Watchdog fails to bite on UK emissions trading scheme

The National Audit Office has lauded the UK emissions trading scheme (UKETS) as a "pioneering initiative with significant achievements".1 Its report confirms many of the scheme's flaws - but pulls its punches on crucial issues such as over-allocation to key participants, the interface with pollution control regulations and the difficulty of meshing the scheme with the new EU emissions trading framework. Meanwhile, a handful of participants are accumulating a vast surplus of allowances - swamping the market and undermining the drive to reduce energy use under the climate change agreements (CCAs).

Industries and governments across Europe are engaged in frantic lobbying and political wrangling over the implementation of the EU emissions trading scheme (ENDS Report 350, pp 47-48 ). Amid all the excitement, the UK's domestic trading scheme may seem small beer.

Yet the UKETS - the world's first, and so far only, economy-wide greenhouse gas trading scheme - offers important lessons in the application of market instruments to environmental policy. Moreover, the scheme will overshadow industrial climate change policy in the UK until it expires at the end of 2006 - and probably for many years thereafter.

Learning by doing?
One important lesson from the UKETS was pointed out by ENDS at the scheme's launch (ENDS Report 326, pp 25-29 ). Over-generous allocations, combined with liberal rules for "banking" surplus allowances, meant that the scheme may deliver little in the way of real, additional emission reductions.

The UKETS was launched two years ago when 34 "direct participants" took on emission reduction targets for each year from 2002 to 2006. The targets were determined at an auction in which companies bid for a share of £215 million in incentive payments put up by the Government to encourage participation.

ENDS' main criticisms were:

  • Most of the claimed savings came from a handful of regulated sources - which appeared already to have met their targets thanks to abatement installed in the late 1990s to comply with regulatory requirements. These firms were set to receive incentive payments worth tens of millions of pounds, along with a glut of "hot air" allowances which they could sell to other direct participants or to the 5,000 companies under CCAs.

  • The voluntary nature of the scheme, and companies' risk-averse approach, meant that many other participants took on targets which represented little more than "business as usual".

  • The Government claimed that the scheme would deliver emission reductions of 4mtCO2e (million tonnes of carbon equivalent) - some 6% of the savings expected under the climate change programme. ENDS concluded that "at least half - and possibly much more - of the claimed emission reductions are either not real, or would have been delivered anyway."

    ENDS' analysis has been challenged repeatedly by Ministers and officials. The official line - in the face of mounting evidence to the contrary - is that the scheme is "very successful" (ENDS Report 340, pp 4-5 ).

    Painting a rosy picture
    The NAO's investigation, launched as a result of ENDS' coverage, set out to address two main questions. Has the £215 million paid out by the Government "achieved the primary aim of delivering greenhouse gas emissions reductions at reasonable cost?" And is the market achieving the expected benefits? Disappointingly, its report fails to offer a clear answer to the first question.

    Sir John Bourn, head of the NAO, described the scheme as "a pioneering initiative which has brought about significant achievements". "Some [emission] reductions were likely to have happened without the scheme," he said, but "most of the reductions were generated by the scheme."

    On closer examination, the full report makes for less comfortable reading. Even so, considerable space is devoted to DEFRA's justifications for its more controversial decisions. ENDS understands that earlier drafts, sent to DEFRA for comment, were more damning.

    The relatively rosy picture may also reflect the NAO's working methods. It interviewed DEFRA officials, direct participants, members of the industry-led UK Emissions Trading Group (UKETG), the European Commission, sector trade associations, brokers, verifiers and consultants.

    None of these groups could be said to have an interest in drawing attention to the scheme's shortcomings. The NAO spoke to ENDS before announcing its study - but declined to consult us, or to show us a draft for comment, once its formal investigation was under way.

    Lessons from the auction
    The NAO's report confirms that in the run-up to the launch DEFRA was preoccupied with securing reasonable levels of participation. Indeed the NAO notes that DEFRA "had to work hard" to stimulate sufficient interest, despite the large sums of cash on the table.

    With hindsight, the pressure to declare the scheme a success appears to have led to some dubious decisions. The NAO notes that the auction was originally planned to be the first of three - and that "a smaller initial auction might have been sufficient to learn lessons, at lower cost". In other words, DEFRA put all its incentivised eggs in one basket.

    The report accepts that the "descending clock" auction was "an effective way of maximising the quantity of reductions bought". However, it argues that an alternative "sealed bid" approach "might have given the Department the option of securing slightly fewer emissions reductions at a much lower price" as it would have given information about the true - very low - costs of abatement.

    What about the hot air?
    The NAO does not even address the concern that the scheme's voluntary nature encouraged many companies to bid in "business as usual" targets - meaning that claimed savings may not be real.

    What about the alleged "hot air" from regulated sources? With masterly understatement, the NAO says that some companies' targets "may be undemanding". Indeed, "in some key cases emissions baselines were well above direct participants' emissions at the start of the scheme."

    In the scheme's first year, direct participants "reduced" emissions by 4.64mtCO2e from their baselines - beating the target by a massive 3.85mtCO2e (ENDS Report 340, pp 4-5 ).

    Two companies alone - Ineos Fluor and Invista (formerly DuPont) - accounted for most of the overshoot. Sites now owned by these two chemical firms had been among the UK's biggest point sources of greenhouse gases until the late 1990s, when abatement plant was fitted to comply with integrated pollution control (IPC) authorisations.

    The NAO employed consultants Byrne Ó Cléirigh to look in detail at Ineos, Invista and two other companies - chemical firm Rhodia Organique Fine and oil giant BP - whose emissions are also subject to environmental regulation. These four firms accounted for 87% of the overshoot in 2002 - and are in line to receive a total of £111 million in incentive payments.

    The consultants estimated that some 66% of the reduction from baseline achieved by the four firms in 2002 was "attributable to the scheme". Only a relatively modest 1.28mtCO2e (or 34%) would have happened without the scheme - although the report offers no further details to stand up this conclusion.

    Ineos claims that the consultants attributed "over 70%" of its reported reductions to the UKETS, and maintains that it has delivered further emission reductions while increasing production by 60% between 2000 and 2003.

    Nevertheless, the consultants' finding seems highly optimistic - and hard to square with emissions data for previous years, particularly for Ineos and Invista. Even the NAO appears unconvinced - noting that the consultants' figures are "cautious", and that "a smaller proportion of the reductions may in fact be attributable to the scheme".

    Bothersome baselines
    Many of the problems stem from DEFRA's poor understanding of environmental regulation on the ground. The first issue concerns the use of regulatory limits to determine the baseline.

    For most direct participants, the average of emissions in 1998-2000 was used for the baseline - but Invista and Ineos would have received huge windfalls because their emissions fell dramatically during this period. DEFRA tried to limit this by retrospectively applying the IPC limit for years before abatement was fitted. It was only partially successful.

    As ENDS pointed out six months before the auction (ENDS Report 320, pp 3-4 ), regulatory limits set a maximum permissible release - and any breach can incur legal action. For this reason, and to allow for variations in output and operating glitches, limits almost always incorporate significant headroom.

    Ineos gained spectacularly from this "headroom effect" - not least because its limit applies to all organic compounds and not just HFC-23, the gas of most relevance for the trading scheme. Invista also gained massively from the Agency's decision, taken just before the auction, to double its emission limit - a curious move given that the old limit has never been breached. The NAO report sheds no light on these detailed, but crucial, issues.

    The NAO confirms that DEFRA's approach led to some companies "benefiting unduly and unexpectedly". However, it meekly accepts DEFRA's claim that it "felt unable to set more demanding baselines" because of the need for "even-handed application of general principles", and to allow some credit for "early action".

    In future schemes, the NAO says, baselines should be set after an assessment of likely average emissions rather than using a regulatory limit. DEFRA should have also involved the Agency much more closely in the design of the scheme.

    The second issue concerns ongoing efforts to reduce emissions. The NAO's consultants found that the four companies have "in practice made significant additional efforts to cut emissions and they report that incentive payments are helping to pay for emissions reductions."

    Whatever happened to BATNEEC?
    However, the NAO ignores one very important factor. The UKETS does not disapply IPC - and operators are still legally obliged to use the "best available techniques not entailing excessive cost" (BATNEEC). This concept is supposed to be a continually moving target rather than a fixed end-point.

    Take Rhodia as an example. The firm manufactures refrigerants at its Avonmouth site. Like Ineos, the most significant release in global warming terms is HFC-23, which is 11,700 times more potent than CO2.

    At the end of 2003, Rhodia commissioned an incinerator which will destroy well over 97% of the HFC-23 release. This will reduce annual emissions by some 1.3mtCO2e - and is being claimed as a success for the trading scheme.

    Does this add up? The incinerator cost a relatively modest £1.25 million. But Rhodia will receive incentive payments of £23 million, plus substantial income from the sale of surplus allowances. It would have been much more cost-effective from the taxpayers' perspective to have given the company a grant to pay for the equipment.

    Moreover, there is a powerful case that the Agency should simply have forced Rhodia to fit and pay for abatement under its IPC authorisation.

    The incinerator will prevent the release of roughly 4mtCO2e over the next three years alone. Even on this short time-frame, the cost of abatement is a paltry £0.3/tCO2e. In contrast, the Treasury uses a yardstick of £35-140/tCO2e for assessing the cost-effectiveness of policies to abate greenhouse gases.

    Moreover, the Agency required Ineos and DuPont to fit similar incinerators in the late 1990s. The regulator clearly felt that these investments - with abatement costs of roughly £0.2-0.3/tCO2e over three years - were justified on cost-benefit grounds.

    It appears that the Agency did not force Rhodia to invest in the site because the company is struggling financially. However, official guidance insists that assessments of excessive cost must be made at a sector level in order to prevent poorly performing companies from continually deferring investment.

    Questions about BATNEEC also apply to Ineos' site. In 2003, the company installed a compressor to capture emissions when the incinerator is off-line. The Agency says that the equipment was installed at the company's request. Moreover, the NAO's consultants claim that Ineos is "investing in emissions control equipment to a greater extent than would have been economic without the incentive funding."

    However, Ineos refused to tell ENDS how much it has invested in further abatement equipment - making it impossible to judge whether it is going further than what might reasonably be expected under BATNEEC.

    Living with a carbon mountain
    The UK's fledgling carbon market is now awash with allowances, thanks to a combination of "hot air" allocations, weak targets and ongoing investment in abatement.

    Direct participants have banked some 3.69mtCO2e surplus allowances from 2002. This huge reserve is set to increase still further. ENDS has obtained data from the Environment Agency which suggest that in 2003 Ineos and Invista each notched up surpluses of 1mtCO2e or more (see table).

     Moreover, Ineos, Invista and Rhodia are set to accumulate a huge combined surplus of up to 15mtCO2e over the scheme's five years. This swamps any potential demand from companies under CCAs. Indeed, in 2002, the first "milestone period", the CCA side of the market also saw large-scale over-compliance and very low demand (ENDS Report 339, pp 23-26 ).

    The NAO notes that reductions achieved - real or otherwise - "may be offset by increased emissions at a later date, or elsewhere." But it is surprising that, given its focus on value for money, the NAO did not look more closely at the potential for the UKETS to undermine energy saving under the CCA framework. Firms under CCAs receive a rebate from the climate change levy worth some £300 million per year.

    One key question is what happens to the mountain of unused UK allowances once the UKETS expires at the end of 2006. The rules for the scheme allow the Government to restrict banking of allowances after 2007, because of concerns that this might undermine compliance with the Kyoto Protocol. However, direct participants are allowed unrestricted banking up to their own in-house over-achievement - a clause which seems to throw the door wide open for Ineos, Invista and Rhodia.

    Alarm bells are now ringing in official circles. DEFRA recently told the UKETG that it has "no current intention to interfere" with the market - but it is reviewing the scheme, and some action to drain the surplus is looking increasingly likely. The NAO calls on DEFRA to explore options such as agreeing further emission cuts or limiting the sale of surplus allowances.

    The market is also jittery. The carbon price, which has bumped along at around £2/tCO2e for the past year, jumped to £4/tCO2e in April. James Emanuel of brokers Evolution Markets says this is because "the shrewder companies [under CCAs] have got wind of the fact that change might be in the air, and are buying everything they might need for the next two or three years."

    Messy interface with EU trading
    The future for direct participants and companies under CCAs is now looking highly uncertain - mainly because of the devilishly complex interface with the EU emissions trading scheme.

    Ironically, one of DEFRA's objectives for the UKETS was to influence the shape of the EU trading scheme. The NAO agrees that the UK influenced thinking on points such as banking and penalties, and bolstered the European Commission's desire to explore emissions trading instead of other abatement policies.

    The NAO goes on to say - with some understatement - that fundamental differences and overlapping timetables will make integration of the two schemes "less straightforward than initially hoped".

    The first issue is whether companies under CCAs and the 10 direct participants covered by the EU trading scheme will be able to opt out from the EU scheme's first phase. To do this, they must demonstrate that emissions will be subject to controls that are at least as stringent as under the EU scheme.

    Steve Sorrell, a leading expert in emissions trading at the University of Sussex, says that concerns about the environmental integrity of the UKETS may scupper plans for an opt-out. "The huge surplus in the UK scheme makes it extremely difficult to demonstrate equivalence," he says. "Any opted-out company can comply with its target simply by buying existing cheap allowances. It really comes down to the relative price of carbon and environmental credibility of the two schemes."

    Other complexities arise from the potential for double counting and double regulation under two parallel trading schemes, and the treatment of electricity use under "residual" CCAs. A very real prospect is that many industrial sites may be carved up between different, potentially overlapping, targets - presenting a minefield for environmental and energy managers.

    Finally, all the goalposts are moving. As well as potential tinkering with the direct participants' targets - not least to demonstrate "equivalence" - DEFRA is reviewing the CCA targets as part of the preparation for the EU trading scheme (ENDS Report 348, pp 18-22 ).

    Credit where it's due
    The NAO rightly draws attention to several positive aspects of the UKETS. For example, it has led to the creation of important, but often over-looked, infrastructure such as the successful allowance registry. DEFRA is now adapting this for the EU trading scheme - and some other Member States are also hoping to take advantage of this.

    Experience with the UK scheme "is helping both the Department and industry prepare for the launch of the EU scheme in 2005," the NAO says. Moreover, there is now a "small core" of emissions trading expertise in the City - though it is "too soon" to say whether London will emerge as a global centre once EU and international trading takes off.

    The NAO concludes that "innovation in policy-making carries risks" - and that the problems with the UKETS "must also be put against the significant achievements of the scheme". It remains to be seen whether the House of Commons Public Accounts Committee, which will consider the report in May, is prepared to take such a charitable view.

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