The timetable for the second phase is challenging - DEFRA aims to issue a draft allocation plan by the end of the year, and must notify the final plan to the European Commission by 30 June 2006.
This leaves little time for consultation. DEFRA wants responses on use of project credits, auctioning, new entrants and closures and small installations by 13 September - with an extra two weeks being on offer for comments on allocation and expansion options.
The consultation follows a paper in the spring which set out the Government's initial thoughts on its approach to the second phase (ENDS Report 363, pp 43-44 ). It also builds on a consultation on the use of imported Kyoto credits to meet EUETS caps (ENDS Report 365, pp 41-42 ).
The Commission has already made clear that it will not be able to amend the EUETS Directive in time to affect allocation for the second phase. Instead, DEFRA is working with other Member States in a bid to ensure greater co-ordination and harmonisation of approach, and is looking to the Commission to produce "clearer, binding guidance" on how it will assess allocation plans.
Key points covered in the consultation include:
Stakeholders such as the UK Emissions Trading Group have argued against mandatory unilateral expansion without EU-wide consensus. A common view is that the scheme should be allowed to bed down before radical changes are made.
Even so, DEFRA says that a key priority is to address any gaps or competitive distortions that have arisen from the coverage of the scheme's first phase.
The biggest anomaly concerns the definition of combustion plant. The UK and several other Member States - including major competitors such as France, Germany, Italy and Spain - have used a "medium" definition, which includes only installations designed specifically for energy production. The rest adopted a "broad" definition, which captures many more installations in the chemical and other industries.
DEFRA intends to stick with its existing approach in the second phase, on the grounds that moving to a broad definition would impose burdensome monitoring and verification requirements on many small installations and raise concerns over competitiveness.
The issue may be taken out of the Government's hands, however. The Commission is keen to ensure greater consistency in the treatment of combustion plant - and may press for the broad definition in forthcoming guidance on the issue.
DEFRA also highlights several sectors as potential candidates for expansion of the scheme. It suggests that perhaps 90 new sites could be brought under the scheme, with annual emissions of 7.9-10.1mtCO2.
A report by consultants NERA and Entec concludes that the gypsum, rock wool and glass sectors are the most promising candidates. This would tackle a number of competitive distortions between or within sectors arising from the boundaries set by the Directive. However, the move would capture only a few dozen sites with relatively low emissions.
Other sectors with more significant emissions tend to raise difficulties. Offshore flaring is a major source, but DEFRA notes that "it may be costly" to develop a monitoring protocol which is sufficiently accurate for EUETS reporting requirements. Continuation of the Department of Trade and Industry's flaring consents regime "may be an effective alternative policy".
The case is clearer for the petrochemicals sector, covering processes such as naphtha crackers. However, there may be only limited scope for abatement because of the maturity of the technology and it could be difficult to define installation boundaries on complex integrated sites. There are strong arguments for fully capturing emissions from integrated steelworks, although doing so could raise competitive distortions if the large number of smaller ferrous metals sites are not also brought in.
Entec and NERA also identify a fair or good case for bringing several other sectors under the EUETS - including fertilisers and ammonia, other chemicals, food and drink, waste incineration and engineering and vehicles. DEFRA has not taken up the baton in its consultation - although its reasons are far from clear.
Indeed, the consultation firmly rules out bringing in several key sources. These include methane from landfill sites, oil and gas production and distribution, land-use change and wastewater treatment; HFCs from one-component foams, solvents, air conditioning and refrigeration; and nitrous oxide from agriculture, adipic acid production and wastewater.
Some stakeholders have called for a rapid expansion of the scheme to include a wide range of gases, in the hope that this will bring in many low-cost abatement opportunities. However, DEFRA points to difficulties with monitoring and reporting, limited abatement potential in some cases, and the fact that other forms of regulation "may be more appropriate".
Even so, three sources are singled out for potential inclusion in future phases, "provided appropriate benchmarks can be set". The candidates are nitrous oxide from nitric acid production, HFCs from foam blowing and methane from coal mining.
Only one nitric acid producer, Terra Nitrogen, operates plants without abatement - though it recently sought to generate Kyoto credits by fitting abatement plant (ENDS Report 363, p 11 ). A report by Future Energy Solutions for DEFRA notes that "it could be argued that [Terra] should already have taken steps to reduce emissions", and suggests that the Environment Agency might require such action under pollution control legislation.
Including coal mines would require an internationally agreed monitoring and verification protocol. Moreover, emissions are falling rapidly anyway because of mine closures and it could be difficult to bring in abandoned mines.
The main barrier to bringing in HFCs from foam blowing is the lack of a protocol to monitor emissions.
FES also notes that there could be a significant impact on the price of carbon and on competitiveness if the UK and other Member States include non-CO2 gases - particularly nitrous oxide from nitric acid plants and HFCs from HCFC-22 production. It also warns of the potential for large windfalls for these sectors - a key problem with the UK's existing emissions trading scheme.
However, the consultation suggests that the use of around 50 sectors in the first phase was too complex, and that broader categories might be used next time round.
DEFRA is also re-examining ways of sharing out sectoral caps between installations. It is keen to take forward benchmarking as "a longer-term objective" because this could reduce distortions and discrimination against installations that have taken early action.
However, a report by consultants Entec and NERA found that it is not feasible to develop robust benchmarks for most sectors in time for the second phase. The Government plans to consider benchmarking for electricity generators and combined heat and power (CHP) plants only, because these sectors have clear measures of capacity and common outputs.
The consultation seeks views on whether the UK should make use of the option to auction up to 10% of allowances in the second phase. However, it suggests that harmonisation across the EU is "desirable" - and it is not yet clear what appetite there may be in other Member States.
DEFRA still regards auctioning as "a long-term goal", because it would ensure that the price of carbon is taken fully into account in investment decisions and enable simpler treatment of new entrants. However, "the timescale to reach this economic ideal is uncertain and is dependent on how many and how quickly other Member States share this vision".
? New entrants and closures: In the first phase, the Government set up a reserve of allowances to issue free to new entrants. Competitiveness concerns mean that a decision on whether to retain this approach will depend largely on the approach taken by other Member States. At present, it seems that most are likely to stick with a reserve.
One problem is that timing constraints mean that new entrants in the first phase may still need to be treated as new entrants in the second phase.
DEFRA is also reviewing rules on closure and rationalisation. Scrapping the rules would make the scheme simpler and encourage closure of old, inefficient plant - but could lead to "double benefits" for some operators and may fall foul of pressure to retain old power stations for reasons of security of supply.
DEFRA flags up the treatment of small installations in the third and subsequent phases of the scheme as a key issue for the Commission's review of the Directive next year. The Commission is also reviewing its monitoring and reporting rules, with lighter verification requirements for small emitters being seen "as a priority".