EU Emissions Trading Scheme: Review of Grandfathering and Benchmarking allocation methodologies for Phase II Recommendations 11 th May 2005 We recommend a hybrid approach in allocation methodology for incumbents, where some sectors adopt a method based on Grandfathering (GF) and others based on Benchmarking (BM). This represents the widespread view of the group and takes recognition of the following factors: In principle, BM offers the potential to be a fairer system than GF since it could be more aligned with future need, provide greater incentive for emissions reductions, provide a consistent allocation methodology for both new entrants and existing installations and reward early action. However, concerns were expressed over any use of projections in defining BMs. In practice, some sectors are more suited to GF and others to BM. This is due to the complexity in defining BMs to account for diversity of products and process for some sectors, and also accounts for availability/sensitivity of data. For some sectors adoption of GF could give an earlier indication of allowances. We recommend that Government works closely and bilaterally with each sector to confirm whether that sector is most suited to GF or BM, and to develop sector specific approaches tailored to their needs. We would hope that sector specific concerns raised in the present review and contained in the attached table are taken into account. We recommend that any BM approach should recognise unavoidable factors that cause differences between the emissions of installations within the same sector. These could include variations in raw materials, processes and products, but not lose sight of the environmental objectives of the scheme. We recommend that the relative merits of a one-stage or two-stage process be assessed. However, if any element of BM is introduced, and particularly if a hybrid approach is adopted, we note that it may be difficult to implement a one-stage approach, given the interest that each sector would then have in other sectors BMs. This would imply a two-stage process. We recommend that if the Government decides to adopt an approach involving BM it recognises the effort needed to develop BMs and allows sufficient time for bilateral discussions. Introduction 1. Through its member questionnaire and Phase I paper review, WG5/6 has identified the choice of allocation methodology as a key issue for Phase II development, in particular the relative merits of possible benchmarking and grandfathering approaches for incumbents. 2. Consequently this paper has been prepared to provide Government with WG5/6 recommendations on the issues surrounding the choice of allocation methodology for Phase II. The process for developing the paper was as follows: A subgroup of volunteers was formed. Attendance on the sub-group was via open invitation circulated by the ETG Secretariat.
The subgroup prepared the discussion paper based on a brainstorming meeting and written contributions from its members. The paper was presented to the WG5/6 meeting on 3 rd May 2005 for discussion. It was subsequently amended to incorporate the views expressed, and circulated for final agreement. Objectives of an allocation methodology Fairness 3. The key objective of the allocation method must be to treat all participating installations as fairly as possible, whilst ensuring the overall policy objective of incentivising emissions reductions. This means not discriminating against new entrants or incumbents, or against any particular sectors, and not determining allocations on arbitrary factors outside of the installations influence. 4. BM offers the potential of being fairer (than GF) as it could give allocations in line with future requirements, if these can be defined. However, the view was expressed that determination of BMs (including factors such as plant utilisations) could amount to central planning with certain technologies favoured. GF, on the other hand, does not necessarily represent the future and will become further out of date (since the baseline will not be updated beyond 2003). 5. A GF approach can also lock chance variations into future allocations. 6. A GF approach could be simpler and more transparent across sectors. However, a BM approach, if well defined, can demonstrate equity, particularly within sectors. It could also allow new entrants to be treated in a similar way to incumbents. There is a widespread view that new entrants and incumbents should be treated equitably. 7. It should be noted that views of fairness may differ between installations and it will not be possible to satisfy everyone s view of fairness. Therefore a pragmatic approach should be adopted when pursuing fairness to avoid unnecessary delays. 8. In summary, on balance a BM approach offers the greater potential for fairness than GF. Note, however, that practicalities and sector specific issues are key industry concerns, and some sectors favour GF. These issues are discussed below. Encourage emissions reductions 9. The main driver for investment will be the price of carbon determined by scarcity of allocations. As a secondary influence, the allocation methodology could be defined in a way that encourages emissions reductions, if standards were set that would form the basis for future allocations. Many believe this to be desirable. However, others have expressed concern that a BM allocation methodology could be designed to prefer a particular route for reductions, and consequently unfairly penalise certain incumbent installations, particularly those whose investment decisions pre-date the EU ETS. 10. A BM approach could encourage efficiency improvements by allocating according to technology standards, depending on how challenging these standards are, whereas GF may simply reward past inefficiency. 11. Any approach aimed at encouraging investment must recognise the long timescales involved. Key to this would be long term signals for overall or sector level allocations, however, with such signals the choice of allocation methodology may also be a factor. BM could offer a long term approach (beyond Phase II) whereas continued use of GF would always be uncertain as the GF period would become increasingly out of date and vulnerable to being changed.
12. A GF approach for Phase II could be announced earlier, giving installations a greater idea of allocations to expect, which would therefore give an earlier signal to encourage investment. BM on the other hand could take longer to develop. 13. Both GF and BM will be subject to the overall cap and in an effort to meet that overall cap allocations under either method are likely to be reduced to achieve this. 14. In summary, the key driver for emissions reductions will be the cost of carbon. However, BM may offer a stronger signal than GF to encourage investment whereas an earlier signal could be given by adopting a GF approach. Recognition for early action 15. GF does not reward early action prior to the GF period with any accuracy, whereas BM could reward early action if activity levels are properly assessed. 16. BM could be based on a number of possible criteria such as latest technology, current average or BAT. If the allocation were divided up within a sector, whichever base was used, early action would be recognised by comparison with non-movers. 17. However, it is noted that BM has the possibility of rewarding actions that were primarily driven by factors other than environmental objectives. 18. The view was expressed that the purpose of free allocations is to compensate for changes in business circumstances as a result of the scheme, which should be borne in mind when developing the methodology. 19. In summary, BM could provide greater recognition for early action, but would also reward action driven by factors other than environmental objectives. EU Harmonisation 20. Harmonisation of allocation methodologies across the EU may be desirable for sectors with strong international competition, such as in the motor industry, since it would help to minimise competitive distortions. However, differences in national and sector allocations are likely to be more significant. 21. Since there is no experience on the effect of Phase I on competition, it is difficult to assess the benefits of future harmonisation in this respect. 22. BM offers potential for EU harmonisation by recognising technology efficiencies, however, it would be very difficult to agree benchmarks across member states, particularly given the various degrees of modernisation across the EU. Furthermore, account must be taken of regional differences (raw materials, markets, weather etc.). 23. GF could, to some extent, account for these regional differences without the need to adopt multiple benchmarks for each product in each sector across the EU, but may not be seen to be encouraging EU-wide improvements. 24. It is noted that the Commission s plan to review EU benchmarks is related to Phase III, and it may be more appropriate to review harmonisation to feed into that work. 25. In summary, neither method offers simple and effective basis for EU harmonisation, and although important for some sectors, it is highly questionable whether this should be a priority objective for the allocation methodology in the UK. One stage versus two stage approach 26. A one-stage allocation would involve an equal reduction factor (assuming a reduction is necessary) applied to the relevant emissions of each installation, whether derived by GF,
BM or a hybrid, such that the total satisfies UK emissions reduction targets. A two-stage process would involve sector level allocations that allow for differentiating factors (growth rates etc.) followed by within sector allocations for each installation. 27. The full implications of a one-stage process versus a two-stage process have not been explored in this review, but the interactions with methodology type have been considered, as follows: 28. It would be extremely difficult to define BMs applicable across sectors, due to the differing nature of activities. It is widely considered that any BMs should be sector specific, noting that some sectors may be more suited to GF. 29. Assuming sector specific allocations, involving some element of BM, a one-stage approach may be difficult since it would require one sector to understand and comment on other sectors BMs. If BMs could be established for each sector then a one-stage approach would then be possible. 30. If GF were adopted for all sectors then a one stage approach would be more achievable. 31. A two-stage process could recognise the burden of other environmental policies as they affect each sector. 32. A benefit of a one-stage process is that it could be simpler (if not fairer). The view was also expressed that a two stage approach could result in reductions to allocations for particular sectors relative to others and could therefore unfairly penalise certain incumbents according to a predetermined view of the reductions they ought to make. 33. In summary, it would be difficult to adopt a one-stage approach if a consistent methodology (BM or GF) is not achieved across all sectors. Comparison between Grandfathering and Benchmarking Points of principle 34. A BM approach needs careful consideration of factors to be included, since some are beyond the control of installations. A view shared by most is that it is important to recognise differences in products, processes and raw materials where these unavoidably influence emissions. Rather than using a single factor, formulas could be applied in a way that accounts for these factors. However, for some sectors such a BM would be very complex or may not be suitable therefore a GF approach would be preferred for these. 35. BM offers the potential to recognise the effects of other environmental policies, as they affect individual installations. This is desired by some but the view was also expressed that only mandatory environmental impacts should be accounted for. 36. It is important that the Government allows sufficient time for bilateral discussions with sectors to develop any BMs and recognises the resulting potential for delaying allocations. 37. In defining any BM care should be taken in the use of projections (such as utilisations), especially where these are uncertain. It is recognised that the use of BMs requires an assumption about the future operation of installations The view was expressed that this poses the possibility that government could use the allocation to determine which technologies should deliver reductions, which is at odds with the principle that the market should be free to respond to emissions trading however it chooses. GF does not require explicit assumptions on future operation, but is based on past operation. 38. BMs could be validated against history to confirm they are appropriate, taking into account changes in market structure, legislation etc.
39. It should be noted that there is a spectrum between pure BM and pure GF. For example, greater use of detailed historic data and further sub-divisions of sectors in defining BMs would tend the methodology towards GF. In practice the best approach may be somewhere in between, and will vary between sectors. 40. If sector level allocations are adopted then the method of any BM (BAT, average technology or another method) may be less significant since any method would distribute a fixed quantity of allowances to a fixed number of installations. 41. It is preferred that emissions are defined by reference to production rather than the Phase I New Entrant approach of using plant capacity, noting that this would require careful and fair treatment of new entrants and installations that may change their product mix. In the paper industry, for example, energy consumption varies tremendously depending on the product and a BM differentiating by production could account for this. 42. Unless appropriately applied, both BM and GF may fail to distinguish between combustion and process emissions. The latter is harder to reduce. A well designed approach is required to recogise this. 43. GF could suffer from being out of date, since installations and markets could evolve away from the original baseline period. 44. The adoption of BM could introduce complexities over the possible future need to update benchmarks for subsequent phases. 45. In summary, BM could be designed to involve less chance differences between allocations for similar installations, compared with GF. However, it is important to recognise the difficulty in introducing a BM methodology that does not unfairly penalise some installations. BM will require a level of complexity for some sectors, and may not be practicable for others, in which case sector specific GF would be preferred. Practicalities 46. For some sectors there is concern over any need to declare future production volumes as part of any BM approach, since this may have competition implications that could also affect future production and emissions. 47. Likewise, the sensitivity of data (such as process efficiency) may make definition of BMs difficult in some sectors. 48. GF has the advantage that data is already available and verified, whereas BM would introduce complexities, additional data requirements and could cause considerable delay to the confirmation of Phase II allocations. 49. GF would introduce difficulties in defining baseline for previous new entrants, therefore continuation of BM for them may be required. 50. GF becomes more complicated in future phases as there will be a number of installation classifications (incumbents, old new-entrants, new new-entrants). Although it would still be possible to treat both new entrant categories as one and allocate to these on the same basis. 51. GF for Phase I introduced a number of rules to deal with anomalies such as commissioning and temporary closure. A continuation of GF may require additional rule changes to account for further changes to plant. 52. In summary, BM could require a great deal more effort and there are difficulties particular to some sectors, however, it could offer a more standardised treatment of incumbents and new entrants compared with GF.
SG5/6 Paper Summary of sector perspectives This table identifies sector specific issues raised during the review. This list is not necessarily comprehensive and further issues may be raised in future discussions with Government. Sector Preferred Comments allocation method Electricity No consensus BM&GF - Use of historic data to support the method may be inappropriate given changes as a result of other legislation and changes in the market. GF - will allow allocations to be determined earlier for base period incumbents without the risk of delay due to debate about the applicability of certain benchmarks and the determination of future utilisation factors. BM - Concern expressed that decisions on technology benchmarks (such as future utilisation rates) could constitute central planning, in that they could be used to favour certain technologies. BM - Views were expressed that BM must take account of other environmental legislation (such as LCPD) and resulting projected utilisation levels and efficiencies. However, the view was also given that optional changes to operation due to legislation changes should not be rewarded with additional allowances (e.g. fitting of FGD under LCPD). BM - However, there may be difficulty in gaining consensus to an approach which differs from using historic data. Will require thorough stakeholder engagement. BM - Phase I NER approach could be built on, but with larger range of emissions factors and utilisations relevant to each technology to avoid punishing existing plant. BM - Product approach should recognise different products within the sector, due to nature of market. Refineries GF for practical reasons BM - Special cases will need consideration. BM- Have been used for many years to improve productivity, but complicated by variety of processes and products. BM - Need to address these variations, and crude approach too inaccurate. BM - Complexities will pose a significant challenge for inclusion in Phase II. BM - Output based benchmark would require historic or projected throughput, which can be uncertain. BM - Attempts for Phase I NAP not successful and the only new entrant was treated independently. BM - Simple approach wouldn t work due to necessary complexities. BM - Phase II requirements even more complex as Phase I NEs were considered extensions to existing sites, but for Phase II would require fully integrated site. BM - Much of the data to establish BM is of proprietary nature. BM - Data collection and verification to support BM may be detailed and extensive. Off-shore No sector specific issues were raised during the review.
SG5/6 Paper Iron and steel Cement Chemicals Strong preference for GF Tendency towards BM Tendency towards GF BM&GF - Process emissions dominate the total. BM&GF - Production chain comprises many discrete processes therefore long term investment required to deliver real emissions reductions. BM - Experience with benchmarking each stage in production process on BAT basis shows that the combined hypothetical plant does not exist. BM - Energy performance data closely guarded since comprises large proportion of production costs. This will make BM difficult/uncertain. BM - Efficiency strongly influenced by economies of scale, which must be accounted for. BM - Other site specific issues can affect emissions factors, such as process and product variations. BM - Definition of installation boundaries (in terms of processes included) varies between member states therefore a consistent approach is desired to avoid competitive distortions. BM - In UK only one CO 2 producing product. BM - Formula would be required to account for different materials and fuels. This could be based on Phase I NE spreadsheet, but would require modification. BM - Wet process kilns should not be penalised since there are long investment lead times. Preferred approach is phased to initially take account of higher moisture. BM - Benchmarking on capacity or historical volumes would not encourage use of most efficient equipment. Pooled company level allocations would encourage use of most efficient plants. BM - Approach should be based on Phase I NE with minor adjustments for clinker production. BM - For combustion installations considerable work will be needed to determine activity levels and this may be impractical within the deadlines for Phase II. There is also concern about how auxiliary capacity would be treated BM - If scope were extended to include chemical activities, it is likely production would be too diverse to benchmark. Pulp and paper GF BM - Approach for Phase I not considered correct since it assumes emissions can be characterised by size of combustion plant. This would have to be resolved for Phase II BM with emissions based on production. BM - Historical attempts to BM sector have proven very complex and lengthy. BM - Significant effort required to gather and verify data. BM - Significant variations in energy consumption with product. Different product and markets would have to be characterised to avoid penalising certain installations. GF - A good measure but should be adjusted for changes in production. BM - Should be considered for new entrants though. Food, drink, tobacco Tendency to BM BM - Preferred method is on the basis of combustion plant not production capacity. There is a wide range of products, with vastly different emissions so arbitrary production approach not practical. BM - Benchmarking on combustion plant would encourage boiler efficiency improvements. BM - Phase I NER should be starting point, but would need to revisit inclusion of standby plant and
SG5/6 Paper utilisation factors. Non-ferrous No sector specific issues were raised during the review. Lime BM BM - Process emissions determined by raw materials which cannot be influenced by the producers BM -A number of benchmarks will be required to recognise range of technologies, products and fuels. BM - method must make allowance for growth or shrinkage of market. Glass GF BM&GF there are interactions with other competing sectors such as in construction and packaging. BM - Proprietary technology not necessarily available. Services No sector specific issues were raised during the review. Other oil and gas No sector specific issues were raised during the review. Ceramics GF BM difficult to establish with a wide range of processes and materials. Would place additional burden on sector that is low emitter compared with others. BM - Any BM should be sector specific. Engineering and vehicles BM - EU harmonisation is important for the motor industry given the extent of competition across member states.