WG8 Subgroup on Harmonisation and Increased Predictability - Report

Harmonisation and Increased Predictability

WG8 Subgroup Report – May 2007

Executive Summary

A subgroup of ETG Working Group 8 was initiated in December 2006 to consider issues relating to “further harmonisation and increased predictability” aspects of the review of the EUETS Directive announced in October 2006. The group has considered the options available taking a number of criteria into consideration. The group has sought to recommend one of the available options. The conclusions are presented in the following summary, grouped into the categories initially presented in the Commission’s Review Document.

Setting of Caps

Recommendation 1 - Overall a single EU Cap appears preferable to the approach of setting individual Member State caps. This is because a single EU cap would be a simpler method of determining the total quantity of allowances, and could be agreed earlier than a set of individual Member State caps.

Recommendation 2 - (If EU Cap chosen) A simple EU Cap set against historic levels generally appears preferable to a EU Cap set solely with reference to "Effort" (based either on Business as Usual projections or abatement potential) due to its simplicity, predictability and its consistency with currently international target setting approach. However, Business as Usual projections could have a role in ensuring a fair distribution of burden between traded and non-traded sectors. Also, an understanding of abatement potential could have a role in ensuring targets are achievable (or realistic), consistent with the principle of supplementarity.

Recommendation 3 -(If Member State Caps chosen)There is little to choose from between setting Caps via the Directive or in Member State NAPs.

Longer period cap vs permanent calculation procedure

Recommendation 4 -Alternative options to setting a fixed longer period cap could include setting a cap with agreed calculation procedure for modification. The procedure could be defined by a number of factors such as fuel price or with reference to international CO2 reduction targets. A preference for any of the options for setting Cap would be very dependent on how the criteria are ranked. Further consideration needs to be given to which factors are the most important.

Auctioning

Recommendation 5 - Relative to the total number of allowances issued astipulated level of auctioning with some free allocationgives the best overall outcome, compared with either a minimum or maximum requirement.

Recommendation 6 - It is most appropriate to allow different levels of auctioning for different sectors, or distinct sub-sectors, rather than applying the same level for all.

Recommendation 7 - When the environmental objective of the system is taken as the most important criteria then the best option for auctioning revenue is to use it for emissions reduction, rather than recycling it directly to participants or treating it as general taxation revenue. Irrespective of what the money is to be used for ETS participants should be informed well in advance as the use the revenues are put to may have a significant impact on the carbon market.

Recommendation 8 – It is preferable to harmonise the rules and structure of auctions at EU level as opposed to having rules and structure determined at Member State level (but administration should then be carried out and National level and revenue should be distributed in Member States where collected).

New Entry and Closure

Recommendation 9 - If environmental objectives and fairness are given the highest priority then MS level NERs are more appropriate than one set and administered at EU level, if simplicity, predictability, market function and engagement are given the highest priority then a centralised NER is most appropriate.

Recommendation 10 – For any sector with some free allocation to incumbents it is preferable that new entrants receive free allowances and future allowances are retained on closure, compared with the current regime of new entrants receiving free allowances and future allowances being forfeited on closure.

1. Introduction

In October, the Commission published a communication highlighting the key themes that need to be addressed in an ETS Directive Review.The key themes for the Directive review process are:

Scope of the scheme
Harmonisation of rules across the EU
Compliance and enforcement
Linking with other schemes

The Commission will publish its proposed amendments to the EU Parliament inlate 2007.

An ETG sub-group was established to explore the EU ETS harmonisation issues under consideration as part of the Commission’s ETS Directive review. This Group looked at the harmonisation issues in 4 workstreams.

A.Cap setting

Longer period cap and permanent calculation procedure
Auctioning
New Entry and Closure.

Each workstream considered the options associated with issues highlighted in the Commission’s review document.

The sub-group members were:

Mark JohnsonBritish Energy

Andy KellyCentrica

Richard LeeseBritish Cement Association

Angus MacRaeScottish and Southern Energy

Freya PhillipsEDF Energy

Jim RushworthLafarge

Neil SmithEON UK

Penny TomlinsonRWE npower

Sue YoungConocoPhillips

2. Assessment Criteria

The group selected the following set of assessment criteria by which the various options could be compared.

A. Impact on Predictability

Predictability is the ability to forecast scarcity within the market (i.e. level of abatement required against unconstrained). Predictability is undermined by political / regulatory uncertainty.

B. Impact on Fairness

(i) Impact on Competitiveness

There are 2 main competitiveness issues:

Extra-community competitiveness[1] – the implementation of EU ETS has created an uneven playing field, with firms and sectors from non-EU countries enjoying an unfair advantage because they are not subject to the same carbon constraints. Imported products into the EU are not subject to the same constraints that the EU ETS imposes on products manufactured within the EU. There is potential for reliance upon imported products to meet EU demands if there are allowance shortfalls, particularly if the shortfalls cannot be met by efficiency savings and/or additional costs cannot be passed on to the consumer. In addition to the movement of manufacturing and the consequential shift in economic structure of the community the reliance upon imported commodity products may increase the carbon intensity of the goods. The additional emissions may come from product transport and potentially higher emissions from plants that are not regulated to the same standards are European plants.

Intra-community competitiveness – This is essentially an EU ETS “implementation problem” where EU countries may create unfair competitive advantages for domestic industry by the manner in which Member States design, implement and regulate EU ETS commitments. The EU is a highly integrated market. The desire for flexibility to elaborate very different national plans for allocating emissions reductions and treatment of new entrants and closures needs to be balanced against competitiveness impacts.

Whilst the paper discusses competitiveness in general terms it does not consider the extent to which the issues raised apply to individual sectors.

(ii) Enterprise Value

The introduction of a regulatory change such as EUETS is likely to change the value of enterprises that are covered where enterprise value can be considered as the net present value of the future profit steams associated with the enterprise’s operations.

C. Effect on environmental objectives

Impact on meeting the objective to reduce greenhouse (GHG) emissions and move towards stabilising the concentration of GHG in the atmosphere at a level of 550 ppm CO2 equivalent. Timeframe to be agreed (2050).

D. Potential for achieving consensus

Potential for gaining agreement across the EU Member states

E. Impact on the efficient functioning of market (clarity / timeliness)

Mature and robust emission allowance market that has the confidence of investors and is capable of providing the long term price signals.
Stable and deep CO2 market
Minimal price volatility and market shocks

F. Simplicity

Administratively simple
Ability to roll out similar scheme in other countries.

G. Engagement of all sectors in the scheme

The integration of the price of carbon into business decisions – both on operational and investment levels.

3. Workstream A – Caps Setting

Single EU level Vs individual MS cap

A single EU wide cap on emissions is taken to mean a cap agreed at EU level in the first instance, but could be subsequently divided amongst member states or amongst sectors as part of a (potentially uneven) burden sharing agreement. On the other hand, individual caps could be set by Member States without necessarily referencing an EU target. The key differences between approaches is that the former is a top-down approach, with the total number of allowances determined near the beginning of the process, and the latter is a bottom up, with the total number of allowances an aggregation of individual member state contributions.

Impact on predictability

Whilst there is no fundamental difference in predictability between EU-wide cap vs. collective Member State caps if they are for the same periods and agreed in the same timeframe, practicalities may mean that if a long term EU wide target is agreed, it maybe easier to gain agreement of the burden sharing between the traded and non-traded sector, hence provide potentially greater predictability of the overall scheme. An EU wide cap has the benefit of being set earlier, rather than waiting for Member States to declare their caps; the last declaration completing the final aggregate total cap.

Impact on fairness/competitiveness

The main issue is the distribution of allowances across the EU. Competitiveness impacts will be greater affected by whether individual Member States have influence over their own caps or not. Since the setting of an EU level cap is likely to be followed by a Member State burden sharing arrangement, there is nothing to distinguish this option from a method based on individual caps, and neither would necessarily improve competitiveness impacts of the scheme.

Effect on environmental objectives

The environmental benefit will be determined by the total scarcity (cap), which should set the carbon price from the abatement cost curve. The environmental benefit will not depend on the way in which the overall cap is determined.

However, if a single cap were weaker than the sum of individual caps this would lead to lesser emission reductions (and vice-versa). This is possible since a single cap would probably avoid any weak national targets but would also curtail other strong national ambitions, whereas the current EC process for assessing individual caps is only concerned with preventing weak national targets. It is not clear whether this effect could be significant. However Phase I experience indicates that many Member States have been reluctant to impose national strict caps on their installations.

Potential for achieving consensus

It may be easier to agree a single EU cap, particularly if based on a reduction against an historic baseline (rather than business-as-usual). However, any subsequent division of burden would be much harder to agree, and consequently there may be little to separate this approach from a method of individual caps. A single cap would make clear the reductions expected from both the traded and non traded sectors, alleviating concerns that the EUETS is the main regulatory vehicle with the potential to achieve significant emissions reductions.

Impact on efficient functioning of market (clarity/timeliness)

An EU-wide cap would provide clarity on the overall scarcity of allowances and offer the potential for a simpler process with fewer market-sensitive announcements than a series of member state NAPs.

Any delays in agreeing a single cap could create significant uncertainty in the run-up to the phase. The process would need to be commenced early to avoid this risk. If an long term EU wide target is agreed, it maybe easier to gain agreement of the burden sharing between the traded and non-traded sector, hence provide potentially greater predictability of the overall scheme.

On the other hand, an approach of individual caps is almost certain to lead to some delays because experience suggests it unlikely that all Member States will meet the deadlines and the Commission would also be required to approve the caps.

Simplicity

A single cap would be a simpler route to establishing overall scheme scarcity. It would be more complex if subsequent burden sharing were required, but there would be a clearer signal as to the trajectory of emissions reductions expected, and overall the approach is considered simpler than the, potentially bottom-up, method of individual caps.

Engagement

Engagement will be determined by the individual treatment of sectors and installations, rather than the process for setting the overall cap.

Option / Predictability / Fairness / Env. Objectives / Consensus / Function of market / Simplicity / Engagement
EU cap / √√ / / / / / / / √√ / √√ / /
MS caps / / / / / / / / / √ / X / /

Means for setting cap if single EU level cap chosen

The following approaches to setting a single EU-wide cap are considered against the assessment criteria.

Definition of cap based on current/historic levels

This would involve a simple reduction factor applied to an EU historic baseline. The factor could be based on the EU post-Kyoto target (which, if agreed in advance, would provide greater predictability) or some other aim, such as a trajectory towards a longer-term aspiration.

Such an approach would have the benefits of being simple, potentially more predictable, easier to gain consensus (than a more complicated route) and provide a timely signal to the market. The setting of a cap based on reductions against historic values would be more aligned with environmental objectives than an approach which sets the cap by reference to growth projections.

Definition of effort based on Business as Usual projections

This approach is similar to the above method. It would apply a simple reduction factor to business-as-usual emissions projections to determine the total number of allowances in the scheme. However, the complexity in making such a prediction and its inherent uncertainty would make the approach less predictable and harder to achieve a consensus, for example with respect to growth projections and the effects of other measures.

However, Business as Usual projections for the whole EU economy could have a role in ensuring a fair distribution of burden between the traded sectors and non-traded sectors. For the reasons of predictability, complexity and ability to gain consensus discussed above, it would be preferable if such projections were kept simple.

Definition of effort accounting for abatement potential

This approach would require business-as-usual predictions, as above, but the level of reduction sought would be determined with reference to the marginal abatement cost curve, and would effectively cap the cost of carbon (cheaper reductions from project mechanisms would in practice deliver a lower cost of carbon). This approach would have the disadvantage of being complex and requiring many assumptions. It would also be a step removed from the environmental objectives, since targets would be determined by the cost of reductions rather than a required emission reduction path. However, the concept of limiting the cost may have political appeal.

Whilst abatement potential is not the preferred main method for determining the cap, it could have a role in ensuring that the cap chosen is realistically achievable. Such a process would need to take into account the requirements for domestic action, and scope for use of project credits, under the supplementarity principle.

Option / Predictability / Fairness / Env. Objectives / Consensus / Function of market / Simplicity / Engagement
Cap / √√√ / / / √ / √√ / √√ / √√√ / /
Effort based on BAU / √ / / / / / √ / / / / / /
Effort with abatement / X / / / X / X / / / X / /

Recommendation 2 (If EU Cap chosen) - A simple EU Cap set against historic levels generally appears preferable to a EU Cap set solely with reference to "Effort" (based either on Business as Usual projections or abatement potential) due to its simplicity, predictability and its consistency with currently international target setting approach. However, Business as Usual projections could have a role in ensuring a fair distribution of burden between traded and non-traded sectors. Also, an understanding of abatement potential could have a role in ensuring targets are achievable (or realistic), consistent with the principle of supplementarity.

Caps set in Directive vs caps set via NAPs if MS level caps chosen

The EC review is considering options for setting caps if they are defined at Member State level. However, here we also consider issues surrounding the setting of an EU wide cap, since the balance between certainty and flexibility also applies in this case. This section considers where caps are set, but not the basis for determining them. The options considered are:

EU-wide cap set in the Directive
EU-wide cap via a separate agreement
Member State caps set in the Directive
Member State caps set via national allocation plans.

Impact on predictability

The total number of allowances would be finalised earlier in Directive than via separate routes since the latter would need to be developed to meet the requirements of the Directive. This applies for an EU level cap or individual Member State Caps. Consequently, caps determined in the Directive would have the advantage of increased predictability.

Impact on fairness/competitiveness

The setting of caps via the Directive (either an EU cap or Member State caps) prevent later adjustment for national or EU circumstances. The avoidance of Member State flexibility later in the process may be considered better for fairness and certain aspects of international competitiveness. The prevention of flexibility at an EU level, however, may be detrimental to the EU’s global competitiveness. However use of project mechanisms credits from outside the EUETS is anticipated, potentially limiting EUA price increases and lessening but not eliminating international competitiveness impacts on EU ETS installations and sites impacted by indirect carbon price effects.

It may be that caps set as part of the Directive would have a greater degree of consistency and common assumptions and could therefore be considered fairer.