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Professor Michael Grubb, Chief Economist at the Carbon Trust, commented: “It is essential the EU ETS provides an effective, efficient design that protects the competitiveness of business in the UK and Europe, whilst providing clear and stable incentives to support low carbon investment. The first phase has successfully created incentives that give financial value to cutting carbon emissions, but it has to evolve. Clarity about this evolution is essential as uncertainly delays investment. Our research indicates that in the second phase, introducing a percentage of revenue neutral auctioning is the best approach to ease over supply of credits and remove the perverse incentives associated with free allocations.”
The study identifies seven key challenges to overcome for the second phase of the EU ETS. If left unaddressed they could result in incentives that are too weak, too mixed and too unstable to support low carbon investment to any significant degree. The challenges are:
- Carbon price instability
- Risk of government interference
- Incentives at closure and for new entrants
- Incumbent distortions where companies believe that higher emissions now will be rewarded by higher allocations in the next phase
- Uneven impacts and excessive profits in the power sector
- Lack of cutback incentives in other sectors
- Risk of over-supply of credits during the second phase
The Carbon Trust study also outlines three key recommendations to address these problems.
- Give all business sectors fewer free allowances than their projected “business as usual”, but cut back free allocations to the electricity sector by more than other sectors This would enable benchmarking of allocations based on best practice and move away from the idea that businesses get allocations based on projections, making sure management more actively considers abatement possibilities. Also, ensuring that all sectors across Europe experience some cutbacks would not impact significantly on competitiveness
- Benchmark the allocations given to power generators and differentiate by technology type for incumbents but not for new entrants. This will remove perverse incentives for new carbon-intensive investments.
- Use auctions to increase supply and stabilise prices. This would avoid the perverse incentives associated with free allocation; reduce the disparity of profit levels between electricity and other sectors and help market transparency and operation. Any revenues would be used to support company investment in energy efficiency and low carbon technologies.
The study also analyses the impact of the EU ETS on the competitiveness of European industries, finding that although most sectors will perform well under phase II and generate increased profit, some will also lose market share. Therefore, the report shows that in order to maintain competitiveness and investment in Europe in the longer term, it is important to change the EU ETS post 2012. It identifies three options that would ensure the Scheme offers effective incentives for low carbon investment in phase III:
- International agreements that cover all major competitors in a specific sector, where carbon costs are reflected in the prices of energy-intensive and internationally mobile goods
- Using border-tax adjustments to compensate industries producing in regions with high carbon costs for those costs when exporting, and apply a systematic tariff to imports
- Make carbon allocations proportional to production levels (either output-indexed or intensity-based allocation), for example per tonne of cement produced
Professor Michael Grubb, Chief Economist at the Carbon Trust, added:
“Phase 1 has been positive but has indicated problems in the way allocations are awarded and it is vital that we learn these lessons. Our research shows that for the next phases, we need to introduce stronger allocations and some auctioning with a shift to a new auctioning-centric approach in the longer term. In our view, these are the essential ingredients for creating a successful long-term investment framework for business.”
More information is available from the Allocation and competitiveness in the EU Emissions Trading System: Options for Phase II and beyond section of the website.
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