Across the EU, preparations for the first phase of the EU emissions trading scheme (EUETS) have led to intense lobbying by industry and high-level political wrangles.
In the UK, the Department of Trade and Industry wants to increase the allocation to industry to reflect changes in its "business as usual" projections (ENDS Report 355, pp 55-56 ). The Environment Department (DEFRA) fears that this could force the UK to resubmit its allocation plan to the European Commission - and badly dent UK claims of leadership on climate change.
The spat between the two Departments was passed up to Prime Minister Tony Blair to resolve. No decision had been taken by the time ENDS went to press.
The Commission was also forced to delay its verdict on the second group of allocation plans from the planned date in mid-October. It is worth remembering that final allocations to all installations were due to be made by the end of September.
The stakes for the second phase, which will run from 2008-12, will be even higher, according to Enviros. Moreover, the consultancy raises serious concerns over whether the trading scheme will deliver the promised reduction in emissions.
"Most businesses are looking at the first phase - but that is not going to be a lot of trouble, it's a relatively small perturbation," said Guy Turner, Enviros' director of climate change policy. "People really need to be thinking out to 2012 and beyond."
Enviros' modelling confirms the view that Member States' allocation plans for the first phase are timid. The consultants warn that they "will provide little incentive to make investments in the technologies that will be necessary to meet national commitments under the Kyoto Protocol."
Allocations are likely to be tightened significantly in the second phase. But Enviros "doubts that even this will provide the stimulus necessary for business to make the required investments."
The first problem is the long life of most capital assets in the energy sector. The second, Enviros says, is the "perceived risks associated with tradable environmental instruments." It points out that banks "rarely give any weighting" to revenue from the sale of renewable obligation certificates when investing in renewables projects in the UK.
Enviros says it is "plausible" that the trading scheme may fail to stimulate new capital investment. This could mean that the supply of low-cost abatement options becomes exhausted by perhaps 2010 - leading to spikes in carbon prices to €50/tCO2 or more.
The consultants warn that "policy commitments to reducing CO2 need to be backed up with clear and unchanging legislation that sets out reduction targets for at least 15 years" in order to create a "stable forward market". All Member States except Poland have restricted banking of allowances between the first and second phase - a move which should prevent over-allocation being carried forward, but which may add to market distortions and price instability.
The EUETS will initially cover 9,200 industrial installations in 23 countries. Other countries such as Romania and Bulgaria are expected to join in the second phase.
The total allocation would allow emissions to rise by 5% - representing an annual shortfall of just 65mtCO2 (million tonnes of CO2). This could stimulate a "moderate degree of market activity", at a likely price of €5/tCO2 - considerably below current forward prices of €9/tCO2.
However, additional allowances will also be available from the reserves which most Member States have set aside for new entrants. Enviros puts the total reserve at 105mtCO2 per year. If this is released in full, total emissions could rise by as much as 11% from 2000 levels - depressing carbon prices still further.
Enviros notes the "stark contrast" with the EU-15 countries' commitment under the Kyoto Protocol to reduce greenhouse gas emissions by 8% between 1990 and 2008-12.
The consultants assumed that each country's allocation will be proportional to the expected difference between its national emissions and its Kyoto target (see table).
In practice, the UK may go considerably further. The Government has promised that allocation will be consistent with its more demanding target to cut CO2 emissions by 20% between 1990 and 2010. Enviros told ENDS that this would reduce the allocation to UK industry from 281 to 251mtCO2 per year - although the impact on carbon prices would be "marginal".
Demand for allowances is likely to increase substantially in the second phase. The key question is what level of supply will be available - and at what price. Enviros reckons that companies in the EU should be able to reduce emissions by some 128mtCO2 at a cost of less than €10/tCO2. Most of this will be delivered by increasing the load factor of existing gas-fired power stations.
Companies will also be able to use credits from the Kyoto Protocol's "flexible mechanisms" to meet their targets. Enviros expects supply to build slowly to 30mtCO2 by 2007. There are huge uncertainties beyond that date - particularly the impact of Russian ratification of the Protocol (see pp 23-25 ) - but Enviros suggests that some 70mtCO2 may be available for the EUETS by 2010.
Provided investments in low-carbon technologies come forward, Enviros expects prices to increase steadily from €8-12/tCO2 in 2008 to €25-35/tCO2 by 2012.
Further complications may arise from plans to expand the scope of the EUETS from 2008. Prime candidates for inclusion are the chemicals and aluminium sectors which are likely to increase the total allocation by some 200mtCO2, according to Enviros. The UK is calling for aviation to fall under the scheme (see p 41 ).
There is also growing pressure to bring in greenhouse gases other than CO2 - driven by the lure of potential low-cost abatement options. However, Enviros warns that allocation for such gases would be "a complicated administrative process" which has "the potential to significantly destabilise the market".