The carbon price in the emissions market, because of the lack of tautness in the EU ETS, has been too low to encourage the necessary investment in low-carbon processes and infrastructure, said a report by the Environmental Audit Committee in the UK.

Carbon allowances were clearly over-allocated in Phase I of the EU ETS, which ran between 2005 and 2007, and emissions as a whole went up over that period. In due course, the declining emissions cap in Phase III (2013–2020) could drive genuine emissions cuts, but in the meantime there is a risk, if economic recession leads to a prolonged reduction in emissions, that Phase II (2008–2012) will also turn out to be significantly over-allocated.

Over Phases II and III, companies will be able to use offsets worth 1.6 billion tonnes of CO2e (1.4 billion in Phase II and 150–200 million in Phase III). Over the period 2008 to 2020, offset credits can be used to meet up to 50% of the cuts in overall emissions imposed by the caps. So far the number of offset credits available has exceeded the demand for them. According to Deutsche Bank, in 2008 only 82 million out of an allowable 265 million offset credits were used by firms within the EU ETS. Companies within the EU ETS can bank any surplus allowances and offset credits (up to certain maximum limits) they have at the end of Phase II for use in Phase III.

As surplus allowances will be usable in what is expected to be a tougher third Phase, they still have value, and Phase II is perhaps unlikely to suffer the same collapse in carbon price as in Phase I. But carrying over banked surplus allowances into Phase III will inflate its cap, and reduce its effectiveness in cutting emissions. The more that offset credits are used, the more EU installations will be funding emissions reductions in other countries, rather than cutting their own.

The EU ETS could also be significantly weakened because surplus allowances may be banked and carried-over into Phase III, because industrial sectors have again been allocated allowances in Phase II in line with business-as-usual projections of their emissions, and because in Phase III they may again have access to free allowances.

The UK Environmental Audit Committee has suggested that the focus ought to be on how to bolster the carbon price when it is particularly low, through setting auction reserve prices, incentives for low-carbon electricity generation and emissions regulation.

“We recommend that the Government establish what conditions must be met for a reserve auction price to be effective as a floor price within the EU ETS (for example what proportion of allowances would need to be auctioned to set the price across the entire System, and what level the reserve price should be set at). If all the practicalities can be addressed, we recommend that the Government work with the European Commission and other member states towards implementation of this proposal in Phase III,” said the Environmental Audit Committee.

The Copenhagen conference in December failed to set binding global emissions reduction targets. Whatever the progress of continuing international negotiations following the conference, the Government should push for the EU to adopt an emissions reduction target which more closely reflects the climate science, and to adopt a revised cap for the EU ETS which might act as a real lever to achieve those targets.

Mechanisms for reducing the EU ETS cap—whether in response to recession-driven reductions in demand for allowances, the success of complementary policies in cutting emissions, or the efforts of the public in reducing their carbon footprint—are urgently needed. The Government should press the EU to consider periodically whether to tighten the EU ETS cap.

Further in reply to criticism of the CDM it said, “We do not believe that critics of the Clean Development Mechanism have convincing alternative proposals for driving carbon mitigation in the developing world. We recommend that the Government press for a reform to CDM rules, in particular to exclude the construction of fossil fuel infrastructure, and more widely to embed sustainable development at the heart of project eligibility criteria.”

Emissions trading can help promote action to tackle climate change. However, the EU ETS has emissions caps set too high to force emitters to make the often costly investment decisions which would reduce emissions. The recession has only served to loosen what little constraint the cap provided. The carbon price, because of the lack of tautness in the EU ETS, has been too low to encourage the necessary investment in low-carbon processes and infrastructure.

The cap mechanism therefore needs to be significantly tightened. This should be supported by cancelling ‘new entrant reserve’ allowances and auctioning as many allowances as possible, rather than giving them away for free (with the revenues possibly hypothecated to climate change measures). The Government should explore the possible use of a carbon tax. It should also encourage more use of allowance auctions with reserve prices, more use of incentives for low-carbon power generation and emissions performance standards for electricity generation. If necessary, the UK should be prepared to act in these areas unilaterally, to demonstrate a continuing leadership role on tackling climate change, said the report.

“We believe that it is imperative that there are mechanisms for reducing the EU ETS cap, whether in response to recession-driven reductions in demand for allowances, the success of complementary policies in cutting emissions, or the efforts of the public in reducing their carbon footprint. We recommend the Government press the EU to consider periodically whether to tighten the EU ETS cap. We further recommend that the Government investigate what financial incentives can be given to companies within the EU ETS to encourage them to cancel allowances they own voluntarily,” said the Environmental Audit Committee.

In terms of linking the EU ETS with other carbon markets, the Environmental Audit Committee said ,”We recommend the Government consult on other mechanisms to remove EU ETS allowances from the market, especially where the threat of being forced to buy and retire allowances could drive other environmentally beneficial actions. If the EU ETS is merged with other emissions trading systems with a more generous allocation of allowances and greater access to offset credits from other countries, or more generous subsidies for low-carbon emitters, then terms of trade—some sort of carbon ‘exchange rate’—could ensure a level playing field. The Government, with its European partners, should however ensure that schemes are not merged without such an ‘exchange rate’ being carefully calibrated.”

Deutsche Bank suggested that, because of the recession, many more allowances would be added to New Entrant Reserves than would be distributed from them, and estimated that the total number of allowances in Reserves across the EU would amount to over 300 million by 2012.58 While two member states have committed to cancelling any surpluses in their New Entrant Reserves, most states are committed to giving them away or auctioning them. Giving away New Entrant Reserves creates the same problems as the over-allocation of allowances.