The place of the UK Emissions Trading Scheme in the UK Climate Change Programme

This page provides a brief description of the UK Emissions Trading Scheme, and its role in the UK Climate Change Programme, drawing on material in our paper, Smith and Swierzbinski (2007). The UK ETS, the world's first large scale application of emissions trading to greenhouse gases, began in 2002, significantly predating the development and introduction of the EU ETS in 2005. Smith and Swierzbinski (2007) analyses the performance of the UK ETS, based on trading and compliance data from the first three years of operation.  A summary of our conclusions can be read here.

Full Reference:   Stephen Smith and Joseph Swierzbinski (2007)  “Assessing the performance of the UK Emissions Trading Scheme”, Environmental and Resource Economics, 37(1), pp 131-158. ISSN 0924-6460. DOI: 10.1007/s10640-007-9108-5     .pdf file at SpringerLink

Extensive material on more recent UK policy developments can be found on the DEFRA website, which also provides links to documentation of the EU Emissions Trading Scheme.

The UK Climate Change Programme

Under the Kyoto Protocol the EU accepted a commitment to reduce greenhouse gas emissions by 8 per cent by 2008-2012, as measured against a baseline of the 1990 emissions level. Within this overall 8 per cent EU abatement target, the United Kingdom was required to achieve a 12.5 per cent emissions reduction. In addition, however, the UK unilaterally stated a policy goal of reducing CO2 emissions to 20 per cent below 1990 levels by 2010.

The UK's Climate Change Programme implemented a package of measures designed to achieve the UK's Kyoto commitments, and the subsequent tougher unilateral UK abatement target. The programme makes use of three different economic instruments, which have interlocking functions:

The Climate Change Levy

The Climate Change Levy was announced in the 1999 Budget, and took effect from April 2001. It takes the form of a single-stage excise, imposed at the time of supply to energy users in industry, the public sector and agriculture, at varying tax rates per unit of energy, depending on the fuel type. The tax is applied to gas and coal at a rate of 0.15 pence per kWh, to non-transport LPG at 0.07 p/kWh and to electricity at 0.43 p/kWh . Fuels supplied for transport, for non-fuel uses, for electricity generation and to the household sector are exempted from the tax. There are also exemptions from the tax for energy generated in 'good quality' CHP (combined heat and power) plants, for fuels derived from waste, and for renewable energy sources such as wind and solar power.

Firms in energy-intensive sectors which have negotiated 'Climate Change Agreements' (see below) benefit from an 80 per cent discount from the Climate Change Levy. The relevance of the Climate Change Levy to the Emissions Trading Scheme is that this 80% discount establishes a financial incentive for industrial sectors to conclude Climate Change Agreements, which, in turn, provide the majority of trading participants in the ETS.

Climate Change Agreements

'Climate Change Agreements' are negotiated agreements between sectoral industry organisations and the government. More than 40 industry associations, representing some 6000 companies, have negotiated CCAs with the environment department (DEFRA), under which they have taken on collective quantitative targets for improvements in energy-efficiency or carbon emissions, in return for an 80 per cent discount from the Climate Change Levy .

The agreements can, in principle, take a number of different forms. They can relate either to carbon emissions, or to energy use. In addition, they may be specified in either absolute or relative terms, in other words, as a reduction of energy use or emissions in tonnes, or as a reduction in the rate of energy use or emissions per unit of output. In practice, the overwhelming majority (39 of the original 44 agreements) have set targets for energy use relative to output, in other words, have been agreements for improvements in energy efficiency. Four agreements have specified absolute targets for reduced energy use – those concerning aerospace, steel, supermarkets and wall coverings. One agreement, for the aluminium industry, set a target for emissions per unit of output.

The agreements all have a two-tier structure, specifying obligations for the sector as a whole, and translating these obligations into targets for each individual firm. Enforcement procedures pay attention both to the sectoral outcome, and to individual firms' responsibility for the sectoral outcome. No enforcement action is taken if the sector as a whole meets its obligations, but where the sector falls short of its target, non-compliant firms are identified and are liable to penalties.

Each CCA sets a final target for 2010, and interim targets for alternate years (2002, 2004, 2006 and 2008). Failure to meet the required target carries a penalty in the form of the loss of the 80 per cent Climate Change Levy discount for the subsequent two years .

Emissions trading

The third element in the Climate Change Programme was an emissions trading scheme for greenhouse gases, which was launched in April 2002, with an initial five year lifespan (2002-06). The scheme aims to provide flexibility for individual firms in their compliance with greenhouse gas abatement obligations, so as to reduce the economic cost of achieving a given abatement total. A second, overt, objective of the emissions trading scheme is to establish the London financial markets as the global location for environmental permit trading. The scheme regulates overall emissions of the six groups of greenhouse gases covered by the Kyoto Protocol, weighted according to global warming potential. Individual emission limits defined under the scheme, and the unit used for trading, are defined in terms of tonnes of carbon dioxide equivalent (tCO2-e) .

There are two principal groups of potential participants in emissions trading, referred to as "direct participants" and "agreement participants".

Direct participants (DPs) are the 32 firms who entered the scheme as a result of an auction of subsidy payments conducted by the government in March 2002 . This auction allowed any organisation to offer abatement of its UK emissions over the period 2002-6, as against baseline emissions in 1998-2000, in exchange for a subsidy per tonne. Firms entering the auction were required to commit to a specified level of abatement in 2006, and to make phased progress towards it in the intermediate years 2002-5, with the 2002 target being 20% of the 2006 target, rising to 40%, 60% and 80% in each of the subsequent years. As a result, a direct participant making a commitment to abate by 1 tonne in 2006 would be committed to a total abatement of 3 tonnes over the period 2002-6 as a whole.

The auction aimed to "buy" as much abatement as possible, using a fixed budget of £215m. The auction was conducted using a descending clock format, with a starting price per tonne of abatement in 2006 of £100 . After nine auction rounds, a market-clearing price was established of £53.37 per tonne of CO2-equivalent. In exchange for a subsidy payment at this level, the DPs were assigned abatement commitments totalling 3.96 million tonnes of CO2e (1.1 million tonnes C) in 2006, and the corresponding phased abatement obligations for the intermediate years. Once the intermediate-year commitments implied by the 2006 target are taken into account, the auction closing price of £53.37 per tonne of CO2e abatement in 2006 is equivalent to a subsidy payment of £17.79 per tonne of CO2e abatement in a single year.

The direct participants are subject to a cap-and-trade system of emissions trading, being allocated allowances equal to their baseline emissions, minus the contracted abatement commitment for each year. They may use trading to meet their abatement commitments, and can sell allowances in the ETS if their abatement exceeds the contracted level.

Agreement participants are the 6000 firms covered by Climate Change Agreements (CCAs). These firms can generate and sell allowances by exceeding their negotiated emission-reduction targets, or alternatively, can achieve compliance with their obligations under the agreement by purchasing permits in place of some or all of their abatement obligations. For these firms, emissions trading is effectively a baseline-and-credit system of emissions trading, and participation in trading by individual firms is wholly voluntary. In practice, about a quarter of the 6000 firms covered by CCAs participated in emissions trading.

An interlocking relationship between the three market-based components of the Climate Change Programme underpins the involvement of agreement participants in the UK ETS. These firms may choose to participate in the ETS to meet compliance obligations which result from their participation in sectoral Climate Change Agreements. In turn, the primary financial motivation for industrial sectors to conclude CCAs with the government was the substantial (80%) reduction to which they were then entitled in the energy tax, the Climate Change Levy.