To encourage all sectors of the economy to contribute towards these goals, the government has already wielded a stick in the form of the Climate Change Levy, introduced in April 2001. With the introduction of the UK Emissions Trading Scheme (ETS), in the first quarter of 2002, it is about to deploy its carrot.
The objective of the voluntary ETS is to allow reductions in greenhouse gas emissions to be obtained in the most efficient and cost-effective way for businesses. This will be achieved by providing financial incentives to firms to sign up to a binding target to reduce their emissions. Government money totalling £215m over five years — equivalent to £30m a year after corporation tax — has been set aside to fund the scheme.
In parallel the European Commission proposes to commence EU-wide trading in 2005, and the UK government is setting up the initial UK scheme, to begin in April next year, to give businesses and organisations early experience in this field. Such trading is already being developed internationally and is a key element of the Kyoto Protocol.
To kick off the process, the government will hold an emissions 'auction', where potential scheme participants will 'bid in' a quantity of CO2 emissions reduction — the quantity of the bid being based upon the estimated costs of abatement to the participant and the incentive price per tonne the government offers. It should be noted that bidders must commit to an absolute reduction quantity that they will achieve by 2006.
Thus it can be seen that if the initial incentive price is set at, say, £100/tonne of CO2 reduction, there are likely to be very large CO2 reductions bid in to the auction as this price will more than cover the cost of abatement for most firms. This may well mean the ETS will be oversubscribed.
To moderate the system, the government will progressively lower the incentive price and bidders will revise their "reduction" quantities. This will be repeated until the aggregated value of all the bids (the sum of all the quantity reductions multiplied by the incentive price per tonne) is equal to the £215m fund. At this point both the incentive price and the 'bid in' reduction quantities will be frozen. The scheme will limit the involvement of any one participant to a maximum of 10 per cent of the incentive fund.
The companies that participate will have two ways in which to meet their binding emissions reduction targets. They may reduce emissions by the agreed amount by instigating efficiency projects and programmes, or, if they have failed to meet their targets through other abatement methods, they will be able to purchase traded 'emissions credits' to cover the shortfall.
Benefits to participants
The benefits to participants who meet their reduction targets will be the payment to them of the government's incentive monies, reduced energy bills and, significantly, any overachievement will bring benefit through receipt of 'emissions credits'. These credits may be banked or alternatively sold on to other participants.
The best strategy between the 'achieve and/or trade' options for a company will be dependent on the market price of credits when compared with the cost of reducing their emissions. Overall, the expectation is that organisations with opportunities to reduce emissions at a lower cost will sell allowances to those for whom reductions would prove more expensive, thus minimising the total cost of achieving the environmental benefits. The higher the number of participants, the greater the potential cost reductions should be.
Having recognised that there are positive financial benefits to be gained from the ETS, the major questions companies must ask themselves are:
- what information do I need in order to decide to participate
- what are the risks to my business in participating
- what are the benefits to my business in participating?
Essential information
Companies need to establish:
- the organisation's current baseline emissions quantity. This is defined as the average emissions for the years 1998, 1999 and 2000. Or, if the historic data is unavailable or can be demonstrated to be unreliable, the 2000 only data may be used
- the potential for, and associated cost per tonne of, reducing the baseline emissions
- a prediction of emissions quantities over the period of the scheme, which runs from 2002 to 2006
- whether the baseline emissions quantity is likely to be affected, up or down, by forecast growth, decline or other changes in business activity or structure over the next five years.
From this analysis, key decisions and participation parameters may be produced, namely:
- check whether any forecast increases in baseline emissions are faster or greater than the company's ability to achieve reductions relative to the baseline? If yes, then the risk of achieving successful participation will be high. In certain circumstances the converse will apply
- establish on a project-by-project basis the quantity and cost per tonne of any available reduction schemes. This will enable a 'bidding' strategy to be established for the auction process and for any subsequent trading activities.
As the emissions target will be an absolute in relation to the baseline figure, the quality of any estimates and forecasts will be paramount in managing the risk of participation.
It should also be noted that for participants, all actual emissions data (historic and reductions achieved) will be subject to audit by an external verification agency. This will be an additional cost to companies for participation.
To calculate the risks to a business of participating, there are three primary risk areas to consider:
- penalties — for participants who neither achieve their targets nor purchase emissions credits to cover any shortfall there is talk of penalties being applied. As yet, the government has not published details of what these penalties might be.
But we could speculate, because the scheme is designed to encourage participation and hence the lowering of emissions, that they will not scare off potential participants by being punitive. More likely they will be pitched at a level just above the cost of purchasing the appropriate emissions credits or for physically installing appropriate abatement measures:
- financial — apart from government penalties under the scheme, there are other financial risks to consider. These would include underestimating the cost of reduction projects or the speed at which they can be implemented
- reputation — once lost, good reputations are notoriously hard to regain. As a contingency to protect yours, you may want to provide for sufficient funds to purchase 'emissions credits' to cover your liability in the event of reduction targets being missed.
Of course, these risks can be mitigated by providing conservative estimates and by bidding 'safe' targets into the scheme, although this will not lever the optimum returns available.
However, it is a stated intention of the ETS to allow companies to gain experience in emissions trading in preparation for (potentially mandatory) international ETS initiatives.
This experience for the future, coupled with the enhancement to be gained to a company's reputation with its stakeholders from being seen to be environmentally responsible and proactive, may far outweigh any financial gain to be achieved in this particular scheme.
Perhaps the real penalty for scheme defaulters will be the adverse publicity associated with any 'name and shame' campaign as the current government has shown that it is not reluctant to use such measures.
There is, of course, much 'devil in the detail', and for those of you who are interested in obtaining more information further details may be gained from the Defra website at http://www.defra.gov.uk/environment/climatechange
Source
The Facilities Business
Postscript
Nicholas Jones is director of energy consulting at Johnson Controls
Tel: 020 7648 5600