European Union Emission Trading Scheme

The European Union Emissions Trading Scheme (EU ETS) also known as the European Union Emissions Trading System, was the first large emissions trading scheme in the world.^[1] It was launched in 2005 to combat climate change and is a major pillar of EU climate policy.^[2] 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.^[3][4]

Under the EU ETS, large emitters of carbon dioxide within the EU must monitor their CO₂ emissions, and annually report them, as 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.^{[citation needed]}

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.^[4] 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.^[5][6]

Mechanisms

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,^[7] 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.^[8])

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).^[9] Too few allowances will result in too high a carbon price (Hepburn, 2006, p. 239).^[10]

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%.^[11]

During Phase I, most allowances in all countries were given freely (known as grandfathering). This approach has been criticized^[12] 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.^[13][14] 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 (Neuhoff, 2009;^[15] Newbery, 2009; Carbon Trust, 2009;^[16] See also the section on competitiveness).

To address these problems,^{[citation needed]} 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.^[17]

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).^[18] 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.^[16] 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;^[15] Newbery, 2009).^[9] A problem with border adjustments is that they might be used as a disguise for trade protectionism (Grubb et al., p. 5).^[19] 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.^[20]

Phase I

In the first phase (2005–2007), the EU ETS included some 12,000 installations, representing approximately 40% of EU CO₂ emissions,^[21] covering energy activities (combustion installations with a rated thermal input exceeding 20 MW, mineral oil refineries, coke ovens), production and processing of ferrous metals, mineral industry (cement clinker, glass and ceramic bricks) and pulp, paper and board activities.

Launch and operation

The scheme, in which all 15 member states that were then members of the European Union participated, nominally commenced operation on 1 January 2005, although national registries were unable to settle transactions for the first few months. However, the prior existence of the UK Emissions Trading Scheme meant that market participants were already in place and ready. In its first year, 362 million tonnes of CO₂ were traded on the market for a sum of €7.2 billion, and a large number of futures and options.^[22] The price of allowances increased more or less steadily to a peak level in April 2006 of about €30 per tonne CO₂,^[23] but fell in May 2006 to under €10/ton on news that some countries were likely to give their industries such generous emission caps that there was no need for them to reduce emissions. Lack of scarcity under the first phase of the scheme continued through 2006 resulting in a trading price of €1.2 a tonne in March 2007, declining to €0.10 in September 2007.

Verified emissions have seen a net increase over the first phase of the scheme. For the countries for which data is available (all 27 member states minus Romania, Bulgaria and Malta), emissions increased by 1.9% between 2005 and 2007.

Country	Verified emissions			Change
	2005	2006	2007	2005–2007
Austria	33,372,826	32,382,804	31,751,165	-4.9%
Belgium	55,363,223	54,775,314	52,795,318	-4.6%
Cyprus	5,078,877	5,259,273	5,396,164	6.2%
Czech Republic	82,454,618	83,624,953	87,834,758	6.5%
Germany	474,990,760	478,016,581	487,004,055	2.5%
Denmark	26,475,718	34,199,588	29,407,355	11.1%
Estonia	12,621,817	12,109,278	15,329,931	21.5%
Spain	183,626,981	179,711,225	186,495,894	1.6%
Finland	33,099,625	44,621,411	42,541,327	28.5%
France	131,263,787	126,979,048	126,634,806	-3.5%
Greece	71,267,736	69,965,145	72,717,006	2.0%
Hungary	26,161,627	25,845,891	26,835,478	2.6%
Ireland	22,441,000	21,705,328	21,246,117	-5.3%
Italy	225,989,357	227,439,408	226,368,773	0.2%
Lithuania	6,603,869	6,516,911	5,998,744	-9.2%
Luxembourg	2,603,349	2,712,972	2,567,231	-1.4%
Latvia	2,854,481	2,940,680	2,849,203	-0.2%
Netherlands	80,351,288	76,701,184	79,874,658	-0.6%
Poland	203,149,562	209,616,285	209,601,993	3.2%
Portugal	36,425,915	33,083,871	31,183,076	-14.4%
Sweden	19,381,623	19,884,147	15,348,209	-20.8%
Slovenia	8,720,548	8,842,181	9,048,633	3.8%
Slovakia	25,231,767	25,543,239	24,516,830	-2.8%
United Kingdom	242,513,099	251,159,840	256,581,160	5.8%
Total	2,012,043,453	2,033,636,557	2,049,927,884	1.9%

• Figures are in tonnes of CO₂
• Source: European Commission Press Release 23 May 2008^[24]

Consequently, observers and NGO's have accused national governments of abusing the system under industry pressure, and have urged for far stricter caps in the second phase (2008–2012).^[25]

Phase II

Million Metric Tonnes of CO2 yearly allowances
Member State	1st period cap	2005 verified emissions	2008-2012 cap
			State request	Cap allowed
Austria	33.0	33.4	32.8	30.7
Belgium	62.08	55.58 †	63.33	58.5
Bulgaria	42.3	40.6	67.6	42.3
Cyprus	5.7	5.1	7.12	5.48
Czech Republic	97.6	82.5	101.9	86.8
Denmark	33.5	26.5	24.5	24.5
Estonia	19	12.62	24.38	12.72
Finland	45.5	33.1	39.6	37.6
France	156.5	131.3	132.8	132.8
Hungary	31.3	26.0	30.7	26.9
Germany	499	474	482	453.1
Greece	74.4	71.3	75.5	69.1
Ireland	22.3	22.4	22.6	21.15
Italy	223.1	222.5	209	195.8
Latvia	4.6	2.9	7.7	3.3
Lithuania	12.3	6.6	16.6	8.8
Luxembourg	3.4	2.6	3.95	2.7
Malta††††	2.9	1.98	2.96	2.1
Netherlands	95.3	80.35 ††	90.4	85.8
Poland	239.1	203.1	284.6	208.5
Portugal	38.9	36.4	35.9	34.8
Romania	74.8	70.8	95.7	75.9
Slovakia	30.5	25.2	41.3	30.9
Slovenia	8.8	8.7	8.3	8.3
Spain	174.4	182.9	152.7	152.3
Sweden	22.9	19.3	25.2	22.8
United Kingdom	245.3	242.4 †††	246.2	246.2
Totals	2057.8	1910.66	2054.92	1859.27
Source: Last EU press release IP/07/1614: "Emissions trading: EU-wide cap for 2008-2012 set at 2.08 billion allowances after assessment of national plans for Bulgaria", 26 October 2007[26]. Access to the previous press releases (Nov 2006 - October 2007) in the linked page. Additional installations and emissions included in the second trading period are not included in this table but are given in the sources. *† Including installations opted out in 2005. *†† Verified emissions for 2005 do not include installations opted out in 2005 which will be covered in 2008 and 2012 and are estimated to amount to some 6 Mt. *††† UK's verified emissions for 2005 do not include installations opted out in 2005 which will be covered in 2008 and 2012 and are estimated to amount to some 30 Mt. *††††Cyprus and Malta, as new EU accession states, but not Annex I countries, will have their own NAPs and participate in trading during Phase II.

The second phase (2008–12) expands the scope significantly:

• CDM and JI credits are introduced in second phase through the EU's 'Linking Directive'. Although this was a theoretical possibility in phase I, the over-allocation of permits combined with the inability to bank them for use in the second phase meant it was not taken up.^[27]
• Aviation emissions are expected to be included from 2012.^[28]
• In 2007, it was announced that three non-EU members, Norway, Iceland, and Liechtenstein joined the scheme.^[29]

The inclusion of aviation is a move considered important due to the large and rapidly growing emissions of the sector. The inclusion of aviation is estimated to lead to an increase in demand of allowances about 10-12 million tonnes of CO₂ per year in phase two. This in turn is expected to lead to an increased use of JI credits from projects in Russia and Ukraine, which would offset the increase in prices and eventually result in no discernible impact on average annual CO₂ prices.^[30]

Ultimately, the Commission wishes the post-2012 ETS to include all greenhouse gases and all sectors, including aviation, maritime transport and forestry.^[31] For the transport sector, the large number of individual users adds complexities, but might be implemented either as a cap-and-trade system for fuel suppliers or a baseline-and-credit system for car manufacturers.^[32]

The National Allocation Plans for Phase II, the first of which were announced on 29 November 2006, result in an average cut of nearly 7% below the 2005 emission levels.^[33] The use of offsets from JI and CDM projects was allowed, with the result that no reductions in the EU will be required to meet the Phase II cap (CCC, 2008, pp. 145, 149).^[34] According to verified EU data from 2008, the ETS saw an emissions reduction of 3%, or 50 million tons. At least 80 million tons of "carbon offsets" which were bought as part of the scheme.^[35]

The annual Member State CO₂ yearly allowances in million tonnes are shown in the table:

In late 2006, European Commission started infringement proceedings against Austria, Czech Republic, Denmark, Hungary, Italy and Spain, for failure to submit their proposed National Allocation Plans on time.^[36]

Carbon price

The carbon price within Phase II increased to over €20/tCO₂ in the first half of 2008 (CCC, 2008, p. 149). The average price was €22/tCO₂ in the second half of 2008, and €13/tCO₂ in the first half of 2009. CCC (2009, p. 67) gave two reasons for this fall in prices:^[37]

• Reduced output in energy-intensive sectors as a result of the recession. This means that less abatement will be required to meet the cap, lowering the carbon price.
• The market perception of future fossil fuel prices may have been revised downwards.

Projections indicate that like Phase I, Phase II will see a surplus in allowances. According to Grubb et al. (2009, p. 12), carbon prices are being sustained by the prospect of banking allowances to use them in the tougher third phase.^[19]

Phase III

For Phase III (2013–20), the European Commission has proposed a number of changes, including (CCC, 2008, p. 149):^[34]

• the setting an overall EU cap, with allowances then allocated to EU members;
• tighter limits on the use of offsets;
• unlimiting banking of allowances between Phases II and III;
• and a move from allowances to auctioning.

Projections to 2020

CCC (2008, p. 151) made projections of the expected cap for the EU ETS out to 2020. For a 20% cut in EU economy-wide emissions relative to 1990 levels, the reduction in total emissions was projected to be around 36 million tonnes per annum. CCC (2009, p. 68) projected a carbon price in 2020 of around 22 Euro/tCO₂.^[37] Most market commentators project a price around or below 30 Euro/tCO₂. These carbon price projections are subject to great uncertainty, e.g., over future fossil fuel prices, and predicting business-as-usual emissions (p. 69).

Costs

According to Grubb et al. (2009, pp. 3–4), the EU ETS has been able to meet its environmental objectives at costs significantly lower than projected.^[19] The estimated cost was a small fraction of 1% GDP. It was suggested that if permits were auctioned, and the revenues used effectively, e.g., to reduce distortionary taxes and fund low-carbon technologies, costs could be eliminated, or even create a positive economic impact.

Overall emission reductions

A number of design flaws have limited the effectiveness of the EU ETS (Jones et al., 2007, p. 64).^[38] In the initial 2005-07 period, emission caps were not tight enough to drive a significant reduction in emissions (CCC, 2008, p. 140).^[34] The total allocation of allowances turned out to exceed actual emissions. This was a factor in driving the carbon price down to zero in 2007, the other main factor being that allowances were not allowed to be 'banked' for use in Phase II, therefore had no monetary value outside of Phase I. This oversupply reflects the difficulty in predicting future emissions which is necessary in setting a cap (Carbon Trust, 2009).^[16]

Phase I

In 2004, Ecofys analysed the then available preliminary NAPs of all EU countries.^[39] The information suggested that the caps for Phase I were lenient; in most countries, the power sector would not need to reduce CO₂ emissions as much as the country as a whole, in other words the other sectors must make more ambitious emission reductions than the power sector under the scheme. More strikingly, a few countries (such as the Netherlands) gave more allowances than Ecofys estimated to be needed under a business-as-usual scenario, implying that no 'real' efforts to reduce emissions would be required. In their analysis of the Phase I NAPs, the NGO Climate Action Network called the caps a 'major disappointment',^[40] arguing that only two (UK and Germany) of the 25 EU states asked the participating industry sectors to reduce emissions compared to historic levels and found that in the 15 old EU member states as a whole, allocations were 4.3% higher than the base year. In May 2006, when several countries revealed registries indicating that their industries had been allocated more allowances than they could use, trading prices crashed from about €30/ton to €10/ton, and (after an initial slight recovery) declined further to €4 in January 2007^[41] and below €1 in February 2007, reaching an all time low of €0.03 at the beginning of December 2007^[42]

Ellerman and Buchner (2008) (referenced by Grubb et al., 2009, p. 11) suggested that during its first two years in operation, the EU ETS turned an expected increase in emissions of 1-2 percent per year into a small absolute decline.^[19] Grubb et al. (2009, p. 11) suggested that a reasonable estimate for the emissions cut achieved during its first two years of operation was 50-100 MtCO₂ per year, or 2.5-5%.

Phase II

In 2006, Ecofys performed an initial assessment of NAPs for phase II, using the proposed but not-yet-approved NAPs.^[43] They found that most member states did not have sufficiently strict caps, and that they would be insufficient in assisting the members in meeting their Kyoto targets. They also compared caps with official business-as-usual (BAU) projections and with independent BAU projections to assess stringency of caps. They concluded that the caps were 7% under official BAU but (except for Portugal, Spain, and UK) the proposed cap was "higher" than the independently estimated BAU, suggesting overallocation.

Partly in response to this, the Commission cut eleven of the first twelve Phase II plans it reviewed (accepting only the U.K.'s plan without revision). The commission tightened the caps some 7%,^[44] also corresponding with 7% below the 2005 emissions. For Phase II, the cap is expected to result in an emissions reduction in 2010 of about 2.4% compared to expected emissions without the cap (business-as-usual emissions) (Jones et al., 2007, p. 64).^[38]

The inclusion of sinks

Currently, the EU does not allow CO₂ credits under ETS to be obtained from sinks (e.g. reducing CO₂ by planting trees). However, some governments and industry representatives lobby for their inclusion. The inclusion is currently opposed by NGOs as well as the EU commission itself, arguing that sinks are surrounded by too many scientific uncertainties over their permanence and that they have inferior long-term contribution to climate change compared to reducing emissions from industrial sources.^[45]

28 Million Euro Cyberfraud

On January 19, 2011, the EU emissions spot market for pollution permits was closed after computer hackers stole 28 to 30 million euros ($41.12 million) worth of emissions allowances from the national registries of several European countries within a few day time period. The Czech Registry for Emissions Trading was especially hard hit with 7 million euros worth of allowances stolen by hackers from Austria, the Czech Republic, Greece, Estonia and Poland. A phishing scam is suspected to have enabled hackers to log into unsuspecting companies' carbon credit accounts and transfer the allowances to themselves, allowing them to then be sold.^[46][47]

The European Commission said it would "proceed to determine together with national authorities what minimum security measures need to be put in place before the suspension of a registry can be lifted." Maria Kokkonen, E.C. spokeswoman for climate issues, said that national registries can be reopened once sufficient security measures have been enacted and member countries submit to the EC a report of their IT security protocol.

The Czech registry said there are still legal and administrative hurdles to be overcome and Jiri Stastny, chairman of OTE AS, the Czech registry operator, said that until there is recourse for victims of such theft, and a system is in place to return allowances to their rightful owners, the Czech registry will remain closed. Registry officials in Germany and Estonia have confirmed they have located 610,000 allowances stolen from the Czech registry, according to Mr. Stastny. Another 500,000 of the stolen Czech allowances are thought to be in accounts in the U.K., the OTE said.^[48][49][47]

The security breaches raised fears among some traders that they might have unknowingly purchased stolen allowances which they might later have to forfeit. The ETS experienced a previous phishing scam in 2010 which caused 13 European markets to shut down, and criminals cleared 5 million euros in another cross-border fraud in 2008 and 2009.^[47]

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).^[50] 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.^[34]

The World Wildlife Fund (2009) commented that there was no indication that the EU ETS had influenced longer-term investment decisions.^[51] 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.^[52]

Criticisms

The EU ETS has been criticized^[53] for several failings, including: over-allocation, windfall profits, price volatility, and in general for failing to meet its goals.^[54] 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.^[55][56][57]

In addition, the EU ETS has been criticized as having caused a disruptive spike in energy prices.^[58] 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.^[57]

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).^[34] This oversupply reflects the difficulty in predicting future emissions which is necessary in setting a cap (Carbon Trust, 2009).^[16] 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.^[57]

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.^{[according to whom?][57]}

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,^[56] and analysis suggests that at least part of that reduction was due to the EU ETS.^[59]

Windfall profits

According to Newbery (2009), the price of EUAs was passed fully in the final price of electricity.^[9] 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 willful 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.^[60] 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.^[57]

This criticism has face validity. In future phases, measures such as banking of allowances and price floors may be used to mitigate volatility.^[61] 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.^[57]

Newbery (2009) commented that the EU ETS was not delivering the stable carbon price necessary for long-term, low-carbon investment decisions.^[9] 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, more specifically missing trader fraud, costing governments more than 5 billion euro.^[62] Cyber fraudsters have also attacked the EU ETS with a "phishing" scam which cost one company €1.5 million.^[63] In response to this, the EU has revised the ETS rules to combat crime.^[64]

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).^[34] 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.^{[65][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.^[66] 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.^[67]

See also

Energy portal

• Carbon emissions trading
• Carbon finance
• Energy policy of the European Union
• European Climate Change Programme
• Mitigation of global warming
• Single European Sky

References

• The European Emission Trading Scheme Put to the Test of State Aid Rules
• Scarcity and Allocation of Allowances in the EU Emissions Trading Scheme - A Legal Analysis.

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External links

Official pages

• European Commission official EU ETS website
• Directive 2003/87/EC Legal text of the EU Directive establishing EU ETS.
• Phase II NAPs

How ETS works

• UK Defra General overview at the UK Department for Environment, Food and Rural Affairs
• Pew Center White Paper : overview of EU ETS
• Emission Trading Fact Book of Inagendo (contains, among others, a glossary of ETS terms
• Video from Climate and Pollution Agency (Norway): The Emission Trading Scheme

Key reports, and assessments

• Application of the Emissions Trading Directive by EU Member States - reporting year 2007
• Fraunhofer Institute November 2006 assessment of preliminary Phase 2 NAPs
• Ecofys evaluation of preliminary Phase 2 NAPs
• Ecofys evaluation of Phase 1 NAPs. ECOFYS, August 2004.
• National Allocation Plans 2005-7: Do they deliver? Executive summary of report by Climate Action Network.
• Climate Action Network Europe "CO₂ emissions: EU member states abuse Emissions Trading System" Press release, 15 May 2006
• Carbon Trade Watch
• Annual European Community greenhouse gas inventory 1990 - 2006 and inventory report 2008
• WWF website "The environmental effectiveness and economic efficiency of the EU ETS: Structural aspects of the allocation". by WWF and Öko-Institut, 09 Nov 2005.