The European Union’s Energy Policy. I. The Emissions Trading System

Summary.  Just prior to entry into force of the Kyoto Protocol in 2005 the European Union adopted a cap-and-trade market mechanism, the Emissions Trading System, to reduce emissions of carbon dioxide and other greenhouse gases.  The System has three phases of operation between 2005 and 2020, the current ending date of the System as devised. 

The System covers 11,000 or more individual facilities.  Phase 1, lasting 3 years, was intended as a trial period.  It suffered from problems in implementation which impeded its effectiveness during this interval.  Phase 2 lasts 5 years and is drawing to an end this year.  In Phase 2 the allocation of emission allowances and operation of the allowance market were optimized, and the coverage of emitting sources is expanded.  Phase 3 is to last to 2020.  Its allowances are to decrease each year, so that greenhouse gas emissions necessarily will fall, to a level about 20% lower than 2005.

The Emission Trading System affords a workable model for a cap-and-trade mechanism for lowering greenhouse gas emissions.  The world’s major emitters of greenhouse gases, China and the U. S., have not implemented national emissions limitation policies.  China, in its current 5 year plan, includes pilot projects using cap-and-trade and carbon taxes.  The U. S. has failed to enact an energy policy, although a cap-and-trade bill passed the lower chamber in 2009.  In order to minimize the significant harms that arise from extreme events ascribed to global warming, the nations of the world should reach agreement as soon as possible on an agreement to limit greenhouse gas emissions and embark on adaptation measures.

Introduction.  This post describes the EU’s Emission Trading System.  The following post considers various technologies envisioned in the EU that contribute to reducing emissions of greenhouse gases.

Climate scientists have determined unambiguously that the long-term global average of temperature has increased since the beginning of the Industrial Revolution (ca. 1850) by about 0.7ºC (1.3ºF) (Intergovernmental Panel on Climate Change (IPCC)).  This is ascribed to the increasing use of fossil fuels for energy that the Industrial Revolution brought on.  Fossil fuels burn to produce carbon dioxide (CO₂), a significant greenhouse gas, in correspondingly increasing amounts.  The trends of fossil fuel use, increasing atmospheric concentration of CO₂, and the rise of the long-term global average temperature correlate closely with each other, and are especially pronounced beginning in the second half of the 20^th century. 

The Fourth Assessment Report of the IPCC, issued in 2007, determined that an essential objective is to limit the accumulation of greenhouse gases in the atmosphere such that the resulting global average temperature rise be less than 2ºC (3.6ºF). It states that “deep cuts in global greenhouse gas emissions are required according to [climate] science” to achieve this objective.  This is because higher global temperatures are predicted to cause damages from altered weather and climate events; these are already occurring, as evidenced variously by increased aridity and drought, or extreme rain and floods, and sea level rise, among other harmful effects, in recent years.

The Kyoto Protocol. In response to earlier assessments by the IPCC and other groups, the United Nations Framework Convention on Climate Change (UNFCCC) established guidelines for reducing humanity’s emissions of greenhouse gases, in the 1990’s.  The Kyoto Protocol, developed in 1998, established the goal of reducing the emission of CO₂ by at least 5%, depending on the nation, below the level for 1990 by the period 2008 to 2012.  The European Union (EU) members at that time acceded to the Protocol with a reduction minimum of 8%, and began implementing programs intended to achieve this goal. The EU has expanded in more recent years, and currently numbers 27 countries, including nations of the former Soviet Union and others, encompassing 500 million people.  The Kyoto Protocol formally entered into force in 2005.  (Nations considered to be developing at the time the Protocol was negotiated, including China, were excluded from coverage.  The U. S. never ratified the Protocol and is likewise excluded.)

Emissions Trading System of the EU.  Even before the entry into force of the Kyoto Protocol, the European Commission established the formalities and the structures for a greenhouse gas emissions trading scheme (ETS) covering its members.  The mechanism for implementing the ETS was a cap-and-trade market mechanism.

In cap-and-trade, allowances granting permission to emit 1 tonne of CO₂ initially are granted to emission sources, based on an assessment of their emissions rate.  (Later, the sources must acquire the allowances by bidding for them in an auction.)  The allowances are transferable, so that an inefficient facility that emits more CO₂ than its allotment must purchase allowances to make up the difference.  The allowances are remitted to the ETS authorities periodically.  More efficient facilities will have excess allowances and can either trade them to a needy facility for an agreed price or save them for later use.  In addition to direct transfers of allowances by purchase, cap-and-trade envisions third-party allowance exchanges which openly buy and sell allowances as trading vehicles in close analogy to other financial exchanges.  The exchanges constitute the best mechanism for establishing a market value for allowances at any given time.  

Thus cap-and-trade mechanisms assign a monetary value to the waste stream that emissions of CO₂ and other greenhouse gases represent.  This has not been done historically; CO₂ has not been considered to be a waste product of our energy economy whose disposal or treatment had to be priced into the purchase value of the fossil fuels from which they originated (see this earlier post).  If allowances are sufficiently scarce, their price will be high enough to serve as an incentive for emitting sources to become more efficient and emit less CO₂.  If the supply of allowances is ample, however, or the market demand is low, their price will fall and the objective of reducing the emissions rate will be discouraged.

Cap-and-trade markets work to reduce emissions by issuing successively lower numbers of allowances into a market region every year.  This limits their supply and should lead to higher prices needed for their purchase.  In addition, as noted above, annual allotments themselves can be issued into an exchange for purchase, rather than being granted at no cost.  The revenue accruing to the issuing agency, here the EU through the ETS, can be used to promote measures for further reduction in use of fossil fuels and in promoting economy-wide efficiency programs.

Operation of the EU Emissions Trading Scheme.  The ETS is being implemented in three phases:

          Phase 1.       2005-2007

          Phase 2.       2008-2012

          Phase 3.       2013-2020.

Since the Kyoto Protocol came into force in 2005, it is clear that planning for Phase I began before that time, and its structure was decided before that date.  As seen below in the chart, emissions allowances in a cap-and-trade regime were already in use prior to 2005.  As an accord intended to govern the operations of 27 sovereign nations, each one had to enact laws codifying the applicability of the ETS structure within its borders.

Phase 1 was characterized as a learning phase.  Its main features were:

• The level of the emissions cap was determined largely by each nation, including additional negotiation with the European Commission;
• It covered only CO₂, and included only power plants with a capacity greater than 20 MW and other industrial facilities; these represented 42% of emissions;
• Allocations of emission allowances relied primarily on recent historical records; they were offered at no cost; and
• Offsets favoring an emitting source from emissions savings reached in projects outside the EU were allowed.

In Phase 2, features that expanded on those above included:

• The level of the emissions cap conformed to the limits of the Kyoto Protocol;
• Emissions of nitrous oxide (N₂O) are partially covered as a greenhouse gas; and
• Limits on emissions from air travel are to begin in 2012.

Phase 3 departs from the earlier phases in important ways:

• National emissions caps are to be replaced by single EU-wide caps covering the entire region; they decrease by 1.74% per year starting in 2010 with the objective of delivering 21% reduction referenced to 2005 by 2020;
• Additional greenhouse gases and a wider range of industries are to be covered;
• Emissions allocations for electric generating plants will not be free; other industries begin with 80% of allowances free but diminishing to none free by 2020; and
• 90% of the allowances will be sold by auction; the proceeds are to be distributed to the member nations according to their 2005 emissions.

Performance of the EU ETS. 

The ETS covers at least 11,000 individual emission sources across the EU.  For additional details concerning the allocation of allowances for Phase 1, see reference 1.

In Phase 1 it turns out that allowances were granted, in certain cases, in excess of need or previous national experience.  Each nation’s specification of the number of allowances it needed was based on historical experience, and acceded to by the EU.  Inadvertently issuance of allowances for Phase 1 was delayed.  For these and other reasons the auction market in these initial years established early prices as high as almost EUR30 per tonne of CO₂ equivalents (tonne, a metric ton), which then fell to EUR0/tonne toward the end of Phase 1 (see the following chart).

Source: Estimations of post-2012 carbon price in Europe, Nicole Dellero (2008)  http://ec.europa.eu/energy/nuclear/forum/opportunities/doc/competitiveness/2008-10-24/areva--co2prices.pdf.

In this chart, each period’s price performance is color coded as shown.  The pale aqua line represents futures trading for (the lower number of) allowances to be granted beginning at the start of Phase 2.  The EU-wide number of allowances for Phase 2 was 11.8% lower than for Phase 1.  Once Phase 2 began in 2008, the actual allowance price and the futures trading for 2009 allowances followed essentially identical paths (see the chart).

The fall of the allowance price to EUR0/tonne in 2007 has been attributed both to the glut of allowances and to the impending economic slowdown preceding the world financial crisis of the coming years.  Of course, with allowances having no penalty value, sources were free to continue “business-as-usual” rates of emission, rather than to curtail them.  On the other hand, when allowances had a significant price, businesses were able to pass along corresponding price increases to customers, which resulted in windfall profits.

                                             

In Phase 3, in addition to the features itemized above, importantly the EU will centrally receive reports on, and verify, emissions from each facility.

Individual firms can reduce emissions and/or generate market profits under the ETS.  They can optionally phase out coal-fired electricity plants by shifting to renewables or gas, improve efficiency by investing in new equipment and creating cogeneration facilities, obtain offsets from emission-reducing programs outside the EU, if available shift generating or manufacturing loads to more efficient facilities, purchase allowances from more efficient companies, and actively trade on allowance exchanges.

Recent ETS results.

According to EurActive (accessed Jan. 21, 2012) industrial emissions of CO₂ fell in 2009 by 11% from the previous year.  This reflected the diminished economic activity brought on by the global recession.  Overall for the EU, emissions in 2009 fell by 7% year-on-year, due to the recession and the growth of renewable energy sources, according the European Environmental Agency (EEA; accessed Jan. 22, 2012). For 2009, emissions were below the pre-established cap, meaning that EU industrial establishments had surplus allowances that remained unused.  (Under the EU ETS, unused allowances can be saved for future use within a phase, and can even be carried forward to the next phase.  Thus the recession could potentially affect the market price for allowances for many years to come.)  EU emissions for 2010 increased 2.4% year-on-year, but the EEA believes the EU is still on track to achieve its Kyoto Protocol emission reduction objective for 2012.  The increased emissions for 2010 compared to 2009 reflect recovery from the recession in Europe as well as the effects of an unusually cold winter which led to increased heating from fossil fuels.

As of Nov. 22, 2011, EEA states that overall EU emissions for 2010 were 15.5% below the reference level of 1990 emissions.  For the original EU-15 (the EU membership at the time of the Kyoto Protocol), the emissions reduction was 10.7% as of 2010, well ahead of the goal of 8% by 2012 established under the Kyoto Protocol.  The EEA points out that, in order to achieve the EU reduction goal of 20% by 2020, additional measures will have to be implemented.  These would presumably include putting the additional policies identified for phase 3 into practice.

Using alternative data and sources, CO₂ emissions and per capita emissions of the full EU-27, the original EU-15 and the U. S. are compared in the table below.   

CO₂ emissions in 2010 (million tonnes CO₂) and CO₂/capita emissions 1990-2010 (unit: tonne CO₂/person)

	Per capita emissions
	Emis-sions 2010	1990	2000	2010	Change 1990-2010	Change in %	Change in CO2, %	Change in population, %
United States	5,250	19.7	20.8	16.9	-2.8	-14%	5%	23%
EU-27	4,050	9.2	8.5	8.1	-1.1	-12%	-7%	6%
EU-15	3,150	9.1	8.8	7.9	-1.2	-13%	-5%	9%

EU-27 = Full 27 current Member States.

EU-15 = 15 EU Member States at the time the Kyoto Protocol was ratified.

Source: Olivier, J.G.J., Janssens-Maenhout, G., et al., (2011), Long-term trend in global CO2 emissions. 2011 report, The Hague: PBL/JRC (accessed 01/21/12). http://edgar.jrc.ec.europa.eu/news_docs/C02%20Mondiaal_%20webdef_19sept.pdf

Annual greenhouse gas emission trends, and projections to 2020, under the EU ETS are shown in the following graphic.

GHG trends and projections 1990–2020 — total emissions.  Bunkers = fuel oil used in marine shipping.  The dotted line represents the goal for reduction of emissions by 2020 under the EU ETS.  Projections with existing measures represent the policies in place under Phase 2 of the ETS.  Projections with additional measures represent the policies to be implemented under Phase 3. Emissions included in emission trading (EU ETS) represents those portions of greenhouse gas emissions regulated under the ETS during Phase 1 and Phase 2, beginning in 2005.  Source: European Environmental Agency (accessed 01/23/12);

http://www.eea.europa.eu/themes/climate/ghg-country-profiles/trends-and-projections-2011-cp/eu-27_tp2011_country_profile.pdf.

The pale blue bars representing the emissions experience under the EU ETS through 2010 reflect the performance under Phase 1 (2005-2007) and the first three years under Phase 2 (2008-2010).  It is seen that regulated emissions increased during Phase 1, presumably reflecting the initial problems encountered in issuing and pricing emission allowances.  Performance during Phase 2 appears to be improving, as may be expected from the expanded coverage and the improved auction market for allowances.

Emissions projected through 2020 continuing the policies of Phase 2 lead to modest reductions in emissions, but are predicted not to suffice to attain the ETS goal of a 20% reduction by 2020 (dashed line).  Implementing expanded emissions reduction policies such as those of Phase 3 are expected to approach the reduction needed to reach the ETS 2020 goal.

The graphic below compares CO₂ emission of the U. S., EU27 and EU15 over 20 years from 1990 to 2010 with those of China.  Whereas emissions of the EU nations

                          0                                                                 10,000

                                      Millions of tonnes of CO₂

Source: Olivier, J.G.J., Janssens-Maenhout, G., et al., (2011), Long-term trend in global CO2 emissions. 2011 report, The Hague: PBL/JRC. http://edgar.jrc.ec.europa.eu/news_docs/C02%20Mondiaal_%20webdef_19sept.pdf

decreased during this interval, those of the U. S. increased modestly, and show a significant reduction in the second decade of this period.  In contrast, CO₂ emissions for China show a dramatic absolute increase, by about 350%, over the same two decades.  Clearly, China (and other developing countries of the world) need to embark on drastic policies to reduce their emissions in order for global greenhouse gas levels to stabilize at a level that avoids the most extreme of the predicted consequences of continued global warming.

Conclusions

The European Union implemented its Emissions Trading System in 2005; clearly, planning for this program began even before entry into force of the Kyoto Protocol in that year.  Establishing the ETS has been a significant achievement, as it required that each of the 27 current EU members enact enabling legislation built around the supranational framework of the ETS.  Because the EU ETS was the earliest emissions reduction program implemented in the world, achieved legislative backing from every member nation, and established significant goals for reducing greenhouse gas emission, it represents a significant step for the world of limiting emissions and constraining the rise of the planet’s long term average temperature.

The ETS is built around an emissions cap and allowance trading mechanism.  Its first three years of operation, termed Phase 1, was overtly acknowledged to be a trial period.  Indeed this turned out to be necessary, for the mechanism for allocating allowances turned out to be too generous, and the auction market for allowances at the outset was not seamless; the auction price fell to EUR0.  Now nearing the end of Phase 2, the ETS will be smoother in many ways, and will affect a larger number of emissions sources, as the EU enters Phase 3.

In the U. S., cap-and-trade emissions markets underlie the Northeastern states’ Regional Greenhouse Gas Initiative (RGGI; see this post) and California’s Global Warming Solutions Act (see this post).  RGGI has been operating for a few years, although its goals are quite limited.  The U. S. House of Representatives passed an energy bill including a cap-and-trade emissions reduction mechanism in 2009 modeled after the EU ETS, but no action was taken in the Senate and the bill was never enacted into law.

Emissions rates of China and the U. S. are the world’s first and second highest.  Neither nation is bound by the Kyoto Protocol; China because at the time of its negotiation developing countries were excluded from coverage, and the U. S. because the Senate voted unanimously against considering it for ratification.  Since that time, the 193 nations of the UNFCCC have been unable, in spite of annual gatherings, to craft a successor to the Kyoto Protocol, which expires at the end of 2012.  Currently the earliest date for placing a successor agreement in force may be 2020 (see this post on the Durban Platform).   In the meantime, as seen above, China and other countries continue to expand their annual rate of greenhouse gas emissions at a rapid pace as they seek to attain a level of industrialization comparable to that of developed countries.  The U. S., in the absence of a unified national legislated energy policy, continues to create a partial patchwork of various state-based and regional energy programs of differing scope and ambition.

Cap-and-trade acts on the supply side of the energy economy by constraining fossil-fuel based energy output.  Carbon taxes on fossil fuels, if implemented, would act on the demand side, constraining fuel and energy use.  Neither regime is without its problems and detractors, but this writer favors a carbon tax (one example is described in this post) for its directness and simplicity of operation, assuming exceptions to coverage are minimal.  A major objection has to do with a perceived constraint on economic activity because purchasing power may be drained off by the tax.  This can be countered by an annual rebate to fossil fuel consumers; even so the principal objective, creating a psychological restraint of demand would be achieved.  Revenue from the tax should also support deployment of renewable energy, thereby supporting new employment in the energy economy.

The nations of the world need to come together to limit greenhouse gases as soon as possible, in order to minimize the harms arising from global warming.  The EU ETS provides a demonstration of one way to contribute to achieving this goal.

References

1. Estimations of post-2012 carbon price in Europe, Nicole Dellero (2008)  (Slide presentation); http://ec.europa.eu/energy/nuclear/forum/opportunities/doc/competitiveness/2008-10-24/areva--.co2prices.pdf

2. Making Cap-And-Trade Work: Lessons From The European Union Experience, Daniel C. Matisoff, Environment Magazine, Jan.-Feb. 2010; http://www.environmentmagazine.org/Archives/Back%20Issues/January-February%202010/making-capfull.html.

3. Long-term trend in global CO₂ emissions. 2011 report, Olivier, J.G.J., Janssens-Maenhout, G., et al., (2011), The Hague: PBL Netherlands Environmental Assessment Agency and European Commission’s Joint Research Centre; http://edgar.jrc.ec.europa.eu/news_docs/C02%20Mondiaal_%20webdef_19sept.pdf

4. Approximated EU GHG inventory: early estimates for 2010; European Environmental Agency, Copenhagen, 2011;  http://www.eea.europa.eu/publications/approximated-eu-ghg-inventory-2010.

© 2011 Henry Auer