New report finds that the EU’s key environment policy is failing
09 August 2007
New report finds that the EU’s key environment policy is failing
Time to fundamentally reconsider emissions trading, says Open Europe
Open Europe today releases a major new study: “Europe’s Dirty Secret: Why the EU Emissions Trading Scheme isn’t working”.
The EU is responsible for running an EU-wide Emissions Trading Scheme (ETS), which is supposed to be Europe’s main policy tool for reducing carbon emissions.
Almost everyone now acknowledges that the first phase of the system - running from 2005 to 2007 - has been a failure: more permits to pollute have been printed than there is pollution. The price of carbon has collapsed to almost zero, creating no incentive to reduce pollution. As a result, UK firms covered by the scheme increased their emissions by 3.6% in the first year alone. Across the EU, emissions from installations covered by the ETS rose by just under 1%.
It was hoped that changes to the system which will apply in the second phase will make it more effective. However, the report finds that in the second phase, important new problems are emerging. Meanwhile, other fundamental problems have not been solved.
In a foreword to the study, Swedish Green MP Max Andersson writes that:
“There has so-far been limited questioning of the hazy assertion that the EU is good for the environment. This new study from Open Europe attempts to challenge this claim, arguing that real environmentalists should be very sceptical indeed of the EU’s record on this area.”
“The EU doesn’t need an Constitution to fight climate change - it simply needs the political will to develop policies that work.”
Open Europe analyst Hugo Robinson said:
“The EU ETS is costing a lot, but it isn’t working. New problems are emerging in the second phase. Member states have opted to buy in vast numbers of what are essentially carbon offsets from developing countries, rather than make real reductions in emissions. But the offsets are often not reducing emissions, or are even subsidising polluters. This approach does nothing for our energy security and it doesn’t appear to be doing much good for the environment.”
“It has also become clear that some member states are clearly using the complexity of the system to provide covert industrial subsidies to polluting industries.”
“International action should focus on setting tough and enforceable national targets for greenhouse gas reduction. How to reach those binding targets should be up to individual countries.”
You can download the full report at:
http://www.openeurope.org.uk/research/etsp2.pdf
KEY POINTS
The first phase of the ETS (2005-2007) was a failure
As the cross-party Commons Environmental Audit Committee noted: “there is little or no evidence that Phase I is leading to any cutbacks in actual emissions at all, whether in the UK or elsewhere in the EU.” In its first year of operation (2005 to 2006) emissions covered by the ETS rose 3.6% in the UK, and rose by 0.8% across the EU as a whole.
Despite promises of improvement, the second phase of the ETS will still not work
Unlike in the first phase, in the second phase (2008-2012) member states will be able to “import” external Kyoto “credits” in order to meet their targets for reductions.
In order to pass the legislation which allows this to happen quickly, member states have simply set their own import quotas.
Overall, EU member states have allowed themselves large enough import quotas that they will be able to meet their entire target for reducing emissions by buying Kyoto credits – like a giant global version of the “carbon offsets” which people can buy to (supposedly) offset their personal flights etc.
The Commons Environmental Audit Committee has noted that “it is theoretically possible the EU ETS might not be responsible for any emissions reductions within the UK at all.” The Government’s response to the Committee report states that “The Committee’s theoretical observation is correct.”
Kyoto credits: are we getting real emissions reductions for our money?
To some extent, importing emissions reductions from overseas would be unobjectionable if it reflected real emissions cuts. But these credits have already been exposed as highly flawed, and often fraudulent.
Kyoto credits don’t always reflect absolute reductions in emissions, many being generated from projects in developing countries that would have happened anyway (meaning that they are in fact subsidising increased pollution).
For example, the Xiaogushan dam in China was awarded US$30m worth of credits, even though construction of the dam had been long underway, was nearing completion, and had already been given loans by the Asian Development Bank. The Jindal metal plant in India, the largest sponge iron plant in the world, is an example of a programme claiming carbon credits for technology that would have been installed anyway.
Around half the money spent on Kyoto credits to date has been awarded to projects to clean up so-called “exotic” greenhouse gasses – many of which are scams. According to a report by Stanford University economist Michael Wara, huge numbers of credits will be generated through an accounting scam involving capture of the gas HFC-23, which allows big polluters to bag massive profits for very little effort. Total projects that should have cost no more that €100m have wasted €4.6bn.
The Commons Environmental Audit Committee concluded that there was “compelling evidence” that such projects “should be subject to serious doubt.” The UN has now cracked down on HFC-23 fraud, but similar frauds are happening relating to other gasses in the Kyoto system.
Paying for reductions elsewhere means losing several of the benefits of reducing domestic emissions
Even if the Kyoto system was delivering emission reductions, it might be worth noting that paying for emissions reductions elsewhere means that the countries paying lose several of the side benefits of reducing their own energy use and emissions. For example, paying for reductions elsewhere will not increase member states’ energy security. It also means losing a demonstration effect – showing the rest of the world that it’s possible to break the link between growth and rising emissions.
Undermining the ETS without getting reductions elsewhere?
Worse still, the Kyoto mechanisms themselves could be swamped by a huge oversupply of permits. It is quite possible that supply of credits in the 2008-12 period will exceed demand, a scenario which would lead to very low carbon prices.
According to a recent (April 2007) report by Professor Catrinus Jepma at the University of Groningen, there will be a supply of around 5.75 billion tonnes worth of Kyoto credits coming onto the market, while there is only going to be demand for 3.5 billion tonnes’ worth.
Because the import limits are so loose, a collapse in Kyoto credit prices would feed into the ETS, driving down the cost of permits in Europe. Professor Jepma argues that “Through the Linking Directive, low credit prices under the Kyoto Protocol will push down second phase EU ETS prices. Also for the EU the opportunity to put real prices on carbon will then be lost.”
Still not a real market in phase two – and ETS is being used to provide covert industrial subsidies to serious polluters
In phase one, power generators are believed to have made over £2bn in the UK alone in windfall profits because they have been allowed to pass on the notional cost of carbon to consumers, while actually having been given permits for free.
Extraordinarily, auctioning of permits still has not been properly utilised in phase two. In fact, auctioning is restricted to 10% of the total, and only around 1.5% of permits will be auctioned in practice (7% in the UK). Having the government decide how much effort each firm should make defeats the whole point of running a trading system.
Worse still, member states are using free allocations to deliver subsidies to polluting industries – particularly coal. As Economist Karsten Neuhoff notes: “Any free allocation represents a subsidy – and where only fossil-fuel generation is subsidized, this distorts investment choices in favour of fossil-fuel generation. Where coal receives a higher allocation than gas, the investment choice is, in addition, distorted towards coal. The level of such subsidies under proposed second-phase NAP is so high that the construction of coal power stations is more profitable under the ETS with such distorting allocation decisions than in the absence of the ETS.”
The Carbon Trust note that Germany is using the scheme to subsidise brown coal – one of the world’s most polluting fuels: “The fact that new emitting sources get free allowances but zero-carbon power sources do not obviously weakens incentives to invest in the latter. This problem is exacerbated by specific details in many of the plans. Most notably, the German NAP offers unlimited ‘technology specific’ free allowances to new power stations, so that coal power stations get about twice as many as gas, and adds a ‘load factor’ correction, in which the most polluting plants (lignite) are granted an additional 10% more allowances, officially on the grounds that they are expected to operate more… many countries offer such fuel-specific subsidies for new entrants, but Germany is unique in the scale of subsidy offered to the most polluting ones.”
Intra-EU economic distortions will remain
Different member states are subject to different levels of stringency in their overall emissions caps and their entitlement to use (cheaper) Kyoto credits, meaning they need to make differentiated levels of ‘effort’. The UK will suffer amongst the highest costs in Europe in absolute terms in order to comply, largely as a result of its smaller credit import quota and tough overall target. Germany, despite emitting 75% more CO2 than the UK, will pay less. France should actually be able to make money out of the system, as its target is above its emissions, and it will be able to sell off its surplus permits at a profit.
For the reasons described above, it is likely that the system will again fail to put a meaningful price on carbon in the second phase. However, if we assume a best case scenario, in which there is no flood of permits into the Kyoto market, and there is serious price on carbon, then we can estimate the relative cost for different member states, given their different levels of effort. The second phase of the ETS would then cost the UK £1.6 to 2.3bn over five years.
Conclusion: There are a number of obvious ways in which the EU ETS should be reformed. However, even this may take a long time due to the slow moving nature of the EU. Nor is it clear that the fundamental problems of emissions trading can be solved.
1: Potentially reformable aspects of the ETS
Lack of auctioning. As long as permits are allocated and not auctioned the system is not going to be worth having. It is absurd that only 1.5% of permits will be auctioned in the second phase.
Too many small installations. At present too many small installations are included. In the UK, 43% of the firms (all facing large admin costs) are producing just 1% of emissions in the system. The cost of including these smaller installations will outweigh the benefits. This could be remedied by raising the threshold for inclusion. However, the Commission has said it will not even look at this issue until after phase two. Again, it may be difficult to get agreement among the 27 to solve this problem in the near term.
2: More fundamental problems with the ETS
Uncertainty and the lack of a long term price. Two aspects of the system make it difficult for firms to plan to make the long-term investments needed to reduce emissions. Firstly, the instability of the carbon price in the system (gyrating wildly between €33 and €0.20 in phase one) and secondly, the short trading periods –which mean that businesses cannot plan far enough ahead to reduce emissions. Both are fairly structural problems.
Getting the allocation ‘right’. Setting a target which is neither too tight nor too loose may not be easy. It involves making a series of guesses about future economic growth, future energy prices, and changing technology over a period of several years. If policy makers get it wrong they cannot correct their mistakes until the next period, say five years later. The negotiations over phase two ETS have demonstrated that bureaucracies are generally not well positioned to judge what caps should be imposed on participants, whilst participants have a strong incentive to exert pressure on the bureaucracy in order to affect these decisions to their advantage.
“Gaming the system.” Since emission allocations in the ETS are effectively assets with total values in the order of hundreds of billions of euros (with state action being the key driver of the prices of these assets), it is hardly surprising that lobby group and member state pressure has been intense. Unlike in a single country emissions trading system, in the EU scheme member states have a powerful incentive to set loose caps as this will result in a large transfer payment from member states which set tighter caps.
Six member states are currently suing the European Commission over their allocations, creating further uncertainty. Germany accepted a reduction of its total emissions cap of 28.9 Mt only in return for an increase in its Kyoto credit import quota of 32.8 Mt – so in reality, while the Commission looked tough, Germany’s overall domestic reduction target was actually weakened during the negotiations.
Do you really get a ‘single price’ for carbon? The stated goal of the ETS is to reduce economic distortions by having a single price for emissions which ensures that emissions reductions are made in the cheapest way possible. This is obviously not the case at present but even if the EU moved to 100% auctioning within the ETS, the ETS carbon price does not cover the whole economy. The ETS does not even directly cover some large industries, like the production of chemicals, aluminium and minerals, coal mining, natural gas leaks, refrigeration and air conditioning, semi-conductor manufacture, food and drink, or oil and gas flaring. In the case of industries like aluminium it was felt that this would simply shift such production overseas. More importantly, the ETS does not cover the majority of the economy: the household sector, surface transport, agriculture etc.
§ Avoidability. Unlike alternative emissions reducing policies (e.g. subsidies for domestic renewables), the ETS would have a serious problem of avoidability even if the carbon price reached a significant level. Firms can move production to just outside the EU and then export their products into the EU having avoided ETS. While some plants and firms are clearly not mobile in this way, others will be.
The report on phase two of the ETS carried out for the Commission by McKinsey suggested that this would be a problem in several sectors. It noted that "The additional costs of about 17% on the marginal unit of steel production may create an incentive to shift marginal production into regions without those costs." It found that "the possibility of production shifts and CO2 leakage in the cement industry is real", and noted that the cost of the ETS to the industry “is roughly equal to freight costs from northern Africa or the eastern European countries outside the EU.” For aluminium production, even though it is not covered directly, "the probable large indirect cost increase resulting from the EU ETS is not covered by any free allowances. This might accelerate a migration of primary aluminium to countries with lower electricity cost."
ETS interacts with, and may cancel out, other climate policies. The ETS is not the only climate policy being pursued by governments and indeed it cannot be. Yet its interaction with other tax and subsidy policies has the potential to cancel out their intended effects. If for example, member states subsidise the large scale building of renewable power plants, then the effect will simply be to reduce the price of carbon in the system (and therefore increase emissions elsewhere). The goal of the ETS is to make efficiency gains by avoiding distortions – but other climate policies are at the same time effectively trying to pre-empt the operation of the market and artificially tilt investment in their favour. A whole range of other taxes, subsidies, and regulations mean that the goal of a completely undistorted market may be a mirage.
Don’t you need global emissions trading to have effective global action?
The attempt to create a global carbon market and a “global price for carbon” through trading is unlikely to be successful. International action should focus on setting tough and enforceable national targets for greenhouse gas reduction. How to reach those binding targets should be up to individual countries.
At present it is proving difficult to even agree the overall targets. Trying to also agree on the policies to meet them would be likely to impede agreement – particularly given that countries like China favour radically different approaches. An intergovernmental agreement is politically a more plausible successor to Kyoto than the creation of a single supranational trading system.
Notes for Editors
1) For more information please contact Neil O’Brien or Hugo Robinson on 0207 197 2333 or 07973 142775
