Cap and Trade: The View from the United Kingdom

Vol. 26 No. 4

Mr. Hutchinson is partner with Mayer Brown LLP. Ms. Laborde is senior associate with Berwin Leighton Paisner LLP.

Even the staunchest of climate sceptics would surely agree that global warming represents one of the most widely debated global policy issues of recent years. Measures to reduce rising carbon emissions are now a priority for the governments of most developed nations and cap and trade schemes are being trialled in a number of jurisdictions. Inexorably, all parts of the economy including the retail sector will feel the impact of these schemes.

In the past decade, the United Kingdom (UK) has set itself challenging targets to transition the country to a low carbon economy, including the ambitious goal of an 80 percent reduction in UK emissions by 2050. In the current economic climate, maintaining competitiveness is a clear priority and, since coming to power, the Coalition Government has shown a commitment to market-based initiatives to incentivize businesses to green their operations. A leaner regulatory agenda has also been promised, as well as compensation packages for some of the industries hardest hit by climate policy.

In 2008, the UK passed legislation introducing the world’s first long-term legally binding framework to tackle the effects of climate change. The Climate Change Act of 2008 includes powers to introduce domestic emissions trading schemes more quickly and easily through secondary legislation. The first use of these powers resulted in the launch in April 2010 of a mandatory emissions trading scheme for non-energy intensive businesses, known as the Carbon Reduction Commitment Energy Efficiency Scheme (or CRC). Whilst the majority of cap and trade schemes focus on mitigating direct emissions from heavy industry and the dirtiest polluters, what is innovative about the CRC is that it regulates the indirect emissions of participants through their energy (primarily electricity) consumption. This includes the retail sector as well as office-based businesses.

At a basic level, cap and trade schemes work by putting a price on carbon emissions. The design of such schemes varies but the majority feature a limit (or cap) placed on emissions from companies within a given sector by a central authority (usually a governmental body). Often the cap will shrink over time putting pressure on affected industries to reduce their emissions. Participants are required to purchase allowances based on their emission levels and, at the end of each compliance period, must surrender sufficient allowances to the central authority to cover those emissions. As a result, good performers will have surplus allowances that can be traded on the secondary market so that there is a direct monetary incentive to innovate and pollute less.

The uptake of emissions trading schemes in certain jurisdictions can largely be traced to events following the landmark international treaty on climate change, the United Nations Framework Convention on Climate Change (UNFCC). Agreed upon at the Rio Earth Summit in 1992, the UNFCC committed developed nations to a range of measures aimed at stabilising the “greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous [human induced] interference with the climate system. . . .” The Kyoto Protocol to the UNFCC, adopted in 1997, consolidated this historic agreement by setting binding targets for 37 industrialised countries and the European Community to reduce their greenhouse gas emissions by at least 5 percent below 1990 levels during the period from 2008 to 2012 and required participants to meet their targets through national measures.

One of the central tenets of the Kyoto Protocol was the use of market-based instruments to tackle climate change, including emissions trading. The European Union (EU) emissions trading scheme (EU ETS) is the largest and arguably most successful of such schemes to date. Entering into force in January 2005, it covers about 45 percent of the EU’s greenhouse gas emissions and has been the main driver behind the growth of the global carbon market. The EU ETS covers electricity generation and the main energy-intensive industries—power stations, refineries and offshore, iron and steel, cement and lime, paper, food and drink, glass, ceramics, engineering, and the manufacture of vehicles. In the UK, it accounts for about 48 percent of national carbon dioxide emissions.

In 2005 one of the UK’s leading environmental think tanks, the Carbon Trust, published a report titled “The UK Climate Change Programme—Potential Evolution for Business and the Public Sector,” in November 2005, analysing the strengths and weaknesses of the UK’s Climate Change Programme. It noted that the use of energy—particularly electricity—in the services and light industry sectors in the UK represented one of the country’s fasted growing sources of carbon emissions. Energy consumption by those business sectors was, however, not directly regulated through the EU ETS or the UK’s main carbon tax, the Climate Change Levy (CCL).

Introduced in 2001, the CCL is a tax on industrial and commercial energy supplies (electricity, gas, solid fuel, and liquefied gas) to non-domestic users principally in the industrial, commercial, agricultural, public, and service sectors. To reduce the potential impact of the CCL on international competition of energy-intensive industries, those affected can receive a substantial discount on the amount they pay (currently 65 percent and rising to 90 percent in 2013) if they participate in so-called Climate Change Agreements (CCAs). CCAs commit participating businesses to demanding targets for improving their energy efficiency and reducing carbon dioxide emissions and are negotiated on an industry-wide basis in more than 50 business sectors, which do not, however, include the retail sector.

The Carbon Trust’s report noted that the services and light industry sectors in the UK were increasingly dominated by large, national companies operating at sites across the country and their energy use was mainly associated with operations in buildings they occupied. UK buildings regulations tend to focus on energy efficiency factors during the construction or (re)development phases in the life of a building and therefore did not provide sufficient impetus to galvanise action on energy efficiency during normal business operations.

It was also noted that many companies in these sectors had highly competent management structures and that there was a need to identify business friendly instruments that could leverage the attention of those companies to address the wastage in their energy use. Given this backdrop, the report concluded that the best instrument to address this gap in coverage of the country’s Climate Change Programme would be an emissions trading system that would address energy uses outside the scope of the EU ETS and the CCA mechanism.

In 2007, the country’s (then) Labour administration formally announced its intention to introduce a mandatory cap and trade system. It would apply to all large non-energy intensive public and private sector organisations operating in the UK such as large retail companies, supermarkets, hotel chains, banks, central government departments, and large local authorities. Combined, these sectors account for about 10 percent of the UK’s carbon emissions.

How the CRC Works

The CRC scheme rules have been elaborated in a myriad of detailed regulations and guidance documents issued by the main regulator, the Environment Agency, and the coordinating government department, the Department for Energy and Climate Change.

In terms of coverage, the CRC applies to any organisation that has “at least one settled half hourly electricity meter settled on the half hourly market and was supplied with more than 6,000MWh electricity” in the relevant qualification year (2008 for Phase 1). This equates to an annual electricity bill of about £500,000 (just over US$770,000 at current exchange rates). Organisations not meeting the threshold electricity supply are required to make an information disclosure to the regulator concerning their energy consumption but are not required to participate fully in the scheme. The Government originally estimated that about 5,000 organisations would be required to join the CRC, although only just over half that number have in fact registered.

Although the CRC primarily regulates energy consumption in the non-energy intensive sectors, all businesses, including the retail sector, are potentially covered by the scheme. However, there are specific exemptions to prevent double-regulation where relevant energy consumption is covered by a CCA or the EU ETS.

The CRC comprises several phases. The Introductory Phase (Phase 1) covers the period from April 1, 2010 to March 31, 2014. Phase 2 runs from April 1, 2013 to March 31, 2019.

CRC participants are required to measure and report their carbon emissions annually following a specific set of measurement rules. The baseline year for measuring emissions was 2008 and the first annual reports of emissions were due in July 2011. Starting in 2012, participants will buy allowances from the Government in each scheme year to cover their emissions in the previous scheme year. The price of allowances is currently set at £12 per tonne of carbon dioxide (the Government has announced that future prices are a matter for budget process) and the initial sale will be on a retrospective “buy to comply” basis. Therefore, there will be no need to have a safety valve mechanism as originally anticipated. At the end of each scheme year, participants must surrender enough allowances to the regulator to cover the amount of carbon they emitted.

It is envisaged that trading of surplus allowances will eventually take place on the secondary market, although the details of the trading mechanism have not yet been finalised. Initially, the CRC registry (operated by the Environment Agency) will have a notice board trading facility to help participants find buyers and sellers of allowances. Third-party downstream trading facilities are likely to develop over time.

One unusual feature of the CRC is that participation is based upon a business “organisation,” as opposed to site-based criteria as is the case for many environmental regulations. Broadly, the CRC organisation for a company will equate to its group, although there are complex rules around how this is determined. Any corporate structure that is part of a group must participate in the CRC as part of that group, with the highest parent undertaking, determined by reference to the Companies Act 2006, being the primary member for the CRC. The group will participate together as a single participant unless it is able to disaggregate any of its large subsidiaries that qualify for the CRC and that will, in turn, participate in the CRC as separate participants. Disaggregation is only permitted if the remaining part of the group still qualifies for participation in the CRC in its own right. If the highest parent undertaking of a group is based outside the UK, but subsidiary members of that group are responsible for energy consumption in the UK, the group must designate one of its UK entities as primary member for the CRC, where it is covered by the scheme.

In some instances, for the purposes of compliance, participation in the CRC will bring together entities that are not legally related under the normal rules of company law. By way of example, a franchisor may be liable for the energy use of its franchisees even if those entities are owned by another CRC participant. The rationale for this seems to be that the franchisor has the ability (through the franchise agreement) to influence the way in which its franchisees consume energy.

Similarly, complex rules also apply to energy in tenanted properties whereby landlords can find themselves responsible for the energy consumption of their tenants if they are responsible for supplying energy directly to their tenants. Many landlords are now reviewing the extent to which they can recover CRC costs from their tenants. While there is no settled law on this point, it will largely depend on the terms of the applicable lease. For large institutional landlords, this liability can be significant and cost recovery is a critical concern.

When the CRC was first mooted, there was alarm within the private equity sector after it emerged that both private equity-owned portfolio companies and the private equity fund entities could be joined to form a single CRC organisation. While the rules have been clarified to some extent following intense lobbying from the industry, many fund managers have had to undertake detailed and costly reviews of their portfolios and group structure to ascertain how the rules apply to them.

The first legal challenge in relation to participation in the CRC took place at a public hearing in November 2011 following an appeal against an enforcement notice served by the Environment Agency following the refusal of by one of the UK’s largest mining companies to register for the CRC. The challenge relates to the operation of a 12km conveyor located at one of the company’s sites. The company claimed that it was not required to register for the CRC because the carbon dioxide emissions from its operations were covered by the exclusion applicable to transport emissions. On March 1, 2012, the Secretary of State for Energy and Climate Change dismissed the appeal and confirmed the Environment Agency’s enforcement notice without amendments. Failure to win its appeal will reportedly increase the appellant’s costs by some £1.4 million (more than US$2.2 million) per annum for each of the three years from April 2011. The outcome of this appeal may well have wider implications for the ongoing operation of the CRC. The appellant is now considering whether to apply for judicial review of the Secretary of State’s appeal decision. Penalties were suspended from the date of the appeal; therefore, the appellant does not face penalties for nonregistration at £500 per day (capped at £45,000). In the current economic climate, such cases also bring into focus the very real threat to certain industries of so-called “carbon leakage” when UK businesses face the harsh reality of tough climate policy and consumers can easily turn to cheaper sources of supply elsewhere.

The Winners and Losers of the Carbon Trade

One of the most widely reported and controversial aspects of the CRC to date has been the publication in the Fall of 2011 of the annual Performance League Table of results. In the Performance League Table, during the Introductory Phase, all participants are ranked according to their relative performance against three weighted metrics. In Year 1, performance is ranked solely on the basis of the so-called “Early Action Metric.” This takes account of each participant’s CRC emissions certified under one of seven accredited carbon management schemes (e.g., the Carbon Trust Standard) and the proportion of the participant’s electricity and gas supplies measured through voluntarily installed automatic meter reading devices, dynamic unmetered supply and daily-read gas meters.

In subsequent years, performance will be judged on additional factors. These will include the participant’s annual percentage reduction of absolute emissions relative to the group’s average emissions over the preceding five years (the Absolute Metric) and the percentage change in emissions per unit turnover over the preceding five years (for the private sector) or revenue expenditure (for the public sector) (the Growth Metric).

The Performance League Table is designed to ignite public and boardroom interest in the relative performance of participants, thus motivating improved performance through comparison with the peer group. A major criticism of the first year results is that the Early Action Metric only rewards an extremely limited range of energy efficient behaviours. In this context, companies that have made major investment in certain longer-term energy efficiency measures may well not see an improvement in their ranking until later years. This said, the results of the Performance League Table have been widely reported (indeed the regulator’s website crashed on the morning of its publication given the vast numbers of people trying to access the site). To this extent, the aim of increasing public debate and awareness within the carbon space may have been achieved.

The regulator intends to audit about 20 percent of CRC participants each year. These will largely be desk-based audits, although some site visits may be carried out. The first annual reports of emissions were due in July 2011 and participants are now bracing themselves for further compliance checks.

In addition, there is a scheme of (principally) civil financial penalties associated with failure to register for the CRC and noncompliance with other key requirements of the scheme. The regulator also has specific powers to “name and shame” those who fail to comply, as well as ranking them at the bottom of the Performance League Table.

In more extreme cases, noncompliance may be a criminal matter (e.g., where false or misleading statements are knowingly or recklessly made). This can lead to terms of imprisonment or significant fines.

When the UK’s Coalition Government came into power in 2010, it announced a major Spending Review to address the country’s budget deficit. As a result of this, it was announced in October 2010 that revenues generated by the CRC would not be recycled to participants as originally planned and will instead support the public finances.

This announcement met with some consternation, given that it had been widely promoted that revenues generated by the scheme (estimated to be worth £1 billion per annum by 2014–15) would be recycled back to participants in proportion to their average annual emissions and with a bonus/penalty depending on their position in Performance League Table. Given this major policy U-turn, many participants have noted that there is no longer any direct financial benefit to develop energy saving strategies or achieve an improved position in the Performance League Table.

The decision to scrap revenue recycling has also led some to question whether the CRC is, in reality, more akin to a conventional form of environmental tax. The Government has concluded that it is not. However, the point was cited in the November 2011 CRC appeal hearing mentioned above and could potentially be raised in a Judicial Review action. If a court were to deem the CRC a form of taxation, it may fall foul of European-wide rules prohibiting differentiated taxation of energy products.

A similar point was recently raised by the Air Transport Association of America and other parties seeking a ruling in the European courts against their inclusion in the EU ETS. In that case, it was claimed that the EU ETS introduces an excise duty on fuel that is prohibited under the Open Skies Agreement and Chicago Convention. However, this argument did not find favour with the court.

Implementing a major new environmental policy is unlikely to be a smooth ride for any government. Less than a year into its operation, the UK authorities have announced a programme of “simplification” measures to make the CRC more palatable to business. The changes will include modifications to the rules on organisational structures so that large organisations no longer need to participate in groups that do not reflect natural business structures. Sites covered by CCAs and the EU ETS will be fully excluded from the CRC and the number of fuels covered by the scheme will be reduced from 29 to 4.

Draft Regulations setting out how allowances are to be sold during the Introduction Phase were published in January 2012. These provide for three sales of allowances, known as primary allocation periods. In addition, there will be secondary allocation periods to enable the Environment Agency to sell allowances in circumstances where the Agency has been unable to process, outside a primary allocation period, a CRC participant’s emissions made during the primary allocation period.

The Government is expected to consult later this year on further legislation to make changes to Phase 2. The proposed auction of allowances in Phase 2 of the scheme will be abandoned and, instead, there will be two fixed price sales per year (a cheaper forward sale and a more expensive retrospective sale).

These concessions should remove the need (in the short term at least) for companies to develop auction strategies and provide greater price certainty to investors. They also go some way towards allaying the concern that the CRC imposes a significant administrative burden at a time of national austerity.

The Future of Cap and Trade

The UK and European authorities appear firmly committed to the development of emissions trading schemes and London, in particular, remains a major hub for the global carbon trade. Other countries experimenting with cap and trade include the United States, Canada, New Zealand, Japan, and Australia.

The U.S. experience following the California Air Resources Board’s landmark decision to adopt the first state-administered cap and trade regulations is a major milestone in the development of cap and trade and will undoubtedly be watched with interest by UK and European counterparts. By a narrow margin, the Australian Senate has last year passed legislation that will establish a trading scheme in 2015 for the country’s top 500 emitters of greenhouse gases. It will be the second largest mandatory carbon trading scheme in the world and may serve as a model for other jurisdictions.

Although the latest round of climate talks in Durban allowed the emergence of a consensus on the adoption of a universal legal agreement on climate change as soon as possible, and no later than 2015, there is widespread pessimism about the form of international action on climate change for the post-2012 period that will emerge from this year’s anniversary summit, the Rio+20 UN Conference on Sustainable Development. Whatever the outcome of these discussions, it seems certain that emissions trading schemes will be a feature of the regulatory landscape for retail and other businesses operating in the UK and Europe for the foreseeable future.

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