In March, DEFRA outlined its own thinking on how the EUETS should be overhauled. Responses to the consultation, which ends on 11 May, will inform a formal consultation later this year.
A key theme of the paper is how to generate a high enough carbon price to make it economic for installations to invest in abatement. One option, DEFRA says, would be to hand over responsibility for cap-setting to the Commission. But other options, such as all member states agreeing an EU-wide cap, or setting sectoral caps, are also on the table.
The way that allowances have been allocated has been widely criticised. In particular, the use of grandfathering - basing allocations on individual sites’ historical emissions - has been slammed for not providing an incentive for firms to cut emissions.
The government has already said it ultimately wants to move to full allowance auctioning, but opposition from industry and some member states makes this unlikely any time soon. Instead, DEFRA is backing benchmarking, whereby allocations are based on those from the most efficient sites in each sector.
"There are potentially perverse incentives associated with [grandfathering], and we would like to explore the scope for moving towards a system based on benchmarking, which we feel would provide stronger incentives for firms to engage in emissions reduction activity," says the paper.
It also warns that the free allocation of enough allowances to meet projected emissions is set to end. In the scheme’s first year, all sectors, apart from electricity generators, were given an average of 11% more allowances than they needed to cover their emissions (ENDS Report 385, p 44 ).
DEFRA may also change the way it deals with new entrants and closures. It recognises that cancelling an installation’s allowance when it closes discourages firms from switching production from old, inefficient plants to more efficient ones. It is therefore thinking of allowing closed plants to retain their allowances for a set period, maybe to the end of a phase.
It also questions the logic of giving new entrants free allowances when they can factor the cost of carbon into their investment decisions.
The paper’s other main theme is how to introduce liquidity into the market. The Commission is already considering expanding the coverage of the EUETS to other sectors and gases, and linking it with other schemes around the world.
But, in addition to these, DEFRA also suggests amending the scheme to cover more emissions from existing sectors. This could be done by adopting a broader definition of "combustion installation" than that currently used in the UK, or simply by including all CO2 emissions from installations, whether they come from process or combustion sources.
In addition to the new sectors proposed by the Commission, DEFRA floats the idea of including non-industrial sectors like transport, heating and land use in the scheme. But it recognises it would be difficult to incorporate these in the scheme’s existing structure. It therefore suggests that projects in these sectors could generate emissions reduction credits that the scheme could recognise, in the same way as the Kyoto protocol’s clean development and joint implementation mechanisms do.
It presents three criteria for determining whether a sector would be suitable for inclusion:
But DEFRA says another way to provide more certainty for investors could be to stick with five years, but guarantee that caps in subsequent phases would be lower, or would decrease by a minimum amount. Alternatively, the caps for two phases could be set simultaneously.
While it supports most of the Commission’s proposals, the DfT wants to see "the earliest possible inclusion of aviation" in the scheme - possibly from 2010. The Commission suggested including internal EU flights from 2011 before expanding the scheme to all flights from 2012.
The government is not convinced by this staged approach (ENDS Report 386, pp 52-53 ). "It seems unlikely that the one-year introductory phase proposed would allow time to learn lessons before applying a wider scheme."
Similarly, while the government supports the Commission’s mix of benchmarking and auctioning to allocate allowances, it argues against the limiting of auctioning to 3% of allowances.
"The UK government sees no reason why individual member states should be limited to a maximum percentage of allowances that may be auctioned," it says. "Auctioning allowances that would otherwise have been allocated for free reduces the potential for airlines to make windfall profits."
The DfT also disagrees with the Commission over the use of revenue from auctioning. The Commission says it should be used to fund climate mitigation and adaptation measures. But, steered by the Treasury, the DfT says "centrally dictated hypothecation is not acceptable."
The paper backs the idea of an EU-wide cap for the sector, but asks whether the baseline proposed by the Commission - average emissions between 2004-2006 - is the right one.
It floats two alternatives: 1990, in common with other sectors in the scheme, or 2008. The earlier baseline would be impossible for the sector to meet given the EU’s aviation emissions have almost doubled since then. But setting a later date may encourage operators to increase their emissions in the run-up to entry to the scheme.
In April, a Commission spokesman told ENDS that frustration at the slow pace of international action to control emissions was behind the decision.
"We can say the EU is definitely going to go ahead alone because the International Maritime Organization has not made as much progress as we would have hoped," he said.