Weighing the carbon cost of heavy industry

The first phase of the EU emissions trading scheme (EUETS), which ran from 2005 to 2007, was always intended to be an experimental one. It was an opportunity to test the structures and rules for a new carbon market that could gradually expand to include a growing number of sectors, greenhouse gases and even countries.

Over its short life, the scheme has scored some notable successes. It has created a brand new commodity market worth billions of euros a year (see p 16 ) and successfully put a price on carbon that firms are factoring into their investment decisions.

The rules, reporting procedures and IT systems supporting the market are also performing well and there have been remarkably few cases of installations failing to comply with the scheme’s rules.

But unsurprisingly, there have also been some high-profile problems and debate still rages over whether the scheme has managed to deliver any real emission reductions (ENDS Report 399, p 10 ).

Most criticism has been aimed at the cap setting and allowance allocation processes. For phase one and phase two, which runs from 2008 to 2012, member states set their own caps on carbon dioxide emissions through their national allocation plans (NAPs). This politicised the process, with some countries unable to resist the temptation to protect key industries.

More than half of the carbon market’s value was wiped out in a few weeks in 2006, when the first set of verified data revealed that some governments had given their industries far more allowances than they needed (ENDS Report 376, pp 12-13 ).

Meanwhile, power generators have been accused of making windfall profits running into billions of euros by passing much of the market price for allowances on to the their customers - even though they received most of their allowances for free (ENDS Report 399, p 11 ).

There has been uncertainty over the long-term direction of the carbon price and market volatility. There are issues around the inconsistent national implementation of the trading scheme and also claims it could damage the international competitiveness of certain sectors, such as steel and cement, and lead to carbon leakage - energy-intensive industries relocating outside the EU.

The Directive establishing the EUETS included a clause requiring the European Commission to review the scheme by June 2006, but it was not until January 2008 that it completed the review and published a draft revised Directive as part of its major package of climate policies (ENDS Report 397, p 46 ).

The review stirred up strong feelings among industry sectors because the trading scheme has a direct impact on the economics of production. This ensured the process was subject to intense scrutiny and lobbying by member states, industry and environmentalists alike. Meanwhile, some member states brought legal challenges against the Commission’s attempts to tighten up their NAPs.

The Commission’s proposals went through numerous iterations and fundamental changes were made right up to the last moment, with at least three drafts leaked to key stakeholders in the weeks just prior to publication.

In the end, the Commission came up with an ambitious package of reforms, which will take effect in the scheme’s third phase from 2013 to 2020. The changes will see the Commission - not member states - set an EU-wide cap, which gets smaller each year. They also mean an end to free allocations, with a gradual but eventually near total switch to auctioning - selling allowances to industry at prices determined by a bidding process (ENDS Report 397, pp 47-48 ).

The Commission aims to have the Directive agreed by early next year. This will be in time to influence the UN climate talks in Copenhagen in November 2009, which will seek to thrash out a post-2012 agreement to succeed the current Kyoto Protocol.

Auctioning versus benchmarking
The most unpopular element of the proposals from industry’s point of view is the end of free allocation of allowances. Currently, most installations except those in the power sector receive enough allowances to cover their projected emissions. Even the UK power sector, which has to pay for more allowances than most, receives more than two thirds for free.

But from 2013, the entire European power sector will have to buy all of its allowances. Other sectors will have more of a breathing space, and will only have to buy 10% of their allowances in 2013. But the amount of auctioning will steadily increase so that by 2020, all sectors will have to buy all of their allowances through some form of auctioning.

Environmental groups support the proposals, but say they do not go far enough. "Excluding some sectors from full auctioning will harm the environmental effectiveness of the EUETS," a coalition of environmental NGOs including Friends of the Earth, Greenpeace, and WWF, said in a statement earlier this year. They want all sectors subjected to 100% auctioning from 2013, arguing that only this would create a carbon price high enough to stimulate the significantly higher levels of research and investment in the low-carbon technologies that are needed.

But energy-intensive sectors claim the cost of auctioning will be crippling. The German heavy industry association VIK, for example, claims it would cost German firms around €113 billion over the third phase. It also argues that auctioning has no environmental benefit because emission cuts achieved under the scheme will be driven by the cap, and that auctioning would be in effect just another revenue-raising tax. Instead it wants allowances distributed with a system of benchmarks - emission levels based on best available technology.

Other trade bodies representing energy-intensive industries are making similar arguments. In the UK the manufacturers’ body EEF has called for a limited and careful transition to auctioning, while the energy-intensive users group has backed the VIK position.

In April the International Federation of Industrial Energy Consumers (IFIEC) floated benchmark proposals for the power sector, which it claims would save €55-83 billion annually and cut industrial energy bills by 10-30%.¹ The Commission would set an emissions benchmark based on tonnes of CO₂ per megawatt hours generated at the start of each trading period. Installations would then receive free allowances each year based on their anticipated production. Lower carbon sources would benefit from the scheme because they would receive more allowances than they need and could sell them on the open market.

Each installation’s allocation would be checked against measured production figures at the end of each year and adjusted accordingly. Any installations with unused allowances stemming from reduced production would be required to hand them back to the Commission for retirement.

"With these economic merits and reduction incentives, an EUETS - with the IFIEC method - can avoid the real threat of competitiveness disadvantage for EU industry and resulting carbon leakage," says Hans Grünfeld, president of IFIEC Europe. "EU industry will be able to remain the global low-carbon leader, while further contributing to the EU’s climate policy."

One of the strengths of the system, says the IFIEC, is that ex-post adjustments would at a stroke eliminate windfall profits in the electricity sector. But amending allocations after the fact is likely to be opposed by the Commission because it would make the market more uncertain and complicate efforts to determine a clear price for allowances, which would in turn make it difficult for companies to plan investments. The Commission has come down firmly against ex-post adjustments in the past and is unlikely to have changed its view.

"Auctioning for [companies in] the power sector is pretty much a done deal, but they’ll still make out pretty well because they will see an increase in marginal profits across their portfolios," says Jason Anderson, head of climate change at the Institute for European Environmental Policy (IEEP). "The main thing is what to do with energy-intensive industries. There may be some traction [for benchmarking] there, but the issue is timing. The Commission wants to wait and see what happens with international negotiations, but industries need a decision now."

Those industries subject to strong international competition will be excluded from auctioning, says the Commission. It has promised to identify the sectors by June 2010, but industry wants it to decide sooner so that it can make investment decisions.

Nick Sturgeon, head of climate change and energy at the Chemical Industries Association (CIA), was disappointed with the delay: "Sectors like chemicals need reassurance that they will be shielded from the full cost of a unilateral EU move to auctioning. Decisions on investment in new plant and innovation require long-term predictability with clear assurances that there will be a sustainable business environment under the revised EU ETS."

Tackling carbon leakage
In April, chemical giant BASF cited lack of certainty over whether it will continue to receive free allowances as the reason for delaying a €1.5 billion investment in a coal gasification plant in Germany. Steelmaker Voestalpine has also delayed an investment in Austria.

The European Climate Change Programme, a Commission advisory body, met in Brussels in April to start the process of identifying excluded sectors. But Environment Commissioner Stavros Dimas says the Commission will wait until the outcome of international negotiations before making a decision and it could be as late as 2011 before the sectors are approved by member states and the European Parliament.

Meanwhile, the French government has promised to champion the idea of border tariff adjustments to tackle carbon leakage when it holds the rotating European presidency in the second half of this year. This could see an import tariff levied on products from countries that do not take part in a regulated emissions trading scheme or do not put a price on carbon in some other way.

Cash cow
The deciding factor on widespread benchmarking may well be the sheer value of auctioning to governments. The Commission estimates that auctioning will raise around €50 billion annually by 2020 - cash that would go directly into government coffers.

Its proposals for member states to spend "at least" 20% of the auctioning revenue they receive on climate measures have met fierce opposition from some member states, including the UK (see box ), which resent being told by Brussels how to spend domestic revenue. Commission "interference" in national state fiscal policy has been a red line rarely crossed.

In February, EU finance ministers agreed that auction revenues "should not be subject to mandatory earmarking at EU level." They justified their position on the grounds of "subsidiarity and sustainable public finances".

But environmental groups argue that all of the revenue - not just a fifth - should be earmarked for climate measures. "At least 50% of the revenues from EU allowance auctioning [should be] invested to assist developing countries in adapting to the effects of climate change," said Brussels-based Climate Action Network. The remainder "should be used in the EU for supporting the development and market introduction of environmentally sound greenhouse gas reduction instruments and technologies."

Industry also dislikes the possibility of auction revenue disappearing into national government coffers and wants at least some of it returned to them to help them reduce their emissions.

Early in May CBI director general Richard Lambert, WWF-UK chief executive David Nussbaum and BT chief executive Ben Verwaayen (who chairs the CBI’s climate change board) wrote a joint letter to Prime Minister Gordon Brown calling for the money raised by auctioning carbon emission permits to fund major new investment in reducing emissions. The government is set to receive around £1.6 billion from selling allowances generated during the scheme’s second phase.

A European cap
The proposal to end the system of national allocation plans and introduce a single pan-European cap has received widespread backing. The current system of national caps set by member states is seen as open to political interference and business lobbying.

Indeed, some member states gave their industries more than 50% more allowances than they needed in the first phase. In spite of the subsequent collapse of the carbon market in 2006, member states continued to set over-generous caps when they drew up NAPs for the second phase later that year. It soon became apparent that the caps were too weak to support a viable carbon market and the price of carbon could fall to zero - forcing the Commission to step in to tighten them (ENDS Report 383, pp 46-47 ).

Giving the Commission responsibility for setting the cap should remove competitive distortions within Europe, says Andy Kerr, director of carbon consultants E3 International. "Getting rid of the NAPs is going to equalise the abatement cost curves much more evenly across Europe."

The decisions to link the cap to the EU target to cut CO₂ emissions by 20% by 2020 and to publish the level of the cap for each year until 2025 has also provided much-needed long-term certainty for the market.

However, an EU-wide cap could cause problems for member states such as the UK and Netherlands, which have adopted their own emission targets. The climate change Bill sets a mandatory target to cut UK emissions by "at least 26%" by 2020.

National caps for greenhouse gases "will partly become defunct", according to a recent report by the Dutch Environment Agency.² After 2012 member states "will no longer have control over the location of emissions reductions in the emissions trading scheme. This implies they also lose a mechanism for steering the achievement of national total emission targets."

Stronger national measures to tackle emissions from EUETS sectors would not lead to additional emissions reductions, says the report, because extra cuts in one country would be offset by increased emissions in another.

This implies that with about half of UK CO₂ emissions coming from EUETS installations, the government will have to rely on measures targeting the rest of the economy should it begin to drift off-target. In the UK that would mean extra pressure on transport and heat emissions, which are notoriously difficult to control.

Jos Olivier, a scientist at the agency and one of the authors of the report, says such countries will have to recast their national targets, perhaps by restricting them to emissions not covered by the EUETS. But he also insists there is still a case for countries to introduce additional measures to control EUETS installations because emissions reductions can also cut air pollution and boost clean technologies.

"It might be in a country’s interest to reduce energy consumption further because it can bring down nitrogen oxides and sulphur dioxide emissions and improve energy security, but it will not help reduce EU emissions beyond the [EUETS] cap."

E3’s Andy Kerr agrees. "The European cap means that all policies to reduce emissions that are above the carbon price [generated by the EUETS] will have to be looked at carefully and the co-benefits assessed."

Demanding targets?
The Commission has also been criticised for the size of the emission cuts it wants the EUETS to deliver and its contribution to the EU’s 2020 emission reduction target. The scheme will be expected to deliver about two thirds of the cut to meet the 2020 target, and EUETS emissions will have to fall by 21% relative to 2005 levels compared to 10% for sectors not covered by the trading scheme.

NGOs do not think this goes far enough. WWF, for example, wants the 2013 cap to be 36% below 2005 levels, and warns that cap levels may have to be tightened if the EU adopts more demanding targets as part of a new international climate agreement.

Jason Anderson of IEEP also thinks the targets could be tightened. "The Commission’s proposals are seen as ambitious, but they’re ambitious in design only. If you look at the trajectory, we’re only going to be going from ten percentage points below [1990 levels] to 20 points over the course of the next ten years."

Tussles ahead
All this makes reaching agreement on the proposed Directive by early 2009 look ambitious - and other issues are only now coming to the fore. Some east European member states dislike the adoption of 2005, rather than 1990, as the baseline year for setting national targets because this ignores the fact that their emissions have fallen significantly since 1990.

The scope of the scheme will also be scrutinised. Irish MEP Avril Doyle, the European Parliament’s rapporteur for the Directive, wants reforestation included - something that had been ruled out by the Commission. "We have to find a way to make living trees more valuable than dead ones," she told the Parliament’s Industry Committee in March. She also wants shipping’s emissions to be included. MEPs have backed tougher terms for the aviation sector.

Meanwhile, some member states have questioned the expansion of the scheme to other greenhouse gases and energy intensive sectors like aluminium.

On top of this, the degree to which emissions reduction credits generated by the Kyoto Protocol’s flexible mechanisms are allowed to enter the scheme will be highly contentious. Environmental groups want strict limits on the quantity allowed and also want to restrict them to projects that comply with their Gold Standard.

But guaranteeing strong demand for foreign credits will encourage developing countries to sign up to a new international agreement - and securing the buy-in of China, India and other emerging global giants is perhaps the most vital thing of all.