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Implications of the EU
Emissions Trading Directive
for UK Climate Policy


Steve Sorrell

Environment and Energy
Programme


January 2003




Research funded by the European
Commission under the project
Interaction in EU Climate Policy (INTERACT)
Acknowledgements
This research has been supported by the European Commission under the project Interaction
in EU Climate Policy (INTERACT).1 The INTERACT project is co-ordinated by SPRU
(Science and Technology Policy Research) at the University of Sussex, and involves partners
in France, Germany, Greece and the Netherlands. The project is studying the conflicts and
synergies between different climate policy instruments at the national and EU levels, with
particular reference to emissions trading. The present report forms one part of the UK case
study.


The author would like to thank the many individuals who gave up their time to be
interviewed for this project. These include representatives from the Department of Trade and
Industry, the Department of Environment, Food and Rural Affairs, the Confederation of
British Industry, UK electricity generators, manufacturing industry, and energy brokerage
and advisory companies. Thanks also to the attendees at a SPRU workshop on the
‘Implementation of the EU Emissions Trading Directive in the UK’, held in June 2001,
together with attendees at workshops on the same topic organised by the UK Carbon Trust
and the Ad Hoc Group on Energy Taxation Strategy (AHGETS). Finally, thanks to Adrian
Smith and Jos Sijm for helpful comments. The usual disclaimers apply.




1
    EVK2-2000-00613.
Contents
ACKNOWLEDGEMENTS ................................................................................................................................. I
CONTENTS ......................................................................................................................................................... II
TABLES AND FIGURES ................................................................................................................................. III
ABBREVIATIONS AND ACRONYMS ...........................................................................................................IV
EXECUTIVE SUMMARY ................. ERROR! BOOKMARK NOT DEFINED.ERROR! BOOKMARK NOT
DEFINED.
    CORE THEMES .................................................................................................................................................... VI
      Policy interaction and ‘double regulation ................................................................................................... vi
      Ownership of emissions and double counting .............................................................................................. vi
      Differential treatment and equivalence of effort ......................................................................................... vii
      Linking trading schemes and the fungibility of trading commodities.......................................................... vii
    CORE CHOICES IN UK CLIMATE POLICY ............................................................................................................VII
      The choice of policy objectives for each instrument: ................................................................................... ix
      The choice between upstream and downstream policy instruments ............................................................. ix
      The choice between direct and indirect treatment of electricity emissions .................................................. ix
      The choice to protect the domestic consumer. .............................................................................................. x
    POLICY RECOMMENDATIONS .............................................................................................................................. X
1. INTRODUCTION ............................................................................................................................................ 1
    1.1 THE EU EMISSIONS TRADING SCHEME ......................................................................................................... 2
    1.2 THE EU EMISSIONS TRADING SCHEME AND UK CLIMATE POLICY ............................................................... 5
    1.3 CORE ISSUES IN POLICY INTERACTION........................................................................................................... 6
       Policy interaction and double regulation ...................................................................................................... 6
       Ownership of emissions and double counting ............................................................................................... 7
       Differential treatment and equivalence of effort ........................................................................................... 7
       Linking trading schemes and the fungibility of trading commodities............................................................ 7
    1.4 ANALYSING INTERACTIONS .......................................................................................................................... 8
2. INTERACTION BETWEEN THE EU ETS AND THE UK CCL/CCLA PACKAGE ............................ 10
    2.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 10
    2.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 13
    2.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 13
    2.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 14
    2.5 POLICY OPTIONS ......................................................................................................................................... 16
    2.6 RECOMMENDATIONS ................................................................................................................................... 18
3. INTERACTION BETWEEN THE EU ETS AND THE UK ETS DIRECT PARTICIPANT SCHEME
.............................................................................................................................................................................. 19
    3.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 21
    3.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 21
    3.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 22
    3.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 22
    3.5 POLICY OPTIONS ......................................................................................................................................... 23
    3.6 RECOMMENDATIONS ................................................................................................................................... 24
4. INTERACTION BETWEEN THE EU ETS AND THE UK ETS PROJECT SCHEME ........................ 25
    4.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 25
    4.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 26
    4.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 26
    4.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 27
    4.5 POLICY OPTIONS ......................................................................................................................................... 28
    4.6 RECOMMENDATIONS ................................................................................................................................... 29
5. INTERACTION BETWEEN THE EU ETS AND THE UK IMPLEMENTATION OF THE IPPC
DIRECTIVE ....................................................................................................................................................... 30
    5.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 31
    5.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 32
    5.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 33
    5.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 33
    5.5 POLICY OPTIONS ......................................................................................................................................... 34
    5.6 RECOMMENDATIONS ................................................................................................................................... 35
6. INTERACTION BETWEEN THE EU ETS AND THE UK RENEWABLES OBLIGATION .............. 36
    6.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 36
    6.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 37
    6.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 38
    6.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 38
    6.5 POLICY OPTIONS ......................................................................................................................................... 40
    6.6 RECOMMENDATIONS ................................................................................................................................... 43
7. INTERACTION BETWEEN THE EU ETS AND THE UK ENERGY EFFICIENCY COMMITMENT
.............................................................................................................................................................................. 44
    7.1 COMPARISON OF INSTRUMENT SCOPE ......................................................................................................... 45
    7.2 COMPARISON OF INSTRUMENT OBJECTIVES ................................................................................................ 45
    7.3 COMPARISON OF INSTRUMENT TIMING ........................................................................................................ 46
    7.4 COMPARISON OF INSTRUMENT OPERATION ................................................................................................. 47
    7.5 POLICY OPTIONS ......................................................................................................................................... 47
    7.6 RECOMMENDATIONS ................................................................................................................................... 49
8. CHOICES IN UK CLIMATE POLICY ....................................................................................................... 50
    8.1 THE CHOICE OF POLICY OBJECTIVES FOR EACH INSTRUMENT ...................................................................... 50
    8.2 THE CHOICE BETWEEN UPSTREAM AND DOWNSTREAM POLICY INSTRUMENTS ............................................ 51
    8.3 THE CHOICE BETWEEN DIRECT AND INDIRECT TREATMENT OF ELECTRICITY EMISSIONS ............................. 52
    8.4 THE CHOICE TO PROTECT THE DOMESTIC CONSUMER .................................................................................. 53
9. SUMMARY ..................................................................................................................................................... 55
10. FURTHER READING ................................................................................................................................. 59
REFERENCES ................................................................................................................................................... 60


Tables and Figures
TABLE E.1 INTERACTION ISSUES FOR EACH OF THE SELECTED INSTRUMENTS .......................................................VII
TABLE E.2 SPECIFIC POLICY RECOMMENDATIONS .................................................................................................XII
TABLE 1.1 KEY ELEMENTS OF THE PROPOSED EU EMISSIONS TRADING SCHEME.................................................... 3
TABLE 1.2 THE NATURE OF THE INTERACTION BETWEEN UK POLICY INSTRUMENTS AND THE EU ETS .................. 9
FIGURE 2.1 OVERLAPS BETWEEN THE TARGET GROUPS FOR THE EU ETS, IPPC, CCL AND CCAS ....................... 11
TABLE 2.1 INCENTIVES FOR LOWER CARBON EMISSIONS FROM ELECTRICITY GENERATION ................................... 12
TABLE 2.2 CATEGORISING THE POTENTIAL INTERACTIONS BETWEEN THE EU ETS AND THE CCL/CCA PACKAGE
     .................................................................................................................................................................... 15
FIGURE 3.1 INTERNAL INTERFACES IN THE EU ETS .............................................................................................. 19
TABLE 3.1 COMPARISON OF THE UK ETS AND THE EU ETS................................................................................. 20
TABLE 3.2 FACTORS INFLUENCING THE FUNGIBILITY OF UK ETS AND EU ETS ALLOWANCES ............................ 24
TABLE 5.1 COMPARISON BETWEEN EMISSIONS TRADING AND IPPC. ..................................................................... 31
FIGURE 6.1 SUPPLY CURVE FOR RENEWABLES....................................................................................................... 39
FIGURE 6.2 COEXISTENCE OF THE RO AND THE EU ETS LEADS TO DOUBLE CREDITING ....................................... 40
TABLE 6.1 DEFINITIONS OF RENEWABLE ELECTRICITY UNDER DIFFERENT POLICY INSTRUMENTS ......................... 42
TABLE 9.1 INTERACTION ISSUES FOR EACH OF THE SELECTED INSTRUMENTS ........................................................ 55
TABLE 9.2 SPECIFIC POLICY RECOMMENDATIONS ................................................................................................. 57




                                                                                       iii
Abbreviations and acronyms
AAU      Assigned Amount Unit
CCL      Climate Change Levy
CCA      Climate Change Agreements
CDM      Clean Development Mechanism
CHP      Combined Heat and Power
DEFRA    Department of Environment, Food and Rural Affairs
DETR     Department of Environment, Transport and the Regions
DTI      Department of Trade and Industry
ECA      Enhanced Capital Allowance
EEC      Energy Efficiency Commitment
ERU      Emission Reduction Unit
ETS      Emissions Trading Scheme
EU ETS   EU Emissions Trading Scheme
EU       European Union
GHG      Greenhouse Gas
IET      International Emissions Trading
IPPC     Integrated Pollution Prevention and Control
JI       Joint Implementation
LCP      Large Combustion Plant
LEC      Levy Exemption Certificate
NETA     New Electricity Trading Arrangements
RO       Renewables Obligation
ROC      Renewables Obligation Certificate
SDC      Sustainable Development Commission
TGC      Tradable Green Certificate
UK ETG   UK Emissions Trading Group
UK ETS   UK Emissions Trading Scheme
UKCP     UK Climate Programme




                                      iv
Executive Summary
On the 10th December 2002, European environment ministers agreed the ground rules for an
EU-wide scheme for greenhouse gas emissions trading, thus paving the way for the largest
and most ambitious trading system yet seen. The design of the EU Emissions Trading
Scheme (EU ETS) represents a pragmatic compromise between economic efficiency and
political acceptability and has won the broad support of both industry lobbyists and
environmental groups. The Directive must still obtain the approval of the European
Parliament, but there appears a very good chance that it will come into force in January 2005
as planned.

This report explores the implications of the Directive for seven instruments within UK
climate policy:

   the Climate Change Levy (CCL);
   the Climate Change Agreements (CCA);
   the UK Emissions Trading Scheme (UK ETS) - direct participants;
   the UK Emissions Trading Scheme (UK ETS) - emission reduction projects;
   the Integrated Pollution Prevention and Control Directive (IPPC);
   the Renewables Obligation (RO); and
   the Energy Efficiency Commitment (EEC).

The main message of the report is that the Directive has major implications for the first four
of these instruments and non-trivial implications for the remaining three. Since these
instruments form the basis of the UK Climate Programme (UKCP), it follows that core
elements of that programme may need to changed. The UK government does not appear to
have fully acknowledged this and the implications of the Directive are only beginning to be
appreciated by relevant stakeholders and commentators.

Throughout the negotiation of the Directive, the strategy of the UK government has been to
secure opt-out provisions. But this strategy has only been partially successful. The Directive
allows only a portion of sectors to opt-out for only the first phase of the scheme (2005-2007).
In the absence of national opt-out provisions, a strategy for implementing the Directive in the
UK needs to be developed. This is likely to require changes to UK climate policy before 2005
and a major overhaul by 2008. None of this was anticipated when the UK Climate
Programme (UKCP) was developed or when key elements of this Programme, such as the
CCAs, were negotiated. There is a need, therefore, for a debate on the preferred shape of UK
climate policy into the first Kyoto commitment period (2008-2012) and beyond and on the
role of the EU ETS within the UK policy mix.

This report is closely linked to an earlier report: The Climate Confusion: implications of the
EU Emissions Trading Scheme for the UK Climate Change Levy and Climate Change
Agreements, which was published in November 2002 (Sorrell, 2002a). The present report
updates the conclusions of this earlier report to reflect the political agreement on the EU
Directive, as well as extending the analysis to five other UK policy instruments. The aim of
the report is to explore the nature of the issues that arise from the interaction between the EU
ETS and the selected climate policy instruments and to identify the ways in which conflicts


                                               v
can be avoided and synergies created. The report takes a structured approach to analysing
policy interaction, examining in turn:

 the scope of the instruments, where scope means the sectors, sites, portions of sites and
  individual emission sources that are directly or indirectly affected by each instrument;
 the objectives of each instrument and the extent to which these reinforce or conflict with
  one another;
 the timing of the instruments in relation to each other and the Kyoto commitment period;
  and
 the operation of each instrument and the interactions between them assuming that they
  exist in parallel.

For each instrument, one or more policy options are examined that could reduce the conflicts
and/or encourage synergies with the EU ETS. On the basis of this analysis, a number of
policy recommendations are made.


Core themes
The potential interaction between the EU ETS and UK climate policy raises four generic
issues:

Policy interaction and ‘double regulation
The issue here is the extent to which any apparent ‘double regulation’ will be seen as
imposing unfair burdens upon particular target groups. Double regulation may be loosely
defined as a situation where an individual target group is affected by two or more instruments
that have very similar objectives. While ‘double regulation’ is a negative term, there may be
many instances where the interaction between policy instruments may be either acceptable or
positively beneficial. To assess whether this is likely to be the case in any particular instance,
it is necessary to examine the multiple objectives of each instrument, the obligations and
incentives they place upon individual target groups, and the likely consequences in practice.

Ownership of emissions and double counting
The issue here is the ‘ownership’ and ‘control’ of carbon emissions and the problems that
arise if ownership is disputed. For example, the EU ETS gives the ownership of emissions
from electricity generation to power stations, while much of UK climate policy gives
ownership to electricity consumers. Ownership disputes may lead to: a) double coverage,
where two instruments give ownership of the same physical emissions to two separate parties,
(or to the same party under two separate terms); and b) double crediting, where disputing
claims over the ownership of emissions allow two separate carbon allowances or carbon
credits to be generated from a single abatement action. Each type of problem introduces
complexity into the regulatory situation and double crediting may threaten the environmental
integrity of an emissions trading scheme.




                                                vi
Differential treatment and equivalence of effort
The issue here is the extent to which different groups are treated differently by environmental
policy instruments and whether the obligations imposed upon one group can be deemed
equivalent to those imposed upon another. Differential treatment may be challenged on legal,
political or environmental grounds and is of central importance in the political debate over
climate policy. Demonstration of equivalence of effort may be required as a means to avoid
differential treatment when an installation, company, sector or Member State is exempted
from a particular policy instrument. But in practice, differences in the scope, form and
stringency of policy instruments may make equivalence of effort extremely difficult to assess.

Linking trading schemes and the fungibility of trading commodities
The issue here is the extent to which two trading schemes may be linked by the exchange of
environmental commodities. The transfer of environmental commodities between two
schemes will be governed by transfer rules, which may restrict movements in either direction
or discriminate between commodities according to their origin (e.g. disallowing carbon
credits from nuclear projects), together with exchange rules which establish the equivalence
of commodities with different denominations. The combination of transfer and exchange
rules defines the fungibility of the trading commodities - which means the extent to which the
commodity used for compliance with the first scheme can also be used for compliance with
the second. These rules will determine the scope for trading between the two schemes and the
consequences of such trading.

Table E.1 summarises the relevance of each of these themes for each of the instruments
examined.

Table E.1 Interaction issues for each of the selected instruments

Acronym      Double regulation    Double counting        Differential           Linking
                                                          treatment
CCL                 
CCAs                                                                            
UK ETS                                                                          
(DPs)
UK ETS                                                                            
(projects)
IPPC                                                         
RO                                                                               
EEC                                                                              



Illustrative problems
The following provides a number of examples of how these issues arise for individual
instruments.




                                              vii
Double regulation
 Electricity generators will incur abatement costs through participating in the EU ETS and
  will pass these on in electricity prices. Many electricity consumers are already paying the
  CCL, while others have targets for electricity consumption under their CCAs. These
  consumers will be effectively paying twice for the carbon emissions associated with
  electricity generation.
 Best Available Technology (BAT) regulation under IPPC is incompatible with emissions
  trading. BAT is frequently implemented through technology requirements rather than
  emission limits, but currently there is no provision for technology requirements to be
  relaxed for EU ETS participants.

Double counting
 A CCA facility that improves electricity efficiency can create allowances for sale in the
  UK ETS. At the same time, the corresponding reduction in electricity generation will ‘free
  up’ allowances held by the electricity generators in the EU ETS. Two allowances will then
  be circulating for a single abatement action.
 A similar problem arises in the UK ETS project scheme when a project is awarded carbon
  credits for improving downstream electricity efficiency. If these credits are subsequently
  traded into the EU ETS, the cap will be breached and the environmental integrity of the
  scheme will be undermined.

Equivalence of effort
 Some of the participants in the UK ETS are also eligible for the EU ETS. Since
  participation in both is likely to be unacceptable, these installations may seek to opt out.
  But subsidised abatement under the UK ETS is unlikely to be considered equivalent to
  mandatory targets under the EU ETS.
 A large number of CCA facilities may seek to opt out of the first Phase of the EU ETS.
  But equivalence of effort will be difficult to prove since the CCA targets are different in
  scope (coverage of emission sources), form (relative versus absolute targets) and
  stringency (economic versus technological potential) from the targets under the EU ETS.

Linking
 The Commission may prevent trading between the UK ETS and the EU ETS owing to
  concerns about non-CO2 gases, hot air and double crediting. But this would leave the UK
  market relatively small and isolated and UK companies would be unable to benefit from
  EU-wide trading.
 If the Commission wanted to preserve environmental integrity by preventing UK project
  credits from entering the EU ETS, it would have to prevent any trading between the UK
  and EU schemes. This is because restrictions on the import of carbon allowances
  according to origin can be very easily circumvented.




                                             viii
Core choices in UK climate policy
To resolve these problems, it will be necessary to re-examine four key choices within UK
climate policy:

The choice of policy objectives for each instrument
Double regulation may be considered acceptable where two instruments have different (if
overlapping) objectives. For example, the coexistence of the EU ETS with the RO may be
considered acceptable as the objectives of the latter go beyond CO2 abatement alone. But one
difficulty with UK climate policy is that some instruments (notably the CCL), have multiple
and partially conflicting objectives.

A core objective of any climate policy should be to ‘internalise the external cost of carbon
emissions’. But this may be subdivided into: a) internalising the cost of carbon in investment
and operational decisions; and b) ensuring that polluters pay for the damage caused by
residual emissions. Owing in part to pressure from the UK, the EU ETS uses free allocation
of allowances in Phase 1 (2005-2008) and allows a maximum of 10% of allowances to be
auctioned in Phase 2 (2008-2012). This means that, while the EU ETS can fulfil the first of
these two objectives it can make only a limited contribution to the second. In contrast, carbon
taxes can fulfil both objectives and can raise revenue which may substitute for other forms of
taxation (‘environmental tax reform’). These considerations are central to decision-making on
the future of the CCL and may override concerns about double regulation.

The choice between upstream and downstream policy instruments
Both emissions trading and carbon taxation can be implemented either upstream (on energy
suppliers) or downstream (on energy users). While both options have their pros and cons, the
EU ETS has constrained future policy by choosing a downstream scheme. Any attempts to
introduce upstream carbon taxes along the lines recently proposed by the Royal Society
(2002), will inevitably lead to double regulation for all fuel and electricity use by all
participants in the EU ETS. The cost implications of this will either be politically
unacceptable or will impose strict limits on the size of any upstream tax. But if UK climate
policy remains downstream, carbon prices are unlikely to be uniform for all sectors and fuels.

The choice between direct and indirect treatment of electricity emissions
Most of the incompatibilities between the EU ETS and UK climate policy stem directly from
their differing treatment of electricity. The EU ETS uses direct treatment of electricity
emissions, where the ‘ownership’ of electricity emissions is allocated to the electricity
generators, while UK climate policy uses indirect treatment, where ownership is allocated to
electricity consumers. Combining the two leads to repeated problems of double coverage and
double crediting. But it is important to distinguish between: a) situations where double
crediting is effectively cancelled out by double coverage (CCAs, direct participants); and b)
situations where the double crediting is not cancelled out (emission reduction projects, RO
and EEC). The first does not threaten the environmental integrity of the EU ETS, while the
second may do. A key challenge, therefore, is to find ways to mitigate this risk whilst
retaining the valuable incentives created by the UK policy instruments.




                                              ix
The choice to protect the domestic consumer
The incompatibilities between the EU ETS and UK climate policy can be traced back to the
choice to protect the domestic consumer from energy price increases. It is this which led the
government to choose indirect treatment of electricity for the CCL in order to shield fuel poor
consumers from electricity price rises. It follows that the elimination of fuel poverty is
necessary not only to curb emissions from the domestic sector, but also to rationalise climate
policy for other sectors. While the EU ETS will raise electricity price rises for domestic
consumers, the increase appears unlikely to be excessive when set in the context of a 26%
reduction in domestic electricity prices since 1995. Moreover, there are a number of options
available to compensate fuel poor households and to encourage greater investment in energy
efficiency in this sector. The EU ETS makes consideration of such approaches all the more
urgent. UK climate policy is likely to remain unnecessarily complex and inefficient until the
fuel poverty problem is eliminated.


Policy recommendations
Table E.2 summarises the policy recommendations made in this report. These
recommendations are based upon a number of principles including:

 Goals: The development of policy options should be based upon clear principles and long-
  term goals. For climate policy, a stable an effective policy framework is required during
  the Kyoto commitment period. This means that policy should be developed by working
  back from where we want to be in 2008.
 Carbon pricing: Energy users in all sectors should pay for carbon emissions, whether
  through taxation or emissions trading. In the long term, organisations in the public,
  commercial and industrial sectors should either be paying a carbon tax or participating in
  a trading scheme. Supplementary policies will be required to address other barriers to
  energy efficiency and to achieve other policy objectives (e.g. promoting renewables). But
  for each target group, only a single instrument should be used for carbon pricing.
 Electricity: The approach in the EU ETS is preferable because: first, it gives ownership of
  electricity emissions to the companies directly responsible for the control of those
  emissions, thereby incentivising both fuel switching and energy efficiency; and second, it
  facilitates cross-border electricity trade in the EU.
 Targets: Absolute targets are to be preferred over relative targets because of their greater
  environmental integrity and consistency with the national emission targets under Kyoto.
  And allowance based trading is to be preferred over baseline and credit trading due to its
  greater economic efficiency, lower transaction costs and consistency with the Kyoto
  framework. The EU ETS reflect these considerations while the CCAs do not. The latter
  should therefore be considered a transitional measure only.
 Supplementarity: There is a risk that abatement in the EU ETS will be achieved through
  purchasing cheap ‘hot air’ from outside the scheme, rather than through domestic action.
  But domestic abatement may be incentivised by either restricting the interface between the
  EU ETS and the international carbon market, or by retaining (or establishing) ‘backup’
  regulations for EU ETS participants. The first approach is preferable and there is a good
  chance that it will be adopted since the Commission is also concerned to restrict the import
  of ‘hot air’. Hence, ‘backup’ regulations should be abandoned as they are likely to



                                               x
  undermine economic efficiency, be more complex to administer and lead to additional
  costs for the target groups.

There are scope for debate over these principles and over the specific recommendations listed
in Table E.2. But the main point is to encourage wider recognition of the challenges that the
EU ETS poses to UK climate policy.




                                             xi
Table E.2 Specific policy recommendations

CCL/        the CCL should be removed from electricity, extended to all fossil fuels (replacing excise
CCAs         duties on oil products) and changed from a downstream energy tax to a downstream carbon
             tax;
            eligible installations should join the EU ETS and their existing CCA agreements should be
             terminated;
            CCA facilities not eligible for the EU ETS should renegotiate their agreements such that the
             targets relate to fuel consumption only;
            participants in the EU ETS should be exempt from the CCL; and
            trading between the CCAs and the EU ETS should be controlled by a Gateway before 2008,
             with no trading after that date.
UK ETS      the UK direct participant scheme should cease in 2006, with no further incentivised rounds;
(DPs)       trading between the direct participants and the EU ETS should be allowed during the two-year
             overlap period;
            further expansion of trading in the UK should be based upon opt-in provisions to the EU ETS
             (based on direct emissions only) and/or sectoral expansion of the EU ETS, together with the
             development of interfaces between the EU ETS and the project mechanisms; and
            participants in the EU ETS should be exempt from the CCL.
UK ETS      the UK should proceed with a small-scale pilot scheme only, with fuller development of the
Projects     project mechanism being linked to the development of ‘modalities’ for interfacing the EU
             ETS to JI and the CDM;
            the pilot scheme should be developed in consultation with the Commission, with the rules
             taking into account the concerns of the Commission, Parliament and other Member States
             about environmental integrity;
            the rules should be consistent with those for JI and CDM and both nuclear and sink projects
             should be excluded;
            no project should be undertaken at sites that may subsequently become eligible for inclusion
             in the EU ETS;
            double crediting should be accepted in the pilot phase, but with an aggregate ceiling on credit
             volumes to preserve environmental integrity; and
            the UK should work to ensure that the subsequent EU proposals are compatible with the UK
             scheme.
IPPC        the interpretation of IPPC energy efficiency requirements that is outlined in the ‘non-paper’
             and in UK guidance is sensible and should be retained;
            the Commission should specify in greater detail the recommended approach to non-CO2
             GHGs for those installations where BAT requirements are expressed as technical
             requirements rather than emission limits;
            the provisions in Article 25 should be extended to those installations and gases that are not
             listed in Annex I but have chosen to opt-in to the EU ETS;
            to avoid problems with ‘hot air’, the inclusion of non-CO2 GHGs in Phase 2 of the EU ETS
             should be based upon both accurate monitoring protocols and very strict criteria for allowance
             allocation;
            installations should not be allowed to opt-out of the EU ETS on the basis of ‘equivalent’ IPPC
             energy efficiency requirements, since these are not ‘national policies’ and in practice are
             unlikely to be strictly enforced.




                                                   xii
RO     the allocation of allowances to UK electricity generators should, as far as possible, take into
        account the renewables targets under the RO;
       during Phase 2, the EU ETS should either: allow one-way trading from schemes like the RO,
        using a similar framework to that adopted for the UK ETS; or encourage crediting projects for
        renewables through the development of suitable modalities for linking the EU ETS to project-
        based mechanisms;
       if the first approach is adopted, this should only apply to overcompliance which has been
        demonstrated by the acquisition of surplus TGCs;
       the small potential for double crediting within such an arrangement should be considered and
        acceptable price to pay for providing an additional incentive for overcompliance with
        renewables targets.
       the incentive for overcompliance should not be considered a substitute for other measures to
        encourage renewables deployment, such as more ambitious targets for renewables after 2010,
        greater flexibility in the banking rules for ROCs and removal of the non-price barriers to
        renewables deployment.
EEC    the allocation of allowances to UK electricity generators should, as far as possible, take into
        account the energy efficiency targets under the EEC, which means that the latter need to be
        agreed within the next 18 months;
       during Phase 2, the EU ETS should either: allow one-way trading from schemes like the EEC,
        using a similar framework to that adopted for the UK ETS; or (preferably) encourage crediting
        projects in this sector through the development of suitable modalities for linking the EU ETS
        to project-based mechanisms;
       the small potential for double crediting within such arrangements should be considered an
        acceptable price to pay for providing an additional incentive for overcompliance with
        domestic sector energy efficiency targets - but this should be kept under review;
       the exemption of the domestic sector from the UK project scheme should be removed; and
       the incentive for overcompliance should not be considered a substitute for other measures,
        such as introducing more ambitious targets for the EEC after 2005 and removing the non-price
        barriers to domestic sector energy efficiency.




                                              xiii
1. Introduction
This report explores the implications of the recently agreed EU Emissions Trading Directive
for seven instruments within UK climate policy. These are:

   the Climate Change Levy (CCL);
   the Climate Change Agreements (CCA);
   the UK Emissions Trading Scheme (UK ETS) - direct participants;
   the UK Emissions Trading Scheme (UK ETS) – emission reduction projects;
   the Integrated Pollution Prevention and Control Directive (IPPC);
   the Renewables Obligation (RO); and
   the Energy Efficiency Commitment (EEC).

The main message of the report is that the Directive has major implications for the first four
of these instruments and non-trivial implications for the remaining three. Since these
instruments form the basis of the UK Climate Programme (UKCP), it follows that core
elements of that programme may need to changed. The UK government does not appear to
have fully acknowledged this and the implications of the Directive are only beginning to be
appreciated by relevant stakeholders and commentators. For example, organisations such as
the Green Alliance (Ekins et al, 2002) and the Royal Society (Ash et al, 2002) have
advocated replacing the CCL with a carbon tax, but these organisations have paid little
attention to how such changes may fit alongside the EU Directive.

Throughout the negotiation of the Directive, the strategy of the UK government has been to
secure opt-out provisions. But this strategy has only been partially successful. The Directive
allows only a portion of sectors to opt-out for only the first phase of the scheme (2005-2007).
In the absence of national opt-out provisions, a strategy for implementing the Directive in the
UK needs to be developed. This may involve rather larger changes to existing policy
instruments than many groups had anticipated. And as with any such changes, this creates
both risks and opportunities.

This report is closely linked to an earlier report: The Climate Confusion: implications of the
EU emissions trading scheme for the Climate Change Levy and Climate Change Agreements,
which was published in November 2002. The present report updates the conclusions of this
earlier report to reflect the political agreement on the EU Directive that was reached in the
Environment Council meeting on the 10th of December 2002. It also extends the analysis to
five other UK policy instruments, including the UK Emissions Trading Scheme and the
Renewables Obligation, and draws some general conclusions on the future of UK climate
policy.

The remainder of this section introduces the EU Directive and the relevant instruments in UK
climate policy, outlines some of the issues that the Directive raises, and provides an overview
of how policy interaction may be analysed. The following six sections explore the potential
interactions between the EU ETS and the selected policy instruments in turn. Each section
uses a structured approach, examining the scope, objectives, timing and operation of the
instruments, and identifies and assesses some of the available policy options. Section 8
identifies the key choices within UK climate policy that are responsible for the


                                               1
incompatibilities with the EU ETS, while the final section summarises the policy
recommendations for each instrument and provides an overall assessment of the implications
of the Directive for the UK.


1.1 The EU Emissions Trading Scheme
On the 10th December 2002, European environment ministers agreed the ground rules for an
EU-wide scheme for greenhouse gas emissions trading, thus paving the way for the largest
and most ambitious trading system yet seen. The proposed Directive will now be sent to the
European Parliament for a second reading in Spring 2003, with remaining differences to be
resolved through conciliation between the Presidency and the Parliament during Summer
2003. The Directive should be adopted in late 2003, which means that there is a good chance
that the scheme will come into force in 2005 as planned.

The design of the EU Emissions Trading Scheme (EU ETS) represents a pragmatic
compromise between economic efficiency and political acceptability. The final text
accommodates the concerns of key Member States such as Germany and has won the broad
support of both industry lobbyists and environmental groups. There is much work still to be
done, notably in devising acceptable allocation rules at the national level. But the key
elements are now in place for a historic leap forward in the implementation of market-based
environmental instruments.

The EU ETS is a ‘cap and trade’ scheme, along the lines of the US Acid Rain Program
(Sorrell and Skea, 1999). It will initially cover some 45% of EU CO2 emissions, and as the
EU is enlarged and more sectors and gases are brought into the scheme, it will cover an
increasingly large proportion of total Annex I emissions under the Kyoto Protocol.
Participants in the scheme include electricity generators, oil refineries and energy intensive
manufacturing installations in sectors such as iron and steel, paper and minerals. Each
participant will be allocated a number of allowances each year on the basis of a range of
criteria, including the technological potential to reduce emissions. On the 30th of April each
year, each participant will be required to surrender a quantity of allowances equal to its
emissions in the preceding calendar year. Participants with high abatement costs will be able
to cover their emissions by purchasing additional allowances, while those with low abatement
costs will be able to reduce emissions and sell their surplus allowances for a profit. The
Commission estimates that the scheme will reduce total abatement costs by some 35%,
leading to cost savings of some 1.3 billion Euros/year by 2010. The main features of the
scheme are summarised in Table 1.1.




                                              2
Table 1.1 Key elements of the proposed EU Emissions Trading Scheme

                        Phase 1: 2005-2007
Timing
                        Phase 2: 2008-2012 (i.e. the first Kyoto Protocol commitment period).
Type of target          Absolute targets for all facilities.
                        All combustion plant >20MW thermal input, including electricity generators
                        Oil refineries, coke ovens, non-ferrous metals, cement clinker, pulp from timber,
                         glass and ceramics
Sectors included
                        Based on IPPC, but many IPPC sectors excluded (e.g. chemicals, food and drink,
                         waste incineration)
                        Sites below IPPC size thresholds in eligible sectors may also be included
                        4000-5000 installations
Size of market
                        45% of EU carbon dioxide emissions
                        Free during Phase 1 with national allocation plans based on Commission
                         guidelines
Allocation
                        Member States have the option to auction up to 10% of allowances in Phase 2
                        The Commission retains the right of veto over national allocation plans
                        Only CO2 in Phase 1
                        Other gases may be included in Phase 2, provided adequate monitoring and
Greenhouse Gases
                         reporting systems are available and provided there is no damage to
                         environmental integrity or distortion to competition
Links with Kyoto        Emission credits from JI and CDM projects to be recognised, subject to
mechanisms               ‘modalities’ to be adopted by the EU by 2005
                        Agreements with third parties listed in Annex B of the Kyoto Protocol may
Links with other
                         provide for the mutual recognition of allowances between the EU ETS and other
schemes
                         schemes
Monitoring
                        Common monitoring, verification and reporting obligations to be elaborated.
Reporting
                        Verification through third-party or government authority.
Verification
Allowance               Linked/harmonised national registries with independent transaction log.
tracking                To be based on Kyoto Protocol registry guidelines and US Acid Rain Program.
                        Phase 1: 40 Euro/tonne penalty
Compliance
                        Phase 2: 100 Euro/tonne EU
                        Banking across years within each compliance period
Banking                 Member States can determine banking from first compliance period (2005-2007)
                         to first Kyoto Protocol commitment period (2008-2012).
Review of system
                        Review in 2006.
design
Source: CEC (2002)

The Directive was the subject of intense negotiation and the Commission found it necessary
to compromise in several areas in order to secure political agreement. The issues that have
caused the greatest difficulty are as follows:

 Opt-outs (Article 25a): The Commission intended the scheme to be mandatory, but this
  was opposed by the UK and Germany who were seeking to protect their existing
  negotiated agreements with manufacturing industry. The final text allows Member States
  to apply to the Commission for the exclusion of installations and ‘activities’ (interpreted as
  sectors) during Phase 1 of the scheme (2005-2007), but with mandatory participation
  being required in Phase 2 (2008-2012). Opt-outs will only be permitted if installations can
  demonstrate that they will, as a result of national policies, limit their emissions by as much
  as would be the case if they were subject to the requirements of the Directive



                                                     3
    (‘equivalence of effort’). Equivalence is also required in the monitoring, reporting and
    verification requirements and in the penalties for non-compliance.
   Opt-ins (Article 23a): Several Member States pressed for opt-in provisions that would
    allow non-eligible installations to voluntarily join the scheme. Opt-in provisions have been
    included in the final text, but only for Phase 2 of the scheme. These are subject to approval
    by the Commission, taking into account the effect on environmental integrity, competition
    and the internal market.
   Sectoral coverage (Annex I): The sectoral coverage of the Directive is based on that of the
    IPPC Directive, but a large number of IPPC sectors and sub-sectors are excluded -
    including chemicals, food and drink, non-ferrous metals and waste incineration. A number
    of Member States considered that the sectoral coverage was inadequate, but proposals for
    expanding the coverage met with strong opposition, particularly from Germany who
    wanted to ensure that the chemicals sector remained outside the scheme. However, Article
    26 allows the Commission to propose the inclusion of additional activities (i.e. sectors) by
    31 December 2004, and to review this issue in the context of an overall review of the
    Directive which is required by 30 June 2006.
   Gas coverage (Article 23a): The UK was one of several Member States who argued for
    the scheme to be extended to other greenhouse gases (GHGs). The Commission opposed
    this on the grounds that monitoring protocols were inadequate. But Article 23(a) allows
    other GHGs to be included in the scheme during Phase 2, on identical terms to the opt-in
    provisions discussed above. In addition, Article 26 allows the Commission to propose the
    inclusion of additional gases in Phase 1 by 30 December 2004. Hence, the inclusion of
    other GHGs during Phase 1 remains a possibility.
   Allocation (Article 9 and Annex III): The choice between free allocation and auctioning
    proved highly contentious, with disagreement between the Commission and the European
    Parliament. The final text requires free allocation during Phase 1, while Member States are
    allowed (but not required) to auction up to 10% of allowances during Phase 2. Concerns
    over international competitiveness may dissuade Member States from auctioning, while
    the 10% ceiling is restrictive and will reduce the economic efficiency of the scheme.
    Allocation plans must be drawn up by Member States and are subject to approval by the
    Commission. The Commission will draw up allocation criteria by 31 December 2003, but
    allocation must be consistent with: national burden sharing targets and progress towards
    meeting those targets; national energy and climate change policies; other EC policy
    instruments; the technological potential of the installation to reduce emissions; and state
    aid and internal market rules. This mixture of top-down and bottom-up requirements could
    be very difficult to interpret and disputes over allocation could well lead to delays.
   Compliance (Article 16): The compliance provisions have been weakened from earlier
    proposals, by reducing the compliance penalty for Phase 1 from 50Euros/tCO2 to
    40Euros/tCO2 (£27/tCO2) and by removing the qualifier ‘…or twice the market price,
    whichever is higher’. In Phase 2, the compliance penalty increases to 100Euros/tCO2
    (£66/tCO2). These penalties place a ceiling on allowance prices and marginal abatement
    costs, which for Phase 1 is relatively low.
   Pooling (Article 25b): Germany secured the inclusion of an additional provision which
    allows installations to form an emissions Pool. Here, a single authority (e.g. a sector
    association) takes on all the responsibility for issuing, trading and surrendering allowances
    for all members of the Pool. This provision, which was designed to protect the German
    negotiated agreements, provides for ‘joint and several’ liability for installations within a
    sector and creates incentives for free riding: i.e. installations that make efforts to reduce


                                                4
  emissions may be subsidising competitors that do not. Pooling has analogies with some
  existing arrangements for the UK CCAs but will require a very coherent sector to be
  successful. It is permitted for both Phase 1 and Phase 2.
 Interfaces (Article 24 and Article 26): Article 24 allows agreements to be concluded with
  third parties to allow for the mutual recognition of allowances between the EU ETS and
  third party trading schemes. The third party must have ratified the Kyoto Protocol, which
  would exclude (at present) trading with the US. Article 26 indicates that links between the
  EU ETS and the project-based mechanisms (JI and CDM) are desirable, and promises a
  proposal on the ‘modalities’; governing such links during 2003. If successful, this should
  allow for the use of CDM credits in the EU ETS during Phase 1. The exclusion of credits
  from sink and nuclear projects is likely, but given the fungibility of international carbon
  commodities after 2008, such rules may be difficult to apply. The relationship between the
  EU ETS and international emissions trading (IET) after 2008 will be addressed in the
  review promised for 2006. This issue is of particular importance, as a combination of the
  withdrawal of the US from Kyoto, the surplus ‘hot air’ in the allocations to Russia and the
  Ukraine, and the generous sink provisions negotiated at Marrakesh has created the
  possibility of very low carbon prices after 2008. In this context, any interface between the
  EU ETS and the international carbon market could reduce the EU ETS allowance price
  and substitute allowance purchase for domestic abatement.


1.2 The EU Emissions Trading Scheme and UK Climate
Policy
Over the last three years, the UK has developed a complex, elaborate and interdependent set
of climate policies which are intended to deliver both its Kyoto obligations and its domestic
target of a 20% reduction in CO2 emissions by 2010. Some elements of this policy mix, such
as the Climate Change Levy (CCL), represent a significant political achievement given the
strength of industrial opposition, while others, such as the UK Emissions Trading Scheme
(UKETS) and the Renewables Obligation (RO), are important and innovative policy
experiments. This policy mix is now fully operational, delivering emission reductions and
attracting interest from around the world. But much of it is fundamentally incompatible with
the EU ETS.

The UK government is now faced with a choice between either accepting the coexistence of
the EU ETS with UK climate policy, or replacing or modifying a number of policy
instruments only a couple of years after they were introduced. The first option leads to double
regulation, complexity and additional cost burdens for affected groups, while the second
implies changing a complex and finely balanced policy mix which took several years to
negotiate and which, in the case of Climate Change Agreements (CCAs), was anticipated to
remain stable until 2013. Neither option is attractive and both will attract opposition. The
extent of disruption will depend on the nature of the changes that are proposed, but to date
there has been very little consideration of the specific options available.

The report explores the nature of the issues that arise from the interaction between the EU
ETS and selected climate policy instruments in the UK. It seeks to identify the ways in which
conflicts can be avoided and synergies created, primarily through modifying the design and
implementation of the UK policy instruments. The discussion represents a summary of the



                                               5
more detailed analysis that has been conducted under the project Interaction in EU Climate
Policy (INTERACT)2 and builds on that in the earlier report The Climate Confusion.3

The December agreement on the EU ETS has made an analysis of this type all the more
important. Even with the inclusion of opt-out provisions in Phase 1, the Directive is likely to
require changes to UK climate policy before 2005. Moreover, with the absence of opt-out
provisions for Phase 2, a major overhaul of UK climate policy is likely to be required by
2008. None of this was anticipated when the UK Climate Programme (UKCP) was developed
or when key elements of this Programme, such as the CCAs, were negotiated. The EU
Directive has driven a coach and horses through UK climate policy and could lead to
substantial adjustment costs as a result. There is a need for a strategic debate on the preferred
shape of UK climate policy into the first Kyoto commitment period (2008-2012) and beyond
and on the role of the EU ETS within the UK policy mix. This report aims to make an
contribution to such a debate.


1.3 Core issues in policy interaction
The potential interaction between the EU ETS and UK climate policy raises four generic
issues:

     interaction and double regulation;
     ownership of emissions and double counting;
     differential treatment and equivalence of effort; and
     fungibility of trading commodities.

These issues are central importance when assessing the potential impact of the EU ETS and
will be referred to repeatedly in each of the following sections. Each issue is briefly
introduced below.

Policy interaction and double regulation
The issue here is the extent to which any apparent ‘double regulation’ will be seen as
imposing unfair burdens upon particular target groups. Double regulation may be loosely
defined as a situation where an individual target group is affected by two or more instruments
that have very similar objectives. While ‘double regulation’ is a negative term, there may be
many instances where the interaction between policy instruments may be either acceptable or
positively beneficial. To assess whether this is likely to be the case in any particular instance,
it is necessary to examine the multiple objectives of each instrument, the obligations and
incentives they place upon individual target groups, and the likely consequences of the
double regulation in practice. For example, taxing the fuel used by a participant in an
emissions trading scheme may be opposed in principle as it raises overall abatement costs,
distorts the operation of the allowance market and potentially leads to a subsidy of competing
firms that are participating in the trading scheme but are not subject to the tax. But if either
the level of the tax or the price of allowances are very low, and are expected to remain low
for the foreseeable future, the coexistence of the two instruments may be considered

2
    http://www.sussex.ac.uk/spru/environment/research/interact.html
3
    http://www.sussex.ac.uk/spru/environment/research/ccfr.pdf


                                                        6
acceptable in order to enhance the incentives for downstream energy efficiency. This is an
inefficient and second-best alternative to tightening the emissions cap or restricting the
import of ‘hot air’ into the trading scheme, but may nevertheless be a pragmatic and sensible
response given real-world constraints on UK and EU climate policy.

Ownership of emissions and double counting
The issue here is the ‘ownership’ and ‘control’ of carbon emissions and the problems that
arise if ownership is disputed. ‘Ownership’ here is defined as the right to make use of a
portion of the atmospheric commons as a sink for carbon emissions, and it includes the right
to make use of, appropriate the returns from and (in the case of emissions trading) sell a legal
asset such as a carbon allowance. The EU ETS gives full ownership of the emissions from
electricity generation to power stations, while much of UK climate policy effectively gives
the ownership of a portion of these emissions to electricity consumers. The ‘control’ that
these two groups can exercise over these emissions is very different. For example, electricity
generators have full and direct control over the carbon intensity of electricity generation but
only indirect and partial control over electricity demand.

Ownership disputes may fall into two categories: a) double coverage, where two instruments
give ownership of the same physical emissions to two separate parties (or to the same party
under two separate terms); and b) double crediting, where disputing claims over the
ownership of emissions allow two separate carbon allowances or carbon credits to be
generated from a single abatement action. Each type of problem introduces complexity into
the regulatory situation and double crediting may threaten the environmental integrity of an
emissions trading scheme.

Differential treatment and equivalence of effort
The issue here is the extent to which different groups are treated differently by environmental
policy instruments and whether the obligations imposed upon one group can be deemed
equivalent to those imposed upon another. Differential treatment may be challenged on legal,
political or environmental grounds and is of central importance in the political debate over
climate policy. Demonstration of equivalence of effort may be required as a means to avoid
differential treatment when an installation, company, sector or Member State is exempted
from a particular policy instrument. But in practice, differences in the scope, form and
stringency of policy instruments may make equivalence of effort extremely difficult to assess.

Linking trading schemes and the fungibility of trading commodities
The issue here is the extent to which two trading schemes may be linked by the exchange of
environmental commodities. The rapid development of GHG emissions trading at the
national, regional and global level has led to increasing interest in linking trading schemes,
but there is a risk that the resulting improvements in economic efficiency will be achieved at
the expense of environmental integrity. At the same time, the growth of Tradable Green
Credit (TGC) schemes for renewable electricity and (in the UK) trading schemes for energy
efficiency has created the possibility of linking schemes with different types of trading
commodity. The transfer of environmental commodities between two schemes will be
governed by transfer rules, which may restrict movements in either direction or discriminate
between commodities according to their origin (e.g. disallowing carbon credits from sink
projects), together with exchange rules which establish the equivalence of commodities with


                                               7
different denominations. The combination of transfer and exchange rules defines the
fungibility of the trading commodities - which means the extent to which the commodity used
for compliance with the first scheme can also be used for compliance with the second. These
rules will determine the scope for trading between the two schemes and the consequences of
such trading.


1.4 Analysing interactions
For any policy instrument, it is useful to distinguish between directly and indirectly affected
target groups. A directly affected target group has obligations and incentives imposed upon it
directly by a policy instrument, while an indirectly affected target group is influenced in
some way by the behavioural changes that are made by a directly affected target group. So
for example, electricity generators are directly affected by the EU ETS, while electricity
consumers are indirectly affected as they face higher electricity prices as a consequence of
the abatement costs incurred by the electricity generators. Indirect effects permeate
throughout the economy. But in this report, attention is confined to the indirect impact of
policy instruments on the electricity market, as it is here that the greatest difficulties lie.

The potential interactions between the EU ETS and individual UK climate policy instruments
may then be classified as follows

 Direct interaction: where the target groups directly affected by the EU ETS overlap in
  some way with those directly affected by the UK policy instrument.
 Indirect interaction: where either:
   the target groups directly affected by the EU ETS overlap with the target groups
     indirectly affected by the UK policy instrument (or vice versa); or
   the target groups indirectly affected by the EU ETS overlap with the target groups
     indirectly affected by the UK policy instrument.
 Trading interaction: where the target groups affected by two policies are, or could be,
  linked by the exchange of an environmental trading commodity, such as a carbon
  allowance or tradable green credit (TGC).

Table 1.2 lists the seven policy instruments examined in this report and indicates the type of
interaction between each of these instruments and the EU ETS. In each case, more than one
type of interaction is relevant.




                                               8
Table 1.2 The nature of the interaction between UK policy instruments and the EU ETS

Category            Instrument                        Acronym      Direct      Indirect   Trading
Carbon/ energy      Climate Change Levy                 CCL                      
taxes
Negotiated          Climate Change Agreements          CCAs                               
agreements
Emissions trading   UK Emissions Trading Scheme        UK ETS                             
                    - direct participants               (DPs)
Emissions trading   UK Emissions Trading Scheme        UK ETS                             
                    – projects                        (projects)
Industrial          Integrated Pollution Prevention     IPPC                     
pollution control   and Control Directive
Support for         Renewables Obligation                RO                                
renewables
Promotion of        Energy Efficiency Commitment        EEC                                
energy efficiency

The following sections summarise the potential interactions between the EU ETS and each of
these instruments in turn. More detailed analysis may be found in the reports listed in section
10. The analysis assumes that the EU ETS is implemented while the existing instruments
remain unchanged. In practice, this may be very unlikely for several of the instruments
(particularly the CCAs), but it provides a useful framework for identifying the relevant
issues. In each section, the following issues are examined in turn:

 the scope of the instruments, where scope means the sectors, sites, portions of sites and
  individual emission sources that are directly or indirectly affected by each instrument;
 the objectives of each instrument and the extent to which these reinforce or conflict with
  one another;
 the timing of the instruments in relation to each other and the Kyoto commitment period;
  and
 the operation of each instrument and the interactions between them assuming that they
  exist in parallel.

Each section pays particular attention to the generic issues identified in section 1.3.

Following the interaction analysis, one or more policy options are examined that could reduce
the conflicts and/or encourage synergies between the selected policy instruments and the EU
ETS. Given that the EU ETS is now relatively finalised, most of these options relate to
modifying the UK policy instruments. On the basis of this analysis, some brief policy
recommendations are made.




                                                 9
2. Interaction between the EU ETS and the UK
CCL/CCA package
The Climate Change Levy (CCL) and Climate Change Agreements (CCAs) need to be
analysed together as they form a package. The CCL is a downstream, revenue-neutral energy
tax for business, commerce and the public sector. It is levied on coal, gas and electricity use,
with oil products, CHP fuel and renewable electricity being exempt. The indirect treatment of
electricity was chosen to avoid electricity price increases for low income households, while
an energy tax was chosen over a carbon tax to protect the UK coal industry. Both decisions
have influenced the entire shape of the UKCP and have created serious compatibility
problems with the EU ETS.

The CCAs run until 2013 and give energy intensive industry exemption from 80% of the
CCL, provided they take on binding targets for energy efficiency or carbon emissions. In
practice, most sectors have adopted relative targets (e.g. energy use per unit of output), based
upon a percentage of the estimated cost effective energy efficiency potential. The penalty for
failing to meet the targets is a return to paying 100% of the CCL. Eligible sites are those
located in sectors which are regulated under IPPC, and include many sites which lie below
the IPPC size threshold. Some sites in non-IPPC sectors (e.g. horticulture) are also included

The potential interactions between the EU ETS and an unchanged CCL/CCLA package are
complex. Both the CCL and the CCAs directly interact with the EUETS, and there is
substantial indirect interaction in relation to electricity emissions. Since the CCAs incorporate
baseline and credit trading arrangements as part of the UK ETS, there is also scope for
trading interaction. The interactions are explored in detail in Sorrell (2002b). This section
summarises the main conclusions of that report and updates them to allow for the outcome of
the Environment Council meeting.


2.1 Comparison of instrument scope
The scope of both the CCAs and the EU ETS is based on that of the IPPC Directive. But
despite this, there are considerable differences at four levels:

 Sectoral coverage: Differences in the sectoral coverage of the CCL, CCAs, IPPC and EU
  ETS suggest that individual sites in the public, commercial, manufacturing and energy
  sectors may face one of ten combinations of the four instruments (Figure 2.1).
 Site coverage: Differences in the coverage of individual technologies within an individual
  site expands the number of possible combinations of instrument coverage from ten to
  eighteen. The differences relate in particular to the coverage of combustion plant and
  process plant emissions and to the size of the main combustion plant.
 Emissions coverage: Further complications are introduced by the differences in coverage
  of CO2 versus other GHGs, combustion versus non-combustion CO2 emissions, and
  combustion emissions from different fossil fuels.
 Electricity coverage: A final layer of complexity is provided by the differing incentives
  each instrument creates for reducing emissions from electricity generation. Each
  instrument gives a different mix of direct and indirect incentives to both the supply and
  demand side of the electricity market, with the result that each instrument incentivises a

                                               10
  different mix of abatement options (Table 2.1). Particular complications are introduced by
  the inconsistent treatment of electricity from various renewable sources.

Figure 2.1 Overlaps between the target groups for the EU ETS, IPPC, CCL and CCAs




                                        1         CCL
                            2
                                8       7


            3           9                     EU ETS

           IPPC
                                10       6

                          4
                                                  CCLAs
                                         5




                                             11
Table 2.1 Incentives for lower carbon emissions from electricity generation

                          Measure                   IPPC                    EU ETS                      CCL                     CCA
Supply     side   Switch to generation                -                   Direct via ESI                 -                       -
incentives          from lower carbon                                     emissions cap
                         fossil fuel
                     Improve thermal          Direct via energy           Direct via ESI                  -                        -
                       efficiency of        efficiency provisions         emissions cap
                         generation
                   Invest in nuclear or                -                  Direct via ESI                  -                        -
                        large hydro                                       emissions cap
                       Invest in new                   -                  Direct via ESI        Indirect via increased             -
                  renewable generation                                    emissions cap              demand from
                          sources                                                               consumers who have
                                                                                                switched to gain CCL
                                                                                                      exemption
Demand side         Purchase electricity               -                Indirect via price      Direct by exemptions               -
incentives         from new renewable                                   advantage of zero         for new renewable
                          sources                                       carbon electricity             electricity
                    Purchase electricity               -                         -                          -                      -
                    from nuclear, large
                  hydro or lower carbon
                       fossil sources
                  Improve efficiency of       Direct via energy      Indirect via electricity     Direct via CCL on           Direct via
                         electricity        efficiency provisions     price increases from       electricity purchases   energy/carbon targets
                        consumption                                         generators
                       Invest in CHP           Direct via energy     Indirect via electricity Direct via exemptions            Direct via
                                             efficiency provisions   price increases (ESI);          for CHP fuel        energy/carbon targets
                                            and encouragement of         offset by direct                                 and requirements to
                                                     CHP                requirement for                                  assess CHP potential
                                                                     additional allowances
                                                                          for CHP fuel
                                                                           (consumer)
Note: The table shows the additional incentives created by the CCA targets. CCA sites still pay 20% of the CCL.



                                                                              12
2.2 Comparison of instrument objectives
The core objective of the three instruments is the same, but they differ in terms of their
relative stringency and the importance they give to various subsidiary objectives

The stringency of the EU ETS is at present unclear and the proposed allowance allocation
criteria include both top-down and bottom up elements which are potentially contradictory.
But there is a possibility that the targets required under the EU ETS will be more stringent
than those currently applicable under the CCAs, quite apart from the fact that these will be
absolute, rather than relative targets. This has important implications for either the use of
CCA targets as a basis for allocation in the EU ETS, or the use of opt-in and opt-out
provisions within the EU ETS at the sector or installation level.

The stringency of the EU ETS will be determined in the first instance by the size of the
overall cap relative to the overall abatement cost curve. But an important complication is the
possibility of interfacing the EU ETS to other trading schemes or to the Kyoto mechanisms
after 2008. In the likely context of low carbon prices after 2008, any interface between the
EU ETS and the international carbon market could have the effect of reducing the EU ETS
allowance price and substituting allowance purchase for domestic abatement.

The design of the CCL/CCA package reflects multiple explicit and implicit objectives,
including the desire to protect domestic consumers, energy intensive industry, and UK coal
producers, together with promoting energy efficiency and avoiding a ‘windfall’ to nuclear
generators. These objectives explain the choice of a downstream rather than upstream tax and
the choice of an energy rather than carbon tax. Each of these objectives is threatened by the
introduction of the EU ETS. The Directive will disadvantage coal-fired electricity generation
and accelerate its decline, raise electricity prices for household consumers, including the fuel
poor, and improve the economics of nuclear power. The political importance of each of these
objectives has changed since the CCL was introduced and is likely to have changed further
by 2005 or 2008. This may make the introduction of the EU ETS easier than it would have
been a few years ago. In particular, given the problems currently faced by the UK nuclear
industry, a nuclear ‘windfall’ may now be positively helpful to government objectives.


2.3 Comparison of instrument timing
The EU ETS is in phase with the Kyoto commitment period, but is due to begin well before
the CCAs end. In contrast, the CCAs extend beyond the end of the Kyoto commitment
period, but targets are only negotiated up to 2010. The CCAs also include emissions trading
provisions as part of the UK ETS, but at present this does not extend beyond 2006.

The situation is simplified somewhat by the inclusion of opt-out provisions in the EU ETS, as
these may allow many of the existing CCAs to continue unchanged up to 2008. But since opt-
outs require demonstration of equivalence of effort, it is likely that the UK electricity
generators and other sectors such as oil refineries will need to join the scheme in 2005 since
these have no ‘equivalent’ regulations. The inclusion of the electricity generators creates a
host of problems for the CCL/CCA package, as a consequence of the resulting double
regulation and double coverage/crediting of electricity emissions. Furthermore, it is far from
clear that retaining the existing CCAs can be considered equivalent to participating in the EU
ETS, owing to substantial differences in the scope, form and stringency of the CCA and EU
ETS targets. As a consequence, it is possible that the partial opt-out provisions included in
the EU ETS will create almost as many problems for the UK is having no opt-out provisions
at all. And the absence of opt-out provisions after 2008, make it inevitable that major changes
will be required to the CCL/CCA package well before the planned end date of the
agreements.


2.4 Comparison of instrument operation
Coexistence of EU ETS with an unchanged CCL/CCLA package appears very unlikely. The
interactions in a coexistence scenario differ between target groups and include:

 price-price interactions: where the indirect impact of the EU ETS on electricity prices is
  additional to the direct price impact of the CCL;
 price-target interactions: where the indirect impact of the EU ETS on electricity prices is
  additional to the direct impact of a target under the CCAs;
 target-price interactions: where the direct impact of an emissions target under the EU ETS
  is additional to the direct price impact of the CCL;
 target-target interactions: where the direct impact of a target under the EU ETS is
  additional to the direct impact of a target under the CCAs.

It is useful to distinguish four categories of target group in the public, commercial and
manufacturing sectors, identified by the combination of instruments for which they are
eligible:

   Group 1: CCL only
   Group 2: CCL and EU ETS;
   Group 3: CCA only;
   Group 4: CCA and EU ETS

Table 2.2 categorises the potential interactions for each of these four groups.
Table 2.2 Categorising the potential interactions between the EU ETS and the CCL/CCA
         package

Type of                     EU ETS               CCL/CCA                           Category
interaction                                       package
price - price            indirect price          direct price                 Group 1 electricity
price - price                                                                 Group 2 electricity
price - target           indirect price          direct target                Group 3 electricity
                                                                              Group 4 electricity
target - price            direct target          direct price                     Group 2 fuel
target - target           direct target          direct target                    Group 4 fuel
no interaction                  -                      -                          Group 1 fuel
                                -                      -                          Group 3 fuel

The scale and consequences of each interaction depends upon a range of factors, the most
important of which is the allowance price in the EU ETS. If the allowance price is high,
double regulation could lead to substantial economic impacts for affected groups and create
pressure to modify the CCL/CCA package - although the compliance provisions provide an
allowance price (marginal abatement cost) ceiling of £27/tCO2 during Phase 1. Conversely, if
the allowance price is very low, the economic consequences of the double regulation could be
relatively small and therefore acceptable. Under certain assumptions,4 an allowance price of
£10/tCO2 would increase average electricity prices by 0.46p/kWh, which is equivalent to the
current level of the CCL on electricity.

Of similar importance is the underlying trends in industrial energy prices. For example, gas
prices increased by 18% in real terms between 1995 and 2001, while electricity prices fell by
23%. Recent reductions in wholesale electricity prices have created a crisis in electricity
generation and there seems little prospect that electricity prices will increase substantially in
the near future.

In a context of low energy prices and low allowance prices, there may be some appeal in
retaining some of the CCL/CCA package unchanged, in order to maintain downstream
incentives to improve energy efficiency (the ‘backup’ scenario). For example, the
continuation of the CCL may be considered acceptable in order to incentivise electricity
efficiency, even though it leads to ‘double regulation’ of electricity for all non-CCA sites (i.e.
electricity prices increase as a result of the generators participating in the EU ETS, but
electricity is also subject to the CCL). This would also ensure the continuation the revenue
raising functions of the CCL. A portion of this remedy is used to fund other climate policy
initiatives, such as Enhanced Capital Allowances (ECAs).

Allowance auctioning in the EU ETS could provide an alternative source of revenue to the
CCL, but the final text rules out auctioning for Phase 1 and imposes a 10% ceiling on


4
  Namely: a) the trading scheme is introduced overnight without companies having the opportunity to change
behaviour; b) the full costs of meeting the emission target are passed on to consumers through electricity price
rises, with none being be passed on to suppliers or absorbed through lower returns; and c) the impact on
electricity prices is independent of the method of allowance allocation (Sorrell, 2002a).
auctioning for Phase 2.5 This means that the EU ETS cannot substitute for the revenue raising
objectives of the CCL. In the absence of allowance auctions, there is no revenue-neutral
mechanism to compensate electricity consumers for the price rises resulting from the
participation of the electricity generators in the EU ETS. Since the CCL has encountered
substantial political opposition, despite being revenue-neutral overall, the possibility of
uncompensated electricity price rises could prove very unpopular. In theory, the increase in
electricity prices will be solely a function of marginal abatement costs and will be
independent of the method of allowance allocation (Sorrell, 2002a). But the EU ETS differs
from the CCL in that the price impacts on electricity are indirect, relatively hidden and (at
present) highly uncertain.

The CCAs have trading provisions as part of the UK ETS. The participation of electricity
generators in the EU ETS, combined with the continuation of these trading provisions will
lead to double coverage and associated double crediting of electricity emissions. These
problems only result from increases above or reductions below the CCA target and from
changes in the emissions intensity of electricity use (Sorrell, 2002). This means that some
emissions increases/reductions will be double covered/credited and some not. Overall, this
double coverage/crediting will not threaten the environmental integrity of either the EU ETS
or the CCAs, but will introduce complexity and confusion into the regulatory situation as a
result of a conflict over the ownership of electricity emissions.

The use of relative targets in the CCAs also means that output growth could increase the total
number of allowances in circulation. If trading were allowed between the UK ETS and EU
ETS, this would create a danger of inflation in the number of EU ETS allowances with a
corresponding risk of violating the EU ETS emissions cap. Such problems could be avoided
through the use of a Gateway arrangement to interface the CCAs to the EU scheme.


2.5 Policy options
The CCL/CCA package may be modified in a number of ways to reduce the negative impacts
of interaction. The most obvious modifications represent combinations of the following
variables:

 CCL: a) remove the CCL on electricity; b) change the CCL to a downstream carbon tax.
 CCA: a) opt-out eligible CCAs from the EU ETS; b) replace eligible CCAs with the EU
  ETS; c) shift the remaining CCAs to fuel only.
 Trading interface between CCAs and EU ETS: a) interface via a Gateway; b) prevent
  trading between the two schemes.

In addition, the appropriate mix of policy options may differ between Phase 1 and Phase 2.

The options are described in detail in Sorrell (2002b). Nearly all of the options offer an
improvement on the coexistence scenario. Similarly, the majority of options improve both
economic efficiency and political acceptability, while reducing environmental effectiveness.



5
    Auctioning is voluntary in Phase 2 and the UK is unlikely to take up the option.
Article 25a of the Directive allows opt-outs at the installation or sector level. This is not
equivalent to a national opt-out, since sectors such as electricity generation will find it
impossible to demonstrate equivalence of effort. If electricity generators join the EU ETS,
double regulation of electricity for sites eligible for the CCL would be unavoidable unless the
CCL is removed from electricity. Similarly, CCA installations that have opted out or are not
eligible to join the EU ETS6 will also have double regulation as these will face electricity
price rises at the same time as having a target for their electricity consumption. This
undermines the rationale for adopting the targets in the first place, particularly if the CCL is
removed from electricity. Installation level opt-outs may also create complications if some
installations within a sector chose to join the EU ETS, while others chose to continue with
their existing CCAs.

If the CCL is removed from electricity, there are benefits to be gained by going one step
further and changing it to a carbon tax. The tax could be extended to oil products and could
replace excise duties since these no longer have an economic rationale. The impact on the
industrial coal market would be relatively small, since most coal is consumed by CCA
companies which are exempt from 80% of the CCL.

The attraction of opting-out is to minimise abatement costs. Movements out of the EU ETS
cap (by high cost participants) should lower allowance demand, lower allowance prices,
reduce marginal abatement costs and bring abatement cost within the cap closer to those
outside. Opt-outs make the EU ETS more acceptable to industry and certain Member State
governments, but the disadvantages include reducing the environmental effectiveness of the
scheme and increasing administrative costs. Differential treatment via opt-outs could distort
competition either between or within Member States. The demonstration of equivalence of
effort could also prove problematic owing to substantial differences in:

 Scope: The EU ETS and CCAs cover different emission sources in different ways.
 Form: Relative targets (CCAs) are not equivalent to absolute targets (EU ETS) because: a)
  absolute targets gives certainty in the environmental outcome, while relative targets do
  not; b) absolute targets give scope for auctioning and revenue raising while relative targets
  do not; and c) relative targets act as a subsidy on production, leading to higher emissions
  for the same level of marginal abatement cost (Gielen et al, 2002).
 Stringency: The basis on which CCA and EU ETS targets are derived and the process
  through which they are developed is different. Current CCA targets appear relatively weak
  and may fall short of the allocation criteria listed in the Directive (Sorrell, 2002a).

In contrast to opt-outs, allowing opt-ins to the EU ETS has a number of advantages,
particularly if combined with restrictions on the fungibility of EU ETS and UK ETS
allowances. But the text agreed at December meeting restricts opt-ins to Phase 2 (Article
23a). The exception is sites in sectors that are covered by the EU ETS but which fall below
the IPPC size threshold. These sites, most of which have CCAs, can choose to join the
scheme before 2008. In practice, however, relatively few of them are likely to chose to do so.

While a range of policy options are available, the basic choice is between, on the one hand,
giving priority to economic efficiency by allowing the EU ETS to operate relatively

6
 This is an important group. It includes sites in the non ferrous, chemicals and food and drink sectors, together
with sites in other energy intensive sectors which are eligible for a CCA but not eligible for the EU ETS. These
account for a large proportion of total industrial energy use.
unhindered; or on the other hand, giving priority to environmental effectiveness by retaining
‘backup’ regulations to incentivise domestic abatement. The second option may be attractive
if EU ETS allowance prices are anticipated to be low, but forecasts of future allowance prices
are speculative and depend in part upon assumptions about the interface between the EU ETS
and the international carbon market after 2008.

Beyond 2008, eligible CCA installations have no choice but to join the EU ETS. This will
require renegotiation of targets, as the EU ETS applies to direct emissions only. This means
that the CCA electricity targets will be lost, unless these installations are prepared to accept
double regulation. The loss of these targets may run counter to UK policy objectives as there
are reasons to believe that downstream targets can be more effective in incentivising
electricity efficiency than indirect price rises.7 Pooling arrangements will be available to
CCA installations, but these are unlikely to be attractive as they could lead to cross subsidy of
competitors.


2.6 Recommendations
If restrictions are placed on the interface between the EU ETS and the international carbon
market, the following recommendations can be made (Sorrell, 2002a):

 the CCL should be removed from electricity, extended to all fossil fuels (replacing excise
  duties on oil products) and changed from a downstream energy tax to a downstream
  carbon tax;
 eligible installations should join the EU ETS and their existing CCA agreements should be
  terminated;
 CCA facilities not eligible for the EU ETS should renegotiate their agreements such that
  the targets relate to fuel consumption only;
 participants in the EU ETS should be exempt from the CCL; and
 trading between the CCAs and the EU ETS should be controlled by a Gateway before
  2008, with no trading after that date.




7
 ETSU (2001) estimate that the CCAs will deliver 2.5MtC annual reductions by 2010, compared to 4MtC if ‘all
cost effective measures’ were adopted. In contrast, ETSU estimate that the reductions resulting from the price
effect of the CCL on its own (i.e. with no agreements and no associated discounts) would be only 0.25MtC.
3. Interaction between the EU ETS and the UK
ETS direct participant scheme
The UK Emissions Trading Scheme (UK ETS) is a voluntary, pilot scheme, jointly developed
by government and business, which began in January 2002 and is intended to run until 2006
(KOKO). The government is providing £43m/year over five years as an inducement for
companies to join the scheme and to adopt absolute emission targets. Electricity generators
are excluded since the scheme uses indirect treatment of electricity, and participants continue
to pay the CCL. The UK ETS is complex and allows for three forms of participation:

 direct participants: voluntary participation in a cap and trade scheme, encouraged by the
  financial incentive;
 CCA: baseline and credit trading by companies with a CCA; and
 project: generation of credits from emission reduction projects in the UK.

As indicated in Figure 3.1, trading between the direct participants and those CCAs with
relative targets is governed by the provisions of the Gateway (Sorrell, 2001).

Figure 3.1 Internal interfaces in the EU ETS




            UK ETS internal interfaces
       CCLA relative
          sector                 allowances

                                                Direct Particpants
                                                  with absolute
                   Gateway
                                                      targets



       CCLA absolute
          sector
                                                 Project credits
                       credits


The differences between the EU ETS and UK ETS are summarised in Table 3.1. The
discussion in this section is confined to the direct participants, while section 4 discusses the
proposed project scheme.
Table 3.1 Comparison of the UK ETS and the EU ETS

                 UK ETS                                                                     EU ETS
                  1st period 2002-2006                                                      Phase 1 2005-2007
Timing
                  No guarantee of 2nd period, but review in 2005.                           Phase 2: 2008-2012.
                  Absolute targets for direct entrants.
Target                                                                                         Absolute targets for all participants.
                  Absolute or relative targets for CCA participants.
                  All industrial sectors eligible except power generation.                    Combustion plant >20MW, including generators
Sectors
                  Transport, landfills, households exempt.                                    Subset of IPPC sectors, but excluding chemicals, food and drink and
included
                                                                                                waste incineration
                    34 direct entrants (~ 1 MtC-reductions over 5 years)                      4000-5000 installations
Size of market
                    Much larger number of CCA businesses (~ 2.5 MtC/year).                    45% of EU carbon dioxide emissions
                                                                                               Free during Phase 1. Member States have the option to auction up to
                    Financial incentive (auction) for direct entrants
Allocation                                                                                      10% of allowances in Phase 2
                    Negotiated energy saving targets through CCAs.
                                                                                               Commission retains the right of veto over national allocation plans
                                                                                               Only CO2 in Phase 1
                    All six GHGs.                                                             Other gases may be included in Phase 2, provided adequate
GHGs
                    Non-CO2 sources require development of monitoring protocols.               monitoring and reporting systems are available and provided there is
                                                                                                no damage to environmental integrity or distortion to competition
                    Intention to allow UK companies to trade internationally during 1st
Links with                                                                                     Emission credits from JI and CDM projects to be recognised, subject
                     commitment period.
IET/JI/ CDM                                                                                     to ‘modalities’ to be adopted by the EU by 2005
                    Possibility of using CDM credits before 2008.
Links with          Mutual recognition between UK and other national trading authority        Commission may conclude agreements with third parties to allow
other schemes        would be necessary.                                                        mutual recognition of allowances
Monitoring/
                    Guidelines prepared for using methodologies and reporting emissions.      Common monitoring/verification/reporting obligations to be
Reporting/
                    Baselines and annual reporting to be verified by third party.              elaborated. Verification through third-party or government authority.
Verification
                    Allowances tracked by electronic registry.
Allowance                                                                                      Linked/harmonised national registries with independent transaction
                    Registry to evolve into Kyoto Protocol registry in 2008.
tracking                                                                                        log, based on Kyoto Protocol registry guidelines.
                    Gateway will limit transfers from relative to absolute sector.
                    Loss and repayment of financial incentive for direct participants.
                                                                                               40 Euro/tonne penalty across EU.
Compliance           Statutory penalties to be introduced.
                                                                                               Increased to 100 Euro/tonne after 2008
                    CCA participants have a separate compliance procedures.
                    Unlimited banking until the end of 2007.                                  Banking across years within each compliance period
Banking             Banking into 2008 only allowed for reductions from absolute sector        Member States can determine banking from first compliance period
                     made by businesses themselves (no buy to bank).                            (2005-2007) to commitment period (2008-2012).
There is a small degree of overlap between the direct participants in the UK ETS and the
sources eligible for the EU ETS (direct interaction), together with indirect interaction related
to the treatment of electricity. There is also the possibility of trading allowances between the
two schemes.


3.1 Comparison of instrument scope
Participation in the UK ETS is on a voluntary basis, subject to qualifying requirements.
Thirty four companies have joined the scheme, securing annual emission reductions of
4MtCO2e by 2006, of which half is from non-CO2 GHGs. Participants are from a diverse
range of sectors and the nine largest companies are responsible for over 90% of the total
reductions.

There is very little overlap between the 34 direct participants and the sites eligible for the EU
ETS. This is because first, most of the direct participants are in sectors which are not eligible
for the EU ETS (e.g. chemicals); and second, of those participants which are eligible, the
emission sources covered by the UK ETS are mostly different from those covered by the EU
ETS.8 Two exceptions are the non-combustion emissions from cement production at one site
and the emissions from >20MW combustion plant at a small number of direct participant
sites which are not already covered by a CCA. In other words, there is potential double
regulation of only a proportion of direct emissions at less than 10% of the direct participant
sites.

There is a more significant overlap in the ~1MtC emissions from electricity consumption at
all the direct participant sites, since these are directly covered by the EU ETS and indirectly
covered by the UK ETS. These emissions are subject to double regulation, with associated
double coverage and crediting.


3.2 Comparison of instrument objectives
The UK ETS is both a voluntary scheme and a secondary element of the UKCP. In contrast,
the EU ETS is intended to be mandatory and is considered essential for EU compliance with
the Kyoto Protocol. The objectives in establishing a trading scheme are different for the UK
and EU, in that the UK is well on course to meet its burden sharing target while on current
trends the EU is heading for non-compliance.

The UK ETS was intended to provide the UK with an early mover advantage in emissions
trading, with benefits such as learning by doing, accelerating institutional developments such
as the allowance Registry, and enabling the City of London to become an international centre
for emissions trading. Similar ‘soft’ benefits are expected at an EU-level from the EU ETS,
although the Directive has the additional objective of avoiding distortions to competition.
However, the incompatibilities between UK ETS and EU ETS has led the UK to negotiate
opt-out provisions for Phase 1. This means that many UK companies could be excluded from
EU-wide trading in Phase 1, or at best be subject to trading restrictions. In other words, the
8
 For example, the EU ETS excludes non-CO2 GHGs, while the UK ETS includes all six GHGs. Similarly direct
participants in the UK ETS cannot include emissions that are already covered by a CCA on the same site and
which may be eligible for the EU ETS. The latter are still included in the UK ETS, however, via the baseline
and credit trading arrangements for the CCAs.
EU ETS has made the UK’s early start in trading look more like a false start. Worse still, the
UK has sought to stall and distort the implementation of the EU ETS in order to protect its
own more limited scheme.


3.3 Comparison of instrument timing
The first period of the UK ETS ends in December 2006, and at present the government has
made no commitment to further incentivised rounds. There is therefore a two-year overlap
between Phase 1 of the EU ETS and the UK ETS. Delays in introducing the EU ETS could
reduce this to one year or zero, although in the latter case Phase 1 may be abandoned
altogether. There are questions regarding the links between the two schemes during the
overlap period and also the future of the direct participant scheme beyond 2006. If the UK
ETS ends in 2006 and if most direct participants are unable to join the EU ETS until 2008,
the learning experience gained through the UK ETS is likely to be lost. Conversely, if the UK
ETS continues beyond 2006, it will remain a limited and isolated scheme unless trading links
can be established with the EU ETS.


3.4 Comparison of instrument operation
Coexistence of the UK ETS with the EU ETS leads to double regulation of a small proportion
of the direct emissions from UK ETS participants, since these are covered by both schemes.
As Phase 1 opt-outs are allowed, these sites could choose to remain in the UK ETS and retain
their financial incentive but, since subsidised abatement is very different from mandatory
targets, there may be considerable difficulties in demonstrating equivalence of effort. The
attractions of opting-out will depend upon a range of factors, including the fungibility of UK
ETS and EU ETS allowances. If these sites chose not to opt-out (or were unable to), they
would need to join the EU ETS and relinquish their financial incentive and UK ETS
responsibilities, with a consequent (limited) effect on the remaining UK ETS market. This
option may also (unfortunately) involve splitting these installations into EU ETS and residual
UK ETS components (e.g. CO2 emissions in EU ETS and non-CO2 emissions in UK ETS).

Coexistence of the two schemes also leads to double regulation of electricity for direct
participants, analogous to the price-target interactions for the CCAs. Electricity prices will
increase as a consequence of the generators joining the EU ETS and incurring abatement
costs and this price increase will be additional to the UK ETS targets which indirectly cover
electricity emissions. Furthermore, since (unlike the CCAs) UK ETS participants continue to
pay the CCL, there is effectively triple regulation of electricity at these sites. As before, the
consequences of this will depend upon trends in energy and allowance prices, but should be
independent of the method of allowance allocation in the EU ETS.

Coexistence also leads to double coverage of electricity emissions and associated double
crediting. Assuming: a) all allowances are used to cover emissions; and b) all UK ETS
participants (including the CCAs) have absolute targets; an increase/decrease in electricity
consumption by the direct participants will lead to an increase/decrease in emissions from the
electricity generators and a corresponding decrease/increase of twice the size in the total
emissions covered by the UK ETS and EU ETS combined. In effect, the double crediting will
be cancelled out by the double coverage (Sorrell, 2002a). Since total emissions will remain
less than or equal to the sum of the allowance caps in the two schemes, overall environmental
integrity will be maintained. In practice, most CCA participants in the UK ETS have relative
targets, which creates the risk that emissions will increase. But this is a consequence of
having relative targets, and not of the double crediting. Nevertheless, the dispute over the
ownership of emissions does create a confused situation, which will be made worse if trading
of allowances is permitted between the two schemes.


3.5 Policy options
The primary options are, first, to allow direct participants to opt-in to the EU ETS, and
second, to allow fungibility between UK ETS and EU ETS allowances (‘linking’ the trading
schemes).

Following the December 2002 agreement, direct participants will only be allowed to opt-in to
the EU ETS after 2008.9 Since this is after the end of the UK scheme (2006), these sites may
have a two-year period in which they have no opportunity to trade. Conversely, if the UK
scheme is extended beyond 2006, it could run into difficulties if some of its participants
chose to leave in 2008 and join the EU ETS.

The advantages of opting-in include widening the scope of the EU ETS, increasing allowance
supply, lowering allowance prices and bringing marginal abatement costs down (most direct
participants would be net sellers). The disadvantages include increased administrative costs
and the risk of injecting (possibly subsidised) hot air into the scheme. The motivation for
opting-in is likely to be either low cost abatement through allowance purchase, or (more
likely) higher prices for allowance sales. If the Commission wished to avoid double
coverage/crediting of electricity emissions, any opt-ins would need to be on the basis of
direct emissions only. The incentive to opt-in to the EU ETS would also be increased if there
were no fungibility between UK ETS and EU ETS allowances.

The pros and cons of linking trading schemes is the subject of a growing literature (Haites
and Mullins, 2001; Baron and Bygrave, 2002). In this particular case, the situation is greatly
complicated by the uncertainties over timing and the complex structure of the UK scheme.
Table 3.2 provides a summary of some relevant issues. For the period 2005-2006, the
advantages of linking appear to outweigh the risks - although it is questionable whether it is
worth the transaction costs involved. Linking beyond 2006 and into the commitment period
may be more problematic however. The latter may be considered if there is a continuation of
the direct participant scheme beyond 2006, and will also be relevant to the UK project
scheme and to the CCAs.




9
    Unless UK is successful in gaining their participation through the ‘review’ provisions in Article 26
Table 3.2 Factors influencing the fungibility of UK ETS and EU ETS allowances

Factor                 Issues
Allocation method      Direct participants have a competitive advantage through the financial incentive. But
                       the majority do not compete with the sectors covered by the EU ETS. Also, the UK
                       scheme was given state aids clearance and the relatively small number of direct
                       participants may reduce equity concerns.
Absolute versus        To protect environmental integrity, a Gateway mechanism would be needed to govern
relative targets       trade between the CCAs with relative targets and the EU ETS. But no such restrictions
                       are needed for trade with direct participants.
Coverage of GHGs       The EU would need to approve the UK monitoring protocols. As with the financial
                       incentive, allowing direct participants, but not EU ETS participants, to credit non-CO2
                       GHGs gives the former a competitive advantage. There may also be concerns regarding
                       the potential ‘hot air’ associated with the non-CO2 GHGs in the UK scheme.
Monitoring,            The protocols should be broadly compatible in the two schemes
reporting,
verification
Registry               The registries should be broadly compatible in the two schemes
Compliance             At present, there are no financial penalties in the UK ETS, but the possibility of losing
                       the financial incentive provides a strong incentive to comply. Furthermore, statutory
                       penalties are proposed for the UK scheme which are broadly equivalent to those in the
                       EU ETS. So this is unlikely to be an obstacle.
Banking                Both schemes allow unrestricted banking prior to 2008. The UK scheme restricts
                       banking beyond 2008, but this is consistent with the EU ETS proposals.
Treatment of           There is a conflict over the ownership of a small proportion of the emissions from
electricity            electricity generation, with consequent problems of double coverage and double
                       crediting. Since the first cancels out the second, the overall environmental integrity of
                       the two schemes is not threatened. But the situation is confused and may not be
                       acceptable to the Commission.
Source: Irving, 2002


3.6 Recommendations
 the UK direct participant scheme should cease in 2006, with no further incentivised
  rounds;
 trading between the direct participants and the EU ETS should be allowed during the two-
  year overlap period;
 further expansion of trading in the UK should be based upon opt-in provisions to the EU
  ETS (based on direct emissions only) and/or sectoral expansion of the EU ETS, together
  with interfaces between the EU ETS and the project mechanisms;
 participants in the EU ETS should be exempt from the CCL;
4. Interaction between the EU ETS and the UK
ETS project scheme
The project based component of the UK ETS is analogous to JI and CDM, but at a national
level. Organisations will be encouraged to invest in emission reduction projects at sites not
covered by the direct participant scheme or the CCAs, and will use these projects to generate
credits which may be sold into the UK ETS. As with JI and CDM, the projects must generate
emission reductions which are additional to those which would have taken place in the
absence of the project scheme. The determination of additionality and the associated
calculation of emission baselines is highly complex and technical (Begg et al, 2002a-d). The
inherent uncertainty of counterfactual emission baselines creates incentives to free ride and to
inflate estimates of the emission reductions achieved, but developing safeguards to prevent
this may increase transaction costs and discourage investors from proposing projects.

There has been extensive consultancy work on the project scheme (Begg et al, 2002a-d) and
the government has announced its intention to go ahead with a pilot phase beginning in May
2003 (DEFRA, 2002). A cautious approach has been adopted in view of both the uncertainty
surrounding the EU ETS and the novelty and technicality of the scheme. In particular, a
quantitative ceiling has been proposed (but not yet defined) for the volume of credits allowed
in the pilot phase. This is important, as banking credits into the commitment period implies
allocating part of the UK's assigned amount to project developers - making it particularly
important that the emission reductions are additional. To date, there has been relatively little
interest from project developers, partly as a consequence of the low carbon price in the UK
ETS.

There appears to be some limited potential for direct interaction between the project scheme
and the EU ETS if projects are undertaken at installations eligible for the EU ETS. There is
also indirect interaction related to the treatment of electricity and the possibility of trading
project credits into the EU ETS. The Commission is proposing to ‘develop modalities’ for
importing JI and CDM credits into the EU ETS. Although UK projects are different from
JI/CDM projects, this may provide a potential route for interfacing the UK project scheme.
The compatibility between the UK scheme and these proposed rules is therefore crucial. At
present, the Commission does not appear to have any plans for an EU-wide project scheme
comparable to that in the UK.


4.1 Comparison of instrument scope
The government has identified five priority ‘sectors’ for emission reduction projects -
electricity supply, CHP, built environment (excluding the domestic sector), methane
abatement (including landfill gas and coal mine methane) and transport – and has also
indicated that projects in other areas will be considered.

This list creates a very wide range of possibilities. In all cases, there are potential interactions
with other climate policy instruments that may require, fund, support or encourage emission
reduction projects, and these may be relevant to the determination of additionality and/or the
calculation of emission baselines. As a result, the potential interactions with the EU ETS are
just one aspect of a highly complex picture (Sorrell and Smith, 2002).
Electricity supply was originally proposed as a priority sector, then withdrawn, then
reinstated. Possible hosts for projects include fossil fuel plants, transmission and distribution
networks and nuclear plant. Energy efficiency at fossil fuel plants was the subject of a major
consultancy study (Mott MacDonald, 2001), but this would lead to double regulation if the
plant subsequently entered the EU ETS. The nuclear industry would like to gain credits for
the life extension of nuclear plant, but this is a politically sensitive issue and may create
difficulties for interfacing the project scheme to the EU ETS. Nuclear projects also have the
potential to generate very large numbers of credits.

If the electricity generators are in the EU ETS, any projects that improve the efficiency of
electricity consumption will lead to double crediting. The project developer gains a credit for
avoided electricity emissions, while the reduced electricity demand ‘frees up’ allowances
owned by the generators. Two allowances are then circulating for only one tonne of emission
reduction.

Projects in the domestic sector are excluded from the scheme on the grounds that their
inclusion could make it more costly for electricity and gas suppliers to meet their Energy
Efficiency Obligation (section 7). This seems a very weak argument given the economic
potential for energy efficiency in this sector and it is unlikely that similar restrictions will be
included in any proposals for project mechanisms at the EU level.


4.2 Comparison of instrument objectives
The UK’s objectives in developing the project scheme include incentivising cost effective
abatement opportunities which lie outside the coverage of the CCAs and direct participant
scheme, facilitating institutional developments in areas such as monitoring and verification,
gaining experience with crediting arrangements to facilitate subsequent engagement in JI and
the CDM, and influencing the subsequent development of project rules at the EU level.

The Commission’s approach is more cautious, owing to concerns about environmental
integrity. The Commission proposes to allow interfaces with JI and CDM from 2005 onwards
(‘subject to modalities to be agreed…’), but there has been only limited consideration of the
role of project mechanisms within the EU. It is possible that the Commission will allow UK
projects to interface to the EU ETS on the same basis as JI and CDM projects, but restrictions
may be placed on project types, additionality provisions and crediting rules. For example,
both the Commission and the European Parliament have indicated their opposition to credits
from sink or nuclear projects. Given both the current lack of interest and the difficulties in
developing suitable rules for project mechanisms, it is very unlikely that the Commission will
propose an EU project scheme before Phase 2 of the EU ETS.


4.3 Comparison of instrument timing
The uncertainties over both the EU ETS and the UK ETS create difficulties for the project
scheme and could deter developers from proposing projects. There is a risk that the UK will
repeat the experience with the direct participant scheme and turn a first mover advantage into
a first mover disadvantage. UK rule-making is taking place prior to final agreement on the
EU ETS and before the Commission has begun work on the rules for interfacing to JI/CDM.
Projects are intended to begin in 2003, before the EU ETS begins, and to continue well after
2006 when the current direct participant scheme comes to an end. The value of credits after
2006 will depend upon a range of factors, including the continuation (if any) of the direct
participant scheme, the extent to which eligible CCA facilities join the EU ETS, the nature of
the trading arrangements for the remaining CCAs, the fungibility of UK ETS and EU ETS
allowances, and the rules for interfacing projects to the EU ETS.

If there is no continuation of the direct participant scheme beyond 2006, and if the
Commission refuses to allow UK project credits to be sold into the EU ETS, the market for
credits after 2006 could be limited. Buyers will be confined to CCA installations that are
either ineligible for the EU ETS or have opted out. If the Commission allows project credits
to be imported after 2008, then pre-2008 credits could be banked - provided, again, that the
Commission allows this. To give confidence to project developers, the government has
indicated that the crediting period for most projects will extend to 2012. But this confidence
may be unwarranted, given the uncertainties indicated above. Also, credit prices during the
commitment period will be influenced by developments in the international carbon market
and could be relatively low. Proposing projects in this context will be a highly risky venture
and developers are only likely to do so if the estimated value of the credit stream makes only
a marginal contribution to project economics - which in turn could make it less likely that the
project is additional.


4.4 Comparison of instrument operation
There is a risk of double regulation if projects are undertaken at sites which subsequently join
the EU ETS. Take for example a project involving co-firing natural gas at a coal-fired power
station. Reductions below the coal-fired baseline would generate credits. But if the plant
subsequently joined the EU ETS, it would need to obtain allowances for its CO2 emissions,
with the allocation being measured from some historical baseline which may be before or
after the introduction of co-firing, or may straddle it. A single plant would then be both
requiring allowances and generating credits at the same time. Entry into the EU ETS may
trigger a revision in the project baseline or even invalidate the further generation of credits.
Hence, unless the UK government can provide some guarantees, developers would be foolish
to propose projects on such sites.

As with the CCAs and direct participants, any project that improves electricity efficiency will
lead to double crediting of the avoided emissions from electricity generation. But in contrast
to the double crediting associated with the CCAs and direct participants, double crediting of
projects will not be not balanced by associated double coverage. If there were no trading
between the project scheme and the EU ETS, the environmental integrity of the latter would
be maintained but the UK would need to allow for the double crediting in its climate
programme. If there were trading between the two schemes, the environmental integrity of
the EU ETS would be undermined. The EU could introduce restrictions on the import of
project credits, but the these could easily be circumvented if there were trading links between
the UK ETS and EU ETS - for example, a direct participant could purchase project credits,
and then sell surplus allowances into the EU ETS instead.10 Differences in banking rules
between Member States could similarly be circumvented. This implies that, if the
Commission considers the threat to environmental integrity posed by the double crediting to

10
  Proposals were made to restrict the purchase of project credits by the CCAs in the UK ETS, but these were
eventually dropped because they were so easy to circumvent (Sorrell, 2001).
be unacceptable, the inclusion of the project scheme in the UK ETS could prevent any trading
of allowances between this and the EU ETS.

The feasibility of trading project credits into the EU ETS may also depend upon the
comparative stringency of the UK project rules and the criteria subsequently adopted by the
EU. If the EU rules are more stringent than the UK rules, this could lead to the modification
of UK project baselines and to the disallowing of some or all of the anticipated project
credits. As with the direct participant scheme, developing the UK project rules in advance of
the EU rules may create a hostage to fortune.


4.5 Policy options
A simple option to avoid the above problems would be to abandon the UK project scheme
altogether and rely on the subsequent development of project mechanisms at the EU level.
But the government has now promised a pilot scheme and substantial work on the project
rules has been undertaken. These rules are certain to precede the development of a
comparable project scheme at the EU level. Hence, an abandonment of the UK project
scheme could result in a lost opportunity to incentivise emission reduction projects at an early
stage.

An option to avoid double crediting would be to restrict the scope of the project scheme to
direct emissions. But this would greatly reduce the potential of the scheme in high priority
sectors such as the built environment and remove a potentially valuable instrument for
promoting downstream electricity efficiency. The issue here is the relative effectiveness of
indirect electricity price increases versus downstream crediting schemes in encouraging
electricity efficiency. This is analogous to the choice between indirect price increases and
downstream targets in the CCAs and the UK ETS. The UK government's view is that price
signals alone are relatively ineffective, given the range of other barriers that inhibit energy
efficiency, which leads to a preference for downstream, target-based instruments. This view
has much to commend it and is one factor explaining the indirect treatment of electricity in
the UKCP. If correct, it means that confining the project scheme to direct emissions would
lead to a loss of environmental effectiveness which many groups would consider
unacceptable.

An alternative option would be to accept a limited amount of double crediting as a price
worth paying for facilitating the introduction of the project scheme. A relevant analogy here
is the existence of ‘hot air’ in trading schemes. While ‘hot air’ runs the risk of damaging
public credibility and environmental integrity, it has facilitated political consensus on
emissions trading and has been seen as a quid pro quo for persuading both countries and
companies to accept a binding emissions cap. Whether a similar approach is acceptable for
double crediting will depend upon the likely scale of the problem and the timescale over
which it is anticipated to persist. If only a small number of relatively small scale emission
reduction projects are expected, double crediting may be considered to be largely irrelevant.
Conversely, if very large projects are expected, which will generate credits over a long period
of time, then double crediting may be considered unacceptable. In practice, the importance of
double crediting may be overshadowed by the potentially large volume of project credits
from non-CO2 GHGs (e.g. methane capture) and the associated concerns over hot air (Begg et
al, 2002d). The most obvious solution for both would be to impose an aggregate ceiling on
credit volumes. This is required anyway to reduce the risk of non-compliance during the
commitment period, and has been included in the UK proposals.


4.6 Recommendations
 the UK should proceed with a small-scale pilot scheme only, with fuller development of
  the project mechanism being linked to the development of ‘modalities’ for interfacing the
  EU ETS to JI and the CDM;
 the pilot scheme should be developed in consultation with the Commission, with the rules
  taking into account the concerns of the Commission, Parliament and other Member States
  about environmental integrity;
 the rules should be consistent with those for JI and CDM and both nuclear and sink
  projects should be excluded;
 no project should be undertaken at sites that may subsequently become eligible for
  inclusion in the EU ETS;
 double crediting should be accepted in the pilot phase, but with an aggregate ceiling on
  credit volumes to preserve environmental integrity; and
 the UK should work to ensure that the subsequent EU proposals are compatible with the
  UK scheme.
5. Interaction between the EU ETS and the UK
implementation of the IPPC Directive
The Integrated Pollution Prevention and Control (IPPC) Directive was transposed into UK
legislation in 1999 and is being introduced in a phased manner, with all eligible installations
coming under IPPC by 2007. The Directive shares many features with the existing UK
regulatory system (Integrated Pollution Control, or IPC), which means that the UK has made
fewer changes to legislation and regulatory practice than other Member States. IPPC requires
operators of industrial processes to use the Best Available Techniques (BAT) to control
polluting releases to all three environmental media (air, land and water) in an integrated
manner. IPPC also requires that installations use energy efficiently (Article 3) and that energy
efficiency is taken into account when determining BAT (Annex IV).

A ‘non-paper’ from the European Commission in January 2002, clarified that the energy
efficiency requirements of IPPC should provide a ‘baseline’ level of effort for energy
efficiency, but should not be used to impose stringent requirements or to set emission limits
for CO2 (CEC, 2002b). Article 25 of the EU ETS Directive proposes amending the IPPC
Directive such that, when an IPPC installation is participating in the EU ETS, emission limits
are not set for any GHGs unless they are required to prevent local pollution problems. This
Article also gives Member States the opportunity of not imposing IPPC energy efficiency
requirements on fuel use at these installations (although requirements may still be imposed on
electricity use). Both these proposals reduce the potential for conflict between IPPC and
emissions trading, while not removing it altogether. There is still direct and indirect
interaction which may be important in some instances. Table 5.1 illustrates that the regulatory
philosophies and practices of IPPC and emissions trading are fundamentally different.
Table 5.1 Comparison between emissions trading and IPPC.

Emissions Trading                                    IPPC
US origins: Offset policy first introduced in 1976   European origins: Technology based principles
                                                     date from the last century.
Economics based: Pollution arises from an            Engineering based: Pollution abatement is
absence of well defined property rights. Cost        considered a technological problem, and
effective control is achieved through issuing a      regulation is designed explicitly to promote
limited number of permits (rights) to emit which     cleaner (or clean-up) technologies.
can be freely traded.
Top down: Basis for pollution control is an          Bottom up: Basis for pollution control is the site-
aggregate emission reduction target for the whole    specific BAT for an installation.
source population.
Target driven: Overall pollution target, with no     Technology driven: No overall pollution target,
specification of individual technologies or          beyond the requirement to minimise pollution
emissions standards.                                 using BAT
Hands off: Technology decisions are the              Hands on: Regulator is involved in individual
responsibility of individual firms.                  technological decisions.
Wide system boundary: The system under the           Narrow system boundary: BAT limits are set
aggregate emission target can be as wide as a        for an individual installation at a single site.
sector, an economy or a geographic region.
Single substance/media: Usually controls a           Multi substance/media: Controls releases of a
single polluting substance in a single media.        wide range of substances to all three media in an
Climate change an exception as there are six         integrated manner.
greenhouse gases.
Flexibility via the market: Installation operators   Flexibility    via     negotiations:  Installation
can seek flexibility and reduced costs through       operators can seek flexibility and reduced costs
trading in the permit market.                        through BAT negotiations with the site inspector.
                                                     Scope for this depends on Member State
                                                     regulatory traditions.
Transparency via the market: Aggregate target,       Transparency via an institutional process:
participants’ performance and permit price are       Public can comment on operator applications.
public knowledge.                                    Public register of permit conditions and
                                                     monitoring returns.
Timetable given by budget period: Should be          Timetable determined by reviews: Regulator
predictable and stable.                              ‘periodically’ reviews and updates permit
                                                     conditions.
Legitimacy depends on target: Secured through        Legitimacy depends on implementation:
stringency of overall target. Resources sufficient   Achieved by public regulator setting individual
to monitor trades and enforce transgressions are     standards and monitoring specific installations.
important. Problems with ‘hot air’ and rights to     Regulatory resources sufficient for this task are
pollute.                                             important.
Source: Sorrell and Smith (2001)


5.1 Comparison of instrument scope
The EU ETS regulates IPPC installations in a subset of ‘IPPC sectors’, but excludes
important sectors such as chemicals and food and drink. Also, the size threshold for
combustion plant is lower for the EU ETS (>20MW) than for IPPC (>50MW), which means
that some sites in non-IPPC sectors will be regulated by the EU ETS but not by IPPC.

IPPC only covers direct emissions from regulated sites, but since electricity generators are
included there will be an indirect (and probably small) impact on electricity consumers via
electricity prices. IPPC also regulates electricity consumption at eligible industrial sites via
the energy efficiency provisions, with an indirect (and probably small) impact on all
electricity generators, regardless of fuel source, as a consequence of reduced electricity
demand.

The EU ETS only applies to CO2 emissions at present, but these may result from either fossil
fuel combustion or from certain types of processes such as cement production. Article 23a
allows other GHGs to be included in Phase 2, provided the environmental integrity of the
scheme is not threatened. In addition, Article 26 creates the possibility that some GHGs will
be included during Phase 1. In contrast to the EU ETS, IPPC regulates all non-CO2 GHGs
from both combustion and process sources, but does not regulate CO2 directly (Annex III).
Hence, in principle, IPPC only covers combustion CO2 emissions indirectly through the
energy efficiency provisions, and excludes process CO2 emissions altogether. Similarly, IPPC
does not have a mechanism to require a switch to a fuel with a lower carbon content, or to
encourage the purchase of renewable electricity.

If an installation qualifies for the EU ETS because of the size of combustion plant, then only
the combustion plant is included. Conversely, if an installation qualifies because of an IPPC
process, then both the IPPC process and the combustion plant are included. This means that a
combustion plant smaller than 20MW may be covered by the EU ETS, if it is associated with
a qualifying IPPC process.


5.2 Comparison of instrument objectives
The EU ETS has the narrow objective of reducing aggregate GHG emissions in a cost-
effective manner, whilst minimising distortions to the internal market. The stringency of the
EU ETS will be largely determined by the allowance allocation, but the proposed allocation
criteria are difficult to interpret and potentially contradictory. In contrast, IPPC aims at both
the best option for the environment as a whole and the adoption of BAT at the installation
level. In IPPC, there is a tension between environmental cost-benefit analysis and the
requirement that BAT be ‘affordable’ for an average company in the sector (Sorrell, 2002b).

The objectives of IPPC are less clear with regard to CO2 abatement, which is only achieved
indirectly and incompletely through the energy efficiency provisions and is secondary to the
BAT requirements for other pollutants. The objectives in promoting energy efficiency go
beyond CO2 abatement alone, while (as with BAT) the stringency of the provisions will
depend inter-alia upon the content of the BAT Reference Notes (BREFs) published by the
Commission, the content of Member State guidance notes, and the implementation practice of
the relevant regulator. The determination of IPPC requirements in the UK is overwhelmingly
a bottom-up, site specific process, based on informal negotiations between the site inspector
and operator, with very limited use of formal economic techniques (Sorrell, 2002b). This
contrasts with the allowance allocation in the EU ETS, which is based in part upon top down
considerations, such as the EU burden sharing agreement. These two approaches have very
different implications for incentives, information asymmetry, stringency, and the scope for
regulatory capture.
5.3 Comparison of instrument timing
Existing installations are being phased into IPPC and for some sectors (e.g. refineries) this
process will not be complete until 2007. This means that the EU ETS may begin before all
eligible installations are brought under IPPC. This may create administrative difficulties,
since the EU ETS and IPPC permitting procedures are required to be co-ordinated (Article 8),
but since most eligible installations are already regulated under IPC in the UK, this is
unlikely to be a major problem. Of greater importance is the potential use of IPPC provisions
to demonstrate equivalence of effort, under the opt-out provisions of Article 25a. Refineries,
for example, would find it difficult to opt-out in 2005 on the basis of ‘equivalent’ IPPC
energy efficiency provisions, since the latter would not have been defined.


5.4 Comparison of instrument operation
For installations affected by both instruments, there is double regulation of electricity,
combustion CO2 emissions and, from Phase 2 onwards, some or all non-CO2 GHG emissions,
but the nature and importance of these interactions differ. Trading is incompatible with strict
BAT requirements for non-CO2 GHGs, whether these are interpreted as quantitative emission
limits or technology requirements. Regularly updated strict BAT requirements would
eliminate the scope for cost-saving trades since, if an installation reduces emissions below
IPPC requirements, this immediately signals to the regulator that the BAT standards need to
be changed. Article 25 of the Directive attempts to get round this by scrapping IPPC emission
limits for installations participating in the EU ETS, unless these are needed to prevent local
pollution problems. In the latter case, the freedom to trade non-CO2 GHGs is constrained
since emissions must remain below the IPPC limit, but if allowance allocations are more
stringent than the IPPC limit, there is still scope for cost saving trades. However, the
Directive fails to clarify the status of technology requirements imposed under IPPC, or the
extent to which these may be updated. This is important, because BAT is often implemented
through technology requirements rather than emission limits.

An anomalous feature of Article 25 is that it is confined to activities and gases listed in
Annex 1 of the Directive. It would therefore appear to exclude installations which have
opted-in to the EU ETS and are regulated by IPPC, but which are not part of the core sectors.
These installations will still be subject to strict BAT requirements on non-CO2 GHGs. If this
provision remains unchanged, it could severely limit the scope for opt-ins of both activities
and gases.

At some sites in the UK ETS, IPPC emission limits are used as the basis for allowance
allocation. Direct participants can earn credits for reducing emissions below these limits,
while the freedom to tighten IPPC requirements over the duration of the UK ETS is
restricted. This is a more restrictive approach than proposed for Annex 1 sectors and gases in
the Directive, but it has still led to serious problems with ‘hot air’. IPPC emission limits were
set for groups of pollutants (e.g. VOCs), rather than specific GHGs, which led to emission
baselines being overestimated and subsidised hot air being granted to key participants such as
Ineos Fluor (ENDS, 2002). This problem was exacerbated by the very high global warming
potential (GWP) of some non-CO2 GHGs, with the result that over half the GHG emission
reductions achieved through the direct participant scheme will be through non-CO2 gases.
Ultimately, the effect of the Directive proposals will depend upon the allocation rules for
non-CO2 GHGs, when they are eventually brought in to the scheme. But the UK experience
suggests that there are serious ‘hot air’ risks with non-CO2 GHGs, which could be
substantially increased if allocations are based on top down, benchmark criteria rather than
site specific determinations.

The ‘non-paper’ recommendation that participating installations adopt ‘baseline’ energy
efficiency requirements has been translated into more detailed guidance in the UK
(Environment Agency, 2001). The proposals for generic, low cost energy efficiency measures
go substantially beyond current practice in many companies and include the preparation of an
energy efficiency plan which describes all technically available efficiency opportunities and
estimates their costs and benefits. Installations participating in trading schemes need only
adopt the ‘basic’ measures in the plan, while installations outside the trading scheme must
appraise each option using an ‘appropriate’ discount rate and implement those that provide
cost savings. Measures that lead to net costs may also be required since: ‘…one would expect
to spend money to reduce other pollutants and it is reasonable to expect to spend money to
reduce the pollutants resulting from energy use’ (Environment Agency, 2002). The guidance
also states that there is insufficient information to set an appropriate cost benchmark at
present and provides a number of caveats regarding cash flow, business cycles, age of plant
and so on.

The ‘basic’ requirements can act as backup regulation to the EU ETS and ensure that
participants take some action to improve energy efficiency, even when allowance prices are
low. The requirements facilitate monitoring, reporting and verification and in principle
should lead to net cost savings for participants. This appears, therefore, to be a pragmatic and
sensible approach. The requirements for non-participants are more problematic, however.
These are designed to ensure ‘equivalence of effort’ with trading scheme participants and to
avoid competitive distortions. But if allowance prices are low, it is possible that the
combination of EU ETS and ‘basic’ IPPC requirements imposed upon participants will be
less stringent than the BAT-based IPPC requirements imposed upon non-participants.11 This
differential treatment may be challenged by non-participants on legal or political grounds, but
the distortions to competition are muted by the fact that EU ETS and non-EU ETS sectors are
(generally) not direct competitors.


5.5 Policy options
The approach adopted in the ‘non-paper’ and UK guidance towards the IPPC energy
efficiency provisions appears sensible and is consistent with previous recommendations from
the INTERACT project (Sorrell and Smith, 2001). But complications arise with the opt-out
provisions in the EU ETS. Installations without CCAs (e.g. refineries) may wish to use the
stricter, non-participant IPPC requirements as the basis for demonstrating equivalence of
effort. As with the CCAs, this is problematic owing to differences in:

 Scope: EU ETS participants have targets for direct combustion and process emissions, but
  not electricity. Non-participants have double regulation of electricity and coverage of
  combustion CO2 emissions only.


11
   This applies both to combustion CO2 (where participants face ‘basic’ energy efficiency requirements plus
allowance allocations) and electricity (where participants face ‘basic’ energy efficiency requirements plus
electricity price rises which are related to allowance prices).
 Form: Allowance allocations and BAT requirements differ in principle and substance, and
  while the former is fixed for 5 year period, the latter should be continually updated.
 Stringency: EU ETS allowance prices provide a measure of marginal abatement costs, but
  the informal, confidential and site-specific nature of IPPC negotiations and the lack of
  economic analysis makes assessment of the comparative stringency of IPPC and the EU
  ETS very difficult. Also, since most IPPC energy efficiency requirements have yet to be
  imposed, such assessments would need to be done ex-ante.

In practice, much will depend upon the manner in which both the EU ETS allowance
allocation and the IPPC energy efficiency requirements are implemented. Evidence suggests
that the implementation of industrial pollution control in the UK has been based upon
informal assessments of what the individual firm can afford and that site-level negotiation
can lead to requirements being watered down (Sorrell, 2002a). This suggests that the energy
efficiency requirements imposed in practice may be weaker than those suggested by the
guidelines, and that as a consequence, installations may view opting-out as an attractive
means to avoid abatement costs. The most obvious way to prevent this is to exclude IPPC
requirements as a suitable basis for opting-out. Article 25a appears to allow for this by
confining eligibility to those installations that are subject to equivalent ‘national policies’.
Since IPPC is an EU Directive, it is not a national policy - although there are very large
differences in how the Directive is implemented in different Member States.


5.6 Recommendations
 the interpretation of IPPC energy efficiency requirements that is outlined in the non-paper
  and in UK guidance is sensible and should be retained;
 the Commission should specify in greater detail the recommended approach to non-CO2
  GHGs for those installations where BAT requirements are expressed as technical
  requirements rather than emission limits;
 the provisions in Article 25 should be extended to those installations and gases that are not
  listed in Annex I but which have chosen to opt-in to the EU ETS;
 to avoid problems with ‘hot air’, the inclusion of non-CO2 GHGs in Phase 2 of the EU
  ETS should be based upon both accurate monitoring protocols and very strict criteria for
  allowance allocation;
 installations should not be allowed to opt-out of the EU ETS on the basis of ‘equivalent’
  IPPC energy efficiency requirements, since IPPC is not a national policy and in practice
  the energy efficiency requirements are unlikely to be strictly enforced.
6. Interaction between the EU ETS and the UK
Renewables Obligation
The Renewables Obligation (RO) is a Tradable Green Certificate (TGC) scheme in which
obligations are placed upon electricity suppliers to purchase a percentage of their electricity
from qualifying ‘new renewable’ sources (existing sources are excluded). The target for
2002/03 is for 3% of electricity to be purchased from new renewable sources and this target
increases annually to 10.4% by 2010. No increase in the target is specified after 2011, but this
will be kept under review. The RO requires a substantial expansion of UK renewables
capacity and implies a much faster rate of increase than was seen during the 1990s under the
previous Non-Fossil Fuel Obligation.

Renewables Obligation Certificates (ROCs) are issued for each MWh of qualifying
renewable electricity generated and each supplier must ensure it has enough ROCs to cover
its RO target. Sales of ROCs are separate from sales of electricity and individual suppliers
may comply by either investing in renewables capacity, purchasing ROCs from other
generators or paying the Buyout Price of 3p/kWh. The latter mitigates the price risk of the
RO by placing a ceiling on ROC prices, but creates the possibility that the RO targets may
not been met. Since buyout revenues are distributed to competing suppliers (‘smearback’),
there is an additional incentive to avoid paying the Buyout Price which should push the ROC
price ceiling above 3p/kWh.12 The risk of price volatility is partly mitigated by the provision
for banking allowances, which may be used to meet a maximum of 25% of the target in the
subsequent RO period. Also, individual suppliers that overcomply with their obligation can
convert their overcompliance from kWh to tonnes of CO2 (using a fixed conversion factor)
and sell the credits into the UK ETS - even if the RO targets overall have not been met. This
trading is one way, however: suppliers cannot buy UK ETS allowances to help them meet
their obligations.


6.1 Comparison of instrument scope
There is no direct interaction between the RO and the EU ETS, since the RO targets
electricity suppliers while the EU ETS targets electricity generators and large industrial
consumers. In the liberalised UK electricity market, many electricity generators have
associated supply businesses and several companies have invested in renewables. This means
that the same company may be involved in both the RO and the EU ETS, but not
simultaneously for the same installation.

The indirect interactions between the RO and the EUETS are complex and significant.
Abatement to meet EU ETS targets will raise wholesale electricity prices, which in turn will
improve the competitiveness of renewable electricity and increase investment in renewables.
The RO will also increase investment in renewables by creating a second revenue stream for
developers. Hence, both instruments will incentivise investment in renewables and this
investment will displace fossil fuel electricity generation and reduce CO2 emissions.



12
 The combination of the Buyout Price, smearback and the exemption of renewable electricity from the CCL
may push the price ceiling as high as 4.8p/kWh (AEP, personal communication) .
The EU ETS will raise consumer electricity prices as generators will pass on a proportion of
marginal abatement costs. But the impact of the RO on consumer prices is ambiguous. If we
assume that demand is relatively static and that wholesale electricity prices are set by the
marginal fossil fuel plant, then wholesale prices may be reduced by the RO (Jensen and
Skytte, 2002). This is because renewable electricity will have displaced fossil fuel plant and
the wholesale price will now be set by a lower cost marginal plant. At the same time,
electricity suppliers will need to purchase ROCS to meet their RO target – with the ROC
price being equal to the difference between the long-run marginal cost of supplying
renewables and the wholesale electricity price (ignoring price ceilings). These two effects
offset each other and could lead to either higher or lower costs for electricity suppliers and, in
turn, higher or lower prices for electricity consumers. In practice, higher costs are more likely
and the government expects the RO to increase average consumer electricity prices by some
4.4% by 2010.

Owners of fossil fuel generation plant must comply with their emission cap from the EU
ETS, while at the same time they have an incentive to invest in renewables from the RO.
New entrants with no existing plant have the same incentive to invest in renewables and have
a disincentive to invest in fossil fuel generation since they would need to obtain allowances to
cover all emissions.

The RO creates a demand for renewable electricity from electricity suppliers, while
exemptions from the CCL create a demand for renewable electricity from electricity
consumers. Unlike the CCL, the EU ETS does not create a demand for renewable electricity
from electricity consumers, since participants are only accountable for direct emissions. But
by raising the price of fossil electricity, the EU ETS improves the competitiveness of
renewables which should translate to increased consumer demand. At present, consumers in
the manufacturing, public and commercial sectors can identify renewable electricity through
the system of Levy Exemption Certificates (LECs). But there are no provisions for carbon
labelling of electricity (disclosure) which would allow consumers to discriminate between
high and low carbon sources and to identify zero carbon nuclear sources.


6.2 Comparison of instrument objectives
The primary objective of the EU ETS is the reduction of CO2 emissions, but the primary
objective of the RO is the promotion of renewable generation. While the RO will help to
reduce CO2 emissions by an anticipated 2.5MtC by 2010 (if the targets are met), the RO has
other objectives, including: nurturing an industry with large export potential; encouraging
economies of scale and learning effects that should improve the competitiveness of renewable
technologies; improving supply security by increasing the diversity of generation sources;
contributing to rural development; improving air quality; and reducing acid deposition. The
provision of these wider public goods and mitigation of non-CO2 externalities provides a
justification for supporting technologies which do not provide the least cost option for CO2
abatement in the short term. As a consequence, the ‘double regulation’ of electricity
consumers – who pay the CCL and are likely to pay higher prices as a result of the RO - is
considered to be acceptable.

The ROC price may usefully be split into two parts: a) the ‘value’ of CO2 abatement to the
UK; and b) the ‘value’ of the remaining objectives, expressed in monetary terms (Morthorst,
2000). The former may be set equal to the cost of alternative abatement options, or related to
the international price of carbon (converted to p/kWh for the UK electricity system), with the
latter considered as a residual, the size of which depends upon the ambition of the RO target.
Since the non-CO2 objectives are local, regional or national in character, any international
trade of ROCs would be problematic. For example, if a supplier purchased TGCs from the
Netherlands, this would contribute nothing to supply security or employment in the UK.
Hence, the RO does not, at present, allow for international trade. Similarly, international trade
in TGCs would require associated adjustment of Assigned Amounts under the Kyoto
Protocol.


6.3 Comparison of instrument timing
The RO began operation in 2002 and the targets extend to 2010. The scheme will need to
continue beyond 2010 to allow developers to recover their costs. A number of commentators
have argued for more ambitious targets for renewables deployment out to 2020 (PIU, 2002),
but further development of the RO will need to take into account the EU Renewables
Directive, completion of the internal market in electricity, the expansion of cross-border trade
in electricity, and the possibility of international trade in TGCs.

The RO targets are increased annually during Phase 1 of the EU ETS, while the targets for
Phase 2 are still unclear. The provisions in Annex III of the EU ETS require that allocation
plans are consistent with national energy policies and EU legislation - including the
Renewables Directive. This suggests that the UK should take the RO targets into account
when deciding upon allowance allocation. But annual allocations in the EU ETS will be fixed
during each Phase and cannot change each year in tandem with the RO.


6.4 Comparison of instrument operation
Figure 6.1 shows a stylised supply curve for renewables. A quantity QE of renewables should
be supplied in the absence of the RO, as this is competitive at the wholesale electricity price
PE. QRO is the relevant target under the RO and this will only be supplied if a price P MC is
obtained for electrical output. This can be achieved through a combination of the wholesale
PE and the price for ROCs, PROC. The ceiling for the latter is provided by P BO, which exceeds
PE by at least 3p/kWh. From this diagram it is clear that increases in wholesale electricity
prices will increase renewables deployment and decrease the price of ROCs. If PE = PMC , the
RO target will be achieved without the help of the Obligation and P ROC will fall to zero.
Similarly, decreases in wholesale electricity prices will increase the price of ROCs, up to a
maximum set by the buyout price. Since the latter is defined in relation to PE, a sufficiently
large fall in wholesale electricity prices will mean that the renewables target will not been
met since: (PE + PROC) < PMC.

The EU ETS will increase wholesale electricity prices, which suggests that a sufficiently
stringent allowance allocation (i.e. a sufficiently high allowance price) could achieve the RO
target by itself, and force ROC prices to zero. Similarly, a sufficiently stringent RO target
could lead to enough displacement of fossil fuel generation by renewables to meet the CO2
targets under the EU ETS, without any further abatement being required. In the latter case, if
the emissions trading scheme was confined to UK generators, the allowance price could fall
to zero (Jensen and Kytte, 2002). But since the scheme is EU-wide, this is unlikely.
Figure 6.1 Supply curve for renewables



               Supply Curve for Renewables
 Price
 (p/kWh)
              PBO
              PMC
                                  PROC
              PE



                                               QE     QRO

                                           Renewables capacity (GW)



Investment in renewable capacity will lead to double crediting of CO2 reductions (Figure
6.2). By displacing fossil fuel generation, this will free up carbon allowances in the EU ETS.
At the same time, the displaced CO2 will be credited in the RO as the ‘CO2 value’ within the
associated ROCs. Renewable generation will be ‘rewarded’ twice for the displaced
emissions: first by PE, which has internalised the cost of carbon in the EU ETS; and second
by PROC, which includes the ‘CO2 value’ of renewables deployment. Fossil fuel generators
will lose market share, but this will be offset by the revenue obtain from the sale of ‘freed up’
EU ETS allowances. If the renewable generation and the fossil generation is owned by the
same company, the investor will be rewarded by the sale of both ROCs and EU ETS
allowances.

As with the UK ETS project scheme, this double crediting will not be balanced by associated
double coverage of electricity emissions. Nevertheless, the double crediting may be less
problematic than for other instruments because, first, the EU ETS allowance allocation
should have taken the RO targets into account, and second, the two markets are entirely
separate with the RO ‘CO2 value’ hidden in the ROC. Also, the double crediting does not
threaten the environmental integrity of either scheme since the EU ETS cap is not breached
and the RO target is not undermined. But since the overall abatement achieved by the EU
ETS and RO will not be equal to the sum of the estimated abatement from each scheme, there
is a risk of double counting when evaluating the overall contribution of each instrument to
UK carbon targets.
Figure 6.2 Coexistence of the RO and the EU ETS leads to double crediting


                                                     Reduce                Increase
       Fossil-fuel combustion plant                                                                Invest in new renewable
                                                     electrical            electrical
          generating electricity                                                                       electricity plant
                                                     output by ‘X’     output by ‘X’




                                                        Fall of ‘Y’     Displaces ‘Y’
                                                           in CO2       amount of CO2
                                                         emissions      from fossil plant


                                                                 Physical
     Releases carbon allowances for sale in EU ETS                carbon                Contributes toward UK RO objective.
                                                               mitigation ‘Y’


Source: Smith (2002)

There is no fungibility between EU ETS allowances and ROCs, since the Directive does not
allow for this. This is in contrast to the present arrangements within the UK ETS, where
overcompliance with an RO target can be used to generate UK ETS allowances, using a fixed
carbon conversion factor. However, if there are trading links between the UK ETS and the
EU ETS, this prohibition can be circumvented. For example, an overcomplying supplier
could convert surplus ROCs into allowances and sell these to a direct participant, who in turn
could sell them into the EU ETS. This possibility may inhibit trading links between the two
schemes.

In practice the renewables market will be influenced by a host of factors other than the RO.
These include wholesale electricity prices, the treatment of intermittent generation within the
electricity trading arrangements, the regulation of transmission and distribution networks and
planning regulations. Most of these are currently unfavourable to renewables deployment
(Smith and Watson, 2002).


6.5 Policy Options
The flexibility of compliance with the RO and EU ETS could be improved through allowing
full fungibility of trading commodities, such that suppliers could comply with their
obligations by purchasing EU ETS allowances. But this approach ignores the non-CO2
benefits of renewables deployment. Given that CO2 abatement through renewables
deployment is generally more costly than alternative options, the likely result would be very
limited investment in renewables. For example, using the government’s recommended
conversion factor of 0.43kgCO2/kWh, a buyout price of 3p/kWh is equivalent to a carbon
price of ~£70/tCO2, which is at least ten times higher than current allowance prices in the UK
ETS, 3.5 times higher than the Commission’s estimate of the marginal cost to the EU of
meeting Kyoto commitments, and 2.5 times higher than the allowance price ceiling in Phase
1 of the EU ETS.13

13
  0.43kgCO2/kWh is the conversion factor for delivered electricity in the CCAs. This takes into account the
average carbon intensity of the UK generation fuel mix, together with efficiency losses in generation,
An alternative would be to adopt the approach currently used in the UK and allow one-way
fungibility. Suppliers who overcomplied with their renewables obligation could convert their
surplus ROCs into carbon allowances and sell them into the EU ETS. This formalises what
could happen anyway if the UK ETS and EU ETS were linked and is equivalent to assuming
that the non-CO2 value of renewables is fully met by the RO targets and that any further
increase is solely of benefit to CO2. But the current text of the EU ETS does not allow for
such a link during Phase 1 and proposals have yet to be made to introduce it for Phase 2. The
conversion process would lead to double crediting in the EU ETS, in that: first, the displaced
fossil fuel generation will free up allowances in the EU ETS; and second, an approximate
equivalent volume of new allowances will enter the EU ETS via the conversion process.

The primary motivation with this option is to encourage overcompliance with the RO. At
present, the only incentive for overcompliance is the ability to sell ‘green’ electricity at a
premium price,14 coupled with the exemption of renewables from the CCL. The ability to
create carbon allowances creates an additional revenue stream. In addition, such conversion
allows overcompliance to be banked in the EU ETS market, which has more flexible banking
rules than the RO. Of course, there may be more sensible and direct routes to encouraging
greater renewables deployment, including: a) increasing the RO targets themselves (and the
buyout price); b) setting a minimum price for ROCs and ensuring that the government will
purchase any surplus; c) allowing greater flexibility in the ROC banking rules; and d)
removing the non-price barriers to renewables deployment. The first of these options would
lead to increased costs for electricity consumers while the second would require government
expenditure, funded through general taxation. The last needs to be urgently addressed,
whether or not the RO targets are increased (Smith and Watson, 2002).

To overcomply with the RO, a supplier must obtain ROCs in excess of its RO target. These
could either be in association with the renewable electricity (including situations where the
supplier owns the renewable plant), or independently of electricity purchases. In the second
case, the only motivation for purchasing surplus ROCs would be if the potential revenue from
allowance sales exceeded the purchase cost of the ROCs, which in practice is unlikely.

A supplier could also purchase a greater amount of renewable electricity than required by the
Obligation, but not obtain the associated ROCs. This may be the case, for example, if the
supplier is providing a 100% renewable ‘green tariff’. The electricity may be certified as
renewable by the use of Levy Exemption Certificates (LECs) under the CCL, or by an
independent certification scheme. Complications may be introduced by different definitions
of renewables in the RO, CCL, Renewables Directive and independent certification schemes
(Table 6.1). The conversion of this type of ‘overcompliance’ into carbon allowances could be
problematic, particularly if the source of the renewable electricity is selling ROCs to another
supplier. This would lead to triple crediting, since the avoided fossil fuel emissions will have:
a) freed up allowances in the EU ETS; b) contributed to the carbon value of the ROCs; and c)
created new allowances in the EU ETS via the conversion process. If the purchaser of the
ROCs also chose to use them to create carbon allowances, there would be three allowances
circulating for a single abatement action. This problem is avoided if the source does not
qualify as renewable under the RO, but in many such cases (e.g. energy from waste) the

transmission and distribution. Using the same factor for renewable generation implies ignoring transmission and
distribution losses. Since renewables are usually ‘embedded’ at lower voltage levels, these losses may be lower
than for centralised fossil fuel generation, but they are not zero.
14
   This is only permitted for renewable generation which is surplus to the required under the RO.
source emits CO2. Similarly, the problem could be avoided if this type of ‘overcompliance’
was not eligible for conversion into allowances, but this would remove a potential incentive
for overcompliance. It should also be noted that: first, overcompliance by one supplier does
not mean that the overall RO target has been achieved; and second, there is a possibility that
conversion of surplus ROCs into carbon allowances could reduce the availability of ROCs
and raise ROC prices.

Table 6.1 Definitions of renewable electricity under different policy instruments
Source                      CCL               RO             EU Renewable        Future Energy
                                                               Directive
Large Hydro
Small Hydro
Geothermal
Solar
Wind
Tidal and wave
Landfill gas
Sewage gas
Biomass
Co-firing of biomass
Advanced energy from
waste technologies
Energy      from    waste
incineration
Notes:
 Light shade = fully supported;      Dark shade = supported with qualification
 Future Energy was an independent certification scheme for ‘green energy’, run by the Energy
   Savings Trust. This has now been withdrawn and there is no obvious replacement.
Source: OFGEM (2001)

The use of a fixed emissions factor for conversion may also create problems of discrepancy
between the actual and claimed emission reductions. The emissions displaced through
renewable generation will depend upon the time of day, week and year and on the location of
the source. A fixed factor based on the average fuel mix will become increasingly inaccurate
over time, unless it is regularly updated. And since marginal fossil fuel plant is likely to be
more carbon intensive than the system average, it is also likely to underestimate the carbon
benefits of renewables. Of course, the same problem applies to the CCAs and the UK ETS.

The above suggests potential problems with carbon accounting when interfacing the RO with
the EU ETS, which may prove unacceptable to the Commission. One alternative which has
been proposed would be to separate the CO2 and non-CO2 ‘values’ of the ROC and trade
them independently in separate markets. The first could interface to the EU ETS and
international markets, while the second could be confined to the UK. Suppliers would be
required to purchase a certain quantity of both to meet their obligation. The difficulty here is
that, with the EU ETS in place, the CO2 value of the ROC has already being reflected in the
allowances ‘freed up’ by the displaced fossil fuel emissions. Creating a separate CO 2 value
for the ROC and trading this into the EU ETS would lead to two allowances being created for
all the emissions displaced by RO-obligated renewable electricity, rather than just from
overcompliance with the obligation. Hence, the existence of the EU ETS would appear to
create a serious obstacle to such a ‘splitting’ of the ROC.

It is important to note that the double crediting problems described above could be largely
theoretical. The price difference between ROCs and carbon allowances is very large and
likely to remain so for the foreseeable future. With limited prospects of trading between the
two schemes, the potential for double crediting could easily be ignored.


6.6 Recommendations
 the allocation of allowances to UK electricity generators should, as far as possible, take
  into account the renewables targets under the RO;
 during Phase 2, the EU ETS should either: allow one-way trading from schemes like the
  RO, using a similar framework to that adopted for the UK ETS; or encourage crediting
  projects for renewables through the development of suitable modalities for linking the EU
  ETS to project-based mechanisms;
 if the first approach is adopted, this should only apply to overcompliance which has been
  demonstrated by the acquisition of surplus TGCs;
 the small potential for double crediting within such an arrangement should be considered
  and acceptable price to pay for providing an additional incentive for overcompliance with
  renewables targets.
 the incentive for overcompliance should not be considered a substitute for other measures
  to encourage renewables deployment, such as more ambitious targets for renewables after
  2010, greater flexibility in the banking rules for ROCs and removal of the non-price
  barriers to renewables deployment.
7. Interaction between the EU ETS and the UK
Energy Efficiency Commitment
The Energy Efficiency Commitment (EEC) is an innovative, market-based scheme for
improving energy efficiency in the domestic sector. It is intended to deliver both energy and
carbon savings and to alleviate fuel poverty among low income groups.

The EEC sets obligations on gas and electricity suppliers to deliver a certain quantity of ‘fuel
standardised energy benefits’ over the period 2002 - 2005 through investment in energy
efficiency. Energy benefits can represent either reduced energy use for the same level of
energy service, or improved levels of energy service for the same level of energy use. Energy
benefits are denominated in GWh and are calculated by estimating the discounted (at 6%)
energy savings over the lifetime of the investment, adjusted for the carbon content of the
relevant fuel mix. The EEC targets are based upon number of customers and do not apply to
suppliers with less than 15,000 customers. In total, the EEC is intended to deliver
64TWh/year of energy benefits by 2005 and to reduce CO2 emissions by 0.4MtC/year. The
total cost is estimated at £162m/year over the three year period, which corresponds to
£7.20/year per household. The benefits from the scheme will be confined to those households
receiving subsidies, but the total benefits averaged over all households are estimated as
£9.93/year per household by 2005. Energy benefits will continue over the lifetime of the
energy saving investment (i.e. well beyond 2005), giving total benefits of around £2 billion.
The EEC has many similarities with the RO, but the relative cost effectiveness of domestic
sector energy efficiency explains the absence of a price ceiling in the form of a ‘buyout
price’.

The energy regulator, OFGEM, is responsible for administering the scheme in collaboration
with the Energy Savings Trust (EST). The energy savings from different types of investment
in different types of household are estimated on a discounted lifetime basis using models
from the Building Research Establishment (BRE). This uses ‘comfort factors’ to take into
account the likely proportion of the investment that is taken up in improved comfort (e.g.
30% for CFLs) and ‘dead-weight’ factors to allow for those investments that would have
gone ahead anyway. The estimates can be converted into carbon savings using emission
factors for the relevant fuel mix.

The EEC scheme incorporates trading in two ways. First, suppliers can trade their targets
(obligations) under the scheme, such that one supplier takes responsibility for a portion of
another supplier’s obligation in exchange for payment. This resembles a cap and trade
scheme and allows trading to take place at any time. Second, suppliers can trade their
performance under the scheme such that one supplier sells GWh of achieved energy benefits
to another energy supplier, who uses this towards their own EEC target. This is a form of
baseline and credit trading and can only take place ex-post, after the compliance of the seller
with its EEC has been verified. In most cases, this will be at the end of the three year period.
Both forms of trading should provide a market incentive to minimise the cost of achieving the
obligation.

In a similar manner to the RO, suppliers who overcomply with their obligation can generate
carbon credits for sale into the UK ETS. As with the RO, the trading is one-way: under-
compliant suppliers cannot satisfy their obligations by purchasing carbon allowances.
7.1 Comparison of instrument scope
There is no direct interaction between the EEC and the EU ETS, since the EEC targets
electricity and gas suppliers while the EU ETS targets electricity generators and large
consumers. Electricity companies with both generation and supply interests may participate
simultaneously in both schemes, but these activities will be largely disconnected.

The EEC will increase electricity and gas costs for all household consumers by an estimated
£3.60 per fuel per year. Not only is this a much smaller increase than would be obtained by
imposing VAT on domestic fuel,15 it is also hidden within the bill and therefore less visible in
the context of changing supply prices. Furthermore, the benefits are returned to consumers in
the form of energy efficiency investments. While all consumers will pay for the EEC, only
those households in receipt of subsidies for energy efficiency investment will benefit.

The EU ETS will increase household electricity (not gas) bills, by an amount related to the
allowance price. Under certain assumptions,16 a £10/tCO2 allowance price will increase the
average domestic bill by 6%, or ~£15/year. In the absence of allowance auctioning, there will
be no mechanism for compensating households for this price increase. The coexistence of the
EU ETS and EEC leads to double regulation of household electricity consumers, but the
anticipated price increase should be placed in the context of a 25% reduction in household
electricity prices between 1995 and 2001.

In principle, the EU ETS could provide generators with an incentive to invest in household
energy efficiency to reduce electricity demand and help them meet their cap (demand-side
management). However, this appears very unlikely as the reduced demand will be shared
between all generators and the abatement and transaction costs will be relatively high. A
more effective incentive could be provided through a projects scheme within the EU ETS,
which would allow generators to obtain carbon credits from individual demand-side
investment projects. As presently structured, however, the EEC provides an obstacle to this.
The UK project scheme excludes investment in the household sector, because (it is claimed)
this would allow ‘cherry picking’ of the best projects to provide carbon credits, and thereby
force up the costs to energy suppliers of meeting their EEC obligations. Similarly, only EEC
obligated suppliers are allowed to convert surplus EECs into carbon credits for sale into the
UK ETS.


7.2 Comparison of instrument objectives
The focus on ‘energy benefits’ in the EEC reflects the fact that it has both energy and social
policy objectives. High ‘comfort factors’ for energy efficiency investment indicate that many
households would like higher levels of energy service, such as warmer homes. This is
particularly the case for the 4.5 million UK households living in fuel poverty - defined as
spending more than 10% of household income of energy. The EEC rules require that at least

15
   VAT is currently charged at only 5% on domestic energy, compared to 17.5% on other goods and services.
Imposing full rate VAT on domestic electricity would add £32.60/year to the the average ‘standard credit’
domestic electricity bill for England and Wales (£261/year).
16
   Namely: a) the trading scheme is introduced overnight without companies having the opportunity to change
behaviour; b) the full costs of meeting the emission target are passed on to consumers through electricity price
rises, with none being be passed on to suppliers or absorbed through lower returns; and c) the impact on
electricity prices is independent of the method of allowance allocation (Sorrell, 2002a).
50% of investment be in the 8.2 million households in receipt of income-related or disability
benefits. These will receive a 100% subsidy for most forms of investment, compared to
around 50% for non-priority groups. Other benefits of the EEC scheme include reducing
building maintenance costs (through reduced mould and condensation), creating jobs in the
energy efficiency industry, and creating market opportunities for new technologies.

The EEC will reduce CO2 emissions by reducing fuel and electricity use. Estimates of the
contribution from electricity efficiency assume a fixed emission factor (0.43kgCO2/kWh
delivered) which leads to the same problems with discrepancy as with the CCAs, UK ETS
and RO. The focus on fuel poverty means that minimising abatement costs is not the primary
objective. The Energy Savings Trust estimates that the minimum cost of abatement measures
under the previous EESoP was around £14/tCO2, while measures in low income households
would cost significantly more, or even lead to zero abatement (Calder and Hough, 2001).

In principle, the price of an EEC credit could be split into two parts: a) the ‘value’ of CO2
abatement to the UK; and b) the ‘value’ of the remaining objectives, expressed in monetary
terms. As with the RO, the non-CO2 objectives are UK-specific. In practice, individual
efficiency investments will make very different contributions to these two objectives - for
example, CO2 abatement will be less (i.e. comfort taking will be higher) for insulation
measures in low income households. Unlike with the RO, there has been no discussion about
splitting the EEC in this way.


7.3 Comparison of instrument timing
The present EEC runs from 2002 to 2005. It is expected to be followed by an expanded
scheme, but the details of this have yet to be developed. The UKCP estimates that the EEC
will contribute between 2.6 and 3.7MtC of abatement per year by 2010. This is five to seven
times larger than the abatement expected from the first phase of the scheme, which suggests
that a very large expansion of the scheme will be needed if the UKCP targets are to be met.
The government estimates have been criticised by Ekins et al (2001), who argue that
abatement on this scale would require the maximum market penetration of technologies such
as cavity wall insulation and compact fluorescents.17

The reduced electricity demand resulting from the EEC may need to be taken into account
when determining the allowance allocation for the EU ETS. At present, however, it is not
clear whether the EU ETS allowance allocation will precede or follow the selection of targets
for second phase (post 2005) of the EEC.

The arrangements for trading surplus carbon credits into the UK ETS have yet to be finalised
and so far there has been little interest from suppliers. The future of the UK ETS is uncertain
beyond 2006 and there seems little prospect of linking the EEC with Phase 1 of the EU ETS.




17
   The Energy Savings Trust estimates the cost-effective potential (>5 year payback) for energy efficiency
investment in the domestic sector to be 5.8MtC (11.8%) by 2010 and 14.7MtC (34%) in the long term.
7.4 Comparison of instrument operation
The EEC interacts with the EU ETS through the treatment of electricity. As with the RO, this
occurs in two ways: target setting and double crediting.

A sufficiently stringent EEC target could lead to enough reduction in domestic sector
electricity demand to meet the electricity generators’ CO2 targets under the EU ETS without
any further abatement being required. In practice this is very unlikely because, first, the
second phase EEC targets are unlikely to be that ambitious; second, the domestic sector only
accounts for a portion of electricity demand; and third, efficiency investment will be
counteracted by comfort taking, rebound effects, falling wholesale electricity prices and
underlying drivers of demand growth, such as increasing appliance ownership. A sufficiently
stringent EU ETS target could lead to large reductions in domestic sector electricity demand,
but this would not be equivalent to meeting the EEC obligation as the ‘energy benefits’ for
low income households would not have been met. In fact, the EU ETS will impose ‘energy
costs’ on these households in the form of higher prices. While higher prices will incentivise
electricity efficiency, the existence of a wide range of barriers makes prices elasticities very
low and the scale of price increase required to make serious inroads into consumption
patterns would have damaging consequences for the fuel poor.

Investment in domestic sector electricity efficiency will lead to double crediting of CO 2
reductions. By reducing fossil fuel generation, this will free up carbon allowances in the EU
ETS, while at the same time the displaced CO2 will be credited as part of the energy benefits
of the EEC. As with the RO and the project scheme, this double crediting is not balanced by
associated double coverage. Nevertheless, it may not be problematic because, first, the EU
ETS allowance allocation should have taken the EEC targets into account (although note the
caveats in the previous section), and second, the two markets are (at present) entirely separate
with the ‘CO2 value’ hidden in the EEC. Also, the double crediting does not threaten the
environmental integrity of either scheme since the EU ETS cap is not breached and the EEC
target is not undermined. But since the overall abatement achieved by the EU ETS and EEC
will not be equal to the sum of the estimated abatement from each scheme, there is a risk of
double counting when evaluating the overall contribution of each instrument to the UKCP.

In principle, overcomplying suppliers can convert their EEC obligations into carbon credits
and sell them into the UK ETS. But there are no comparable arrangements for selling carbon
credits into the EU ETS. As with the project scheme and the RO, if there are trading links
between the UK ETS and the EU ETS, this prohibition could be circumvented. For example,
an overcomplying supplier could convert surplus EEC credits into UK ETS allowances and
sell these to a direct participant, who in turn could sell them into the EU ETS. This possibility
could inhibit trading links between the two schemes. But it should be noted that there has
been very limited interest from suppliers in such trading links and the relatively high
abatement costs in the domestic sector (resulting, in part, from comfort taking) would appear
to militate against this.


7.5 Policy options
As with the RO, The flexibility of compliance with the EEC and EU ETS could be improved
through allowing full fungibility of trading commodities, such that suppliers could comply
with their obligations by purchasing EU ETS allowances. But this approach ignores the non-
CO2 benefits of the EEC. Since the comfort taking associated with domestic sector efficiency
investment tends to make it more costly (on a £/tCO2 basis) than alternative options, the
likely result of full fungibility would be less investment in domestic sector energy efficiency.

An alternative would be to adopt the approach currently used in the UK and allow one-way
fungibility with the EU ETS. This is not an option for Phase 1 of the EU ETS, but may
perhaps be considered for Phase 2. Suppliers who overcomplied with their EEC could convert
their surplus EEC credits into carbon allowances and sell them into the EU ETS. This
formalises what could happen anyway if the UK ETS and EU ETS were linked. For
investments that improve electricity (as opposed to fuel) efficiency, the conversion process
leads to double crediting in the EU ETS, in that, first, the displaced fossil fuel electricity
generation will free up allowances in the EU ETS; and second, an approximate equivalent
volume of new allowances will enter in the EU ETS via the conversion process. As with the
RO, the perceived importance of this double crediting will depend upon its likely scale. At
present, it seems unlikely to be large enough to merit serious concern, although this may
change over time and would need to be kept under review.

The motivation in introducing one-way fungibility is to encourage overcompliance with the
EEC. At present, individual suppliers may overcomply if they can sell EEC credits for a
profit, but the only incentive for aggregate overcompliance is the potential to bank EEC
credits into the second phase. In the absence of either finalised banking rules or targets for the
second phase, the value of banked credits is unclear and the incentives weak. The opportunity
to create carbon credits would provide an alternative revenue stream whose value would
depend upon both the allowance price in the EU ETS and any differences in banking rules
between the EEC and EU ETS. The benefits of overcompliance include additional energy
benefits for household consumers and lowering of compliance costs in the EU ETS. The first
of these is recognised as an important objective, that can be achieved very cost effectively.
While encouraging overcompliance may be helpful for this objective, there may be more
sensible and direct routes, including: a) establishing more ambitious targets for the EEC itself
after 2005; allowing full flexibility in the EEC banking rules, combined with early agreement
on the targets for phase 2; and c) addressing the numerous non-price barriers to energy
efficiency in the domestic sector.

One-way fungibility raises a number of issues (Calder and Hough, 2001). First, the
monitoring and verification of carbon savings from EEC projects may not meet the required
standards of the EU ETS. The estimated carbon value of kWh energy benefits will depend
upon the accuracy of: a) the BRE models; b) the assessment of the types of households in
which measures are installed; c) the assumptions about comfort taking; and d) the
assumptions about fuel mix and emission factors, including the discrepancy problems with
electricity. Taken together, these may introduce too much uncertainty to be acceptable.
Second, fungibility may only be possible at the end of the three year period, when
verification of supplier performance is complete. Third, the government may wish to prevent
the generation of allowances by individual suppliers in circumstances where the overall EEC
obligation (i.e. all suppliers) has not been met. But this would undermine flexibility and
reduce the potential cost savings from the overcompliance mechanism. Finally, there are
issues regarding the proceeds from allowance sales: consumers will pay for the additional
investments (and some households will benefit from efficiency improvements), but the
proceeds from allowance sales may go to the shareholders of the supply companies. This may
be unacceptable to OFGEM.18

A related issue is the potential for non-obligated companies to invest in domestic energy
efficiency projects and to trade the resulting carbon credits into the EU ETS. The proposed
‘modalities’ for linking the EU ETS to the project mechanisms may address this issue, but at
present this is not an option for project developers in the UK since the sale of domestic sector
credits into the UK ETS is blocked by the EEC rules. At present, the only way in which an
independent company could generate carbon credits from domestic sector projects would be
through selling energy benefits to an overcompliant supplier who in turn could convert them
into credits and selling them into the UK ETS. This seems an unnecessary obstacle to cost
effective projects in a sector which desperately needs additional investment.


7.6 Recommendations
 the allocation of allowances to UK electricity generators should, as far as possible, take
  into account the energy efficiency targets under the EEC, which means that the latter need
  to be agreed within the next 18 months;
 during Phase 2, the EU ETS should either: allow one-way trading from schemes like the
  EEC, using a similar framework to that adopted for the UK ETS; or (preferably)
  encourage crediting projects in this sector through the development of suitable modalities
  for linking the EU ETS to project-based mechanisms;
 the small potential for double crediting within such arrangements should be considered an
  acceptable price to pay for providing an additional incentive for overcompliance with
  domestic sector energy efficiency targets - but this should be kept under review;
 the exemption of the domestic sector from the UK project scheme should be removed; and
 the incentive for overcompliance should not be considered a substitute for other measures,
  such as introducing more ambitious targets for the EEC after 2005 and the removal of the
  non-price barriers to domestic sector energy efficiency.




18
     The same consideration applies to overcompliance with the RO.
8. Choices in UK climate policy
The problems of double regulation and double coverage/crediting have occurred repeatedly in
the preceding sections. But lying behind these problems are four key choices within UK
climate policy:

   the choice of policy objectives for each instrument;
   the choice between upstream and downstream policy instruments;
   the choice between direct and indirect treatment of electricity emissions; and
   the choice to protect the domestic consumer.

These choices are explored briefly below.


8.1 The choice of policy objectives for each instrument
The design of the CCL has shaped the subsequent design of the CCAs and UK ETS and led
directly to the incompatibilities with the EU ETS. At present, the efficiency of the CCL is
undermined because it is trying to meet several objectives at once in a manner that is far from
transparent. These include: reducing CO2 emissions; encouraging energy efficiency;
protecting the competitiveness of energy intensive industry; protecting the coal industry;
avoiding ‘windfall’ benefits to nuclear power; promoting renewables and CHP; and
preventing welfare losses among low income domestic consumers. It should be possible to
achieve several of these objectives through a combination of a more efficient price instrument
(i.e. a carbon tax) and supplementary policies such as subsidies for the fuel poor. This would
give a much-needed clarity to the policy mix.

‘Double regulation’ may be considered acceptable where two instruments have different
objectives - even if these objectives are overlapping. This is why the coexistence of the EU
ETS with the RO and EEC is likely to be acceptable and why the coexistence of the EU ETS
with the IPPC Directive should be acceptable once the latter has been suitably modified. But
this may not be the case for the EU ETS and the CCL since, in this case, two market-based
instruments are being used at the same time for the same primary objective - to internalise the
external cost of carbon emissions. The coexistence of the two instruments raises marginal
abatement costs, distorts the operation of the allowance market and potentially undermines
the competitiveness of the relevant firms.

However, a slightly different perspective may be given by recognising that ‘internalising the
external cost of carbon emissions’ may be interpreted in two ways:

 internalising the cost of carbon in investment and operational decisions; and
 ensuring that polluters pay for the damage caused by residual emissions.

The attraction of carbon taxes is that they achieve both of these objectives. But emissions
trading only achieves the second objective if the allowances are auctioned. With free
allocation, polluters do not pay for residual emissions and the government denies itself the
opportunity to raise revenue. Free allocation is equivalent to a lump sum subsidy which will
increase the value of the participating firms, thereby making shareholders wealthier. With
auctioning, the economic rent is captured by the government and may be used in a variety of
ways, including reducing other forms of taxation and compensating affected groups. As
described in Sorrell (2002), the price impact for the consumers of a firm’s products
(electricity in the case of the generators) should be identical in both cases. The price impact
results solely from the marginal abatement costs and should be independent of the method of
allowance allocation.

Auctions tend to be advocated by economists as the revenue generated may be used either to
reduce other forms of taxation, and thereby improve overall economic efficiency, or to
compensate affected groups, (Cramton and Kerr, 1997). But auctions are strongly opposed by
industry. During the negotiation of the EU ETS, the UK government argued strongly for free
allocation in both Phase 1 and Phase 2, thereby protecting the interests of energy intensive
industry at the expense of overall economic efficiency and the competitiveness of the wider
UK economy.

The EU ETS requires free allocation during Phase 1 and a maximum of 10% of allowances
can be auctioned during Phase 2. Furthermore, Member States have the choice whether to use
this provision or not, and it is likely that the UK will continue with free allocation during
Phase 2. Since the EU ETS cannot, therefore, substitute for the revenue raised from the CCL,
any changes to the CCL will have important implications for government revenue. For
example, removing the CCL from electricity may reduce government revenue by up to £0.5
billion. This would create a corresponding requirement to either raise the revenue by other
means or to reduce government spending. These fiscal considerations will weigh heavily in
government decision-making and may potentially override concerns about double regulation.

This all points to the need for a debate on double regulation, to identify where it is acceptable
and where it is not. This must take into account:

 the objectives of the relevant instruments;
 the likely scale of the impacts, allowing for energy and allowance price forecasts; and
 the potential for revenue raising and the use of that revenue.

Circumstances where double regulation may be considered acceptable include:

 where the two instruments have different (if overlapping) objectives;
 where the scale of impacts is likely to be small; and
 where the double regulation provides a pragmatic, second-best alternative to the
  theoretically ideal approach.

Of particular importance will be the relative weight given to the two interpretations of
‘internalising the cost of carbon emissions’, given above.


8.2 The choice between upstream and downstream policy
instruments
The EU ETS is a downstream emissions trading scheme, in which fossil fuel users surrender
allowances for their emissions. The alternative (which the Commission rejected) is an
upstream scheme, in which fossil fuel producers, processors and transporters surrender
allowances for the carbon content of the fuel. An analogous approach is available with
carbon/energy taxes which can be levied either upstream on all fuel produced or sold, or
downstream on a subset of fuel users. The CCL is a downstream tax which excludes the
domestic sector.

Each option has pros and cons. Upstream trading schemes may present difficulties as they
effectively place a cap on the market for fossil fuels. Since fuel demand is inelastic in the
short term, fuel prices may rise significantly, with negative effects for all classes of
consumer. Upstream carbon taxes overcome this problem at the expense of unpredictability
in meeting an emissions target. A legal obligation to meet an emissions target in a
downstream scheme may be more effective in incentivising abatement than an increase in
energy prices in an upstream scheme. But downstream schemes tend to be confined to large
users and hence cover only a portion of fossil fuel emissions. Also, while upstream schemes
ensure a single price for carbon throughout the economy, downstream schemes may lead to
carbon being price differently between sectors and fuels.

Whatever the relative merits of the two approaches, the EU ETS has constrained future policy
by choosing a downstream scheme. The UK cannot now introduce an upstream
carbon/energy tax without this leading to double regulation for all fuel and electricity use by
all participants in the trading scheme. As it stands, the CCL only leads to double regulation of
electricity for a subset of participants. Whether either form of double regulation is acceptable
is a matter for debate. But the problem is clearly greater for an upstream tax than a
downstream tax. The cost implications of the double regulation are likely to be vigourously
opposed, thereby either ruling out an upstream tax or imposing strict limits on its size.

This suggests that the EU ETS may have seriously undermined the scope for policy reforms
along the lines recently suggested by the Royal Society (2002). While changes may be made
to the CCL, it may nevertheless be preferable to keep it as a downstream tax to avoid these
problems with double regulation. As a consequence, carbon prices may not be uniform
throughout all sectors. For example, electricity prices should reflect the cost of carbon in the
EU ETS, but this will be different from the cost of carbon in a downstream carbon/energy
tax. A manufacturing site that is eligible for the tax but not eligible for the EU ETS will face
different carbon prices for fuel and electricity.


8.3 The choice between direct and indirect treatment of
electricity emissions
Most of the incompatibilities between the EU ETS and UK climate policy stem directly from
the treatment of electricity. The EU ETS uses direct treatment of electricity emissions, where
carbon allowances are allocated to electricity generators, while the UK ETS uses indirect
treatment, where carbon allowances are allocated to electricity consumers. The UK approach
follows from the design of the CCL, which in turn stems from the objective of shielding
domestic consumers from electricity price rises. In contrast, the EU approach stems (in part)
from the objective of promoting cross-border trade in electricity. While the fuel poverty
problem in the UK may be expected to decline over time, the volume of cross-border
electricity trade in the EU may be expected to increase. This is one reason for preferring the
EU approach.
The choice between direct and indirect treatment of electricity emissions leads to very
different implications for incentives and abatement options. Electricity generators have full
and direct control over the carbon intensity of electricity generation, through investment and
operational decisions such as fuel switching, but they have only indirect and partial control
over total electricity demand through electricity prices. In contrast, electricity consumers
have full and direct control over their electricity demand, through investment and operational
decisions such as energy efficiency, but have no control over the carbon intensity of
electricity generation unless some form of ‘carbon labelling’ (or disclosure) of electricity is
available.19 It is likely that the UK approach will the more effective of the two in
incentivising electricity efficiency, while it is certain that the EU approach will be more
effective in incentivising fuel switching in electricity generation. Given that the government
may wish to promote energy efficiency for reasons other than climate policy, and may also
wish to restrict fuel switching for reasons of supply security, the EU approach may run
counter to some government objectives.

UK climate policy is consistent with an indirect treatment of electricity, but it is entirely
inconsistent with the direct treatment of electricity in the EU ETS. It is this which leads to the
repeated problems of double coverage and double crediting that are described in earlier
sections. As with double regulation, a debate is required on double coverage and crediting to
identify where it is acceptable and where it is not. This must take into account both the
principles surrounding the ‘ownership’ and ‘control’ of emissions and the likely
consequences of different options in practice. The problems fall into two categories:

 Situations where double crediting is cancelled out by double coverage: This applies to the
  CCAs and to the direct participants in the UK ETS. In this case the environmental
  integrity of the individual trading schemes is not threatened, but the conflicts over
  ownership create some confusion. This is worsened if trading of allowances is allowed
  between the two schemes.
 Situations where the double crediting is one way: This applies to the UK project scheme
  and also to the RO and the EEC, if these are interfaced to the EU ETS. In this case, the
  double crediting does threaten environmental integrity as it allows two allowances to be
  created for only one tonne of abatement. The importance of this may depend upon the
  likely scale of the problem. At present, for the RO and EEC double crediting appears to
  pose only a small risk and may easily be ignored. For the project scheme, the risk may be
  reduced through placing an aggregate ceiling on total credit volumes.


8.4 The choice to protect the domestic consumer
If most of the incompatibilities between the EU ETS and UK climate policy stem from the
differing treatment of electricity, the primary reason for this difference lies in the choice to
protect the domestic consumer from energy price increases. At present, 4.5 million UK
households (18%) are living in fuel poverty, defined as spending more than 10% of their
income on energy.20 Fuel poverty is a highly sensitive political issue and has prevented
previous governments from imposing VAT on domestic fuel. It also led the government to

19
   Currently being discussed in the context of the proposed Directive on the Liberalisation of the European
Electricity Market.
20
   This is 1 million less than in 1996 due to reductions in domestic energy prices.
choose indirect treatment of electricity for the CCL in order to shield fuel poor consumers
from electricity price rises. Since all domestic consumers have been shielded from price rises
in order to protect this vulnerable group, the government has created a fundamental tension
between climate and social policy in this sector. And since the CCAs and UK ETS were
required to adopt a similar treatment of electricity to the CCL, UK climate policy has come
into direct conflict with the EU ETS.

It follows that the elimination of fuel poverty is necessary both to curb emissions from the
domestic sector and to rationalise climate policy for other sectors. The government has a
target of eliminating fuel poverty among vulnerable groups by 2010 and has established a
number of important initiatives, such as the EEC and the new Home Energy Efficiency
Scheme (HEES) to achieve this goal. But research suggests that these initiatives need to be
expanded if the target is to be achieved (Ekins et al, 2001).

The EU ETS will raise electricity price rises for domestic consumers by an uncertain amount
– the illustration given earlier was for a rise of ~6% for allowance prices of £10/tCO2. In the
context of a 26% reduction in domestic electricity prices since 1995, this does not appear
excessive.21 Moreover, there are a number of options available to compensate fuel poor
households, including reductions in income tax, lump-sum redistribution through the social
security system, council tax rebates, differential tariff structures or changing the balance
between standing and unit charges in energy bills (Johnson, McKay and Smith, 1990). The
EU ETS makes consideration of such approaches all the more urgent. UK climate policy is
likely to remain unnecessarily complex and inefficient until the fuel poverty problem is
eliminated.




21
     However, this fall in prices has taken around 1 million households out of fuel poverty.
9. Summary
The December agreement on the EU ETS has far-reaching implications for UK climate
policy. Changes to a number of policy instruments will be required before 2005 and a major
overhaul will be required by 2008. None of this was anticipated when the UK Climate
Programme was developed or when key elements of this Programme, such as the CCAs, were
negotiated. There is a need, therefore, for debate on the preferred shape of UK climate policy
into the first Kyoto commitment period (2008-2012) and beyond, and on the role of the EU
ETS within this.

The implementation of the EU ETS raises a number of specific issues for each of the seven
instruments examined in this report. In the case of the CCL, CCAs and UK ETS, these
problems are serious enough to merit major reforms. In the case of IPPC, the RO and the
EEC, the problems are less serious but still need to be addressed. The common themes that
underlie these problems are:

   interaction and double regulation;
   ownership of emissions and double counting;
   differential treatment and equivalence of effort; and
   the fungibility of trading commodities.

Table 9.1 summarises the relevance of each of these themes for each of the selected
instruments.

Table 9.1 Interaction issues for each of the selected instruments

Acronym      Double regulation     Double counting          Differential         Linking
                                                             treatment
CCL                  
CCAs                                                                              
UK ETS                                                                            
(DPs)
UK ETS                                                                              
(projects)
IPPC                                                            
RO                                                                                 
EEC                                                                                

To resolve these problems, it will be necessary to re-examine four key choices within UK
climate policy:

   the choice of policy objectives for each instrument;
   the choice between upstream and downstream policy instruments;
   the choice between direct and indirect treatment of electricity emissions; and
   the choice to protect the domestic consumer.
The recommendations summarised in Table 9.2 provide one way forward. These
recommendations are based upon a number of principles including

 Goals: The development of policy options should be based upon clear principles and long-
  term goals. For climate policy, a stable an effective policy framework is required during
  the commitment period. This means that policy should be developed by working back
  from where we want to be in 2008.
 Complexity: The existing UK policy mix is complex and the relationship between different
  instruments is poorly understood by individual target groups. Hence, any changes should
  aim to simplify this mix and not to add further complexity.
 Carbon pricing: Energy users in all sectors should pay for carbon emissions, whether
  through taxation or emissions trading. In the long term, organisations in the public,
  commercial and industrial sectors should either be paying a carbon tax or participating in
  a trading scheme. Supplementary policies will be required to address other barriers to
  energy efficiency and to achieve other policy objectives (e.g. promoting renewables). But
  for each target group, only a single instrument should be used for carbon pricing.
 Electricity: The approach in the EU ETS is preferable because: first, it gives ownership of
  electricity emissions to the companies directly responsible for the control of those
  emissions, thereby incentivising both fuel switching and energy efficiency; and second, it
  facilitates cross-border electricity trade in the EU.
 Targets: Absolute targets are to be preferred over relative targets because of their greater
  environmental integrity and consistency with the national emission targets under Kyoto.
  And allowance based trading is to be preferred over baseline and credit trading due to its
  greater economic efficiency, lower transaction costs and consistency with the Kyoto
  framework. The EU ETS reflect these considerations while the CCAs do not. The latter
  should therefore be considered a transitional measure only.
 supplementarity: There is a risk that abatement in the EU ETS will be achieved through
  purchasing cheap hot air from outside the scheme, rather than through domestic action.
  But domestic abatement may be incentivised by either restricting the interface between the
  EU ETS and the international carbon market, or by retaining (or establishing) ‘backup’
  regulations for EU ETS participants. The first approach is preferable and the Commission
  is concerned to restrict the import of ‘hot air’. Hence, ‘backup’ regulations should be
  abandoned as they are likely to undermine economic efficiency, be more complex to
  administer and lead to additional costs for the target groups.

There is scope for debate over these principles and over the specific recommendations. But
the important point is to encourage wider recognition of the challenges that the EU ETS
poses to UK climate policy.
Table 9.2 Specific policy recommendations

CCL/        the CCL should be removed from electricity, extended to all fossil fuels (replacing excise
CCAs         duties on oil products) and changed from a downstream energy tax to a downstream carbon
             tax;
            eligible installations should join the EU ETS and their existing CCA agreements should be
             terminated;
            CCA facilities not eligible for the EU ETS should renegotiate their agreements such that the
             targets relate to fuel consumption only;
            participants in the EU ETS should be exempt from the CCL; and
            trading between the CCAs and the EU ETS should be controlled by a Gateway before 2008,
              with no trading after that date.
UK ETS      the UK direct participant scheme should cease in 2006, with no further incentivised rounds;
(DPs)       trading between the direct participants and the EU ETS should be allowed during the two-year
             overlap period;
            further expansion of trading in the UK should be based upon opt-in provisions to the EU ETS
             (based on direct emissions only) and/or sectoral expansion of the EU ETS, together with
             interfaces between the EU ETS and the project mechanisms;
            participants in the EU ETS should be exempt from the CCL;
UK ETS      the UK should proceed with a small-scale pilot scheme only, with fuller development of the
Projects     project mechanism being linked to the development of ‘modalities’ for interfacing the EU
             ETS to JI and the CDM;
            the pilot scheme should be developed in consultation with the Commission, with the rules
             taking into account the concerns of the Commission, Parliament and other Member States
             about environmental integrity;
            the rules should be consistent with those for JI and CDM and both nuclear and sink projects
             should be excluded;
            no project should be undertaken at sites that may subsequently become eligible for inclusion
             in the EU ETS;
            double crediting should be accepted in the pilot phase, but with an aggregate ceiling on credit
             volumes to preserve environmental integrity; and
            the UK should work to ensure that the subsequent EU proposals are compatible with the UK
             scheme.
IPPC        the interpretation of IPPC energy efficiency requirements that is outlined in the non-paper and
             in UK guidance is sensible and should be retained;
            the Commission should specify in greater detail the recommended approach to non-CO2
             GHGs for those installations where BAT requirements are expressed as technical
             requirements rather than emission limits;
            the provisions in Article 25 should be extended to those installations and gases that are not
             listed in Annex I but have chosen to opt-in to the EU ETS;
            to avoid problems with ‘hot air’, the inclusion of non-CO2 GHGs in Phase 2 of the EU ETS
             should be based upon both accurate monitoring protocols and very strict criteria for allowance
             allocation;
            installations should not be allowed to opt-out of the EU ETS on the basis of ‘equivalent’ IPPC
             energy efficiency requirements, since these are not ‘national policies’ and in practice are
             unlikely to be strictly enforced.
RO     the allocation of allowances to UK electricity generators should, as far as possible, take into
        account the renewables targets under the RO;
       in Phase 2, the EU ETS should be modified to allow one-way trading from TGC schemes like
        the RO, using a similar framework to that adopted for the UK ETS;
       this one-way trading should only apply to overcompliance which has been demonstrated by
        the acquisition of surplus TGCs;
       the small potential for double crediting within such an arrangement should be considered and
        acceptable price to pay for providing an additional incentive for overcompliance with
        renewables targets.
       the incentive for overcompliance should not be considered a substitute for other measures to
        encourage renewables deployment, such as more ambitious targets for renewables after 2010,
        greater flexibility in the banking rules for ROCs and removing the non-price barriers to
        renewables deployment.
EEC    the allocation of allowances to UK electricity generators should, as far as possible, take into
        account the renewables targets under the RO;
       during Phase 2, the EU ETS should either: allow one-way trading from schemes like the RO,
        using a similar framework to that adopted for the UK ETS; or encourage crediting projects in
        this sector through the development of suitable modalities for linking the EU ETS to project-
        based mechanisms;
       if the first approach is adopted, this should only apply to overcompliance which has been
        demonstrated by the acquisition of surplus TGCs;
       the small potential for double crediting within such an arrangement should be considered and
        acceptable price to pay for providing an additional incentive for overcompliance with
        renewables targets.
       the incentive for overcompliance should not be considered a substitute for other measures to
        encourage renewables deployment, such as more ambitious targets for renewables after 2010,
        greater flexibility in the banking rules for ROCs and removal of the non-price barriers to
        renewables deployment.
10. Further Reading
CCL and CCAs
Sorrell, S. (2002), The Climate Confusion: Implications of the EU Emissions Trading
  Directive for the UK Climate Change Levy and Climate Change Agreements, SPRU
  (Science and Technology Policy Research), University of Sussex, Brighton.

Available at: http://www.sussex.ac.uk/spru/environment/research/ccfr.pdf

UK ETS direct participants
Irving, W. (2002) The EU Trading Proposal and the UK Emissions Trading Scheme,
  ICCEPT, Imperial College, London.

Available from the UK Emissions Trading Group

UK ETS project scheme
Sorrell, S. and A. Smith (2002), Policy additionality for UK emission reduction projects, a
  report for the Department of Trade and Industry, SPRU (Science and Technology Policy
  Research), University of Sussex, Brighton.

Available at: http://www.sussex.ac.uk/spru/environment/research/policyadd.pdf

IPPC, RO and EEC
Smith, A. (2002), Implications of the EU Emissions Trading Directive for IPPC, the
 Renewables Obligation and the Energy Efficiency Commitment, a report to DG Research
 under the project ‘Interaction in EU Climate Policy’, SPRU (Science and Technology
 Policy Research), University of Sussex, Brighton.

Available at: http://www.sussex.ac.uk/spru/environment/research/wp5uk.pdf
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