During the summer, the Department for Energy and Climate Change (DECC) published the Government’s vision for the next phase of the European Commission’s EU Emissions Trading Scheme (EU ETS) for greenhouse gas (GHG) emissions. Rick Gould reports.

Recently, the EU ETS has faced some notable challenges, such as the dramatic fall in the price of GHG or carbon allowances, the continuing challenge of carbon leakage — which means that businesses relocate their activities to other countries where the regulatory controls are not as strong — and the stalled application of the EU ETS to aviation. The current phase of the EU ETS runs until 2020 so, bearing in mind the recent challenges to the scheme, how does the Government view the EU ETS and its future?

Overall, although the Government would like to see significant improvements to the EU ETS, it still strongly supports the scheme and would like to see it remain as a strong foundation of the EU’s policies on energy and climate change, for three main reasons.

  1. The Government believes that the EU ETS delivers consistent, long-term reductions in emissions of GHGs.

  2. As the EU ETS is the first international scheme of its kind, it demonstrates global leadership in addressing climate change.

  3. The Government’s view is that the scheme is broadly designed in such a way that energy-intensive industries can remain competitive during the transition to a low-carbon economy.

Around the same time that the DECC published its EU ETS vision statement, Vivid Economics and Ecofys published a report for the DECC on carbon leakage, which, in turn, informs the Government’s strategy for dealing with this challenge to climate change policy. Therefore, this feature will describe the main aspects of both reports.

Leading up to 2020 and beyond

The EU ETS has been operating since 2005 and is now in its third phase, which runs until 2020. The first phase, which operated for three years, was a pilot programme and was broadly a success. So the second phase, which ran until the end of 2012, had a widened scope in terms of industrial processes and participating countries. The third and current phase now includes aviation. Overall, the EU ETS has been successful in that it has reduced emissions of GHGs through market-based mechanisms. Consequently, the Government broadly supports the EU ETS and wishes to see it continue well beyond 2020.

On the other hand, the vision statement emphasises that the scheme needs substantial reform as it has been beset by some significant problems; these include the dramatic fall in the price of GHG allowances, and the threat of carbon leakage, whereby businesses relocate some or all of their activities to countries with fewer regulatory constraints.

Considering the price of carbon allowances, too low a price can be problematic because it does not encourage industrial process operators to reduce their GHG emissions through alternative sources of low or zero-carbon energy. In one respect, the concept of emissions trading applies the sustainability principle of “the polluter pays”, so operators automatically have an incentive to either reduce or eliminate their emissions. On the other hand, even if operators have to buy some or all of their allowances through auctions, a very low price is hardly a deterrent.

Lower than expected emissions and a huge surplus of allowances — which currently stands at about 2 billion — have driven down the price from over €32 in April 2006 to a low of less than €4 in April 2014; although the EC implemented a measure known as back-loading, or temporarily nullifying allowances, to help remedy this situation, the Government would like to see much firmer but more flexible action to reduce the cap on total emissions when needed.

This in turn would maintain the supply of allowances at a level that would stimulate the demand for low or zero-carbon energy sources. Indeed, the Government’s position is that the EC needs to rigorously apply the basic premise in economics of managing supply and demand in a flexible, effective and timely way.

Carbon leakage

Indeed, there is ample evidence that sound economics has both underpinned and informed the vision statement. For example, in their 2014 report, the consultancies Vivid Economics and Ecofys address the issue of carbon leakage as a potentially significant risk for energy intensive industries. A great deal has been said about the threats of carbon leakage, so the report examines the evidence for this and the measures that can be applied to reduce the risks and mitigate them.

Specifically, the consultants examined areas such as: the characteristics of industries at risk; the suitability of the current approach for identifying at-risk sectors and whether alternative eligibility criteria would be appropriate; the relationship between carbon leakage and price levels; and what policy options could be used to mitigate risk, including alternatives to free allocation.

Regarding the evidence for carbon leakage, it was notable that, while theoretical studies suggest that leakage could be substantial, the empirical evidence to date does not support this. So to investigate the reasons for this, the report includes a modelling exercise of 26 potentially at-risk sectors, to determine the potential for carbon leakage for three different prices of carbon allowances, set at €15, €30 and €50 per tonne. The results showed that the sectors most at risk were cement, steel, lime, paper, glass, nitrogen fertilisers and wood boards.

There was also a good correlation between leakage and the rising price of carbon allowances. The findings of this modelling study are supported by the apparent lack of significant carbon leakage to date; carbon allowance prices, although high at certain periods, have never remained high. In other words, leakage is proportional to prices, so when the price of carbon allowances rise, the risk of leakage will increase signficantly.

The report also examines the current eligibility criteria that the EC uses for determining which sectors may receive free allowances, and proposes changes to the methodology in order to increase its robustness. This proposal is reflected in the vision statement.

Simplification and proportionality

Lastl, the vision statement includes proposals to simplify the EU ETS where appropriate, and make it both more effective and efficient. For example, the UK has applied the option in the EU ETS for an opt-out scheme for small-emitters; this is not a waiver per se, as the legislation requires EU member states to replace the EU ETS with another mechanism to reduce GHG emissions. So, the Environment Agency developed for the DECC a simpler ETS for small emitters and hospitals, which significantly reduces both the costs and regulatory burdens for them while still applying mechanisms to reduce GHG emissions. Therefore, the Government would like to see the next phase of the EU ETS include more provisions for risk-based regulation and proportionality.

Last reviewed 8 October 2014