Greenhouse gases—including carbon dioxide, methane, nitrous oxide, and synthetic chemicals such as fluorinated gases—trap heat in the atmosphere and prevent it from returning to space. The heat-trapping effect, known as the greenhouse effect, moderates atmospheric and surface temperatures, keeping the earth warm enough to support life and varies depending on the gas. Each unit of the non-carbon-dioxide gas generally has a greater warming effect than each unit of carbon dioxide, although carbon dioxide is the most prevalent anthropogenic greenhouse gas and has the greatest overall effect on warming. According to the Intergovernmental Panel on Climate Change (IPCC)—an organization within the UN that assesses scientific, technical, and economic information on the effects of climate change—global atmospheric concentrations of these greenhouse gases have increased markedly as a result of human activities over the past 200 years, contributing to a warming of the earth’s climate. Climate change is a long-term and global issue because greenhouse gases disperse widely in the atmosphere once emitted and can remain there for an extended period of time. Among other potential impacts, climate change could threaten coastal areas with rising sea levels, alter agricultural productivity, and increase the intensity and frequency of floods and tropical storms. The effect of increases in atmospheric concentrations of greenhouse gases and temperature on ecosystems and economic growth is expected to vary across regions, countries, and economic sectors. One of the greatest challenges underlying policies to address climate change is reducing greenhouse gases while meeting rising energy demands. Energy demands are met largely through fossil fuel combustion, which releases greenhouse gases—primarily carbon dioxide. In fact, fossil fuel combustion accounts for the largest share of growth in greenhouse gas emissions, according to the IPCC. For example, greenhouse gas emissions from electricity and heat production grew 145 percent between 1970 and 2004; emissions from road transportation increased 120 percent. Other sources of greenhouse gas emissions include agricultural activities, transportation, forestry, waste management, and residential and commercial activities. According to the IPCC, in 2004, developed countries, including the United States, constituted 20 percent of global population, but were responsible for nearly half of global greenhouse gas emissions. The total emissions from some developing countries, which have lower per capita emissions but larger populations, have begun to approach the total emissions from developed countries, which tend to have higher per capita emissions and smaller populations. Recent economic development in nations such as China and India has reduced poverty but also has increased energy use, which has caused rapid growth in emissions. In the absence of mitigation policies—i.e., policies that would reduce greenhouse gas emissions—the IPCC projects that between 2000 and 2030, two-thirds to three-quarters of the projected increase in global carbon dioxide emissions will occur in developing countries, although per capita emissions will remain substantially lower than those of developed countries. The IPCC also projects that compared to 2000, global greenhouse gas emissions will increase between 25 percent and 90 percent by 2030 in the absence of new climate mitigation policies. According to the IPCC, climate mitigation policies are essential to facilitate a transition to a less-carbon-intensive energy infrastructure and stabilize the climate. In the short term, policies designed to increase energy efficiency or induce a switch to less-carbon-intensive fuels, such as from coal to natural gas, can reduce emissions. In the long term, however, major technology changes will be needed to establish a less-carbon- intensive energy infrastructure. To that end, climate mitigation policies may require facilities to achieve specified reductions or provide an incentive to reduce emissions by, for example, establishing a price on emissions. The policies that set a price on emissions, also known as market-based programs, include emissions trading and emissions taxes. The cost for facilities to reduce emissions depends on numerous factors that may vary by facility, such as the age of capital equipment. Under an emissions trading program, the cost of an allowance to emit greenhouse gases influences each facility’s decision about whether and how much to reduce emissions. Because reduction costs vary among the facilities, some will choose to reduce emissions and sell excess allowances while others will opt to purchase allowances to cover emissions. According to economic theory, this will result in reductions at the facilities with the lowest costs. As the emissions cap becomes stricter, the supply of allowances decreases and causes prices to rise. As a result, the incentive to reduce emissions increases. In short, the allowance price is key to achieving a net reduction in emissions. A problem may arise, however, if economic activity similar to that covered under one country’s market-based program is not likewise subject to binding carbon limits in another country. This can lead to the movement of economic activities associated with emissions from countries that have adopted binding emissions limits to countries that have not done so. This geographic displacement of emissions is a concept known as leakage. Overall, leakage could impede progress toward the environmental objectives of a market-based program by shifting emissions to areas without a binding carbon limit. As allowance prices rise, production may be shifted abroad to existing competitors or new firms; in addition, covered entities may shift some of their production to facilities that exist in countries without binding carbon dioxide limits. Many countries, such as the member states of the EU, have begun to mitigate or reduce greenhouse gas emissions by adopting market-based policies such as carbon taxes, cap-and-trade programs, and offset programs, as well as other policies, including energy efficiency standards; voluntary agreements; education campaigns; and research, development, and deployment of advanced technologies. Governments also may use a portfolio of policies. For example, in the EU, a variety of measures are underway to reduce greenhouse gas emissions, including the ETS—its cornerstone—as well as measures to promote renewable energy sources, implement performance standards intended to improve energy efficiency in new buildings, and reduce carbon dioxide emissions from new passenger cars. The EU—a unique economic and political partnership between 27 countries—is composed of multiple institutions, including three decision- making institutions. Two bodies serve as the EU’s legislative branch—the European Parliament, composed of representatives directly elected by EU citizens, and the Council of the European Union, composed of a representative from each member state. In the environmental field, both bodies must approve legislation for it to become law. However, neither branch can initiate legislation; they may act only on legislative proposals submitted by the European Commission, which is the EU’s executive branch. Although each member state is represented on the Commission, Commission members serve the common EU interest rather than representing their member state. In addition to proposing legislation, the Commission ensures proper implementation of EU directives, including those enacted as part of the European Climate Change Programme. For example, the Commission proposed the ETS Directive to establish the Emission Trading Scheme, which was amended and then approved by the Parliament and Council, and has implemented it by approving member states’ National Allocation Plans, helping to develop a system to track allowances, and assessing progress of the ETS, among other tasks. The Court of Justice of the European Communities has considered law suits brought by member states challenging the Commission’s rejection of National Allocation Plans and by covered entities challenging various aspects of the ETS, but has otherwise not played a significant role with respect to the ETS. According to available information and experts, the primary effect of the first ETS phase was to establish a functioning carbon market for emissions allowances, but its effects on emissions, the European economy, and technology investment are less certain. In particular, data limitations make it impossible to know whether phase I reduced emissions below the level that would have occurred in the absence of the ETS. Nonetheless, experts suggest that phase I offers important lessons about program design and implementation that may prove useful in informing congressional decision making. The primary effect of the first ETS phase was to establish a functioning carbon market for allowances in which emissions caps were set and allowances to emit carbon dioxide were distributed, bought, and sold. By limiting the total number of allowances under the program and enabling covered entities to sell or buy allowances to cover their emissions, the ETS used market forces to set a price on carbon emissions that fluctuated based on changes in supply and demand. For example, EU emissions allowances known as EUAs traded at €8.57 ($10.40) per metric ton of carbon dioxide on January 3, 2005; reached a peak price of €31.58 ($37.48) per metric ton on April 19, 2006; and then collapsed when the 2005 emissions data, which had been verified by third parties, showed that phase I was overallocated. That is, the overall cap exceeded actual emissions—the supply of allowances was greater than the demand. The price collapse also resulted partially from the fact that covered entities were largely unable to carry unused allowances to the next trading phase, a concept known as banking. The general prohibition on banking allowances, however, helped confine the overallocation to phase I because the member states set new caps in 2008 and issued new allowances. Interperiod banking would have given covered entities an incentive to reduce emissions during phase I, despite overallocation, and to save unused allowances for a later trading phase, which had more stringent emissions caps. Although the absolute supply of allowances did not change during phase I, the market’s perception of the balance of supply and demand dramatically changed. Prior to the release of 2005 verified emissions data in the spring of 2006, ETS participants and market analysts expected a shortage of allowances, and allowance prices steadily increased. The release of verified emissions data, however, showed that the 2005 emissions cap— i.e., the supply of allowances—exceeded actual emissions that year, causing the price collapse. See figure 1 for a graph displaying the allowance price trends in phase I. The demand for allowances, on the other hand, was influenced by covered entities’ allowance allocation, the cost of carbon dioxide abatement options, and the level of carbon dioxide emissions over the course of phase I.