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This month Sandbag launched its annual report on the environmental outlook for the EU ETS. ‘[Buckle Up](http://www.sandbag.org.uk/annual_review/ “Annual Reports Page”)’ once more finds the ETS to be heavily oversupplied to certain sectors. This oversupply is not the result of installations actively reducing their emissions, but of inflated allocations and a recession that could push industrial permit surpluses to 855Mt by 2012. Such an oversupply has contributed to a depressed carbon price, held afloat in part by the ability to bank these permits forward into Phase III. This, in turn, will allow business-as-usual emissions to continue unabated for many industries well into Phase III, further delaying the early reduction in emissions that is both economically cost-effective and environmentally necessary.

Sandbag’s events in [Westminster](http://www.sandbag.org.uk/blog/2011/jul/11/buckle-report-lords/ “Westminster launch”) and [Brussels](http://www.sandbag.org.uk/blog/2011/jul/15/buckle-report-ep/ “Brussels launch”) offered an opportunity to debate these findings with a broad audience of industry representatives, NGOs, press and government officials (see previous blog posts for details). Both in the report launches and in wider commentary on the ETS, much of the current debate focuses on the level of the cap, the role of the surplus, and the need for a set-aside. Crucially, is the current surplus of permits accrued by some sectors a necessary evil that ensures compliance with a scheme that will eventually (we hope) drive effective abatement? Or is it simply delaying emissions reductions and providing windfall profits to certain companies?

Industries covered by the ETS would of course reject the latter observation. Where Sandbag has shown companies to have large surpluses (see the [latest Fat Cats report](http://www.carbonfatcats.eu “”)), the response has always been that any profits made from the sale of excess permits are reinvested into sustainability and efficiency initiatives, or used to offset increasing energy prices (of which the ETS has played a part). Either way, they continue, the notion that we should condemn profits made from the ETS is absurd, as this is what a market mechanism should and will incentivise.

Sandbag does not contest the ability of companies to profit from the ETS, if these profits are linked to actual abatement; we do however have a problem with an ineffectual policy framework that leads to excessive windfalls and fails to incentivise investment in low-carbon technology.

It is worth recalling how emissions trading is supposed to provide such incentives. In a perfectly functioning carbon market with 100% auctioning of permits in all sectors (a distinctly remote prospect at this point), companies would buy permits to cover their emissions; if they emitted under that amount, they would have spare permits to sell, creating an incentive to reduce emissions through a mixture of efficiency measures and investment in new technologies. In such a utopian world, a surplus would be indicative of a company actively engaged in abatement.

The reality in the ETS is somewhat different. Current Phase II surpluses are the result of generous National Allocation Plans, with this oversupply exacerbated by the dip in emissions caused by the recession. The heaviest emitters received the most EUAs, and unsurprisingly, now have the largest surpluses.

But again, the industry response is that the accumulation of a permit surplus over Phase II is completely rational in the face of stricter Phase III rules, and increasing competition from industry outside the EU. What’s more, with the spectre of the recession still looming, and economic recovery for some member states fragile and slow at best, the argument broadens to that of ‘carbon leakage’, and the emissions and (more importantly) jobs that will be lost to international competitors if measures are taken to tighten the emissions cap.

This is a genuine concern for all, but as ‘Buckle Up’ makes clear, the ETS was never designed to encourage industries to increase or recover their emissions, or to financially subsidise their economic growth or recovery, and yet this is precisely the use to which these allowances are being dedicated.

Many companies are understandably focused on the future of the ETS, and the Phase III rules that will begin to reduce the inflated surpluses they have become used to. But given that the Phase III cap has been set in relation to average Phase II allocations, they cannot ignore the massive distortions caused by these surpluses that are already present in the ETS, and which threaten to weaken emissions reduction goals. As the failure of the recent vote in the European Parliament to support an increase in the EU wide emission reduction target showed, even with this oversupply there is very little ambition for what is a very achievable goal.

This is disappointing given that many of the industries opposed to higher targets readily pay lip service to the notion of sustainability, and the positive-sum vision of growth and emissions reductions this implies. Yet in lobbying for weaker emissions reduction targets, they continually rely on zero-sum arguments: either we have a tighter cap, carbon leakage and de-industrialisation, or weak targets, strong growth, and globally competitive industry in the EU.

How do we move past this impasse? Clearly, the ETS cannot continue to exist for its own sake, but must be made to work to benefit Europe through reducing emissions and driving low-carbon investment. If particular sectors continue to hold back the ambition of the ETS, then it is worth considering their removal from the scheme altogether. Alternatively, Sandbag would welcome the kind of constructive dialogue in evidence during its report launches, where stakeholders from industry, government and the NGO community work not to weaken the ETS, but to find positive solutions to its flaws.

Moreover, there needs to be an honest debate about surpluses. The ETS is not designed to reward indirect falls in emissions due to reductions in industrial output, and so measures must be taken to address the impact of exogenous events (such as a recession) on the supply of permits both now and in the future. Rather than cancel these permits retrospectively, Sandbag believes that a 1.7Gt set-aside of the permits sold at auction in Phase III should be implemented to correct for direct and indirect oversupply in Phase II. Not only will this go some of the way to correcting such distortions, but it will signal real intent in shifting the ETS from a system that delivers windfall profits to certain companies and sectors, to a system that drives effective emissions reductions and investment in lower emitting and more energy efficient technology.