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The findings show that although Phase II will encourage further reductions in operational emissions across power generation and heavy industry, the impact on new investment in lower carbon technologies in many countries will be limited due to a number of perverse incentives.
Detailed analysis reveals that most National Allocation Plans (NAPs) offer free carbon allowances to new entrants. In around half of the NAPs, including the German plan, the new entrant rules actually give higher numbers of free allowances to more carbon intensive fuels, such as coal and lignite, which creates a perverse incentive to build new power facilities that emit high levels of CO2. The lack of clarity about future Phases of the scheme beyond 2012 further undermines its ability to drive new low carbon investment.
The key to making the EU ETS more effective in promoting new low carbon investment is for Member States to adopt a higher level of auctioning in Phase II, and to move rapidly to define a third Phase of the scheme that addresses the problems in particular surrounding new entrant rules and creates sufficient certainty to incentivise long lived investments.
Professor Michael Grubb, Chief Economist at the Carbon Trust and Executive Director of Climate Strategies, commented:
“Although the EU should be applauded for its strong stance on NAPs last year, our research shows that the devil is in the detail. Too many countries are using special provisions to try and protect carbon intensive investments. Policy, on a national and pan-EU level, should be focused on investing in low carbon alternatives. There is still time for Member States to improve the incentives by auctioning more of the existing allowances. Moving rapidly to remove the Phase II loopholes in the subsequent phase will also send a strong signal that low carbon investments will be properly rewarded over time.”
The Carbon Trust’s research looks in detail at the implications for the carbon market during the second phase of the EU ETS (2008 – 2012) and highlights the following themes as key areas for consideration moving ahead:
Commission ruling on draft NAPs last year should be applauded – the EC ruling turned a set of proposed allocation plans that represented a 5 per cent increase on CO2 emissions above verified 2005 levels, into a five per cent decrease below 2005 levels. This was integral to retaining the credibility of the EU ETS and establishing a viable carbon market for 2008-12;
Carbon price remains uncertain – although the forward carbon price for Phase II has remained steady at below €20 per tonne of CO2, spot prices will be highly uncertain;
Ongoing encouragement of CO2 emissions reduction across power generation and heavy industry – if the carbon price remains positive, this will drive some abatement, particularly in power generation and cement manufacturing;
Power companies will still make big profits – Europe’s power companies have made well over €1 billion profits from the EU ETS to date and the Carbon Trust’s analysis suggests that the sector will make net profits of €tens of billions during Phase II;
More auctioning will be important in Phase II and beyond - the current NAPs only propose a small amount of auctioning but governments retain the right to decide to auction more. This could be effective to improve incentives for low carbon investment by using auction revenues to support such investment; by reducing peverse incentives and by enabling a reserve auction price that would help to stabilise price expectations; and
Attention to detail will be critical in Phase III – real focus needs to be placed on the details of scheme design that affect individual investment incentives, in particular new entrant and closure rules, in Phase III - going beyond the focus on volumes and prices that has dominated debate on Phase II allocations.
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