Emissions Trading System
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The European Union Emissions Trading Scheme (EU ETS) also known as the European Union Emissions Trading System, is the largest multi-national emissions trading scheme in the world. It was launched in 2005 and is a major pillar of EU climate policy. The EU ETS currently covers more than 10,000 installations with a net heat excess of 20 MW in the energy and industrial sectors which are collectively responsible for close to half of the EU's emissions of CO2 and 40% of its total greenhouse gas emissions.
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 return an amount of emission allowances to the government that is equivalent to their CO2 emissions in that year. In order to neutralize annual irregularities in CO2-emission levels that may occur due to extreme weather events (such as harsh winters or very hot summers), emission credits for any plant operator subject to the EU ETS are given out for a sequence of several years at once. Each such sequence of years is called a Trading Period. The 1st EU ETS Trading Period expired in December 2007; it had covered all EU ETS emissions since January 2005. With its termination, the 1st phase EU allowances became invalid. Since January 2008, the 2nd Trading Period is under way which will last until December 2012. Currently, the installations get the trading credits from the NAPS (national allowance plans) which is part of each country's government. Besides receiving this initial allocation, an operator may purchase EU and international trading credits. If an installation has performed well at reducing its carbon emissions then it has the opportunity to sell its credits and make a profit. this allows the system to be more self contained and be part of the stock exchange without much government intervention.
In January 2008, the European Commission proposed a number of changes to the scheme, including centralized allocation (no more national allocation plans) by an EU authority, a turn to auctioning a greater share (60+ %) of permits rather than allocating freely, and inclusion of other greenhouse gases, such as nitrous oxide and perfluorocarbons. These changes are still in a draft stage; the mentioned amendments are only likely to become effective from January 2013 onwards, i.e. in the 3rd Trading Period under the EU ETS. Also, the proposed caps for the 3rd Trading Period foresee an overall reduction of greenhouse gases for the sector of 21% in 2020 compared to 2005 emissions. The EU ETS has recently been extended to the airline industry as well, but these changes will not take place until 2012.
The first phase of the EU scheme was created to operate apart from international climate change treaties such as the pre-existing United Nations Framework Convention on Climate Change (UNFCCC, 1992) or the Kyoto Protocol that was subsequently (1997) established under it. When the Kyoto Protocol came into force on 16 February 2005, Phase I of the EU ETS had already become operational. The EU later agreed to incorporate Kyoto flexible mechanism certificates as compliance tools within the EU ETS. The "Linking Directive" allows operators to use a certain amount of Kyoto certificates from flexible mechanism projects in order to cover their emissions.
The Kyoto flexible mechanisms are:
Joint Implementation projects (JI) defined by Article 6 of the Kyoto Protocol, which produce Emission Reduction Units (ERUs). One ERU represents the successful emissions reduction equivalent to one tonne of carbon dioxide equivalent (tCO2e).
the Clean Development Mechanism (CDM) defined by Article 12, which produces Certified Emission Reductions (CERs). One CER represents the successful emissions reduction equivalent to one tonne of carbon dioxide equivalent (tCO2e).
International Emissions Trading (IET) defined by Article 17.
IET is relevant as the reductions achieved through CDM projects are a compliance tool for EU ETS operators. These Certified Emission Reductions (CERs) can be obtained by implementing emission reduction projects in developing countries, outside the EU, that have ratified (or acceded to) the Kyoto Protocol. The implementation of Clean Development Projects is largely specified by the Marrakech Accords, a follow-on set of agreements by the Conference of the Parties to the Kyoto Protocol. The legislators of the EU ETS drew up the scheme independently but called on the experiences gained during the running of the voluntary UK Emissions Trading Scheme in the previous years,and collaborated with other parties to ensure its units and mechanisms were compatible with the design agreed through the UNFCCC.
Under the EU ETS, the governments of the EU Member States agree on national emission caps which have to be approved by the EU commission. Those countries then allocate allowances to their industrial operators, and track and validate the actual emissions in accordance with the relevant assigned amount. They 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
Like any other financial instrument, trading consists of matching buyers and sellers between members of the exchange and then settling by depositing a valid 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, and need not be regulated operators.
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 also validates the allowance and 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 Emission Reduction Units (ERU) to comply with its obligations. A Kyoto Certified Emission Reduction unit (CER), produced by a carbon project that has been certified by the UNFCCC's Clean Development Mechanism Executive Board, or Emission Reduction Unit (ERU) certified by the Joint Implementation project's host country or by the Joint Implementation Supervisory Committee, are accepted by the EU as equivalent.
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, because of the EU's decision to accept Kyoto-CERs as equivalent to EU-EUA's, it is possible to trade EUA's and UNFCCC-validated CERs on a one-to-one basis within the same system. (However, the EU was not able to link trades from all its countries until 2008-9 because of its technical problems connecting to the UN systems.)
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 an ETS, the total number of permits issued (either auctioned or allocated) determines the price for carbon. The actual carbon price is determined by the market. Too many allowances will result in a low carbon price, and reduced emission abatement efforts (Newbery, 2009). Too few allowances will result in too high a carbon price (Hepburn, 2006, p. 239).
For each EU ETS 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%.
During Phase I, most allowances in all countries were given freely (known as grandfathering). This approach has been criticized[by whom?] 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. On the other hand, allocation rather than auctioning may be justified for a few sectors, e.g., aluminium and steel, that face international competition, and where the price of carbon is important
To address these problems, the European Commission proposed various changes in a January 2008 package, including the abolishment of NAPs from 2013 and auctioning a far greater share (ca. 60% in 2013, growing afterward) of emission permits.
From the start of Phase III (January 2013) there will be a centralised allocation of permits, not National Allocation Plans, with a greater share of auctioning of permits.
Competitiveness: Allocation can act as a means of addressing concerns over loss of competitiveness, and possible "leakage" (carbon leakage) of emissions outside the EU. Leakage is the effect of emissions increasing in countries or sectors that have weaker regulation of emissions than the regulation in another country or sector (Barker et al., 2007). Carbon Trust (2009) cited research that showed competitiveness concerns could affect the following sectors: cement, steel, aluminium, pulp and paper, basic inorganic chemicals and fertilisers/ammonia. Leakage from these sectors was thought likely not to be more than 1% of total EU emissions. According to the Carbon Trust (2009), correcting for leakage by allocating permits acts as a temporary subsidy for affected industries, but does not fix the underlying problem. Border adjustments would be the economically efficient choice, where imports are taxed according to their carbon content (Neuhoff, 2009; Newbery, 2009). A problem with border adjustments is that they might be used as a disguise for trade protectionism (Grubb et al., p. 5). Some adjustments may also not prevent emissions leakage.
Banking and borrowing: Within a trading phase, banking and borrowing is allowed. For example, a 2006 EUA can be used in 2007 (Banking) or in 2005 (Borrowing). Interperiod borrowing is not allowed. Member states had the discretion to decide if banking EUA's from Phase I to Phase II was allowed or not.
Views on the EU ETS
Different people and organizations have responded differently to the EU ETS. Mr Anne Theo Seinen, of the EC's Directorate-General for the Environment, described Phase I as a "learning phase," where, for example, the infrastructure and institutions for the ETS were set up (UK Parliament, 2009). In his view, the carbon price in Phase I had resulted in some abatement. Seinen also commented that the EU ETS needed to be supported by other policies for technology and renewable energy. According to CCC (2008, p. 155), technology policy is necessary to overcome market failures associated with delivering low-carbon technologies, e.g., by supporting research and development.
The World Wildlife Fund (2009) commented that there was no indication that the EU ETS had influenced longer-term investment decisions. In their view, the Phase III scheme brought about significant improvements, but still suffered from major weaknesses. Jones et al. (2008, p. 24) suggested that the EU ETS needed further reform to achieve its potential.
Criticisms: The EU ETS has been criticized for several failings, including: over-allocation, windfall profits, price volatility, and in general for failing to meet its goals. Proponents[who?] argue, however, that Phase I of the EU ETS (2005–2007) was a "learning phase" designed primarily to establish baselines and create the infrastructure for a carbon market, not to achieve significant reductions.
In addition, the EU ETS has been criticized as having caused a disruptive spike in energy prices. They say that it does not correlate with the price of permits, and in fact the largest price increase occurred at a time (Mar-Dec 2007) when the cost of permits was negligible.
Over-allocation: There was an oversupply of emissions allowances for EU ETS Phase I. This drove the carbon price down to zero in 2007 (CCC, 2008, p. 140). This oversupply reflects the difficulty in predicting future emissions which is necessary in setting a cap (Carbon Trust, 2009). Given poor data about emissions baselines, inherent uncertainty of emissions forecasts, and the very modest reduction goals of the Phase I cap (1-2% across the EU), it was entirely expected that[according to whom?] the cap might be set too high.
This problem naturally diminishes as the cap tightens. The EU's Phase II cap is more than 6% below 2005 levels, much stronger than Phase I, and readily distinguishable from business-as-usual emissions levels.
Also, note that over-allocation does not imply that no abatement occurred. Even with over-allocation, there was a real price on carbon, and that price had an effect on emitters' behavior. Verified emissions in 2005 were 3-4% below projected emissions,and analysis suggests that at least part of that reduction was due to the EU ETS.
Windfall profits: According to Newbery (2009), the price of EUAs was passed fully in the final price of electricity. The free allocation of permits was cashed in at the EUA price by fossil generators, resulting in a "massive windfall gain." Newbery (2009) wrote that "[there] is no case for repeating such a wilful misuse of the value of a common property resource that should be owned by the country." In the view of 4CMR (2009), all permits in the EU ETS should be auctioned. This would avoid possible windfall profits in all sectors.
Price volatility: The price of emissions permits tripled in the first six months of Phase I, collapsed by half in a one-week period in 2006, and declined to zero over the next twelve months. Such movements and the implied volatility raise questions about the viability of this trading system to provide stable incentives to emitters. This criticism has face validity. In future phases, measures such as banking of allowances and price floors may be used to mitigate volatility. However, it's important to note that considerable volatility is expected of this type of market, and the volatility seen is quite in line with that of energy commodities generally. Nonetheless, producers and consumers in those markets respond rationally and effectively to price signals.
Newbery (2009) commented that the EU ETS was not delivering the stable carbon price necessary for long-term, low-carbon investment decisions. He suggested that efforts should be made to stabilize carbon price, e.g., by having a price-ceiling and a price-floor.
Crime: In 2009 Europol informed that 90% market volume of emissions traded in some countries could be result of tax fraud, costing governments more than 5 billion euro. Cyber fraudsters have also attacked the EU ETS with a "phishing" scam which cost one company €1.5 million. In response to this, the EU has revised the ETS rules to combat crime.
Offsetting: The EU ETS allows the use of offset credits from JI and CDM projects. The main advantage of allowing free trading of credits is that it allows mitigation to be done at least-cost (CCC, 2008, p. 160). This is because the marginal costs (that is to say, the incremental costs of preventing the emission of one extra ton of CO2e into the atmosphere) of abatement differs among countries. In terms of the UK's climate change policy, CCC (2008), noted three arguments against too great a reliance on credits:
Rich countries need to demonstrate that a low-carbon economy is possible and compatible with economic prosperity. This is in order to convince developing countries to lower their emissions. Additionally, domestic action by rich countries drives investment towards a low-carbon economy.
An ambitious long-term target to reduce emissions, e.g., an 80% cut in UK emissions by 2050, requires significant domestic progress by 2020 and 2030 to reduce emissions.
CDM credits are inherently less robust than a cap and trade system, where reductions are required in total emissions.
Due to the economic downturn, states have pushed successfully for a more generous approach towards the use of CDM/JI credits post-2012.[attribution needed] The 2009 EU ETS Amending Directive states that credits can be used for up to 50 % of the EU-wide reductions below the 2005 levels of existing sectors over the period 2008-2020. Moreover, it has been argued that the volume of CDM/JI credits, if carried over from phase II (2008–2012 to phase III 2013-2020) in the EU ETS will undermine its environmental effectiveness, despite the requirement of supplementarity in the Kyoto Protocol.