House of COMMONS






the role of carbon markets in preventing
dangerous climate change



Tuesday 21 April 2009



Evidence heard in Public Questions 49 - 114




This is a corrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.



The transcript is an approved formal record of these proceedings. It will be printed in due course.


Oral Evidence

Taken before the Environmental Audit Committee

on Tuesday 21 April 2009

Members present

Mr Tim Yeo, in the Chair

Mr Martin Caton

Colin Challen

Mr David Chaytor

Dr Desmond Turner

Joan Walley


Memorandum submitted by CBI (ET17) and
Engineering Employers' Federation (ET13)


Examination of Witnesses

Witnesses: Mr Matthew Farrow, Head of Environment, Mr Murray Birt, Senior Policy Adviser, CBI, Mr Gareth Stace, Head of Climate & Environment Policy, and Mr Ian Rodgers, Director, UK Steel, gave evidence.

Q49 Chairman: Good morning. Welcome. As you know, this is the second evidence session we are having in this inquiry. We looked at emissions trading a couple of years ago and we thought it was timely to revisit the subject. Both because of the potential discussions at Copenhagen but, also, because the United States are now looking at it quite seriously as well, it seemed to us to be very topical. When we reported two years ago, we concluded that Phase One of the EU ETS showed that you could have a workable system across a group of countries which had not done much to reduce emissions. Hopes obviously rose, that Phase Two was going to be tougher and would produce some cuts, but would you say now that perhaps that was an overly optimistic conclusion for us to draw?

Mr Farrow: Thank you, Chairman. Good morning. I think it is worth perhaps saying, to kick off, why the CBI has been such a strong supporter of emissions trading carbon markets, as Members will be aware. I think it has particular advantages as a policy tool. The science shows us that we need to make a set amount of reductions in a set time scale and with a cap allowance you can do that, of course. Also, ETS creates a carbon price, which means you can get very wide incentives across the economy to make least-cost reduction. I think the least-cost point is important because, if you look at what the Climate Change Committee says about the carbon budgets - could increase fuel poverty by 1.7 million households, obviously concern from business about the costs - I think holding to this point that emissions trading pushes least-cost abatement is particularly important. In terms of Phase Two, our view would be that we are making progress, the market is functioning. That is important. I think there is a lot of concern at the moment about the low carbon price, and our starting point would be that a particular set of factors have come together at once to depress the carbon price: you have obviously the recession (and colleagues may want to talk about that); you have the companies selling allowances to raise cash. Those factors are depressing the carbon price at the moment. Our view is that those factors are unlikely to persist together and there are various indications which would suggest the carbon price will pick up. Our view at the moment is that we should persist with Phase Two; we should look at ways to increase confidence in Phase Three and Phase Four going forward; but a knee-jerk reaction at this point is something we are not convinced about.

Mr Rodgers: I certainly would agree with that. It is far too early to draw any conclusions. We have had only one year in Phase Two and the data are only now becoming available for the first years' emissions. The fact that the market price has started picking up recently suggests that in fact the market believes that we have not been over-allocated in the first year. An analyst's report I was reading only this morning was suggesting that emissions in the first year of Phase Two were four to five per cent below the 2007 level. Bearing in mind that the scope has changed as well, that we now have more enterprises, more units within the scope of the scheme than we did in Phase One, again it is very difficult to make any rapid, hasty decisions.

Q50 Chairman: The price may have to go up a bit but it is still less than half of what it was last summer. Is that fall in the price and, indeed, is the reduction in emissions more to do with the recession and the consequences of that for the manufacturing industry than it is to do with Phase Two?

Mr Rodgers: I am not sure how you can quite analyse cause and effect in that way, but certainly the recession has been a major impact. For the steel sector it has had a major impact on our output. By the end of last year, output was down by about 50% compared with normal levels, so clearly the recession has had an effect. Now the data is being released, the fact that carbon prices are rising, in the midst of the deepest recession we have seen for a long time, suggests that the scheme is having some effect.

Mr Farrow: The recession clearly has had a huge impact, and it has hit the steel sector, as Ian says. In cement, as well, production is down significantly, and there is data about that. There is some evidence from New Carbon Finance which suggests that as well as falls of production due to the recession, there has been an energy efficiency impact in firms through ETS in improved energy efficiency and that has pushed emissions down. Because more general credit markets have been so glued up, as it were, firms who have held allowances have in some cases chosen to sell them, and maybe buy options for future allowances, just to raise some working cash, and the sense we get from talking to traders in the market is that that phase is probably coming to an end and that selling of allowances just to monetise them has slowed down. Obviously it was a sort of short-term stopgap measure some companies took, and, again, as that slows down, you would expect the market to start to increase. I do not know, Murray, if you have anything else you would like to add.

Mr Birt: No, I think that is right. Barclays, especially, recently had a note analysing it and showing that some companies were selling current allowances and then buying an option for allowances in 2012, almost like a loan, and the price between them was the effective interest rate for the loan, and because they could not have issues with the overall financial market.[1] But of course that rests on somebody willing to sell them the option and the individual from Barclays, the analyst, was saying that that is perhaps closing down now.

Q51 Chairman: Disentangling the effects of the recession and the policy, the Phase Two, is going to be quite challenging. I accept that it is very hard to do that issue for the Committee on Climate Change when they are looking at carbon budgets and so on. On this question of companies selling allowances to raise cash, they would be companies clearly under cash flow pressures at the moment. Looking ahead is there a risk that that may then produce a subsequent spike? If demand in the economy picks up and these companies then need more allowances, they will be forced back into the market. Could you see a sort of artificial increase in the price coming along in a couple of years' time?

Mr Farrow: I think it is possible. Whether it would be a spike, I am not certain about, but I think you would naturally assume, if the recession ends, as we hope it will, and production starts to pick up, companies need to supply those allowances to surrender them. That suggests you would get this fluctuation. I think this is a market that has some flexibility within it and, therefore, would naturally get that fluctuation. It seems to me it suggests that, rather than an instant reaction to say that the price has suddenly dropped and we need to intervene to prop up that price, we should see how the market unfolds in the next couple of years. I do not know if others have a view, but, I think, rather than a price spike, you would simply see a firming up of prices as the recession ended.

Mr Stace: As different sectors recover from the recession at different times, I would have thought we would not be seeing a spike there. We are also seeing further investment in carbon abatement with companies. We are even seeing that now, with the carbon price as it is, where the carbon price is one factor that that will enable a company to bring forward an investment decision. One of our member companies at the moment is investing £60 million in a project that will reduce emissions by 300,000 tonnes. Carbon would have been a factor there, whereas really the major factor was the price of energy. However, also the price of energy is related to the price of carbon in terms of the pass-through costs from the electricity generators.

Q52 Colin Challen: It seems to be quite difficult to me to understand quite how the ETS is influencing decisions as opposed to all the other things. Pursuing this question, there is some research that shows that the power sector, for example, has moved to decarbonising. There has been a switch from coal to gas, which the research suggests is directly related to the ETS. Could we just work a little bit more on these concrete examples of the other sectors and their relationship to the ETS? It seems to me, with a very volatile price in carbon, plus probably we can all foresee a trend in rising energy prices, that surely it is the energy price that is the determining factor for most companies. How easy is it to separate out very clearly the impact of the ETS in boardroom decisions?

Mr Farrow: I think it is difficult to disentangle it. Does that matter? What matters ultimately is that the economy as a whole is transitioning to a low carbon world in a way that protects competitiveness. In a sense, the point of ETS is to provide a carbon price within the DNA of business and then you have additional policies where you need them. The CBI has lobbied for regulation around domestic housing or CCS support, for example, where we think the carbon price is not sufficient. But the evidence, such as it is, suggests that it has a direct impact on companies. Point Carbon did a survey recently in which they said that about two-thirds of the respondents, companies in the scheme, said ETS specifically had an impact on investment decisions. Murray, do you have any examples of specific companies?

Mr Birt: One example is Real* Tinto* Alcan, where they have increased their efficiency of the production process quite significantly over the past number of years, and carbon plays a role in that because it adds to the cost of energy and so it is sometimes the marginal decision - not necessarily in all cases, but it is influencing them, as that survey was showing. Cement companies are putting in place biomass use and alternative fuels for use in cement plants, doing energy efficiency programmes in refineries. Companies are taking action on this. Energy prices are volatile, carbon prices are volatile - actually somewhat less volatile than overall energy prices - but the clear indication is that energy prices and carbon prices are rising over time and that is what creates the business case for companies to invest in low carbon technologies.

Mr Farrow: Although there is a lot of focus on spot price - and that is what the media tends to focus on and people with concerns focus on, which is understandable - if you make an investment over a long time scale, if it is a nuclear power station, for example, obviously you are concerned not about the spot price now but the likely price from 2015 onwards when you are trying to earn a return on that asset. Again, if you look at the projections the Climate Change Committee has done, they are projecting €40 to €105 per tonne as the price in 2020. Again, there is not a firm forward market to that point, but companies try those estimates. Again talking to people in the market, people expect quite a significant carbon price around 2015 onwards, so it is not the spot price, now that necessarily it is low, that stops people investing, it is more expectations about the long term.

Q53 Colin Challen: You might be able to help me overcome my cynicism to a certain extent, but might some people say that, yes, they are doing these things because of the ETS, knowing that the ETS is a very gentle way to try to tackle climate change, and they might want to do that and say that to avoid tougher actions, which might range from carbon taxation to more regulation and all of those things which companies do not like?

Mr Rodgers: I think we would have to come back to the point that we have quite a complex mix of policy measures already. Certainly, talking for the steel sector, we have had a climate change agreement for getting on for ten years now, so we have been living, breathing a low carbon agenda for some time. The European steel industry is investing many tens of millions of euros in trying to identify what the new technology might be for low carbon steel making - that technology just does not exist at the moment without research and development - and is on the verge, now going through to the next phase, where you are talking about hundreds of millions of euros investing in pilot plants. This has been on the boardroom agenda for a long time, but you cannot isolate ETS from the rest of the signals that are being sent to industry.

Mr Farrow: You were saying in the question that the ETS is a very gentle mechanism and that is why companies are saying they can see it having an impact. I think it is fair to say that in Phase One, and, at the moment, because of the recession, in Phase Two, low carbon prices are caps which the economy can keep within. That is true, but I think any companies which think that Phase Three will be a similar gentle decline in emissions are being quite naοve. If you look at the way the cap declines, it is an absolute top-down cap. If you look at the intention in the Directive, that if there is an agreement at Copenhagen, as we all hope there will be, that cap is probably going to be immediately cut significantly further; the impact of aviation joining the scheme, probably being a net buyer of EUAs, forcing up the price. While no-one can be certain, because it is a market mechanism, I think Phase One was a learning phase. One of the things we learned from Phase One was that having Member States setting national allocation plans does not work in the long term. You do not get enough tightness in the cap. When I talk to companies they do recognise that Phase One and to some extent Phase Two are not indicative of the tightness of the scheme going forward.

Mr Birt: We should also remember that the UK second phase cap was set based on an 11 per cent reduction from business as usual. Unfortunately, the recession means that we are in business not as usual, and that is part of the reason for the decline in emissions and the carbon price. The price depends on analysis of many things: on the policy, on project credits, and also on fundamentals, things like temperature, weather, seasons, the ability to switch fuels. The Phase Two cap was set where we gave most of the under-allocation to the power sector and that is why we are seeing more emission reductions from fuel switching and other technologies from the power sector.

Colin Challen: Thank you.

Q54 Dr Turner: All the putative effects of ETS and company decisions are so far fairly marginal, even if you can identify them - or at least the ones that you have quoted, unless I have been hearing you wrong. Of course the National Audit Office has agreed with us that the price of EU ETS allowances, which is effectively the carbon price, is not high enough to simulate long-term investment in low carbon energy generation. Would you agree with that? Alternatively, can you cite any examples where companies have made such long-term strategic decisions to genuinely low carbon energy generation for the future?

Mr Farrow: I think there are two points to make. The first is a distinction between the current spot price and what companies expect future prices to be. What we find is that even at current spot price, which is obviously relatively low, as we have been saying, although it is picking up a little bit, quite a bit of low carbon technology, and nuclear is the obvious example, is economically viable, and so the interest we have seen in buying the sites at auction, for example, the amount of money those companies are putting in to buying sites, shows very clearly the energy industry thinks nuclear is now viable as a technology in terms of economics, and it is the existence of a carbon price in ETS that is helping to incentivise that. On the examples Murray was giving about biomass and CHP, I take the point that they sound quite marginal when you discuss them as individual examples, but the analysis which we have done and the Climate Change Committee has done shows that to meet the 2020 targets you need both the big ticket investments, such as nuclear, but also a huge number of small processes and small scale investments across the industrial sector and the housing sector. Even at the current carbon price, a lot of technology is viable, but I think what is more significant is the fact that expectation was about the prices in Phase Three. If it was absolutely clear the carbon price would never get above €5 or €10, then I think, yes, there would be some very serious questions to be asked: Was the current model of ETS working at all? Was it flawed? Would intervention be necessary? But the fact that the Climate Change Committee projections are €40 to €105 per tonne 2020, for companies who are thinking about these long-term investments that is a judgment they are trying to make. Certainly when I talk to them they are not saying, "We're projecting a carbon price to stay at this level" - although, even if there were some big ticket investments have still come through. It is a judgment about a much tighter cap, going to 30 per cent reductions perhaps, the economy picking up, aviation being a buyer possibly, and that is a judgment companies make.

Mr Rodgers: Your question referred specifically to power generation, but if we look at the industrial sector, as I have said, in the steel industry, and it is true of other industries, we are currently reaching the state where very little additional abatement opportunities exist on current technology; nevertheless, the NAO report quotes a steel company that invested £50 million in some energy-saving technology that resulted in a one per cent reduction in CO2 emissions. £50 million for a one per cent reduction is an indication of the order of magnitude of investment that is needed today to make whatever marginal carbon savings are still possible. As I have said, research and development in new technology is where the steel industry in Europe is putting all of its money currently, because until we get that new technology we cannot get any step change in carbon reductions.

Mr Birt: We are also just seeing the first release of the data for 2008, at the beginning of April, from the Commission. That is being digested and analysed but some of the initial indications are that for companies that were in for 2007 and 2008 there is about a 4.2 or a 4.3 per cent emission reduction and this includes a decline of 13.5 per cent of emissions from coal electricity generation, with some three per cent increase in emissions from gas-fired generation. This fuel switching is where we are on the abatement cost curve, and we are moving along, taking that opportunity up and other energy efficiency opportunities, as has been mentioned.

Q55 Dr Turner: What sort of level of carbon price do you think is needed to provide a very clear signal for investment in low carbon technology?

Mr Stace: I think we need to be careful that we do not rely on the carbon price within the EU ETS to provide investments outside of the EU ETS in terms of a low carbon future there. We have the cap within EU ETS, and the cap will be met, whatever the carbon price. And so that is the aim of the EU ETS. The aim of the EU ETS is not to drive economy-wide reductions in carbon. It will go beyond those installations that are caught by it but there are other policy instruments - the Renewables Obligation and the Climate Change Act and so forth - that will also drive further investment.

Q56 Dr Turner: But we are talking about longer-term decisions than that. We are talking about, say, ten-year time scales, minimum. The ETS caps cannot provide to that to a sufficient degree. Once again I come back to the carbon price. By whatever means it is achieved, what carbon price do you think is needed to be the floor that would trigger long-term investment.

Mr Farrow: If you take the energy system or electricity as an example of what you need to do, it is pretty clear, if you look at the work that the CBI has done, our Climate Change Taskforce report and the Climate Change Committee analysis, that you do need to make very significant progress towards completely decarbonising electricity - good progress by 2020, shall we say. Although in the electricity market people will make individual decisions, you obviously need new nuclear, and it is pretty clear the existence of ETS, and even the current prices we are seeing, is making nuclear economic. You clearly need a lot of renewables ----

Q57 Dr Turner: Allegedly.

Mr Farrow: I do not think companies would be spending the sort of money they are on the sites if they were not pretty convinced. The analysis we did - this is in our Climate Change Taskforce report, it is public analysis which we did with McKinsey's* - shows that nuclear is almost economic at very low carbon prices - and you have to make assumptions about fossil fuel prices and so on - so even a modest carbon price would incentivise nuclear. Onshore wind as well, as the cost of that comes down, even fairly low carbon prices will incentivise that. With something like carbon capture and storage - which, again, you clearly have to have as part of the energy mix, certainly by the 2020s - you would need an extremely high carbon price right now to make that definitely the thing to do, which we do not have. That is why I think it is right to say, as we have said - and we will see what the Government says, maybe this week, but hopefully they will make an announcement on this - that you have to have a specific policy to incentivise CCS; involving demonstration projects, for example. For offshore wind, uprating the Renewables Obligation is normally seen as the most effective way to drive offshore wind. Rather than saying that we have to have a carbon price of €100 or something to incentivise every bit of technology we need, the best way to approach it, we think, is a functionary market: the carbon price (as I say, the CCC projection of €40 to €100 by 2020 because of the tightness of the cap), but then specific policies for specific technologies - marine/wave technology, for example, where at the moment the carbon price would have to be at a ridiculous level to incentivise that - which you could easily generate.

Q58 Dr Turner: Why are you so coy about naming a price? Is this some sort of general reluctance and disaffection for carbon pricing? The alternative is regulation. Clearly there would have to be some sort of combination, but you do not want more regulation than you have already, do you?

Mr Farrow: In some areas regulation is a better alternative. If you take particularly domestic housing, for example, and energy efficiency there, because of the hassle factor - because for most households, and the same is true to some extent of some service companies, the energy costs are a tiny proportion of the household bill or the company's turnover - you could have a very high carbon price and you probably would not get the impact you want. On something like energy efficient appliances, we have lobbied publicly for regulations to improve that. For something like buildings, again we have lobbied for building standards that would drive an improvement. We have always been very open about the fact that, while certainly we want effective regulation, we do not want regulation for its own sake, it is very difficult in the economy, we have simply to use carbon pricing in all cases to drive the sort of change we need, so you need a mix of carbon pricing and a mix of regulation in some areas. We think the reason it is not sensible to say that this is the particular price we need, is that what matters overall is the emission cuts, which is the cap. You have the cap within ETS sectors and the price will emerge that will drive the cap to be met, so you have to make sure you get the cap right up front, which is a crucial issue, and then, ideally, we should let the price look after itself. If the price is wrong, if the price is too low, as it were, in terms of the concerns you have, you look at the cap.

Q59 Dr Turner: We do not know what the caps will be at the times that concern us at this moment. In any case, the reductions in emissions are an outcome, and in order to will the outcome you have to have the means. You clearly would agree that, whether it stands on its own or not, carbon pricing is definitely one of the means. Would you agree that it is helpful in terms of investment decisions if companies can have some confidence in the level of the carbon tax and a feeling of security that, whatever it is, they know roughly what it is going to be and can plan accordingly?

Mr Stace: Going forward, in terms of understanding the market up to 2020, allowances traded now are still valid up to 2020, so that provides that long-term certainty. There is long-term certainty in terms of the target to 2020, and so, in terms of investment cycles, there is some certainty there and, as we have said, we expect the price to firm up quite a lot more over the next couple of years, especially as we come out of recession. Also, aside from the price of carbon, if we look at the now famous McKinsey cost curve, a significant amount of carbon abatement can be achieved at very low, or no cost. It is not the carbon price that is really going to tackle that. We have had a higher carbon price, and we are still seeing available abatement opportunities not being taken up. Our studies have shown that that is really a behavioural change issue that we need to overcome, both within industry and in domestic emissions. We have called on the Climate Change Committee, that one of the skills that they perhaps need to include on the Committee is some form of behavioural change specialist who can look at why, when the savings are so obvious, they are not taken up?

Q60 Dr Turner: I have to say, I cannot remember us ever having a high carbon price, but let that one pass. Lord Turner has gone further. He has strongly suggested that there should be a floor to the carbon price and that if it does not emerge naturally we should put it there by some means. How do you react to that?

Mr Farrow: The view we take is that if it became clear that the carbon price was collapsing and would just not recover, then there is a case for looking at whether you need to look at ETS to see how you can improve the operation of the system. When we talk to members about this, they say it is not the carbon price that matters at the moment; it is the long-term future of the scheme. They say they expect the carbon price to firm up, to recover - as I say, the €40 to €100 projection the CCC makes. It seems to us would it not be more logical, perhaps, to look again at the caps, if it was completely clear the carbon price was not recovering, because it is the cap that drives the price and it is the cap that it is the key outcome of the scheme. Also, there are practical difficulties about setting a floor price. If you asked everyone in this room, "What should the floor price be?" we would probably all have a different judgment about what the price should be. You have to do it, particularly, for Phase Three, which I think is where our key concern lies in terms of the long-term investment decisions you were talking about. You would have to do it at European level, I think, so you would have to get all the key European Member States to agree on a set figure. We just think, in practical terms, with the horse trading that would go on, that you would end up with a very arbitrary carbon price which would not necessarily drive the sorts of technology which I think you are very keen to see come forward. Our view is: let us make sure the scheme is functioning, let us make sure the caps are right, and we will drive this part of the economy to make the right contribution to the 2020 targets going forward.

Mr Rodgers: I would agree with that, but for the steel sector and for other industrial sectors subject to international competition I would add the following point: in effect, we have two ETS schemes. We have a hybrid scheme. For power generation and other sectors not subject to international competition, allowances will be subject to auctioning, and clearly the price becomes a far more significant driver for those sectors subject to international competition, where, hopefully, we will be receiving and continue to receive free allocations through to 2020. And, there, as Matthew has suggested, is the cap that is the main driver. One of the problems with putting in a floor price is that you are saying, "Okay, the market is over-supplied at the moment, because we are in recession, therefore we need to prop up the market with some new artificial measure." That is a problem that only arises when you have an ex ante system for those sectors where allowances are allocated as opposed to auctioned. If you had an ex post system, which is what we were advocating for a long time during the run-up to the Phase Three agreement, you would not have this problem, that fluctuations in supply and demand based purely on output from those sectors would cease to have an impact on the price.

Q61 Chairman: Just to be clear, were you saying, Matthew, that if the price fell to an unsustainably low level and showed no sign of recovery that you would contemplate a mid-term reduction in the cap as a better way of driving a sustainable price than having some artificially imposed minimum price?

Mr Farrow: I think we are talking about Phase Three, to be honest. In Phase One, clearly the price collapsed and it was clear that the allocation had not worked properly. As I was saying earlier on, our view is that this has not been replicated in Phase Two. You have some particular factors that have come together to depress the carbon price. We do not expect those factors to persist and, therefore, we think it would be wrong to have an immediate, knee-jerk reaction. If, however, contrary to our expectations the price did collapse for some reason and was not going to recover by 2020, I think we would recognise that ETS was not functioning as it was supposed to, it was not driving lowest cost abatement, and, therefore, we would have to look again at the scheme. Most people say, "Well, instantly you need to prop up price; that is the way to do it." Our view is: How would you pick the right price to get the right reductions? How could you co‑ordinate that at European level? Would it not make more sense to look at the cap? I think the way that would be done is, if there was a Copenhagen agreement, the EU Directive says the cap will be cut - not yet automatically, it does not specify the level, so there has to be some discussion through co-decision about that. If the price really had collapsed and was not recovering, that would be a point at which to do that, but, as I say, we do not think that this low level of price will persist.

Q62 Mr Chaytor: Matthew, you mentioned earlier the importance of other policies as well as the trading scheme, and of course there has been a longstanding debate about the value of a carbon tax. It seems in recent months the argument for a carbon tax has reasserted itself and EEF has specifically come out in favour of a carbon tax. First, I am curious as to why EEF has had this change of policy. Second, what is the CBI's view of carbon tax now?

Mr Rodgers: I am not sure we have explicitly come out in favour of a carbon tax. We are saying - and I come back to this issue that there are a number of sectors subject to international competition - that particularly for those sectors, we have found getting something out of ETS which does not undermine our competitiveness has been very difficult. We have ended up with some tortuous debates in Europe and we have ended up with a Directive we think we can live with, but is it necessarily the most cost-effective way of dealing with the situation for our sorts of sectors? An awful lot depends on what is agreed in Copenhagen. If we end up with all major trading partners agreeing to a cap and trade scheme in Copenhagen, then clearly it makes a lot of sense to stick with cap and trade. If, on the other hand, we end up with some major trading blocs, like the USA, going down the carbon tax route, then the interactions between the two different types of systems become more complex. All we are saying at the moment is: let us not totally close the door today to a carbon tax in the future as a solution, if the outcome from Copenhagen is one that suggests that may be a more sensible and more cost-effective way for our sort of sector.

Q63 Mr Chaytor: If in the USA the move was towards carbon tax, would you then argue that steel, for example, should be taken out of the Phase Three ETS in 2012?

Mr Rodgers: It is certainly something we would be looking at. I cannot say today that that is what our position would be. The advantage of a carbon tax is that you can exercise control at the borders in a way that you cannot with a trading scheme.

Q64 Mr Chaytor: Are the two mutually exclusive? In view of Matthew's comments earlier about the significance of a different range of policies, why does it have to be either a trading scheme or a carbon tax scheme?

Mr Rodgers: I would argue strongly that you only need one system to set the carbon price that we are all agreed is necessary. The question is which is the more effective way of doing it. We are living with a hybrid system already, with the climate change levy in this country and similar energy taxes in other countries, so having multiple layers of taxation and trading I think would be just far too complex.

Q65 Mr Chaytor: Matthew, in terms of your organisation's view of carbon tax.

Mr Farrow: I think people can make and do make an intellectual case for both alternatives, of course, and if you go back a decade or so there was a very lively debate about this. The reason we came down on the trading side was partly the cap. We felt that science says you have to make reductions of a certain level by a certain time and no-one knows, if you set a tax, what outcome you would get, whereas a legally binding, top-down cap should allow you to be confident you get those reductions and then the price which emerges should be the lowest cost way to achieve those reductions. As I say - and you might expect us to say this - I think cost does matter. Tackling climate change is not cheap but let us try to make it not so expensive. It is hard to maintain popular support, whether that is the costs on business which have to buy allowances and which we do not want to be off-shored or the costs on households paying fuel bills. We still think that ETS is the right way to go. It certainly has proved highly complex, as trading schemes tend to. I feel it is a little bit that the grass is always greener, in that because a tax is more of an idea, people think perhaps that would be simpler, whereas when I talk to businesses about government tax policy or international tax policy they tend to throw up their hands and say, "It's so complicated, you could never get it co‑ordinated." It is not obvious to us that a tax would be a lot simpler and easier to implement, but it is hard to be clear. We feel that businesses put a lot of hard work into getting ETS up and running, the cap is functioning in the carbon market. I think one has to think, as well, what is the end game here? What are we all trying to achieve? We are trying to get to a world in 2040/2050 when it is a low carbon world. To do that, EU/UK emissions must peak pretty much now and start declining, and we need to be, at the same time, getting some real momentum behind abatement in the developing world and they need to take on binding targets at some stage. We cannot really conceive of a route map to get to that world that does not involve a strong ETS that works effectively and has a strong cap, and then is progressively linked, first of all through CDM and then to other trading schemes around the world. As Ian says, if the US and other parts of the world go towards a tax route, one would have to look at other ways to try to link those systems, but I think we are not there yet. We have put so much effort into ETS and I think it is starting to have an effect. The Phase Three cap is going to be pretty tight. We have found, I think, ways of free allocation to get the right balance between sectors such as steel doing what they ought to be doing but not putting them in an impossible position. I just think that at this stage saying, "No, we should switch to a tax," would not be our position.

Mr Birt: It is also worth remembering that Europe was trying to go for a carbon tax as the main mechanism for tackling climate change and it just was not ----

Mr Farrow: Back in the early 1990s.

Mr Birt: -- in the 1990s, and it was just proving much more difficult to get agreement. You will get other taxes where the EU tries to co‑ordinate action and there is a strong view, not just within Europe but internationally, that tax is a matter of sovereignty and it proves quite difficult to try to harmonise taxation internationally. That is a bit of a barrier. But where tax and ETS do interact, and we have a climate change levy in the UK, it does get a bit messy. There is a role, I think, for a carbon tax for sectors that are excluded from the ETS and providing some sort of incentive to them to show equivalence of effort, and that will be important for the Phase Three deal across Europe as well. In the UK we have looked again at trying to harmonise it and streamline it a bit with the system of climate change agreements that we have to provide an incentive for sectors that are not in the ETS.

Q66 Colin Challen: The report we have had from the National Audit Office concludes that the ETS has had little impact at all on the competitiveness of UK companies. Do you agree with that conclusion?

Mr Farrow: I would agree that it is unlikely to have had a huge impact on competitiveness up to this point. Not surprising: industrial sectors were allocated on business as usual quite explicitly in the UK in Phase One and largely in Phase Two. For individual companies that might not have been the case, due to the way the individual allocations were made with the sectors as a whole. Plus, of course, the carbon price, while it has fluctuated, has had periods where it has been quite low, so you would not necessarily expect to have had a huge impact. Having said that, one of our cement members, Lafarge, again have publicly said that they have put a hold on investment in the EU until it is much clearer how the benchmarking is going to be worked out for Phase Three. I think all the analysis that has been done, whether that is by the Climate Change Committee or by the Carbon Trust, shows that the competitiveness issue is real for some sectors. If you look at the impact of the carbon price on the profit margins, the gross value added, there is a genuine risk there that if you simply say those sectors should take whatever carbon price the market throws at them, you will offshore emissions - which makes no sense at all. We feel it is vital for Phase Three that there is an appropriate methodology to try to protect those sectors, and the approach is benchmarking. Benchmarking is based on the ten per cent most efficient installations around Europe. The benchmark allocation is within the cap, so again it is fixed over time. I think competitiveness is a genuine issue. It is not surprising there have not been major impacts yet, but there have been some impacts, but for Phase Three, I think the deal we have can make sure that EU competitiveness is not undermined but it is something which we have to watch very closely.

Mr Rodgers: I agree with everything Matthew has said. We argued strongly in Phase Three that in order to protect our international competitiveness we needed free allocation. It looks like we will continue to receive free allocations, so there is no internalisation of the cost of carbon for sectors subject to international competition. Second, the other factor is the size of the cap. Currently, "thanks" to the recession, if that is the right word, we are not short of allowances. Going forward into Phase Three, there is a worry that the constantly reducing cap could act as a brake on output if we enter another period of sustained improvement in global steel demand. But that is for the future. We do not know what the future holds. Certainly, as of today, I do not think it has had an impact on competitiveness.

Q67 Mr Caton: You have all just repeated your welcome for the proposal to increase free allocations to be handed to industry in Phase Three, agreed in December. What are the advantages of giving away free allowances over other ways of protecting industries vulnerable to carbon leakage, such as a border tax on certain imports?

Mr Rodgers: We have always had concerns - and there is perhaps common ground with the CBI on this point - about linking ETS with a border tax. First, it would become very complex to administer because you are not dealing with a constant price, you are dealing with a variable: the price of allowances varies every day, so how you will apply that at the border becomes complex to start with. Second, where you have to, in effect, treat imports in exactly the same way as domestic production, making it WTO compliant becomes virtually impossible. The other argument is that for sectors which are substantial exporters - and the steel industry is one such - applying a tax at the border would not offset the impact on the international competitiveness of our exports. It could only work in terms of offsetting loss of competitiveness against importers. It basically fails on both counts when part of an ETS.

Mr Farrow: We agree with that. Border taxes in some ways are quite an elegant solution to part of the problem but in practical terms it is just hard to see how they would work. Just to pick up one point you made: you referred to the benchmark allocation as such as an increase in free allocation. We would see it as a decrease because, of course, hitherto, those sectors have had free allocation on a business as usual basis. So this new proposal is not an increase in free allocation, it is a tightening of it, but it is rightly, I think, focusing the free allocation on sectors which genuinely could not cope without some free allocation.

Q68 Mr Caton: I think it is an increase in the sense of what was originally envisaged.

Mr Farrow: In the original Directive proposal? In the original Directive proposal I think the Commission had said there is this issue about carbon leakage. They accepted that, and I think from memory they floated different options at which you could have border taxes or you could have the method we have gone for. In all the negotiations leading up to the deal in December, they came down on having basic criteria to decide which sector has free allocation or not. We felt that at least they had used an evidence base to do it. You can argue, perhaps, that the final deal was a bit too cautious, in including some sectors on which, on some of the analysis, the impact is pretty small, but, as I say, the Commission was always clear up front that you would need some approach which would either be border taxes or free allocation.

Mr Rodgers: For carbon leakage sectors, the initial draft said free allocation of "up to 100 per cent." Now it says "100 per cent." I guess you could argue that that was potentially a loosening, but, equally, it was potentially no difference at all.

Q69 Mr Caton: I accept what you have just said, that you are not proposing a carbon tax but it is something you think should be being considered, but, as I understand it, in your proposal to at least consider it you talk about a carbon tax being applied at the borders. Does that have fewer problems than the alternative?

Mr Rodgers: Look at it like VAT, for example. VAT is applied to domestic sales and it is applied to imports at exactly the same level. Equally VAT is rebated for exports. You could apply a carbon tax in the same way. I agree with Matthew, it would not be easy at all. It would be a very complex set of calculations that you needed to do to get exact equivalence between the treatment of domestic production and the treatment of foreign production, but in WTO terms it becomes a lot more acceptable because you are dealing with a tax -----

Mr Stace: Bear in mind that what we are really looking for is a truly international agreement, where there would be no need for a border tax adjustment: all sectors in whatever geographical region in the world are sitting on a level playing field where a tonne of carbon from one region is the same as a tonne of carbon in another region.

Q70 Mr Caton: You have all pointed out, I think, that these vulnerable industries are not to be given all the allowance that they want. They will have to face some increased costs by buying extra allowances or investing in new technology to reduce emissions. How big a factor will these costs be? Which industries will be particularly affected?

Mr Rodgers: We cannot predict which industries will be particularly affected today because it will depend on global supply and demand within each individual sector. Remember that at the time that we started talking about Phase Three, world steel demand was increasing by three or four per cent a year. Obviously that is not the case any more. Fundamentally, we see no reason why that should not return once the recession is over. If you have a constantly declining cap of 1.7 something per cent, I believe it is, and a constantly rising demand of three or four per cent, obviously you get quite a tight squeeze in terms of European operators being able to take advantage of that increase in demand. That is what our concern was. Sorry, I have not answered your question, because I honestly do not know.

Q71 Mr Caton: If you do not know, you do not know.

Mr Stace: When we look at the steel sector from 2005 to 2020, we have seen from our studies that there may be a reduction of 20 per cent in emissions. That would be between one and two per cent per annum, but that would be at a cost of €1 billion. Also, that is without any breakthrough technologies that Ian has mentioned earlier. That is for the steel sector. When we look at the ETS as a whole, the targets are applied across the board and each sector is going to have very different abatement opportunities from one another. For the steel sector we believe there is not that much in terms of abatement opportunities available and in terms of the way steel is made. Ninety per cent of the emissions are process emissions; they are unavoidable; they take place in blast furnace. Without a breakthrough technology or changing the laws of chemistry you are not going to be able to tackle those emissions, so you are looking at the ten per cent that is available to you to reduce emissions.

Q72 Mr Caton: In your memo[2] the CBI argued that industries which consume a lot of electricity, such as the aluminium sector, will suffer due to increased auctioning in the power sector, since this will lead to higher electricity prices, but in our last inquiry we have heard that auctioning allowances to the power sector should not make any difference to electricity bills, since power companies are already adding the market value of allowances to their prices - and earning windfall profits, incidentally, as a result. Are you telling us that power companies are going to put their prices up again?

Mr Birt: As it moved to full auctioning, the price will be passed through fully. There is some pass-through in power prices currently, but as carbon prices increase, the direct impact on companies will also increase. That is why the Phase Three Directive provides some allowance for Member States to give state aid to particularly electro-intensive industries. There are really only a couple, and from our view they are probably aluminium production and chlor-alkali production, and perhaps some others. For instance, in the chlor-alkali industry, increasing costs of ten per cent or more would be the result, and that represents in excess of its profits over the last five years. That increase from auctioning in the power sector could have that impact unless there was some sort of compensation view, and our view is that kind of compensation mechanism should take place until there is a level playing field for those industries globally and on a level playing field for Europe.

Mr Rodgers: To add to Murray's list of sectors: electric arc furnace steel making, which is also electro-intensive. All we are saying is that provision now exists in the Directive for Member States to provide state aid to electro-intensive industries. If the UK finds that the Spanish, Italians, Germans or whoever are subsidising legitimately their electro-intensive industries, then the UK would have to follow suit or our competitiveness would be very seriously interrupted.

Mr Farrow: In terms of whether there will be an increase in energy costs, electricity costs, our view is that it is quite likely. If you look at the Government renewables consultation last summer, when that came out it had some pretty sobering figures towards the end of it about the projected increase in gas and electricity costs for industry due to existing climate change policies, of which ETS is one, and due to the costs of meeting the renewables target on top of that. I do not have the figures to hand but we could help your officials find them. As I say, they were quite sobering, multiples of ten per cent, so the expectation is that climate change policies and costs pass-through will lead to additional electricity cost impacts. As Ian was saying, rightly I think the Directive allows Member States to compensate for that. There is clearly a level playing field issue. This would be a year in which we would urge the Government to keep a close watch on that as necessary.

Q73 Mr Caton: Thinking about those windfall profits, are you aware of any other industries which have made a profit by raising their prices to capture the market value of their carbon allowances?

Mr Farrow: No, is the answer. There is a lot of debate about the windfall profits' analysis and all the different parties to that debate have given their own views on it, but, no, I am not aware of any other sector where it has been discussed.

Q74 Joan Walley: Could I apologise for having missed all your evidence because of problems on the West Coast mainline this morning. In relation to the scope that you have just covered about the whole issue of carbon leakage and other industries, could I ask Mr Farrow what scope you think there might be for detailed research into intensive industries, such as the ceramics industry, which I know are particularly concerned about the need to look at ways of doing this in sectoral way rather than on a geographical basis. How do you think that the two issues can be balanced in terms of meeting the carbon emissions but at the same time retaining the UK ceramics industry?

Mr Farrow: In terms of international sector agreements?

Q75 Joan Walley: Yes, and the fact that it could be much easier to produce offshore, where there are not the same restrictions.

Mr Farrow: The whole carbon issue is a significant issue, as we were saying. Ceramic industry companies are in many cases CBI members and I do hear a lot of deep anxiety from them. In terms of within ETS, we have always made clear that this is a real issue. If you look at the work which has been done by a range of bodies, such as Climate Strategies, while not all sectors involved would agree with the precise details of that, that sort of analysis very clearly shows that a range of sectors, such as ceramics, are generally affected, and so within ETS we have pushed very, very hard for what has been the outcome: an evidence-based process where industries like ceramics can make their case with the Commission and say, "We need a benchmark free allocation." Having said that, I think there is a lot of interest from sectors, including from steel, of course, in the role of these international agreements, where in principle, I think, if those agreements could be devised in a way where they were rigorous, and they were properly monitored and verified and they guaranteed a comparable emissions restraint that you get under EU ETS and similar actions elsewhere throughout the world, then there could well be possibly an easier way to deliver the same environmental outcome while protecting competitiveness. So we are interested in global sector agreements. We talk to a number of our members about them. We tend to leave it to the sectors themselves to do the work with their counterparts across the world. Clearly they must be rigorous, as rigorous in terms of outcomes as alternatives, but if they can be developed then we would support them.

Mr Stace: Within the EU ETS Directive it is for the sectors to prove that they are at risk of international competition and therefore should be seen at risk rather than the other way round. My advice for the ceramics sector is, as Matthew says, they should be feeding into the Commission's current data trawl for the Commission's study. We in the steel sector, slightly over a year ago now, commissioned an independent consultant to look into this very subject and to see if the Steel sector was indeed at risk of international competition. Again, in terms of global sector approaches, for the sectors to take a lead there to show they can develop a sectoral agreement globally. In the steel sector, that is what we are doing, working with the World Steel Association, formally the international Iron and Steel Institute, and making very good progress there in terms of bringing in countries or regions of the world, such as China, in developing data collection that had never taken place before, discussions of benchmarks and global agreement that we would not have seen before.

Q76 Dr Turner: You are obviously familiar with your sister organisations in other countries who are clearly going to be having an input in Copenhagen. What is your assessment of the prospects of Copenhagen in terms of producing binding targets on all major emitting countries or, alternatively, on major sectoral emitters?

Mr Farrow: That is a big question to throw in towards the latter stages of the session and the honest answer is we are all speculating because there are so many physical factors at play. In terms of our sister organisations, I suppose there are two points I would want to make. One is we have seen it as part of our role to work with those other organisations to try to explain why CBI and UK business has taken what is seen by some of those organisations as a relatively progressive stance on climate change. We talked to them about our own taskforce work and the Stern work and so on and how we are convinced, although it is going to be very difficult, we can meet these targets in a way which is compatible with a functioning economy. We felt it was part of our job to do that and we have a lot of contact with other organisations. Certainly, talking about the US big organisations, if you go back to, say, 2004-2005, we wanted to run a big event with one of the big American business organisations on emissions trading, not about the politics of it but trying to share views on the technical details and how it would work, and we could not get any interest. They just did not want to go there. Now that has completely changed. Richard Lambert goes out to the US - he was out there a couple of weeks ago, I think - and we have meetings with the administration, with the US Chamber and so on, and we find there is a completely different discussion going on. What that will mean in terms of Copenhagen is very hard to suggest. We have published some work on what we would see as an acceptable outcome for Copenhagen which we will certainly send in to you. We have said the EU is right to have this sort of dual-track tactic of saying 20 per cent cuts if the rest of you do not step up to the plate but it will go up to potentially 30 per cent if there is a meaningful deal. That seems a reasonable attempt to play the tactics. I guess we are concerned that, if a deal is done of some sort, there is proper scrutiny, just to make sure that there are significant comparable commitments by other countries before we instantly say that the whole carbon leakage issue has been solved because we have these signatories on board, but I would be cautious to speculate the actual outcome.

Q77 Dr Turner: One suggestion that has been made is for global sectoral caps and trading schemes to go with them, covering, for instance, all major steel companies throughout the world. How practical do you think that suggestion could be?

Mr Rodgers: It is certainly an approach that we have been advocating. As Gareth was just explaining, the World Steel Association has brought together most of the major emitters around the world and has already started collecting emissions data on a common basis, which is actually quite revolutionary for our sector and I suspect for any other as well. If you are going to go further and turn that into a binding international cap of some nature, that could only be done with the support and involvement of governments as well. Competition law, apart from anything else, would require that within Europe and within the USA. What matters to us is not the extent to which we compete with the cement industry, say, what matters to us is whether we are able to compete on an equal basis with the Chinese, Russian, Brazilian and Indian producers who have the more rapidly emerging companies around the world.

Q78 Mr Chaytor: In terms of the possibility of the US trading scheme, would your preference be for it to be fully integrated with the European trading scheme, if it were to continue? Is there any advantage in having two separate trading schemes?

Mr Rodgers: If we continue to go down the trading route, then the more integrated the trading is around the world the better. If you have a US scheme that is different from a European scheme, it may well be that one is biting harder than the other. One may be internalising the cost of carbon more than the other. If it is a single one, then you do not run the same risk of distortion. That is a purely speculative answer.

Q79 Mr Chaytor: In respect of China, India, Brazil, Russia, I see on my emails this morning that China has recently now accepted the concept of strict emission targets, so this may be a first step to a growing interest in China in these trading schemes. Is there any information you have about the thinking in these four countries as to the role of trading in their economies in the future?

Mr Farrow: On the US point, there is a lot of momentum behind cap and trade and there are various bills around and solutional schemes. To be honest about it, there is also quite a bit of scepticism from people who say, "The European scheme is very bureaucratic and we don't want that here". I think that is over-emphasised, to be honest, and part of our work is trying to explain how ETS is working. We cannot really see an easier route to a global low carbon 2050 which does not involve regional trading schemes which are linked through CDM initially, and gradual links more formally. As Ian has said, this will take time because it would be a huge mistake to link schemes which are quite different and completely distorted them. I do not know about China. Obviously there is a developing debate there and they are thinking about their strategy for Copenhagen. We will have to see how quickly they are willing to take on binding targets but that has to be the medium-term goal, and I think linked trading schemes are part of the argument there because they can persuade those countries they can meet what seem to them tough targets in a low cost way.

Mr Stace: We must be careful we do not mix apples and pears together in terms of global trading schemes and linking them up. If we look at China, it is my understanding they may be looking down the route of more efficiency targets rather than absolute targets, which would be very difficult to link with the European scheme. I know Japan is looking at more energy targets rather than carbon targets. So in the run-up to Copenhagen and beyond, there is an awful lot of trying to mish-mash and bring them together to, as I said before, achieving our overall goal of international agreement which places all participants on an equal footing.

Q80 Chairman: EEF is in favour of more Government investment in decarbonising the economy - I think we probably all share that view - but you have argued against hypothecating auction revenues for this purpose. Why is that?

Mr Stace: What we would like to do is go beyond the auction revenues really, in the sense that what we are looking at here is a revolution in terms of reducing carbon emissions, and is a huge step change in the technology which is used to create products and services which we have in the UK. To rely on the auction revenues - and we have talked a lot today about the changing price - really does not provide that long-term stability and certainty that we believe EEF members would need to invest heavily in the new technologies. For example, if the price of carbon is low, our members need that support all the more, so if it is hypothecated they will be getting less money, and when they next need that support and the price of carbon is high, they will be getting more money. So what we want to see - and we will see tomorrow in the Budget - is more firm, long-term commitment from Government to enable manufacturers to produce the products and services which will ensure the UK meets its obligations under the Climate Change Act.

Q81 Chairman: But against the present background of the public finances, there are not going to be other sources of taxpayers' money readily available for this sort of investment. Would the revenues, even though they might not be entirely adequate or even completely predictable, not be a good start?

Mr Stace: They would certainly be a good start but there are other revenues - the climate change levy and the landfill tax and the like. If we are looking at the economic situation now, that I hope would be very different going forward into Phase 3 when we will see significant revenues from the ETS. So we are absolutely not calling for the revenues to go somewhere else, we are saying there should be the revenues and more.

Q82 Chairman: One of the proposals from the US administration is that the revenues from auctioning, if they proceed down the trading route, will be used to top up the social security budget. That seems to me something which might get the whole concept of auctioning discredited. At least by using them for some directly related purpose, would in your judgment be a better alternative?

Mr Stace: Yes.

Q83 Chairman: What effect do you think the revisions to the proposals for free allocations in Phase III will have on the amount of revenue which could be raised?

Mr Stace: It certainly will reduce it slightly, but the benefits of free allocation, and therefore avoiding any carbon leakage, would far outweigh the loss in terms of revenue that the Exchequer would get.

Mr Farrow: We have not done the analysis of this but if there are few allowances to be auctioned, that is not a huge difference but actually that might mean the price at auction is higher than it would otherwise be, so it might equalise. We have not done the modelling.

Q84 Chairman: We are going to have to call it a day as we have some other witnesses to talk to. Thank you very much for your time and your responses this morning and I hope we can keep in touch with all your organisations as well.

Mr Farrow: Thank you.

Memorandum submitted by The Carbon Trust (ET19)

Examination of Witnesses

Witnesses: Professor Michael Grubb, Chief Economist and Dr Thomas Counsell, Strategy Associate, Carbon Trust, examined.

Q85 Chairman: Good morning and welcome back to the Committee. We have returned to this subject after a couple of years because it is timely and topical to do so. In the written evidence you sent us[3], you say, "Carbon markets are essential ... because they provide firms with an incentive to abate whilst limiting overall emissions." How successful do you think the EU ETS has been so far in reaching those objectives, incentivising companies to find ways of abating carbon and in capping overall emissions?

Professor Grubb: I think some objectives are met with different degrees of success. I think, first and foremost, the system has seized the attention of top management and one hears very much climate change discussed at board level compared with previously when it was largely ignored. That is worth something. In terms of the operational behaviour of the companies, I think there is compelling evidence that in a number of areas - for example, some elements of fuel switching, power generation, certainly cement, plant operation, mixing - there have been quite significant and associated emissions reductions. As we ourselves have said in publications of the Carbon Trust, we think it has been less successful to date in terms of fostering low carbon investment for the long term, and we have gone into some of the reasons for that. So I would give a qualified success to date.

Q86 Chairman: What about the impact of the recession, because that has bitten much harder than when plans for Phase II were being discussed? Do we need to make changes, either to the working of Phase II or to the preparations for Phase III because of the recession?

Professor Grubb: From my reading of the legal texts, I do not think there are any changes required in Phase II but I do think something needs to be done in the area of how auctions are conducted. In our evidence we mentioned the possibility of in effect establishing a price floor using reserve price auctions, and that may be something we will come back to in more depth. I think that is a broadly sensible measure and I think it can be conducted in Phase II without the need for any legal changes. Phase III - it is still somewhat early days to see exactly how the recession will pan out and we await some evidence on that and will know a lot more by the time the Copenhagen deal is concluded, whatever form it takes, and then do we need to take a decision in the round which takes account of both what has been achieved at Copenhagen and what we have learnt about the recession. My strong suspicion is that we will discover the European targets to 2020 look easier early next year than was thought at the time they were originally negotiated, therefore, perhaps strengthening the case for moving towards the 30 per cent.

Q87 Chairman: The proposed cap in Phase III is supposed to deliver a cut of 21 per cent in emissions from power and manufacturing sectors, but if the full quota of project credits is used, which comes of course from an unlimited pool, the average reduction across Phases II and III might be as little as 7 per cent. How does that relate to the targets we have got, both British targets and EU targets, in relation to the limit of a 2oC rise in global average temperatures?

Professor Grubb: I think that combination is too weak. It does not set us fully on course for a reasonable probability of achieving 2oC.

Dr Counsell: I think the assumption has to be in business that we are going for a 30 per cent target, minimum.

Professor Grubb: One has to recognise that the European 20 per cent target (and the associated 21 per cent in the trading sectors relative to 2005) is in effect the interim planning for a world in which there is no coherent global action. If there is not coherent global action then we have failed to reach 2o anyway. Frankly, I think we would both prefer to focus our attention, and believe that industry should focus its attention, on planning for success in terms of both Copenhagen, a global deal and a consequent strengthening of the actions.

Q88 Colin Challen: You seem to be very confident about the effectiveness of the flexible mechanisms - CDM and the JI - saying they will deliver about 2 billion tonnes of emission reductions by 2012. How do you justify that confidence when there are so many people very happy to criticise the flexible mechanisms?

Professor Grubb: We looked in considerable depth at these and have the impression you have seen some of the reports we have produced, as mentioned in our evidence. There is a lot of criticism out there, in the first place; we are well aware of that. Quite a lot of that criticism has actually not been differentiated between the voluntary markets and the compliance regulated markets. Our studies and all of our comments are really around the compliance regulated market - Clean Development Mechanism and Joint Implementation. Let us run through a few dimensions of the evidence in that area. First, the calculation of the volume of emission credits we present will be around 1,800 million tonnes plus or minus probably 2 per cent.[4] That looks fairly robust, for the reasons we lay out in that report. My sense is that the debate you are alluding to is how good and how valid are those credits. Some of the underlying research we did went into some depth around that and we did argue there are indeed a number of areas of problems. Looked at in the round, it is important to be pretty clear about the following considerations. First of all, a significant part of those emission credits are coming from either industrial gas retrofit projects or from landfill waste projects. Those are things which do involve some additional investment; the industrial gas ones in particular are very cheap, but one would have to struggle to make a case that many of the developing countries would have done this without any economic incentive or any assistance from industrialised countries having to pay for them. So there is a very, very high probability those projects are genuinely additional, they are in fact saving very, very long life gases, and I think it is an extremely good thing we had a mechanism to clean those up as quickly as possible. Some of the other debates are around, if you like, the next big tranche of emissions savings from renewable energy programmes particularly in Asia, where the volume of credits is dominated by wind energy and hydro investments. My own reading of that, and certainly some of my discussions with Chinese colleagues, is some of those projects might have gone ahead but frankly there is no question that CDM incentives were very valuable in accelerating the growth of renewable energy in Asia. In fact we have seen an explosive growth in wind energy in both India and China of a kind I think we would not have dreamed of five years ago, and I would classify establishing a rapid growth in a vibrant renewable energy capacity in Asia as a huge success. Whilst recognising there will always be debates about how much of this might have happened in its absence, one is into the land of speculation about what we would have invested in wind energy if it was not quite so economical, would the Chinese have introduced these policies to support them, et cetera. There will always be grey areas around additionality. The final comment I would make is, what I think nobody can dispute is that CDM credits do make these zero carbon investments more profitable than they would otherwise have been, and on the whole I think that is a good thing.

Q89 Colin Challen: You mentioned China, that is where one of the criticisms recently has been, because the Chinese were building factories which one might describe as HFC-avoidance factories as they were making more money out of the credits than the actual products they were allegedly built to manufacture. That is one of the criticisms, where you run into billions of dollars or whatever or investments, described in the FT as a "scam". The other criticism is that no account is taken in CDMs of the associated growth that may spring from a CDM investment and the associated growth in infrastructure is not accounted for, and that could be the normal, "business as usual" type of growth, aided by this extra investment which itself perhaps measures up but the rest of its associated activity does not. Do you accept either of those critiques?

Professor Grubb: Maybe taking the second one first: I cannot think of any mechanism which realistically could take account of secondary spill-over effects on broad economic patterns in any quantified way, and I would argue that if the incentive mechanism is targeted at low carbon investment then the spill-over effects are actually more likely to be positive than negative. In other words, you are more likely to accelerate expansion of additional renewable energy because the industry is established and looking to propagate and grow, than coal grants, some of which have been squeezed out by the growth of low carbon. I am not saying that there is no indirect effect, but I would expect it to be predominantly in a positive rather than a negative direction. On the first critique, to my mind it was a strength of the system that it was flexible enough to actually step in and outlaw any crediting for new greenfield investments of that sort, precisely to prevent the perverse incentives, and they introduced a specific rule saying that plants beyond a certain date, ie plants which are already constructed, could be credited for retrofit to clean up equipment but that any new plants could not claim an on-going stream of credits, precisely because of the problem you allude to. In any regulation you cannot foresee all eventualities, all you can ask is that when they are spotted the regulation will adapt, and it did.

Dr Counsell: It is only going to get harder in a way to prove additionality in all these projects and therefore basically you need to design a scheme so that it can evolve going forward, to make sure the projects are as additional as possible whilst still getting the scale of investment and flows of money that you need.

Q90 Colin Challen: Should there not be some equivalence between the carbon which we are producing ourselves and will carry on emitting and the stuff that CDM is allegedly avoiding? Because you can measure the stuff very accurately from aircraft emissions but if they start to talk about introducing, say, anti-deforestation measures into the CDM, there is no equivalent there at all, is there, so it is really just a fictional kind of approach?

Dr Counsell: The CDMs and such like should only be there to allow you to take tougher targets in the developed world than would otherwise be possible or acceptable, so you should always be trying to cut yourself first and then use CDMs. In terms of their equivalents, I personally think there might be a case for thinking about whether you have a one-to-one equivalent or not, but that would be something you would evolve over time I think through the system.

Professor Grubb: The question of project by project additionality is bound to be problematic, for the reasons which you and others allude to and we lay out in our report. But one can be equally confident that the opposite approach (no use of international mechanisms) also really does not make sense. To say that we should just confine ourselves to domestic action and completely ignore the possibility that there are strongly effective ways of reducing emissions in other countries, which probably are not and should not be expected to pay for themselves, is an equal extreme I certainly would not support. I think it is very healthy that we have a system which does enable and encourage investment to flow in emissions reduction projects in developing countries. I think what we are talking about really is, what is the balance and the strength of the domestic commitment in a large number of those international accreditings, and what kind of projects do we think are legitimate and want support through these kind of mechanisms and which do not, and maybe there are some grey ones in the middle where the uncertainties are greater and you use discounting of credits.

Dr Counsell: Certainly the CDM is not going to be the only mechanism we have going forward in the developing world. That is clear.

Q91 Mr Caton: Some Eastern European governments have been developing a Green Investment Scheme as a way of ensuring that their sales of emissions credits yield real environmental benefits. Do you know how this will work and what is your view of this potential?

Professor Grubb: If you like, it is the newest kid on the block in the armoury of instruments, at least in terms of any real transactions. It is probably a question most simply answered by reference to the example about which we know most which has resulted in some transfers, which is the Hungarian scheme. Hungary spent many years developing legislation to try and offer assurance to potential investors that revenues from selling some of the Hungarian Kyoto surplus would be used particularly to refurbish and increase the efficiency of the Hungarian building stock, a lot of which of course is largely inherited, not terribly efficient buildings. Of course they have a lot of domestic reasons for wanting that to be pursued, it is also a highly cost effective way of cutting emissions. There are some other elements of the Hungarian scheme I believe, including some distributed renewable energy from small scale biomass. They took that proposal through their domestic parliamentary procedures in order to establish guarantees about how the revenue would be used, because obviously it is quite sensitive for a country, for a government, to promise another government how it is going to use money. I believe they reached a sufficient level of assurance and confidence that Belgium and Spain both agreed to buy allowances under the terms of that Green Investment Scheme. I believe at present there are at least half a dozen other East European countries with Green Investment Schemes at various stages of development. I am not an expert on exactly where they all stand, some of those are detailed in the report that the Carbon Trust published and in an underlying report by Climate Strategies especially about Green Investment Schemes. There have been reports also of the Japanese purchase of allowances from the Ukraine under a Ukrainian Green Investment Scheme, which has also gone through some parliamentary procedures and is not subject to some of the additional constraints, for example, like state aid concerns. I cannot testify as to the depth or the full-scale monitoring of that scheme. I think they are an interesting development and it is too early really to evaluate the success or not.

Q92 Mr Caton: The European Commission are talking about modernising, if you like, some of the older kids on the block, and they are proposing the CDM be reformed so instead of individual projects generating credits, whole economic sectors are able to do so. How do you see this working in practice and what are your views about that?

Professor Grubb: Things ideally would move in that direction because clearly any project by project assessment is inherently going to be a little heavy weather, and it tends to mean that larger projects are better able to carry the transaction costs, et cetera, although there are some small ones. It would be nice to engage sectors strategically to develop them in low carbon directions. That said, there has been quite a lot of hype and I think the most obvious worry is that we cannot exactly claim in Europe we have been terribly good at allocating emissions to our sectors in aggregate particularly outside the power sector. It looks like again last year we find most in the second phase have ended up with a surplus, and of course the same risk pertains to sector level caps. So I think a driving question is what level of confidence does one have about how those sector targets would be developed and until we have answers to those questions, that is a real concern.

Dr Counsell: I assume the benefit they are looking for is that you get people ready for proper cap and trade schemes across those countries and across those areas, so the way it might work is if you do have a sector-wide baseline and you get below your baseline you can sell the difference as credits. You would put in a requirement for the whole sector to put in the monitoring of their emissions, to think about what their emissions are and what the growth of emissions can be, and that gets people starting to think about, just like Phase I of the EU ETS but about what those emissions are and how to manage them, and gives you a stepping stone perhaps towards a proper cap and trade or fixed cap system.

Q93 Mr Chaytor: The Committee on Climate Change made a strong distinction between the use of ETS allowances and CDM credits. In view of your earlier remarks, and I think they come up in your submission, about your confidence in the integrity of the CDM, why should you make such a distinction?

Professor Grubb: You are asking me with a Climate Change Committee hat on in part. In the first place, the EU ETS is an overall capped structure, so you do have the confidence there that what you are buying when importing into or exporting from the UK is associated with a directly equivalent change in someone else's constraint. As you said, CDM is more complicated, it is trying to make estimates of additional emissions savings compared with baseline, and that means there is less certainty. Also part of the reason for the debate around constraints upon imports of credits is because, if we are going to solve climate change, the industrialised countries do need to be driving their economies on a lower carbon path to substantial decarbonisation, and therefore it does make sense to have a degree of focus on domestic action, but we would argue that should apply right across Europe. One should not draw a distinction that we are being less successful in decarbonising industrial economies if it happens in France rather than UK, for example; it is the collective effort in an industrialised region that matters. That is differentiated from CDM where in effect one is trying to provide a way of supporting low carbon investment in growing economies. So those are the fundamental architectural reasons for drawing a distinction, as well as the accounting problems given it is a free market.

Q94 Mr Chaytor: The EU has recently increased the total number of credits that can be used for offsetting purposes. Do you think that will lead to a re-think of the Committee on Climate Change's position, or does an ETS credit still have the same value following the change of policy by the EU?

Professor Grubb: These will not make a dramatic change of policy in terms of volume of credits. There has been some move there. Obviously, yes, within those constraints there is legitimate argument that one can substitute - we might import EU allowances so someone else can import credits in the ETS within the context of that cap. I guess the way I think it might be useful to think about this is that the Committee on Climate Change drew a clear distinction overall between the type of constraints on the trading sector and the type of constraints on other sectors of the economy, and in effect what we would thereby say is that the trading sector has a set of rules and principles about the extent of its openness to crediting which are developed and agreed at a European level, and the non-trading sector which is a UK target remains basically a UK sovereignty to decide what kind of credits. We draw that distinction, so our separate discussion about import credits is about what might the Government legitimately purchase to alleviate the pressure on the non-trading sector UK emissions.

Q95 Joan Walley: One of the things about the Climate Change Bill, when our Select Committee looked at it, was that we felt there would be a limit in the amount of time that the Government could rely on emissions trading as a way of reducing carbon emissions rather than other means, and I wondered what your view is. Is emissions trading going to go on for ever and ever and ever, beyond Phase I, Phase II, Phase III? Presumably it will only be a successful pathway once nations are able to reduce the amount of carbon they produce through emissions trading. Do you see there to be an end date? How do you see decades ahead? How do you see it shaping up over the medium to long term?

Dr Counsell: If I look at the IPCC kind of curve to get us to a 2o world, it will make carbon dioxide emissions illegal before I die, possibly, and therefore it clearly has to be only a temporary scheme. However, that does not mean it has a very short life, because actually what is going to happen is that a right to emit will become a scarcer and scarcer resource and therefore you want to have it only used by higher and higher value activities, and a market is a pretty good way of working out what those higher values are and therefore the most worthwhile uses of that right. That will happen for quite a long time, I think.

Q96 Joan Walley: It will happen when?

Dr Counsell: When will it go out of date? When we finally have got to the point when we are not emitting carbon dioxide. I expect there will be a role for a market until then because you have to keep allocating a scarce and shrinking pie of these rights to emit, and the only effective way of working the highest value thing is a market of consumers.

Professor Grubb: I think there has to be a very important transition in how we think about the role of these mechanisms. In the first place I hope everyone accepts that carbon trading is not the be-all-and-end-all of climate policy; there are lots of other things which are relevant. However, it is still seen largely in the context of this debate about helping developing countries, alleviating our constraints to some degree, north-south transfers, et cetera, whereas I think over time it would be increasingly recognised a little more in the sense the EU trading scheme is, as a way of introducing some flexibility and incentives in a fundamentally uncertain world. I think in three decades' time we still will not know everything about exactly where the best opportunities lie. We will still want economic incentives which reward sectors for doing more both with something to sell and those who have found it even tougher than they expected. So there will still be a role for economic incentives and I think it is a sensible way of introducing such an incentive in the face of considerable uncertainties. I think that will persist.

Q97 Joan Walley: Are you confident that this sort of medium to longer term strategy is being discussed and debated and informing the EU trading scheme and our own carbon trading through the climate change legislation? Is there a mechanism for looking at the way in which the transitional stage will eventually peter out, leading to policies which will actually reduce the use of carbon altogether? Is there a mechanism within which that is taking place?

Professor Grubb: Let me answer that at the UK, EU and global level. I think the UK has probably gone about as far as anyone in trying to do that, and of course the Climate Change Act and Committee are a central part of that effort. I am not pretending that is perfect by any means but the job of the Committee is to help business look further ahead; it is not that long before we will be debating Fourth Period carbon budgets and so forth, and further elaborate the transition towards the 2050 target, et cetera. At EU level we have a new target, the 2o target, as adopted by the EU. I would say there is a less complete institutional process for trying to help join the dots. If you look at the Phase III EU target-setting, they were informed by the trajectory and some of the implementation details were perhaps less so. At the global level, as we say in our report, we think the lack of coherent, focused advice and "are these sets of agreements really going to deliver what is needed", is worrying. I do not think the dots are well joined up in terms of global negotiations.

Q98 Colin Challen: How big a problem is the volatility in the price of allowances which we have seen lately? To what extent are low prices likely to reduce the amount of investment that people make in the low carbon economy?

Professor Grubb: Maybe I will offer some comments and Thomas also has some interaction directly from some of the businesses the Carbon Trust works with. I think price volatility is a problem, particularly extremes of prices. It would be nice to have a less degree of swings in prices. To some extent we need to break it down. First, in a market structure one would expect and indeed hope prices respond to circumstances to a degree, so if things in the wider world change then you would expect there to be a response in terms of how costly people think it would be to achieve the targets and quantities set. Nothing wrong with that; industries deal with price uncertainties in almost every market they live in. Where I think we have a problem arising from that, is that, first, unlike most markets this is one which we have constructed explicitly to deliver public policy goals. At the beginning of the session I outlined several possible goals and I think there is no question that the goal of fostering low carbon investment is undermined if the price collapses, and to some degree the efficiency is undermined if the price is too volatile. It will be higher when the price is high with experts in low carbon, et cetera, et cetera, and then some of the talent will be lost and shared when it falls. So a price which is too much is a problem both in terms of efficiency and delivering some of the core objectives. I do think there needs to be a more focused discussion around what level of price variation is reasonable and what takes us outside the range of what we are really planning for and starts to undermine the objectives of the system and then what can be done about that.

Q99 Colin Challen: What should be the floor price, do you think? What level should we currently aim for?

Professor Grubb: I think one would need a much more extensive debate about what should drive a floor price and how and who should decide and on what basis. I think there are a number of different factors which would play into that. I think just in terms of the sheer broad credibility of the instrument and a signal to industry that there will be a carbon price continuing, even if the impact of the recession starts to bite even deeper on market outlook so to speak, and in terms of developing country engagement, one needs a price of at least 10 euros. If you look at other objectives, what kind of investment one might want to drive with this instrument, frankly, we want to see substantially higher prices than that.

Dr Counsell: I have a couple of points. On the price volatility, I see it as a symptom of a problem in a way, in the sense that part of the problem is we have not set our caps tight enough in effect, and the other part of the problem is along the lines of the science of what is required to get down over the long-run. The other part of the problem is that companies have not universally addressed the question of exactly how much it will cost us to get down to make the abatement required. A third element is that they do not necessarily believe the longer term vision of what is going to happen. I think what we are looking for with the pricing is that it will be enough to encourage companies to really take it seriously and really seriously do their own analysis of what they have to do to completely decarbonise. The Economist Intelligence Unit did a survey which we co-sponsored and it asked people what price level would be required to make a significant impact on their business. There is a range, obviously, because some companies are already doing that analysis and doing things, but you get perhaps half of companies, by the time you get into the 40 euros per tonne mark, saying it would have an impact. The question is, "At what price will it significantly affect how your business considers its energy use?" That is perhaps the sort of price you might require.

Q100 Colin Challen: This volatility in the prices though is not just about our domestic effort and how much companies are willing to invest in low carbon technologies, but surely in this year in the run-up to Copenhagen, this volatility in prices must be very damaging to the EU leadership in those negotiations, because developing countries will see that leadership rising and falling on the back of the price. We are talking a lot about how great it is going to be in Phase III - we heard that talk before Phase II started, how Phase II with these tightened caps was going to deliver us, and it has not, partly because of the recession ----

Dr Counsell: It has done better than Phase I. We are improving in each phase.

Q101 Colin Challen: It is not really good enough, is it, if the EU wants to show leadership in Copenhagen, merely to have that leadership given or taken away depending on the volatility of the price in the ETS. That is how many people are beginning to see it.

Professor Grubb: I think there is an element of that, and that is why we do think there is a case for taking appropriate measures. To some extent we should be fair ourselves and acknowledge a couple of things. First, in part, definitely not in total, this is a problem of success. In part we are seeing that achieving some of these targets is turning out to be easier than anybody thought when they set the targets, and that is partly to do with responsiveness in certain sectors, partly to do with the decline in gas prices, partly to do with the recession. It seems to me there is a valid debate to be had which says some volatility or some variance in price is entirely legitimate because you do want to reward more success than you expected in the first place. But if it goes outside certain bounds and is clearly due to other extraneous factors, and particularly now the dominant one being a recession, then my personal view remains that in effect what we are learning is that several years ago we negotiated a set of quantified constraints which we thought would drive prices in the 20, 30 euros or more level, and it is now turning out we were wrong. It is nobody's fault but the fact is it has turned out to be a lot easier than we thought, partly due to extraneous factors. In those circumstances, yes, I think a correction action of the kind we have outlined is an entirely legitimate debate. In particular, what we are facing is that in most markets price changes are an arbiter of both supply and demand. The price goes up, you get more investment in supply and people cut back demand, and the other way round, the opposites happen. In this market we seem to think by an article of faith we create a quantity and it should be totally unresponsive to prices; irrespective of how far the price swings, the quantity shall remain fixed. I think it is entirely sensible to say that beyond certain bounds, providing we can have mechanisms which do not introduce perverse incentives, it will be good if you find out that emissions are going down anyway for other reasons; there is a mechanism which helps some of those emission allowances not come on to the market and thereby sustain a price.

Q102 Chairman: Is there a case for governments operating a sort of stabiliser effect, so you could smooth the price trajectory by governments being willing to come in and buy allowances when the price is very, very low but equally being willing to sell them - assuming they still had some to sell of course - when the price is very, very high?

Professor Grubb: I am a bit more nervous about that kind of proposal because I think it implies an active role for governments as price managers as well as raising questions of who is going to dig out the cash to buy allowances at certain times. It implies a degree of day-to-day involvement in the market which I think would not necessarily be helpful. I would not completely rule it out but you need to be really clear about the role and the powers and the reasons and expectations et cetera,. I think we are a long way from that, which is why what we have focused on is something much simpler, which is a simple reserve price at auction and if people do not want to pay that much then those allowances will not enter the market. You could argue that that would only work if there is a degree of international co-ordination and then there has to be a debate about what that price level would be internationally, but I still think it is several steps short of the full panoply of government intervention in the market, which is something I would be pretty nervous of frankly.

Dr Counsell: In effect, the CBI were talking earlier about adjusting the cap rather than using a price floor, and in a way it is pretty similar. The idea is to have an auction which sucks allowances out of the market at the right moment because our targets are not as tight as they could have been.

Professor Grubb: The idea of including the banking of emission allowances in a future period is partly to smooth some of these variations and hopefully, if there is sufficient confidence in the system and to some extent in the banking sector, then you would expect that to have some of these characteristics as well.

Q103 Mr Chaytor: Can I ask about the issue of free allocation? The Trust's written submission was fairly sceptical about this as a long-term policy, but since then, last December, the EU has increased the use of free allocations. Could you tell us a little more about your concerns about that and what effect that is likely to have on the price?

Professor Grubb: First, in theory free allocation should not affect the price. It is the overall cap which sets the price and how much is auctioned versus how much is given for free should not really drive that. There may be effects at the margin in terms of companies sitting on free allocations or other factors. The risks from giving too much free allocation to certain sectors is that they basically feel shielded from really having to worry very much about the problem or do anything about it, and that is not what the system is there for. It is pretty simple at that level; there are more sophisticated arguments about the economic benefits of auctioning versus excessive free allocations but what it comes down to is a system designed to drive incentives for companies to start decarbonising.

Q104 Mr Chaytor: I am not clear of the scope of the increase which was agreed last December, but is it of a significant size to make companies feel even more complacent?

Dr Counsell: For me, I think more of the issue is going to be as they go through the discussion of which sectors are at risk of leakage and how many of those sectors are truly at risk of leakage in the early phases of the next phase, so from 2013 to, say, 2015, and whether in that period we are going to end up giving those groups perhaps too many free allowances, and therefore reducing the pressure on them.

Q105 Mr Chaytor: So the issue is, at this stage it is not really possible to identify exactly which sectors are at risk of leakage until the system has run through?

Dr Counsell: It is very hard to predict going forward.

Professor Grubb: I think the power sector goal is zero free allocations. For most manufacturing industry in theory the default is 2013 starting with 80 per cent of the cap going to 30 per cent. I think that is not an unreasonable place to be, it sends a very clear incentive that the days of pumping out carbon dioxide for free are limited, and you can see how they are limited and how it is going to screw down more tightly over time. As Thomas says, the problem is where you have sectors which may be classified at risk of carbon leakage and offered 100 per cent free allocation as the solution. True, that is 100 per cent of a declining cap, but given the recession it is unclear to me whether that may carry a risk of surplus in some of these sectors. In terms of which sectors we are talking about, there is a vibrant debate in Brussels about both the technicalities and data about leaving some of the principles of what is being compared with what, so it is really not possible to say what may come out at the far end of that process at the moment.

Dr Counsell: In particular the challenge is doing it at EU-wide level. The firms which are facing international competition in these sectors are quite different in each country. They are going to feel that difficulty shortly I think.

Q106 Chairman: You have been quite forceful about the theoretical advantages of trading, which is an argument I personally accept, but when we saw Kevin Anderson from the Tyndall Centre he made the point that the growth of emission reductions which are going to be required from developed countries like ours historically have only ever been achieved when there has been a collapse in their economy, it has never been associated with a period of growth. Do you think we can therefore harness the carbon markets sufficiently effectively to achieve something which has never been done before?

Dr Counsell: I am an optimist so I would say, yes, because I am unclear how else you basically get the entrepreneurial spirit involved, apart from something which effectively makes it much easier for you to profit massively from having a clever invention.

Professor Grubb: I agree. People expect the carbon markets will themselves and on their own drive the scale of transformation required, and I think they will be sadly mistaken. There are other things which need to be done, not all of which will just emerge out of market incentives. Obvious examples include all the issues around adequacy of grid infrastructure and planning on renewables, addressing a lot of the market failures around buildings, a lot of the infrastructure and innovation will require other kinds of action and much of that driven by government. But to conclude from that, you do not need a carbon price incentive or quantitative goals, is I think bizarre. Obviously that is pretty central to the incentive and it is just making sure you drive that hard enough and you have sufficient complementary measures in my view. Again, can it be done? One of the things we keep discovering is that it turns out to be easier than expected, and that is why we have this pattern of boom and bust in part in the carbon markets. So, yes, I think it can be done.

Q107 Chairman: Do you want to enlarge on why you think cap and trade is so much better than carbon taxes?

Professor Grubb: It seems to me that the most fundamental reason is the one of the political economy. We spent the first half of the 1990s trying to develop a European carbon tax. Many countries in Europe went ahead and did things they claimed were a carbon tax, but they are all very messy, the European one failed and the national ones are bits and pieces with all sorts of exemptions. It is not hard to see why this happened, with a carbon tax you are actually doing two very difficult things at the same time. You are both trying to set a price and extract very large amounts of money out of very powerful industries and give it over to the government. That is going to raise very strong political objections, which is what happened. I think the fundamental reason why we have made progress with emissions trading where we could not with the carbon tax is because it gives you an additional degree of freedom, namely how much re-allocation you have to give away to buy off the powerful lobbies so you can at least set a price or a target somewhere in the region you are trying to get to, rather than having the whole thing riddled with complete exemptions from powerful actors who end up really not involved in any incentive scheme at all. So I cannot, for the life of me, understand why people look at the incomplete success of the carbon trading scheme, which is largely to do with the power of industrial lobbies going for free allocation, and conclude that therefore you should move to a system which they completely destroyed in the past because you could not extract that much revenue out from industries and get a price you were after.

Q108 Chairman: Are there circumstances under which carbon taxation could complement a market system?

Professor Grubb: Yes, definitely. I am not saying at all carbon trading would be the instrument of choice in the transport or building sectors, it may be simpler to go for a tax based approach in some of those. You do have the price feed-through effect from the power sector control in the trading scheme, but you need complementary instruments adapted to the characteristics of those sectors.

Q109 Chairman: Given that one of the justifications for emissions trading is that it brings businesses into a co-operative process of trying to cut emissions, are they doing enough, given that they are being allowed to take part in a market system? Should we expect them to deliver rather more in the way of emissions cuts because they are not being hit by taxation?

Dr Counsell: In theory it should be cheaper for them to work to a market, and therefore you could expect the targets you are going for to be ---

Q110 Chairman: But that argues for no leakage through the purchase of credits outside, does it not?

Professor Grubb: That takes us back to the argument about whether the targets were set tough enough to motivate domestic action and import credits, which is a key point about the whole balance. Are companies doing enough? It depends in part on what you expect companies to do. By and large they are responsible to shareholders to try and maximise profits and other such things and they will respond to incentives the Government set. There is no question that one can see some companies who obviously have debates about how much resource to put towards emissions reductions versus how much to put towards lobbying for more generous allocations, but that to some extent is the nature of the political and economic systems that we have. Can you blame companies for behaving that way? Not if they have a duty to shareholders to pursue that. I think I am disappointed in some sectors we do not see more strategic investment on low carbon innovation. They are not 100 per cent convinced that governments have really got the guts to see this through to the end, otherwise some sectors would not be investing in the way some of them are.

Q111 Joan Walley: We are coming to the end of our time but, very quickly, given what you have just said, do you think the Carbon Trust is doing enough to help companies plan that strategic investment in decarbonising their companies?

Professor Grubb: That is arguably a question you should ask of other people. We are certainly doing a lot. We have both the energy efficiency side of the business and the low carbon investment side of the business, and the whole Insights Team which Thomas and I work for try and emphasise to UK business it is not just these few years, this is a strategic challenge, and we work with investors in the City of London.

Dr Counsell: In particular, we have expanded the innovations side, so it is about strategic investments and about how we get groups of companies together to work on common problems in terms of technology. We have been increasing that rapidly over the last year or so and we are going to increase it even more in terms of the strategic future working out how to get companies to co-operate in some ways and compete in others. That will be critical.

Q112 Joan Walley: Finally, we have seen a change in the US in terms of new policies. In your view, is the UK likely to adopt a federal cap and trade scheme or do you think it will go down the route of the carbon tax?

Professor Grubb: I think it will adopt a federal cap and trade scheme.

Q113 Joan Walley: What would need to be done before the EU ETS could be linked to either a US federal scheme or the current and planned cap and trade schemes covering several states within the US?

Professor Grubb: A lot of careful thinking and analysis how the two systems were designed and the implications of linking. I am sorry that sounds slightly like dodging the question but it is actually very important. It would be lovely to link in principle but it really is one of these cases where there is potentially quite a lot of devil in the detail.

Q114 Joan Walley: On that note, our Committee will be going to visit the US in the not too distant future, so it might be helpful to have some further comments from you on how that could be achieved.

Professor Grubb: Yes.

Chairman: Thank you very much for coming in. It has been very helpful. I have no doubt we will be in further contact with you.

[1] Note by Witness: The witness meant to say during the evidence session that "the price between them was the effective interest rate of the loan, and because they had issues with the overall financial market. Not could have not had issues with the overall financial market.

[2] See Ev....

[3] See Ev...

[4] Note by Witness: The figure is, in fact, 20 per cent, not 2 per cent as stated during the evidence session.