UK: Controlling Carbon

Thousands of large businesses in the UK face a mandatory emissions trading scheme. The Government is now consulting on implementation proposals. How will your business be affected?

The 2006 Energy Review committed the Government to reducing energy use in large non-energy intensive organisations by an amount equivalent to 1.2 million tonnes of carbon dioxide (MtC) emissions per year by 2020. The target sector (which will include organisations such as large banks, supermarkets, rail operators, hotel chains and central government departments) reportedly accounts for approximately 10% of the UK’s total carbon emissions.

In the recently published 2007 Energy White Paper the Government announced the introduction of an emissions trading scheme called the Carbon Reduction Commitment (CRC).

The CRC is the new name for the Energy Performance Commitment (EPC) proposal on which the Government consulted in 2006. It is a mandatory emissions trading scheme designed, together with implementing the Energy Performance of Buildings Directive, to help secure carbon savings of 0.5MtC by 2015 and 1.2MtC per year by 2020. The draft Climate Change Bill includes powers which would enable the Government to introduce this type of scheme.

A 15-week public consultation on implementation proposals for the CRC was launched on 26 June 2007 (the Consultation Paper). It is a 103 page document which raises a number of important issues for scheme participants and other stakeholders.

The scheme will apply to business and public organisations that have annual electricity consumption in excess of 6,000 megawatt-hours (MWh).¹ At current energy prices, the CRC will therefore generally apply to organisations with annual electricity bills over £500,000. The Government estimates that this will cover up to around 5,000 organisations, accounting for around 14 MtC.

Proposed exemptions are:

• a total exemption for organisations which have more than 25% of their energy use emissions covered by Climate Change Agreements (CCA); and
• organisations whose direct emissions are subject to a greenhouse gas emissions permit under the EU ETS."² or whose energy use is subject to CCAs will have those EU ETS and CCA emissions excluded from the CRC.

The definition of a CRC organisation for the purposes of the scheme is likely to be a consultation issue that will get some attention. For group structures, the Consultation Paper proposes that the CRC will apply to emissions from the whole group, with the legal CRC obligation resting with the highest UK parent organisation. We suspect some organisations may dislike this approach as they will wish to have the liabilities and reporting practices of subsidiaries kept separate from other members of the group. For others it will require a considerable amount of time and effort to ascertain whether the CRC applies to them and, if it does, to ensure that all their energy use is accounted for.

The CRC will be an auction-based "cap and trade" scheme in which participants will be required to purchase and surrender allowances corresponding to their annual energy use converted into an equivalent number of tonnes of CO₂ emitted. There will be an overall cap on emissions allowances available for the whole scheme, and this will gradually be reduced over time to ensure emissions reductions from the target sector.

Each allowance will represent one tonne of carbon dioxide. Participants can comply with the scheme by either reducing their own energy use or by purchasing more allowances that give them the right to emit.

There will be an uncapped three-year introductory phase (commencing in January 2010), followed by an undetermined number of capped five-year phases. Phase 1 is proposed to commence in January 2013 (which will align with Phase 3 of the EU ETS and whatever scheme succeeds Kyoto).

The introductory phase is designed to give participants the chance to become familiar with the way the scheme operates and also to help the Government generate data to measure emissions profiles for the sector. During this phase the price of allowances will be fixed (i.e. not auctioned or distributed freely). The Consultation Paper proposes a fixed price amount of £12 to £16 per tonne of CO₂.

No overall cap has yet been proposed for the first capped phase of the scheme. It is the Government’s intention that no overall cap shall apply during the introductory phase so as to allow time to analyse the sector’s emissions profile and to allow glitches to be addressed without the pressure of competitive auctioning of allowances. For subsequent capped phases, the Government proposes that cap setting should take place "as far in advance as possible", but it fails to give any further details or date estimation. Presumably, this process will feed into the setting of carbon budgets and target setting envisaged by the Government’s proposed Climate Change Bill (CC Bill).

For investment certainty, the announcement of specific reduction targets and capped amounts will be a key issue for business and other stakeholders in the scheme. It is very difficult for participants to otherwise know what required energy use reduction levels they will need to prepare for. Without such clarity it is unlikely that the scheme will lead to significant capital investment in the near term.

Participants will be able to purchase allowances from three sources:

• Government auction held in January of each scheme year (or fixed price sale during the introductory phase). Auctioning allowances in the CRC scheme will help avoid a potential over-allocation of allowances as was seen in Phase 1 of the EU ETS when allowances were distributed freely.

• Secondary market for CRC allowances. Once allowances have been purchased in the initial auction sale, participants will be able to trade on the secondary CRC market, should they wish to buy or sell allowances. Non-participants (such as specialist brokers, traders and individuals) will be allowed to trade in the secondary market.

• Safety valve mechanism. The CRC will include a safety valve mechanism which will prevent CRC allowance prices (both in the auction and the secondary market) rising undesirably high. The Consultation Paper proposes that the safety valve will take the form of a "buy-only" link to the EU ETS modified by a minimum floor price. The safety valve price, at any given point, would either be the prevailing EU ETS price, or a pre-defined floor price. In the event of a crash in the price of EU ETS allowances, the minimum floor price would prevent cheap EU ETS allowances from flooding the CRC market. The scheme administrator will administer the safety-valve mechanism, acting as an intermediary with the EU ETS market and setting the floor-price.

Each emissions year will be followed by a reconciliation period that will be familiar to those operating in the EU ETS – a period of three months during which organisations can collate their emissions data, buy or sell allowances on the secondary market, report their emissions figures to the Government and surrender emissions allowances. At the end of the reconciliation period, organisations holding more allowances than they need for compliance will be entitled to bank their allowances for use or sale in future years or phases of the scheme. Banking will not, however, be allowed between the introductory fixed-price phase of the scheme and the subsequent capped phase of the scheme.

Notably, there is currently no mechanism proposed in the Consultation Paper to allow participating organisations to surrender other carbon credits (e.g. VERs, CERs, ERUs etc.) that they may already hold or acquire before the start of the scheme. Organisations should be aware of this in considering any strategy for carbon offsetting.

Treatment of green electricity and renewables

Significantly, the Government proposes that there should be no distinction between the generation sources of grid-sourced electricity (i.e. nuclear, coal, gas or renewables) when calculating the CRC obligation of participants. This would be subject to review at the start of each phase. The Government’s rationale in not providing an exemption for grid-sourced renewables is that the CRC should be designed to achieve energy efficiency gains and not simply be another incentive for the renewables industry.³ The CRC will, however, encourage micro-generation from on-site renewables. Generation from on-site renewables that is not used to generate Renewables Obligation Certificates will not give rise to any obligation to surrender allowances.

Revenue recycling

The CRC is intended to be revenue-neutral, with the Government proposing to recycle revenue raised by the sale or auction of CRC allowances back to participants. Payments would be proportional to participants’ average annual emissions since the start of the scheme, with a percentage bonus or penalty based on their position within the performance league table (see below).⁴ The payment would be made in July of each year, around six months after the end of the emissions year, to allow for reporting of emissions and reconciliation.

The Consultation Paper claims that recycling revenue to participants means that costs should be (on average) reduced to just the administrative costs of implementing emissions abatement measures. It further states that analysis has shown that, by designing the scheme to limit these costs, the scheme will have an estimated positive net present value of £755m to participants (mainly through a reduction in energy costs). Notably, this benefit is the estimated benefit over the life of the scheme (not annually), which we understand to be estimated at 20 years.

Significantly, the Consultation Paper proposes that a "performance league table" that ranks participants based on their "performance" within the scheme will be published at the end of each reconciliation period. It also invites views on a proposal to award a bonus or penalty payment of between +/-10% (or higher) of an organisation’s recycling payment based on its position within the league table.

The performance league table is a significant proposal in the CRC scheme as it will leverage organisations’ reputational drivers. The final construction of the table is therefore an important issue for businesses. Currently, the Government proposes to rank participants according to:

• Core absolute carbon reduction (60% weighting): percentage carbon reduction relative to annual average emissions since the start of the scheme.

• Early action (20% weighting): the extent to which organisations had been undertaking good energy-management practices before the start of the CRC scheme. The Consultation Paper proposes to use an early action metric based on the extent of roll out of automatic metering (technology for automatically collecting data from energy metering devices) above and beyond the legal minimum. It also asks whether other criteria could be added.

• Carbon efficiency (20% weighting): percentage reduction in carbon emissions per unit turnover since the start of the scheme (suggested for discussion in light of concern over ensuring that organisational growth is recognised).

The construction of the performance league table is likely to be a contentious consultation issue. Given that the CRC is likely to apply to about 5,000 installations, we anticipate that a fair and accurate assessment of participants against anything other than simple metrics would most likely prove to be administratively very difficult and perhaps impossible. The most sensible metric would seem to be one that recognises carbon efficiency gains as well as organisational growth (which is not always represented by annual turnover alone). The Government’s proposal to give only a 20% weighting to the carbon efficiency metric and 60% to the core absolute reduction metric is perhaps problematic in this regard.

The CRC is designed to have more of a "light touch" approach in terms of administration requirements than the EU ETS. There will be no requirement for independent third-party verification and participants will self-certify their emissions. The Consultation Paper proposes that this will be backed by an audit target of around 20% of organisations each year.

Organisations would be required to report on their annual emissions by 31 March of the following year. Depending on the outcome of the Consultation Paper, annual reporting is likely to be web-based and would require submission of information such as the annual consumption and types of energy used, as well as information from automatically read meters. The reporting obligation as proposed in the Consultation Paper does not seem to be onerous and organisations that are already monitoring their energy use should already be collating sufficient information on usage.

Hand in hand with a "light touch" administrative approach, the Government is proposing a raft of strong penalties to help deter abuse and secure compliance. In broad terms, the Government is proposing penalties which are analogous to those used under the EU ETS. There are various penalties relating to participation in the scheme, reporting and surrender of allowances and the operation of the auction. In addition to standard offences (e.g. failure to provide information to Government or comply with an enforcement notice etc.) failure to provide annual data within three months of being required to do so, provision of false annual emissions data and failure to surrender allowances corresponding to reported emissions will result in a penalty of £70 per tonne of CO₂.

The closing date for the submission of Consultation Paper responses is 9 October 2007 and we expect the Government to publish its responses before the end of the year. Assuming there are no obstacles to its implementation, the introductory phase of the scheme will then commence in January 2010.

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