Emissions trading: the implications for industry

Next month will see the launch of an emissions trading scheme as part of a range of measures designed to help the UK meet its commitments on greenhouse gas reductions. Likely participants fall into two categories: those who are part of a Climate Change Levy Agreement, and those who are not. William Blyth, climate change consultant for Cirrus, the strategy practice of AEA Technology Environment, looks at the issues facing both camps.

Companies will be eligible to join the emissions trading scheme if they take on a target to reduce their emissions. If they do better than the target, they will generate permits which they can sell, whereas if they fail to meet the target they will have to buy permits.

The scheme will be administered by an ‘Emissions Trading Authority’, to be set up by government, and there will be a register of trades which will record purchases and sales of permits. The actual trading itself can either be between individual companies, or through brokers. Reported emissions reductions will be underpinned by a system of verification.

Since the scheme will be voluntary, the question arises: who would want to join such a scheme? Likely participants fall into two categories, those who are part of a Climate Change Levy Agreement, and those who are not.

Companies operating within sectors covered by the IPPC Directive have been given the opportunity of an 80% discount on the CCL if they sign up to targets either for energy efficiency improvements or CO2 reductions. These targets have been the subject of negotiation for the past 18 months, and many have now been finalised.

Administrative burden

The negotiations have been carried out at two levels. The DETR has negotiated sector-wide targets with the relevant trade associations – the trade associations have then agreed individual targets with their member companies. These targets are set for 2010, with two intermediate milestone targets.

For these companies, the threat of losing their 80% Levy discount provides a strong incentive to meet the agreed target. Progress will be assessed at the milestone years, and they will have to show that they have met their efficiency targets by providing energy and production figures to their trade associations.

Companies are allowed to use emissions permits purchased from the trading scheme to help them meet these milestone targets. On the other hand, if they do better than the agreed target, they will be able to sell permits. This ability to use emissions trading means companies can take a much more flexible and lower-risk approach to managing their CO2 emissions, since they do not have to exactly meet the target in order to continue to qualify for the levy discount.

The only real barrier to these companies joining the scheme is the administrative burden of registration and compliance. In order to keep this to a minimum, reporting requirements have been harmonised as far as possible with the requirements of the CCL agreements. For trading purposes, however, emissions figures will have to be verified by an independent organisation, which does introduce an additional expenditure.

Individual scrutiny

Since the CCL agreements have been brokered by trade associations, there exists a strong role for such associations to play in co-ordinating sector approaches to meeting the targets. If a sector-wide target is met as a whole, then all member companies will continue to receive the 80 per cent discount, regardless of individual performance. However, if the sector-wide target is not met, then individual company performance will be assessed. It is, therefore, in the interests of the sector to meet this overall target in order to minimise overall administrative burden.

For a sector to meet its targets, the companies who do better than predicted will need to share their success with the rest of the sector. Whether there is any financial incentive for them to do so – e.g. internal trading within the sector – depends on arrangements made by the trade association.

However, it should be remembered that companies will be free to buy or sell permits on the ‘open’ market outside of their sectors – they can go in search of the best price for their permits. If enough companies choose to sell their excess permits outside of the sector, therefore, the sector-wide target could be at risk. Companies with poorer performance would then need to consider buying permits in order to meet the sector target and avoid laying themselves open to individual scrutiny.

Most businesses will not be part of a CCL agreement, and will either be paying the full CCL rate, or they may be exempt – e.g. upstream energy generation and supply companies. These companies face a different set of decisions, because they do not have the same incentive (i.e. possible loss of the CCL discount) to make emissions reductions.

Incentive scheme

In order to join the emissions trading scheme, companies have to take on a target to reduce their emissions. The magnitude of this target has not yet been finalised, but could be in the region of one per cent reduction per year. For many companies this will represent a risk, since limiting their emissions could impose a limit on future growth – after all, it is currently free to emit CO2, so why impose constraints on yourself?

For some companies, however, there will be some incentive to join a voluntary emissions trading scheme. If a company is predicting flat production levels, for example, or is moving into products which are less energy intensive to manufacture, then it might be relatively easy to meet the minimum reductions through efficiency measures. Any improvements beyond the minimum target level can then be sold via the trading scheme. This improves the return on investment companies will get on their efficiency projects.

Business has campaigned for many years to be allowed to control environmental performance through flexible market-based options. Many companies have been involved in setting up the emissions trading scheme via the Emissions Trading Group, and several of these will probably join in order to ensure that the scheme is successful.

The government envisages that emissions trading will become more widespread internationally. By taking a lead in this area, UK companies could develop a competitive advantage through ‘learning by doing’.

One of the risks business faces in the future is the threat of tighter controls on CO2 emissions. This could mean that, as pressure mounts on companies to reduce emissions, the effective cost of permits will rise. There may therefore be an incentive to join to make use of possible cheaper permits in the early stages of the scheme.

The government has announced funding of an incentive scheme worth £30m per year over five years to encourage companies to come on board. This will be paid via auction – companies will bid in with emissions reductions, and the money will go to the most cost-effective bids. The rules of this auction will be announced later in the Spring, and companies will need to prepare their bids ready for the auction in the Autumn.

As discussed above, there will be various different routes into the scheme, but some fundamental features will apply to all. First of all, it should be recognised that CO2 emissions are calculated primarily on the basis of energy consumption. Records of energy consumption will be used to demonstrate progress towards emissions targets.

Given that progress will be subject to verification, companies will need to have confidence in their systems for collecting this data. Companies which operate an environmental management system certified to ISO 14001 or EMAS (the EU Eco-management and Audit Scheme), will most likely meet data quality requirements.

Companies will also have to follow a standard protocol for calculating CO2 emissions. A protocol is being developed by AEA Technology and accountants Ernst & Young on behalf of the UK Emissions Trading Group, drawing on best practice for GHG emissions reporting from a variety of sources. The protocol also gives guidance on how emissions should be reported, and the requirements of verification.

In order to make the most of emissions trading, companies may need to set up systems for collecting information on emissions reductions opportunities. In many firms, such opportunities often go unnoticed because they are not centrally reported. The costs of such opportunities will also need to be recorded so that the best package of measures can be carried out.

Cost abatement

With this information, companies will be able to compare the costs of reducing emissions with the cost of buying additional permits (or, conversely, the benefits of selling surplus permits against the costs of beating the target). This approach can be summarised in a cost-abatement curve, above, which shows the relative costs of abatement measures compared to potential permit prices. This is the fundamental process your company will need to go through to manage carbon trading.

It will also be important for those managing emissions trading to link into the company’s overall business objectives. The implications of changes to production levels, processes, outsourcing and acquisition decisions will need to be taken on board. This may require the development of new communication channels within the company, since these functions are often dealt with by distinct departments. Armed with this knowledge of abatement costs and likely business developments, managers will be in a position to tackle the question of whether or not to trade.

There may be a ‘gateway’ restriction on the amount of permits that can be sold by companies with an efficiency target rather than an absolute carbon target. This is to prevent a devaluation which might result if the market was flooded with cheap permits. There will not, however, be a restriction on the number of permits bought by companies with efficiency targets. This gateway does not apply to any company with an absolute carbon reduction target.

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