Oral Evidence

Taken before the Energy and Climate Change Committee

on Wednesday 7 September 2011

Members present:

Mr Tim Yeo (Chair)

Dan Byles

Barry Gardiner

Ian Lavery

Dr Phillip Lee

Christopher Pincher

John Robertson

Laura Sandys

Dr Alan Whitehead

________________

Examination of Witnesses

Witnesses: Professor Michael Grubb, University of Cambridge, and Professor Samuel Fankhauser, London School of Economics, gave evidence.

Q1 Chair: Welcome, and thank you for coming in at the start of our new inquiry on emissions trading. It seems to be a perennial topic and likely to remain one for quite a long time, I suspect. Could I start off with a general question about how you think phases I and II of the EU ETS have performed? Do you think we have seen progress towards the aims that were identified in advance? Do you think those aims have been achieved or not?

Professor Grubb: I think we have seen progress, but not of the scale that was hoped for. There are various estimates of how much emission savings have been achieved under the system. I think perhaps most authoritative are ones that were identified by Denny Ellerman and his team, who published a book on that, and I expect you will have those numbers. Their best estimate would be a couple of hundred million tonnes of carbon dioxide saved in the first phase. I have not seen an update estimate for Phase II. Clearly, the system has had problems with over-allocation. I think those were somewhat predictable problems. In most quantified environmental regulation we have seen it appears that, with hindsight, it turned out to be a lot easier for whatever reasons to achieve caps than, shall we say, was initially negotiated.

I think that has illustrated both strengths and weaknesses of the system. The weakness has been a tendency to over-allocation and a lower price than projected, which I think has seriously undermined the system‚Ä(tm)s incentives for investment, although it has had an impact on operations. The positive side is, despite over-allocation, there is still an incentive for companies to cut emissions. An irony that some perhaps find a little hard to see, is that even companies that know they have a surplus will still do better economically if they undertake some mitigation action to sell those allowances. So, one does preserve an environmental incentive despite the misallocation.

Professor Fankhauser: One or two more points reinforce that. On the good side, the key thing for me is that the EU ETS has changed the behaviour of regulated firms. They completely behave differently. They manage carbon now in the same way as they manage any other costly input, in the same way as they manage fuel or other capital inputs. That sort of change in behaviour, I think, is probably the key achievement that we have had.

If you are simple about things, we have achieved our environmental outcome in a sense that emissions are exactly where regulators want the emissions to be. We have met our target. You can then argue that maybe the regulator has set the target at the wrong level but the market per se has delivered the target that the regulator wanted to have.

On the negative side, in addition to what Michael has said, I would point out one or two things. On the regulatory side there have been weaknesses. The regulation has not been perfect. We have had instances where the regulator has upset the market by being non- professional, if you will, or not sufficiently in tune with markets. Incidents of fraud have not been weeded out quick enough. The system has created a lot of rent, has created a lot of windfall profits for certain players and it takes a long time to get those out of the system.

Q2 Chair: You have raised quite a few points, which we will come back to, but just on the question of over-allocation, Phase I, which was sort of a stab in the dark, was subject to a lot of lobbying. Phase II may be a bit unlucky because the limits were set before the severity of the recession was known about. Does that raise a case for saying, because these things have to be set in advance, that as long as there was a stated formula in advance for lowering the cap in the event of an unexpectedly sharp decline in EU GDP, Phase II limits could have been reduced because of what we had not been able to foresee in 2007?

Professor Grubb: I think the ETS has faced a problem, which I have witnessed in many policy areas, which is the political system always acknowledges the future is uncertain and then designs instruments as if it was not. I think one has to build in the design from the outset. You have indicated one possible way. That faces a problem that one starts to lose some of the incentives in the system if there are emission reductions that lead to a withdrawal of allowances directly, then there is something a bit funny going on in the incentives, and to try and disentangle what was due to a recession versus what was not is, I think, very difficult.

I have always been of the view that the ETS should have been designed with a price floor from the beginning, precisely because of, as my own research has made me well aware, the old saying that energy forecasting was invented to make economic forecasting look good. We have always been bad about it. Usually the errors have been on the low side compared with projections in nearly every case I have looked at. If one said in advance that there will be auctions and there will be a reserve price on those auctions of, for the sake of argument, ‚ā¨20 a tonne in Phase II, we would not be in the position where we are now. That approach is not ‚Äėex-post‚Ä(tm) to interference and it is not messing up with the market; a lot of auctions have reserve prices. What it means is that if circumstances conspire to drive the price below that threshold, people are not going to buy allowances from the auctions at that price, and so that sets a de facto price floor by withholding allowances in a way that everybody understands in advance.

Professor Fankhauser: I agree. There is a school of thought that says the EU ETS has been an automatic stabiliser for the economy, sort of a tax cut at the time when a tax cut was needed. I would be more on the side that says that as a regulator you have to be able to respond to new circumstances. You have to be able to learn and the ETS has not learned in Phase I; once we figured out it was over-allocated there was no way to react to it. It was not able to learn in Phase II; once we figured out we were in a recession, there was no way to react to that.

The question is how one does that reacting. Like Michael, I am in favour of an auction reserve price. I think that is an easy simple way that people understand. Other ways of softening the volatility would be to allow more banking into future periods of the EU ETS, and we have seen that at work in Phase II. The only reason why the price has not collapsed in Phase II is that firms are able to bank surplus credit into future trading phases. So that is another way of doing it.

Q3 Chair: The price has not collapsed but it is still well below the level at which you might set a floor price. Do you think the current price is enough to produce any emissions reductions in the immediate future?

Professor Fankhauser: It is okay to reduce emission reductions in a sense that-you can look at it in a positive way. Regulators in their infinite wisdom have set a carbon target and the market is delivering that and they have found a cheap way of doing it. The problem is if you take a long term view, all those emission reductions are achieved through operational changes, switching between coal and gas. They are not being achieved through deep long-term changes in investment patterns, so we need that additional incentive to change investment and that can be a combination of the higher price but it can also include other investment incentives.

Professor Grubb: I think the price has gone too low in the sense of maintaining the incentives for the kind of changes we need. At the margin it will still have some impact, particularly depending upon relative coal gas prices and indeed some of the prices in some of the other sectors, like inputs to cement. But obviously the lower price, the less impact it has and the weaker the investment incentives.

Q4 Chair: You mentioned the fact that the price might be even lower if it was not for the opportunity of banking allowances for the next phase, but if a lot of that takes place we will still have a situation in Phase III, at least to begin with, where there is insufficient incentive to drive low carbon investment.

Professor Fankhauser: That is a function of what target you set in Phase III. The EU has sort of indicated what the Phase III target would be but there is nothing that prevents people ahead of time from tightening that, if it is necessary.

Professor Grubb: I think you are right. Banking was banned in the first period because they knew that it was a new system with so many uncertainties. They did not want it to pollute in a sense, pardon the phrase, the second period. It was then assumed that we knew what we were doing, but with the recession, it is plain that we did not, and I think the scale of surplus is now at risk of undermining the objectives that were intended in Phase III. I think that leaves us with three options perhaps, one of which is a rather ad hoc process of the bureaucracy withholding allowances, and there has been obviously some discussion of that partly around the energy efficiency directive and its impact on price. I think a second option would still be to negotiate a reserve floor price for Phase III. The third option would be a full political renegotiation of the target on the combined grounds that there was always this slightly ambiguous figure of 20% to 30% and the fact that the recession has now fundamentally changed the economic expectations of Phase III.

Q5 Ian Lavery: It is debateable whether Phase I and Phase II met its objectives and you said that there were massive problems with allocation as well as regulatory problems. The cap is to reduce annually by 1.74% of the Phase II cap. Do you agree that the cap for Phase III needs to be revised down?

Professor Grubb: In my view, yes.

Professor Fankhauser: I agree, yes, it has to become tighter.

Q6 Ian Lavery: It is as simple as that?

Professor Fankhauser: Yes. It is the simplest way. I mean there are other ways of getting us there but that is by far the simplest way of doing it.

Q7 Ian Lavery: When is the cap likely to be lower than the business as usual emissions?

Professor Grubb: It is always hard to disentangle that kind of question because business as usual no longer exists anyway. It has already been affected by having a carbon price, so emissions are somewhat lower than they would have been, and if one took the cap off entirely where would emissions go? It is kind of hard to say. And also, of course, every few months we get revisions about the overall impact of the recession and its longevity.

I think it is clear that the Phase III targets do require real emission reductions. They would almost certainly in themselves still bite. They would still have some impact, which is in part why we have a positive price at the moment, but that is not as strong as it was expected or intended to be and it is further weakened by the carry-over of surplus allowances. If you throw in the surplus allowances and say, "When would the cap bite?" I do not know, but maybe in the middle of the period, but it all depends on how you think the market is going to be banking surplus forward. We do have a relatively weak cap compared with the original intent.

Professor Fankhauser: I would not be too much hung up about business as usual, because there comes a time when you forget what would have happened otherwise. The two anchor points that I can see is, one, does it get us to the carbon targets we have, and we know what those are in the case of the UK, it is 50% by 2027, so given that the ETS relates to half of the economy, does that half of the economy perform consistent with our target? The other anchor point to consider is whether is the carbon price high enough to get us into that investment change that we need.

Q8 Ian Lavery: There is a question mark over the possibility of needing to reopen the Emissions Trading Directive in order to reduce the cap. Is it your view that that would need to be done and if it is, when and how soon could that be done?

Professor Grubb: I am not a legal expert on the processes. My understanding is that at present the approach being adopted is to look at options that do not require reopening the directive, largely through the set-aside proposals. Certainly my understanding is that formally revising the cap on the ETS or Europe-wide-there is 20% to 30% to debate-would require reopening the directive and of course that makes people nervous. I do not know whether setting a price floor would involve renegotiating the directive. It probably would, but I have not checked that.

Regarding timescales, I think this is a process that ideally should be initiated under the Polish presidency for completion under the Danish presidency in the first half of next year, so that one then enters 2013 with the rules clearly defined in a way that gives everyone more confidence in the outcome.

Professor Fankhauser: Yes, whatever the legal situation is, there is an investment perspective and a policy or political perspective and both of them suggest you want to move early. I think playing around with set-asides and stuff like that is fine but it is sort of a sticking plaster. At some point you have to bite the bullet and say, "Do we mean what we said when we set 80% by 2050?" and collectively move from 20% to 30%. You need to do that very early on from the investment perspective because people want to know what the situation is going to be.

Q9 Ian Lavery: You mentioned the over-allocation in Phase I and Phase II, I think this is generally because of industry lobbying; certainly partly because of industry lobbying. What input has the industry had in lobbying for the design of Phase III?

Professor Grubb: It has been a huge lobbying exercise. I think one would expect it. There is a lot of money at stake. So, yes, there was a lot of lobbying input into Phase III, perhaps more at the level of individual allocation distribution even than the overall cap, although I think Business Europe has made it plain that it is opposed to strengthening the cap.

Professor Fankhauser: I think I would distinguish between helpful lobbying and egoistic lobbying, if you will. The fact that each firm wants to get the biggest possible allocation for themselves is sort of ugly, but natural. We can phase that out by moving to auctioning as quickly as possible. Of course that itself is subject to lobbying because it has a huge revenue implication.

But there are also some more helpful interventions by industry to improve the system, particularly when we have seen that regulation was not always as good as it could have been. It is sort of helpful to get industry feedback, to hear from industry, just how far ahead they need to know things, what they would think about the auction reserve price. The outcry when the spot market closed down after the latest fraud case was, in my view, very helpful because it taught the regulator that we have to be better next time.

Q10 Ian Lavery: How influential have the lobbyists been?

Professor Fankhauser: I do not know. How do you measure that, given that auctioning takes a long time to come in? If we look at that piece of analysis that asks which sectors should continue to obtain free allowances because they are exposed to international competition, you see a lot of industry influence in that.

Q11 Ian Lavery: Finally, what difference would an EU economy wide 30% emissions reductions target make to the ETS?

Professor Fankhauser: I do not know what it would do to the price but it would put us back on track to meet our carbon reduction roadmap. As long as we are on the 20% trajectory, the UK will find it very hard to do its own 50% target by 2027-it will still do it hopefully, but in a more expensive way. Even the EU will probably find it hard to get to its 40% target by 2030.

Professor Grubb: For any system, if you draw a straight line between where we are now and deep reductions by 2050, one thing to remember is that the implied rate at which you are acting percentage wise is accelerating. So if you are looking at a straight line towards an 80% reduction in 2050, you are talking about maybe a 25% reduction in the first decade and a halving in the last decade-just from the maths of a straight line.

The EU 20% target is well short of even a straight line trajectory and in that sense it is a very costly policy because of the amount of trouble it would store up for later and the sheer rate of change that we would be expecting industry and infrastructure to change later.

On the Committee on Climate Change a lot of our thinking was informed by looking at an exponential trajectory, which implies something stronger even than 30% at a European level.

Q12 Christopher Pincher: Just on the subject of auctioning, in Phase III I think that 100% of allowance will be auctioned in the power sector. Given that in Phases I and II those allowances were essentially grandfathered so those companies got those allowances for free, yet several companies still passed on the cost to consumers into their bills as if they had to pay for them, do you think that there is a risk that 100% allowance auctioning in the power sector in Phase III will result in higher consumer bills?

Professor Grubb: The economic theory would say if they are passing it through with free allowances anyway then auctioning has no impact on electricity prices, it merely secures the revenue for the public rather than for profits. I think the reality, as monitored, has been pretty close to the economic theory on this one. Most of the costs have been passed through, therefore moving to auctioning will not have an impact on power prices.

Professor Fankhauser: Let me add two points to reinforce what Michael said. One is a slight defence on behalf of the power companies. I mean the fact that they pass on the price is not sort of collusion, it is the way the market functions because the price of power is set by the cost of the marginal producer, the last guy who was producing a kilowatt hour. The last guy who was producing a kilowatt hour did have to pay for the permit and so the guy who bought the permit sets the price. The fact that everybody else did not pay for it is just good for them.

The second observation I would make-usually I defend straight economics and Michael finds the subtleties but this is the other way round-is that the one thing that we have learned that might deviate from the straight economics is that the price expectations of traders is different if they get free permits versus if they have to pay for them. It is some sort of psychological flaw in traders, if you will, but they think the future price of permits is lower if they have been given them for free.

Q13 John Robertson: When you look at the international view of the emissions trading, is it necessary for the post-2012 regime to continue the top-down approach to the Kyoto Protocol?

Professor Grubb: If it is necessary then we are in deep trouble because I see very little sign of the international system continuing the Kyoto Protocol, certainly with the kind of participation that was envisaged.

This could take us into a very long conversation about the international system, where it is at and how it relates to ETS. I could summarise my view by saying that in this respect the major problem of ETS has simply been somehow the expectation that it would be part of a global cap-and-trade system within the decade. That is a fantasy, and I think it always was, but now that is clear. The name of the game changes. The policy should always have been about how can one develop systems that impose a carbon price in ways that make sense for collaboration among a coalition of low-carbon economies without putting their economies at the disadvantage vis-√ -vis the free riders? That to me is the question and I think there absolutely are ways of doing it. So, no, I do not think we need a global regime to underpin the future of the ETS but I do think we need a change in some of the thinking behind it.

Q14 John Robertson: If it is not going to be top down, then it will be a bottom up?

Professor Grubb: You can have hybrids and in reality there tends to be some interaction.

John Robertson: You start in the middle.

Professor Grubb: I think the biggest, deepest danger arising from the situation international negotiations are in is if we lose a common accounting system and a common framework, which people understand. What is a tonne of carbon emissions? How is it counted? If you are doing any international exchanges, and so on, what is the agreed basis? If everybody invents their own rules as to how to count the stuff then we are in deep trouble.

In that sense I think Kyoto has been extremely helpful and will continue to be extremely helpful because it sets a standard of rules that are acknowledged and understood by the vast majority of the world. If you include the ramifications through the fact that some of the Americas are part of that system and the developing countries through the CDM, there is a default set of rules and that in itself is very helpful. What you then have to work out additionally are the economics of differential degrees of participation.

Q15 John Robertson: Should then the distinction between developed and developing countries, which was set out in the Kyoto Protocol, be looked at and changed?

Professor Fankhauser: In reality that is already changing. I agree with Michael that we are moving away from something that is exclusively top down, which means that you start seeing a lot of the action across the board. It is no longer a division between annex 1 and non- annex 1. You see a lot of things happening in countries such as China, India and Brazil on deforestation, and I think that is important for several reasons. One is that the reality is that half of the emissions going forward will come from those markets. The second is, as Michael said, that whatever the international agreement, it has to be based on legal action or legislation at the national level and action at the national level because that gives the credibility to whatever the international regime is. It gives the credibility that things will happen. It can also drive national action and the confidence that comes with it allows countries to perhaps agree on stricter targets.

Q16 John Robertson: In the future are we at the stage where if we do not get China, India, United States to sign on to some form of new protocol, we are just wasting our time?

Professor Grubb: I do not think that way anymore at all, for a couple of reasons. One is that, exactly as Sam said, we see a very interesting mix of actions emerging, frequently in places we had not fully expected. For example, in its five-year plan adopted earlier this year, China has six pilot emissions trading programmes with the explicit intent to learn from them with a view to whether it may start to develop national emission caps. India has newly legislated a perform, achieve trade system, which caps nine industrial sectors, very much like the EU ETS, but on an intensity basis. It is an energy efficiency based cap. We all know that Korea, and so on, are adopting significant legislation.

Frankly, I have very low hopes of what may happen at federal level in the United States. I think it is a big mistake to hang everything on that. California is moving ahead with its cap-and-trade scheme. We are going to have a very complicated world and, as I said, I no longer quite see it as we need to get everybody on board or it is pointless. I think we need to develop the structures between regions, which are moving ahead, and where progress is not blocked by the kind of extraordinary degree of lobbying that we saw in Washington last year. We work with the regions that are capable of taking action and work out how to make that work, stick and expand, and I think that is eminently possible.

Professor Fankhauser: I am perhaps na√Įve, but I would see the US or more narrowly the US federal level as a slight outlier at the moment if you sort of compare what everybody else is doing. We did a survey, GLOBE jointly with LSE, of legislation in the 16 major emitters, as it were, and you find climate legislation in all of them, and quite good and quite aggressive legislation.

Q17 John Robertson: In Copenhagen, you made the statement, professor, that if there is not global action then we will have failed to reach a target of limiting climate change to 2 degrees C? Would it be fair to say that you have changed your opinion on that?

Professor Grubb: I would be very surprised if we hit a target of limiting to 2 degrees because I think that what happened at Copenhagen has slowed down progress, it has undermined progress. It has forced us a rethink, which, of course, one can always make the case with hindsight is absolutely necessary. What I am saying is that the failure to get an effective global agreement of the kind that was envisaged in the run up to Copenhagen does not mean that all international discourse is a waste of time and we should all give up. In fact, I think it simply points to the need to rethink how we are going about the process of constructing an international deal. The more I think about it, the more I can see ways forward.

Q18 John Robertson: Basically, the EU has led the way in this so what more can the EU do to promote development of robust compatible schemes?

Professor Grubb: I think there are several strands to the answer. One is to stop obsessing with Washington, because that will lead nowhere. It would be much more productive to engage with major emerging economies, so geopolitically that is how I would reframe things.

Technically, it is important to keep a UN process on the go to maintain, at absolute minimum, a common accounting framework, drawing upon the Kyoto rules. My sense is the major emerging economies would probably need a few more years before they are ready to sign on to a really major binding deal of the kind that the EU is ready for. Internally, it would help enormously if the EU could take the kind of decisions on the EU ETS that we were alluding to earlier to strengthen the target. I think there are one or two structural reforms that would be helpful as well, including, in my view, some areas of the treatment of energy intensive goods, but that leads us into a more complex terrain.

But I think you are right. After Copenhagen, people had rather given up on the EU as being a force for anything very much in climate because it did not get what it wanted at all at Copenhagen. It had been sidelined, all eyes turned to the US, China, and so on, that was where all the action was. When US legislation failed and after the outcome we saw at Cancun that managed to keep the show on the road, by Bonn people were very much saying to me, "The real irony is now that Europe is once again the centre in the eyes of the developing countries. It is the region that has done something serious and shown it is able to deliver something serious and therefore was worth negotiating with, whereas the US is simply unable to deliver anything." What happened has ended up putting the EU back in a strong position in the international system.

Professor Fankhauser: There are three things the EU can do. First, it can continue to lead by example. So, to be credible internationally you have to do stuff at home. That means 30% rather than 20%. The second thing the EU can do is to team up with other countries that have a similar sort of objective and mindset and, as Michael says, that is probably no longer, or for the time being, the US. It may be somebody like China, it may be-it is probably somebody East rather than West, let us put it that way. Finally, it can emphasise the green growth narrative that comes with some of the things we want to do. The whole Kyoto Protocol is about constraints, targets and penalties if you miss them. It is not a very attractive thing to sign. If you start talking about opportunities and possibilities for growth, innovation, prosperity and productivity, perhaps that makes it a bit more attractive to join up. So maybe that is the sort of language that we have to start talking.

Q19 Chair: Without departing too much from emissions trading, are you saying that as we come towards the next COP, if the EU plus a couple of the BRIC countries could collaborate on an agenda, which might eventually lead to something quite co-operative, that is a more promising line than bashing our heads against the wall in Washington DC?

Professor Grubb: Yes.

Professor Fankhauser: I would agree.

Q20 Barry Gardiner: Absolutely. It is said that offshoring by UK industry leads to leakage. What actual evidence do you have of that and is the UK more susceptible to it than other EU countries that participate in the trading scheme?

Professor Fankhauser: Go ahead, Michael, it is your thing.

Professor Grubb: I think pinning down the evidence as to whether leakage has happened is phenomenally difficult because there is continual structural change-just look at what has happened in the euro exchange rate, and that is probably dominated most of the effects that there would be from carbon. Structural change is huge in the steel sector, for example, which is partly driven by ore and there is lots of other stuff driven by labour costs. It is incredibly difficult to be clear, particularly on any issues of investment leakage, that is the movement of capital elsewhere. What companies will say is that they are under a process of internal competition for capital within their company, and that the ETS risks making Europe less attractive. To judge from the surpluses we have seen one might think that is not entirely clear, to say the least.

There is some evidence, I would say tentative evidence, of operational leakage in the cement sector. In other words whether or not anyone is building a new plant, they may be running some plants less in Europe and importing because there was a rise in clinker imports, in particular up to 2008, now that has the reversed sharply. Again, it is a very complicated story because cement trade is a lot about inherent imbalances between the construction industry and domestic manufacturing capability at one point in time and surpluses in others.

If one looks at the analytic evidence, as we published in work at the Carbon Trust, there are half a dozen sectors that run primary carbon intensive commodity activities for which carbon costs, in the area of ‚ā¨20 a tonne plus, would be quite a significant cost. In some of those areas there will be impact on operation, and in others impact on investment. I think there is a reasonable case to say, "Yes, there is a good case for concern around those half dozen sectors". I do not see any real analytic evidence to include the long tail a mapped out in the European Directive of which the vast majority of sectors are to do with trade intensity, nothing to do with carbon intensity. I see no evidence that there is a significant leakage problem in those sectors.

I still very much maintain the view that carbon leakage is an issue of real concern around half a dozen carbon intensive primary sectors, which account for a small fraction of GDP, but that does not mean they are unimportant, and they account for half of the carbon in the manufacturing industry, so with a carbon lens they are really important.

Q21 Barry Gardiner: Do you believe that industry is exaggerating the problem of leakage and that investors are exaggerating the problem of leakage in order to ensure that the caps are not as tight and that they have sufficient allocations to profit from?

Professor Grubb: If I was a UK or European-based operative I would stress the risks of leakage as much as I could because it might get me more free allowances, which increases profitability, and because I do not want my operations to be out bid by some foreign operations even if it is within the same company. Is that exaggeration? Well, it means one is looking at it and lobbying from a certain perspective.

Q22 Laura Sandys: But there is another issue, it is not just leakage out but it is about inward investment and what sort of decision-making process would you look at and how would you assess that? If you are trying to inward invest into the UK to deliver on a lower carbon economy, then fantastic. But I do not know whether anybody has done any research or allowances of what might happen if you are not in that sector and what level of deterrent there would be.

Professor Grubb: As you say, it should help for lower carbon investments; insofar as there may be any deterrent effect, I think it would stem more from the lack of long-term certainty about where ETS going, including the carbon price, the strength of the caps, and its treatment of energy intensive industries. That is set against the value of at least knowing the system you are operating in as opposed to being stuck in a situation, maybe Australia at the moment, where everybody is fighting over whether there will be legislation and what on earth it will look like, and so on. Industries hate being in that position. At least in Europe they know what the rules are, which is quite valuable. They would like a lot more clarity on some dimensions.

I do not see a big problem around inward investment personally but I think we could do a lot better if we could get clearer about the overall vision of the system going forward.

Professor Fankhauser: The only other thing I would add to that is that carbon is only one of many factors that determine where companies invest, probably not the major one in the decisions of the companies we are talking about.

Q23 Barry Gardiner: Given the action by the Government on the support for the carbon price earlier this year, do you think that has any significant effect on leakage either of investment or the sort we are talking about?

Professor Grubb: I think the UK carbon floor price is interesting-brave might even be the word-because it is a doubled-edged sword. It helps to clarify more than other European countries have what the investment context might be for low-carbon investment. For the first time it introduces the possibility of intra European leakage. I still remember five years ago, when I was doing studies with Carbon Trust, we had a round table, and I had done all this analysis about the potential for leakage from Europe to other parts of the world and loads of detailed number crunching. At a review meeting with the refining industry they said, "We are not talking about leakage to the rest of the world. We are worried about what happens in Rotterdam". That is one of the reasons also why there is such strong lobbying around allocation in the earlier national allocation plans and why we have now done very well to move to a harmonised European allocation process. The UK carbon floor price-

Q24 Barry Gardiner: Puts that out of kilter

Professor Grubb: -puts that out of kilter. It introduces one region within a trading zone that has a different price setting structure that has big risks. On the other hand, as I said, in principle a floor price is an extremely sensible thing to do in designing a trading system, so you might say, "If it is a gamble that then provokes Europe to acknowledge there is a sensible case for a floor price and we can get it at European level, then that is an extraordinarily good pay-off. For as long as that does not happen the UK is in an awkward position and I do not blame industry, electricity intensive industries in particular, for being upset about it, and hence the clauses on possible special treatment.

Q25 Barry Gardiner: You have given a very persuasive and clear answer, but can I pin you on the question of do you think it will have a significant-let me phrase the question in response to the answer you gave. How long would it not have been adopted by the rest of Europe and what sort of timescale would then have an effect on leakage? Obviously if they were to move to that in the next year or so that might be one thing, but if they did not move to it for another five years it might be quite another. Do you have some feel for when leakage might result from that differential and what sort of timescale we might be looking at for you to be able to get any clear evidence of leakage arising?

Professor Fankhauser: Let me try two answers on that and to give Michael time to think. The first one is that the leakage from the UK into the rest of Europe happens instantaneously in the sense that whatever additional emission reductions that UK firms do result in extra permits that they have that they will sell. We have done absolutely nothing to change the cap Europe-wide, so whatever the UK does not do somebody else does. It is 100% leakage if the market is liquid enough to react to that immediately. That leakage is instantaneous and 100%. You do need to have those other reasons why you want to do these things.

What will happen at the Europe level is interesting. There might be less leakage from the EU to the outside world because what the UK unilateral action does reduces the carbon price Europe-wide, because UK firms have less of a demand for permits, so the permit price goes down, which in turn means there is going to be less leakage from the EU to the outside world.

Professor Grubb: In your question I am quite glad you used the word "feel" because I have not done any explicit analysis, so let me make that clear. I would make some observations. One slightly saving grace in this area is that when you look at the structure of carbon on cost exposure, direct carbon emissions tend to be very heavily concentrated in the big sectors that we mapped out. Electricity, which is what we talk about here, tends to be pretty widely spread across a lot more industry and much lower levels, so the relative cost impact tends to be a lot lower. There are some exceptions, aluminium being the most obvious, but where there are those big exceptions they tend to have long-term contracts though I believe these are pretty close to expiry certainly for some of the UK smelters.

That then leads you into how are those sectors treated in respect of their electricity consumption, their contracts, and so on. That gets us into a different ballpark and I think your question is doubly hard even to give a feel for because the Treasury decision on the floor price was accompanied by a statement that those sectors would receive some kind of special or ameliorating treatment. Sorry, I do not know the language. I certainly do not know the content because I think there is a certain amount of consternation at the moment as to exactly what will that look like. I have views on what that should look like but clearly if that sentence is delivered effectively then that would go a long way towards ameliorating the problem you pose. There are some quite interesting ways to do it.

Q26 Laura Sandys: Just following on from Barry‚Ä(tm)s questions, one of the things that we have been looking at in other areas is the complexity in the UK of different mechanisms and how that drives different behaviours. The previous Government was very clear that emissions trading was the platform that it wanted to use. Do you feel the current Government has that same level of commitment to emissions trading?

Professor Fankhauser: You would have to ask the Government, I guess. What I would say is that the complexity in the UK does not necessarily come from individual policy instruments. Some are highly complex, like the CRC, but the main complexity comes from the sheer number of policy instruments there are, to the point that analytically we do not always know how they interact and what they do to each other. So for me that is the main complexity rather than something like the EU ETS, which one has to learn how to use but in its own right is quite straightforward for industry.

Professor Grubb: Again, it is not for me to speculate on what the Government thinks about it. I agree with Sam totally that EU ETS is a relatively clear, straightforward clean instrument that goes a long way towards the sort of principles that economists would lay out for some effective incentives with the carbon price. What I think has changed-apart from the recession and the surplus and those issues and the complexities that does introduce-in my view is that five years ago, certainly 10 years ago, probably a substantial majority of economic advisers took the view that if you get the carbon price right you have fixed everything. You get carbon price, carbon cap-sorted. I may be caricaturing, but I think it is very clear that for a problem of this nature and scale in terms of longevity, the scale of assets, the importance of energy efficiency, and so on, you have to have at least three categories of instruments. You need instruments that address the long term investment within which public-led investment will have an important role, and R&D is a key issue there; essentially all the things where private actors are not going to make a return easily, even if there is a carbon price. We need instruments to address those.

You need a carbon price because we believe in market economics, you are never going to solve this problem without putting a price on carbon. And you need a third category of instruments, which address all of the things we have learnt about behavioural anomalies in both individuals, corporate incentives, corporate branding incentive, lots and lots of other stuff, which is at the heart, for example, of the CRC proposals. I think a coherent policy on an issue of this magnitude has to have all of those three components and it has to understand how they interact. Maybe the problem we have is that, rather than design, we got there by just kind of muddling our way and discovering we had not quite fixed that bit, so we added an instrument there.

Q27 Laura Sandys: In our other investigations we have looked at this issue of complexity, layering and behaviour against different policies, but you were saying that there is not total clarity on how the market will respond and that that could throw up some difficulties?

Professor Grubb: I am not sure there is total clarity on how any markets respond and that is both good and bad. It makes it harder to design for but-

Q28 Laura Sandys: But the complexity of the market-

Professor Grubb: For example we have learned a lot about mitigation options in the cement industry that nobody thought about it until there was a carbon price, so that was pretty good uncertainty, in a sense. Particularly in terms of the investment response, we have been reminded that industries do not look ahead, plan and assume on the credibility of Government policy in the future in the way maybe that Governments would like, and therefore one does not get the level of investment response that one might have hoped for.

Q29 Laura Sandys: When you start to compare the UK regime, the proposed regime and the rest of the EU, is there an issue about complexity that makes this market more difficult to either invest in or retain activities in?

Professor Fankhauser: It is a combination of complexity and uncertainty. We talk to renewable energy investors, for example, and something one hears-and they play games by telling you that-is that the combination of uncertainty, how long will we have ROCs, when do we have something else, what will the something else be, plus the complexity is what deters investment. If you stick to a particular regime and keep it, people will learn and will start using it.

Professor Grubb: Yes, I think on your question I draw quite a sharp distinction between renewables and the broader carbon agenda. I think on renewable energy the UK has not done well statistically, that is clear from our investment relative to other countries. I think we have had further uncertainty in the regulatory regime. We have uncertainty magnified by some attempts to suggest the UK should try and abandon its renewables target, which would further amplify uncertainties and the cost of capital and everything else, quite apart from being against European law.

I think the UK has not been in a very happy place for renewables investment per se, and it obviously is trying to fix that.

In terms of broader carbon issues and how, strategically, the bulk of UK industry can manage the climate issue, I think the UK is in a good position because it has always been clear it believed in market instruments and it always was clear there should and would be a carbon price that rises over time. The structure of the Climate Change Act is well designed to give industry an assurance about the continuing evolution of regulation in this area, which is helpful, as I am sure corporate leader groups and others have said, and not many countries can match that in terms of the degree of confidence they are giving to business about the strategic direction of the UK economy and decarbonising.

Q30 Dr Lee: Good morning, gentlemen. Going back to a global emissions trading scheme perspective, and particularly to China, its CO2 emissions rose by 10% last year, chances are it is going to continue growing in the present circumstances. How likely do you think it is that China will develop cap-and-trade schemes in the near future and will they be compatible with EU schemes that are in place?

Professor Grubb: I think it is certain China is developing pilot cap-and-trade schemes. They have six moving forward. Four of those are city-based schemes, two are regional schemes. One of them is Guangdong, which is obviously a major industrial area in China. How compatible are they? We need to see what the designs are. My sense is that again Europe was a little na√Įve in thinking that other trading schemes would look like its own. They will not. The Indian scheme looks nothing like the EU ETS but it is still a trading scheme. Guangdong, I would imagine, would look different again. It does not necessarily preclude linkages.

Q31 Dr Lee: When I am out on the streets of Bracknell and I mention climate change, because I am on this Committee, most of my constituents understand that it is happening to varying degrees but what they are concerned about is the competitiveness of the British economy and ultimately they are more worried about having a job than they are about saving the polar bears, to be blunt. I have quite some difficulty trying to persuade them of the need for us to act. They always come back at me with the same sort refrain, "It‚Ä(tm)s all very well we could do this but the Chinese are pumping loads of stuff into the air". Professor Fankhauser, you recently noted on your blog that the FO is doing work with China on climate change policy. Do you have any suggestions what they should be suggesting in terms of promoting emission reductions in China, which also might reduce the impact it might have on UK competitors in the economic term?

Professor Fankhauser: Absolutely. Let me start with an anecdote. When I was doing that FCO trip to China, something that surprised me was that the Chinese were worried about their carbon policy in terms of their competitiveness, so it is something that seems to be everybody‚Ä(tm)s worry. It is not a unilateral thing.

As for what we can do, leakage goes away and competitiveness issues go away if you team up, if you have a sort of larger pool of countries that think about carbon policies in the same way, exchange ideas, do trading with each other and have similar types of regulation. So the easiest and most obvious way to deal with the competitiveness or leakage issue vis-√ -vis China is to work together with China. You could say China and the EU together probably create enough critical mass that other countries might all of a sudden think, "Yes, this is a good thing" and might want to join.

Professor Grubb: Two additions. It is pretty clear that trying to row back on our own policies is not going to help the advancement of the Chinese policies and, in fact, some Chinese experts say that China watches very closely the European 20%, 30% debate, future ETS, and so on, because they want to know that some other region is doing some serious stuff.

The other point, which brings us into different, but related territory, is that China has on many occasions said that it is not fair that they are getting blamed for having emissions that now exceed the US when a quarter of their emissions come from producing goods for export. They believe that the system should somehow address consumption as the problem rather than production and all those other debates in the UK. My answer to that is "absolutely". Where it can be done, you should have a conversation about that, which leads to the conclusion that for some of the big energy intensive goods you should address them on a consumption basis, so we need to address the European consumption of steel, cement, and so on, and that means one has to put all those emissions under the same regulatory cap, namely include imports in the EU ETS. I think there is a deal that could be done there.

Q32 Dr Lee: You think if it is specifically capped in certain sectors that could be tied in with ETS in the EU?

Professor Grubb: In the cement sector it would be very much like we treat excise duties on petroleum anyway. Nobody suggests we should let petroleum in without subjecting it to excise duties. So particularly for cement, which is the easy case for various reasons, I see no reason why we should not do the same for that.

Q33 Dr Lee: One final question, I note that in a last-ditch effort to meet the energy intensity target the Chinese shut down large swathes of industrial capacity in certain provinces, this is in 2006, 2010. If I made a suggestion to cut down the industrial capacity of Scotland, I think John would be quite upset. To what extent do we rely upon an autocratic Government in China for all of this to work? I say that because you have spoken about the problem with Washington-well, the problem with Washington is it is democratic and that there are large areas in certain key swing states, states to win in presidential elections, that are not at all signed up to the climate change idea. Texas is a classic example of that. To what extent are we relying upon there being an autocratic Government and that all of these targets and figures that we are aiming for are pie in the sky if 1.4 billion people suddenly have a vote.

Professor Fankhauser: I would say that the ethics of China‚Ä(tm)s policies are above my pay grade, but what I would say as an economist is that we do not have a choice. China is a very big economic power. It is the biggest emitter.

Q34 Dr Lee: Of course we have to work with them, but we could come to all of these agreements but it is predicated upon their being able to shut down the industrial capacity of a province. I am sorry but that would not happen in democratic countries. Is there a danger that we are going to sign up to things and then the game changes?

Professor Fankhauser: I sort of agree that this is a particularly stupid way of meeting a target. You can look at it the other way. The Chinese were committed to meeting the target. There are other countries out there that sign up to things and then do not meet them. In a sense, the good news I take out of that is that you can probably have a certain amount of trust in Chinese targets, and that they will do everything in their power, including some things that should not be in their power, to meet them.

Professor Grubb: As to your comment about democracy in Washington being a problem, I think the problem in Washington is to do with some very specific things around the structure of Congress and the way that operates combined with the intense and deliberate politicisation of the issue.

I am not sure there is much fruit in getting drawn into a debate of that sort, clearly shutting down plants is a very extreme measure and the analysis I have seen on how we tackle climate change does not imply one needs to resort to those kinds of measures. One needs to get the incentives right and make sure you have clear rules and stick to them.

Q35 Dr Whitehead: The EU is going to introduce aviation into ETS 2012, how do you think that is going to affect the overall ETS Market?

Professor Fankhauser: It is going to do a couple of things. If the cap is set tightly enough, as I currently understand it will be, it will create a net source of demand for permits in a sense that a lot of the aviation companies will find it easier to buy up permits rather than reduce their own emissions beyond a certain efficiency level. That is a good thing because it supports the price.

The other thing that it does is it broadens the pool. It makes the market more liquid. It has more players in it. It also has players in it that perhaps are less correlated in their economic activities than some of the others. It sort of brings into the regulatory regime a source of emissions that has grown much faster than many others.

Q36 Dr Whitehead: You mentioned quite a bit earlier the effect on the behaviour of companies involved in ETS. Does that apply to aviation in the future, airlines, sustainable air travel, innovations in transport modes, engines, and so on. Is there any evidence that the arrival of aviation within ETS is driving any of those sorts of changes?

Professor Fankhauser: I do not know if it is ETS but I suspect the prospect of regulation in the aviation industry is changing the behaviour. It is not an area that I know particularly well, but I suspect that like in other sectors, the main emphasis in the short term is on operational changes rather than on the sort of deep investment changes that we want. On the technology side in the aviation sector, we do not have the wealth of technological possibilities that we have, say, in electric power, so it is much harder to do.

Professor Grubb: One different point about aviation, which is an interesting feature, is that it is charging and requires allowances for both departing and incoming flights, which has obviously raised a lot of controversy. It does show it is a case where the EU has been willing to get tough and the EU has made it plain that flights coming from regions that also charge carbon on those emissions will not be subject to the EU ETS charge, so the country of origin can keep the revenues associated with charging for carbon. I think that is the sensible structure. It gives a clear incentive and my understanding is some of the small island states at least have already said that is what they will do, and they will adopt carbon pricing on aviation for flights to the EU. I think that is interesting because, in part, it is also a precursor of the kind of things that I think we need to do in energy intensive, carbon intensive goods trade.

Q37 Dr Whitehead: I think you anticipated my next question. Bearing in mind what the EU has done, against some pressure, by simply saying flights coming in and out have to purchase a proportion of their carbon emissions, do you think that is a potential trading model for other sectors?

Professor Grubb: With adaptation, yes-if it is adapted to the characteristics of other sectors.

Q38 Dr Whitehead: Bearing in mind what you said, do you see or could you see the aviation model as a potential sectoral driver well outside the EU, and as one of the benefits of ETS in the first place, as we have discussed previously?

Professor Grubb: Yes. To reinforce the underlying point, I do not think we are going to succeed in ambitions on climate policy as long as the only option on the table, for sectors that can make a case of a credible risk that they might move is exemption de facto by lots of free allowances forever. That undermines incentives and you cannot solve the problem in that way.

I think one has to find ways of moving those sectors towards more auctioning and that means for those sectors being able to do something to address the competitiveness fallout. I think the model of aviation absolutely does have some carry-overs, although the driver is not the same-competitiveness per se in the aviation sector is not driving it.

Ultimately where we want to get to and the incentive structure we want to get to, is rather like international treatment of VAT-if it has been paid at source, you do not pay it when it comes into here and if it has not been paid at source, you pay it when it comes into Europe. That is the logical structure for an international regulatory system that enables a coalition of countries to move forward without the whole of the world on board. That is a long way from here to there. It is complicated. I am not pretending it is not. But that is the actual structure we should be looking towards. I think that is explicable to other countries, including the developing countries. They can see and understand the dilemma.

Q39 Dr Whitehead: One of the witnesses who gave us evidence, Heathrow Airport, indicated that in future it would be likely that aviation would effectively have to be treated as a country with further negotiations. Is that something that would be likely to happen and would that then perhaps create within ETS, if that applies to other sectors, any issues of overlapping jurisdiction?

Professor Fankhauser: I can sort of see the logic of that in a sense that aviation by design is such an international business. If you started designing an ideal system from scratch you would have a global system that has everybody in it just because the chances of leakage and the like are so high. Whether you want to call that country aviation or just call it the sector agreement is semantics. But treating aviation as comprehensively internationally as you can I think makes a lot of sense.

Q40 Chair: Just one final question. Professor Grubb, when you gave evidence on electricity and market reform, you talked about long-term low-carbon contracts with energy suppliers. How do you see those reconciling with the role the carbon price might play?

Professor Grubb: I think in two quite important ways, one of which I alluded to in that evidence. Amidst all the discussion about long-term contracts not many people seemed to have looked at the fact there may be companies that want to buy long-term contracts for low-carbon electricity for a mix of reasons. One could establish a contractual structure, which would enable such long-term contracts to be traded, and I outlined the potential benefits.

I think one of the benefits of that is it restores a role for the carbon price because one of the risks, as I see it, of having long-term contracts done purely by Government as the central driver is that the government sets the contract price, relegating the role of the market and the carbon price along with that. If there were a private market in long-term contracts, in effect that long-term market would be competing with spot electricity that included a carbon price. The higher the carbon price went ,the more attractive those long-term contracts would get. I think that is a very valuable structure to have; it basically drives the system towards the kind of low carbon investments we need without losing a market underpinning it.

The other feature is if we are looking for solutions to electricity intensive industries, one could offer such contracts and top them up with a kind of feed-in tariff structure, so that in effect those electricity intensive industries would be buying low-carbon electricity that took them out of the impact of the carbon pricing - of having to pay the carbon price on electricity whatever they tried to do in terms of electricity sourcing ‚Ä" ie buying zero-carbon power directly should be facilitated and that shouldn‚Ä(tm)t carry a carbon price. I think in the short run that would require a top-up of the FIT type that is being considered anyway. It does integrate with the EU ETS discussions.

Q41 Chair: Thank you very much, we have run over time but we are grateful to you for coming in.

Professor Grubb: Thank you.

Professor Fankhauser: Thank you very much.

Examination of Witnesses

Witnesses: Baroness Bryony Worthington, Sandbag, Damien Morris, Senior Policy Advisor, Sandbag, and Larry Lohmann, Corner House, gave evidence.

Q42 Chair: Hello, thank you for being patient. I hope that we will remain quorate for enough time to get through some more business this morning. Can I start with Sandbag? You suggested in your submission that setting aside the EU allowances and adjusting the cap could help to achieve real emission reductions in Phase III. Do you just want to reiterate why you think that is necessary?

Damien Morris: For a few reasons. Firstly, Phase II of the scheme is going to be over supplied at the net level but we have also seen beneath the immediate oversupply within the scheme there is a large surplus accruing to industry. Between both of these issues this has pushed up the baseline from which the Phase III cap is going to be derived. So we both have an issue of direct oversupply being carried forward into Phase III and we also have this indirect effect of an artificially tied baseline from which this 1.74% trajectory is going to be set in Phase III. Between the two of these effects we see about 1.7 gigatonnes needed to correct for these.

Q43 Chair: How will the offsets gap reduce the environmental effectiveness of Phase III?

Damien Morris: Clarify what you mean by the "offset gap".

Chair: The extent to which we can buy or the EU countries can buy certified emission reductions from outside the territory.

Damien Morris: It is often neglected in the debates around the scheme that offsets are actual abatement. There are some controversies around particular credits, but we expect the full 1.6 billion approximate offset allowance over Phase II and Phase III to be exhausted but that will largely be abatement. Is it abatement that we would rather see in Europe? Yes. We think at the moment the emphasis on where abatement has taken place has shifted disproportionately to outside of Europe to overseas. This is largely an artefact of the recession. It was originally expected that offsetting would contribute only half of the reductions towards our 2020 targets but with so much of the reductions we have seen over Phase II being contributed by economic contraction this means actual concrete abatement rather than emissions reductions per se is being shifted abroad.

Q44 Chair: Is there not a danger that even though it may be genuine abatement, that would have taken place in those other countries anyway and, therefore, there has been possibly a kind of net loss of what might have been achieved globally?

Damien Morris: As I said before, there have been issues raised around the additonality of offset credits and we have seen the European Commission move to remove the eligibility of the most controversial credits. So, this is one of the proofs that the ETS is being reformed, is a reformable mechanism, when problems emerge in it they can be fixed, though there are long lead-times in that. But with the most controversial, the most problematic credits the HFC and N2O adipic industrial gas credits, they will no longer be available within the scheme from April 2013.

Q45 Chair: When do you think the EU ETS will start to achieve emissions reductions beyond those that would have been achieved on business as usual?

Damien Morris: If we are talking absolute reductions, whether they happen domestically or overseas, relatively soon. Not as soon as we would like but around 2014, 2015, there will be some reductions through offsetting taking place. In terms of driving domestic emissions reductions, if we wait for all of the international credits to be exhausted we could be waiting until 2018. That is for the ETS to drive emissions reductions. There is another issue that so-called complementary policies within the 2020 package will drive emissions reductions faster than the ETS will, which will prevent emissions from ever getting near the cap until well after 2020. But the ETS itself will drive emissions reductions well before then.

Baroness Worthington: I would just add to that that because there is a positive price there is already abatement happening at the level of fuel switching so the point at which you would switch from gas to coal is delayed by the fact that there is a carbon price on coal. So, at the very minimum, that is the first set of emissions abatement you would get on the map curve for Europe. In fact before even that you get black coal to brown coal, brown coal to black coal switching. So at that level, that price is helping, but it is far away from stimulating investment in new capacity or proper abatement.

Q46 Chair: Mr Lohmann, if the EU ETS was to be scrapped, are there already existing alternatives to emissions trading that would provide a substitute?

Larry Lohmann: Yes, there always have been, and you can divide that into two parts. But first you have to understand that the central issue with climate change has always been fossil fuels, as we know. As Chris Huhne mentioned earlier this year, it is a matter of national interest for the UK to shift away from fossil fuels and to decarbonise. It is really not a choice that we have to stop taking fossil fuels out of the ground. One way or other most remaining fossil fuels are going to have to be left in the ground. According to the Potsdam Institute studying climate change, 80% of the fossil fuel reserves are going to have to be left in the ground over the next 40 years.

So, if we take that as a premise I think we can divide the existing alternatives and the alternatives that are already in some sense active into two parts: supply and demand. We have to cut off the supply of fossil fuels, the movement of fossil fuels out of the earth and into the atmosphere and the oceans and so forth and also simultaneously we have to address the issue of demand for fossil fuels. You cannot do just one of those, you really have to tackle both of those at the same time.

In terms of supply, I think there are at least five suggestions I would make right away, just to point to measures that can be taken and are already being taken. First of all, here at home in the UK obviously stop tax breaks for oil and gas exploration in the UK‚Ä(tm)s own reserves, tax breaks that were announced in June. Stop support for the maximum recovery of the North Sea reserves. Support what my Ecuadorian colleagues call "Yasuni-ization", the Ecuadorian proposal for keeping fossil fuels in the ground as a contribution to climate change mitigation. There is active discussion with colleagues in South Africa, Nigeria and other countries about expanding this model to many countries.

The fourth suggestion would be to use the UK Government‚Ä(tm)s influence in international financial institutions to stop their support for continued exploration and exploitation of fossil fuel.

Finally, the UK Government could do much more than it has been doing so far to support local efforts to keep coal in the ground, and local efforts to nourish a renewables industry. The Vestas example certainly comes to mind. On the demand side, the second side, obviously we need to talk about what Michael Grubb mentioned in his testimony just now. There should be a concerted shift in long-term investment, the sort of things that the market cannot provide and, although Michael Grubb skated over this point a little bit, this sort of investment is actually in conflict with the EU ETS.

What has to have pride of place on the demand side is the shifting of investment away from fossil fuels and towards a different kind of investment. That is not only industrial infrastructure, we are talking about transport, we are talking about things like community structure, supermarkets, there is a whole list of things.

The second measure on the demand side would be more concerted support for selected price mechanisms such as feed-in tariffs, which, as I think you realise, have been responsible for the great mass of development of wind energy in Europe over the past years. Again, although Michael Grubb did not mention this, this is in conflict with the EU ETS. The EU ETS is actively working against these sorts of measures. Whenever there is legislation to move toward supporting efficiency, supporting investment, the concern is always, "Well, will this drive the carbon price down? Heavens, what will we do if the carbon price goes down?" This is not only a concern within the UK but it is also a concern within the EU and the people who have invested their careers in the EU ETS such as Jos Delbeke, Jos√(c) Barosso and so forth, who are always very concerned when they hear about measures to promote efficiency by Governments, "Oh, this will drive the carbon price down. We have to stick with one mechanism. Heaven forbid we should have a carbon price which is going down". So, there is a problem here. This is certainly one important element on the demand side.

The third element on the demand side is again to work with the international financial institutions to stop support for fossil-fuel consuming infrastructure in the global south. I am thinking particularly of one recent example that is on my mind, which is the World Bank support for Eskom‚Ä(tm)s-this is South Africa-3.5 billion dollar coal-fired power plant which is not doing any good to the citizens of South Africa although it is doing quite a lot of good to the mining industry in Australia. This kind of project has no place in international financial institutions‚Ä(tm) programmes and, as the World Bank‚Ä(tm)s own panel pointed out years ago, the World Bank should stop support for this kind of development. It is not doing anyone any good and it is certainly not doing the climate any good.

Finally, on technology standards, efficiency standards, there is a lot more scope for the Government to support setting of efficiency standards and again this is outside the market structure and to a great extent it is in conflict with the market structure, as I mentioned earlier. Whenever you have an initiative to start mandating greater efficiency in the industrial sector, the transport sector and the housing sector suddenly there is this worry, "Oh, but what about the carbon price?" As I think Dieter Helm at Oxford said last year, and he put it very well, "The EU ETS has moved from being a means to a carbon end to being an end in itself". It is too bad that the development of the EU ETS could not have been interrupted, could not have been slowed and phased out years ago. Then we would not have developed these large institutions and the large number of careers that have become associated with them, and it would be much easier to phase it out now. But still, the imperative is to phase it out as quickly as possible.

Chair: I think we are going to need slightly crisper replies if we are going to get through what we want to cover this morning. It requires quite a big leap of faith in my view to think that taking away tax incentives for North Sea oil and gas exploration will produce anything other than an increase in imports of cheap oil from the Middle East, but anyway we will leave that on one side.

Q47 Dan Byles: I just wanted to discuss voluntary emissions trading and whether you think that it is realistic to expect a voluntary emissions scheme to make a significant contribution.

Baroness Worthington: No, they have been helpful in terms of educating people about how you can apply a market to an externality like carbon, but if you want to get large reductions over a certain time period, which is what we need, you need regulatory back-up and I do not think that the voluntary mechanism would really deliver that. So, they can be useful in terms of preparing the ground for a regulated system but on their own I think they are very limited.

Q48 Dan Byles: Do you think that the closure of DECC‚Ä(tm)s quality assurance scheme is likely to make that worse? Is that going to have a significant impact? Was it working? Was it doing anything?

Baroness Worthington: I suspect it will not be noticed. I do not think that market is doing very well in the current recession anyway.

Q49 Dan Byles: You think it is something people do in the good times but not in the bad times.

Baroness Worthington: Yes, absolutely. Something you do for PR, CSR value but if is not in your driven bottom line, it is the first thing that is jettisoned. So, I do not think that is a big issue.

Q50 Dan Byles: Just briefly on the EU, you have already discussed the fact that the EU are trying to get away with some more controversial types of emission trading. If the EU start to only accept certified emission reductions from least developed countries will there be enough available to meet demand?

Damien Morris: It will create supply. If there is the financial incentive to start generating projects, the projects will come.

Q51 Dan Byles: Is there a danger that if these projects are being designed entirely around this they are not necessarily going to be the sort of sustainable projects that we would have liked to have seen put in place, in other words if it was not being generated as a result of this, but rather being generated from scratch simply as what is right for the country, if that makes sense. I did not ask that very articulately.

Damien Morris: I think the reason it is being pushed out to least developed countries rather than emerging economies is because there is this potential to-if you start incentivising providing Europe with carbon reductions, it can discourage the country to start committing to their own reductions but with least developed countries in most cases they are so far from being at development level to start considering domestic legislation on their carbon reductions that this is generally a positive.

Baroness Worthington: I think the alternative to not having projects in least developing countries is no projects because one of the things about this market is that it does give people confidence to invest in some countries where perhaps they would not be willing to otherwise if they did not have the security of this UN-backed issuance of credits. So, I think the benefits outweigh the disbenefits.

Q52 Dan Byles: So you think that the move to only accepting them from least developed countries is on the whole a good move?

Baroness Worthington: Yes.

Damien Morris: Yes.

Larry Lohmann: If I can just add a little to that. I think the problem you mention is certainly a concern. My colleagues and I believe that all offsets, whether they are from the so-called least developed countries or the other developing countries have essentially the same sets of problems. But what we have seen recently in the push for example to trying to expand, to get more CDM credits coming from Africa, for example, is very instructive and I think it illustrates the concern that you mentioned.

I am thinking particularly of land-based offsets or forest-based offsets; there is a great push for what is called REDD, reducing emissions from deforestation and forest degradation. The justification for this is, "Oh, poor Africa. Africa only has 1% or so of CDM projects. Perhaps these least developed countries should have more CDM projects that would benefit them?" For example, industrial gas projects like you see in Korea or Mexico are simply lacking in Africa and you cannot get these quick, cheap offset returns. You have to look to some other sector. Well, what sector are they looking to for example in Africa? It is the land sector, it is the forest sector. What does that mean in practice? What that means in practice is essentially a quite frightening land grab in many countries. I think it was only last year that the President of Liberia demanded the extradition of British businessmen who were involved in bribery in an attempt to get control over something like one-fifth of the Liberian land area for use as carbon offsets, which would mostly be sold to Europe.

So, we have to look at the details of the different dynamics of the different countries. All offsets are problematic but in terms of the idea that we can simply shift around the problem and we can produce offsets wherever, we need to look at the specific details of the specific cases and certainly the example of REDD indicates that there is a lot of need for caution in that respect.

Q53 Dr Alan Whitehead: Would not exactly the same thing happen were one to introduce some form of credit for keeping mineral reserves in the ground?

Larry Lohmann: It would, yes.

Q54 Dr Alan Whitehead: I think you just advocated that.

Larry Lohmann: No, I did not advocate that. What I advocated was something quite distinct. Although I can understand the confusion, because I think there is confusion about the proposal currently being put forward by Ecuador as well. I think my colleagues who work in Ecuador and I visualise this Yasuni-ization not as a matter of producing carbon credits, so you sell carbon credits for not producing oil in Ecuador to Europe so that Europe can produce more, or Europe can emit more. Obviously that is counterproductive and probably would lead to an increase in emissions. The proposal is rather distinct. The proposal is explicitly not to put this in the carbon market but to compensate countries for not exploiting their-

Q55 Dr Alan Whitehead: Yes, I accept that point, but the principle is the same I assume in as much as presumably you could have a bonanza in non-production prospecting on the basis of finding out what conceivable reserves there were in order not to take them out of the ground, in order to get some form of compensation for not providing them to anybody.

Larry Lohmann: Well, all to the good. The more that their exploitation can be avoided then that is all to the good.

Q56 Dr Alan Whitehead: So, would you get a glut of non-production credits across the world?

Larry Lohmann: There would not be credits. They would not be bought and sold on the market, so we are not talking about credit payments.

Q57 Dr Alan Whitehead: You are talking about payments of some description. Presumably-

Larry Lohmann: Payments, yes, of course, and I appreciate absolutely there would be a lot of political bargaining and a lot of horse-trading. Saudi Arabia as we know has already mooted this sort of proposal to say, "Okay, you don‚Ä(tm)t want us to export our oil: then give us some compensation". But that is something I think that has to be addressed in open debate and not suppressed. I think it is an important part of political bargaining about what are we going to do in order to keep the fossil fuels in the ground. Of course people are going to demand compensation for that and other people are going to be unwilling to give the compensation for that and that is the political process.

Chair: It makes the reform of the ETS sound like a tea party.

Larry Lohmann: I think it is the same level of political process.

Q58 Dr Alan Whitehead: Bryony, you appeared before the Environment Audit Committee last year and you said at that time that emissions trading needs to be better understood and better appreciated by the public. Do you think we are on track for better appreciation of the public at the moment as we stand before this Committee today?

Baroness Worthington: No, sadly, I still think it is a policy that is little understood and often characterised quite wrongly, and I do not think we do have the public with us on this one. Essentially yes, it is a political decision how to tighten the cap, so the danger is if we do not have an informed populace we will always lose out to the lobbying that takes place from very concentrated vested interests who do know how to work the political system very well and you need a counterbalance of public opinion that will hold Government and hold Parliamentarians to account to do the right the thing and set challenging targets. That imbalance is still there.

The NGOs do what they can with limited resources to address it and by and large the media have played quite a good role in trying to put forward stories about the need for reform of the ETS but it would certainly be a lot easier if we had a more informed public. But I do not see that we have made great strides on that.

Q59 Dr Alan Whitehead: In terms of the question of what might be done to improve the public image of emissions trading, assuming one wished to improve the public image of emissions trading, do you think that on the negative side the salience of fraud, the publicity around fraud in ETS and the over-allocation of windfall profits, or over-allocation of emissions and indeed profits in the first phase, are so far on the negative side that it is extremely difficult to improve any sort of public perception of ETS?

Baroness Worthington: The specific issues you have mentioned around fraud will naturally attract attention and be talked about but they have been by and large fixed and again, as Damien pointed out, one of the things about the ETS is it has proved itself to be reformable. We have been able to improve it over time and the big change between phase II and phase III brought huge improvements as it was centralised into Europe. So, it will always be a headline grabber and that does not help in terms of improving it.

One thing you could do that would help would be to take some of the revenues that will be accruing to Governments from the auctioning of permits and to do something that the public appreciates, either through handing back tax credits or through improvements to their houses or their communities, renewable initiatives. That essentially we have this large windfall of money arriving into the Treasury, the Treasury have been very tight-lipped about how they are going to spend it-it will probably go into the general fund as most things do-but it would be sensible to earmark at least some of it towards consumer-facing initiatives that will make people realise that they can benefit from a low-carbon future.

Q60 Dr Alan Whitehead: An associated point is, as we discussed earlier, the original purpose that many people envisaged for ETS, namely, that it would run for a relatively short phase prior to trading going global and therefore linkage would be made with other emerging schemes and before very long there would be a global trading scheme. The fact of the matter is that although indeed there are a number of emerging schemes by no means can that be or will that be regarded as global in the foreseeable future, and therefore the ETS, as it were, in terms of its completeness remains fairly isolated in the world. Does that in your view have particular issues, firstly, on the protection of vulnerable industries within Europe, and secondly, on the question of leakage outside Europe to other areas of the world economy, with the consequent perception of a negative effect that that produces?

Baroness Worthington: I am sure Damien can add to this, but essentially as previous people have mentioned, the number of sectors that are exposed to leakage is quite limited. We have always advocated that emissions trading schemes should focus on sectors that are least exposed to competition and by and large that means power, transport fuels, heating fuels, not tradeable commodities that can cross borders easily. But having decided to opt for the sector that we have, we do have to take measures to protect the genuinely vulnerable.

The best way is to seek bilateral agreements with neighbouring countries. If you press the steel industry in Europe hard enough, they will admit that they are not really worried about competition with China, it is more neighbouring countries such as Ukraine, Turkey, Russia. There are moves afoot already to introduce carbon pricing into Turkey and into the Ukraine and Russia is a big player in the carbon market too. So, it is not beyond the realms of reason that you could have bilateral agreements on those sectors and in those countries and I think that is something the EU should look to. They should certainly look eastwards into protecting their eastern borders and I think that is where the real nub of the problem is.

Q61 Dr Alan Whitehead: A border adjustment tax?

Baroness Worthington: That could be one of the discussions, but ideally it would be to extend regulations in those countries to have equivalent measures.

Damien Morris: If I could add to that briefly, I think sometimes the rumours of the death of the expansion of emissions trading have been exaggerated. It is been slower than we expected but there seems to be this kind of critical year of 2015 around which a whole gamut of emissions trading schemes are going to pop up, I think with the expectation of coinciding and linking shortly thereafter across-the California scheme will have expanded then to a larger scope, we will have Australia‚Ä(tm)s proper trading scheme coming on board around then and similar moves in South Korea. China is flagged to be beyond pilot stage at that stage as well. So, some momentum is being generated in those key countries.

Q62 Dr Alan Whitehead: So, is it your view that that prospect is slower but still a distinct possibility within the idea of a critical mass emerging that then, as it were, tips the global balance? A different way of doing it but-

Damien Morris: Maybe not a full global carbon price but I think, as Michael was saying in the previous session, key regions will be coming together, especially within Europe and emerging economies, and large regions within the US, which are accounting for a sizeable share of global emissions and a sizeable share of the climate problem.

Baroness Worthington: It is worth reminding ourselves as well that the offset mechanism is global. It does not create a price penalty but it certainly offers the incentive payment to anyone who wishes to participate. So, in that sense you already have a global mechanism, it is up to countries to come forward and participate in it and it creates a positive news story about participating in carbon markets because they are receiving revenues for investing in good projects. So, that element of the architecture will continue and I think it is a good element.

Q63 Chair: The EU has linked up already with Norway and Iceland. Do you see other opportunities for linkages in the near future?

Baroness Worthington: I think it will be difficult. As I say, the offsetting mechanism creates a kind of bridge between them already and I suspect it will be a wait-and-see situation. I know that Europe is very keen to. It might mean that Europe has to change its own scheme in order to be compatible as well as other schemes adapting so it will not happen overnight but there is always potential.

Q64 Chair: Do you think it is a good idea that they should try and achieve this?

Baroness Worthington: Only if there is enough ambition.

Q65 Chair: How about if you had linking on an individual sector which could therefore go to countries which did not have an absolute cap on their total emissions but who had sectoral limits that could extend to new participants, would that work?

Damien Morris: Yes, that would be attractive. Once again, we have emphasised the electricity sector as the first place to do that. But, again, you simultaneously deal with carbon leakage issues if sectors like steel and cement are in the joint scheme across different countries and regions.

Q66 Chair: We are going to lose our quorum in about 30 seconds‚Ä(tm) time. Let us finish with one question. Do you think there is any point in Britain having a more ambitious target for climate change for the electricity sector than the rest of Europe?

Baroness Worthington: Yes, I think it is important that the UK continues to show leadership. I think we have to be very careful in how we go about meeting that ambition. I think the idea behind putting in a carbon floor price is sound. However, in reality it is going to be quite an expensive policy that does not necessarily guarantee you that anything gets built and that is my concern. It is a very imprecise policy that applies-you have a very large amount of revenue that gets diverted to particular companies who have no obligation to then deliver on any infrastructure. So, I have a concern that our policy choice needs to be perhaps reviewed but the fact that we are being ambitious and communicating to the world that we remain ambitious is hugely important.

Damien Morris: If I can just add a little bit to that. It is always a bit of a chicken and egg arrangement so the UK‚Ä(tm)s ambition can potentially leverage ambition within Europe. We have to take a little bit of a risk and put ourselves out there but we are also showing we are putting our money where our mouth is.

Chair: Sure. Well, thank you very much for coming down. I am sorry that the counter-attractions of Prime Minister‚Ä(tm)s questions are proving overwhelming so we are going to lose our quorum but if we have some other issues we have not managed to cover perhaps we might write to you and deal with it like that. Thank you.

Prepared 25th January 2012