Government heads for showdown with Brussels on carbon allocation

The dispute between the Government and the European Commission over the UK's allocation under the EU emissions trading scheme (EUETS) has escalated further - casting a pall over the UK's forthcoming Presidency of the EU. The Environment Department (DEFRA) has set out the allocation to sectors and individual installations,1 along with the first outputs from its review of climate change agreement (CCA) targets.2

The Commission approved the UK's national allocation plan (NAP) for the first phase of the EUETS last summer. In October, however, the Government announced that it wanted to increase the UK's allocation for the three-year period from 736 to 756 million tonnes of CO2 (ENDS Report 358, pp 22-25 ).

There were two main reasons for the increase. Firstly, the Department of Trade and Industry's ongoing work on new energy forecasts pointed to a much higher level of "business as usual" emissions from electricity generation. Secondly, DEFRA settled for much less ambitious tightening of the CCA targets for manufacturing industry than it had initially hoped (see p 41 ).

Appearing before a Parliamentary inquiry in February, Environment Secretary Margaret Beckett argued that the Government had always regarded the figures in the approved NAP as "provisional". She stressed that the UK's "new proposals, based on a more realistic set of evidence, are more rigorous than our original proposals."

Moreover, on 8 February Prime Minister Tony Blair told MPs that he had been responsible for the decision to seek a higher allocation - and that it was needed "because otherwise we will do unnecessary damage to our business" (see p 35 ).

However, in a letter to Mrs Beckett in early February, Environment Commissioner Stavros Dimas warned that the move to increase the allocation was "unacceptable". The Commission fears that increasing the UK's allocation would encourage other Member States to revisit their NAPs - and it is confident that it has a strong legal basis for its stance.

In mid-February, Mr Dimas expressed his hope that the issue would be resolved quickly. "We would like to see [the UK's] participation as soon as possible in the trading system," he said. "I would like to stress that the Commission will not be able to change the total allocation."

On 14 February - five weeks later than originally planned - the Government issued a revised list of installation-level allocations. It maintained that "the proposed amendment to the NAP is compatible with the requirements of the EUETS legislation" - and raised the stakes by warning that it "is taking steps to protect its legal position."

Even so, the Government has prepared the ground for a retreat by confirming that any reduction in allocation below the desired 756 million tonnes will be taken from the power generators. The allocation to manufacturing industry will be unchanged regardless of the dispute with the Commission - a decision which provides welcome certainty for the sectors concerned.

The stand-off means that the UK will miss the 28 February deadline for issuing allowances - and British companies will be unable to take part in the emerging spot market until the issue is resolved. Players in the UK's emerging climate services industry are concerned that the UK cannot open its registry until allowances are handed out - and that London may lose its early lead as the main gateway for the EU carbon market.

Senior Commission official Peter Vis told a recent conference that "even if the Commission were to entertain" a second assessment, this might not be complete until May.

Indeed, there is a real and embarrassing prospect that the dispute will not be resolved before the UK takes over the Presidency of the EU in July. The scrap is also highly damaging to Prime Minister Tony Blair's efforts to prioritise climate change under the UK's Presidency of the G8.

It remains far from clear why the Government has gone to war when, in objective terms, the stakes are low. The disputed allocation of 19.8mtCO2 is worth less than €150 million, or €50 million per year, at today's carbon prices.

However, Sir Digby Jones, director-general of the Confederation of British Industry, said that "business backs government to the hilt in its determination to stick to the revised allocation plan." The original plan would "increase further the energy prices paid only by UK businesses", he said, putting UK jobs "unfairly at risk".

Key aspects of the announcement include:

  • Sectoral breakdown: The new data from DEFRA confirm that the allocation for most sectors has been increased significantly compared to the approved NAP (ENDS Report 352, pp 41-44 ). Particularly large increases of 10% or more have been granted to the iron and steel and cement sectors.

    The power generators' effective allocation, after removal of the new entrant reserve (NER), has been increased by 16.2mtCO2 (4%) over three years. Even so, the allocation is significantly below the high level of emissions in the last couple of years (see table).

    However, the allocation for manufacturing industry is based on "business as usual" requirements, taking account of existing policies such as the CCAs. These sectors have now won a total allocation 16.8mtCO2 (5.5%) greater than in the NAP approved by the Commission.

    Overall, manufacturing sectors will be allowed to emit 10% more per year in 2005-7 than they did in 2003. The finding contrasts with the CBI's recent complaint that "employers are increasingly frustrated that they are being asked to carry the can alone for the climate change problem."

  • Opt-out for CCA participants: DEFRA plans to apply to the Commission in early March to allow operators under CCAs to opt out of the first phase of the EUETS. Any operator wishing to opt-out had to notify DEFRA by the end of February.

    The CCAs currently set biannual targets. In order to demonstrate equivalence between the CCAs and EUETS, annual targets will need to be set for the CCAs. Other tricky issues include the fact that CCAs include electricity use as well as direct emissions; most use targets expressed relative to ouput; some CCAs give credit for burning waste fuels or reducing greenhouse gases other than CO2; and CCAs do not cover process emissions of CO2.

    DEFRA intends to stick with the existing verification requirements for CCAs, but warns that the Commission may impose changes.

    Operators under CCAs are entitled to an 80% reduction in the climate change levy. DEFRA had originally proposed that CCAs should be split into areas inside and outside EUETS coverage. Industry argued successfully that this would be too complicated and difficult - with the result that CCA targets will not be changed, and "will continue to be the only source of entitlement" to discount from the levy.

    However, the decision creates a significant overlap between the EU and UK carbon markets - raising the prospect of double counting, double benefits or double penalties for the same action. DEFRA proposes a complex system of "netting off" to prevent this happening.

  • New entrant reserve: DEFRA has confirmed that 49.9mtCO2, or 6.6% of the total allocation, will be set aside for new entrants. This will be taken from the allocation for each sector in differing amounts, depending on the expected level of new entry.

    The slice taken from the generators' allocation has been reduced considerably. High relative contributions come from the iron and steel (14.4%), cement (13.4%), pulp and paper (9.6%) and offshore (8%) sectors

    The Government has decided to ring-fence 15.5mtCO2 from the NER to award to good quality combined heat and power (CHP) projects that qualify as new entrants. This figure is derived from Cambridge Econometrics' estimate that 8.1GW of CHP will be installed by 2010 on current policies - and not on the Government's notional target of 10GW by that date.

    DEFRA is still awaiting the Commission's approval for its proposed rules on handling new entrants and closures.

  • "Late" installations: The Government says that it is possible that some operators covered by the EUETS have not yet applied for a permit, because they may have been unaware of the requirements or made genuine mistakes.

    DEFRA has decided to set aside 1.5mtCO2 from the total to issue to any late applicants. However, operators applying after the 28 February will receive 10% fewer allowances than they need, increasing to 25% after six months.

    However, operators which have applied for permits but fail to submit verification opinions by the end of February will not receive any free allowances on the grounds that they have been aware of DEFRA's requirements.

  • Guidance on market development issues: In late January, DEFRA issued brief guidance on important issues concerning the treatment of emission allowances under the existing legal and fiscal framework. The guidance covers the tax treatment of allowances, particularly the application of VAT. It also addresses accounting issues, financial regulation and insolvency.

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