The future shape of carbon

Whatever your views on climate change or the Kyoto Protocol, if your business operates in Europe, it must prepare now for the impact of the European Union Community-wide Greenhouse Gas (GHG) Emission Allowance Trading Scheme (EU ETS). Forward looking companies such as BP, Dupont, Lefarge, Nuon, Tractebel and Shell, amongst others, have made climate change an important business issue for some time. Now, however, mainstream European industry, including multi-national companies with European interests, must quickly adapt and prepare for a carbon constrained future.
The EU ETS is expected to eventually cover as many as 17,000 installations in 28 European countries and will be the world’s first multi-national emissions allowance trading scheme for major carbon dioxide (CO2) emitters.

Some experts estimate the market will create carbon assets and liabilities worth many billions of euros. The sheer scale of the EU ETS may result in it becoming the foundation of international emissions trading to which other countries, including, Canada, Japan and potentially even Australia and the US, will subscribe.
The directive establishing the EU ETS entered into force on October 25, 2003 when it was published in the Official Journal. The directive is designed to reduce emissions of CO2 from installations involved in (1) energy activities, (2) the production and processing of ferrous metals, (3) the mineral industry (e.g. cement, glass or ceramic production), and (4) pulp, paper or board production. Each operator of an installation carrying out one or more of the activities above the relevant thresholds will be required to hold a site-specific and non-transferable GHG Permit. The GHG Permit will require the operator to hold EU Allowances in its compliance account in the Member State’s registry at the end of each calendar year at least equal to the actual GHG emissions monitored, reported and verified from that installation during that calendar year.

Failure will result in heavy penalties: E40 in the first period (2005-2007) rising to E100 in the second period (2008-2012) for each tonne of CO2 equivalent by which an installation exceeds the number of allowances it holds. Furthermore, operators will need to obtain additional allowances in the following year to rectify their shortfall. The timeline for implementation of the EU ETS Directive is extremely tight. Member States must implement the directive by December 31, 2003, a directive which was only adopted in July and barely 18 months after the scheme was proposed by the EU in a green paper. This unprecedented timetable will make it extremely difficult for governments to implement the directive in a timely and considered fashion. In addition, they have the added pressure of drawing up the plans for the allocation of allowances to individual installations for the first phase of the scheme (2005-2007) by March 2004.

The allocation process is extremely important to operators in the EU ETS as it determines the baseline of their carbon liabilities. National governments are in the process of developing their National Allocation Plans and are at varying degrees of readiness. This tight timetable may cause the incomplete or imperfect implementation of the directive, which could create fertile ground for litigation challenging either the implementation of the directive or, more likely, the distribution of allowances in the National Allocation Plans. Whilst the Commission retains a right of veto over the plans, there may be substantial differences between the allocation mechanisms adopted by each Member State, which could lead to discrepancies in the way similar industries are treated across the EU. Operators of installations may be unhappy with their allocation in absolute terms or relative to others. These real or perceived inequalities may lead to legal action.

The Commission may take action against a Member State for failing to implement the directive properly or at all. An action may be brought under State Aid rules if a Member State’s allocation effectively affords an unfair advantage to a national, thereby distorting competition between Member States. In certain jurisdictions, individuals or corporations may attempt to challenge the constitutionality of the implementing legislation, on the basis that it affects their fundamental rights. They may also bring administrative proceedings before their domestic courts against the competent authority if they believe it acted unreasonably when awarding the allocations, or did not adopt a fair procedure. These potential claims may delay the timing of the scheme which is due to start on January 1, 2005.

Whilst the decision to leave responsibility for the allocation process to individual Member States enabled the directive to be approved in an almost unprecedented timescale, it does give rise to some potential problems. These problems could arise from different approaches by Member States to issues such as banking, new entrants and closure. If one Member State allows unlimited banking from the first period to the second, it may find its registry flooded with banked allowances from operators in other Member States which do not allow banking or limit banking in some way. Another problem will arise when formulating the National Allocation Plan for the second period. If banking is unlimited, Member States will not know how many allowances are likely to be banked at the time the plan is due in mid-2006.

Many Member States are alive to these issues and are discussing, on an informal basis, the possibility of developing a co-ordinated approach. Such a coordinated approach may extend to the legal nature of the allowances and their consequential tax and regulatory treatment. There is a clear consensus amongst the companies that we have spoken to that the certainty such harmonisation would bring would be welcomed by the market and enable the EU ETS to function more efficiently.

Many companies are already lobbying relevant Member State governments both as part of and separate from formal consultation processes about their likely allocation under the National Allocation Plan. This is the critical moment in which industry can attempt to influence the allocation they are likely to receive. Once the plans are published, operators must work with what they are given or take legal action if they feel they have been unfairly treated. There are a number of other decisions that must be made by operators, particularly companies with installations across a number of Member States, before trading begins in 2005. The company should also consider who retains ‘ownership’ of any emission reductions that are achieved by specific installations and screen relevant contracts to assess where ownership of such rights lies.

Whilst some companies are already working to reduce their emissions through internal efficiencies or external programmes such as the WWF CO2 reduction commitment, there are also other means of obtaining emission reductions under the scheme. The Clean Development Mechanism (CDM) incentivises the investment by companies in industrialised countries in emissions reduction projects in developing countries by awarding credits in the form of certified emission reductions (CERs) which can be used to fulfil the company’s own reduction commitments or be traded on the CDM market. Joint Implementation (JI) projects encourage cooperative efforts between industrialised countries to reduce emissions and allows reduction commitments to be met in countries where greenhouse gas abatement costs are lower. Again, emissions reductions achieved are awarded with CERs which are tradeable on the market.

Some companies have already purchased, or put aside the funds to purchase, the right to allowances or credits from future projects. Other companies are looking to institutions such as the World Bank who are providing funds through which CERs or ERUs can be purchased from a broad portfolio of projects thereby spreading the risk of any individual projects failing. The Commission is currently proposing an amendment to the EU ETS Directive to allow operators to effectively use credits generated by JI and CDM projects towards satisfying their obligations under the directive.

In addition to these public funds, there has been a great deal of activity in the private sector surrounding the development of financial mechanisms for investing in renewable energies. Many organisations such as Swiss Re, Allianz and Henderson Global are backing renewable energies with their investment power, whilst investment banks and private equity houses, including Merrill Lynch, Impax, ISIS and HG Capital, have prominent specialist environment or energy funds for investment in renewable energies.

The creation of the EU ETS creates potentially enormous carbon liabilities depending on the price for allowances and the corresponding costs of achieving emissions reductions. In practice there will be both winners and losers resulting from the national allocation processes in each Member State. Certainly, emitting carbon dioxide and other greenhouse gases will no longer be free. Costs to reduce GHG emissions and/or purchase EU allowances or credits will be significant for many companies and must be accounted for on balance sheets although exactly what methods are used to do this has yet to be determined. Mainstream European industry, including multi-national companies with European interests, must quickly adapt and prepare for a carbon constrained future. Carbon liabilities are real now.