Time to get tough on carbon emissions

Bulletin article
01 December 2006

The single biggest challenge facing the world may be to decouple economic growth from growth in emissions of greenhouse gases. On current trends, the International Energy Agency estimates that emissions of greenhouse gases will expand by more than half between now and 2030. There is an urgent need to close the gap between the policy response required and what can be achieved with the existing instruments. The EU can and must take a lead on this issue, starting with reforming its flawed Emissions Trading Scheme (ETS).

The EU has a good record on environmental policy, at least by the standards of other developed economies. EU countries are the world’s biggest investors in renewable energy sources. The European Commission has set down stringent energy efficiency standards for the single market. In 2005 the EU established the ETS to help member-states meet their Kyoto protocol commitments to cut greenhouse gas emissions by 8 per cent (from 1990 levels) by 2012.

The ETS, a so-called ‘cap and trade’ scheme, covers energy-intensive industries such as oil refineries, energy utilities and steel producers. It works by setting a limit or ‘cap’ on each member-state’s emissions from these sectors. Companies are free to buy or sell the ‘right’ to emit carbon dioxide, with those emitting less than their limit able to sell emissions certificates on the open market. They can also purchase emission rights by investing in projects in developing countries through the UN Clean Development Mechanism.

The EU deserves considerable credit for establishing the ETS. But substantial reform is required if its potential is to be realised. Price signals need to be long, loud and clear to convince companies to invest in low emission technologies. Unfortunately, the first phase of the ETS – from 2005 to 2007 – has suffered from very low and unstable carbon prices. There are three principle reasons for this:

★ EU members are responsible for setting their own emissions caps or ‘national allocation plans’ (NAPs). The Commission’s authority is limited to assessing whether these caps are consistent with the country’s targets under Kyoto. Under phase one of the ETS nearly all member-states allocated more emissions permits than the industries included in the scheme actually needed to cover their emissions, resulting in very low carbon prices.

★ Member-state governments distributed nearly all emission permits free of charge to companies, according to current needs, rather than auctioning them to the highest bidder. As a result, a coal-fired power station that generates a similar amount of energy to a gas-fired one but emits twice the volume of greenhouse gases, receives double the allocation of permits. This undermines the incentive for energy producers to invest in more sustainable capacity

. ★ There is uncertainty over what will replace the current Kyoto protocol which ends in 2012. Investors fear that if the US fails to sign up to a successor to Kyoto, EU member-states will decide against adopting ambitious targets for reductions in their emissions for the post-2012 period.

The weaknesses of the EU ETS have led some to question whether carbon trading can work as a mechanism for reducing emissions of greenhouse gases. This is the wrong conclusion. On its own, carbon trading will not lead to a big jump in research and development spending on new energy technologies. Neither will it ensure the modernisation of Europe’s unwieldy and inefficient electricity grid infrastructure. At present, it is seldom cost-effective for smaller-scale renewable energy projects to connect up to the grid. However, carbon trading is a crucial element of the necessary response, along with taxes and tough energy efficiency standards.

The EU has a major opportunity to consolidate the ETS as the hub of a global carbon market that could help slow down climate change. This opportunity will be lost if the Commission fails to ensure a big enough gap between allocated emissions and actual emissions during the second phase of the ETS. The portents are not good. Most EU countries have now submitted their second phase NAPs – to run from 2008 to 2012 – and together they again exceed projected emissions.

Member-state governments are concerned that tighter caps would impair the competitiveness of energy-intensive industries. The EU certainly needs to work hard to persuade other countries, and crucially the US, to join the ETS, so as to establish a level playing field. Nevertheless, concerns over competitiveness are overblown. First, there is a strong correlation between high energy prices and energy efficiency. Anything that encourages European businesses to adopt energy efficient technologies will stand them in good stead in a world of increasing energy scarcity, and strengthen the EU’s energy security. Second, tight emissions caps would enable Europe to consolidate its existing lead in many energy efficient technologies and help European companies to set global technical standards.

The Commission is due to give its assessment of the second phase NAPs in December 2006. It must reject those that are inconsistent with members’ commitments under Kyoto. The Commission must ensure that member-states increase the proportion of permits that are auctioned rather than allocated free of charge. It should push hard to bring aviation and road transport – which are responsible for increasing amounts of greenhouse gas emissions – into the ETS. The EU must also ensure that it moves quickly to resolve uncertainty over the post-2012 regime. If international negotiations on a follow-up to the Kyoto protocol fail to deliver agreement, EU governments should unilaterally commit to reducing total EU emissions of greenhouse emissions by 30 per cent (from 1990 levels) by 2020. An ambitious target such as this would provide certainty for investors.

Before the third phase of the scheme commences in 2013, there will need to be thorough-going reform of the allocation of emissions caps under the ETS. Rather than relying on member-states determining their own emissions caps, the EU needs to set an EU-wide ETS cap which is consistent with its target for overall emission reductions between 2012 and 2020. The Commission should be empowered to allocate carbon quotas to each member-state on the basis of a harmonised methodology. Alternatively, in order to take politics out of the process, this function could be delegated to a new, independent authority, perhaps modelled on the European Central Bank.

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