THEOMAI*

RED DE ESTUDIOS SOBRE SOCIEDAD, NATURALEZA Y DESARROLLO /
 
SOCIETY, NATURE AND DEVELOPMENT STUDIES NETWORK 

    


Interaction between environmental policy instruments: carbon emissions trading and Integrated Pollution. Prevention and Control

Adrian Smith and Steve Sorrell

SPRU - Science and Technology Policy Research, Mantell Building, University of Sussex, Brighton, BN1 9RF, UK

(Published in: International Journal of Environment and Pollution, 2001, Vol.15, No.1, pp.22-41.)

Abstract

As the number of environmental policy instruments grows, so the potential for interaction between different instruments increases. This interaction can be detrimental or beneficial. To avoid conflict, it is essential that the potential for interaction be assessed during the formulation of new policy instruments. This paper illustrates this through an analysis of how the European Directive on Integrated Pollution Prevention and Control might interact with future schemes for carbon emissions trading. Both instruments encourage industrial energy efficiency, but in fundamentally different ways. This is demonstrated through a detailed comparison of the two policy instruments, followed by the development of three implementation scenarios for IPPC, in which the interaction with potential carbon trading schemes is assessed. The paper concludes that the interpretation of the IPPC energy efficiency requirements could either constrain or facilitate the participation of regulated installations in any carbon trading scheme.

KEYWORDS

environmental policy instruments; IPPC; emissions trading; regulatory interaction

1: Introduction

Environmental policy has grown enormously over the last 30 years, both in the number of policy instruments and the variety of institutional levels and arenas from which they arise (Weale, 1992). As environmental policy matures so the potential for interaction between different policy instruments grows. This interaction can be complementary and mutually reinforcing - such as the implementation of industrial pollution regulations assisting the development of business environmental management systems (Smith, 1996) - but there is also the risk that different policy instruments might interfere with one another and undermine the objectives and credibility of each. It is important, therefore, that policy makers understand the features and dynamics of existing policy instruments and assess the likely interactions with any new measures they propose (Hahn & Noll, 1983).

This paper seeks to illustrate policy interaction by examining two instruments whose objectives include, directly or indirectly, the promotion of energy efficiency in European industry. The first policy instrument, the Integrated Pollution Prevention and Control (IPPC) Directive (96/61/EC) will be introduced in all Member States in 1999. The IPPC Directive shares many features with the existing system of Integrated Pollution Control (IPC) in the UK (Skea & Smith, 1997). Its central requirement is that operators of industrial processes use the Best Available Techniques (BAT) to control polluting releases to all three environmental media (air, land and water) and to promote energy efficiency. It is this last element of IPPC which is relevant to this paper.

The second policy instrument considered here is currently being debated in the wake of the 1997 Kyoto Protocol to the Framework Convention on Climate Change, namely tradable permits for greenhouse gas (GHG) emissions (Skea & Sorrell, 1998). The Kyoto Protocol provides a framework for international emissions trading between countries with legally binding emission targets (Article 17). While the rules for this trading regime are still being negotiated, it is likely that some countries will wish to develop national GHG trading schemes that may be integrated with the emerging international market. Monitoring difficulties for GHGs are likely to confine trading schemes to carbon dioxide (CO2) in the first instance. Therefore, this paper focuses solely upon carbon emissions. The focus of any national carbon trading schemes is likely to be large industrial energy users, such as those installations regulated under IPPC.

This paper does not aim to map out the future shape of national carbon trading schemes, nor to assess the pros and cons of trading. Rather, the paper seeks to illustrate how the implementation of IPPC energy efficiency requirements could either constrain or facilitate the participation of regulated installations in any trading scheme.

The fact that a trading scheme is not yet in place makes our analysis particularly relevant. Within the EU, the UK in particular is debating the merits of carbon trading. Some UK business leaders are strongly supportive of carbon trading as it provides an attractive alternative to carbon/energy taxes for energy intensive users. BP, for example, are developing an internal system for trading carbon emissions between their refineries, and both the Association of Electricity Producers and the International Petroleum Exchange are advocating the development of a national carbon trading scheme (AEP, 1998; IPE, 1998). Trading was examined as an option in a Treasury study on Economic Instruments and the Business Use of Energy (Her Majesty’s Treasury, 1998) and the government is considering the establishment of a ‘dry run trading pilot’ (Her Majesty’s Customs & Excise, 1999). Hence, whilst our analysis is relevant throughout the EU, the paper focuses on the UK, where discussion on carbon trading is most advanced.

So how would a trading scheme interact with IPPC? And could a trading scheme be bolted onto IPPC as a recent government consultation paper suggests (Department of Environment, Transport & the Regions, 1998, p.18)? Our analysis cannot provide definitive answers, but we do illustrate a process by which policy interaction can be explored. We conclude that the manner in which IPPC is implemented will significantly affect the scope for regulated processes to participate in future carbon trading schemes.

The paper begins with an exploration of the IPPC policy target, namely the character of energy efficiency measures in industry. Improved energy efficiency will lower carbon emissions, both from reduced fossil fuel combustion at the installation and from reducing the demand for imported electricity. Indeed, since carbon emissions cannot be abated like other pollutants, energy efficiency and fuel switching must form the central elements of climate policy. Interaction between IPPC and carbon trading will therefore hinge on the interpretation of the IPPC energy efficiency requirements.

In sections 3 and 4, we analyse the fundamental features of the two policy instruments: first IPPC, then carbon trading. In sections 5 to 8 we evaluate the overlap between the instruments, the potential for interaction and conflict, and the feasibility of operating both in parallel for IPPC regulated installations. This is achieved through the development of three implementation scenarios. The concluding section assesses the conditions and scope for IPPC regulated installations to participate in carbon trading, and the relevance of our analysis to broader issues of policy design.

2: Energy efficiency in industry

Broadly speaking, energy efficiency improvements to industrial processes fall into one of two types. The first type (Type I) are discrete measures dedicated to energy efficiency. These may include, for example, insulation, improved boiler control systems, variable speed drives on electric motors, waste heat recovery, heat pumps and the cogeneration of heat and power. Type I measures can be categorised by the scale of investment, beginning with minor housekeeping measures and moving through low cost engineering/operational improvements, higher cost improvements, investment in new plant with improved performance and finally, investment in new facilities incorporating fundamental changes in the basic technology (Bell, 1990, p12).

The key feature of Type I measures is that their primary purpose is to reduce energy use and energy expenditure. A corollary is that calculating the cost-effectiveness of Type I measures ought to be relatively straightforward - though determining the relevant cost-effective criteria can be problematic, e.g. should we look at private costs and benefits alone or should we include social costs and benefits? With this qualification, it nevertheless seems that Type I energy efficiency improvements are broadly suited to the costs and advantages assessment necessary for the determination of BAT under IPPC (see below).

Type II industrial energy efficiency measures are less straightforward. These are instances in which energy saving is largely a by-product of investment and improvement in process technologies, where the primary motivation is improvement in productivity or product quality. This type of technical change is of fundamental importance. Empirical evidence suggests the historical improvement in the energy intensity of industrial economies has depended as much on these broader changes as on energy specific investments (Bell, 1990; Schipper, 1987). This is the primary reason that energy efficiency has continued to improve when energy prices were low or falling, albeit not as fast as growth in absolute energy consumption. Furthermore, these broader changes result as much from incremental forms of technical and organisational change (learning by doing) as from major investment in new production facilities (Bell, 1990).

The characteristics of Type II measures suggest that calculating their energy efficiency cost-effectiveness is much less straightforward. Given that the primary purpose behind the measure is not energy efficiency but a production investment, how large a proportion of the investment cost do we attribute to our energy efficiency cost-effectiveness calculation? Furthermore, if the savings result from behavioural or organisational change, or from minor engineering improvements, the notion of investment cost may be inappropriate. This suggests that identification of discrete energy costs and savings from Type II measures can be extremely difficult. Consequently, determining cost-effectiveness criteria might be even less straightforward than for Type I measures. Energy savings are made nevertheless and these could reduce carbon emissions from the firm. In a trading scheme, these could ‘free up’ tradable permits for sale outside the company.

3: The regulatory framework for Integrated Pollution Prevention and Control

The IPPC Directive was passed in September 1996. The central thrust of IPPC is multi-media pollution control from major industrial installations, where the aim is to prevent pollution being displaced from one media to another. Included in this is an energy efficiency requirement, introduced during the Directive’s long negotiation, which could have major implications for any carbon reduction policy. Implementation of IPPC will be phased in, sector by sector, beginning in 1999. By 2008 all relevant sectors will be included within IPPC. The scope of the Directive is wide, including energy intensive industrial sectors such as electricity generation, iron and steel, non-ferrous metal, cement, paper and board, and chemicals.

In contrast to trading, IPPC is a bottom-up regulatory regime. The mechanism IPPC uses to achieve emission reductions is a permit regime. Each operator of a prescribed industrial installation must seek a permit containing emission limits and improvement targets to prevent and reduce environmental releases to air, water and land. A prescribed installation cannot operate without this permit which must also take account of efficiency of energy use, consumption of raw materials, and noise.

IPPC contains no overall reduction targets. The negotiation of a permit with a regulator will turn upon the technology-based regulatory principle ‘best available techniques’ (BAT). In practice, BAT is implemented through ‘..emission limit values...... equivalent parameters or technical measures’ (Article 9(3)), where these are understood to be based on the underlying technology-based BAT principle (Article 9(4)). BAT has several precedents in European regulatory practice including: ‘Best Available Technology Not Entailing Excessive Costs’ (the Air Framework Directive); ‘Stand der Technik’ (Germany); and ‘Best Practicable Means’ (UK). A common feature of such principles is that they require a high level of technical competence on behalf of the regulator before they can be effectively implemented. Regulation is thus a hands on process, with the regulator becoming involved in technological decisions.

The European Commission is committed to produce guidance on BAT for each industrial sector in the form of BAT Reference Documents (BREFs), but these will not prescribe the technology to be used in specific cases. In the final analysis, BAT for emissions reduction and energy efficiency must take ‘into account the technical characteristics of the installation concerned, its geographical location and the local environmental conditions’ (Article 9(4)). Thus a distinction must be drawn between generic standards produced for guidance purposes, such as in BREFs, and the local or site specific limits set in individual permits. Some Member States, such as the UK, have a regulatory culture which emphasises negotiation and discretion and which allows local standards to depart significantly from those in the generic guidance. Others, such as Germany, adopt a more standardised approach in which the generic standards are transposed directly into local limits (Boehmer-Christiansen and Skea, 1991).

Member State interpretation of BREF generic standards and the way they relate these to local limits will determine the extent to which regulators and operators can negotiate flexibility. While BREF notes may support greater uniformity of environmental standards, the final decision on BAT limits in each permit is in the hands of the regulator.

There is less scope for flexibility over system boundaries. The unit of regulation is the industrial installation, or ‘technical unit’, carrying out the activities listed in the Directive (Annex I). BAT will apply to fairly fixed industrial installations within industrial sites.

To be successful, IPPC requires that operators and regulators have good information about the technologies used in Annex I activities, their energy efficiency and associated emissions. and the costs and benefits of their use. As regulators move away from reliance on end-of-pipe controls and seek pollution prevention measures (less discrete, more embodied in cleaner production processes) so this knowledge will need to become increasingly detailed. In addition, environmental expertise will be required in order to balance the overall profile of releases to air, water and land. However, there are limits to our scientific knowledge of environmental toxicology, and methods for comparing the impacts of different pollutants are inherently subjective and context dependent (Stirling, 1996). Judgements are therefore necessary, and IPPC provides for the outcome of these judgements (the permit) to be transparent to the public. Procedures must be established for public consultation over an operator’s application for an IPPC permit; and both the permit and the subsequent monitoring records must be placed on a public register (Article 15).

The Directive requires the permits to be reviewed periodically, with the review period being at the discretion of the Member State (Article 13). However, if changes in BAT make it possible to reduce emissions without imposing excessive costs then the permit must be reviewed ‘in any event’. Continuous improvement is therefore required, with the timetable for emission reduction open to negotiation.

Pollution control is, fundamentally, as much a political task as it is a technical task so the public legitimacy for any pollution reduction regime is crucial (Davies and Davies, 1975). For IPPC this will rest on the stringency of the standards in the permits, the adequacy of pollution monitoring, and the credibility of the regulator in detecting and punishing violations. Legitimacy therefore depends on the transparency of the regulatory process and the resources available to the regulator.

Finally, BAT regulation such as IPPC seems primarily suited to encouraging Type I energy efficiency improvements, where costs and benefits can be clearly identified. Type II improvements are much harder to encourage through this type of mechanism.

4: Emissions trading schemes

Traditional responses to pollution problems have frequently been based on fixed emission limits for individual sources. Economists have long criticised such approaches for being unable to control pollution in the most cost effective manner. While it may be cheaper for some sources to control pollution than others, this information may not be known to the regulator. The sources have the required information, but have no incentive to transfer it to the regulator. Economists offer two broad solutions to this dilemma. Pollution may be subject to a tax to ensure that environmental damage costs are reflected in the polluters’ decisions. Or ‘emission allowances’ may be created by the state, allocated or sold to polluters and made tradable. This second instrument is known as emissions trading.

In its simplest form, the operation of an emissions trading scheme is straightforward. Once the political process has determined that a particular level of emissions is acceptable, a fixed number of emission allowances can be allocated to the sources responsible. This allocation may decline in time in a phased manner. Each source must ensure that its emissions are equal to or less than its current allowance holdings. If allowances can be traded, those who face high pollution abatement costs can continue to pollute by buying additional allowances. Those facing low costs can take abatement action and sell their surplus allowances for a profit. In this way, each source can trade off the cost of controlling pollution with the cost of buying or selling allowances. This flexibility allows each source to minimise its overall abatement costs. In practice, the implementation of trading schemes is far from straightforward and success depends heavily on details of the design (Sorrell & Skea, 1999b).

Emissions trading developed in an incremental fashion in the United States as a means of introducing flexibility into an extremely rigid regulatory framework (Sorrell, 1994). While the early schemes met with mixed results, the second generation of US schemes, including the nation-wide Acid Rain Program, have proved highly successful (Ellerman et al, 1999). Attempts to introduce trading in Europe have so far been unsuccessful and have highlighted the conflicts between trading and existing regulatory traditions (Sorrell & Skea, 1999a).

The Kyoto Protocol greatly expands the scope for emissions trading. It provides the framework for an international system of GHG trading between countries with agreed emission targets (Article 17), together with the provision for ‘emission credits’ from projects that reduce GHG emissions in countries without targets (Article 12). While states are responsible for compliance with the Protocol, it is widely accepted that effective trading requires the direct involvement of individual companies. This may either be through individual ‘joint implementation’ projects or through the development of national carbon trading schemes.

In contrast to source specific regimes such as IPPC, trading is a top down regulatory approach. Priority is given to the aggregate target for the sum of emissions from all the regulated sources. The final distribution of emissions between sources is decided through trading in the allowance market. The regulator is concerned solely to ensure that the emissions from each individual source do not exceed their allowance holdings and hence that the overall target is attained.

Flexibility, or cost effectiveness, in a trading scheme is achieved through use of the allowance market. A well functioning market gives scope for cost effective trades with other sources while an extra dimension of flexibility may be introduced through the use of allowance banking. Regulation is then a hands-off process. While the regulator must monitor emissions, track allowance holdings and verify compliance, there is no involvement in individual technology decisions. Similarly, negotiations with the regulator form no part of scheme operation, although negotiations may be of considerable importance during the initial design of the scheme. Disputes over the equity of the initial allowance allocation can create a major obstacle to the introduction of such a scheme (Sorrell, 1999).

Trading schemes are generally confined to a single pollutant in a single media. The Kyoto Protocol is a rare exception to this as, in principle, six different greenhouse gases can be traded using global warming potential (GWP) as the exchange rate. A successful trading scheme requires the pollutants to be readily quantifiable and easily measured, and their environmental effect to be largely independent of the location of the source. Trading schemes do not prevent the displacement of pollution from one media to another and are poorly suited to pollutants having multiple environmental effects. This fact, coupled with other requirements, tends to confine trading to a relatively small number of environmental problems (Klaassen, 1998; Sorrell & Skea, 1999b). Carbon emissions from large point sources satisfy these conditions.

The system boundary of a trading scheme can be flexible. It can be confined to multiple sources at a single site, to multiple sites owned by a single company, to an industrial sector, to a region, or to a national economy. To be fully effective, a domestic carbon trading regime needs to be compatible with the international market in greenhouse gas emissions. A constraint is the need for certainty and predictability in a trading scheme and the difficulty of expanding the scheme once established (Sorrell, 1994, p 129-134; Atkeson, 1997).

Success with a trading scheme depends upon the environmental objective being clearly defined, sufficiently stringent to pose a challenge, and unlikely to be modified for a reasonable period of time. The Kyoto Protocol provides national targets for a ‘budget period’ of 2008-2012. Average annual emissions during this period must be an agreed percentage below 1990 emissions - after adjusting for any international trades. The budget period will be followed by a second when the targets will be reduced. This firm timetable provides a framework for domestic trading schemes.

Trading schemes are transparent in that the overall target and the standards achieved by individual participants are public knowledge. While the allowance price in individual trades may be confidential, an overall market price should emerge. This provides an indication of the cost of emission reduction and hence the stringency of the target.

The legitimacy of a trading scheme hinges on the adequacy of monitoring and enforcement and on the political acceptability of both the pollution target and allowance allocations to individual participants. The inclusion of requirements that trading be ‘..supplemental to domestic action’ (Article 17) within the Kyoto Protocol reflects a basic legitimacy concern: countries should be seen to be doing something at home before engaging in international trade. Similar concerns could lead to restrictions being imposed on the freedom to trade within a domestic trading scheme.

With regard to energy efficiency measures for carbon emissions reduction, an important advantage of instruments such as trading is that they factor considerations about energy efficiency into all business decisions, without the regulator needing to become involved. Trading schemes can therefore encourage both Type I and Type II energy efficiency improvements. Furthermore, trading provides a continuous incentive for technical innovation since efficiency improvements can allow for the profitable sale of surplus allowances.

5: Analysing interaction between the two policy instruments

The previous sections have demonstrated that IPPC and emission trading are fundamentally different policy instruments. The basic features of each are summarised and compared in Table 1 below. Recognising IPPC and trading as different does not mean they are incompatible. However, the scale of the differences suggests that careful implementation is required if conflict between them is to be prevented.

Table 1. A comparison between emissions trading schemes and the IPPC regulatory framework.

Trading

IPPC

US origins

Offset policy first introduced in 1976

European origins

Technology based principles date from the last century.

Economics based

Pollution arises from an absence of well defined property rights. Cost effective control is achieved through issuing a limited number of allowances (rights) to emit which can be freely traded.

Engineering based

Pollution abatement is considered a technological problem, and regulation is designed explicitly to promote cleaner (or clean-up) technologies.

Top down

Basis for pollution control is an aggregate emission reduction target for the whole scheme.

Bottom up

Basis for pollution control is the site-specific BAT for an installation.

Target driven

Overall pollution target, with no specification of individual technologies or emissions standards.

Technology driven

No overall pollution target, beyond the requirement to minimise pollution using BAT

Hands off

Technology decisions are the responsibility of individual firms.

Hands on

Regulator is involved in individual technological decisions.

Wide system boundary

The system under the aggregate emission target can be as wide as a sector, an economy or a geographic region.

Narrow system boundary

BAT limits are set for an individual installation at a single site.

Single substance/media

Usually controls a single polluting substance in a single media. Climate change an exception as there are six greenhouse gases.

Multi substance/media

Controls releases of a wide range of substances to all three media in an integrated manner.

Flexibility via the market

Installation operators can seek flexibility and reduced costs through trading in the allowance market.

Flexibility via negotiations

Installation operators can seek flexibility and reduced costs through BAT negotiations with the site inspector. Scope for this depends on Member State regulatory traditions.

Transparency via the market

Aggregate target, participants’ performance and allowance price are public knowledge.

Transparency via an institutional process

Public can comment on operator applications. Public register of permit conditions and monitoring returns.

Timetable given by budget period

Should be predictable and stable.

Timetable determined by reviews

Regulator periodically reviews and updates permit conditions.

Legitimacy depends on target

Secured through stringency of overall target. Resources sufficient to monitor trades and enforce transgressions are important. Problems with ‘hot air’ and rights to pollute.

Legitimacy depends on implementation

Achieved by public regulator setting individual standards and monitoring specific installations. Regulatory resources sufficient for this task are important.

Given these differences, the following sections explore the conditions under which interaction between the two policy instruments is more or less favourable. The analysis hinges upon the implementation of IPPC, since it is this which will influence the scope for regulated processes to participate in any subsequent trading schemes.

5.1: Overlap between IPPC and trading

A primary question is, to what extent will IPPC (in its present form) overlap with any likely carbon trading scheme? It is important to note that IPPC does not regulate CO2 directly. Instead, energy efficiency forms one of the general obligations on operators (Article 3), and represents one of the considerations to be taken into account when determining BAT (Annex IV). CO2 is not listed in Annex III as one of the substances for which emission limit values are particularly applicable (Article 2(6)). However, the wording of the Directive is such that CO2 emission limits may be justified. Article 2(6) suggests that emission limit values may be assigned for substances not listed in Annex III, while Article 9(4) requires that ‘in all circumstances’ provision should be made for the minimisation of long distance or transboundary pollution. Hence, whilst CO2 is not mentioned explicitly in the Directive, the ambiguity of language permits a range of interpretation - including CO2 emission limits.

The first paragraph of Article 3 requires authorities to ‘ensure that installations are operated in such a way that.... energy is used efficiently’. But the second paragraph modifies this by stating ‘...it shall be sufficient if Member States ensure that the competent authorities take account of the general principles set out in this Article....’. A strict interpretation could be that the Article requires quantitative standards for the amount of energy used, while a loose interpretation could be that authorities must simply ensure that energy efficiency is pursued more broadly. One possible way of achieving this, which is relevant for our purposes, is through participation in a carbon trading scheme.

Table 2 summarises the options available for a quantitative interpretation of the energy efficiency requirements, and the implications of these for different abatement measures. The limits are assumed to apply to the total installation, although limits on individual process technologies are also a possibility. Non-quantitative interpretations could include a requirement to use particular ‘Type 1’ energy efficient technologies.

Table 2 Possible limits on energy use and carbon emissions

Interpretation

Abatement measure

 

Reduce output

Improve energy efficiency

Switch to low carbon fuel

Limit on energy use per unit of output (MJ/unit)

 

 

Limit on total energy use (MJ)

 

Limit on carbon emissions per unit of output (tonnes/unit)

 

Limit on total carbon emissions (tonnes)

Turning to trading, the scope of any national scheme is at present unclear. However, the choice of which sources to include should be governed by a number of principles, including: i) covering as high a percentage of total emissions as possible; ii) keeping the total number of regulated sources to a manageable level; and iii) ensuring adequate methods of measurement, monitoring and verification. A trading scheme linked to the energy intensive IPPC installations scores well under these criteria. As Table 3 indicates, IPPC covers around 1200 installations that are typically considered as energy intensive in the UK. Taken together, these installations account for over half of UK CO2 emissions (Department of Environment, Transport and the Regions, 1997, p.13). The total number of IPPC installations in the UK is around 8000, which is considered administratively feasible for a trading scheme (Festa, 1998) and compares to 2200 installations in the US Acid Rain Program. In addition: IPPC procedures provide a basis for monitoring and verification; the industries are sufficiently large and sophisticated to participate in trade; and some of them are strong supporters of such a scheme. While other criteria for inclusion in a scheme are possible, it seems inevitable there will be significant overlap between IPPC installations and potential trading participants.

Table 3: IPPC installations, energy use and carbon dioxide emissions in the UK1

Sector

Energy used by companies liable to IPPC (PJ)

Energy covered by IPPC, % of sector

Estimated carbon dioxide emissions from IPPC sites (ktC)

Number of installations covered by IPPC2

Iron and steel

289

86

7400

100-120

Non-ferrous metals

30

63

1100

478

Non-metallic metals

3

10

70

15

Bricks

20

95

360

77

Cement

69

100

1600

34

Glass

29

95

600

57

Potteries

3

20

70

8

Chemicals

211

83

5000

333

Mechanical engineering

10

16

290

538

Vehicle engineering

11

16

290

165

Food, drink, tabacco

41

24

850

1597

Textiles, leather, clothing

27

54

650

27

Paper

96

63

2400

99

Plastics and rubber

3

5

80

1

Total manufacturing

 

58

 

3529-3549

Coke ovens

29

100

700

9

Oil refineries

270

100

5600

16

Gas production

189

100

2800

1

Waste

-

-

-

1738

Agricultre

-

-

-

974

Total industry

1330

 

>29860

5293-5313

Source: ETSU (cited in HM Treasury, 1998, p.53)

Notes:
Excludes power stations. England & Wales only


5.2 Interpretation of energy efficiency under IPPC and implications for trading

The ambiguity of the IPPC Directive allows for a wide range of interpretations. Member States have different regulatory traditions with respect to industrial pollution control, and it is likely that each will read the Directive to mean something different. In Germany, for example, standards are applied fairly uniformly - specifying an emissions ceiling for each process which no operator is allowed to exceed (Scharer, 1998). By contrast, the UK tends to publish guidance which the regulator considers to be the best possible - a target to which installation operators should aspire but which they need not necessarily meet (HMIP, 1995, p.1). The final interpretation is an issue, which will be influenced by decisions at four levels:

legal guidance from the Commission;

the content of the BREF notes;

legal interpretations by Member State governments; and

the implementation practice of the relevant regulators.

To overcome uncertainty and variety in the future implementation of IPPC, we analyse the likely interaction with trading under three implementation scenarios. All three scenarios have been suggested in our conversations with policy practitioners in Europe:

A strict interpretation, in which quantitative BAT limits for energy use or carbon emissions are set individually for each site.

A minimalist interpretation, in which energy efficiency is not interpreted as requiring quantitative limits and treated as a secondary consideration under IPPC.

A trading-based interpretation, in which the energy efficiency requirements of IPPC are assumed to be met through participation in a trading scheme. Two alternatives are of particular interest here:

a local BAT allocation scenario, in which site specific BAT assessments are used to guide the initial allocation of carbon allowances; and

a generic BAT allocation scenario, in which generic BAT assessments are used to guide the initial allocation of carbon allowances.

6. Scenario 1: a strict interpretation

The strict interpretation of IPPC is taken to mean a situation in which Member State regulatory authorities require installation operators to achieve locally determined quantitative BAT standards for carbon emissions or energy use. In other words, a regulatory regime in which the costs and advantages for specific installations are determined, and IPPC permit conditions are set which include quantitative limits on carbon emissions or energy use for the installation in question. Specification of BAT limits for energy use require assessment of the full range of energy using and energy conversion technologies at the installation, while BAT limits for carbon require additional decisions on the costs and advantages of switching to fuels with a lower carbon content.

It is important to note that setting quantitative BAT limits for carbon or energy use pose some major practical challenges. These challenges are associated with the nature of energy efficiency measures (Type I and Type II), the variety of installations and their circumstances, and with the information gaps and asymmetries between regulators and regulated. Assuming good information, and depending upon the uniformity of installation technologies in a given sector, it might be possible to set generic BAT standards for energy efficiency. These could appear in the BREF notes or in Member State guidance on IPPC and are most likely to represent Type I efficiency measures. Generic standards differ from the local limits considered here because they do not allow for site specific considerations.

If the BAT standards take the form of a limit on carbon emissions, it is difficult to see how the installation could participate in a trading scheme. To illustrate this, suppose the installation has been allocated a number of carbon allowances and that these sum to less than the current BAT carbon emission limit. Suppose further that the installation is able to operate with this number of allowances. But operating with emissions below the BAT limit immediately signals to the regulator that the BAT determination was wrong in the first place, or has become outdated. If a plant can operate with emissions below its BAT limit then it is clearly using a technology that is both better and affordable. In that case, the BAT limit should be reduced to reflect this. Similarly, suppose the number of carbon allowances sum to more than the current BAT limit. The installation would be unable to make use of this flexibility as increasing emissions above the BAT limit would constitute a violation of the IPPC permit. There is no flexibility for operators struggling to meet carbon limits to buy up allowances from over-complying operators.

This strict BAT scenario has a precedent in the UK government’s aborted attempt to introduce a sulphur trading scheme alongside the existing Integrated Pollution Control regulations (see Box 1). The latter required sulphur emissions to be cut using the BATNEEC principle, which is essentially the same as BAT under IPPC (Skea & Smith, 1997). Strict interpretation of BATNEEC by the regulator prevented a trading scheme from getting off the ground.

[BOX 1)

There is marginally more flexibility if the BAT standards take the form of a limit on energy consumption; however, this is unlikely to be sufficient to accommodate trading. In this situation, energy consumption could remain at the level of the BAT limit but a switch to a lower carbon fuel could reduce the associated carbon emissions. The installation could then profit from the sale of surplus carbon allowances. The same could be achieved through an improvement in energy efficiency, but the incentive to do this is undermined by the existence of the BAT energy limit. Lowering energy consumption is likely to trigger a revision of the BAT limit and a consequent reduction in the operators’ flexibility. Similarly, a switch to a more energy intensive process is precluded, regardless of whether surplus allowances are available in the allowance market.

In summary, if the IPPC energy efficiency requirements are interpreted to mean quantitative limits for energy use or carbon emissions, there is effectively no room for installations to participate in a carbon trading scheme.

7. Scenario 2: a minimalist interpretation

In the second scenario, the IPPC energy efficiency requirements are implemented in a minimalist way. The Directive is interpreted as not requiring specific BAT energy efficiency measures. Instead, the energy efficiency requirements are simply interpreted as ensuring that integrated pollution control measures have no perverse, energy intensifying effects. Regard for energy efficiency then becomes a back-stop measure which may tilt the balance in favour of a lower energy solution to a pollution problem compared with the alternative abatement techniques on offer. Process modifications and improvements will be made to reduce other polluting emissions, but checks will be made to ensure they do not lead to an unjustified increase in energy use.

Such a scenario should leave room for installations to participate in a carbon trading scheme since there would be little prescription in the IPPC permit conditions relating to energy use, and none relating directly to carbon emissions. Thus, carbon trading could operate alongside the IPPC regulation of other pollutants, yet include IPPC installations. Relatively little interaction between IPPC and trading should arise, owing to the clear separation of policy targets between the two policy instruments. IPPC becomes primarily an instrument for non-CO2 pollution control, while carbon trading (or some other instrument) is used to improve industrial energy efficiency.

Member States adopting a minimalist interpretation must be confident that this is a robust interpretation of the Directive. If it seems to stretch interpretation too far then it may prove difficult to sustain, particularly if other Member States, the EU BREF notes, or the Commission decide upon a stricter approach.

Even a minimalist interpretation could create some phenomena of interaction. First, some IPPC regulatory decisions will indirectly affect energy use, thereby restricting an operators flexibility to balance energy costs against allowance prices. This interaction seems both unavoidable and justifiable, and may stimulate the market in some instances by freeing up allowances for sale. Second, the mismatch between the IPPC and Kyoto timetables may create problems. Article 13 of the IPPC Directive requires that permit standards be reviewed periodically, which in the case of the UK is every four years. For practical reasons, different sectors will undergo reviews at different times and these will not be coincident with the reviews of the national targets under the Kyoto Protocol. Regulatory decisions during IPPC reviews may have implications for the subsequent requirement for carbon allowances and it is possible that this may inhibit sources from engaging in trade. Again, if IPPC decisions only affect energy use in a minor and indirect fashion this should not be a crucial issue.

One important point here is that a minimalist interpretation effectively prevents IPPC from becoming a viable instrument for reducing industrial energy use. Some parties may legitimately argue that the widening of the concept of integration that is implied by the energy efficiency requirements is largely invalidated by this form of interpretation.

8. Scenario 3: a trading based interpretation

The third scenario falls somewhere between the alternatives above. Under this interpretation, IPPC energy efficiency obligations are assumed to be met through participation in a carbon trading scheme. No additional obligations are imposed that restrict the flexibility to trade.

The simplest solution would be for all IPPC installations to participate in the trading scheme. If only a portion of installations participate, a decision would still be required on how to interpret the energy efficiency obligations for non-participants.

Interpreting the energy efficiency obligations in this way raises two questions:

what is the overall target under the carbon trading scheme (i.e. how many carbon allowances should be distributed); and

what is the criteria for allowance allocation (i.e. how many allowances should each installation receive)

The first question relates to the overall strategy for meeting a countries’ Kyoto obligations and hence is largely beyond the scope of this paper. However, any climate strategy should give some confidence that the Kyoto targets will be met and should ensure that each sector makes a contribution. In the spirit of trading, the aggregate target in any trading scheme should be related primarily to the Kyoto target. This means that, in principle, the allowance allocations to each installation could be more or less stringent than implied by site specific BAT determinations.

The second question is where the interaction between IPPC and trading could potentially be beneficial. This is because the IPPC BAT determinations could provide benchmarks that may help resolve the issue of initial allowance allocation.

Allocation decisions are typically presented as a choice between distributing allowances free on the basis of historic emissions (grandfathering), or selling allowances in an auction. While auctions are economically efficient, the revenue transfers involved tend to make them politically difficult. Grandfathering avoids this problem, but tends to penalise those installations that have reduced emissions already while rewarding those that have not. To avoid this, existing trading schemes have used some form of benchmarking, where allowance allocation is not directly related to historic emissions. For example, the US Acid Rain Program distributed allowances according to a formula based on historic fuel consumption multiplied by an emission factor. Such formulae are typically combined with extensive negotiations over concessions and bonus allowances (Sorrell, 1994, pp 83-85). The attraction of using BAT assessments in a benchmarking formula is that they include explicit consideration of costs and advantages and thereby address equity concerns. They also provide a direct link to the IPPC framework. Indeed, such an approach has been suggested in recent consultation documents from the UK Treasury (HM Treasury, 1998, p10) and the Department of the Environment, Transport and the Regions (1998).

There are two broad possibilities for BAT benchmarking:.

8.1 Scenario 3a: Local BAT benchmarking

Here, initial site specific BAT assessments for carbon emissions are made at each installation. The BAT assessments are then used to apportion a share of the total number of allowances between each installation. The aggregate carbon limit itself (total number of allowances) is defined separately, in relation to the Kyoto targets. The site-specific BAT assessment provides a benchmark, but the installation is not required to comply with this benchmark subsequently. Instead, the benchmark is used as one element of an allocation formula for carbon allowances. IPPC thus becomes the vehicle for allowance allocation in the trading scheme.

This scenario represents a more radical departure from the intent of IPPC than the previous scenarios. It may therefore prove harder to provide adequate legal justification. It also suffers from a fundamental drawback. The use of locally determined BAT limits for allocation negates the important ‘hands off’ benefit of trading schemes - avoiding the regulator getting into the details of assessing BAT. The proposal therefore compounds the cost of making local BAT determinations with the cost of administering a trading scheme.

8.2 Scenario 3b: Generic BAT benchmarking

The second option is similar to that above, but avoids some of the associated problems. Here generic BAT standards rather than local limits become the basis for allocation. Industrial sectors in which installation technologies are fairly homogenous, such as cement and steel, may be amenable to the development of generic BAT standards. Carbon allowances could then be allocated using a formula of the form (Skea et al, 1998) :

plant capacity (tonnes) *

generic BAT standard for energy intensity (GJ/tonne)*

carbon intensity (tonnes CO2/GJ) *

sectoral adjustment factor (linked to Kyoto targets)

Hence, whilst local BAT limits could prove too burdensome for allocation purposes, generic BAT standards, which might appear in BREFs or national documents, could be a suitable allocation vehicle in certain sectors. Of course, not all sectors have installation technologies sufficiently homogenous to facilitate generic standards. In such sectors recourse to grandfathering and other allocation formulae may have to be made. No doubt the final allocation process will involve a pragmatic mix of benchmarking, grandfathering, negotiation and auctions. The process will inevitably be protracted and contentious as different operators lobby for their sector to be allocated carbon allowances according to their preferred methodology.

The attraction of this scenario is its use of information generated by the IPPC process to facilitate a trading scheme, while avoiding the additional burden of site level BAT assessments. The allocation formula includes consideration of costs and advantages at the generic process level, but not at the site level. Individual companies may dispute the allocation formula, but in principle will have unrestricted freedom to trade.

With both options: a) the energy efficiency obligations of IPPC are assumed to be ensured through participation in a trading scheme; and b) the stringency of the overall target under this scheme is linked to the Kyoto targets. Whether this provides adequate assurance that the IPPC energy efficiency obligations have been met is a matter for legal judgement.

9. Factors influencing the choice of implementation scenario

The regulatory cultures and traditions in each Member State will have an important influence on how each interprets and implements the IPPC Directive. But the European Commission will also play an influential role. First, the interpretation of the energy efficiency requirements in the BREF notes may restrict the scope for Member State flexibility. A minimalist interpretation may be particularly difficult to sustain if the BREF notes suggest BAT standards for energy efficiency. Early draft BREFs do not set BAT standards for energy efficiency, so such a constraint appears unlikely. Second, the scope for trading could be enhanced if the Commission were to clarify the legal conditions under which it may operate. Useful precedents here include the recent Communication on the use of environmental agreements (COM (96) 561 final), and the Communication on environmental taxes, charges and levies in the Single Market (COM (97) 9).

Third, the relative roles assigned to IPPC and flexible mechanisms in the EU Post-Kyoto strategy will be highly influential. The current Communication advocates a step-by-step approach to flexible mechanisms, sees a role for an EC wide approach to emissions trading, and makes no mention of IPPC (COM (98) 353). However, the conclusions of a June 1998 Environment Council meeting on a Community Strategy on Climate Change noted that significant emission reductions could be achieved through the ‘...more widespread adoption of current energy efficiency best practice, in particular taking into account the application of Best Available Techniques as provided for under the IPPC Directive’ (Council of the European Union, 1998).

At the Member State level, a factor of primary importance is the national regulatory culture and in particular the balance between uniform or more flexible approaches. The level and quality of resources available to regulators is also crucial (Smith, 1997). Staff, information, time, political support, and other resources have to be sufficiently available for regulators to undertake their activities. If any one of these is limited then the scope and boundaries of interpretation may also be limited. So, for example, it may not be possible to take a strict, BAT interpretation of the IPPC energy efficiency requirement because the regulator is ill-equipped, and resources dictate a more minimalist interpretation. This resource issue is important for the success of IPPC alone, quite apart from trading.

10. Conclusion

The nature of the interaction between IPPC and carbon trading will hinge on the interpretation of the IPPC energy efficiency requirements. This paper identifies some tensions between the two policy instruments, but practitioners are only beginning to appreciate that these tensions exist.

By considering three possible scenarios for the implementation of IPPC, it has been possible to identify how these tensions vary in quality and magnitude. The following conclusions may be drawn:

IPPC and carbon trading are fundamentally different regulatory approaches. Both aim, either directly or indirectly, to improve industrial energy efficiency. Some interaction between them is inevitable, and the IPPC energy efficiency requirements must be interpreted carefully if the interaction is to be positive.

IPPC is primarily suited to the promotion of discrete, Type I energy efficiency measures. The advantage of trading mechanisms is that they can promote both Type I and Type II efficiency gains.

The energy efficiency requirements within the IPPC Directive potentially constrains the full participation of regulated installations in a trading scheme. Participation will be impossible if the BAT requirements are interpreted in a strict, quantitative manner. Fuller participation may be viable if either:

the IPPC energy efficiency requirements are interpreted in a minimalist way (scenario 2); or

the energy efficiency requirements are assumed to be met through participation in a trading scheme (scenario 3).

The generic BAT standards developed under IPPC may facilitate allowance allocation. In contrast, the use of local BAT standards for allocation would entail unnecessary administrative effort.

While generic BAT standards could be used to assist allowance allocation, the total number of allowances should be linked to the Kyoto targets. This means that, in scenario 3 above, the required energy efficiency of IPPC installations will be linked to the Kyoto targets rather than BAT determinations. This may pose a challenge to the legal interpretation of IPPC.

A minimalist interpretation of the energy efficiency requirements may still interact with a trading scheme owing to the indirect energy consequences of other pollution control measures.

The IPPC/trading case highlights a broader conflict between integrated approaches to environmental problems and market based policy instruments. Both are advocated as solutions to problems associated with earlier regulatory instruments and both are increasingly represented in European environmental policy. But neither are appropriate in all situations. Principles such as BAT are suited to complex regulatory situations where a large number of chemical compounds are emitted from many different release points. These represent the most common situations encountered under IPPC and would be impossible to handle with emissions taxes or tradable permits. But for point source emissions of a single pollutant into a single medium, market based instruments can have significant advantages. Carbon dioxide emissions is one area where emissions trading seems particularly appropriate and where the framework created by the Kyoto Protocol offers significant opportunities. This opportunity may be undermined if the potential interaction with IPPC is not addressed at an early stage.

Integration is required in policy design to in the sense that the pursuit of one objective does not undermine another. To do this we need a collection of policy instruments that target effectively the desired policy objectives. This IPPC/trading case study illustrates how important it is to view the collection of policy instruments together. In assessing the scope for interaction it is necessary to identify the nature of the target objective (energy efficiency in this case); the features and dynamics of the relevant policy instruments; and the conditions for positive and negative interaction. It seems certain that as policy attempts to deliver sustainability grow, so the issue of interaction will grow too.

ACKNOWLEDGEMENTS

The authors are grateful to a number of SPRU colleagues for helpful comments, including Frans Berkhout, Malcolm Eames, Kath Kidd, Jim Skea and Jim Watson. Thanks also to Chris Hewitt, Martin O’Connor and an anonymous referee.

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Box 1 The UK experience with sulphur trading

Under the EU Large Combustion Plant Directive (LCPD), the UK was obliged to reduce the total volume of sulphur emissions from large combustion plants in industry, oil refining and electricity generation. Implementation took the form of annual emissions quotas assigned to individual sectors within each country (England, Scotland, Wales, Northern Ireland), followed by the distribution of quotas to combustion plant within each sector. At the same time, combustion plants were required to meet BATNEEC standards under the UK system of Integrated Pollution Control (IPC). BATNEEC was typically interpreted as an annual emissions limit (the BATNEEC limit) and the plants were required to submit an upgrading program to demonstrate how emissions could be reduced in the future.

The original quota allocation lead to some plants being constrained while the UK overall was well within its target. To prevent this, the government proposed a system of emissions trading in which plants could trade quotas in order to reduce the cost of abatement. For trading to work under this system, the BATNEEC limits would have to act as an overall emissions ceiling which was set some way above the quota allocation to allow room for trade. But if the ceiling exceeded current emissions, it did not represent the ‘best’ that was achievable. Giving priority to tradable quotas rather than BATNEEC was difficult to justify under IPC legislation and represented a reversal of traditional regulatory practice. With the regulator claiming that a strict interpretation of BATNEEC was necessary, the government was forced to conclude that any trading scheme would be redundant as there would be no room left for trade.

Electricity generators were given a limited form of flexibility, analogous to trading, through the use of company emission bubbles. But this flexibility was radically reduced by the stringent emissions reductions required by the IPC upgrading program. These went substantially further than was required for the UK to meet its international obligations and followed the IPC timetable rather than that required for the LCPD. Again, the site specific interpretation of BATNEEC took priority over aggregate targets and the proposed trading regime.

The UK experience demonstrates clearly that emissions trading cannot coexist with a strict interpretation of regulatory principles such as BAT.

 

   

 

    
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