Clearing the air

With the smoke of battle still obscuring government and industry over the Climate Change Levy, ANDREW CAVENAGH finds emissions trading may be the source of an unlikely detente

The animosity between the UK government and industry over the Climate Change Levy has been one of the defining features of this Parliament. It is remarkable, then, that on emissions trading – another plank of government strategy to contain greenhouse gas emissions – there has been an outbreak of unprecedented co-operation.

Last month, as part of its spending review, the government announced £30m in incentives to companies to sign up to a scheme that will put a price on atmospheric pollution and so encourage companies to reduce their emissions.

Funding of £30m may not seem much compared to other handouts Chancellor Gordon Brown announced in the review, but it is the amount asked for by the industry-led Emissions Trading Group, which developed the scheme.

This was the final piece of the jigsaw putting the UK on course to pioneer trading in permits which will, in theory, enable industry to reduce greenhouse gas emissions cost-effectively. And since trading schemes are one of the key mechanisms identified by the 1997 Kyoto agreement for combating global warming, this will put the UK in an influential position when European and international schemes are developed.

Industry is more enthusiastic about trading than the Climate Change Levy, says Richard Jackson, CBI senior energy policy adviser. `Trading is more flexible than a blunt tax affecting all sectors regardless of abatement costs. Trading allows industry to find the cheapest option for cutting emissions, and to bring in emissions-saving projects.’

The scheme arose from the 1997 Kyoto Protocol to the United Nations Framework Convention on Climate, held in Rio in 1992. By the agreement, developed countries committed to reduce their emissions of six greenhouse gases – of which carbon dioxide is predominant – by 5.2% of 1990 levels between 2012 and 2018.

To help meet the European Union’s share of this burden, the UK committed itself to a 12.5% reduction, and made a further manifesto goal of a 20% cut in carbon dioxide emissions by 2020.

The Kyoto accord outlines three methods by which countries may fulfill their commitments, one of which is emissions trading. The principle is straightforward (see box on page 18): companies are given a target for their emissions – set below their current levels – and are given a permit to cover that volume. Those that can cut their output of greenhouse gases beyond that target can then sell the excess on their permit – the difference between what they are allowed to emit and what they actually do emit – to companies that cannot reduce their emissions without incurring high costs.

But in 1998, a task-force chaired by Lord Marshall looked into the use of economic instruments to reduce business energy-use. In November that year, he recommended that an energy tax, along the lines of what would become the Climate Change Levy, was needed – much to the consternation of a large part of British industry. However, he also recommended that a pilot emissions trading scheme should be run. Marshall anticipated difficulties, however, and did not expect a statutory UK scheme to be operating before 2008.

Trading places

The government offered participation in a trading scheme as an option enabling energy-intensive industries to qualify for an 80% rebate on the Climate Change Levy, if they met negotiated energy-efficiency targets.

The Advisory Committee on Business and the Environment and the CBI set up an Emissions Trading Group in June 1999, chaired by BP Amoco’s deputy chief executive Rodney Chase, to develop a scheme. Uniquely, as well as including about 30 of the UK’s leading companies, the group also included representatives of the three relevant government departments: Trade and Industry; Environment, Transport and the Regions; and the Treasury.

The ETG outlined proposals for a scheme to the government in October 1999, which was welcomed by ministers. The government also accepted that financial incentives would be the key to early adoption of the scheme, and made the allocation of £30m for 2003/4, with more funds in the following two years.

Any description of what the ETG has come up with inevitably reads like the rules of a slightly complex board game. But in a nutshell, three classes of participants are planned. The first will be firms that agree absolute targets for reducing emissions. The second will be firms that sign up to reduction targets related to units of output under a negotiated agreement to receive a Climate Change Levy rebate. These will be intensive energy users, and it allows them to increase production without busting their emissions target. The third class will include companies that participate in specific projects aimed at greenhouse gas emissions reduction.

Companies in the first group will receive tradeable permits matching their agreed annual emission limits. Those that have output-related targets will not receive permits directly but will have the right to buy permits to help them to meet their targets. The third sector will enable projects, generating credits which can either be used to meet targets or be sold into the market.

All companies have the option to agree targets for all six greenhouse gases or carbon dioxide alone, and can bank unused permits for future use.

Firms failing to meet their targets must buy permits to cover emissions above their agreed limits. If they fail to do so, they will be liable for penalties.

The three-tier structure is intended to encourage maximum participation. `You cannot design a scheme without aiming to bring in all companies,’ says the CBI’s Richard Jackson.

By mid-October, the government will have developed the ETG’s outline into a fully-fledged framework. This will specify the baseline emission levels according to which targets will be set, and the structure of financial incentives. It may include an indicative range of the price per tonne of carbon the government will offer for different levels of reduction. For instance, a firm’s commitment to reduce carbon emissions by 20% may be worth £15 per tonne, whereas a 10% cut may qualify for only £5 per tonne.

Companies will be invited to make offers against the various prices in February or March next year. It might make financial sense for a company to offer a reduction of 200 tonnes a year at £15 per tonne but only 50 tonnes at £10 per tonne, due to the cost of measures required to meet the respective targets. `It will be like an instant auction,’ says Margaret Mogford, head of the ETG secretariat, on secondment from BG.

The plan is that the government will make offers on the basis of the bids received in April, at the same time as the energy tax is introduced, selecting the price that offers the maximum overall reduction in emissions for the £30m it has to give away. Companies selected will be issued with permits for the agreed levels of emissions.

From April 2001 to April 2002, these companies will either have to effect the necessary reductions or buy permits from others in the scheme to cover any shortfall. Once their emissions for the year have been verified and audited, the participants will receive their incentive payments, probably in the form of a reduction of their energy tax bill.

The scheme will be overseen by an Emissions Trading Authority, which will operate a register and accredit verification bodies and certifiers. But many crucial details have yet to be resolved, such as the basis for establishing baseline emission levels, the method for measuring carbon dioxide emissions, and the exact scope and composition of the ETA.

Also to be finalised is the mechanism for trading permits. Mogford says that a dedicated exchange is not planned, and that companies should be able to trade bilaterally or via multiple brokers.

Another issue to be resolved is the entry of power generation companies into the scheme. `We have some problems with the power generators coming in,’ says Mogford, suggesting they are unlikely to enter the scheme until it is into its second or third year.

Power politics

If companies cut their consumption to meet a target, any associated reduction in a local power plant’s output (and carbon dioxide emissions) should not count as a separate reduction. Coal-fired generators will also have to reconcile their strategies with government plans for the future of the UK coal industry.

The ETG believes the scheme has the potential to bring far more companies into the effort to reduce emissions than are now engaged under the CCL. It will also provide an impetus for investment in environmental projects in the domestic and transport sectors.

From an international perspective, cross-border trading of permits will be a key factor in achieving the longer-term objectives of the Kyoto accord. As the Marshall task force report said: `Emissions trading at an international level will be a reality by 2008, when the commitment period for meeting Kyoto targets begins.’ On trading within nations, Marshall expected that the country that solved most problems inherent in setting up a workable scheme would have greatest influence in the design of an international system.

Although similar initiatives are underway in other countries – France is developing a scheme and the German Green Party is looking into the idea, as are the governments of Canada and Australia – the UK seems to be leading the field and could exploit this for national benefit. The City of London, for instance, could become the world centre for trading emissions permits.

The scheme has been well received by environmental groups. As Paul Ekins, programme director at the influential Forum for the Future, says: `While there are still many areas that need sorting out, a lot of useful work has been done by the ETG. I think it’s vitally important to get a pilot scheme along the lines the ETG has developed up and running as soon as possible.’

Doubts remain, however, about the relevance of the scheme for all but the largest industrial manufacturers. The Marshall report identified this problem, and cited it as the principal justification for introducing an energy tax to run concurrently with the scheme.

Helen Woolston, environmental adviser at the Engineering Employers’ Federation, thinks it unlikely that joining the scheme will make economic sense for more than 10% of the organisation’s near 6,000 member firms.

Woolston adds: `At the level of small companies there’s a basic awareness problem – they just don’t know what trading permits are.’

ETG officials admit that for many companies the administrative costs of emissions reduction may be such that it is not worth pursuing. However, there could be scope for smaller firms to club together in a similar manner to companies with multiple sites.

Jackson at the CBI says: `It is very difficult to say who will come in at the moment. I imagine it would be larger companies.’ It seems probable that there may be only 12 to 15 participants signed up by next April. Nevertheless, this would be enough to get the scheme under way – enabling the government to dispense the full £30m – which its backers hope will generate a snowball effect in subsequent years.

Love-hate relationship

Industry may love emissions trading, but it detests the Climate Change Levy. Unfortunately, the two have been designed to work together. Here’s how:

Both the Climate Change Levy (CCL) and emissions trading will be brought into play in April 2001. Companies in some energy-intensive sectors will be able to enter negotiated agreements to cut emissions in return for an 80% rebate on the CCL. Such agreements only apply to plants covered by the Integrated Pollution Prevention and Control regime. One way that companies will be able to meet their obligations to cut emissions will be to trade in permits: in other words, they could qualify for the CCL rebate by a mix of cutting emissions and buying permits.For trading, there are three categories of firms:

1 `Absolute’ Firms which agree annual emission limits – the `absolute’ sector, which is open to all companies, irrespective of whether or not they qualify for a CCL rebate.

2 `Unit’ Firms which agree a target to reduce emissions per-unit of output – the `unit’ sectors, which are ONLY available to firms negotiating a CCL reduction.

3 `Project’ Firms which participate in greenhouse gas emission-saving projects – available to any company.

For full details, visit the ETG website on www.uketg.com

A fictional deal: How Cleanco and Dirtomatic could both win

Cleanco & Co. agrees to cap emissions at 100 units of carbon dioxide equivalent and receives a permit accordingly.

Dirtomatic Ltd also agrees a cap of 100 units and receives permits for this amount.

Cleanco discovers technology with which it can reduce emissions to 80 units by investing £5m. This leaves it with a permit for 20 surplus units which it sells to B for £10m.

Demand for Dirtomatic’s products rises. It increases production, but discovers it will produce 120 emission units by the year end.To prevent this it would have to buy £20m of equipment.

The deal: Dirtomatic buys Cleanco’s permit for the extra 20 units for £10m. Both win, and the investment in reducing emissions is made where it is most cost-effective.

Next year, both companies’ caps reduce to 95 units. So if nothing else changes, B will have to find an extra 25 units of permits, but have to shop around because A will only have 15 units spare. The extra permits will cost more and B will find it worthwhile, if production stays at the same rate, to invest in cutting emissions.