EU ETS hits crunch time

The EU ETS is the central pillar of implementing CO2 emission reductions in the EU and has emerged as the backbone of the emerging global carbon market.

The carbon price and its stability are defined by the scarcity created by government allocations. Most EU countries have now submitted proposals for their allocations in Phase II, the Kyoto period of 2008-12. New research for the Carbon Trust carried out by Climate Strategies and ENTEC, shows that the current allocation plans will not deliver the robust and stable carbon price that is necessary for efficient business investment in low carbon solutions.

Professor Michael Grubb, chief economist at the Carbon Trust, said: “If the current national allocation plans are allowed to stand, it could seriously undermine the credibility of the EU ETS and the mechanism of carbon trading as an effective way to tackle carbon emissions. A more consistent approach to national allocations across Europe is essential. Energy intensive sectors need a level playing field to avoid competitive distortions, and all companies need a robust carbon market to ensure that their investments take into account the long term realities of a carbon constrained world. If nothing is done, inflated allocations could become the Achilles heel of the European response to climate change and Kyoto implementation. The EU Commission and Member States should consider very carefully whether any of the plans, other than those of Spain, Italy, and the UK, are fit for purpose”

• The currently proposed allocations for Phase II will not deliver a robust carbon market. Collectively, they exceed a simple trend projection of emissions. Given the likely availability of emission credits from Clean Development Mechanism projects carried out in developing countries, they imply a high risk of carbon prices that are too low to offer any significant incentive to reduce emissions.
• This outcome would be at odds with declared European positions on climate change. It would undermine European authority on the issue as well as business confidence in the credibility of government targets and incentives.
• For many countries, the proposed allocations represent inadequate cutbacks in relation to Kyoto targets. This would place increasing pressure on Government Treasuries to make up the shortfall by purchasing international emission credits, which could strain Kyoto compliance.
• The current allocation plans make little use of auctioning, which could increase the stability and credibility of the system, reduce perverse incentives arising from excessive free allocation, and generate revenues to help for example with government purchase of allowances.

Recommendation

• Two fundamental changes are required to create a robust carbon market. Compared to the current proposed allocation plans, total free allocations should be cut back 300-400MtCO2/yr, and 100-200MtCO2/yr should be re-injected back into the market through auctioning.

EU Emissions Trading Scheme:
Key points on proposed allocations for Phase II (Kyoto period, 2008-12)

(ii) Comparison of allocation plans
It is important to compare the efforts being made in different countries, particularly amongst the energy-intensive traded goods sector. At the same time, countries are in different positions in terms of growth prospects and distance from Kyoto targets, partly due to actions already taken. Based upon the draft NAPs, as summarised in the Figure below, we conclude:

• Among the current proposed allocation plans, Italy and Spain are proposing the most significant cutbacks, more than 10% reductions below the sector emissions in 2005, followed closely by the UK. No other countries are proposing significant reductions below 2005 levels.
• The UK will comfortably exceed its Kyoto commitment, and based on an “equal share of effort” analysis, Spain and Italy will be close to their Kyoto commitments. All other countries fall short on this measure.
• Austria and Finland are notable for allocations which leave a huge gap relative to their Kyoto target.
• The Netherlands, Belgium and France also fall short, owing to provisions for ‘new entrant reserves’ which would allow a big expansion and take these countries much further from their Kyoto targets. Sweden’s huge New Entrant Reserve would also take it some distance from a Kyoto-consistent allocation.
• Germany has a special responsibility as it is by far the largest emitter (more than 20 per cent of EU total), and will host the EU and G8 Presidencies next year on a platform of leading the fight against climate change. However, its proposed allocation would result in a net increase in national emissions, and provisions in the plan are designed to protect the construction of new coal plant. These features are inconsistent with stated German goals on climate change commitments and targets.
• Almost all the Accession Countries are allocating a big increase in emissions, which in many countries would breach even the existing scope to increase under their Kyoto targets. Such increases are in sharp contrast with historical trends and are not credible.
• Even in the three countries proposing significant cutbacks, they are placed almost entirely upon the power sector and most allocate growth close to ‘business as usual’ needs in other sectors. The UK plan fails to make any cutbacks at all outside the power sector, but in other respects, especially its use of auctioning, is one of the most robust plans.

Recommendation
The NAPs need to provide an effective incentive, with a fair distribution of effort across Europe. They must do so in ways that are consistent with national Kyoto commitments, the EU’s international position, and the business need for a robust carbon market against which to make the investments necessary for a low carbon future. The EU Commission and Member States should consider very carefully whether any of the plans, other than those of Spain, Italy, and the UK, are fit for purpose.

* Many EU ETS phase II plans are draft and proposed cutbacks may change. Fair share cutback calculated using 2004 country emissions data compared to 2005 EU ETS emissions data. Note that changes in coverage of NAPs between phase I and phase II affect some countries (UK, France, Sweden) and phase II data has been adjusted to enable a like for like comparison (e.g. excluding UK phase I opt outs from consideration in phase II). Polish data estimated as Phase I 2005 data incomplete.

Notes:

• Data are incomplete for some allocation plans. The Italian and Spanish plans are in draft, not yet submitted to the European Commission. Italy has indicated that it may revise its plan before formal submission.
• UK, German, Sweden and France adjusted for changes in installation coverage between Phase I and Phase II.

Source: Carbon Trust, drawing upon commissioned research by Climate Strategies and ENTEC. The full Climate Strategies research reports will be released at press conference in Brussels, 9 November 2006, and downloadable as from 12.30 Central European Time from www.climate-strategies.org.