EU EAGER TO WORK WITH U.S. ON CAP AND TRADE SYSTEMS

UNCLAS SECTION 01 OF 04 BRUSSELS 000259

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SUBJECT: EU EAGER TO WORK WITH U.S. ON CAP AND TRADE SYSTEMS

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USEU would like to thank Embassy London for its assistance in
preparing this cable.


1. (SBU) Summary: EU Commission officials, industry reps,
climate traders, and NGOs, are eager for a U.S. cap and trade
system and anxious to share their experiences on the 2008
revision process of the EU,s Emissions Trading Scheme (ETS).
Seeking U.S. leadership on climate change, all aspire to a
global carbon market, commencing with a common transatlantic
market. Thus, the EU Commission is pushing to establish a
U.S.-EU task-force to explore ways to link the ETS with a
U.S. cap and trade system. The overwhelming consensus is that
once a transatlantic market is established, the other major
economies will join. The main recommendations for developing
a cap and trade system, according to the different groups:

-- any carbon market should aim to "reward the efficient
and penalize the inefficient," drive technology development,
and foster sustainable growth in developing economies;

-- there are three keys to linking systems: (1) the
ambition level of the caps must be compatible, including the
distribution system for emissions allowances; (2) limiting
safety valves or price floors in the carbon price; and (3)
comparable level of quality and quantity of offsets;

-- in the absence of an international agreement, there
will be continuing pressure to level the playing field
vis-a-vis imports if industries in other countries are not
required to purchase carbon credits. End Summary.

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EU anxious for U.S. to take leadership role
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2. (SBU) Following the December 2008 enactment of its
comprehensive internal climate legislation, the EU has now
set its sights on the U.S. One component of the EU's Climate
and Energy package was the revision of its emissions trading
scheme (ETS) and the extension to its third phase. (Note:
ETS entered in force in 2005 and phase I ran from 2005 to
2008, phase II runs from 2008 to 2012, and phase III
commences in 2013. End note.) As we consider whether to
develop our own cap and trade system, Europeans are eager to
engage us in hope of eventually linking the two systems, so
much so, that the EU has proposed a U.S.-EU task force on
carbon markets.


3. (SBU) EU leaders, such as Commission President Barroso,
Environment Commissioner Dimas, and several parliamentarians
are anxious for the U.S. to resume the leadership role on
climate. "The EU wants the U.S. back in the mix," said MEP
Avril Doyle (EPP-ED, IR) the rapporteur for the ETS
legislation. "The U.S. should be leading world debate."
However, the EU defines the global climate agreement as
distinct from the development of a global carbon market. The
former, as it argues in the recent Communication on the
Copenhagen process, should be handled under the UN Framework.
(Note: The EU,s objectives for Copenhagen are: (1)
mitigation targets, (2) financing mechanisms, and (3)
international offsets. End note.) Linking carbon markets, on
the other hand, is a critical aspect to addressing climate
change, but should be handled under bilateral and other
multilateral processes. Indeed, Robert Stavins, co-chair of
Harvard's Project on International Climate Agreements, told
us that even if no agreement is reached in Copenhagen, an
international carbon trading system would suffice. The
EU's ultimate goal is a global carbon market, but one that is
led by an OECD-wide market, preferably by 2015. EU leaders
view the ETS as global model to which other schemes can be
docked and see the U.S. as a natural partner. Germany's
foreign minister Steinmeier has called for a "powerful new
trans-Atlantic (carbon) market." Doyle said the "U.S. and EU
can provide the building blocks for an international system."
Combined, "our leverage will be irresistible to countries
that seek to trade with us."

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EU realizes difficulty in designing a system
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4. (SBU) Despite their (over)eagerness to have the U.S.
rejoin the fold, the Europeans realize that designing a cap
and trade system is a time consuming, complex process. In
this respect, they are anxious to share their experiences.
"We identified a lot of problems during the second phase,
especially allocation of credits, carbon leakage and affect
on jobs," said Dimas. A report prepared for the Parliament

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cited a number of deficiencies in the first two phases of
ETS, notably over allocation of credits, distortion in the
allocations to member states and windfall profits for the
power sector.


5. (SBU) Doyle said the first objective is to "establish a
functioning carbon market" with participation by the
political, scientific, and industrial communities. She
stressed the importance of buy-in from the latter: "let
industry know the government will support it through the
transition. There is no need to go for the jugular at the
outset; the legislation can be strengthened in the future."
Industry representatives stressed the need for incentives to
develop technology. NGO representatives agreed, urging that
new legislation "reward the efficient and penalize the
inefficient." Sanjeev Kuma of WWF said cap and trade
legislation should "drive technology, reduce emissions, and
build capacity in developing countries."

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If the U.S. leads, others will follow
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6. (SBU) Government and industry leaders alike believe a
transatlantic carbon market would open the way to a global
market. Dimas predicted that if the U.S. and EU link trading
systems, Australia and Japan would quickly enter. The
general consensus is that China would be compelled to join a
U.S.-EU based carbon market. Jill Duggan of the UK's
Department of Energy and Climate predicted that China would
enter such a market within ten years of its inception, but
without U.S. participation, China would be less inclined.
Duggan said that linked systems would "provide more certainty
and stability for industry." Industry representatives
concurred, stating that a global system would provide a level
playing field, minimize trade barriers, and encourage Russia,
China, and the Middle East to follow suit. In addition to
attracting emerging economies and diversifying abatement
options, linkage would increase the scale of the market,
improve the liquidity of carbon credits, and more efficiently
allocate resources.

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Linking requires substantial coordination
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7. (SBU) Linking the EU's ETS with a U.S. cap and trade
system may sound ideal in the abstract, but several
complications could arise should U.S. legislation be enacted.
Thus, understanding the differences between schemes will be
necessary to determine the expediency of linkage.
Government, industry, and NGO officials are in general
agreement that there are three keys to linking systems.
First and foremost, the ambition level of the caps must be
compatible. Too large a divergence will cause a large
fluctuation in market prices and drive allowances in one
direction. Second, the existence of safety valves or price
floors in one system where none exist in the other could
provide a "money printing machine" for one of the economies.
Finally, the quality and quantity of offsets must be
comparable. If it is too easy to gain credit through
offsets, the carbon price will be driven by one market, again
causing an imbalance.


8. (SBU) Setting the emissions cap will be a key component of
the U.S. system that will impact the prospects for linkage.
The EU learned the hard way during the early phases of the
ETS by establishing an emissions cap that was too high to
stimulate reductions. The EU based its initial cap on
"business-as-usual" predictions without factoring in other
considerations such as economic growth/decline and fuel
costs. At the time, it also had to deal with limitations on
available data and intense lobbying by affected sectors. The
result was an early flood of carbon allowances in the market
and a sharp decline in their price. Targets should be based
on historical data for emissions over an extended period and
should use the best available technology as the baseline.


9. (SBU) Complications could arise if the margin between the
market prices is too great. Market prices will be greatly
influenced by the emissions cap, the amount of credits and
manner in which they are distributed, and any
cost-containment measures. Other factors to be considered
include offsets and trade restrictions, such as border
adjustment measures (BAMs). Nevertheless, Dimas said "once
the U.S. system is designed, we will cooperate to link them."
Doyle and Duggan concurred, noting that the EU institutions
would work to harmonize the ETS with U.S. legislation.

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Indeed, the EU Parliament commissioned a study for this very
purpose. In the meantime, EU officials will seek to
influence the U.S. legislative process to encourage the
highest degree of compatibility. Duggan said an
internationally compatible system is in the interests of the
U.S.


10. (SBU) Another aspect our European colleagues will follow
closely is the distribution and handling of emissions
allowances, which has been a contentious issue for the EU.
It began during the early phases of the ETS, when power
companies were given free allowances to help ease what Duggan
termed "the burden of compliance." Given the inflated cap,
the power companies reaped windfall profits from increased
rates passed on to consumers and revenues from the free
emissions credits. This led to a debate over whether credits
should be given away or auctioned. Doyle acknowledged that
the EU was under political pressure to provide power
companies with free credits, most recently by the
coal-dependent, eastern member states. Notwithstanding the
influence of regulated sectors to receive free credits,
traders Neil Eckerts of the Climate Exchange and Patrick
Birley of the European Climate Exchange advocated for the
U.S. to issue free credits. Birley compared emissions caps
to a tax and likened auctioning of credits to a double tax on
businesses. He said credits should be provided except where
the covered emitter has a monopoly. In theory, free credits
would stem carbon leakage, but there is a risk that companies
would sell the credits and relocate operations to a cap-free
jurisdiction.


11. (SBU) Proponents of auctions contend they are necessary
to abate emissions and promote innovation. Chris Leeds of
Barclay's Bank said that if companies must purchase emissions
allowances, they will purchase what they need and seek to
reduce emissions to cut costs. If the allowances are free,
they will gobble up what they can get, eliminating incentives
to reduce emissions. Many business representatives adamantly
advocated the "polluter pay principle"; "don't reward dirty
companies" they urged, citing the example of the power
companies. Doyle said that auctions, while imposing costs on
businesses, generate revenues which can be used to offset
costs to consumers or fund new technologies. The third phase
of the ETS will combine auctioning with free credits for
certain sectors. If the U.S. were to implement an auction
only scheme, a Commission official said the EU would revert
to a total auction scheme if the two were to be linked.


12. (SBU) Most all of our interlocutors stressed the need for
minimal intervention in the market. Birley warned against
price ceilings. He said the object of a cap and trade system
is to encourage abatement, which a ceiling could inhibit.
Leeds also spoke against cost containment. He and Doyle
warned that excessive intervention could chill investment.
(Note: Not all of Doyle's fellow parliamentarians subscribe
to this view, and this proved to be very contentious in
Parliamentary debates. End note.) The EU has no controls in
place, and if the U.S. were to do so, it could impact on
linkage. For instance, if the systems were linked and the
U.S. had a price ceiling of $30 dollars per ton, all EU
credits would become subject to the same ceiling. Doyle said
the market can be regulated, but the price should not be
interfered with. To the extent necessary, governments can
influence the price through auctions and the availability of
credits. In fact, the ETS does have a price stability
mechanism which authorizes the Commission to intervene only
if the price is too high or low, but even then, the amount of
power given to the Commission is very limited. Leeds also
recommends unlimited banking of credits, which, if the cap is
properly set, could increase abatement in the short-term.
Borrowing presents another potential obstacle. If one scheme
permits borrowing from future allocations, it could draw down
the price of carbon. Under the ETS, credits can be banked
for future use, but they cannot be borrowed against future
allocations.


13. (SBU) Offsets and use of the clean development mechanisms
can also pose a challenge to linkage. Dimas noted the U.S.
fondness for sinks is a potential obstacle, given the EU's
skepticism on reforestation, but he believes this can be
worked out. Environmental NGOs were even more blunt, saying
(with some disregard to the overall carbon level) the U.S.
use of extensive re-forestation offsets would make linking
the systems impossible. Birley said that CDMs are laborious
to implement and difficult to manage. If schemes are to be
merged, CDMs would have to be well regulated "to maintain the
quality of the currency." Industry representatives noted the
need to find common ground on CDMs, which they suggested be

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capped. One proposal is to specify permissible offsets in
domestic and international markets. This is one area where
the EU expects the UN process to drive the discussion, as the
EU plans to argue for a global reassessment of offset
mechanisms to ensure the quality is sufficient to effect
change. As one EU official put it, "in all projects, one of
the two partners has to suffer," or there will be no true
emissions reduction.


14. (SBU) A final issue that came up in our discussions was
treatment of imports from non-regulated economies. Both in
the United States and in the EU, there will be continuing
pressures to "level the playing field" vis-a-vis imports if
companies in the United States or the EU have to purchase
carbon credits and their exporting competitors do not. One
of the options that has been proposed in both jurisdictions
is a border adjustment mechanism (BAM) which could, for
instance, require importers to purchase credits or to simply
pay an offsetting charge. A unilateral BAM, however, can
present challenges under international trading rules, and the
EU in its climate package postponed consideration of such
unilateral measures until 2011, when the results of
international discussions are clearer.

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Comment: Working Group Concept Likely Useful
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16 (SBU) The EU,s checkered experience with ETS has
demonstrated amply that devising a successful carbon
emissions trading scheme within an economy is tremendously
difficult; building a linked and eventually a global carbon
market will be much more so. The EU's proposal to develop a
U.S.-EU task force on carbon markets, with an eye toward
eventual linking, thus would seem useful. The EU, having
experienced many of the same obstacles and pitfalls likely to
be encountered in the U.S., in particular with "carbon
leakage," free allowances vs. full or partial auctioning, and
the definition of "economy-wide," can provide insights that
could help as the U.S. considers this option. Additionally,
given the anxiousness of the EU to link the systems, a task
force could provide a venue to encourage revisions to ETS to
promote harmonization, which Commission officials have stated
they are prepared to do.

MURRAY
.