European Union Emissions Trading System

The European Union’s Emission Trading Scheme (ETS) is the first and largest trading system for CO2 emissions in the world. ETS began operations in January 2005 and currently includes the 27 countries of the European Union and three non-EU members, Norway, Iceland, and Liechtenstein. The system covers over 11,500 energy-intensive installations across Europe, such as combustion plants, oil refineries, coke ovens, iron and steel plants, and factories making cement, glass, lime, brick, ceramics, pulp and paper. These installations represent almost half of Europe’s emissions of CO2.¹

To date, the environmental goals of ETS have been weakened by the over allocation of free allowances, creating a windfall for some companies without reducing overall CO2 emissions. To address these concerns, the European Union has put forth revisions to the system that will be phased by 2013. How these revisions are implemented and how ETS performs in the current economic slow down will be closely watched to see whether emissions trading is a viable, long-term policy tool to effectively curb greenhouse gas emissions.

Overview

ETS is known as a “cap and trade” system in which an emission target, or “cap,” is set for each political jurisdiction and industry covered by the system. These countries and industries can “trade” emissions rights, called allowances, or in some cases they can purchase offsets, to help them meet their emission targets. The theory behind a cap and trade system is that the cap will create scarcity, which in turn will create a market price for carbon. By then giving regulated entities the option to meet their emission targets through trading allowances and buying offsets, these entities will find the most cost effective ways to reduce green house gas emissions. This in turn will help the larger society reduce the overall cost of addressing the climate change problem.²

ETS stems from the commitments made by the member states under the Kyoto Protocol. Under Kyoto, the EU has agreed to a cut green house gas emissions by 8% from 1990 emission levels over the five-year period of 2008-12.³ Kyoto allows for emissions trading as a way for the Parties to meet their emission reduction commitments.⁴ The EU established ETS in October 2003,⁵ and in 2005, it began operations.

The ETS system is divided into trading periods or phases. The first period of ETS was launched in January 2005 and ended in 2007. The EU refers to this period as the “learn by doing” phase. Based on lessons learned from this phase, the EU has implemented a number of changes in the second phase, which runs from 2008-2012, and they will introduce more significant changes as part of the third phase, which will run from 2013 to 2020.

In the first phase of the emissions were capped -- inadvertently -- at levels higher than actual emissions.⁶ In the second phase, which coincides with Kyoto’s first commitment period, emissions have been capped around 6.5 percent below 2005 levels.⁷ In the third trading period, emissions will have an annually declining cap, resulting in a 21 percent reduction in emissions by 2020 compared to 2005.⁸

Allowances

Currently under ETS, each member state decides how many allowances to allocate per trading period based upon criteria established by the European Commission. The member states draw up national allocation plans (NAPs), which the Commission must adopt. The countries, through their NAPs, set the overall emission caps, establish a set number of allowances, and distribute those allowances to the regulated installations within their countries.

A number of criteria guide the Commission’s assessment of a NAP. These criteria involve assessing whether the allocation of the allowances to the industries will help the countries meet their Kyoto targets, does not discriminate between companies and sectors, and is in compliance with EU state aid and competition rules. The criteria also contain provisions relating to new entrants and how to accommodate early GHG reduction efforts.⁹

Allowances in the ETS system are referred to as Emission Allowance Units, or EUAs. They give the holder the right to emit one metric ton of CO2 emissions. Each year, installations must surrender the amount of allowances that cover their emissions for the preceding year. If an entity has extra allowances because it has cut its emissions below its cap, it may hold on to those allowances for the current trading period, called “banking,” or it can sell them to a facility whose emissions have exceeded their allowances. If a facility does not have enough allowances because its emissions have exceeded cap, it must buy allowances from a facility that has extra allowances or it can, under certain circumstances, buy offsets.¹⁰

Participants within ETS may trade allowances privately between one another, “over-the-counter,” via a dealer or a broker, or on a European climate exchange, such as the European Climate Exchange. The price of these allowances is a function of the supply and demand in the market. The Commission and member states do not intervene on the price, and European competition law governs regulates the market.¹¹

Offsets

ETS’s Linking Directive¹² authorizes operators to use a certain amount of Kyoto offsets from Joint Implementation projects (JI) and the Clean Development Mechanism (CDM). Carbon offsets are purchased reductions in greenhouse gas emissions, which allow individuals and organizations to counteract or compensate for their own greenhouse gas emissions by funding projects that reduce green house gas emissions in sectors not required to reduce their emissions. These mechanisms give countries the opportunity to lower the cost of complying with their commitments by investing in greenhouse gas reductions (GHG) in countries where those reductions may be less expensive, and it allows the host countries to receive the benefit of foreign investments.

Joint implementation (JI) is a mechanism in the Kyoto Protocol that allows a country with an emission reduction or limitation commitment under Annex 1 of the Protocol to invest in projects that reduce greenhouse gas emissions in other Annex 1 countries and have the credits generated by those projects count toward meeting their Kyoto commitments. It was designed primarily to encourage investment by industrialized countries in countries “undergoing the process of transition to market economy.” Under the JI program, approved emission reductions are awarded credits called Emission Reduction Units (ERUs). One ERU represents an emission reduction equaling one ton of CO2 equivalent (Mt CO2e).¹³

The Clean Development Mechanism (CDM) is like the JI mechanism, only the CDM allows developed countries listed in Annex 1 of the Protocol to invest in projects that reduce greenhouse gas (GHG) emissions in developing countries (those not listed in Annex 1) and have those reductions count toward their Kyoto targets. CDM-approved emission-reduction projects, like JI projects, can earn certified emission reduction (CER) credits, which are equivalent to one metric ton of CO2. These CERs can be bought, sold, and traded by industrialized countries to a meet a part of their emission reduction targets under the Kyoto Protocol. ¹⁴

Each NAP must specify the maximum amount of CERs and ERUs that may be used for compliance purposes. The Commission does not specify a specific limit, but instead reaffirms that the use of offsets should be guided by the Kyoto Protocols principle of supplementarity. This principle refers to the idea that offsets must be supplemental to each nation’s individual efforts to reduce their own emissions. The Commission allows member states to choose whether to apply individual limits to institutions or collectively to all institutions, however the Commission recommends that member states apply the limits for the entire trading period and collectively to all institutions.¹⁵

Tracking Registries

Each ETS member state must have a national registry, which ensures the accurate accounting of all units under the Kyoto Protocol plus the accurate accounting of allowances under the Community scheme for greenhouse gas emission allowance trading. The Community Independent Transaction Log (CITL) records the issuance, transfer, cancellation, retirement and banking of allowances that take place in the registry. In October 2008, a connection was established between the CITL and Member State registries with the UNFCCC International Transaction Log (ITL). This connection allows for a better tracking on the use of offsets in the ETS from Joint Implementation projects and projects generated through the Clean Development Mechanism.¹⁶

First trading period results

The main result to date of ETS shas been the establishment of a functioning market for carbon allowances and offsets. The environmental effects of ETS in the first trading period are limited, however. CO2 emissions increased about 1.9 % between 2005-2007 in the countries for which data is available¹⁷ and the European Union has concluded that the overall emissions cap exceeded actual emissions by 3 percent in the first phase of ETS mainly due to the allocation of allowances before verified emissions data was available.¹⁸

In the first trading period, the carbon market established by the Commission operated as expected, on the principle of supply and demand. When data showed an oversupply of allowances, the price collapse of EUAs collapsed. On January 3, 2005, EUAs traded at €8.57 per metric ton of CO2. Their price peaked on April 19, 2006 at €31.58, and then collapsed when 2005 emission data showed that the countries had allocated more allowances than emissions. By September 2007, they were trading at € 0.10.¹⁹

The demand and prices for allowances were influenced not only by their over-allocation, but also by how allocations occurred within countries and between sectors. Some covered entities did not receive enough allowances to cover their emissions, or were in a “short” position, while others received too many allowances, or were in a “long position,” creating a market between those with short positions and those with long positions. Power generation facilities were generally short while manufacturing and industrial facilities were generally long. This occurred because member states felt that the power generation sector could reduce its emissions at a lower cost than the industrial and manufacturing sectors. In addition, member countries were concerned that manufacturing and industrial facilities would move their operations outside the European Union if the costs of compliance became too great, a concept known as leakage.²⁰

Long and short positions also existed between countries, in addition to facilities. The net position of covered entities in Greece, Ireland, Italy, Spain, Slovenia, and the United Kingdom were short, meaning that these countries allocated fewer allowances than their actual emissions, while the positions of the other countries were long, raising important questions about the accuracy of individual countries NAPs, and about whether these allocations have resulted in wealth transfers from those countries that were short to those countries that were long. While one study concludes that overall these transfers were minimal, it also reports that the United Kingdom imported about 14 percent of its verified emissions.²¹

Revised system

In 2008, the European Commission adopted a number of changes to ETS to take effect in the third phase in 2013. These changes build upon changes that were implemented in 2008 and respond to many of the issues that arose in the first trading period. ²²

One important change is that in the third trading period, there will be one single EU-wide cap based on an EU-wide rule. Individual national governments will no longer be responsible for allocating allowances. In the first and second trading periods, when member states allocated allowances, significant differences between the states emerged in how these allocations were done, and each state had strong incentives to favor its own industry. ²³

The EU also agreed to three additional important system changes. They agreed to extend the trading period to eight years, tighten the emissions cap so that 21 percent reductions would occur by 2020, and increase the amount of allowances auctioned from 4 percent in the second phase to more than half in the third phase.²⁴

The auctioning of more allowances in the third trading period is an important change in ETS. When governments give allowances away for free, the incentives for industries to reduce their CO2 emissions is less than if it were auctioned.²⁵ In addition to these cost factors, giving away allowances can create a windfall for companies who receive an over-allocation of allowances, as some did in the first trading period of ETS, and then are able to sell those to companies that received an under-allocation of allowances. The problem of windfall profits will likely continue into the second phase. A study commissioned by WWF from Point Carbon estimates that the windfall to electricity generators in the UK, Germany, Spain, Italy and Poland in the second trading period Trading System (ETS) could be between €23 and €71 billion ($US 36 -111 billion).²⁶

In addition to these systems changes, the scope of ETS will be expanded to include new industries and new gases. The aviation industry will be included in ETS as of 2012, and CO2 emissions from petrochemicals, ammonia and aluminum will be included as of 2013, as will NO2 emissions from the production of nitric, adipic and glyocalic acid production and perfluorocarbons from the aluminum sector. In addition, the capture, transport, and geological storage of GHG will be covered.²⁷

Lessons learned

There are a number of lessons learned from the operations of ETS to date. Among those are:

Accurate monitoring and accounting of CO2 emissions is critical to the success of a cap and trade program. Without this, caps may be set too high resulting in too many allowances being distributed.
The manner in which allowances are allocated can redistribute wealth between countries and industries. These consequences should be clearly understood by parties involved, and political mechanisms should be available to deal with any unintended consequences of these allocations.
Cap and trade systems alone will not lead to the reductions necessary to combat climate change. Instead they may, if designed properly, be able to complement other legal and policy efforts.
It remains to be seen how much CO2 emissions will decline because of a weakening global economy, and if they do decline significantly, whether they will decline to levels below the current caps. While this may be a positive development in terms of CO2 emissions, it does not mean that companies are adopting more energy efficient practices or switching to cleaner forms of energy, which will still be needed to address climate change.

Footnotes

¹"Emission Trading System (EU ETS)," European Commission, European Union, last updated 7 May 09. Accessed Nov 26, 2009.

²Take, for example, power plant 1 in country A and power plant 2 in country B. Both are part of one cap and trade system and both emit 11 million tons of CO2 per year. Both are given an emission allowance of 10 million metric tons of CO2. Power plant 1 determines it can cost effectively reduce its carbon emissions to 9 million metric tons through internal process changes. Power plant 2, however, finds that such changes would be too expensive and that it would be more cost effective to buy allowances from a company whose emissions are below its cap. Under a cap and trade system, power plant 2 could buy 1 million MtCO2 of allowances from power plant 1. Both plants would be within their cap, and overall emissions would be reduced by 2 million MtCO2.

³Kyoto Protocol, Annex B.

⁴Kyoto Protocol, Article 17.

⁵Directive 2003/87/EC of the European Parliament and of the Council of 13 October 2003 establishing a scheme for greenhouse gas emission allowance trading within the Community and amending Council Directive 96/61/EC.

⁶See text accompanying footnote 8.

⁷"National Allocation Plans: Second Phase (2008-2012)," European Commission, European Union, last updated 30 Oct 09. Accessed Nov 26, 2009

⁸MEMO/08/796 Questions and Answers on the revised EU Emissions Trading System, page 5

⁹Commission for the European Communities, Further guidance on the allocation plans for the 2008 to 2012 trading period of the EU Emission Trading System, December 22, 2005, COM (2005) 703 Final. Annex III contains the first allocation guidance document, which was issued in 2003 (EU Directive 2003/87/EC).

¹⁰MEMO/05/84 Questions & Answers on Emissions Trading and National Allocation Plans, updated version 20 June 2005.

¹¹Id.

¹²Directive 2004/101/EC of the European Parliament and of the Council of 27 October 2004 amending Directive 2003/87/EC establishing a scheme for greenhouse gas emission allowance trading within the Community, in respect of the Kyoto Protocol's project mechanisms.

¹³http://ji.unfccc.int/index.html

¹⁴http://cdm.unfccc.int/index.html

¹⁵See footnote 9, paragraphs 21-25.

¹⁶http://ec.europa.eu/environment/climat/emission/citl_en.htm.

¹⁷Calculated from figures provided in Europa, Emissions trading: 2007 verified emissions from EU ETS businesses, IP/08/787, Brussels, 23 May 2008.

¹⁸ European Environment Agency, Greenhouse gas emission trends and projections in Europe 2008.

¹⁹GAO, International Climate Change Programs: Lessons Learned from the European Union's Emissions Trading Scheme and the Kyoto Protocol's Clean Development Mechanism, November 2008, pages 13-14.

²⁰Id, citing Convery, Frank and Luke Redmond, Market and Price Developments in the European Union Emissions Trading Scheme, Review of Environmental Economics and Policy, vol. 1 no. 1 (2007).

²¹Id., citing Ellerman, A. Denny, The EU Emissions Trading Scheme: Prototype of a Global System? Discussion paper 08-02 (Cambridge, Mass. Harvard Project on International Climate Agreements, August 2008).

²²European Parliament legislative resolution of 17 December 2008 on the proposal for a directive of the European Parliament and of the Council amending Directive 2003/87/EC so as to improve and extend the greenhouse gas emission allowance trading system of the Community (COM(2008)0016 – C6-0043/2008 – 2008/0013(COD))

²³See footnote 8, page 5.

²⁴Id., page 3.

²⁵For example, take power plant 1 in country A from footnote one. If that power plant emits 11 million tons of CO2 per year and is given an emission allowance of 10 million metric tons of CO2, under an auction system, it would have to buy EUAs to cover its emission allowance of 10 million metric tons. If EUAs were selling for €3, the facility would need to pay €30 million to buy allowances, creating a strong incentive to reduce its CO2 emissions.

²⁶Point Carbon, EU ETS Phase II -- The potential and scale of windfall profits in the power sector, WWF, 2008

²⁷See footnote 8. See also http://ec.europa.eu/environment/climat/aviation_en.htm

References

Markus Wråke, "Emissions Trading: The Ugly Duckling in European Climate Policy?" (pdf) (Report B1856), Swedish Environmental Research Institute, July 2009. Accessed Nov 26, 2009. Provides overview and analysis of the most contentious issues surrounding the EU emissions trading system, as well as an extensive list of resources.

Powered by Climate Lab