The EU reached political agreement in December on a directive on greenhouse gas emissions trading. In pursuit of a uniform trading system, the EU is seeking to require certain heavy industries to meet challenging carbon dioxide emissions reduction targets.

This is the first serious attempt to implement the Kyoto Protocol at international level. The Directive has to go to the European Parliament before becoming law but it is now substantially in the form likely to be adopted later this year. The Directive will have significant implications for businesses in the UK, particularly those with direct CO2 emissions or which are covered by the UK’s voluntary emissions trading scheme (UK ETS) or by climate change levy negotiated agreements.

A draft directive has been around for some time but there was uncertainty over timing of implementation, sectors to be covered, mandatory or voluntary schemes, method of allocation of emissions credits and interaction with existing legislation. This made it difficult to assess the impact of the EU’s plans. Now that some of these issues have been addressed and there is some certainty that the directive will become law, it is time for UK industry to sit up and take notice.

Scope and impact

The UK won several concessions during the recent negotiations leading to the latest proposal. Certain installations can be temporarily excluded until 2008 and, from 2008, it will be possible to widen the scope of the EU ETS by voluntarily including further sectors that are subject to the Integrated Pollution Prevention and Control (IPPC) regime.

This should allow those that will be covered by the EU ETS to stay within the UK ETS for its full term if they are part of it. However, it leaves the future of the UK ETS beyond 2008 very uncertain. The principal problem for Government is that EU ETS only applies to a limited number of IPPC installations that directly emit CO2. The UK ETS has no such IPPC requirement and makes no distinction between direct CO2 emissions and indirect (electricity use) emissions.

It is likely that, however painful for the UK Government and those involved in the UK ETS, it will ultimately be decided that the EU model will apply within the UK. This does not preclude the operation of a separate system using economic instruments to encourage energy efficiency in other sectors not covered by the Directive but it does mean that such a system would not link with the EU ETS and therefore international trading schemes.

The EU ETS will also have significant impacts on businesses with obligations under CCL Agreements. The CCL applies at the point of final energy consumption. Generators of electricity are exempt from CCL in respect of their consumption of fossil fuel and instead the CCL is applied at the point of supply of the electricity to business end users.

Therefore CCL Agreements cover both indirect and direct emissions. As stated above, the EU ETS will impose mandatory caps on direct emissions of CO2 for certain IPPC installations. It follows that a business could be under a mandatory EU ETS cap as well as a CCL Agreement cap covering a different portfolio of energy consumption. In addition, concerns about double counting of emissions will make it difficult to allow free trading between the EU ETS and CCL Agreement systems.

The positive news for CCL Agreements is that sector wide pooling arrangements will be allowed to continue under the EU ETS, although they are unlikely to be particularly attractive because they are likely to prevent business from taking full advantage of trading as part of managing energy efficiency.

Gas coverage

The Kyoto Protocol identifies six greenhouse gases that are to be controlled to prevent or mitigate climate change. The EU proposal only deals with carbon dioxide, the principal greenhouse gas. Although, tonne for tonne, other gases have much greater greenhouse gas warming potential, the EU has felt it necessary to exclude them, presumably because the quantities emitted are small compared to CO2 and there are difficulties associated with monitoring and evidencing reductions.

It has compromised this position to some extent by allowing member states, on a unilateral basis, to add further gases from 2008, the date at which the Kyoto Protocol comes into force. The decision to exclude non-CO2 greenhouse gases will be seen by some, as a disappointment as reductions in these gases have in the past been a particularly lucrative area for development of emissions reduction projects. This may be because a relatively small reduction in gas emissions corresponds with a large equivalent reduction of CO2 gas reductions, making the project more financially viable.

The EU has particular concerns about the way in which allowances are allocated. It wishes to ensure that a level playing field is created throughout the European market in sectors subject to the requirement to reduce greenhouse gases.

It was thought that allocation of allowances by way of auction (where each person subject to the requirements bids for their allowances) was the fairest mechanism. It has the advantage of removing any barriers to new entrants to the market and was felt to give the most energy efficient operators a market advantage. The difficulty is that it would represent a large cost to industry and also would create difficulties in terms of dealing with the revenue derived from the auction.

The alternative, that of awarding allowances based on historical rates of activity, has draw backs in terms of allowing new entrants and also can create inequity where there have been substantial changes in the nature of the business activities of the relevant participants since the date of the base line. The Commission has bowed to Member State pressure and industry will receive its allocation free of charge for the pre-commitment period up to 2008. Moreover, only 10 per cent of emissions can be allocated by auction during the commitment period from 2008.

Penalties and timing

The EU is still confident of meeting an commencement date for trading of 1 January 2005. An initial three-year trial period will apply until 2008 when the full scheme will come into force. Business should also note that the scheme is mandatory and that penalties of e40 per ton of CO2 for the period 2005-2007 and e100 from 2008 will apply for failing to be within an emissions cap.

In summary, the EU has cleared up some of the uncertainty surrounding the draft Directive. However, it has become clear as a result that the Directive will have a significant impact on UK businesses, particularly those with direct CO2 emissions and also on the future of Government’s climate change policy.

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