Climate Change: The European Union's Emissions Trading System (EU-ETS)
Released: 2006-07-31T00:00:00

Overview

Climate change is generally viewed as a global issue, but proposed responses typicallyrequire action at the national level. With the 1997 Kyoto Protocol now in force, countries that ratified the protocol are developing appropriate implementation strategies to begin reducing theiremissions of greenhouse gases. (1) In particular, the European Union (EU) has decided to use anemissions trading scheme (called a "cap-and-trade" program), along with other market-orientedmechanisms permitted under the Protocol, to help it achieve compliance at least cost. (2) The decision to use emissiontrading to implement the Kyoto Protocol is at least partly based on the successful emissions tradingprogram used by the United States to implement its sulfur dioxide (acid rain) control programcontained in Title IV of the 1990 Clean Act Amendments. (3)

The EU's Emissions Trading System (ETS) is a cornerstone of the EU's efforts to meet itsobligation under the Kyoto Protocol. It covers more than 11,500 energy intensive facilities acrossthe 25 EU Member countries, including oil refineries, powerplants over 20 megawatts (MW) incapacity, coke ovens, and iron and steel plants, along with cement, glass, lime, brick, ceramics, andpulp and paper installations. Covered entities emit about 45% of the EU's carbon dioxide emissions.The trading program does not cover emissions of non-CO 2 greenhouse gases, which account forabout 20% of the EU's total greenhouse gas emissions. The first trading period began January 1,2005. A second trading period is scheduled to begin in 2008, covering the period of the KyotoProtocol, with a third one planned for 2013. (4)

Under the Kyoto Protocol, the then-existing 15 nations of the EU agreed to reduce theiremissions by 8% from 1990 levels under a collective arrangement called a "bubble." By 2001,collective greenhouse gas emissions in the EU were 2.3% below 1990 levels, mostly the result ofa structural shift from coal to natural gas in the United Kingdom and the incorporation of EastGermany into West Germany. Several countries, including Ireland, Spain, and Portugal, experiencedemissions growth of over 30% during this period. (5) In light of the Kyoto Protocol targets, the EU adopted a directiveestablishing the EU-ETS that entered into force October 13, 2003. (6) The importance of emissionstrading was elevated by the accession of 10 additional central and eastern Europe countries to EUmembership in May 2004. Collectively, these 10 countries' greenhouse gas emissions dropped 22.6%from 1990-2001, with only Slovenia's emissions increasing during that time (10.4%). Thisexpansion of the EU trading zone to 25 countries greatly increases the opportunities forcost-effective allowance trades.

In deciding on its trading program, the European Commission (EC) adopted a"learning-by-doing" approach to prepare the EU for the Kyoto Protocol's emissions limitations. TheEU does not have major experience with emissions trading, and the EC felt an initial programbeginning in 2005 would give the EU practical familiarity in operating such a system. The EC alsowanted the most comprehensive program possible. As stated in its "Green Paper":

The wider the scope of the system, the greater will bethe variation in the costs of compliance of individual companies, and the greater the potential forlowering costs overall. This argues in favour of a comprehensive trading scheme across differentMember States covering all 6 greenhouse gases and sinks, and encompassing all emissionssources. (7)

Economic analysis conducted by the European Commission confirms the potentialcost-saving available from a comprehensive trading scheme. As shown in Table 1 , a comprehensivetrading program is estimated by the EC to reduce Kyoto compliance costs to EU countries by 3billion euro, or one-third over a compliance scenario that does not include trading among Membercountries, and by 0.9 billion euro, or 13% below the estimate cost of compliance with the tradingscheme ultimately chosen by the EC.

Table 1: Cost of Reaching Kyoto Target to EU Member Statesin 2010

(in billions of 1999 euro)

Source: EC Green Paper (Mar. 8, 2000), p. 27.

For a variety of reasons, the EC chose a trading system with limited coverage rather than acomprehensive system covering all sources and gases. Some European analysts have noted that EUpolitics played an important role in preventing serious consideration of a comprehensive program. As noted by Boemare and Quirion:

A significantly wider coverage could have beenprovided only by an upstream system, which had been excluded by the [European] Commission atthe beginning of the process. The reason was again political: an upstream scheme would have toomuch looked like a tax. (8)

Not surprisingly, this reason was not employed by the EC in explaining its decision to createa less comprehensive trading scheme at this time. As stated by the EC:

... there are sound scientific and practical reasons whythe Community might not wish to establish a comprehensive scheme at this stage. There areconsiderable uncertainties surrounding the emissions of the fluorinated gases [HFC, PFC, SF 6 ] andthe absorption of carbon dioxide by sinks. Allocating allowances, monitoring emissions andenforcing compliance of small mobile emitters, such as private cars, raise complex technical andadministrative issues. (9)

For determining the size of the trading program, the EC looked at five criteria: (1)environmental effectiveness, (2) economic efficiency, (3) the potential effects on competition, (4)feasibility, and (5) existence of alternative policies and measures. It felt that starting with a relativelysmall number of economic sectors and sources that contribute significantly to total emissions andfor which trading could reduce cost significantly would "substantially" satisfy these criteria. (10) As noted, the six sectorschosen emit about 45% of the EU15's CO 2 emissions (which are about 80% of the EU's totalgreenhouse gas emissions). The coverage for individual countries varies widely; only 20% ofFrance's greenhouse gas emissions are covered, compared with 69% of Estonia's emissions. (11)

Implementing the ETS: National Allocation Plans

National Allocation Plans (NAPs) are central to the EU's effort to achieve its Kyotoobligations. Each Member of the EU must submit a NAP that lays out its allocation scheme underthe ETS, including individual allocations to each affected unit. For the first trading period, eachcountry had to prepare a NAP by March 31, 2004 (May 1, 2004 for the 10 new EU Members). NAPsfor the second period were due June 30, 2006. These NAPs are assessed by the EC to determinecompliance with 11 criteria (12 for the second period) delineated in an annex to the emissionstrading directive. (12) Criteria include requirements that the emissions caps and other measures proposed by the state aresufficient to put it on the path toward its Kyoto target, protections against discrimination betweencompanies and sectors, along with provisions for new entrants, clean technology, and early reductioncredits. For the second period, the NAP must guarantee Kyoto compliance.

For the first period, the EC approved most of the necessary NAPs by the end of 2004. Thelast NAP was approved June 20, 2006 (from Greece). In general, the primary problem the EC foundwith NAPs that resulted in revisions were excessive allocation of allowances and state efforts topermit "ex-post adjustments" to their allocations. Excessive allocation problems resulted from statesthat left a gap in how they would achieve their target, to be filled with measures to be defined later;insufficiently delineated plans to purchase allowances; and unrealistic economic or emissions growthassumptions. Ex-post adjustments by states are not allowed; such adjustments are seen by the ECas potentially disruptive to the emissions market and creating uncertainty for companies.

Results From the First Year

Emissions Levels

For the 2005-2007 period, the European Union is not attempting to meet the Kyoto Protocolbut to get experience with emissions trading with some modest emissions targets (i.e., to put the EUon the path toward meeting the Kyoto requirements). Table 2 provides the national emissionsallocations and 2005 emissions levels for 21 EU countries as recorded by the CommunityIndependent Transaction Log (CITL) by the compliance deadline of April 30, 2006. (13) For the first trading period,the 21 countries have allocated an annual average of 1.8295 billion allowances and set aside 73.4million allowances for allocation to new sources or for auctions. Verified emissions in 2005 forcovered sources is 1.7853 billion metric tons, according to the CITL. (14) The 44.2 millionallowances allocated in excess of actual 2005 emissions have been characterized by EU'sEnvironment Commissioner as an "over-allocation" of allowances (15) and is consideredresponsible for a significant drop in allowances prices in May, 2006. The 2005 emissions totalreflects emissions from 8,980 sources representing more than 99% of the allowances allocated. Asof April 30, 849 sources in the 21 countries had not surrendered sufficient allowances. The EC willdetermine whether the insufficiency is the result of technical difficulties in national registries,tardiness, or noncompliance. Noncomplying sources are subject to a 40-euro penalty for each tonof emissions in excess of surrendered allowances under the ETS.

Table 2. Summary Information Per Member State

Note: As all data are held in the CITL and national registries, no data are available for those Member States without an active registry.

a. The figures in this column indicate the number of installations with active registry accounts on 30 April 2006. They differ from figurescommunicated in earlier press releases because they are updated for installations that opted-out for the first trading period, opted-in, andinstallations without open accounts.

b. The figures in this column are allowances allocated to existing installations at the start of the scheme.

c. The figures in this column are allowances not allocated to existing installations at the start of the scheme but put aside mainly for new entrants andauctioning (in the cases of Denmark, Hungary, Ireland, and Lithuania).

d. Due to technical problems in the national registries of the Czech Republic, France, the Slovak Republic, and Spain, the CITL did not receivewholly reliable information on the installation level surrenders from these Member States. Therefore, some fields are empty for theseMember States. All data represented in the table were communicated directly to the European Commission by the respective authorities ofthese Member States.

Some commentators have suggested that annual average 2005-2007 allocations that are actually 44.1 million metric tons higher than the reported 2005emissions are neither putting the EU on the path to the Kyoto requirements nordeveloping the trading market. In addition, this "over-allocation" does not includethe 73.4 million metric tons of allowances held in reserve by the various countriesfor new entrants. The Climate Action Network (CAN), a network of 365non-governmental organizations, stated the following:

Emissions limits set by MemberStates for the first phase were a major disappointment. To ensure maximumenvironmental benefit of the ETS and the overall success of the system as awhole, they need to be strengthened considerably. The Kyoto targets requireambitious caps with absolute reductions for the phase 2008-2012. (16)

In general, the EC has seen the over-allocation issue as part of the"learning-by-doing" process that should help the EU in implementing the secondtrading period beginning in 2008. As stated in its press release:

The new 2005 emissions data givesindependently assessed installation-level figures for the first time and so providesMember States with an excellent factual basis for deciding upon the caps in theirforthcoming national allocations plans for the second trading period, when theKyoto targets have to be met. The plans are subject to approval by theCommission, which will also be making extensive use of the 2005 emissionsdata. (17)

Market Activity, Prices, and Impact

According to Point Carbon's proprietary databases, the EU-ETS traded 362million metric tons of CO 2 in 2005, valued at 7.218 billion euro. Brokers wereresponsible for 57% of the volume, exchange markets did 15%, and bilateraltransactions accounted for 28%. Of the exchange market volume, the EuropeanClimate Exchange (ECX) had the largest share at 63%, followed by Nord Poolwith 24%, and Powernext with 7.9%. (18)

The average price for an allowance traded in 2005 was 19.9 euro, withbrokered and exchanged allowances averaging 20.6 euro and bilateral transactionsaveraging 18.2 euro. However, allowance prices have been quite volatile sincetrading begin in 2005, as indicated in Figure 1 below. (19) Inparticular, allowance prices dropped from almost 30 euro to about 9-11 euro inApril and May, sparked by a series of reported over-allocation of allowances inseveral Member States. By July 2006, allowance prices had recovered to about 17euro in July.

Figure 1. CO2 Market: Even If No "Big" News Highly Volatile

Source: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006),p. 14.

There are several reasons for the overall volatility in the allowance market.The EU-ETS is a maturing but still narrow market. Monthly volumes areincreasing, but have never exceeded a 1.6% share of phase 1 allocations. (20) Modestvolume for a new system is not surprising; trading volumes under the U.S. CleanAir Act Title IV sulfur dioxide trading program were very thin in the beginning. Even after several years of operation, SO 2 allowances prices can changeunpredictably and inexplicably. (21)

Some reasons for ETS allowance price derivatives are explicable. Asillustrated by Figure 2 , the ETS market responded to a variety of regulatory,climatic, and economic events over the first trading period. Regulatory eventsinclude the late approval of NAPs for several countries, along with the resultingover-allocation causing the sudden market correction in May 2006. Climaticevents influencing prices include cold weather, which increased energy usage, anddry conditions, which decreased the availability of hydroelectric power. (22)

Figure 2. CO2 Market: Large Price Changes in Very Short Amount of Time

Source: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006),p. 14.

The primary economic influence on the ETS revolved around fuel prices.During 2005, Point Carbon analysis indicates 79% of the variance (R 2 ) inallowance prices was explained by changes in fuel prices (particularly for electricpower), with 23% of the variance explained by the weather. This linkage betweenallowance prices and the power market is not surprising, as the power sectorconducted the majority of trades in 2005 and therefore significantly influencedprice development.

Kaasik argues that the evidence from the past year indicates that fuelprices influence carbon prices, but not the reverse. Specifically, Kaasik seesallowance prices as a derivative of natural gas and coal pricing, at least in theshort-term. Assuming natural gas-fired and coal-fired generation are the marginalcost suppliers of power, allowance prices will respond positively to increasingnatural gas prices or decreasing coal prices. Likewise, allowance prices willrespond negatively to decreasing natural gas prices or increasing coal prices. Thiscreates a correlation over time between allowance prices and electricity price byinfluencing the marginal price of electricity. How this has evolved during the firsttrading period is illustrated by Figure 3 .

Figure 3. There is a Very Long-Term Correlation Between CO2 and Electricity Price: Link Via Marginal Producer

Source: Margus Kaasik, Eesti Energia, Carbon Market: EUETS (May 9, 2006) p.11.

Use of Clean Development Mechanism (CDM) and Joint Implementation (JI)

The EU-ETS has provisions for linking its trading scheme to the JointImplementation (JI) and Clean Development Mechanism (CDM) components ofthe Kyoto Protocol for countries that have ratified it. These project-basedinstruments involve Annex 1 countries in the case of JI, and between Annex 1 anddeveloping countries in the case of CDM. (23) TheEC's linking directive allows operators to fulfil their allowance obligations underthe EU-ETS using credits derived from JI and CDM projects. Their credits areequivalent to allowances in environmental and economic terms, but are notinterchangeable. "Certified Emissions Reductions" (CERs) under the CDM mustbe issued by the Clean Development Mechanism Executive Board and may beused in either the first or banked for use in the second trading period. (24) Emissions Reduction Units (ERUs) under JI are transferred from one country toanother -- an exchange that cannot begin until the second trading period. NeitherCERs nor ERUs are converted into EU-ETS allowances; rather, they are entereddirectly into the surrendered allowance table. There are other restrictions on theuse of CERs and ERUs. In particular, for the second trading period the amount ofCERs and ERUs that can used by an affected unit is limited by a percentagespecified by its country. Several EU countries have established carbon funds topursue JI and CDM opportunities. (25)

In general, CER and ERU credits have sold at a discount to ETS allowanceprices. The degree of discount has depended on the riskiness of the project. CERand ERU credits are available only when the projects are completed. Thus, wherebuyers take the risk of non-delivery, such as an emissions reduction purchaseagreement (ERPA), prices are in the range of 8-12 euro. In contrast, for CERsalready issued, or where the sellers take the risk, prices are in the range of 13-15euro. (26) The real impact of CDM and JI on theEU-ETS system will not be fully known until the second trading period, when EUdemand for credits will increase substantially and other non-EU countries wouldbe implementing their own Kyoto compliance strategies.

Issues

To assist its review of the ETS, the EC has surveyed stakeholders'viewpoints on ETS implementation and long-term issues. (27) Thereport surveys the viewpoints of participating companies, governments, industryassociations, market intermediaries, and non-governmental organizations (NGOs)from June to September 2005. Asked which of 12 topics surrounding ETSimplementation entities felt were most important to them, companies, industryassociations, and governments all ranked topics such as emissions reductiontargets, allocation rules, and rules for new entrants and closures as the mostimportant -- topics that all relate to long-term uncertainty. Table 3 indicates thetop five topics according to governments surveyed, along with their correspondingranking by other stakeholders. The five issues are discussed below.

Table 3. Importance of EU ETSTopics

(ranking)

Source: European Commission, Review of EU Emissions Trading Scheme (November 2005), p. 13.

Tightening of Emissions Caps

With the over-allocation issue in the first trading period, it is likely that theEC will take a harder stance in reviewing NAPs for the second trading period. Therelationship between the ETS cap for the first trading period and the estimated ETScap for the second trading period (the Kyoto Protocol requirements) variessubstantially between countries, as illustrated in Table 4 . In general, the originalEU-15 countries have to reduce their emissions caps the most to meet their share ofthe EU's requirements under the Kyoto Protocol, with several countries facingdouble-digit percentage reductions. As indicated, EU-15 states, on average, have toreduce their emissions caps 6.8% (119 million metric tons) from their current levelsto meet their requirements under the Kyoto Protocol-based second trading period. In contrast, as a group, the newer countries and the EU as a whole are in substantiallybetter shape. (28)

Table 4: Comparison of 1st and 2nd TradingPeriod ETS Caps

(in millions of metric tons of CO 2 Equivalent unlessotherwise noted)

Source: Based on data provided in Annex 1, European Commission, "FurtherGuidance on Allocation Plans for the 2008 to 2012 trading period of the EUEmissions Trading Scheme" (Brussels, Dec. 12, 2005) p. 11.

a. These figures do not account for changes to the number of installationssubsequent to the respective Commission decision (e.g., opt-ins or opt-outsof installations).

At first glance, it would appear that the EU would have little difficulty meeting its Kyoto Protocol requirements during the second trading period. Theanticipated deficit between the second trading period for the original 15 MemberStates can be covered by trading with the newer Member States that anticipate asurplus. However, there are other considerations. First, countries with potentialsurpluses may want to retain at least some of that surplus to help fuel their countries'economic growth, possibly at the expense of a Member State that needs allowances. Second, the extent to which surplus credits would be created via JI, the EC linkingdirective, requires that such credits (including from CDM) be "supplemental" to acountry's domestic efforts. Each country is to spell out what "supplemental" meansin its NAP for the second trading period.

A third consideration is the overall commitment of the Kyoto Protocol. Asnoted earlier, the ETS only covers a percentage of the overall greenhouse gasemissions in the various Member States of the EU. The analysis provided in Table3 assumes that the ETS will have to provide a proportional amount of that reductionbased on 2003 emissions. However, some sectors not covered by the ETS may growfaster than sectors covered by the ETS, creating difficulties for compliance. Inparticular, the transportation area has become a major source of concern. Thetransportation sector is not a part of the ETS and is not likely to be included beforethe third trading period. (29) Instead, transport controls are based on voluntaryagreements with automobile manufacturers to improve fuel economy, fuel-economylabelling of cars, and promoting fuel efficiency by fiscal measures. (30) Thecornerstone is the agreements with automobile manufacturers to achieve improvenew car fleet average CO 2 emissions rates. As announced in 1996, the objective ofthe EU Council of Environmental Ministers and European Parliament was to achievea new car fleet average CO 2 emissions rate of 120 grams per kilometer (g CO 2 /km)by 2005, or by 2010 at the latest. (31)

This objective was not met in 2005 and is unlikely to be met by 2010. Voluntary commitments by the European, Japanese, and Korean AutomobileManufacturers Associations in 1998 and subsequently endorsed by the EC set targetsof 140 g CO 2 /km by 2008/2009. At the end of 2005, the average new car emissionsrate is about 160 g CO 2 /km. The rate of reduction in CO 2 /km for new cars wouldhave to double for the automobile manufacturers to achieve their commitments,which appears unlikely. (32) Indeed, despite improvements in emissions rates,CO 2 emissions in the EU continue to rise because of increased miles driven,increased size and weight of cars, and falling car occupancy rates. The EC 2005progress report also notes that despite EU's effort to increase information on fuelefficiency and CO 2 emissions for consumers, the effectiveness of the effort seemslow: "a significant impact on consumer's decisions could not yet be noticed." (33)

Attempts to balance the burden between ETS and non-ETS sectors havealready created tension in Germany with respect to the second trading period. In itsdraft NAP for the second trading period (NAP II) submitted June 28, 2006, Germanyproposes to reduce its ETS allocation from about 499 million metric tons to about471 million metric tons, a decrease of 5.6%. (34) However,Germany's 2005 emissions were only 474 million metric tons; thus the reduction isonly 0.6% from last year's emissions. In addition, Germany is proposing to permitevery new power station built between 2008 and 2012 to opt out from CO 2 caps andthe ETS for 14 years, generally to encourage construction of coal-fired facilities. These emissions increases will have to be covered by the non-ETS sectors --commercial, residential, and transportation. An assessment done for GreenpeaceInternational states that the German NAP II places "a disproportionate burden foremissions reductions on the non-ETS sectors" in terms of meeting its commitmentsunder the EU Burden Sharing agreement. (35) Policies to fill in the gap reportedly include oneplan to reduce emissions by 3 million tons by training German drivers to drive moreeconomically. (36) As noted by the EC Report cited above, theeffectiveness of public education programs such as this may be problematic.

Harmonizing NAPs

The EU-ETS system involves an interplay between definitions and proceduresthat are EU-wide and those that are nationwide. The groundwork for the system is theKyoto Protocol, which (1) defines the pollutants and sets the countries' emissionstargets; (2) defines the scope of participation: Annex 1 countries may implementemissions trading programs, and non-Annex 1 countries may participate through theCDM; (3) defines baseline emissions years and sinks; and (4) sets national inventoryand compliance requirements. Within this framework, the EU defines the elementsthat make the EU-ETS work, including industry participants, the unit of trade(tradeable allowances equal to 1 metric ton of CO 2 ), trading periods, settling upprocedures, and linkages within and beyond the EU.

With respect to the individual Member's NAPs, the EC harmonizes the NAPswith respect to penalties, allocation method (e.g., grandfathering), monitoring, andregistries with the goal of achieving the Kyoto targets. It allows Members flexibilitywith respect to allocations to individual participants, the extent to which banking ispermitted, and whether to permit the auctioning of up to 10% of allowances in thesecond trading period. As a result of this framework, there are significant differencesbetween Members with respect to participant definitions, industry level emissionscaps and allocations, and enforcement.

To increase the economic and administrative efficiency of the ETS, somestakeholders are interested in improved harmonization of NAPs by the EC. Besidesthe issue of new entrants and definition of affected units specifically identified by theEC survey, harmonization issues include allocation methods and the use of auctions,the degree to which JI and CDM credits may be used for compliance, and monitoring,verification, and reporting rules. Table 5 illustrates the scope of potentialharmonization issues facing the EU-ETS.

Table 5: NAP HarmonizationIssues

Source : Adapted from Fiona Mullins, EU ETS Implementation: Room forHarmonisation (The Royal Institute of International Affairs, 2005).

One issue of particular interest is the effort to increase the use of "benchmarking" standards in setting allocations. Benchmarking generally involvesallocating allowances based on best available technology and practices, rather thanon historical emissions. However, the EC does not have the authority to scrutinizeallocations at the facility level, so any allocation harmonization would be on avoluntary basis ("soft harmonization"). Also, allocation schemes, such asbenchmarking, may not be suitable for some industries. (37) The EC'ssurvey of ETS stakeholders revealed that although more than two-thirds of therespondents from the cement, aluminum, and chemical industries thoughtbenchmarking was an "interesting alternative," less than a third of the respondentsfrom the pulp and paper industry and refineries thought so. (38)

In many ways, diversity between Member countries with respect to the ETSis inevitable. As stated by Grubb and Neuhoff with respect to allocation:

The final way in which the EU ETSdiffers from many other trading systems is in the devolution of allocationresponsibilities, in this case to its 25 Member States. This was an essential part of thedeal that enabled the adoption of the Directive: Member States would have neverceded to the European Commission the power to distribute valuable assets to theirindustries. Nor is the EU ETS unique in devolving powers of allocation: it is typicalin a number of US systems. Moreover, there are different degrees of harmonization,applicable to different aspects of the EU ETS, and the Commission can and does seekto increase the degree of harmonization through guidance notes. (39) [footnoteomitted]

New Entrants

The economic value of allowances is nowhere more evident than indiscussions of new entrants. Indeed, as noted above, Germany is proposing to permitnew coal-fired powerplants built between 2008-2012 to opt-out of the ETS for thefirst 14 years of operation in order to encourage construction. In its survey of ETSstakeholders, the EC found that 85% of all respondents favor a harmonized approachto new entrants and closures. Nearly 75% believed that those allowances should beprovided free. (40) Likewise, an EU questionnaire conducted by theEuropean Environmental Agency's Topic Centre on Air and Climate Changeindicated that most Member States would welcome harmonization of the treatmentof new entrants and closures across the EU. (41)

Analogous to the U.S. acid rain program, EU states have set up reserves toprovide allowances to new entrants. In general, these allowances are provided free,as that is widely seen as helping boost new investment. However, the allocationmethods developed by the Member States differ. Most states have yet to dip intotheir reserves for new entrants; however, the importance of the reserve will increaseas the ETS enters its second, and eventually third, trading period. The manner inwhich new entrants receive allowances may have a significant effect on the long-termdirection of investment -- whether it is directed toward low-carbon opportunities orused to support continuation of current economic development irrespective of itscarbon intensity. Allocating allowances according to output and not differentiatingaccording to the carbon intensity of the project would provide an incentive to developlow carbon alternatives. An example provided by Grubb and Neuhoff:

New entrant reserves should be basedon output or capacity, and avoid differentiating according to the CO 2 -intensity of thenew investment. In particular, giving more to coal than gas plants rewardsinvestment in new coal facilities, which would conflict with objectives to tackleclimate change, increase the cost of future emissions reductions, and in the long runcould lead to higher electricity prices. The damaging effects would be amplified ifcarbon-intensive new entrants not only receive free allowances for the period2008-2012 but also receive promises for subsequent periods. (42)

The proposed treatment of coal-fired powerplants by the German Governmentindicates how difficult it will be to direct future investment toward low-carbonprojects. However, it could be argued that the long-term success of the ETS and theEU's commitment to Kyoto and any subsequent agreements rests on such aredirection with respect to new entrants and long-term investment.

Definition of Affected Units

Another area in which several Member States would like more harmonizationacross the EU is the definition of a combustion installation. (43) Concernsrevolve around ambiguity in the current definition of a combustion installation andthe number of small installations covered under the ETS. The ETS applies to energyactivities for all sectors with combustion installations above 20 MW of thermal ratedinput, oil refineries, coke ovens, and, subject to size criteria, iron and steel, cement,lime, glass, ceramics, and pulp and paper facilities. However, Finland and Swedenopted to include small district heating installations with a rated thermal input below20 MW. (44) In contrast, as noted previously, Germany isattempting to have some planned coal-fired powerplants, which will be largeproducers of CO 2 , able to opt-out of the ETS for 14 years.

In addition to the consistency issue, small installations (between 20MW and50MW) account for 30% (about 3,000) of the total facilities covered under the ETS,but a very small percentage of total CO 2 emissions. (45) Surveying22 Member States, 36% of the covered installations produced less than 10,000 metrictons of CO 2 annually. (46) The somewhat weak emissions data available atthe time of the EU questionnaire suggest that while three-quarters of all emissionsare produced by the largest 7.5% of installations, the small installations (under10,000 metric tons) are responsible for less than 1%. Whether the ETS shouldcontinue to cover the roughly 3,500 facilities under 10,000 metric tons annuallyremains a hotly debated issue.

Expansion of Coverage

In choosing a gradual, incremental approach to emissions trading, the EU isrelying on other programs to control greenhouse gas emissions in other sectors, suchas transportation. The difficulties the EC may encounter in not choosing acomprehensive approach to begin with is suggested by its survey of stakeholders.

The survey suggests that the future direction of the ETS in terms of increasingcoverage is toward incrementally adding more economic sectors, rather thanaddressing the more complex issue of a comprehensive system. Based on the survey,the focus is currently on the chemical, aviation, and aluminum industries. (47) Given thatthe number-one recommendation for future implementation of the ETS is to provideparticipants with a longer time frame for implementation, it is unclear when the ETSwill become as comprehensive as the European Commission would like.

Conclusion

At first glance, the ETS would appear an effective vehicle for the EU to meetits Kyoto Protocol obligations during the second trading period. The anticipateddeficit between the second trading period for the original 15 Member States can becovered by trading with the newer Member States that anticipate a surplus. Inaddition, potential CERs and ERUs from the CDM and JI respectively may helpmaintain limits on allowance costs. Table 6 provides one series of estimates ofavailable allowances for the Kyoto Protocol's five-year compliance period.Obviously, not all these allowances may be available to the EU alone; othercountries, such as Japan and Canada, may decide to incorporate emissions tradinginto their implementation strategies and acquire allowances from these sources. Yet,the totals suggest that all else being equal, the supply of allowances would beadequate.

Table 6: International Supply of EmissionsCredits and Allowances

(cumulative total 2008-2012, million metric tonsCO 2 )

Source: Compiled by Grubb and Neuhoff, "Allocation and Competitiveness in theEU Emissions Trading Scheme: Policy Overview," p. 20.

However, there are other considerations. The availability of surplus credits created via JI and CDM is restricted by the EC linking directive that requires thatsuch credits be "supplemental" to a country's domestic efforts. Each country is tospell out what "supplemental" means in its NAP for the second trading period.Individual countries are likely to define that term differently -- restricting allowancetrades and purchases in some countries.

Another consideration is the overall commitment of the Kyoto Protocol. Asnoted earlier, the ETS only covers a percentage of the overall greenhouse gasemissions in the various Member States of the EU. Some sectors not covered by theETS may grow faster than sectors covered by the ETS, creating difficulties forcompliance. In particular, the transportation area is already a major source ofconcern.

A final consideration for the ETS is its suitability for directing long-terminvestment toward a low-carbon future -- the ultimate goal of any climate changeprogram. It is too early to tell whether the ETS market signal and individualcountries' NAPs will move investment in the appropriate direction. The early signsare not particularly encouraging, with the 2005-2008 NAPs producing anover-allocation of allowances, and one major Member State, Germany, attemptingto direct its second NAP toward carbon-intensive, coal-fired electric generatingfacilities rather than low-carbon alternatives. Reluctance by countries to redirecttheir NAPs and an inconsistent price from the ETS make the long-term effect of theETS uncertain.

Appendix: Norway's Trading System

Norway, a non-EU country, also has an emissions trading system that beganoperating on January 1, 2005. Norway's system covers 51 facilities in the energy andprocess sectors such as oil refining and iron and steel processing, and has severalfeatures in common with the EU ETS. (48) These sectors account for about 10-15% of thecountry's emissions. Other parts of Norway's industry, particularly its offshore oiland gas sector, are covered by the country's carbon tax of almost 40 euro per metrictonne of CO 2 -- much higher than the anticipated allowance price under the tradingprogram. The carbon tax is levied on about 64% of the country's CO 2 emissions --about half the country's total greenhouse gas emissions. (49) The firstphase of the trading program covers the period 2005-2007, with a second, expandedphase to begin in 2008.

Developing its initial trading scheme independently of the EU, Norway's"Quota Commission" (created in 1998) stressed that the 2008 program be ascomprehensive as possible, suggesting that the system could include close to 90% ofthe country's greenhouse gas emissions. (50) To achieve this coverage, the Commissionenvisioned a hybrid system of quotas, depending on cost-effectiveness andpracticality considerations. Arguing in favor of regulating CO 2 emissions at theproducer (upstream) level from mobile sources and some stationary sources, theQuota Commission states:

For these emissions, regulation at theproducer level will not create weaker incentives for reducing emissions thanregulation at the consumer level, because the volume of emissions from a particularcommodity is not dependent on technology. For those process emissions which arerecommended for inclusion in the system, regulation by quotas should be imposedat the end-user level in cases where the processes originate with major industrialcompanies. For process emissions stemming from a series of small sources, e.g.emissions of N 2 O from commercial fertilizers, regulation by quotas should beimposed on retailers, or importers in order to avoid unacceptably high systemcosts. (51)

The Commission's recommendation that "regulation by quotas be imposed inpart on the producer, in part on the sales or import chain, and in part on theend-user" (52) may be overtaken by development of the EU ETS,which is likely to influence the future direction of Norway's trading system. TheInternational Energy Agency (IEA) states:

The government had indicated earlierthat it would consider expanding the [trading] system from 2008 to include as manysources of emissions as practical through an upstream system allocating allowancesto fossil fuel producers and importers. With the adoption of the EU ETS designfeatures, Norway seems to move away from this option. (53)