What does the future hold for the CRC?

Just as the CRC Energy Efficiency Scheme hits its stride the government is proposing to change it. James Richens looks at the options, from modest simplification to radical overhaul, including replacing it with a new carbon tax

The Carbon Reduction Commitment (CRC) Energy Efficiency Scheme is at a crossroads.

The scheme went live in April 2010 after five years of painstaking development and three exhaustive rounds of public consultation. Some 2,800 organisations have registered with the Environment Agency, the scheme’s regulator, as full participants in the emissions trading scheme. A further 12,500 with lower energy use have registered as information declarers (see figure).

But not long after May’s general election, the new coalition government promised to consider simplifying the scheme, responding to criticism from some business groups that it was too complicated.

Then it dropped a bomb. In October’s spending review, the ­government removed the CRC’s complex revenue recycling mechanism, turning it into a £1bn per year tax (ENDS Report 429, p 7).

The move was forced on the energy and climate department (DECC) by the Treasury, hungry for extra tax revenue to cut the public deficit. This was simplification, but not what business groups had intended.

In November, DECC published a consultation to kick off the reform process (ENDS Report 430, pp 8-9) – the fourth consultation in the CRC’s history. It heralds a further period of uncertainty: the thing companies hate the most because it makes business planning difficult and risky.

Complicating the picture further is the government’s plan to introduce a carbon floor price by reforming the climate change levy (CCL) (ENDS Report 427, pp 45-46). The government is also considering mandatory carbon reporting.

The big question is how far will the government go? At one extreme it could settle for some modest simplification. At the other it could fundamentally reform the scheme.

Tom Bainbridge, a partner at law firm Nabarro specialising in energy and carbon, says: “Should the CRC be reformed? Absolutely. The key problem with the CRC is its disproportionate complexity relative to its lack of environmental ambition.”

By 2020 the CRC will cut CO2 emissions by only four million tonnes, or 0.6% of the current UK total.

Mr Bainbridge argues that this complexity means participants have spent large sums on lawyers and consultants to assist with the registration process; money that would have been better spent on improving energy efficiency.

Others are not so sure. Energy company Npower wears three CRC hats: participant, energy supplier and consultant advising others how to deal with the scheme. Dave Lewis, its head of business energy services, says: “We’ve been working on the CRC for two years… We’ve put systems in place to manage it, so to change the scheme now is a burden, not a simplification.

“I’ve heard a lot of companies saying it’s difficult because you’ve got to collect all this data and report it… but the government is only asking you what your costs are,” he says. “If you don’t know this, are you running your business properly?”

Playing for time

There was some expectation that DECC’s latest consultation would set out some substantive reforms. In fact, it plays for time by delaying the CRC’s next main phase. DECC says many ideas for reform would need more fundamental legislative changes, which are not possible within the CRC’s current timetable.

Its main proposal is to postpone phase two – the scheme’s cap-and-trade phase – by delaying registration by two years and emissions trading by one (see figure).

Phases of the CRC

Under current rules, phase two starts with the footprint report and registration year in 2011/12. The annual report year follows in 2012/13 and allowance auctioning starts in 2013/14.

DECC proposes that 2013/14 will be the first year of the second phase by making it the registration, footprint report and annual report year. Auctioning of allowances would start in 2014/15.

Combining the footprint and annual report into one year for the second and subsequent phases would make them run for six years rather than seven. The final phase, starting in 2038/39, will be only five years so as not to extend the CRC’s lifetime.

DECC will also extend the CRC’s introductory phase by 12 months so it runs for four years until the end of 2013/14 rather than 2012/13. During this period participants will have to buy allowances for £12 per tonne to cover their annual emissions.

The most obvious target to simplify the CRC is to scrap emissions trading. This is proposed by the government’s advisory body the Committee on Climate Change (ENDS Report 428, pp 5-6).

It says cap and trade “would add an extra layer of complexity to what is already a very complex scheme with no apparent benefits” for encouraging energy efficiency. Participants would have to develop carbon trading strategies or pay intermediaries to do it, and the agency would need to administer carbon allowance auctions.

What could replace cap and trade? The climate committee suggested one option is to simply continue with an upfront, fixed-price sale of unlimited allowances as envisaged for the introductory phase.

The government has already gone some way down this line by proposing to extend the introductory phase by a year. It has also shifted the first allowance sale in 2011/12 from the start of the year to the end. A retrospective sale simplifies the CRC because participants no longer have to predict how many allowances to buy.

Bureaucratic tax

For Nabarro’s Tom Bainbridge, that would spell the beginning of the end of the CRC. He argues that fixed price retrospective sales with no revenue recycling turns the CRC into an expensive and bureaucratic way to gather a tax.

“If you do fixed price end-of-year sales then you may as well just accept that you’ve killed off the CRC as an emissions trading scheme and you may as well go to a much simpler mechanism such as the CCL,” he says. “If it’s going to act like a tax then why not collect it like a tax.”

The CCL is a tax on business and public sector energy use introduced in 2001. Almost all CRC participants already pay it.

Under the CCL, energy-intensive firms are offered rebates if they sign up to a climate change agreement to improve energy efficiency through their trade associations. This would be difficult to replicate for the myriad of private and public sector organisations under the CRC. Mr Bainbridge suggests rebates could instead be offered to companies that achieve the Carbon Trust Standard or one of its equivalents which certify emissions reductions.

The great disadvantage is that taxes are much less visible to companies and may not result in long-term behavioural change. Emissions trading requires active participation that makes energy use a top-of-mind issue.

Mark Johnson, principal consultant at AEA specialising in the CRC and emissions trading, thinks keeping the CRC fixed price payments is an attractive way to simplify the scheme.

He agrees retrospective payments are simpler, but says the price signal it sends is weaker than upfront sales. “If you’re having to buy things upfront it puts you more in the mindset of pursuing emissions reductions.”

Mr Johnson says fixed price sales also raise the question of what the right price of allowances is and how it is set. An independent body such as the Committee on Climate Change would have to advise the Treasury on the precise level to ensure it encouraged carbon abatement investment and was not just a way to raise revenue.

In contrast, Ben Wielgus, KPMG’s lead CRC adviser, is keen to defend emissions trading. He says the firm has given more than 400 presentations on the scheme to the boards of organisations and most found emissions trading fairly easy to understand. He argues that a myth has built up that organisations need to develop a complex carbon trading strategy for the CRC.

In fact, most participants need only take a conservative approach, which involves buying enough carbon allowances at the start of the year to cover an organisation’s predicted emissions, plus a few extra. These can be used, for example if the winter is unusually cold and the organisation uses more energy for heating. Because allowances can be banked from year to year, the money is not wasted. It also means organisations do not have to check their energy use every month.

The strategy does cost slightly more but many organisations, especially in the public sector, are risk-averse (ENDS CRC special report, March 2010, p 13).

Mr Wielgus said only big energy users such as supermarkets and water companies are likely to develop more sophisticated trading strategies aimed at minimising the costs of the CRC.

He says carbon trading is often seen as the most efficient way to reduce emissions at least cost. It has also helped get carbon management onto boardroom agendas.

Chris Huhne, courtesy of Alex Folkes, Fishnik photography

For government, setting an emissions cap and limiting the number of allowances that participants can buy underneath it provides more certainty for meeting UK carbon budgets.

He predicts that, although fixed-price retrospective sales will continue while reforms are made, the government will keep the CRC in a format that allows it to continue as a trading scheme.

One problem DECC would face with moving from retrospective allowances sales to upfront sales under cap and trade is that there will have to be a double sale of allowances in one year. For firms such as South West Water, which will have to pay £1.74m per year for allowances, a double sale is a big extra hit (see pp 18-19).

The real complexity of the CRC is not emissions trading, Mr Wielgus argues, but in the rules surrounding organisational structure and measuring and reporting emissions.

The basic rule is that any organisation with at least one half-hourly electricity meter and a total usage of 6,000 megawatt hours during 2008 qualifies as a full CRC participant. For a single company the rule is simple. But many companies are subsidiaries of a group. To maximise the CRC’s coverage, the regulations specify that if one subsidiary meets the basic rule, all other subsidiaries in the group are caught.

To identify the legal parent and subsidiaries, company lawyers may have to trawl through the Companies Act 2006, which sets out tests based on whether the parent body has a right to exercise control over the subsidiary. The main one is whether the parent company has a majority shareholding in the subsidiary. If it does, in many cases, the subsidiary is part of the group and covered by the CRC. However, other control tests must also be considered.

The same tests also apply to joint ventures, private finance initiatives and public-private partnerships. Under the CRC, franchisors – in effect the brand owners – are responsible for the energy supply of their franchisees even if these are owned by another organisation (ENDS CRC special report, March 2010, pp 6-12).

Tom Bainbridge says: “The problem is that the boundaries of the CRC are defined by commercial agreements which define organisational structure and supply responsibility. These can change regularly for reasons that are nothing to do with energy consumption or the CRC.”

He points out it makes the Environment Agency’s job more difficult too. It must review a participant’s complex suite of contractual arrangements, which is not what the agency is set up to do.

Mr Wielgus agrees. They both suggest the government should switch to using well-established accountancy rules for working out organisational boundaries under the CRC.

In some case though, this may reduce the scheme’s scope. One example is private equity houses, which are deemed to be parent companies under current CRC organisational rules to catch the energy used by the companies in their investment portfolios. Under financial reporting rules, private equity houses would not be caught.

Speaking at an ENDS conference in November, Jane Dennett-Thorpe, head of CRC policy at DECC, confirmed that the scheme’s organisational rules are an area for potential simplification. Other areas include rules for working out which energy supplies are covered.

Andrew Hitchings, CRC implementation manger at the Environment Agency, told delegates that most queries received by its helpdesk related to these issues (see pp 16-17).

Mandatory reporting

Under the Climate Change Act 2008, the government must consider introducing mandatory carbon reporting. Mr Bainbridge suggests this could replace the CRC’s performance league table. Under the coalition’s proposed ‘one in, one out rule’ for regulations (for any new regulation, another set of rules must be abolished), mandatory reporting could be introduced and the CRC’s league table dropped.

Mandatory reporting may need some sort of compulsory third-party verification if it were to succeed the CRC’s league table. The cost of this may reduce its attractiveness as a simplification measure.

CRC reporting requirements could also be simplified. For instance, at present, participants have to footprint all emissions from energy use and identify those from core emissions sources regulated under CRC. Up to 10% of residual emissions from non-core sources such as fuel used for back-up generators can be excluded.

AEA’s Mark Johnson suggests the requirement could be removed, allowing all residual emissions out of the CRC. This would mean reducing the scheme’s coverage, but probably not by a significant amount. The electricity consumption threshold for inclusion in the scheme could be lowered to compensate.

DECC is also examining how the CRC can be tied in with plans to widen the use of public building Display Energy Certificates (DECs) in 2013. The data for DECs are similar to that for CRC, so it makes sense to integrate the schemes.

The only concrete simplification proposal in DECC’s consultation is to remove the requirement for 12,500 organisations that are ‘information declarers’ but not full participants to continue disclosing energy use information at the start of future phases.

DECC says the requirement has achieved its purpose of gathering information on electricity use to ensure the CRC’s boundaries are set correctly. By 30 September, information declarers – any organisation with one or more half-hourly electricity meters – and full participants had to register with the Environment Agency.

However, the change will save little money. DECC estimates all information declarers will save a total of £591,000 over all six future phases. This is just £10 per organisation per phase. DECC says completing a declaration takes just 30 minutes.

The change reduces the likelihood that DECC could use the information to expand the CRC to smaller emitters, an idea mooted by the government’s Committee on Climate Change. This cited evidence from the Carbon Trust that there is “abundant” potential for carbon savings among smaller firms.

However, Hugh Jones, head of the Carbon Trust’s advisory services, welcomed the requirement’s removal. He says smaller firms could be encouraged to reduce carbon emissions through supply chain projects run by large firms rather than the CRC.

The end of revenue recycling is the biggest change to the CRC. Its loss – without any consultation – incensed the CBI and other business groups who dubbed it a £1bn per year “stealth tax”.

At a recent CBI conference, energy and climate secretary Chris Huhne said the decision was “taken against a background of unprecedented pressure on the public finances… Given a blank slate, we would do things a little differently”.

Mr Bainbridge says CRC revenue recycling was “a real dog’s dinner” and getting rid of it was a step forward, although the money should not be lost to the public purse.

He argues that emissions trading is an effective market-based mechanism to determine cost-effective emissions abatement; those who can reduce CO2 most cheaply and easily are encouraged to do so. But revenue recycling interfered with that investment signal by creating an incentive for everyone to reduce emissions to get their money back and potentially earn a bonus.

Mr Johnson agrees. Revenue recycling made the business case for trying to perform well uncertain because the reward was not clear. League table performance was impossible to predict because it was relative to other participants.

DECC believes ending revenue recycling gives participants more incentive to cut energy use because the scheme would now pose a real cost. As a result, the agency will have to be alive to some participants attempting to find ways to play the CRC rules to find ways to reduce its coverage, Mr Wielgus warns.

He suggests DECC could compensate for the loss of revenue recycling by allocating some of the money to a fund which could be drawn on by participants to pay for energy efficiency improvements. ENDS understands DECC is to make this proposal to the Treasury.

He suggests only the top and bottom portions of the CRC league table get access to this funding to provide a reward and incentive effect. It could be used to create a fund for low-interest loans, paid back through savings on energy bills and replenishing the fund.

The end of revenue recycling has important implications for landlords and tenants. While the CRC was a levy, the terms and conditions of most property leases meant landlords were not able simply to pass on the costs of the CRC to tenants. But now that the CRC operates more like a tax, it could be passed on.

Some leaseholders argue this is a retrograde step. The CRC had forced landlords and tenants to talk about improving energy efficiency that had not happened before. Now there could be much less pressure on landlords to improve energy efficiency.

Georgie Messent, partner at law firm Burgess Salmon and head of its emissions trading team, says landlords were previously looking to restructure leases to pass on the costs. If it changes to a tax then it could be recoverable under the existing tax-recovery provisions of leases. She says this issue is being considered in detail in five cases where clients are taking legal advice.

Scotland and Wales have yet to decide whether to follow the UK government’s lead on removing revenue recycling. The Welsh Assembly Government says it does not agree with the decision and is in talks with the Treasury. This raises the prospect of English companies being at a disadvantage with competitors in Wales.

CRC future

So what does the future of the CRC hold? There is no escaping the fact that the Treasury’s decision to keep CRC revenues has fundamentally changed the scheme. DECC could decide there is now little point retaining the CRC as a complicated way to gather a tax. The parallel review of other climate policies such as the CCL may mean DECC decides to bite the bullet and replace the CRC with a carbon tax and mandatory carbon reporting.

A note of a recent meeting between the CBI and senior DECC officials, seen by ENDS, concludes: “There seemed to be a general consensus that the overall policy landscape should be consolidated to have CCL and CRC together in the form of a carbon tax but still to retain the mandatory corporate and league table elements of the CRC.”

This is music to the ears of manufacturers’ organisations, such as the EEF, which have called on the government to use the review to rationalise the “confusing tangle” of climate policies (ENDS Report 426, p 15).

On the other hand, DECC may settle for modest simplification of some of the CRC’s more arcane aspects. It may decide it is premature to reject the CRC as an emissions trading scheme before it has even started, wasting the years of time and effort that government officials and participants have put into creating it.

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