Emissions trading - Says who?

The UK is likley to be one of the first, if not the first country, to have a functioning Greenhouse Gas Emissions Trading Scheme. As Anthony Hobley of environment law firm CMS Cameron Mckenna explains, however, such a scheme, at least initially, will have no clear legal basis for governance and non-compliance.

The issue of non-compliance is one of the main criticisms levelled at the government's proposals for an Emissions Trading Scheme (ETS), published in its consultation document, A Greenhouse Gas Emissions Trading Scheme for the United Kingdom, in November last year.

Why, therefore, is the government (and business) so determined to develop an emissions trading scheme before others do so, even if this means putting into place such a scheme without legislation and consequently without clear powers to impose and enforce penalties? Such a pioneering approach is fraught with risks, not least getting too far ahead of the international community and placing a system which is inconsistent with systems in other countries.

Economic advantages
Government clearly believes that there are potential economic advantages to the UK in being one of the first countries to develop a functioning ETS. It justifies this belief by stating that the early development of a domestic ETS will mean that the UK government, UK business and the City of London will be well placed to play a leading and influential role in both the development and use of these schemes in other countries and internationally. Industry would seem to share this view, as the form of the ETS being proposed is largely the result of a business-led initiative (in June 1999 the Confederation of British Industry (CBI) and the Advisory Committee on Business and the Environment (ACBE) set up the UK Emissions Trading Group (ETG) to design a UK ETS).

In brief, it is intended that the ETS will cover not only carbon dioxide emissions but also the other five GHGs, provided that suitable protocols for measuring and verifying emissions have been developed. To begin with there will be two major mutually exclusive ways to obtain access to the ETS: (i) voluntary participation; and (ii) as a party to a Climate Change Levy Agreement.

The Consultation document proposes that private companies and other commercial entities will initially enter such an ETS on a voluntary basis. Prospective participants will have to bid for part of an annual incentive of £30m available over five years. The current timetable envisages, somewhat optimistically, that bids for the incentive should be received by early Autumn, even though government does not expect the rules for the ETS itself to be finalised before late Autumn. In return for a slice of the incentive, participants will accept an obligation to achieve absolute and binding GHG emissions reductions. How then are these binding rules to be effectively enforced over and above the non-payment of the incentive?

It is proposed that the ETS will start on 1 January 2002, when participants will be issued with allowances permitting the holder to emit a given quantity of greenhouse gases. Participants will, subject to the rules of the ETS, be allowed to trade these allowances - so-called 'Cap and Trade'. On 31 December 2002 it will be determined whether or not participants have achieved their targets, with incentive payments made in April 2003. This process will be repeated annually.

In contrast, those companies which have entered into the mutually exclusive Climate Change Levy Agreements (CCLAs) with the government for the purpose of securing an 80% rebate from the Climate Change Levy obligations, will only be issued with allowances when, and if, they have exceeded their targets - so-called 'Credit and Trade'. Under the proposed Credit and Trade system for CCLA participants enforcement is likely to be less of an issue, except in relation to false reporting, which will be an issue for both systems.

As there is, initially, to be no new legislation to set up the ETS, the scheme is to be brought into being using the government's existing administrative powers. Participants will each be required to enter into agreements with the government (drafts of which have yet to be circulated), possibly similar to the CCLAs. And like the CCLAs, ETS agreements will probably not be contractually binding.

As government will have the key role in setting up the ETS, it is proposed that, at first, it will have the key role in administering the ETS. This, it is proposing to do through a pseudo Emissions Trading Authority (ETA), which will simply be a function within central government, probably based at the DETR or DTI.

The Consultation Document expressly states that in the longer term the ETA will be established as a statutory independent body. This will almost certainly require primary legislation, and so is unlikely to happen for at least two years or probably longer. The Consultation Document proposes that the ETA should have responsibility for:

  • approval of monitoring and reporting protocols;
  • approval of the accreditation process for verifiers;
  • enforcing ETS rules;
  • operating the registry of allowance holdings; and
  • approving emissions reductions projects.

The consultation document also makes it very clear that in the early stages of the ETS there will be no express statutory sanctions for breaches of the rules, other than withholding the incentive or expelling a participant. Is this a problem? In some cases it is possible that the cost of compliance may easily exceed the value of the incentive. This raises the possibility that there may not be, to begin with, an effective deterrent against non-compliance.

It is rather optimistically suggested in the consultation document that reliance could be placed on criminal law. Criminal offences were not, however, drafted with emissions trading in mind, and considering the difficulties already experienced in prosecuting complicated financial fraud cases or environmental offences in the ordinary courts, criminal law is unlikely to be an effective enforcement mechanism for anything other than perhaps deliberate and dishonest practices, e.g. falsifying emission returns. Criminal law will certainly not apply where a company simply fails to meet its target, for example because it fails to invest in the necessary equipment or to purchase sufficient allowances.

The other suggestion put forward is that participants might themselves agree to a self-imposed regime of penalties for breaches of ETS rules. Such a regime would almost certainly have to rely on some form of contractual arrangement between participants, in addition to administrative agreements with government. Participants would also probably need to appoint a body to be party to these agreements and enforce them. Case law suggests, however, that such contractual penalties may not actually be enforced by the courts and, therefore, such a scheme will rely very much on the goodwill of the participants in accepting any penalties imposed. As soon as a party chooses to challenge the contractual penalties, the entire enforcement scheme is placed in jeopardy.

Similar schemes do work in some areas. If a football club refused to pay a penalty imposed upon it by the Football Association, for example, it could be expelled and so could, in effect, be prevented from playing competitive football. The benefits derived from membership are central to a football club's existence, and so it is unlikely to risk expulsion - unlikely to be the case for an ETS member. On the other hand, with recent developments such as on-line exchanges and the like, in the US and UK, appropriate penalty clauses are now more likely to be given sympathetic considerations by the courts.

The government was at one point looking to sidestep the entire issue of penalties and compliance within the ETS, by favouring 'buyer liability' as opposed to 'seller liability'. Buyer liability would entail the buyer of any allowances accepting the risk that all or some of those allowances purchased would subsequently be revoked if the entity to whom such allowances had originally been issued, failed to comply with its emissions targets. However, sources within government have indicated that it has now dropped any serious consideration of the buyer liability model in favour of seller liability. It is also believed that the buyer liability approach is losing ground at international level and may be dropped as a serious consideration when COP-6 resumes later this year. Under seller liability, allowances in the ETS will have a guaranteed value once they have been sold.

Government and business share many, but not all, of the same objectives. Business, for instance, is hoping for a system which is as open and cheap to participate in as possible. The government, on the other hand, wants a scheme which is internationally credible. These objectives are not always compatible.

In a number of aspects it is business which has carried the day, particularly in relation to proposals in the consultation document for plant closures and major reductions in output. It seems that in neither case will allowances associated with the relevant entities and activities be withdrawn or reduced. Government seems to have accepted the argument from business that to do anything else would require business to report output as well as emissions. It is felt this would mount additional burdens and costs on businesses, which would persuade them not to join a voluntary scheme. However, this does give rise to the possibility that emissions reductions from plant closures or major reductions in output could give rise to a flood of cheap allowances onto the market. In extreme cases this may also result in allowances being granted for the same activities more than once, for example in the UK, where the activities close down, and again in another country where they are relocated. Opportunities for 'gaming' may also arise in cases of mergers, de-mergers, acquisitions and disposals because, unlike the CCLAs, participants in the ETS are based on a legal definition of an entity, and not the specific activity in relation to which the emissions relate.

Interaction with IPPC
There also exist issues of double regulation, where the relevant activities of a participant in the ETS are also subject to regulation under the European Directive on Integrated Pollution Prevention and Control. Because CO2 does not have local environmental effects, and is therefore not directly regulated by IPPC, the only regulatory concern in relation to CO2 emissions is the IPPC energy efficiency requirement. Whilst the energy efficiency obligation will not be totally removed for ETS participants, it is understood that a Memorandum of Understanding has been established between the DETR and the Environment Agency, which means that those in the ETS will only be subject to a baseline regulation in connection with this requirement. Those outside both CCLAs and the ETS will be subject to much more onerous energy efficiency obligations under IPPC.

There will, however, be more complicated regulation issues with regard to the other five GHGs, particularly those which have local environmental impacts, in addition to their global ones. Some of these will be regulated directly under IPPC by means of local emission limits. Because the IPPC regime is based on the principle of Best Available Techniques, this will give rise to ever increasing standards. There is, therefore, a question which is yet to be satisfactorily answered, namely whether there will be any head room between these local emission limits, where they apply, and the caps imposed pursuant to the ETS. If the local emission limits are tighter than the ETS caps, what impact will this have on a company's ability to trade the excess above the local emission limits?

If one views the ETS as essentially a pilot programme developed jointly by business and government, so that both may 'learn by doing', it is then a reasonable assumption that the ETS will work in the short term, without specific statutory provisions as to enforcement and penalties. Many of its objectives are to help make the UK a centre of expertise in this new market. It is not expected that it will be perfect. Many of the companies taking part are likely to be enthusiastic. Therefore, they will also probably believe that making early emissions reductions, and learning how to trade emissions, will give them a commercial advantage over their competitors.

However, the ETS will not be a pilot scheme indefinitely; in the medium to longer term it will probably only survive if it is put on a full statutory footing, with clear statutory penalties for non-compliance.

Government wants robust enforcement to ensure real emissions reductions; whilst business wants robust enforcement to minimise 'free riders', and so keep transaction costs to a minimum. Robust enforcement is also likely to give rise to a more vibrant emissions trading market than otherwise would be the case, because non-compliance would be a serious issue with clearly defined consequences. Whether robust enforcement can be achieved in a voluntary non-statutory scheme, only time will tell. The betting money, however, is likely to be on a mandatory scheme with statutory-based penalties in the medium term.



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