Who will buy?

Tim Denne, previously deputy director of the Centre for Clean Air Policy in Washington, DC, and whose recent work includes the design of a possible greenhouse gas emissions trading system for the European Commission, looks at the options available to companies under UK emissions trading proposals.

The UK Emissions Trading Group (www.uketg.org) is designing a greenhouse-gas emissions-trading system for the UK. Emissions trading requires firms to limit emissions to permitted levels, but allows them to buy permits if they wish to increase their total allowed emission rates, or to sell permits if they can reduce emissions. Unlike emissions-trading systems in other countries, and notably for SO2 in the USA, this proposal is for a voluntary scheme. Companies are likely to be given the opportunity to take on an emissions cap and join the trading system, and the government has just announced plans to provide financial incentives for them to do so. But the choice is not straightforward.

The proposed UK emissions-trading system had a curious beginning. The 1998 Marshall Report on economic instruments and the business use of energy considered the relative merits of taxes and emissions permits and opted for the more straightforward tax solution. However, rather than introduce a tax that reflected the carbon content of energy use, the Climate Change Levy (CCL), which is to take effect from April 2001, requires all commercial and industrial users of energy to pay a charge based on the energy content of their fuels. This provides incentives for energy efficiency, and, thus, some reductions in greenhouse-gas emissions, but provides no incentives for fuel-switching from carbon-intensive fuels (such as coal) to low-carbon fuels (such as natural gas). The largest and least-cost emission-reduction opportunities are available through such fuel-switching.

Subsequent industry lobbying focused on the effects on energy-intensive sectors. It has led to a government programme to agree voluntary negotiated agreements that will require firms to reach energy-efficiency or emissions targets in return for an 80% reduction in the levy. These are significant incentives.

However, industry has had additional ideas. An Emissions Trading Group (ETG) was launched in June 1999 by the Confederation of British Industry (CBI) and the Advisory Committee on Business and the Environment (ACBE), and includes company representatives and government officials. It has developed plans for an emissions-trading system that would provide firms with an alternative way of avoiding the CCL; outline proposals were given to the government in October 1999. There are three different components of the proposed emissions-trading system.

System components

Core participants – firms that accept an absolute cap on their emissions would be given permits equal to the cap level. They would be allowed to sell any permits that are freed up by reducing emissions below their cap, or they can buy permits to increase their cap and their emissions. Formulae for calculating the initial cap (average emission rates for a number of historical years) are being discussed.

Unit participants – firms that have a negotiated agreement to limit emissions per unit of output or to achieve energy intensity targets would be able to convert this into a permit requirement. They could then sell permits when they have reduced their emissions below the target level of intensity. However, because these firms do not have a total cap on their emissions (emissions can increase if total production increases) while the government is seeking to limit total emissions, there would be restrictions on sales. The ETG has proposed a gateway that would only allow sales from firms in the unit sector to firms in the core sector after other firms in the unit sector have bought permits Ð the unit sector can never be a net source of permits.

Emissions-saving projects – firms without caps, and otherwise outside the trading system, but which take actions to reduce their emissions, can convert these into permits. Measured emission reductions can be used as permits and sold into the system.

Chequered history

The design is complex, and a long way from the simple cap-and-trade system used so successfully for SO2 emissions trading in the USA, but it reflects the chequered history during which the government has been persuaded to add new features over time to the flawed CCL. The truth is, the emerging trading system would never have resembled its current design had it started from a clean slate.

One of the key current concerns is that, although firms might opt in to the trading system if they could reduce their emissions below their cap at low cost, it is not clear whether any firm would voluntarily take on a cap if there was a risk that it would subsequently need to buy permits. The trading system might be made up of numerous potential sellers but no buyers – a recipe for low permit prices and little downward pressure on emissions. The caps themselves might result in emissions reductions, but there may not be any trading. In response to this problem, the government has recently announced its intention to provide incentives for firms to opt in to trading. The details have not been announced, but it is expected to take the form of payments on a per-tonne of CO2-equivalent basis, for taking on a tight cap; the payment is likely to be for the difference between the tight cap and a cap that otherwise would be agreed through a standardised approach to cap-setting.

However, it is not clear whether this introduces any new buyers into the system. Rather, it might establish the government as a single monopoly buyer. Companies will only take on tighter caps if they can reduce their emissions more cheaply than the government is willing to pay, or if they believe that they can purchase permits on the market more cheaply. But the sources of cheap permits will be better off taking the government’s money for a tighter cap than selling their permits on the market. Thus the government might simply be purchasing permits that otherwise would be available on the market, driving up prices and reducing incentives for potential permit buyers to join. The incentive programme may only work as a kick-start to trading if firms judge wrongly their costs of limiting emissions, or if they expect other firms to do so.

The options for firms

All of this leaves firms with a highly confusing array of options to the CCL, with no clear best choice, nor any clear information on the long-term implications of their choices.

Firms can choose simply to pay the CCL. This will cost in the order of 0.15p/kWh for most fuels and 0.43p/kWh for electricity; these costs represent an approximate 30% price increase for coal and gas, and an approximate 12% price increase for electricity. The levy is payable on every unit of fuel consumed; it increases not only total costs, but also the marginal costs of production, and, thus, the competitiveness of firms in international markets.

Some firms will have the option of responding to a voluntary agreement. The government is in negotiation with approximately 40 trade associations regarding the establishment of voluntary negotiated agreements. There is a strong incentive to reach an agreement Ð an 80% reduction in the CCL. The government will be seeking significant commitments to improve energy intensity or limit emissions. Firms included in negotiated agreements may face significant investment costs to achieve efficiency improvements; however, their marginal costs of production will fall because of the reduced levy rate.

The main benefit of joining the trading system is the 80% reduction in the CCL, the same as being part of a voluntary agreement. For firms that can reduce their emissions cheaply, there is also the potential to sell emissions permits on the market at a price greater than the costs of emissions reductions. For firms needing to buy permits, the purchase price may still be less than the savings from avoiding 80% of the CCL. For all firms that join trading, however, there is an effect on their competitiveness that is different from being part of a voluntary agreement. Under an absolute cap, for every unit of production there is an opportunity cost associated with producing and emitting, because a permit must be surrendered for every emission. Reducing production allows more permits to be sold. Firms should take account of these opportunity costs in pricing their goods. Failure to do so may mean that they are producing goods where they would have been better off selling permits.

A difficult choice

The choice between opting in to the trading system, negotiated agreements or paying the CCL depends crucially on the expected price of permits and their availability. This, in turn, depends to a great extent on the way that the UK trading system interacts with international trading systems, whether international permits will be available to UK firms in meeting their commitments? This is clearly expected, but it is not necessarily an option prior to 2008, when international trading fully begins.

Depending on the permit price relative to the CCL, opting in to emissions trading is likely to be advantageous to firms that are energy-intensive but not carbon-intensive – i.e. users of natural gas. But for firms with the option of a negotiated agreement, trading looks advantageous only for firms that can reduce their emissions cheaply, and these firms will only benefit if there is someone there to buy.

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