Has the European Union Emissions Trading System Been a Success?

Has the European Union Emissions Trading System Been a Success?

Energy Law – Professor Palmiter

November 19, 2010

Lauren Tozzi

Introduction

The European Union Emissions Trading System (“ETS”) is the first international trading system for CO2. As the world struggles to find viable ways of reducing greenhouse gas emissions, the success or failure of the ETS will determine whether other countries adopt carbon-trading schemes. Since the ETS became active in 2005, Europe’s long-term goal has been to attain a 20 percent reduction of 1990 emissions levels by 2020 (“20/20 Plan”), and its short-term goal under the Kyoto Protocol has been to attain an 8 percent reduction of 1990 emissions levels by 2012. A brief analysis of statistical trends, setbacks, and short-term progress all illustrate that the ETS is on track to meet its goals, and should serve as a model cap-and-trade system.

Background: The Kyoto Protocol

The Kyoto Protocol was added to the United Nations Framework Convention on Climate Change (“the Convention”) in 1997. The Kyoto Protocol fortified the Convention by setting specific targets for reducing greenhouse gas emissions (“GHG emissions”) and establishing legally binding deadlines for states to meet these targets. Under the Kyoto Protocol, both the EU and its Member States are committed to reducing CO2 emissions by 8% of 1990 levels during the first commitment period, which lasts from 2008-2012. In Directive 2003/87/EC (“Original Directive”), the EU established the ETS as a means of meeting its emissions reduction target under the Kyoto Protocol.

Two components of the Kyoto Protocol are fundamental to the design of the ETS. First, the Kyoto Protocol allows parties to pursue their emissions reduction targets individually or jointly. Governments that agree to work together, as the Member States in the EU have agreed to do, may aggregate their emissions to fulfill their Kyoto obligations. Second, parties may engage in emissions trading to meet their goals. Thus, the ETS is a cap-and-trade program that covers all Member States, and the entities within the Member States that must comply with the ETS, such as steel and cement factories, are called “covered installations.” The covered installations may trade allowances with one another to meet their designated emissions caps, and each installation must annually submit a number of “allowances” equal to its total emissions for the year. For example, if Installation A emits more tons of CO2 than the number of allowances it has for the year, and Installation B emits fewer tons of CO2, then Installation Bcould sell its extra allowances to Installation A. Installation A would pay Installation B for these extra allowances so that it would be in compliance when it made its annual submission. This trade in allowances creates a carbon market that lowers the overall cost of compliance.

Not all GHG emitters are covered by the ETS. In fact, the current participants are only responsible for 40 percent of GHG emissions in the EU, and the ETS will not cover emissions from the aviation sector until 2012. Thus, the ETS has room to grow within the EU, and in the long-term, to expand beyond the EU. Market expansion is an important goal because the larger the market, the lower the cost of compliance. Furthermore, it is in the EU’s best interest that industries outside the EU participate in emissions trading so that European industries are not at a competitive disadvantage.

Three Phases

The European Union (“EU”) designed the ETS to be a flexible system that could evolve over time. By implementing the ETS in a series of three phases, the EU has been able to respond to problems and implement changes as necessary. As a result, the ETS has grown stronger and more effective since its inception.

The Original Directive established two initial phases for the ETS. The first phase was considered a trial period and lasted from 2005 to 2007. The second phase, which is currently in progress, coincides with the first commitment period under the Kyoto Protocol, and lasts from 2008 to 2012. Under Directive 2009/29/EC (“Revised Directive”), there will be a third phase that lasts from 2013 to 2020.

Without the example of an internationalcap-and-trade scheme to follow, the EU wisely includeda trial phase as a means of setting up the infrastructure to effectively run the ETS. Unsurprisingly, the trial phase revealed a number of weaknesses in the ETS, but the EU was able to respond to these problems in its plans for subsequent phases. The most important problem that the trial phase revealed was that the EU had distributed too many allowances, rendering the price of an allowance worthless.

Market Crash Lead Some to Call ETS “Failure”

Under the Original Directive, which governed Phases I and II, Member States wrote their own National Allocation Plans (“NAPs”), which set the total number of emission allowances that each state could allocate to its covered installations, and included plans for distributing the allowances. In Phase I, Member States overestimated the number of allowances they would need, in part, because the data underlying their requests did not require independent verification. When Member States’ verified emissions data were published in 2006, the price of carbon plummeted because states’ emissions were much lower than expected, leaving an over-supply of allowances on the carbon market. The crash in the price of carbon threatened the stability of the ETS and even led some critics to call it a “failure.”

Comprehensive Solution to Market Instability

The Commission responded to this problem by taking a more active role in reviewing Member States’ NAPs for Phase II. Prior to Phase II, each Member State had to submit its NAP to the Commission far in advance of the trading period to give the Commissiontime to reject, approve, or partially reject the plan. If a NAP successfully complied withcertain criteria, then the Member State could implement it and distribute allowances to covered installations. The Commission rejected NAPs that set annual emissions allowances too high and required Member States to revise them. By independently verifying each NAP, the Commission assured that Member States were accurately estimating how much CO2 they would emit. Thus, the Commission played a more important role in the allocation of allowances in Phase II than in Phase I. As a result of this more centralized control over allocation of allowances, carbon prices have remained relatively stable in Phase II.

The EU isimplementing changes in Phase III that will further centralize control over the number of allowances allocated. In Phase III, the Commission will set an EU-wide cap on emissions, and the Member States will auction allowances, rather than receive them for free. Under the Revised Directive, which governs allocation for Phase III, Member States will no longer determine their total number of allowances, nor will they issue thembased on NAPs. Instead, the Commission will determine an EU-wide cap on allowances and distribute them in relation to the national totals set in Phase II. The EU-wide cap will decline at an annual rate (1.74%), which will enable the EU to meet its 20/20 Plan.

To further assure accurate pricingin Phase III, allowances will be auctioned. After the Commission distributes allowances to the Member States, the Member Stateswill auction them to their covered installations. Under the Revised Directive,Member States keep the revenue from their auctions, but they must spend approximately 50% of it on reducing GHG emissions. Acceptable expenditures include developing renewable energy, financing research in clean technologies, and encouraging a shift to low-emission and public transportation.

The EU distributed too many allowances in the trial phase, but since then, it has twice improved upon its allocation system. First, Member States had to submit NAPs for Commission approval in Phase II. Now, for Phase III, the Commission will independently set the number of allowances per Member State, and the Member States will auction them. Although the price collapse in the trial phase revealed a vital weakness in the ETS, the EU has quickly responded with a comprehensive solution.

Additional Improvements under the Revised Directive

More centralized control over distribution of allowancessolved other problems in addition to price instability. Increased centralization in the Revised Directive assured that states would enjoy fairer competition with one another, andimproved upon the structure of the ETS so that it would be better suited to international carbon trading.

Under the old NAP system each Member State allocated its allowances differently, which led to comparative advantages for some states and disadvantages for others. The allocation system under the Revised Directive assures greater harmonizationbecause the Commission sets the allowances, and Member States share a uniform system of distributionby auction, which will lead to fairer competition.

The centralized allocation system under the Revised Directive will also facilitate administration of the ETS on a global scale, which will help the EU meet its long-term goal of establishing an international carbon trading market. The EU seeks to expand the ETS internationally because as the size of its market increases, the cost of compliance falls. Whereas the Original Directive only allowed tradingbetween industrialized countries, the Revised Directive allowstrading between the ETS and any country or administrative entity, including states or groups of states. More centralized control in the Commission will facilitate communications with international trading partners. In contrast, outside trading partners would have had to communicate with twenty-seven different Member States under the Original Directive. Under the Revised Directive, the Commission is merely required to consult with the European Parliament and Council in order to engage new international trading partners.

Current Threats to Market Stability

One of the many negative repercussions of the economic downturn is that it has led to excess allowances in the ETSbecause factories areemitting less than they were expected to when the allocations were made. As a result, some covered installations have not needed all the allowances they received from the government for free, and they are selling their excess allowances as a way of offsetting other financial losses. Compared with 2008, emissions from covered installations in the metals sector fell by about 30 percent, and emissions in the cement, lime and glass sectors fell by about 20 percent. Despite the flood of unused allowances onto the market, the price per allowance has not suffered. And although 72 million tons worth of excess allowances may remain in the market in 2010, the price per allowance is still expected to increase because of the tighter EU-wide cap on emissions and the soon-to-be-implemented auction format for distributing allowances. In addition, those covered installations holding excess allowances can wait until Phase III (2013-2020) to use them. This carryover option was not available when the market crashed at the end of the trial period.

The economic downturn has not been the only threat to market stability. There has also been a series of discouraging events regarding worldwide cooperation on climate change in the past couple of years. The climate summit in Copenhagen in 2009 made little progress, and the U.S. is still far from adopting climate change legislation. Such dismal prospects would presumably threaten the price of carbon in the ETS, yet the market has not responded in a volatile way. Following the disappointing results of the Copenhagen climate summit, the cost of emitting one ton of carbon only dipped from €14.60 to €12.70. Likewise, the loss of the democratic Senate seat in Massachusetts sounded the death knell for an American cap-and-trade scheme, but the EU carbon market merely hiccupped. The market’s steady response to such negative events led The Economist to conclude that the long-term prospects for the ETS “remain reasonable, if humble.”

The crash in the price of carbon at the end of the trial phase threatened to undermine the entire system, but that threat stands in stark contrast to the current strength of the market. The price of carbon is holding steady despite the economic downturn and lack of global cooperation in solving the climate crisis. Furthermore, the ETS is effectively reducing GHG emissions.

The ETS is Reducing GHG Emissions in the EU

Determining how much the ETS has reduced GHG emissions is a complex calculation because it requires an estimation of what emissions would have been without the ETS. Many variables may affect the level of GHG emissions and the price of carbon, including economic growth, energy prices, and weather. For example, if the price of natural gas falls while the price of coal rises, then fuel-users will tend to switch to gas, regardless of the price of an allowance. With all these variables, it is difficult to link cause and effect, and it is unclear precisely how much of an impact the ETS is having on GHG emissions.

Despite these uncertainties, there has been a reduction in the level of GHG emissions in the EU since the inception of the ETS. Although the trial phase was not expected to yield significant emissions reductions, a 2008 Massachusetts Institute of Technology study (“MIT study”) reported that covered emissions may have been reduced by as much as 5 percent during that period. While five percent may be a modest change, the main purpose of the trial phase was to establish an infrastructure for the future operation of the ETS, not to yield significant emissions reductions. Indeed, the MIT study focused on how the ETS could be improved, not on how it had already succeeded.

In May of this year, the EU Commission reported that emissions from covered entities fell 11.6 percent in 2009 compared with 2010. This was the largest annual decline since the ETS began in 2005. While this result can be partly attributed to the economic downturn, the Commission insists that the ETS is reducing emissions as well. Most importantly, the Commission reports that it is “well on-track” to meet its upcoming goal under the Kyoto Protocol of reducing emissions during the 2008-2012 period to 8 percent below 1990 levels.

With a steady market and reduced GHG emissions, the ETS certainly seems to be “well on-track.” Despite these encouraging signs, some critics say that the price of carbon needs to be higher to force “profound changes in energy generation.” Fortunately, the EU has the means to increase the cost of carbon, and seems willing to make the necessary changes – again.

Political Will Power to Further Strengthen the Market

If the ETS needs a boost following the recession, EU politicians can likely tweak it accordingly, and may be preparing to do so because the Commission has initiated dialogue about raising the EU goal for 2020. Rather than aiming to reduce emissions by 20 percent of 1990 levels by 2020, the Commission is considering a 30 percent reduction. This has been a potential course of action for the EU since 2007, when the Council agreed to strive for a 30 percentreduction in emissions if other major economies made similar commitments. The European Commissioner for Climate Action, Connie Hedegaard, seems to be using this carrot from prior negotiations as a means of bolstering the ETS following the economic downturn. Rather than waiting for other countries to make similar commitments, Ms. Hedegaard is suggesting that the EU commit to a 30% reduction“when the timing and conditions are right.”

Conclusion

While the statistics show that the ETS is reducing GHG emissions, this is only part of what the ETS has accomplished. What is truly remarkable about the ETS is that it is the first international cap-and-trade system, and it has already overcome challenges and evolved into a system that will serve as avaluable model to other governments worldwide.

The ETS is succeeding because it is a flexible system that will gradually reduce emissions in pursuit of the EU’s emissions targets. Although the Commission cannot yet report that the ETS has drastically reduced GHG emissions, the ETS is constantly evolving into a system that will help solve the climate crisis. If the ETS had been more rigidly designed, then the EU could not have madeimportant and necessary changes to it. Although the ETS has many critics, the EU is responding quickly and effectively to problems as they arise. The modifications to the allocation system and the current political willingness to increase the 2020 goal demonstrate theEU’s assertive approach to making the ETS a success.

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