Box 112 The EU Emissions Trading Scheme

The EU ETS is a cap and trade scheme covering CO2 emissions from electricity generation, oil refining and energy intensive manufacturing industries, such as steel, cement and paper. The first phase of the scheme (Phase 1) ran from 2005 to 2007, while the current phase (Phase 2) coincides with the first commitment period of the Kyoto Protocol (2008 to 2012). In January 2008 the Commission published proposals for Phase 3, which will run from 2013 to 2020 (CEC, 2008). These proposals are reviewed in this chapter (Box 11.3), but at the time of writing were not yet enshrined in legislation.

For Phases 1 and 2, each member state submitted a National Allocation Plan (NAP) to the Commission specifying the total number of allowances that would be allocated, how these would be distributed between the participating installations and how new entrants and plant closures would be handled. The NAPs were required to comply with broad guidelines set out in the 2003 Directive (CEC, 2003) and the Commission reserved the right to modify the NAPs if these requirements were not met. Most of the allowances were allocated for free, although the Directive allowed up to five per cent to be auctioned in Phase 1 and ten per cent in Phase 2. Hence, in each phase, the aggregate EU ETS cap was set in a bottom-up fashion through the sum of the targets in the individual NAPs.

Each of the roughly 11,000 installations participating in the EU ETS have been allocated a specified number of allowances, which can be freely traded with other installations. Banking of allowances was not permitted from Phase 1 to Phase 2, but Phase 2 allowances could be banked for subsequent use during Phase 3. Non-compliance penalties were set at 40 Euros per tonne of CO2 (€/tCO2) in Phase 1 and increased to €100/tC02 in Phase 2. These penalties, in combination with the requirement to surrender allowances in the subsequent phase to cover any excess emissions, effectively set a ceiling on the allowance price. Emissions credits from JI and CDM projects may also be used for compliance, subject to an aggregate limit on the total number imported (which in Phase 2 amounts to 14 per cent of capped emissions).

The establishment of the EU ETS represents an unprecedented achievement for EU climate policy and one that has long term and global implications. Given factors such as the difficulties of collective decision making with 25 member states, the limited experience of most member states with emissions trading at the time the scheme was proposed, the lack of information on baseline emissions (and even on which sites were eligible for inclusion), the diversity of sectors and number of sites involved (over 11,000), the potentially significant economic impacts, the ambitious timetable for implementation and the value of the assets being distributed (over €20 billion at allowance prices of €10/tC02), the scale of this achievement should not be underestimated.

Nevertheless most independent commentators would agree with the UK Carbon Trust's verdict on Phase 1, namely: 'The overarching lesson is that the market and verification worked but the initial allocation didn't' (Carbon Trust, 2006a). The allocations to individual installations were decided by individual member states through the Phase 1 NAPs, with the sum of these providing the overall cap. While the Commission could have modified the Phase 1 NAPs, its scope for manoeuvre was constrained by legal and political considerations and especially by the tight timescale for implementation. The predictable result was a 'race to the bottom', with the aggregate cap being only slightly below official forecasts of business as usual emissions and within the range of forecasting error. Moreover, the emission forecasts themselves are likely to have been upwardly biased (Grubb and Ferrario, 2006). The suspicion of over-allocation was confirmed in May 2006 when the release of verified emission data for 2005 showed that actual emissions were some 100MtC02 (five per cent) below allowance allocations.2 This triggered a price collapse (Figure 11.2), and by early 2007 a combination of the accumulating allowance surplus, the falling price of gas relative to coal and the inability to bank allowances into Phase 2 had pushed the Phase 1 allowance price to as low as €1/tC02.

While Phase 1 should be regarded as a learning phase, a repeat of the same mistakes in Phase 2 would have more serious consequences since

45 40 35 30

25 a

20 15 10 5

ci1 & & & & & & & & $ $ & ,<?> & <§> ■ Volume traded (MtCO2) -Phase I allowance price-Phase II allowance price|

45 40 35 30

25 a

20 15 10 5

ci1 & & & & & & & & $ $ & ,<?> & <§> ■ Volume traded (MtCO2) -Phase I allowance price-Phase II allowance price|

Figure 11.2 EU ETS allowance price trends

Source: Provided to the author by NERA Economic Consulting (prepared using data from PointCarbon)

Table 11.1 Early assessment of the stringency of EU ETS Phase 2 National Allocation Plans

Proposed allocations compared to:

'Old' Member States (EU-15)

'New' Member States (EU-12)


2005 actual emissions


+ 31.3%

+ 2.7%

Phase 1 cap


+ 21.0%


NAP/official emission


+ 21.1%



this would threaten member state compliance with their Kyoto obligations. Despite this, the majority of member states proposed relatively weak emission caps in their Phase 2 NAPs. Table 11.1 compares the aggregate caps provided in 18 of the Phase 2 NAPs submitted to the Commission in 2006 (representing about 87 per cent of total allowances) against: (i) actual emissions in 2005, (ii) the corresponding Phase 1 cap and (iii) official emission projections (Betz et al., 2006). If the Commission had accepted these proposals, the overall Phase 2 cap would have exceeded that in Phase 1 (i.e. permitting an increase in emissions) and the allowance price would have been close to zero.

Fortunately, the Commission decisively intervened to maintain the credibility and effectiveness of the EU ETS by reducing the total number of allowances that member states were allowed to allocate. The only countries that did not have their Phase 2 NAPs modified were Denmark, France, Slovenia and the UK. Overall, the required changes led to a 10.4 per cent reduction in allowed emissions, giving an aggregate cap of 2098 MtCO2 per year. This corresponds to a reduction of approximately six per cent (130 MtCO2) below 2005 verified emissions.3 However, while the cap for the 'old' member states (EU-15) was set at 8.7 per cent below verified 2005 emissions, that for the 'new' members states (EU-12) was set at 3.6 per cent above (IETA, 2008). The Commission also placed stricter limits on the number of JI and CDM credits that could be imported in Phase 2 (a maximum of 306 MtCO2/year).

Analysts are divided on the implications of these changes for the supply/demand balance in Phase 2 and the corresponding market price of allowances. This will depend upon economic growth and fuel price trends, the impact of parallel commitments to expand the share of renewable energy, the number of imported JI and CDM credits and the extent to which these are used during Phase 2 or banked into Phase 3. Under some assumptions, the number of JI and CDM credits available in Phase 2 could still exceed the anticipated shortfall, thereby giving little incentive for domestic abatement. Conversely, under alternative assumptions the allowance price may be as high as €35/tCO2 (IETA, 2008). But whatever the outcome, member states must still comply with their Kyoto obligations. Hence, an insufficiently stringent EU ETS cap could mean either that additional abatement is required in non-EU ETS sectors (which generally have higher abatement costs), or that some member states need to use the Kyoto mechanisms to comply (with the costs being borne by taxpayers). In either case, the aggregate costs for complying with the Kyoto Protocol could be increased, together with the cost burden on low-income groups (Betz et al., 2004).

In contrast to the aggregate targets, the Commission made relatively few changes to the proposed allocation rules for individual installations - with the result that these largely repeat the distortions introduced in Phase 1. For example, most allowances are allocated on the basis of historic emissions rather than best practice benchmarks, thereby rewarding the 'dirtier' plants and penalising the cleaner ones. Similar, new installations are allocated allowances for free, creating both an effective subsidy on output and a disincentive to low carbon innovation (Neuhoff et al., 2006).

In November 2006, the Commission began a wide-ranging review of the EU ETS which sought to address some of the weaknesses identified above. The review highlighted the need for more centralisation and harmonisation in the allocation rules, together with more stringent caps that provided greater predictability in carbon prices over the longer term. The prospects for this were considerably strengthened by the European Council's decision in February 2007 to commit the EU to a 20 per cent reduction of GHG emissions by 2020 compared to 1990 levels, increasing to 30 per cent if other developed countries did the same (Council of the European Union, 2007b). The Commission published its proposals for EU ETS Phase 3 in January 2008, alongside a number of other proposals on climate change and renewable energy (CEC, 2008). The key points are summarised in Box 11.3.

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