The cap fits - it's time to wear it

Phase III of the EU's Emissions Trading Scheme will bring in stricter emissions caps in the name of fighting climate change. Merlin Hyman says it has to be done - despite dissenting voices from some quarters

A move to a low-carbon, resource-efficient economy is not only environmentally essential, but brings huge opportunities. This message has increasingly gained acceptance in mainstream business and government. Even the CBI - for many years the standard-bearer in business opposition to environmental standards - called for, in its recent report, a shift to a world where carbon becomes the new currency.

One area where there are huge economic opportunities in tackling the environmental challenges we face is the developing carbon-trading sector. Carbon trading will be a key component of future efforts to tackle climate change. Central to its success will be a strong, effective EU Emissions Trading Scheme (ETS).

The Environmental Industries Commission's carbon-trading working group, which represents international market leaders in the carbon-trading sector, has been working to build support for effective policy measures to create a real market for carbon. Its work programme centres on ensuring that measures, such as the ETS and the forthcoming Carbon Reduction Commitment deliver meaningful emissions reductions.

By capping carbon emissions, the EU ETS has the potential to be a key instrument in driving the much-needed transition to a low- carbon economy and stimulating innovation in new technologies that will increase the competitiveness of the EU in global markets.

To date, the EU ETS has been hampered by problems in the over allocation of allowances - due, in a large part to the poor quality of some of the historic and future emissions projections used to determine allowance allocations. This is not to mention scaremongering from polluting industries about the costs of strict emission limits and, subsequently, a lack of political will by member states to allocate allowances effectively.

In phase II the situation has improved somewhat and we are now starting to see an ETS emerge that has the potential to help the EU achieve the much-needed
transition to a low-carbon economy. By setting strict emissions caps, reducing the free allocation of allowances, expanding the scheme to cover as many sectors as possible - including aviation - and limiting the use of overseas credits so that the EU ETS drives emission reductions, the EU ETS can help drive investment in the low-carbon technologies.

For the past 14 years the EIC has argued that applying the highest environmental standards is essential in the transition to a low- carbon, resource-efficient economy.
This is a message that is finally beginning to hit home. Phase III offers a valuable opportunity, therefore, to apply this message in a meaningful way.

So can we now say we have reached a new era in how we approach environmental protection? Can we also say that tired old debates about environment versus jobs are consigned to the past, in favour of recognising high environmental standards are
central to the future of economic competitiveness in the EU?

Not quite.

The political establishment appears to have accepted, in principle at least, the need for a strengthened EU ETS. But look at the claims made by some sectors about the costs of proposals for phase III and you will realise an intelligent debate on environmental protection and competitiveness is yet to emerge fully.

We saw the same in phase I, where a combination of lobbying by the traditional polluting industries and a lack of political will led to an over allocation of allowances. This subsequently led to the collapse of the price of carbon, effectively removing any incentive to invest in low-carbon technologies.

There is no evidence to justify claims the EU ETS will damage competitiveness. For example, a recent Carbon Trust report concluded: "Overall, the EU ETS can extend with deeper emission cutbacks in phase III (post 2012), without damaging UK or European competitiveness."

The EIC believes high environmental standards are essential for our future economic well-being and for the competitiveness of the EU economy. A key question over the next year, therefore, is whether the EU has the will to face down vested interests and put in place a framework for phase III of the EU ETS that drives real emission reductions.

Central to the competitiveness debate is the issue of how allowances are allocated.

It is proposed that the power sector and carbon capture and storage will be subject to 100% auctioning from 2013. Installations in other sectors will receive a partial free allocation. This starts at 80% of their emissions for the period 2005-2007 in 2013.

It will gradually decline by equal amounts each year to zero free allocation in 2020.
Expections will be made for installations in sectors that are exposed to international competition and, therefore, pose a risk for carbon leakage.

This is where the installations relocate production to countries outside the scope of the EU ETS that do not set similar emissions caps, therefore leaving them free to pollute. Installations in these sectors will receive up to 100% of their allowances for free.

A decision will be taken on which sectors are at risk by 2010.

The EIC believes auctioning is the most efficient, transparent and equitable means of allocating allowances and welcomes the commission's proposals for greater auctioning of allowances.

For those sectors exposed to international competition there is concern that auctioning could drive business outside the scope of the EU ETS to areas where they would be free to pollute. The evidence suggests this concern is much overplayed, but highlights the importance of securing a post- 2012 international agreement on tackling climate change.

If a truly global agreement is reached, the risk of carbon leakage will be a lot smaller because more countries will have binding emission limits. In the context of a post-2012 international agreement, the commission should look to apply 100% auctioning across all EU ETS sectors from the start of phase III.

In addition to competitiveness, one of the key debates emerging from proposals for phase III concerns the extent to which organisations operating under the EU ETS can make use of overseas credits to meet their targets.

The commission has set out two proposals for the use of overseas credits in phase III. The first is based on achieving the EU's overall target of reducing emissions by 20% by 2020. In this scenario, operators will only be able to make use of any unused credits from phase II of the EU ETS. The commission estimates this will allow operators to achieve more than a third of the emission reductions required in phase III through the use of overseas credits.

Following a post-Kyoto international agreement, the EU has committed to increase its target to reduce carbon emissions to 30% by 2020. In this context, the limit on the use of overseas credits will be automatically increased up to half of the additional reduction effort.

The continued use of overseas credits is crucial for engaging all nations in the fight against climate change and forming the foundation of a global trading scheme. But there must be a limit on the use of such credits, as overseas emission reduction projects must supplement, rather than undermine, domestic action.

The EIC welcomes the commission's proposals to set a cap on total emissions at the EU level from the start of phase III. This is a significant step forwards from previous phases, where member states were able to set their own caps through national allocation plans.

From the start of phase III, allowances will be reduced annually by 1.74% in order to put the EU ETS on a pathway to meet its contribution to achieving the overall EU
target for reducing greenhouse gas emissions from 1990 levels by 20% by 2020.

To align with the timeframe for meeting this target, phase III will be extended to run from 2013-2020. The clarity provided by a longer phase, with annual reductions, is welcomed, but the scheme is still not ambitious enough.

The debate surrounding competitiveness has drawn attention away from the critical issue of the level of emission reductions the scheme delivers.

And whether or not the cap for phase III is sufficient for the EU ETS to play a central role in averting dangerous climate change.

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