The cost of carbon targets

While the macroeconomic crisis is all-consuming, there are other important economic policy issues on the agenda. Let me add to Richard Tol’s earlier post on the implications of the EU‘s Climate Change and Energy package formally adopted in December 2008. This sets demanding targets for reductions in Irish greenhouse gas emissions by 2020, and particularly for the non-ETS sector of which Irish agriculture is a major part. How agriculture, and the non-ETS sector generally, is to meet these targets remains largely uncharted. The targets, and the policies implemented to meet them, will have major economic implications over the next decade. Like Richard, I agree that achieving the non-ETS targets for Ireland set out in the Effort Sharing Directive agreed in December 2008 now looks to be considerably less costly than earlier thought.

Briefly, the overall EU target is to reduce greenhouse gas emissions by 20% compared to 1990 levels, and this could be increased to 30% if there is a satisfactory agreement at the Copenhagen climate change conference at the end of this year.

This overall target is divided between the ‘trading’ sector (those sectors and large firms involved in the EU’s Emissions Trading System ETS) and the non-ETS sector.  The latter, which largely comprises transport, small industrial and service firms, agriculture, residential and the waste sector, has an overall reduction target of 10% over 2005 levels, which is differentiated by member state. Ireland’s non-ETS sector reduction target is 20% by 2020 over 2005 levels.

The composition of expected GHG emissions by non-ETS sectors in 2020 is shown in the EPA’s latest projections (September 2008) under three different scenarios. The ‘baseline’ scenario is based on an energy demand forecast produced by Sustainable Energy Ireland in 2007 and includes measures and policies which were legislatively provided for up to the end of 2006. The ‘with measures’ scenario includes existing measures in the National Climate Change Strategy which could not be included in the baseline. The ‘additional measures’ scenario builds in the measures foreseen in the Energy White Paper and the Energy Efficiency Action Plan. The key point is that agriculture and transport together account for 70-78% of total non-ETS emissions under all scenarios. The overall target for 2020 (with targets following a path of linear reductions from 2013 on) is 37.9Mt CO2eq.

There are two important questions about this target. The first is how difficult it is going to be to achieve it, and the second is how best to incentivise the non-ETS sectors to meet this target at minimum cost. I address the first question in this post.

The EPA projections contain an estimate of the likely ‘distance to target’ in 2020 under each of the scenarios. Under the baseline scenario, the distance to target would be 15.4 Mt CO2eq, or an overshoot of 41%.  However, under the ‘additional measures’ scenario, the distance to target reduces to 7.0 Mt C02eq, or an overshoot of just over 18%.

These targets appear very demanding, as the ‘additional measures’ scenario includes policies which some observers are sceptical about our ability to achieve. For example, it assumes:

• Energy efficiency increases in the industrial and services sectors in line with the Energy Efficiency Action Plan
• 12% of thermal heat to come from renewables (RES-H) by 2020 (this compares to around 1% currently)
• The Landfill Directive targets for the diversion of biodegradable waste from landfill are progressively met.
• Biofuels contribute 10% of all road transport fuel use by 2020 with significant GHG savings.
• In the residential sector, all of the relevant measures outlined in the Energy Efficiency Action Plan, which includes new building regulations, an insulation scheme and technologies for existing homes, are assumed to be adopted and implemented on time and, in addition, to deliver the emissions savings anticipated in the Action Plan.

On the other hand, there are a number of areas where the ‘distance to target’ in the projections may be overstated:

• Most obviously, the growth rate targets underlying the baseline scenario may now be too high. The GDP growth rates assumed were on average 4.2% between 2005 and 2010, 3.1% between 2010 and 2015, and 3.2% between 2015 and 2020.
• Second, there will be a change in the treatment of forestry under the EU’s Effort Sharing Directive. Currently, the EU does not recognise forest sinks although they can be included in GHG accounting balances under the Kyoto Agreement. However, the Effort Sharing Directive states that forestry (as well as land use and land use change) emissions and removals should be included on the basis of the rules resulting from the Copenhagen conference and, if the conference is unsuccessful, in any event no later than 2013. The EPA projects that including afforestation could reduce the distance to target by 4.7 MT CO2eq. However, this assumes that rates of afforestation increase from 7-8,000 hectares achieved in 2006 and 2007 to 15,000 hectares per annum over the period 2006-2020.
• Third, Teagasc has recently reduced its projections of agricultural emissions below those used by the EPA. The EPA projections assumed that emissions would increase by 3% over the period 2006-2020 to 19.9 Mt CO2eq. Teagasc has now reduced its projected 2020 emissions under what it calls its Reference Scenario to 17.3 Mt CO2eq, thus reducing the distance to target by 2.6 Mt C02eq. Even the Reference Scenario is likely to be overstated, as it assumes no WTO trade deal and the continuation of the Single Farm Payment at its current levels to 2020.  If either of these assumptions were not met, further reductions in cattle numbers over and beyond those projected in the Reference Scenario would occur. It is important to highlight that, in the EPA projections, any change in agricultural emissions is assumed to arise from agricultural policy changes solely. No specific climate change measures have been proposed and, if they were, these would lead to a further reduction in agricultural emissions. In part, this is because of the difficulty in monitoring and verifying reduction in diffuse emissions from the agricultural sector. In part, it is because land use and land use change emissions and removals are not currently recognised in the EU framework.

Finally, new flexibilities were introduced into the Effort Sharing Directive as adopted as compared to the Commission’s initial proposals. Apart from temporal flexibility (the ability to move unused allocations forward or back one year to help meet the target in any year over the 2013 to 2020 period), there will also be geographical flexibility. That is, those Member States required to reduce emissions in the non-ETS sectors can purchase up to 5% of the non-ETS emission allocation of any other Member State (provided that these MS would still be able to respect their new, lower targets) and use this purchase to fulfil its obligations either in that year or in any subsequent years up to 2020 – thus these trades are not unrestricted as Richard suggests in his post). These transfers can be made in any mutually convenient manner, including via auctions, the use of market intermediaries or by way of a bilateral arrangement.

This is clearly an important flexibility for Ireland with a relatively small emission allocation requirement relative to the rest of the EU. How important will depend on whether any MS emerge as potential net sellers. Richard points out that Poland, the Czech Republic and Bulgaria have all been given emission allocations much higher than they can hope to emit, so there should be a ready supply of emission rights available from these countries. On the demand side, of course, there may be other countries also looking to use this flexibility.  Richard suggests that the marginal cost of non-ETS carbon will be €30/tCO2, but I am not sure how we can establish this at this stage.

Taking these various elements into account suggests that the 20% reduction target for the non-ETS sectors, while stringent, may well be achievable at relatively low cost. The critical element is likely to be the growth rate of transport emissions which are expected to slow significantly in the EPA projections compared to their growth in the period 1990 through 2006. Raising the target further in the wake of an international agreement at the Copenhagen climate change conference at end-2009 would raise the bar considerably and all bets would be off.