETG, will be a "gateway" mechanism between these firms and the trading scheme. This will guard against "inflation" within the scheme by sales of surplus credits which are generated without an absolute reduction in emissions in the unit sector. Sales by this sector would be permitted only if equivalent sales had been made into the sector.
The gateway will also be closed in 2008, providing an incentive for firms in the unit sector to take on absolute targets as international emissions trading begins. In addition, because businesses in the unit sector are not taking on the risk of accepting absolute emission targets, the Government says it is "not minded to" allow them access to trading "flexibilities" - notably by earning credits from overseas or domestic emission reduction projects (see below).
The ETG is keen for all six gases to be covered from the outset, and is working on a verification protocol which it hopes to have ready early next year. In particular, it wants firms within the sectoral agreements to be able to take on targets for gases other than CO2 and qualify for the trading incentive.
The paper notes there is some concern that firms will be able to "cherry pick" between the six gases. It proposes that companies should be able to trade either in CO2 only, or in CO2 plus any of the other five gases which they emit.
On domestic projects, the Government hopes that this will stimulate emission reduction projects in areas such as transport, household energy efficiency and businesses which do not participate in trading.
A major issue here will be the need to demonstrate that emission reductions below "business as usual" are achieved. The rules and approval process for this are still being discussed with the ETG, and are unlikely to be finalised by the scheme's launch. As an interim measure, the Government is considering producing a list of projects with pre-agreed baselines which might be approved before the finished rules are in place.
One key decision, though, appears to have been taken. According to the paper, "the UK's priority should be emission reductions rather than carbon sequestration because of the complexities and uncertainties involved with forestry projects and other carbon sinks" - and so "for the time being" these will be excluded from trading.
On the international front, the Government says it intends to allow firms to use credits from the two global "flexible mechanisms" - Joint Implementation and the Clean Development Mechanism (CDM) - to meet their targets under the UK scheme. Final decisions on this will depend on the outcome of the Kyoto Protocol negotiations.
The only question which the paper poses about the use of these mechanisms is whether overseas projects should require Government approval before credits can be used in the UK scheme. It does not elaborate on the threat to the scheme from credits from CDM projects in particular, which are expected to get off the ground fairly swiftly.
However, Margaret Mogford points out that "if there are a lot of very cheap carbon credits swilling around internationally and the UK trading scheme is the only one in which they can be monetised, this could allow UK companies to meet their targets without abatement, damaging the scheme's credibility. The answer to that may be in the international rules for CDM projects - but if these are loose then the UK may need to superimpose its own rules."
The paper says that there has been much debate within the ETG about whether a company's targets should be varied in this scenario. "Unfortunately, there seems to be no easy way by which these concerns can be met, without imposing increased administrative burden on participants in the scheme (for example, through a requirement to impose output as well as emissions), or without penalising genuine efforts to reduce emissions by managing production."
Margaret Mogford argues that moving out of high-carbon products - even if this involves plant closures - is a legitimate way of meeting emission targets and should not be restricted. She believes that the need to protect corporate reputations will be a safeguard against profiteering in such situations. Even so, this could become a major concern.
Other company changes - such as mergers, demergers, acquisitions and outsourcing - will be less difficult to handle. The Government says it is "minded to" address these by requiring that emission targets be retained by the activities covered by them.
The paper also deals with a series of possible participants in trading - including electricity suppliers which beat their targets under the coming renewables obligation, gas and electricity utilities which beat targets under the new Energy Efficiency Commitment scheme for 2002-05, offshore operators involved in a pilot trading scheme in gas flaring consents, and the aviation sector.
The authority will be established within central government. But without legislative back-up it will have no tailored statutory sanctions for breaches of the trading rules or failures by companies to meet their targets. The latter can be penalised by the Government withholding financial incentives, but in other cases the only resort appears to be the criminal law - although the paper suggests that market participants might agree a penalty regime among themselves.
The ETG has been arguing for a regime which imposes clear and predictable penalties for non-compliance to ensure the scheme's international credibility.
The ETG also wants the authority to be moved out of central government as quickly as possible so as to minimise the scope for Ministerial interference.
The ETG has urged bodies with experience of verification to notify the UK Accreditation Service of their interest by 31 December. This is the deadline for firms to participate in an accreditation process during next year so that they can begin verification work at the start of 2002.