New entrants rules

Nevertheless, the devolution of allocation responsibilities does cause significant problems. The most notable area is with respect to new-entrant rules, where free allocation forms a subsidy to new investments. This raises the prospect of a race to the bottom as Member States compete to attract investment - though such subsidies are usually at a macroeconomic cost, in this case exacerbated by the need to then cut back emissions more elsewhere in the economy (or to buy international credits) to comply with Kyoto targets. 

The details of allocation methods matter new entrant, closure, and incumbent allocation rules all affect the incentives, pricing and efficiency of the scheme. 

Most phase I NAPs provide for NE allocations based on a general emission rate and predicted activity level. For example in The Netherlands (NL), new entrants are allocated allowances based on projected output or fixed cap factor multiplied by uniform emission rate in line with that of a combined-cycle gas turbine (CCGT). In France, Germany and Poland, C02-intensive power generators, such as coal-fired installations, receive the highest number of allowances per kW installed. The literature highlights the risk that NE provisions can create distortions (Harrison and Radov, 2002). In order to illustrate how these rules can impact electricity prices and C02 emissions in our GB simulations, we focus on two approaches one based on a uniform benchmark and one based on a fuel-specific benchmark. In both cases the forecast capacity factor of new entrants is fixed at 60%. 

This article illustrates the set of distortions that can result from allocation of C02 allowances to existing facilities and new entrants in the form of closure rules where allocation is lost once the facility shuts down, updating where allocation in forthcoming compliance periods is a function of generation or emissions levels today, and allocations to new entrants based on different benchmarks. 

Finally the allocation method - notably the updating criteria, the treatment of new entrants and the closure rules - turns out to be a variable of importance to determine the competitiveness impacts and the C02 emissions reduction achieved at the world level under the EU ETS. 

Meanwhile, proposals to introduce uniform allocation to all new entrants in the electricity sector (on a per kW or per kWh basis), without reference to whether or not they qualify as installations under the current EU ETS Directive, would seem to be inconsistent with the Directive in its present form. The combination of Article 3(e) and Annex I of the Directive require installations to perform certain activities if they are to be covered by the Directive, and in the energy sector this only relates to combustion installations with a rated thermal output exceeding 20 MW . Amendment of these provisions would require legislation (see Section 4.2.3). Such uniform allocation to new entrants could alleviate some of the difficulties of selectivity created by free allocation under the present regime, as it would not reserve the pass-through of opportunity costs to installations covered by the EU ETS. However, careful attention would need to be paid to the proportionality of such allocation in order to satisfy State aid rules (see Section 3.3.2.1). 

Additionally, if the rules provide for higher allocations to dirtier new entrants, then entrants have an incentive to construct more carbon-intensive facilities than is economically efficient. 

Another major challenge in designing the first plans relates to new entrants and closure rules. Again on this aspect the Directive does not give much guidance and leaves it to national discretion whether to build a new entrants reserve and how to do so as well as whether to continue to allocate allowances to installations closed during the trading period. 

Ex-post adjustments in many variants were also disallowed in more than half of the plans. The national allocation decision based on the plan as approved by the Commission has a final and irreversible character. This implies that neither the total number of allowances nor the quantities indicated in the notified plan and the final allocation decision may be revised ex post. A number of notified allocation plans had various provisions that would possibly result in ex-post adjustments of allowances allocated to individual installations. A few examples in the Dutch plan it was intended that any allowances not allocated to newly constructed installations out of the new entrants reserve would be distributed pro rata to installations listed in the plan towards the end of the trading period. In several plans it was intended that the allowances allocated to an installation would be curtailed, in case the installation was found to emit less than a certain percentage of its baseline emissions or allocation in a given year.17 These examples demonstrate that ex-post adjustments were intended both upwards (increasing the allocation of an installation) and downwards (reducing the allocation of an installation). Most intended ex-post adjustments were rule-based, i.e. the circumstances under which they would be applied and the exact character were laid down in abstract terms in the plan. 

The rules for new entrants, expansion of existing capacity and closures were developed during the spring and summer of 2004. 

Formulas for new entrants. For most sectors, the rules for new entrants were tied to the addition of capacity (whether to a new site or an existing site) of the covered activity explicitly referred to in the Directive. This meant that certain types of capacity expansion (for example de-bottlenecking at chemicals installations) would not qualify for new entrant allocations.9 The basic formula used for new entrants in most sectors can be summarised as follows ... 

Benchmarks for 2003 facilities. The benchmarks developed for new entrants were also used to calculate allocations to incumbent sites that began operation in 2003, but for which insufficient data were available to apply the drop minimum rule. However, allowances for these sites are not deducted from the new entrants reserve. Instead they are deducted from the residual sector allocations available to other incumbents, before the incumbent emissions are divided among sites for which sufficient historical data were available. 

One area where concerns about harmonisation may have played a very significant role is in the development of the rules for new entrants and closure. Providing a new entrants reserve seemed necessary in light of competitive concerns. Many industry representatives in the UK expressed concerns about the potential implications for UK competitiveness if the UK did not provide for a new entrants reserve when other Member States were planning to do so and when other non-EU competitors would not face any mandatory CO2 constraints at all. New entrant benchmarks were developed to be consistent with best practice. This meant that certain types of technologies or fuels would not receive as high an allocation as they would need to cover all emissions -for example, all power stations would receive an allocation based on natural gas, even if they used a different fuel. 

There are three general rules for the allocation for new entrants, mostly resulting from the (preliminary) political discussion, but also from the affected companies themselves ... 

It became clear, however, that such an approach could only be partially implemented within the political process. Ultimately, the effective compliance factor, i.e. the relation between the allocated allowances and the historical emissions of the base period, played the central role in all of the negotiations. In order to meet the maximum fulfilment factor of 0.97, which constituted the political target, special allocation rules were modified on the one hand (e.g. a reduction of the special allocation for CHP), and the new entrants reserve was reduced on the other hand. Furthermore, the aggregated emission cap for the pilot phase 2005-2007 was increased. Nevertheless, contrary to the stated political objective, the underestimation of the effects of the flexibilisa-tion option finally led, to rise up to a 0.926 of the effective compliance factor for the affected plants. 

The reality of a multi-period emissions trading scheme with free allocation for new installations in connection with the (mainly policy-driven) attempt to avoid shut-down premiums for plant closure demonstrates that the allocation rules could have a considerable influence upon the efficiency of the emission trading system. As a result of differentiated new plant allocations, as well as a series of ex-post adjustments, an erosion in the CO2 price signal for operational or investment decisions by the economic entities within the scope of the EU ETS could arise. The development of the allocation provisions for new entrants is one of the key decisions for future NAPs. 

The easy way to allocate allowances to new entrants23 is to allocate no allowances. This would mean that new entrants meet the full environmental costs of their investment decisions. Though many experts would agree to this in principle, most NAPs ended up with a large number of rather complicated - and not harmonised - rules for allocation to new entrants. 

There is a problem in having different allocation rules for incumbents and new entrants. For example, new entrants in the energy sector will receive a smaller allocation than the corresponding plants that were built before 2002 (O. Hansen, pers. comm.). 

The allocation process has demonstrated that some issues may need tighter rules/harmonisation, in particular the transparency of capsetting and projections calculations, harmonised rules for allocation to new entrants, for the treatment of closures and for the use of auction and requirements on data quality and verification. 

Hungary s NAP is not among the most complex NAPs, but it has some solutions that are somewhat unwieldy to implement. This is true in particular with respect to the evaluation of the planned emissions of new entrants, and with respect to the distribution of the early action reserve. The development of implementation provisions for these rules requires much more time and effort than would by justified by their significance. Smaller Member States in particular cannot afford to spend too many resources on the development of rules. An important lesson is to strive for simpler allocation rules wherever possible. 

The sub-section on basic allocation briefly mentioned that these reference emissions could be modified under specific circumstances for two reasons. First, the two years with the highest emissions in the period 2000-2002 were used for installations that had become operational in 1999, while for installations that had become operational in 2000, the corresponding two years in the period 2001-2003 were used. The year with the highest emissions in the period 2002-2003 was used for installations that had become operational in 2001. For such installations, REj therefore equals the emissions in that year. For installations that had become operational in 2002, REj is equal to the emissions in 2003. For installations that had become operational in 2003 and 2004, allowances were allocated in accordance with the rules for new entrants from the reserve for new entrants. 

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