The Department for Energy and Climate Change (DECC) has launched a consultation on draft legislation that will introduce the Carbon Reduction Commitment (CRC). The CRC is a mandatory emissions trading scheme that is due to commence in April 2010 and will apply to a wide range of organisations in the private and public sectors, many of whom have had no prior experience of emissions trading.

The main requirement will be for businesses to purchase sufficient carbon allowances to cover carbon dioxide emissions resulting from their consumption of electricity, gas and certain other fuels. In theory, organisations should have already verified their inclusion within the CRC, and now need to begin gathering data and plan compliance carefully in order to ensure that they are in a position to reap the environmental and economic gains under the new regime. A key part of the scheme is the annual publication of a league table highlighting good and bad performance. Experience of the EU Emissions Trading Scheme (EU ETS) shows that significant benefits, in both financial and reputational terms, can be achieved by those organisations that are well prepared and that respond to the opportunities and risks that emissions trading and carbon reporting presents.

In this bulletin, we consider the revised design and operation of the CRC, and address some of the practical measures that businesses should now be taking. Further guidance notes looking in more detail at how the CRC applies in specific circumstances will be published by us shortly.

Background

The CRC is a central part of the UK Government's strategy to meet its statutory targets set out in the Climate Change Act 2008, including the target to reduce emissions of carbon dioxide by 80% by 2050. This target which was originally set at 60% but increased to 80% in October 2008 on the advice of the new Committee on Climate Change (click here for the Herbert Smith e-bulletin on the Climate Change Act 2008).

Will the CRC apply to my business?  

Unlike other emissions trading schemes, including the EU ETS, the CRC will target emissions at an organisation rather than a site or installation level basis. UK parent and subsidiary companies will be treated as a single organisation to aggregate emissions for the purpose of the CRC, with a nominated 'primary member' participating on behalf of the group. In most cases, the primary member will be the highest UK parent entity. If the structure of an organisation changes - for example, where there is a merger or an acquisition or sale of shares - detailed rules set out how the transfer of CRC responsibility is to be dealt with. There are, however, no special rules for asset sales.

The Government's conclusion at present is that it should not create any derogation from the parent/subsidiary rule for ownership by UK private equity and other UK investment vehicles that hold majority stakes. Specific rules do however apply for certain arrangements including joint ventures, PFI, PPP and overseas parent companies.

As a general rule, responsibility for energy consumption rests with the organisation that is the counterparty to the relevant energy supply contract, although as discussed below, this rule could cause complexity in certain situations, particularly between landlords and tenants and in outsourcing arrangements.

Qualification threshold

The CRC is expected to cover around 5,000 organisations, including retailers, supermarkets, transport operators, large offices and banks. Participation in the first phase of the CRC will be compulsory for organisations that consumed at least 6,000 MWh of half-hourly metered electricity during 2008. This is roughly equivalent to an annual electricity bill of between £700,000 and £1,000,000 depending on tariff. A half-hourly meter is one that records electricity consumption every half hour and passes this information automatically to the energy supplier – a good proportion of commercial premises within the UK that consume significant amounts of electricity are equipped with such meters. The CRC will also apply to Government departments and local authorities regardless of their level of electricity consumption.

Organisations which do not meet the qualification threshold but which consume any level of electricity settled through half-hourly meters will still be required to disclose information about their electricity usage. It is estimated that 15,000 organisations not covered by the CRC will need to comply with this requirement, or face criminal prosecution.

Energy sources

Although qualification for the scheme is dependant on half-hourly metered electricity use, a much wider measure of energy use is taken into account to determine the number of allowances needed. This requires an assessment of carbon dioxide emissions resulting from the consumption of electricity, gas supplied through a pipe supply, and certain other specified fuels.

Exemptions

The draft legislation provides exemptions for emissions arising from energy used for transport (but not energy used to move people around certain types of places and within premises in equipment such as lifts and escalators) and, to avoid double burdening, for emissions covered by the EU ETS or a Climate Change Agreement (CCA).

Organisations that meet the qualifying threshold, but after having subtracted electricity used for transport consumed less than 1,000 MWh during 2008 will be exempt from participation in the CRC.

Subsidiaries (and in some cases entire organisations) that have a CCA covering more than 25% of their emissions will be exempt from participating in the CRC. Where the CCA applies to a subsidiary, only the subsidiary will be exempt from participation in the CRC. The rest of the organisation will still have to participate, although if after exempting subsidiaries the whole organisation consumed less than 1,000 MWh of electricity, then the entire organisation would be exempt.

Franchises

Specific rules have been established for franchises and other vertical distribution agreements. Under the CRC, franchisors will be responsible for the energy use of all their franchisees, even if the franchisee is owned by another qualifying organisation.

As such, a franchisor will need to consider the energy usage of all its franchisees to determine whether it meets the qualification criteria and if so, the number of allowances it will be required to purchase.

For example, the emissions of car dealerships will be the responsibility of the car manufacturer provided that the distribution agreement meets the requirements of the definition contained in the draft legislation of a franchise agreement. In broad terms, a franchise agreement is defined as an agreement by which the franchisor conducts its business by either selling or distributing goods or providing services, and by which the franchisee equips or presents its premises as instructed by the franchisor. Petrol stations and post offices may operate under agreements, which although not usually regarded as franchising agreements, may also be covered by this definition.

How will the CRC operate?

The CRC will be divided into phases:

Introductory phase (April 2010 to March 2013)

  • To allow participants the opportunity to adjust to emissions trading, an introductory phase will run from April 2010 to March 2013.
  • Allowances will be sold at a fixed price of £12 per tonne of carbon dioxide. (This compares with a current EU ETS allowance price of €12.35 per tonne. What happens to the EU ETS carbon price going forwards, however, prevents some interesting questions in terms of the operation and the effectiveness of the CRC). The first sale of allowances is due in April 2011, when participating organisations will need to purchase allowances to cover their emissions during 2010 and their expected emissions during 2011. This first sale is unique, because subsequent annual sales will be for allowances to cover the year immediately ahead only.  
  • By each July following a scheme year, organisations must ensure that they hold and then surrender to the CRC Administrator (the Environment Agency in England and Wales) sufficient allowances to cover their emissions. It will be possible to buy and sell allowances through a secondary market, but the costs of these allowances will be uncertain and determined by market supply and demand.  

Capped phases (April 2013 onwards)

  • From 2013, successive phases of the CRC will each run for compliance periods of five years (although the phase period is often described as being seven years to take account of the qualification period and the footprint year (see below)).
  • The total emissions allowances within the CRC will be capped by the Government and will be reduced over time at a rate to be determined but which will be set to reflect the UK's emissions targets fixed under the Climate Change Act 2008.  
  • Allowances will be sold to organisations in an online auction at the start of each scheme year. By reducing the cap, the average price of allowances should rise year on year, providing an increasing financial incentive to organisations to reduce energy usage.  
  • The limited availability of allowances should also drive the development of an active secondary market in allowances, and any person, not just participants, will be free to trade allowances (although only participants and their agents can purchase allowances at the annual sale/auctions).  

Each phase is preceded by a qualification period, during which organisations must assess whether or not they meet the qualification threshold. For the introductory phase, the qualification period is the 2008 calendar year, and for each of the capped phases, the financial year that ends two years prior to the first year of the phase (ie, 2010/2011 for the first capped phase).

There is also a footprint year during which participants must establish the sources of energy use to be included in CRC for the forthcoming phase. In order to reduce the administrative burden, the draft legislation allows some small sources of energy to be excluded, provided that at least 90% of the total emissions, as calculated during the footprint year, are included. For the introductory phase, the footprint year will run concurrently with the first year of the phase from April 2010 to March 2011, and for each of the capped phases, it will be the financial year after the qualification period (ie, 2011/2012 for the first capped phase).

Participants will be required to 'self-certify' their energy use, although it is proposed that about 20% of organisations will be independently audited by the Administrator each year. Proper data management systems, accurate assessments and, for some businesses the ability to require others to provide this data, will be critical as there will be potentially severe civil and criminal penalties for mis-reporting emissions (see below).

Revenue recycling: cost and cash flow implications

Using DECC’s electricity to carbon conversion factor of 0.523 kg/kWh, the qualification threshold of 6,000 MWh translates into approximately 3,100 tonnes of carbon dioxide. At the initial fixed price of £12 per tonne, this means that an organisation that consumes the threshold amount of electricity would need to purchase approximately £37,600 worth of allowances. If an organisation uses more energy than the threshold level, the cost will be greater. Although the price of allowances during the capped phases is impossible to predict, the price is expected to increase over time as the cap on allowances is reduced. Government is keen to emphasise, however, that its analysis suggests that by driving improvements in energy efficiency, the CRC will deliver net benefits of £1 billion to participants through savings in energy costs.

By way of example, a large water and sewerage undertaker reported total greenhouse gas emissions for 2007/2008 of 876,010 tonnes of carbon dioxide equivalent. Assuming that all these emissions are emissions of carbon dioxide covered by the CRC, this would, at a price of £12 per tonne, result in an annual cost of allowances of £10.5 million. A leading insurance and financial group reported 130,219 tonnes of carbon dioxide for 2007, which at £12 per tonne, would result in an annual cost of allowances of £1.5 million. In the first sale, two years of allowances would need to be purchased and budgets will clearly need to be set aside for this.

The financial impact to participants will in most cases be more in terms of cash flow and management than in terms of the cost of buying allowances. This is because the CRC is designed to be revenue neutral with the total revenue raised by the annual sale/auction of allowances in April - less the scheme's administration costs - recycled back to participants in October by means of an annual payment. The amount recycled to an organisation will be proportional to its emissions during the first footprint year (2010/2011) multiplied by a percentage bonus or penalty based on league table performance. The six month delay between the sale of allowances and the recycling payments being made could have a not insignificant cash flow impact, although the position is much improved on the 18 month pay-back delay that was originally being proposed. However, it should be noted that the recycling payment will not be based on the amount that an organisation has spent on allowances in the preceding sale/auction. This therefore provides organisations with the option of purchasing allowances either on the secondary market or via the safety valve (see below) after the recycling payment has been made, albeit at the risk that the price of allowances on the market may increase, and will in any case be priced no lower than the minimum price floor set under the safety valve (£12 during the introductory phase).

As there is no guarantee that all participants will buy allowances equivalent to their annual energy usage in each sale/auction, the amount recycled to any particular participant could well be more or less than the amount it spends at the sale/auction. However, relatively good performers (in terms of energy reductions, and particularly those effected at the optimum time) should find themselves financially better off in terms of the total amounts they receive back. Conversely, relatively poor performers could find themselves severely out of pocket - particularly when the penalties are set at 50% or more from year five of the scheme onwards (see further below). This, of itself, is a real driver to energy performance improvements.

CRC league table: reputational implications

The performance of all participating organisations will be rated in a league table, and the Government appears eager to ensure that this table receives as much publicity as possible. Organisations that perform well and are placed at the top of the table can expect favourable publicity associated with this. On the other hand, a culture of naming and shaming the worst performers may also arise. Organisations will also be asked to answer some questions as to how they manage carbon performance generally. Although it is not mandatory to provide answers, any answers that are provided, or the absence of these, will be made public.

The revenue raised by the Government will be recycled back to CRC participants with upper-ranking performers in the league table receiving a recycling payment plus a bonus, and lower-ranking performers receiving recycling payments less a penalty. In the first year of the scheme, calculations will be made on a +/-10% basis rising to +/-50% after five years. The consultation paper comments that this figure could rise to +/-100% in the future, which could mean no recycling payments being made, just additional costs to poor performers or those unable to perform any better. It should be noted that there will be no sector-by-sector tables and all businesses will be measured against each other in terms of the reductions they are able to achieve.

In order to rate organisations against each other, performance is calculated using three metrics:

  • Early action metric: this metric, which will apply during the introductory phase only, gives recognition to organisations that monitor emissions voluntarily essentially with a view to reductions. It is based on the percentage of electricity and gas measured using voluntarily installed automatic meters and the percentage of emissions covered by a Carbon Trust Standard or Energy Efficiency Accreditation Scheme certificate.
  • Absolute metric: this is the main metric and reflects the percentage change in an organisation’s emissions, compared to a rolling five year average (where five years data is not yet available, the rolling average of all the years of data available up to that point will be used).  
  • Growth metric: this metric compensates for an organisation's commercial growth and compares the current level of emissions per unit turnover relative to the average over the preceding five years.  

When the league table is produced at the end of the first year of the CRC, only one year of emissions data will be available, and neither the absolute nor the growth metrics can be applied. An organisation’s performance will therefore be based solely on the early action metric.

Organisations need to be aware that the scope of the early action metric is limited, and that any steps taken to reduce emissions before the end of the footprint year might compromise an organisation's ability to deliver further reductions and therefore impact future league table performance. Actions will therefore need to be evaluated in terms of their timing to see which produces the best pay-back financially and also environmentally.

The safety valve

The safety valve is a mechanism by which participants can buy additional allowances from the Administrator at any time, to compensate for the fact that there will be only one sale/auction per year. Its purpose is to prevent the price of allowances on the secondary market rising undesirably high, and placing too great a financial burden on participants. Participants will be free to acquire safety valve allowances at any time, at the cost of the prevailing EU ETS allowance price or a predefined floor price (which the Government proposes to set at £12 per tonne initially), whichever is the higher. Safety valve allowances can be traded and used for compliance in the same way as any other CRC allowance.

The safety valve mechanism means that the cost of CRC allowances will always be as high as the cost of EU ETS allowances, but could be higher. At current EU ETS allowance prices, CRC participants (whether buying at auction or through the safety vale mechanism) face a higher cost for allowances than EU ETS participants. Although the Administrator will, for safety valve purposes, purchase EU ETS allowances and convert these into CRC allowances, scheme participants cannot purchase and use EU ETS allowances directly for the purpose of CRC compliance.

Landlord and tenant

The Government has gone back on its earlier plans to allow, in certain circumstances, responsibility for emissions to be transferred between landlord and tenant by mutual agreement. Landlords will be responsible for their tenants' emissions (and for compliance costs and any bonus or penalty payments) where, as is often the case in many multi-let properties, the landlord is the counterparty to the energy supply contract. This is the case even where the landlord may have little practical control over the amount of energy consumed by the tenant. In such cases, there will inevitably be issues, and potentially tensions, over how costs (management, infrastructure, allowances etc) and bonuses and penalties under the CRC are passed through or otherwise shared. This is complicated further by the fact that the CRC is evaluated at a business organisation level and not at an individual site level.

It may be possible for landlords to pass costs on through existing service charges or by a separate charging or cost recovery term in the lease. Landlords and tenants will need to consider ensuring that new leases include clauses that specifically address CRC requirements including reporting and sharing of costs and benefits. Ideally, existing arrangements should also be modified where appropriate to reflect the CRC.

Landlords with energy management and carbon pricing expertise will be best placed to maximise potential CRC benefits. Landlords with energy management and carbon pricing expertise will be based placed to maximise potential CRC benefits. Collaborative good practice between landlords and tenants will need to be encouraged, but further incentives, particularly in relation to beneficial tax treatment of sinking funds may require further investigation by DECC, as well as other possible mechanism that allocate costs and responsibilities fairly, especially in the current difficult economic climate.  

Electricity generation and 'green energy'

It is proposed that electricity generated by participants and exported to the grid will be eligible for electricity credits that can be used to offset an organisation's emissions. This, however, will not apply to electricity generated by in an EU ETS installation, a nuclear station, or a large hydro station that is pump storage operated or ineligible for the Renewables Obligation).

The use of electricity generated by on-site renewables will not give rise to an obligation to surrender allowances provided that Renewables Obligation Certificates (ROCs) are not claimed. Where electricity generated by on-site renewables is exported, the participant can claim credits - however, if ROCs are issued the benefit of the credits will be cancelled.

The consumption of 'green tariff' electricity supplied by the national grid will be treated no differently from any other tariffs. The Government's view is that to count green tariff electricity as having zero carbon content would undermine the CRC's objective of achieving additional emissions reductions through lowering levels of energy consumption and increasing energy efficiency. Indeed, the Government states that to draw any distinction as to how grid electricity consumed by an organisation is generated may divert the scheme’s focus away from additional actions by the end user. In this respect, the focus is one on efficiency and not carbon reduction.

Penalties

Criminal penalties

The draft legislation provides for potentially severe criminal penalties for certain non-compliance, falsification of information and obstruction. Non-compliance is generally punishable by a fine of £5,000, but in certain cases a further fine of £0.05 per tonne of carbon dioxide per working day can be imposed for on-going non-compliance. For falsification (including knowingly or recklessly making false or misleading statements) and obstruction the maximum penalty on conviction in the Magistrates' Court is three months imprisonment and/or a £50,000 fine, and on conviction in the Crown Court, two years imprisonment and/or an unlimited fine.

Civil penalties

In addition to criminal penalties for non-compliance, substantial civil penalties can be imposed. In the event that an organisation reports emissions to the administrator incorrectly (which means when there is a margin of error greater than 5%) or fails to purchase and surrender allowances, a penalty of £40 for each tonne incorrectly reported or for each allowance that should have been purchased and surrender is payable. The Government has stated that it intends to rely primarily on these civil penalties to enforce the scheme.

Directors and other individuals

The draft legislation provides for circumstances in which directors, members of a committee of management, chief executives, managers, and secretaries can attract personal criminal liability. Where an offence that is committed by a body corporate is committed with the consent or connivance of such individual or as a result of their neglect, the individual and the body corporate are guilty of the offence and liable to the same criminal penalties.

Organisations

Where a CRC organisation consists of more than one legal person, for example groups of companies, there are rules by which legal liability is extended beyond the primary participant. We are looking further into the operation and implications of these rules, but there is a current intention to allow for the joint and several liability of each company within a group, and to ensure that directors and other officers of any group company can be caught where there is consent, connivance or neglect by them.

What should organisations be doing now?

  • Qualification packs were sent last year to the billing address for each half-hourly metered organisation. In theory, therefore, all organisations should have received these packs and have already verified their inclusion within the CRC.
  • Assessing responsibility for emissions can be complex in all but the most straightforward cases. Organisations will need to examine their group structure carefully together with their arrangements with third parties, in order to assess which entities are responsible and for what emissions. Data will need to be collected across all sites and for all relevant energy sources. In group companies, individual company assessments will need to be made and aggregated. Specific rules apply to subsidiaries which themselves meet the 6,000 MWh qualification threshold in relation to reporting requirements, and in the context of any sale or acquisition of such subsidiaries.  
  • Even though the CRC does not commence until April 2010, qualifying organisations are advised to start early in terms of gathering data to identify their sources of energy and levels of usage in order to plan their compliance, and identify opportunities for energy saving.  
  • Carbon management strategies must, however, take future league table performance into account, including the metrics by which performance will be measured. The cost of any emissions reduction measures planned should be carefully assessed against the benefits and cost pay-back.  
  • Qualifying organisations must register between April and September 2010 and by the last working day of each subsequent first year of a phase. Organisations must remember that even if they do not meet the qualification threshold, they may still be required to disclose information about their energy consumption.  

Conclusion

Although described as administratively simple, the CRC rules and some of the potential ramifications are hugely complex. Nevertheless, the revised draft rules are a great improvement on earlier proposals, and are revolutionary in their ambition to procure carbon reductions across such a large and wide-ranging group of businesses.