By Nigel Blackaby
It is increasingly accepted that for power producers and industry alike, emissions trading mechanisms represent one of the most flexible and efficient ways of achieving the goal of reducing worldwide emissions and that benefits would flow from developing as wide a market in emissions trading as possible.
The power industry is inextricably linked to the issue of climate change. Despite making substantial reductions, the industry remains a major emitter of CO2 yet it has the capability of delivering electricity carbon-free through the use of renewable energy and nuclear technology.
The UK-ETS began in April 2002 and aims to save 2 million t of CO2e per annum by 2010
For the European Union, an emissions trading scheme is a vital element in meeting its Kyoto commitments.
Trading in greenhouse gases was pioneered in the USA during the 1990s when the government’s Acid Rain Programme sought to control emissions of sulphur dioxide and as a result, dozens of state-based schemes have developed. Within Europe, only Denmark and the UK have government-backed schemes in operation. The European Union plans to introduce an emissions trading scheme by 2005 but questions remain as to how it will integrate the considerable difference between existing trading schemes and other voluntary climate change arrangements.
Emissions trading was established by Article 17 of the 1997 Kyoto Protocol as one of the three key flexibility mechanisms for reducing emissions of greenhouse gases (GHG). Parties with GHG emissions commitments can trade their emission allowances with other parties with the aim of improving the overall flexibility and economic efficiency of reducing emissions. Kyoto envisages that an international platform for emissions trading will be in place by 2008.
The Kyoto Protocol will not take effect until it is ratified by 55 per cent of the nations emitting 55 per cent of six greenhouse gases. The European Union and other participating countries are moving rapidly towards the ratification of the protocol with the intention of achieving this in time for the World Summit on Sustainable Development set for Johannesburg in August 2002. Despite the withdrawal of the US, countries and individual companies are starting to anticipate the imposition of an international framework for emissions trading and a market is emerging, albeit in a fragmented way.
Actual progress in the reduction of total EU greenhouse gas emissions in relation to the Kyoto target
The Pew Center on Global Climate Change estimates that approximately 65 GHG trades for quantities above 1000 tonnes (t) of carbon dioxide equivalent (CO2e) have occurred worldwide since 1996. The figures include trading in derivatives, and the Pew Center says prices have ranged between $0.60 and $3.50/t CO2e.
In addition to the absence of internationally agreed emissions reductions rules, a further obstacle to a unified basis of emissions trading is the differences in rules between existing schemes. Cross border transactions are impeded by, among other things, the lack of mutual recognition of trading units, differences in gases being traded and economic sectors participating. This can be illustrated by comparing the Danish and UK emissions trading schemes.
Cap and trade
Denmark has focussed its emissions reductions strategy on power generators, having had some success with trading schemes for sulphur dioxide and nitrogen oxides. In June 1999 it established a ‘Cap and Trade’ CO2 scheme to run up to the end of 2003.
Cap and Trade emissions trading systems require a strict emissions cap to be set for all participants. Allowances are allocated up to the level of the cap and trading can take place where one participant is able to generate excess allowances, due to lower marginal abatement costs, and sells them to another participant who either chooses to or has not been able to make emission reductions as cost effectively.
In the case of Denmark, the Minister for Environment and Energy allocated emission permits for the electricity generation sector covering compliance periods ending in 2001, 2002 and 2003.
The scheme looked to reduce CO2 emissions by 23 million t in 2000, 21 million t in 2002 and 20 million t in 2003. It involved just eight of the largest electricity companies operating in Denmark including Germany’s E.ON and Vattenfall of Sweden. These companies account for 90 per cent of emissions by the power sector. Allowances were based on historical emissions in the period 1994-1998 of 30.6 million t CO2 – 50 per cent of Denmark’s overall emissions.
Any emissions in excess of permitted levels result in a modest penalty of g5.4 ($4.9)/t CO2. Participants are also required to pay an administration fee of g0.01/t CO2 allowance but the low non-compliance disincentive and lack of liquidity as a result of so few participants has meant the Danish scheme has been slow to get off the ground.
The scheme also suffered from a lack of clarity concerning the bankability of certificates and 2001 allowances were not allowed to be carried over. In the run-up to the 2001 compliance period, five deals were done. Bankability is expected to be permitted for 2002 onwards.
The main player within the Danish scheme has been power company Elsam. Of the five registered trades in 2001, Elsam was involved in four, trading 300 000 t CO2. Head of climate change at Elsam, Peter Markussen, told delegates at an emissions trading conference in Amsterdam in February that despite its shortcomings, Elsam had gained valuable experience by participating in the Danish scheme. He said that it had enabled Elsam to develop its CO2 management strategy in anticipation of a broader international trading basis.
“The Danish cap and trade scheme required the flexibility of allowing banking for companies and third parties,” said Markussen. “The penalty imposed acts as an export tax and does not promote new investment.” The tendency in the Danish scheme has been for the trades to be concentrated in the period running up to the compliance deadlines – a factor also noted in the various emissions trading simulations that have been undertaken.
Even though the Danish scheme will be running concurrently with the UK scheme for two years, there is no direct compatibility between the two markets. It is, however, more in line with the EU proposal and to that extent may prove to be a valuable exercise for Denmark and its power sector.
Learning by doing
Along with Denmark, the UK has set itself up as a pioneer of GHG emissions trading by launching its own scheme this year, supported by the European Union. Like Denmark, the UK hopes that both government and business will gain valuable ‘learning by doing’ experience in GHG emissions trading which should enable it to have a greater influence on the development of the proposed mandatory EU-wide scheme which is set to commence in 2005.
With the International Emissions Trading Association estimating the world market in greenhouse gas emissions trading at $13 000 billion by 2050, it is easy to see why there is benefit to be gained from taking a lead in developing the carbon marketplace.
The UK emission trading scheme (known as the UK-ETS) began operating in April 2002 and aims to save 2 million t of CO2e per annum by 2010. It is entirely voluntary and is open to two different group of participants: Agreement Participants and Direct Participants.
Agreement Participants are those who are already party to a Climate Change Levy Agreement (CCLA) and have therefore negotiated a reduction in the Climate Change tax they pay on their energy use in exchange for accepting energy use targets. CCLAs cover around 8000 sites in the UK and these companies have the right to meet their emissions reductions targets by purchasing allowances in the UK-ETS if that is more cost effective than direct compliance. Companies who beat their target can claim allowance by having their performance independently verified.
Direct Participants operate within a cap and trade market and successfully bid for the à‚£215 million ($314 million) of government financial incentives on offer. The bidding process closed in February 2002 and resulted in 34 companies agreeing to cut their GHG emissions by more than 4 million t of CO2e over the next five years, in return for à‚£53.37/t. This represents about five per cent of the UK’s Kyoto target, which is a reduction of 12.5 per cent relative to 1990 levels by 2010.
Firms that can cut GHG emissions in excess of their ‘cap’ will have surplus allowances to sell while others struggling to meet the cap may, depending on the market price, have reason to buy.
Companies that successfully bid for the incentives include Shell, BP, DuPont, ICI and Blue Circle as well as British Airways, Tesco and the Natural History Museum. Unlike the Danish scheme, the UK-ETS specifically excludes direct power producers, arguing that it is more efficient to put the onus of emissions reductions on the end user and that a higher level of emission reductions will be achieved this way.
Trading for Direct Participants in the UK-ETS officially commenced on 2 April. On 10 April BP announced it had carried out the first trades within the scheme including selling 1000 carbon credits to building materials firm Imerys. Since then, the UK Department for Environment, Food and Rural Affairs (Defra), whose Global Atmosphere Division administers the scheme, will only say that there have been “a number of trades”. Defra expects that little trading will occur until greater liquidity exists through the involvement of Agreement Participants. This is likely to take place towards the end of the year, at the end of the first Climate Change Levy commitment period, when companies will know how successful they have been in achieving their targets.
The European proposal
On 23 October 2001, the European Commission released its draft of an EU-wide emission trading scheme, tailored to suit the Kyoto protocol, which it plans to start in 2005. The EU argues that the purpose of the scheme is not to introduce new emissions cuts but to mitigate the cost of meeting the already agreed Kyoto reduction targets.
The EU proposes a mandatory scheme, open to five industry sectors across the 15 EU states, as well as the EEA states and the 12 central and eastern European countries due to join the EU by 2004.
The scheme will cover all GHG covered by Kyoto but only CO2 will be traded in the first instance as it accounts for 80 per cent of emissions.
The scheme covers power generation of over 20 MW, including industrial installations as well as oil refineries, coke ovens, metals, minerals and the pulp and paper industries. These sectors are estimated to account for 46 per cent of the EU’s total CO2 emissions in 2010 and there are likely to be about 5000 installations affected.
Unlike the UK-ETS, all applicable installations, including power producers, will automatically be governed by the EU Directive and will require a permit to emit greenhouse gases. Although trading will not be mandatory, it is expected that it will follow as a rational response.
National registers will be set up to ensure accurate accounting of the holding and transfer of allowances as well as a Community level record being kept. As with all emissions trading schemes, the EU will have to establish a registry, agree a common currency and create monitoring and verification procedures.
Individual companies will be allocated an emissions limit and will be able to buy certificates to cover this in the open market. Compliance with the limit will be measured at the end of each phase, with the first phase running from 2005 to 2007. Any company that has emissions in excess of its limit not covered by registered certificates will be liable to a fine of H50 for every excess tonne. Spare certificates can be banked into the next phase, 2008-2012, or sold on the open market. In phase two the fine rises to g100/excess t.
The European Commission’s proposals combine the mandatory emissions cuts of the Danish scheme with the broader range of participants chosen by the UK, but with the inclusion of electricity generators.
As with many pan-European plans, a number of obstacles need to be overcome if the 15 EU member governments are to agree to the arrangements. Issues of integration with individual country’s arrangements will need to be tackled, not just reconciling differences between the UK-ETS but also allowing voluntary climate change schemes such as the one in operation in Germany, to continue. The Commission and European Parliament are currently considering these issues.
“The UK supports the EU plan so long it leads to actual emissions trading rather than adding a further regulatory burden,” says Chris Leigh, who is responsible for the UK-ETS at Defra. Leigh, who is involved in the EU negotiations, believes that it will be feasible to integrate the schemes even though at present there is a two-year overlap. “It is possible that there might be an opt out during the first stage for states who have voluntary agreements in place. Negotiations are proceeding slowly and it may be that the overlap period with the UK scheme reduces,” says Leigh.
There are no plans to extend the Danish emissions trading scheme, which is not scheduled to overlap with the European proposals.
Despite the differences between the UK and Danish schemes, Elsam and Shell arranged in May an innovative swap of Danish and UK allowances This enabled Elsam to carry over excess allowances beyond the end of the Danish scheme and proved that trans-frontier deals can occur despite that lack of formal links between national schemes.