European Union Emission Trading Scheme

The European Union Emission Trading Scheme (EU ETS) is the largest multi-national, greenhouse gas emissions trading scheme in the world ^[1], and is a major pillar of EU climate policy.

Under the EU ETS, large emitters of carbon dioxide within the EU must monitor and annually report their CO2 emissions, and they are obliged every year to surrender (give back) an amount of emission allowances to the government that is equivalent to their CO2 emissions in that year. The installations may get the allowances for free from the government, or may purchase them from others (installations, traders, the government.) If an installation has received more free allowances than it needs, it may sell them to anybody.

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Mechanisms

The EU scheme is largely built on the mechanisms agreed under the Marrakech Accords of the Kyoto Protocol, and the experience gained during the running of the voluntary UK Emissions Trading Scheme in the previous years^[2].

Thus the governments of the EU Member States agree national emission caps, allocate allowances to their industrial operators, track and validate the actual emissions in accordance against the relevant assigned amount, and require the allowances to be retired after the end of each year. The operators within the ETS may reassign or trade their allowances by several means:

• privately, moving allowances between operators within a company and across national borders
• over the counter, using a broker to privately match buyers and sellers
• trading on the spot market of one of Europe's climate exchanges (the most liquid being the European Climate Exchange). Like any other financial instrument, trading consists of matching buyers and sellers between members of the exchange and then settling by depositing an allowance in exchange for the agreed financial consideration. Much like a stock market, companies and private individuals can trade through brokers who are listed on the exchange.

When each change of ownership of an allowance is proposed, the national registry and the European Commission are informed in order for them to validate the transaction. During Phase II of the EU ETS the UNFCCC will also validate any change that alters the distribution within each national allocation plan.

Like the Kyoto trading scheme, the EU scheme allows a regulated operator to use carbon credits in the form of Certified Emission Reductions (CER) or Emission Reduction Units (ERU) to comply with its obligations. A CER or ERU is produced by a carbon project that has been certified by the UNFCCC's Clean Development Mechanism Executive Board or the Joint Implementation project's host country, respectively.

Thus one EU Allowance Unit of one tonne of CO2, or "EUA", was designed to be identical ("fungible") with the equivalent "Assigned Amount Unit" (AAU) of CO2 defined under Kyoto. Hence it is possible to trade EAUs and UNFCCC-validated CERs on a one-to-one basis within the same system.

During Phase II of the EU ETS, the operators within each Member State must surrender their allowances for inspection by the EU before they can be "retired" by the UNFCCC.

Allocation

In order to make sure that real trading emerges (and that CO2 emissions are reduced), EU governments must make sure that the total amount of allowances issued to installations is less than the amount that would have been emitted under a business-as-usual scenario. For each Phase, the total quantity to be allocated by each Member State is defined in the Member State National Allocation Plan (NAP) (equivalent to its UNFCCC-defined carbon account.) The European Commission has oversight of the NAP process and decides if the NAP fulfills the 12 criteria set out in the Annex III of the Emission Trading Directive (EU Directive 2003/87/EC). The first and foremost criterion is that the proposed total quantity is in line with a Member State's Kyoto target.

Of course, the Member State's plan can, and should, also take account of emission levels in other sectors not covered by the EU ETS, and address these within its own domestic policies. For instance, transport is responsible for 21% of EU greenhouse gas emissions, households and small businesses for 17% and agriculture for 10%^[3].

During Phase I, most allowances in all countries were given freely (known as grandfathering). This approach has been criticized as giving rise to windfall profits, being less efficient than auctioning, and providing too little incentive for innovative new competition to provide clean, renewable energy^{[4] [5]}.

Phase I

In the first phase (2005-2007), the EU ETS includes some 12,000 installations, representing approximately 40% of EU CO₂ emissions^[6], covering energy activities (combustion installations with a rated thermal input exceeding 20 MW, mineral oil refineries, coke ovens), production and processing of ferrous metals, mineral industry (cement clinker, glass and ceramic bricks) and pulp, paper and board activities.

Launch and operation

The scheme, in which all 15 member states that were then members of the European Union participated, commenced operation on 1 January 2005, although many national registries were unable to settle transactions for the first few months. However, the prior existence of the UK Emissions Trading Scheme meant that market participants were already in place and ready. In its first year, 362 million tonnes of CO₂ were traded on the market for a sum of €7.2 billion, and a large number of futures and options ^[7]. The price of allowances increased more or less steadily to its peak level in April 2006 of about €30 per tonne CO₂ ^[8], but fell in May 2006 to under €10/ton on news that some countries were likely to give their industries such generous emission caps that there was no need for them to reduce emissions. Lack of scarcity under the first phase of the scheme continued through 2006 resulting in a trading price of €1.2 a tonne in March 2007, declining to €0.10 in September 2007.

Consequently, observers and NGO's have accused national governments of abusing the system under industry pressure, and have urged for far stricter caps in the second phase (2008-2012)^[9].

Phase II

The second phase (2008-12) expands the scope significantly:

• All greenhouse gases, and not only CO₂ will be included.
• CDM and JI credits are expected to be introduced in second phase through the EU's 'Linking Directive', although it has been agreed that schemes can be started in advance during Phase I^[11]
• Aviation emissions are expected to be included from 2010^[12].
• Four non-EU members, Norway, Iceland, Liechtenstein, and Switzerland join the scheme^[13].

The inclusion of aviation is a move considered important due to the large and rapidly growing emissions of the sector. The inclusion of aviation is estimated to lead to an increase in demand of allowances of about 10-12 million tonnes of CO₂ per year in phase two. This in turn is expected to lead to an increased use of JI credits from projects in Russia and Ukraine, which would offset the increase in prices and eventually result in no discernible impact on average annual CO₂ prices^[14].

Ultimately, the Commission wishes the post-2012 ETS to include all greenhouse gases and all sectors, including aviation, maritime transport and forestry^[15]. For the transport sector, the large number of individual users adds complexities, but might be implemented either as a cap-and-trade system for fuel suppliers or a baseline-and-credit system for car manufacturers^[16].

The National Allocation Plans for Phase II, the first of which were announced on 29 November 2006, will result in an average cut of nearly 7% below the 2005 emission levels^[17]. The annual Member State CO₂ allowances in million tonnes allowances are:

The European Commission has started infringement proceedings against Austria, Czech Republic, Denmark, Hungary, Italy and Spain, for failure to submit their proposed National Allocation Plans on time^[18].

Overall emission reductions

The environmental effectiveness of the scheme rests on the tightness of the caps. So far, Phase 1 is widely believed to be overallocated, implying that little additional overall emission reductions have been achieved. However, the first phase is not over and any analysis of the overall emission reductions is therefore preliminary.

Phase I

In 2004, Ecofys analysed the then available preliminary NAPs of all EU countries^[19]. The information suggested that the caps for Phase I were lenient; in most countries, the power sector would not need to reduce CO₂ emissions as much as the country as a whole, in other words the other sectors must make more ambitious emission reductions than the power sector under the scheme. More strikingly, a few countries (such as the Netherlands) gave more allowances than Ecofys estimated to be needed under a business-as-usual scenario, implying that no 'real' efforts to reduce emissions would be required. In their analysis of the Phase I NAPs, the NGO Climate Action Network called the caps a 'major disappointment'^[20], arguing that only two (UK and Germany) of the 25 EU states asked the participating industry sectors to reduce emissions compared to historic levels and found that in the 15 old EU member states as a whole, allocations were 4.3% higher than the base year. In May 2006, when several countries revealed registries indicating that their industries had been allocated more allowances than they could use, trading prices crashed from about €30/ton to €10/ton, and have (after an initial slight recovery) declined further to €4 in January 2007^[21] and below €1 in February 2007, reaching an all time low of €0.03 at the beginning of December 2007^[22]

Phase II

In 2006, Ecofys performed an initial assessment of NAPs for phase II, using the proposed but not-yet-approved NAPs ^[23]. They found that most member states did not have sufficiently strict caps, and that they would be insufficient in assisting the members in meeting their Kyoto targets. They also compared caps with official business-as-usual (BAU) projections and with independent BAU projections to assess stringency of caps. They concluded that the caps were 7% under official BAU but (except for Portugal, Spain, and UK) the proposed cap was "higher" than the independently estimated BAU, suggesting overallocation.

Partly in response to this, the Commission cut eleven of the first twelve Phase II plans it reviewed (accepting only the U.K.'s plan without revision). The commission tightened the caps some 7%^[24], also corresponding with 7% below the 2005 emissions. However, as of January 2007, not all plans have been finalized.

The inclusion of sinks

Currently, the EU does not allow CO₂ credits under ETS to be obtained from sinks (e.g. reducing CO₂ by planting trees). However, some governments and industry representatives lobby for their inclusion. The inclusion is currently opposed by NGO's as well as the EU commission itself, arguing that sinks are surrounded by too many scientific uncertainties over their permanence and that they have inferior long-term contribution to climate change compared to reducing emissions from industrial sources^[25].

References

See also

• Energy policy of the European Union
• European Climate Change Programme
• Mitigation of global warming
• Carbon emissions trading
• Kyoto Protocol

How ETS works

• UK Defra General overview at the UK Department for Environment, Food and Rural Affairs
• Pew Center White Paper : overview of EU ETS

Key reports, and assessments

• Fraunhofer Institute November 2006 assessment of preliminary Phase 2 NAPs
• Ecofys evaluation of preliminary Phase 2 NAPs
• Ecofys evaluation of Phase 1 NAPs. ECOFYS, August 2004.
• National Allocation Plans 2005-7: Do they deliver? Executive summary of report by Climate Action Network.
• WWF website "The environmental effectiveness and economic efficiency of the EU ETS: Structural aspects of the allocation". by WWF and Öko-Institut, 09 Nov 2005.
• Climate Action Network Europe "CO2 emissions: EU member states abuse Emissions Trading System" Press release, 15 May 2006
• Carbon Trade Watch