The comprehensive report of Sir Nicholas Stern on the economic appraisal of climate change compelled the attention of top level policy makers and institutional leaders. OECD Secretary-General Angel Gurría for example welcomed the publication with the words: “The report is a necessary reminder that acting now is imperative to confront the many problems which will flow from climate change. I strongly endorse the major direction of the report that argues that the benefits of early action far outweigh the costs,” adding congratulations to both UK Prime Minister Tony Blair and the Chancellor of the Exchequer Gordon Brown for commissioning the Study, as well as for sharing it with the world’s public opinion.

Right after this period of the aftermath of the Stern report which makes special emphasis on global greenhouse gas trading mechanisms with the international post 2012 climate change talks going on in Nairobi, the European Commission released its long delayed Communication on the Emissions Trading Scheme (ETS). It was mandatory to report to the Council and the Parliament on the progress of the scheme by mid 2006 according to Article 30 of the Directive 2003/87/EC but the timing clashed with the deadline of member state’s national allocation plans. How the Commission judges these plans has come sharper under a critical eye following the revelation in the release of the first verified emissions data mid-May that a credible cap had failed to be set in the supposed cap-and-trade scheme…

It is nonetheless a serious attempt, even though it needs some reform to make it work effectively. The Review foresees that this Commission Communication preludes will lead to legal modifications of the design of the scheme to include other gases and sectors. However, these will not apply to the second phase of the scheme, in order to avoid rupturing it as it stands, but rather be directed to the third phase post 2012. Whilst the future design is of utmost importance, and treated as such by Stern and others, the Commission’s first priority in respect of the ETS is to prevent current problems from recurring in the next phase 2008-2012 by analyzing national allocation plans stringently and returning them for revision if they produce no constraint on emissions within that member state. They are using the real emissions recorded in 2005 as the baseline. After a protracted dribbling in of national allocation plans (NAPs) from the member states, Environment Commissioner Stavros Dimas has seen enough of them to reveal that collectively they cover an emission level that is 15% higher than the 2005 emission level. As the first phase cap was set too high by over-inflated government projections of economic growth based on submissions by covered installations, Dimas does not want to be led down the same path and has already said that he will be sending some NAPs back for tightening.

In respect of the Communication, it is more of a guideline document that serves as a precursor to the main Review which will be based on a more thorough consultative process, mainly held within a dedicated working group within the auspices of the European Climate Change Programme (ECCP). It is short on detail and brings out fairly well trodden points such as the wish to simplify the scheme that the Commission has already made known. The aptitude for distortion within the system embodied by each member state making its own rules and levels of cuts within a framework is a structural weakness that the Commission is keen to overcome. Hence it has proposed a harmonized EU cap and repeated its goal of simplification – in rules and in definitions such as for combustion installations or ‘small’ installations.

The strategic themes, that the Commission wishes to take through the consultative process, are: harmonization and increased predictability; robust compliance and enforcement; defining the scope of the Directive (as in dealing with the question of expanding the emissions trading scheme to other gases and sectors) and working out links to third countries.

A fundamental element that needs to be changed, according to EWEA, NGOs and economists is the free allocation of permits, or grandfathering where permits are distributed and weighed according to historical emissions. It has been responsible for electricity companies passing through the opportunity cost with no restraint generating windfall profits. In countries where electricity price regulation exists, prohibiting the scope to do this, distortions then arise in relative advantages among member states. EWEA is a proponent of auctioning, as it would remove many of the distortions in the current ETS design. Companies are forced to assess what number of emission permits they cannot forego, weighed against the price of the permits in the market, leading to a decision on what price they will bid in an auction. It puts the cost component of carbon along the lines of a marginal cost of production, which is what the cost of carbon is supposed to be. Economic efficiencies are thereby engendered whilst also attaining environmental ends. Economists have argued in favour of auctioning from the beginning as it prevents perverse incentives from being created. On 9 November a statement was presented to Commissioner Dimas, signed by 50 leading economists, stressing the need for effective implementation of the European emissions trading scheme.

The first phase has only allowed up to 5% auctioning; the second up to 10%. Barely any countries have made use of this meager band, showing the strength of resistance among the covered sectors to it. If the scheme is to work as a functioning market cutting down on emissions, then auctioning is essential. It has another very important and desirable side-effect – that of being a means to provide price transparency and thereby reduce price volatility. Price volatility is currently a key characteristic of the market inhibiting clean investment. Nobody wants to risk high investment outlays on such a volatile and uncertain market. EWEA, in concert with NGOs and many other stakeholders, propounds 100% auctioning for phase III. The review will look into how to expand auctioning of allowances.

Sir Nicholas Stern says that it is very important to put an appropriate price on carbon to make once and for all greenhouse gases the externality that they are. It can be done explicitly through tax or trading, or implicitly through regulation. Whichever way it would make people face up to the full social cost of their actions. Consequently in time it “will lead individuals and businesses to switch away from high-carbon goods and services, and to invest in low-carbon alternatives.”

The European Emissions Trading Scheme is the preferred method, offering flexible ways to cut down emissions, and is the model that will be expanded and followed. Long term certainty and knowledge of what sort of regulatory framework will exist is imperative for investment action’, repeat ETS participants, Stern, and stakeholders. Nairobi talks are making progress in providing more certainty.

Although the fundamental basis of the scheme, that a meaningful cap is in place, is now appreciated by the Commission, there are several elements that still detract from the scheme’s environmental effectiveness. One is that of new entrant reserve and another is plant closure rules. The national allocation plans for the second phase have generally shown how countries push up their cap by reserving permits for new entrants. Plant closure prognoses allow governments to make adjustments after the limits have been set (ex-post.)

For the global goal of preserving a clean and sustainable future, EWEA advocates extending the emissions trading scheme to other gases and other sectors of the economy. It agrees with the message of the Stern report that a global system needs to be created where the price of carbon matches that of other nation’s trading platforms, keeping the carbon price firm instead of solely channeling into the flexible mechanism projects which have every indication at present of deflating the price. Also it would prevent leakage of industry to unregulated markets and overcome the major obstacle that serious cuts in emissions in industrialized countries do not really occur.

Stable legislative and political signals will decrease volatility as will strong compliance enforcement. EWEA is pleased to see that this is the track that is being taken.

The latest meeting of the European Commission appointed High Level Group on Competitiveness, Energy and Environment on 30 October and also endorsed expansion of the scheme: “In order to manage the impact on the competitiveness of EU industry, not only must the cost of internalization be broadened to all those responsible for emissions including transport and household sectors, but an international approach has to be built.”

Conclusions from the first ECCP working group on the ETS presented by leader of the ETS in the Commission, Jos Delbecke, were these: firstly the Baseline from which they have been working “has been very over-optimistic;” secondly, implementation of ECCP policies and measures have been very variable in member state countries. “Laggards will have to speed up their policy developments.” Lastly he admitted that although they have been quite good in estimating emissions from waste, industrial gases etc, they have not been so good in estimating them from energy generating and transport, especially transport. The next point made was that massive investments in the energy system are needed until 2030. It goes to prove that wind power is a cleaner answer to the energy generation problem than the ETS.